Taking Risks and Reaping Rewards

The Sure Double Dip

It's not often we clearly see an iceberg through the windshield filled with our foggy future, but Meredith Whitney says she has seen one when she said, "The housing market surely will double dip."

When we hear such comments there are two things that we need to think about before we accept or reject what they have said.

The first is, "How credible is the source and what bias might they have?"

The second is, "How did they come to their conclusion and do we agree or disagree with their method and findings?"

In this case, Ms. Whitney's resume is solid in both education and professional experience. She was named "Power Player of 2008" by CNBC beating out Warren Buffett, Ben Bernanke, and everyone else.

More importantly she runs her own firm which means her bias is to being correct as it will reflect directly on her. In other words, she might not be right, but she's not trying to pull the wool over our eyes or mislead us in any way. If she says it, she believes it. (This is way less prevalent that you might like to think).

I also love the fact she married a professional wrestler. To me, this means that this is a strong person that makes her own decisions and isn't looking for approval from outsiders. And she has what we all should be looking for: independent thoughts.

So if we don't dismiss her comments out of hand, then we need to understand why she thinks this way and see if we agree.

Her reason is that the housing market has been supported by government programs, such as loan modifications and buying of Mortgage Backed Securities (MBS), and as those programs are coming to an end, a lot of supply will hit the market.

Basically, it's more supply, less demand, prices fall, in this case, AGAIN.

Is that true? Well, yes the Fed has said quite clearly they are ending the mortgage support. If they do, will others pick up the slack? Probably not as there isn't any profit in it for them to modify loans unless the government is forcing them or sponsoring it. So this is pretty clear analysis to me. 

Does that sound logical and right? Yea, probably does.

But can we find hard evidence to confirm our suspicion that she's really on to something?

In a previous post, I addressed wall of mortgage resets coming. That clearly showed evidence that a ton more mortgages are going to get hit with large resets, which will mean defaults for many or most of them. This will happen in the next year or two.

Read this again, then think consider that Ms. Whitney is an expert in this and has built her reputation on being right.

What can you learn from this?

It's likely that there will be another housing downturn, plan accordingly.

More importantly, there are at minimum two things to think through when you hear someone make a prediction in such clear language.

One is who they are, why they are saying it (bias) and make a judgment call about their credibility.

Two is how did they come to their conclusion and can you find evidence to confirm or reject it. Evidence counts, hoping they are right or wrong doesn't.

Remember: Hope is not an investment strategy.

Chugging Ahead or Are We?

The Federal Reserve Open Market Committee (FOMC) left interest rates unchanged and released a statement that updated their position on the economy just a bit. A comparison of this statement vs. the previous one in January can be found HERE.

Notable changes were changing the words "Deterioration in the labor market was abating" to "The labor market is stabilizing." While that's little consolation if you are out of a job, it's clearly a minor improvement.

Also, the addition of "business spending has risen significantly" is a positive sign as is the removal of the special liquidity they put in place during the crisis.

Could this be a return to normalcy? Are we going to just go chugging ahead?

Maybe.

But before we go to our cabin and take a nap feeling all is well, it should be noted that what they didn't change may be more telling.

They continue with language that "bank lending continues to contract" which means that banks are doing something other than lending with their money.

The one dissenting vote, from Thomas Hoenig, President of the Federal Reserve Bank of Kansas City, continued his stance that things have "improved enough that the expectation of low rates for an extended period was no longer warranted because it could lead to the buildup of financial imbalances and increase risks to longer-run macroeconomic and financial stability."

What can you learn from this?

The economy is still in need of help because otherwise they would be moving interest rates up to more normal levels.

The rear view mirror shows some positive signs that we are headed on the right path, but the windshield is still foggy and there are still some icebergs out there.

So full steam ahead is very risky.

The reduction in the special liquidity is the first step in normalizing monetary policy and before they move interest rates, the Fed will have to see how the market reacts to the reduction this action.

The potential for another bubble is already forming. (or worse, one has already formed!) This is the concern of Fed President Hoenig.

Me too.

The banks are able to borrow money at basically zero percent. Anything they do with it is a positive return. They could lend this money to consumers or businesses, but consumers aren't interested in excessive borrowing and small businesses are risky. So banks take that interest free money and invest it in stocks and other assets that they can sell quickly should an iceberg appear. Also, they are still using leverage, perhaps high leverage, which exacerbates the problem and increases their desire to pull back quickly at any sign of real trouble.

That desire to pull back the sign of trouble wouldn't be there if asset prices were fairly valued. But the markets are priced at levels that anticipate a solid future expansion. If that's not what happens, all that money put into the markets will disappear, probably fairly quickly. The potential for a quick pull back combines with plenty of potential reasons to have a pull back to provide clear concern about the foggy future.

Icebergs...I hate icebergs.

Another Iceberg in the Foggy Distance

The Capitan of the Titanic was asleep in his cabin when they hit the iceberg.

In today's dangerous waters, it's tough to get any sleep at all because of icebergs like this: High Yield Debt Refunding Requirements

A recent Moody's report says, "U.S. speculative-grade issuers face more than $800 billion in refunding requirements over the next five years, including $555 billion in bank credit facilities and $250 billion of bonds. About 995 of our 1,300 speculative-grade issuers have debt maturing over this period. The enormous amount of debt due over the next five years stems from a robust period of refinancing and leveraged buy-out activity prior to summer 2007."

The tidal wave of junk bond refinancing that will need to take place is concerning as the market may not be in a position to absorb such debt or have the risk appetite for it.

This comes as the Fed, as will other global banks, will very likely be increasing interest rates or may already have, so even if the debt can be rolled over, the price isn't certain at all.

But assuming someone will to lend them money at some price, this can impact the other debt markets and a crowding out could occur. This means other needy folks can't borrow the money they want or need. All of which slows the economy going forward.

More Yuck!

What this means to you

Right this minute, nothing. The debt has been rolled over and we are in another eye of the hurricane waiting for the next wall to see how hard it will hit us.

This is really just another lesson in looking out the foggy windshield and looking for things that might need to be avoided in the future.

Like icebergs of junk bonds.

Eye of the Housing Hurricane

After the first wall of the hurricane passes, there's a lull.

You're in the eye of the hurricane. 

It may feel like it's over, but it's not. It just feels better because the wind stopped blowing for a minute. But when the second wall comes through, it could be just as bad as the first.

In housing, we weathered the storm - BARELY. 

But that was just the first wall. The second wall is approaching and some us need to take cover. 

Here's a chart that shows the impending mortgages that are going to reset in the next year or so. 

 

 As you can see, the second wall is coming. The first was the subprime loans, shown here in green. The second is the Option Adjustable Rate (Option ARM) loans, shown here in beige.

An Option ARM loan is often called a pick a payment loan as the borrower can decide what type of payment they want to make. Typically they can choose between a fixed rate of 15 or 30 years or interest only or a negative amortization minimum payment. 

The first two options are basically regular loans, so while the option exists, no one chooses it. The second two are where the problems come in.

Interest only provides a lower payment as you aren't paying the prinicpal back. But eventually, you have to start paying back the principal and when that happens the loan payment resets potentially sharply upward. 

If that wasn't enough of a problem, the other option is a negative amortization payment where not only have borrowers avoiding paying on the principal, they haven't even been paying the full interest due on the loan. So the balance due has been increasing. 

For example, if you borrowed $400,000 on a house, paid less than the interest on the loan each month, you could owe $440,000 now years later, and that home might only be worth $250,000.

88 percent of Option ARMs originated between 2004 and 2007 are going to adjust higher between now and 2012. Those option ARM borrowers could see their housing bills go up as much as 63 percent, according to Fitch ratings.

 

With house values still struggling, when this next wall of payment resets hits, who's going to stay in their house with that kind of payment increase and little hope for an increase in value?

Some reports are citing almost 500,000 option ARM loans in California that will reset between now and 2012. With the state already struggling, people won't be able to make the higher payments, putting a huge block of inventory on the market, which will simply kill prices in the "Golden" State.

What's even worse is that the Federal Reserve is going to start raising interest rates to offset potential inflation. Many option ARM loans will go up with them so the payments just get bigger.

Why this matters to you

You may be thinking that this doesn't impact you because you aren't in one of these crazy loans. You may even think that some people deserve to lose their home because they acted recklessly and this should be a lesson to them. 

Well, a lesson it is, but it does impact you too. Why?

Because another wave of housing foreclosures will impact the overall economy and will certainly impact residential real estate prices.

Going from "owning" a house to renting an apartment may not be the disaster of a lifetime, but no one does it, and then goes out and throws a party. And those watching it happen on TV and talking about it around the water cooler, don't throw parties either.

Consumer spending is almost 70% of the economy and if consumers are seeing people being thrown out of their homes, their own home price falling still, and the economy slowing again, it's likely they will tighten their purse strings. Which means the economy slows just that much faster.

We rarely get such a glimpse out the foggy windshield to the future. But in this case, it sure seems like the fog parted and it's pretty easy to see the road ahead. 

The next wall of the hurricane is approaching. It's on the radar and we can see it.  Batten down the hatches, and hold on. This could be a rough ride.

This is not a drill.

Greek Tragedy Coming to a Theatre Near You

Global markets are focused on the situation in Greece and the need for Germany to step up and bail out the troubled nation.

Protesters will likely take to the streets if something doesn't get resolved this week as they need to borrow money by next week or go into default.

It's likely that either Germany by itself or with a nudge from the EU and ECB will take steps to avoid widespread panic. But that's not guaranteed and has never been done.

Anytime you are in uncharted waters, you can hit icebergs you didn't see coming.

The solution to Greek situation is financially simple, but politically almost impossible.

Simply increase taxes and decrease benefits to put their fiscal house in order.

To put it in personal financial terms, work more and spend less. (Not many politicians running on that platform are there?)

They have proposed raising the retirement age from 61 to 63, and predictably, the baklava hit the fan.

While the extension to 63 doesn't seem like a Greek Tragedy to us, it sure does to them.

Why this matters to you

California has the lowest debt rating of any State and both Moody's and Fitch rate it below Greece!

Note: California's economy is five to six times larger than Greece.

And California isn't the only state that is in this trouble.

Because Greece is a member of the European Union, they don't have their own currency. So they can't pay their bills by printing money like our Federal Government can or any other truly sovereign nation.

Greece is like California in this respect. They have to pay their bills by borrowing money or collecting taxes. When the lenders stop lending, the only option is to collect more taxes or go bankrupt.

But this won't happen to us. The federal government will save us.

Won't it?

Here's the rub.

For Germany, or the ECB for that matter, to agree to bail out Greece, they are going to have conditions and they are concerned that whatever is done for Greece will need to be done for Portugal, Spain, Ireland, Iceland and maybe more.

So the conditions will be harsh; increasing taxes, cutting programs, other measures to put their fiscal house in order.

Exactly what the protesters are against and what will increase the unrest.

For the US federal government to bail out California, a similar problem exists. They could help us, but then they would have to help many, if not all, the other states.

And the conditions of their help could be more harsh that Californian's would like because they need to stop every other state from asking for the same thing.

Governments are no different than individuals. If you can't pay your bills, your lifestyle has to change until you can.

Most Americans aren't paying attention to Greece or any of the problems "over there" but they should be.

It's a rehearsal of our own version of a Greek Tragedy that could be coming to theater near you.

 

 

Greenspan's Right

On Meet the Press yesterday, former Federal Reserve Chairman Alan Greenspan said a U.S. economic recovery is "going to be a slow, trudging thing," and that he "would get very concerned" if stock prices continue to fall.

He went on to say that a drop in stock prices is "...more than a warning sign. It's important to remember that equity values, stock prices, are not just paper profits. They actually have a profoundly important impact on economic activity."

He's right.

And we should be worried about this.

The masses that feels like they are hanging on by a thread, but at least their 401K has recovered somewhat, could easily become very discouraged at significant return to lower stock prices.

The result of that would be to spend less, which in turn would slow the economy, which in turn would lower stock values further, which would push people to spend even less.

If the downward spiral isn't broken fairly quickly, which is easier said than done, then the description of the economy recovery being "a slow trudging thing" would start to sound good. 

Downward spirals can last a long time. Look at what happened to Japan over the last two decades.

In the last 20 years the Nikkei 225, the broad measure of the Japanese stock market, has fallen from a high of 40,000 to around 10,000 today. The last 20 years in Japan show clearly that a major modern industrial nation can go long periods in a downward spiral. 

Will we slide this much or this long? 

We already lost a decade as the Dow is basically at the same place it was 10 years ago and the NASDAQ is down over 50% from 2000 highs. So one could view this as 10 years down, 10 years to go. 

Looking out the foggy windshield doesn't often provide clarity, but it's where we should be looking nonetheless.

Greenspan's right. If the markets continue to slide, the economic road ahead may be not only twisty and bumpy, but downhill.

Would you lend money to Portugal?

Portugal's ability to borrow money stopped yesterday. They tried to sell bonds to raise money to pay its bills. There weren't enough buyers and they canceled the sale.

(I wonder if they actually cut up the national credit card in front of the heads of state or if they just take it away and give them the look of shame?)

This is bad, very bad.

Here's why:

Countries borrow money.

We know that the U.S. borrows money. We see it in the news all the time as national debt and the yearly deficit adding to that debt make top headlines.

And most people understand that there will be a point when all this debt comes due and those that have loaned the money will want the borrowers to pay it back. So how much is borrowed and how easily it can be paid back is important in determining if investors are willing to loan you money.

While continual borrowing hasn't been a problem for the US yet, it is a problem in many other countries right now. Portugal, Italy, Ireland, Greece, and Spain (PIIGS) have put themselves in to a situation where they need to borrow money to pay their bills, but fewer and fewer people are willing to lend to them.

Other countries like former Soviet Union nations share similar circumstances.

Lenders lend based on several factors not least of which is the ability to repay the loan. Repayment risk in the aforementioned countries is rising, and therefore so are interest rates. At some point, the risk isn't worth any reward and all the lenders simply stop lending.

This is what happed in Portugal.

The result of not being able to borrow to pay your bills is that you go bankrupt. While Portugal isn't quite there yet, clearly having a failed attempt at borrowing is a sign they are close.

Countries have gone bankrupt before and will continue to do so in the future. While never a good thing, if the country is small and somewhat isolated, like Zimbabwe, the impact on everyone else is small.

However, if the country isn't isolated, for example part of the European Union (EU), then the damage can spread, potentially like wild fire.

Another major issue with the EU is the separation of monetary and fiscal policy. When a nation joins the EU they give away the monetary function of that nation to the overall EU. They lose a bit of their sovereignty.

Now, just when they need to have control over their monetary policy, they are forced to go to outside organization that doesn't have only the interests of one nation at heart.

For Americans that would be like allowing the Federal Reserve functions to be carried out by someone other than Americans with the goal of doing what's best for everyone even at the expense of Americans. Americans wouldn't think of giving up that control.

The obvious solution is to raise taxes, cut spending, and painfully change the way the debtor nations operate. Equally obvious is the political turmoil that will cause and the strong desire of politicians to avoid it.

It's possible that many of the nations in trouble, if this continues to get worse, will want that control of monetary policy back and wonder why they gave it away in the first place. While it's still unlikely that the EU would break up, it's not beyond the realm of possibility.

Because someone better loan Portugal and several other nations some money, look for the European Central Bank (ECB), headed by Jean-Claude Trichet, to announce a plan to help. But the extent to which other nations are willing to help at the expense of their own fragile situation isn't clear.

Depending on what is proposed, this could calm the markets or stir controversy and pit nations against each other with the ECB in the middle. Regardless, much like our own bailouts, the fix isn't always a smooth transition to good times and uncertainty will linger.

Uncertainty increases risk and that hurts rewards and market prices fall. That's why few investors will lend money to Portugal and why this could be very, very bad.

Fed Meeting Press Release Changes for November 2009

The Federal Reserve bascially kicked the can down the road with their announcement after the November 4, 2009 meeting. They only made minor changes to the language, as you can see below, and the only thing they made crystal clear is that they don't see inflation on the horizon.

FOMC meetings offer opportunity to not just talk about financial markets but also critical thinking and learning new skills. If you took the last statement and used Word to compare it to this statement, you would see exactly what has changed. Viewing the information in this way not only eliminates the middle man and their filter or bias, but also provides a faster more productive way to see what has changed.

Many financial analysts use this comparison method to see what changes quarter over quarter in company statements. You can use it in your work as well. Any document that gets updated regularly can be copy/pasted to see what the differences are. It's faster and more accurate than trying to remember or figure out what changed.

To do this open Word, go to Review tab, then Compare. Select the two docs and viola! Really helpful in some situations.

Here's the result of today's meeting vs. the meeting from September 23, 2009:

Got Your Attention Yet?

The FT reported that the Bank of England cut it's official interest rate to a 315 year low of 1.5%. In December, the US Fed cut it's target interest rate to historic lows between zero and 25 bps and the discount rate will drop to 50 bps, a level not seen since the 1940's.

As if it wasn't already obvious that the situation was historic, these moves provide ample evidence that we have never seen anything like this and are unlikely to see it again in our lifetimes.

Apparently, historic problems call for historic solutions.

What can we learn from this?

Psychology is an integral and crucial part of markets. The impact of an extra 25 bps is negligible, basically worthless. They didn't drop rates to historic lows by accident. They did it to make a statement, hopefully a bold one. If that extra 25 bps gets a headline because it's historic, the psychological impact can be very helpful by showing that they are doing major and significant things to turn the economic situation around, not just empty gestures like a $600 tax rebate check.

In doing this, the goal is for everyone to take notice that the Central Banks are on this and staying on this until things improve.

Will it work? The answer to that is highly related to we all answer this question:

Got your attention yet?

What Will the Fed Do?

The Federal Reserve is meeting today and tomorrow and the money is on a 25 basis point cut in rates, down to 2%, and then a pause from the rate cuts. As the fed knows that this is the expectation, and there isn't any fed noise about it being wrong, it's likely that it will occur. But that begs the question, if the economy is still getting worse, why would they signal a pause in rate cuts?

As we know, the Federal Reserve is responsible for the economy and financial system. They have already used some unique and rare measures during this crisis. But their primary gun is running out of bullets. If they go to low right now with interest rate cuts, firing off too many of their limited bullets, they have no where easy or good to go if things continue to get worse. By keeping another 100 basis points or so in the gun, they will have an option that is more traditional if they need to fire another shot.

What can we learn from this?

Holding back a bullet or two is a wise strategy. In a portfolio, it's keeping some cash available. In a household budget, it's keeping some emergency savings. For the fed, it's keeping some room for future rate cuts. Keeping a cushion keeps options open. Do you have a cushion for your next crisis?