Step 2 of the Bailout Plan

Step 2 of the housing and banking bailout was announced yesterday evening, when Citigroup, JP Morgan, and Bank of America announced the creation of a Super SIV, apparently funded with $100 billion of their own equity.

A simple Google of SIV and Citibank will bring up tons of articles discussing the relative merits and disadvantages of the proposal. I am instead looking at it as more of a confirmation of the serious issues that exist in the real estate market and now credit markets as well. The real estate is the underlying collateral for most of the debt instruments. The markets for the different types of debt instruments continue to seize up because investors are having a difficult time assessing default risk of the various securities AND the underlying collateral in the case of default.

The SIV bailout proposal which has been authorized will help to create an artificial buyer for the SIV assets - these currently undesired debt instruments (re: subprime mbs, mbs of any kind, CDOs, asset backed commercial paper) and may even succeed in propping up the asset values temporarily. Still the bailout proposal fails to address the problems of the drop in value of the collateral backing the different debt instruments as well the increasing defaults the instruments are experiencing.

As a result - Step 2 of the bailout plan is doomed to fail. As we speak housing prices in Chula Vista, California are down approximately 35% from their 2005 peak. I am revising my estimates from a year or two ago expecting a 50% REAL drop in price (= inflation adjusted) from peak to a 70% REAL drop in price over the next two years (2008-2009). This would put us at residential real estate prices as far back as 2000 and completely erase the home price gains of the past three years.

-BG

A Perilous Dichotomy

The reaction to the Fed Rate Cut has unfolded largely as discussed here two weeks ago. The scenario currently given the most credence is that inflation will run out of control as the dollar depreciates rapidly against commodities and other currencies. Gold is nearing all time highs and is currently near $750 an oz, oil and food prices are also taking off.

The stealth move which is largely ignored for the time being is the real estate debacle which is slowly and steadily unfolding. The financial media and most of the pundits seem to have the response of - OK - the Fed has cut rates, the worst is behind us - lets move on to the next story. The problem is - this is the crisis that just will not go away for the next several years. Get used to the phrase - all subprime - all the time as the new slogan for Bloomberg and CNBC - because the real estate crisis has just begun. This has negative implications for banking and financial stocks.

We are just seeing the first slew of writedowns affecting the banks which are related only to the sub-prime sections of the mortgage securities market. Still in the pipeline are impairments resulting from a 50% drop in collateral values. Take WAMU for example - they love to cite their LTV ratio in the 50-70% range as of September 2005 and September 2006 underwriting time. The problem is that after home values fall 35-50% - the new LTV ratios are 100-120% - leaving zero margin for air in the case of a foreclosure.

As credit risk is reintroduced into the mortgage backed securities market we should see a continued tightening of credit to the Jumbo loan market. As the credit is cut off Mortgage Equity Withdrawal gets hit and consumer spending goes in the crapper. All of these variables combine to give us a recession in the USA.

The tragedy of most of the hot money mutual fund managers as this point is they have soiled themselves thinking about how the Fed rate cuts will affect the financials have jumped in hand over fist buying the regional and money center banks - under the idea of bigger Net Interest Margins. This analysis is a mistake because it ignores the collateral and credit risk side of the equation.

Anyways - I can't say that I am surprised to see this blow off in commodities, gold, and foreign equities right now, but I will insist that it is not a good entry point. That is to say - the more those markets run - the greater the fall will be when the world realizes the USA is in a full blown recession. Long volatility (e.g. commodities and emerging markets) will prove to be a very scary play at that point. We've already had the first scare about two months ago. I expect the second this fall.

-BG