Imperfect Models

The New York Fed recently released a staff report in usual timely fashion, that being after the information is primarily useful, titled Juvenile Delinquent Mortgages: Bad Credit or Bad Economy?

Abstract:

We study early default, defined as serious delinquency or foreclosure in the first year, among nonprime mortgages from the 2001 to 2007 vintages. After documenting a dramatic rise in such defaults and discussing their correlates, we examine two primary explanations: changes in underwriting standards that took place over this period and changes in the economic environment. We find that while credit standards were important in determining the probability of an early default, changes in the economy after 2004—especially a sharp reversal in house price appreciation—were the more critical factor in the increase in default rates. A notable additional result is that despite our rich set of covariates, much of the increase remains unexplained, even in retrospect. Thus, the fact that the credit markets seemed surprised by the rate of early defaults in the 2006 and 2007 nonprime vintages becomes more understandable.

This last sentence struck a match with me. The prevailing thought in economics, financials, mortgages, real estate, etc. is that models can fairly accurately predict future outcomes. A phrase comes to mind; The triumph of financial innovation over common sense.

The ignorance here is the complete disregard for the human element. If you were to follow the pdf that leads to the 38 page paper, you would learn that residential real estate turned into option theory. Here is an exert:

Residential mortgages are complex financial instruments that confer important options on the borrower. The extensive body of previous research on residential mortgage default has adapted option theory to the study of mortgage valuation, since there exist well-developed theory and empirical methods for valuing financial derivatives and their exercise (Black and Scholes 1973).

An important feature of most residential mortgages is that they are “non-recourse” loans, either de jure or de facto. This means that in the event of a default, creditors can sell the house to cover the loan balance, but typically do not legally pursue the borrower for any deficiency.4 This creates a “put” option for the borrower which he/she can exercise if the house value falls sufficiently relative to the loan balance. In addition to this default option, borrowers may continue to make the scheduled payments until the mortgage debt is discharged, or prepay the mortgage either by selling the house and paying off the balance on the mortgage or by refinancing into a new loan (Kau, Keenan, Mueller and Epperson, 1995). The option to prepay is often referred to as the “call” option that borrowers hold when they take out a mortgage.

Just like in 87', the theory misses the big picture, where markets are uniformly using the same models and experience the same problems at the same time from taking on the same risks. This throws the other side of the option out the door when aggregated, prices begin falling and the option to sell is then not available.

So there is the whole, a deep one at that. No scheme can make lending to an unqualified borrower profitable in the long term and the effect is the toppling over of the pyramid that was structured with no anchors.

The fact that credit markets were surprised at all is a testament to the lack of common sense and vision associated with those at the top making decisions, sitting upon their stacks of employee options, just looking to Earn and Burn.

The paper gives greater weight to the economy being the major factor to increased defaults via home price depreciation rather than bad credit underwriting. This paper misses one huge factor though that directly relates to housing price levels; borrowing against equity. This paper cannot explain why such large levels of early defaults starting in 2005 vintages were accounted for.

My own opinion is that price depreciation was just a catalyst. Poor credit underwriting was the rising action. Too much underwriting was the result. This sparked a wave of predictable early defaults. The extra burden of HELOC's made price depreciation that much less manageable for borrowers who were already less than worthy. As stated, home price depreciation was just the catalyst.

There is obviously very little confidence in those running our currency to be had if they cannot connect the dots on this one.

CMBS Spreads Off the Charts!

The FT Alphaville calls the Subprime CMBS:

From a spread of 475bps at the end of May, it’s now coming close to 1000bp. The particularly steep rise in the spread - in mid-August - occurred after Markit announced it wouldn’t be constituting a new index - there simply wasn’t enough issuance.



Here’s the spread of the double-B tranche of the CMBX:



Nearly 3200bps!

And the not so silver lining:

If the commercial real estate market was a beach ball, picture my arm holding the ball. If I take my arm away, everyone knows that ball will fall to the ground. However, many foolishly believe that somehow if you take cheap financing (my arm) away, the ball will remain afloat. Risk premiums for this type of debt have skyrocketed as exhibited by the CMBX. If you dramatically increase the risk premium for an asset class, especially one that is so heavily financed, the value of that asset class must fall. End of story.

I've been jibba jabberin about this for some time...CMBX recap:

The CRE Report, Delinquencies Soar, CMBX Loss Estimates, and Commercial Real Estate Delinquencies Rise should get you up to speed, but note you can go even further and follow even older stories within those links.

Inflation Is Not The Problem

The debate in 2008 that has been all the rage is if this years is comparable to the stagflationary period of the 1970's. Now my opinion might support this if it were not for the massive sector known as the financials that is shedding billions of dollars in assets, residential real estate that continues to slide in value and commercial real estate that is teetering on the brink of disaster. This brings me to the conclusion that deflation, not inflation is the monster at hand, with $500 billion in financial institution write offs, and estimates of up to $2 trillion (Roubini) in total when all is said and done, inflation worries are unjustified. Before I get more into why oil shock is not inflationary in aggregate, consider the rising pressure At The Fed, A Debate Over Countering Inflation Grows Louder:

“The Fed overreacted to the slowdown in economic activity,” Willem H. Buiter, a professor of European political economy at the London School of Economics and Political Science, declared in his presentation, offering harsh criticism of his hosts. The Fed, he added, “cut the official policy rate too fast and too far and risked its reputation for being serious about inflation.”

Ben S. Bernanke, the chairman of the Federal Reserve, rejects that thinking, as do a majority of the Fed’s policy makers. They argue — and several of them repeated their arguments in interviews here that were mostly off the record — that they had no choice but to cut the key lending rate that the Fed controls to 2 percent from 5.25 percent in just eight months. Otherwise, they said, the housing and credit crises would have resulted in much more damage to the economy.

Now, they argue, the so-called federal funds rate must be kept at 2 percent — for no one knows how long — so that banks and other lenders can borrow at low rates and lend at higher ones, using their fattened earnings from this process to rebuild the capital they need. The banks’ capital eroded as numerous loans made during the bubble years went bad and were written off, reducing their ability and willingness to lend to the public.

“Lenders have been hit by a shock so severe that they are contracting and withdrawing from private sector lending,” Janet L. Yellen, president of the Federal Reserve Bank of San Francisco, said in an interview.

The view expressed by Professor Buiter, however — that a central bank’s overriding concern should be fighting inflation, while a sinking economy is left to be refloated by other means — is welcome thinking for the five or so Fed policy makers, all of them presidents of regional Fed banks, who say that the Fed must begin to raise rates right away.

Mr. Bernanke, in a speech here, said that inflation is likely to moderate as commodity prices come down and the dollar stabilizes. But the Fed bank presidents who want a rate increase now say that he is missing the point. Unless the Fed takes action, they say, people will lose faith in it as a guardian against a rising inflation rate.

When prices do begin to rise, according to their argument, instead of counting on the Fed to stop the process, the American public will ask for and somehow get higher wages to afford the rising prices. Employers will respond by pushing up prices even more — unless the Fed snuffs out this inflationary spiral, or any chance of it, by raising rates, starting now.

This wage-price spiral is an unlikely scenario. Dissenters from Bernanke argue as such:

A big issue in that debate is whether a 2 percent federal funds rate is “accommodative,” as Mr. Plosser put it. Those in his camp argue that it is low enough to encourage people to borrow and spend. Companies would respond to this surge in spending by raising prices, and hence the inflation rate would rise.

Where is the spending? Where is the lending? Here is a clue from The American Bankruptcy Institute:

August 4, 2008, Alexandria, Va.— U.S. consumer bankruptcy filings increased 48 percent nationwide in July from the same period a year ago, according to the American Bankruptcy Institute (ABI), relying on data from the National Bankruptcy Research Center (NBKRC). The overall July consumer filing total of 94,124 also represented an increase of 13.7 percent from the 82,770 filings recorded in June. Chapter 13 filings constituted 32.5 percent of all consumer cases in July, a slight decrease from June.

“The most recent uptick in bankruptcy filings reflects growing stress on the household finances of U.S. families,” said ABI Executive Director Samuel J. Gerdano. “We expect bankruptcies to continue to surge past 1 million new cases by year end.”

The debt level has passed its critical point and now there is neither the will or the means to continue spending fruitlessly. Consumer recession is abound. Which leads me to my next point on oil. Economists have mistaken the recent rise in oil prices as an overall inflationary trend. While this has added to upward price pressures in the short run, they're not seeing the big picture. That is credit, a crucial part of the money supply, is contracting. For example, in Bank of America's most recent 10Q, I calculated that loans and leases net of allowance decreased yoy by 1.32%. The number decreased without the revision for allowances as well. That's just one tiny example, but the trend is broad, see Credit Destruction for more proof. Furthermore, please consider the global trend in demand for oil:

According to preliminary data, total OECD inland deliveries (oil products supplied by refineries,
pipelines and terminals) contracted by 0.7% year-on-year in May, with losses in North America and
Europe offsetting gains in the Pacific. In OECD North America (including US Territories), oil product
demand fell by 2.0%, as the US economy continues to weaken amid continually rising oil prices. In OECD
Europe, demand fell by 1.0%, pulled down by Germany, the UK and Italy. In OECD Pacific, by contrast,
demand rose by 3.9%, supported by strong Japanese growth.

Don't count on that Japanese growth for too long....quick headline: Japan: Gloomy Economic Assessment.

Now, the Global Oil Supply:

Global oil supply during June increased by 285 kb/d from May to reach 86.5 mb/d. The increase came largely from OPEC, as non-OPEC output slipped by 65 kb/d overall. North Sea maintenance and unscheduled outages curbed production there by 325 kb/d, with only partial offsets coming from Latin America, China and the FSU. July could see a sharp rebound in non-OPEC supply before further maintenance stoppages affect August, and higher July OPEC crude supply also appears likely.

I'm not going to make outrageous claims that oil will drop below $100, but the numbers above reflect weakening demand and increased supply. This should ease tension in oil markets less some unpredictable outliers and should in theory support a lower price per barrel than north of $140. Peak Oil is Still Scary in the long run, but credit destruction is eating away demand in the short term.

The CRE Report

Quick update on the CRE situation, but you may first wish to inquire back to my previous call for CMBS to Tumble to get a little background.

I've been following the MIT Center for Real Estate data on CRE, here is the latest Transaction Based Index Release:



















As you can see, prices are now in line with the persisting demand destruction. Even if falling demand slows, prices still have room to fall as they have consistently outpaced demand since 2006.

Also consider below the retail space supply vs. demand index and take notice of how it is cliff diving:

The next charge-off and delinquency rate for all loans and leases of commercial banks will be interesting to see, which is released 60 days after the end of it respective quarter. My guess is it will be even higher than it's last report.

Banks will most likely be slow to recognize and admit his problem. My assumption is another waive of large write-offs will ensue in 2009 when the media becomes more savvy with the issue, forcing banks to recognize mark-to-market losses.

Credit Destruction

Barron's reports:

"In its latest quarterly survey of bank lending officers, the Fed found nearly 80% of banks had tightened their lending standards for prime mortgages since the previous survey in April, when 60% said they were imposing more stringent criteria. For so-called nontraditional loans, 85% said they tightened their standards, up from 75% in the previous survey. And in the subprime market, about six out of seven respondents said they tightened standards, up slightly from the previous survey.

Standards for home equity lines of credit were tightened by 80% of the banks in the survey, up from 70% in April. Only 10% reported weaker demand for HELOCs, down from 20% in the prior survey, so homeowners continue to want to tap their houses as if they were ATMs.

Perhaps that's because it's never been tougher to get credit cards or other consumer loan since the Fed began its surveys of loan officers during the credit crunch of the early 1990s. A record two out of three banks said they were tightening standards for credit cards and other consumer loans.

As private-sector banks have stepped back from providing mortgage credit, the task increasingly is being left to the government. Fannie, Freddie and the Federal Housing Administration (which also guarantees mortgages that are typically pooled into Ginnie Mae pass-throughs) accounted for an astounding 90% of U.S. home mortgages in the second quarter. That was the highest proportion in at least 50 years and up from 49% a year earlier, according to Inside Mortgage Finance, a trade publication cited by Dow Jones Newswires."

Tightening in credit standards among banks is good news, but to hear that two of the most troubled financial institutions are providing 90% of US home mortgages is sickening. Of course, this is no surprise, but it just adds more strain on these now explicitly government guaranteed agencies which translates unto the taxpayer in a bailout of mammoth proportions. The tragedy that is Fannie and Freddie is nothing new, but the above statistics are just ridiculous. However, this next reference is even more mind blowing:

"Despite the best efforts of the Fed, which has slashed its fed-funds target to 2% from 5.25% last September, and the federal government's efforts to prop up the mortgage market -- backstopping Fannie and Freddie, taking over IndyMac, while pumping billions into Countrywide via the Federal Home Loan Banks -- credit is contracting.

The pullback from borrowing and lending is stifling credit growth, in turn restraining demand and, in a negative feedback loop, making borrowers and lenders hunker down even more. This has the potential in creating losses in garden-variety loans that could exceed the high-profile hits in mortgage securities seen so far.

Perhaps crude oil and other commodity markets have caught on to the deflationary portent of this spiral. Even Russia making war on Georgia and potentially disrupting a major pipeline can't overcome the deflationary pull of credit contraction on oil prices.

That deflationary tide is especially evident in the 40% plunge in the Baltic Freight Index, an indicator of world trade. On that score, China's central bank, which had been standing hard on the brakes for more than a year, is tapping on the gas because of the risk of a slowdown.

How all this leads to a rally in U.S. stocks is for greater minds than mine to explain."

This is the first major publisher I've come across to recognize the deflationary trend, where normally fear of stagflation has prevailed, which in my belief is incorrect. I have mentioned here and there concerns of deflation before. It's commonsensical actually, the extension of credit is inflationary, the contraction is deflationary. Add to this contraction in lending contraction in balance sheets and huge tax payer burdens via government bailouts and a massive deflationary trend is certainly underway.

Security Analysis for a focused portfolio – A review of philosophy

In light of the recent nonsystemic risks that have developed, particularly in the banking, brokerage and real estate industries, it’s important to review your investing philosophy and research strategies. The following bullet points list my very thorough and focused ideology for reducing nonsystemic risk (business risk) in determining whether to buy/sell common stocks:

• Check the short interest and kinds and volume of option writing/buying/selling. Does it indicate that investors on the other side of the trade have a widely dissenting opinion from yours?
• Who holds the stocks? Individual, institutions, insiders, mutual funds? And at what percentages of shareholders do each represent.
• If buying or selling has been the most recent trend, who has been active in the trading (refer to the above holders)
• Financial statements must be reformulated to reflect not current and long term assets and liabilities, but operations and finances (going back at least 5 yrs). Intangible assets, or uncertain assets should be amortized or depreciated heavily
• Profitability analysis, ratio analysis, Discounted PV analysis (earnings or cash flows) should all be calculated to determine intrinsic value
• Earnings should be matched with cash flows to determine the quality of the earnings. Are depleting cash flows suggesting transitory or fraudulent earnings?
• For when to buy and sell, have technical analyses revealed any developing trends that might indicate an opportune buy/sell at a specific point in time?
• Read the 10k’s for the past 5 yrs and match items and MD&A. Are management’s policies and accounting consistent? Are they fraudulent? Conservative or aggressive?
• Read the most recent 10q’s since the last 10k (same analysis applies as above)
• How does the firm stack up to their competition in terms of competitive advantage and profitability? Valuation? This will be more generalized and less intense analysis
• Industries and sectors, what are the outlook/economics?
• Finally summarize and organize all of the above findings into an easily readable report

The research workload is no doubt very heavy, but considering the consequences of laziness (or in the case of many stockbrokers or portfolio managers, greediness), taking a note from greats like Graham & Dodd, Buffett and as I’m so bold to say Einhorn, and intensively researching these inherent nonsystemic risks can greatly reduce your losses and provide more safety of principal with satisfactory returns despite the lack of diversification (deworsification?).

Any thoughts?

What Defines US Markets?

Sitting back and looking at the economic mess we're in, I thought what uncertainties do US securities markets put into question right now, both positive and negative as well as our economic system in general. Here are my thoughts:

Securities Markets

Regulation - There is no defined line between if the SEC, Fed or Congress are more regulators or interveners here. The recent move to temporarily ban naked shorting is a prime example. Furthermore, regulation is almost never on time, innovators predominantly outpace regulators.

Moral Hazard - Why are institutions being bailed out for their mismanagement? Bear Stearns, Fannie and Freddie, these institutions are costing tax payers a lot of money at just the time when they don't have the extra dollars to spare. Will Lehman, Wachovia and WaMu be added to this list?

Transparency - Financial institutions are the back bone of any economy, yet they are allowed to carry massive amounts of paper off their books and carry assets on their books at levels unknown to even themselves (level III assets). Furthermore, GAAP is lax with regards to financial shenanigans. Unless a trained astute investor learns how to spot these, investors can get burned from overlooking them.

Transparency/Regulation - The US has developed a system of 'shadow banking' where the line between investment banks and commercial banks is thinly drawn, except in the case of required capital reserves. Investment banks have loose requirements here.

Media - The mainstream media, both general and financial, are cheerleaders. They overlook facts and/or fail to mention them all. Twisting of the facts is another common misrepresentation along with bias opinions. They are market salesman, and bad at that, rarely offering intelligent dissenting views of their own, but occasionally a witty guest will come on and rattle the cages.

The US Economy

The Fed - By far the greatest travesty to ever occur to the US economy, Wilson must surely be burning in Hell for his ignorant optimism. How can I count the ways; responsible for inflation, adding volatility and uncertainty to the business cycle through the use of setting interest rates (blunt tool) and/or the attempt at preventing the cycle altogether which leads to an effect similar to piling junk in the closet. In more recent history, the Fed has turned a cheek to their financial oversight responsibility and is attempting to grab more oversight powers (hmmm?). Lastly, the Fed is a privately held institution with no regulator that has gone unaudited for approximately 30 years. The Fed should not be given more oversight, but more scrutiny.

Data - The BLS, BEA, etc. you name it, their numbers are skewed. Don't believe a single release without careful investigation.

Energy - Ridiculous policies are pursued in favor of lobbyists and bureaucrats. Just look at our ethanol policies for support of that claim.

Taxes and spending - I follow the teachings of Austrian Economics, and therefore abhor taxes and big government, but that is not so. Taxes have become more regressive in the US, period. Inequality is a large problem. This is in addition to the anormous growth in public and privae debt since 1980, fueled by artificially low (and sometimes negative) real interest rates. This leads to speculative malinvestment. The US especially has spent its way into oblivion, with entitlement obligations so large they will never be realized. It's not a matter of if, but when the global economy wises up and refrains from investing in US guaranteed debt obligations.

Military Industrial Complex - US leaders have consistently preached peace, but consistently engaged in war, usually without official declaration or approval from congress. This complex fuels growth and power, but at the cost of lives and massive deficits. The difference between military engagements now and WWII, is that US citizens hardly bare any direct economic costs. Our taxes don't increase and we don't sacrifice consumption. In fact, we've increased that. In the long run, this world policing will not be sustainable.

Consumers - In a simple sense, ignorance has been bliss for the US consumer. Spend and accept has been the motto. Believe what you hear on tv, go buy another hummer you don't need, finance another mortgage on your overvalued house and tap that equity, and add to your already disproportionate debt levels. Meanwhile, productive jobs are shipped overseas as result of income wage disparity.

Conclusion

With the prevailing bear market, normally long term contrarian/value investors as myself would be active to say the least, with an egregious amount of Magnums and Cialis. However, for the reasons summarized above, safety of principal (cash) is king right now. That or speculative bets against the US economy.

The US propoganda machine has clearly crossed too many boundaries. Stable and logical policies are rarely given the time of day. For the up and coming generation, my generation, deep intuition is needed to cut through the crap. If US citizens refuse to accept the garbage our government spews at us, then a reversal of polisies will ensue. It is obvious that the US economy is not sound and recognition solutions are needed. As always, I promote common sense over corruption. Remember, TANSTAAFL!

*Please note, this is just a brief, non comprehensive overview, please add to this in comments if you like.

Einhorn - View From The Markets

Daivid Einhorn, founder of Greenlight Capital Fund:

Part I on the new naked shorting ban (click picture for part I):
























Part II on the rating agencies: "Rating agencies are understaffed"

Part III on investing in stocks and debt (distressed)

The rating agency dilemma is not a new issue, but Einhorn is the first I've heard to report that they are severely understaffed, contributing to their ratings that seem lost in space.