Wednesday, October 28, 2009

Weekly Railroad Data - Still Negative

As suggested in the chart above, weekly railroad carloads (a favorite metric of Buffett to gauge the health of the economy) continue to experience mid-teens year-over-year declines despite a growing consensus that the economy is on the mend. While certain categories are showing hints of a bottom, including grains and chemicals, many continue to experience 30+% year-over-year declines (i.e. metallic ores, crushed stone, forest products, and lumber).

While some would argue that carloads provide less of a snapshot of the economy relative to years past (primarily because services & technology represent such a greater chunk of our output), a mid-teens decline exiting a recession would be unprecedented. As such, I remain skeptical that the massive rally we have seen in the equity and credit markets (particularly the latter) can be justified based on what is going on in the real economy.

Interestingly, high quality stocks such as Walmart, P&G, etc, which have done nothing since the March bottom in the equity markets, have performed relatively well over the last week. While only a few days old, I suspect we are finally seeing a reversion to large cap value names vs. the “dash to trash” that has occurred over the last few months.

Portfolios positioned defensively should hold up much better as we exit 2009.

Tuesday, October 27, 2009

America's Growing Short-Term Debt

This chart summarizes the precarious nature of the treasury’s funding situation. As suggested by the table below, the amount of US government debt maturing in less than a year has spiked to nearly 45% vs. approximately 30% over the prior 25 years. A shortening of the maturity schedule reflects the growing concern that foreign governments and institutions have over our ballooning debt. While the treasury continues to have minimal difficulty in raising money, just as with any distressed borrower, lenders are putting the US on an increasingly short leash.

While near-term risk to the dollar’s vaunted status as the world’s reserve currency remains minimal (if only because a credible alternative does not exist), central banks have collectively started to voice concerns over our fiscal predicament. Most intend to gradually reduce the dollar’s share of their foreign currency reserves. For the sake of the dollar, lets hope they don’t all head for the exits at the same time.

Sunday, October 25, 2009

Lend America Faces Probe for Alleged Fraud on FHA Loans

The Wall Street Journal reported late last week that the government was investigating Lend America ("Lend America Faces Probe for Alleged Fraud"), a NY-based mortgage lender, for falsely certifying borrowers that received $14 million in FHA-backed loans.

Anyone in the New York area has probably seen their commercials, set in the style of a breaking news flash, encouraging borrowers to refinance into FHA-backed loans. According to the WSJ article, Lend America is the 22nd largest FHA lender by volume, having originated some 11,300 FHA mortgages over the last 2 years, with defaults on their mortgages running 2-3x the national average.

The investigation follows on the heels of HUD’s suspension of mortgage lender Taylor, Bean & Whitaker in August, which subsequently filed Chapter 11 only days later. Up until its filing, Taylor Bean was the third largest originator of FHA mortgages and the 12th largest mortgage lender in total.

While small in comparison to the total mortgage market, the recent problems at Lend America and Taylor Bean reflect the rampant fraud that has been occurring at the FHA (not dissimilar to what we saw unfold in subprime in early 2007). With the government-controlled entity insuring approximately 25% of new mortgages, investors should remain deeply skeptical as to the sustainability of the apparent bottom in housing.

Friday, October 23, 2009

A Top of the Market Quote From the Chairman of CIC

I recently came across the quote below from Lou Jiwei, Chairman of China Investment Corp, which pretty much sums up the investment philosophy of fund managers chasing this rally 60% off its lows.

“It will not be too bad this year. Both China and America are addressing bubbles by creating more bubbles and we’re just taking advantage of that. So we can’t lose.”

As long as the US and China continue to flood their economies with endless amounts of monetary and fiscal stimulus this mother of all bear market rallies could continue. However, with unemployment approaching double digits, credit in the real economy evaporating by the day (how many retailers have reintroduced lay-a-way programs??), and rising food and energy costs pinching the American consumer, this rally has far exceeded any justifiable levels based on the fundamentals.

Even more excessive has been the massive rebound in the high yield market. Whereas the average bond traded at 55 cents on the dollar at the depths of the market low in December 2008 (an absolutely once in a generation buying opportunity), the average high yield note now trades at a very rich 92 cents on the dollar. Nearly all CCC or lower rated bonds have rallied by over 100% off the lows, with many having high probabilities of receiving no recovery in a bankruptcy scenario.

While glimmers of an economic improvement have justified a rebound in credit, particularly given the depressed levels at the trough, fund flows are largely driving the compression in credit spreads. Flush with liquidity, bond managers are compelled to put money to work. Most professionals are shaking their heads, but as long as fund flows remain robust, they have to put this money to work no matter how overstretched the credit markets seem.

Bernake & Co. appears committed to maintaining a very accommodative stance. Backward looking measures of unemployment, inflation, and capacity utilization warrant their concern. However, just as steady interest rate increases in 2005/2006 eventually choked off the housing/LBO credit bubbles, the first hints of tightening by the Federal Reserve will undoubtedly cut short this resurgence in credit.

Liquidity is so elusive in the credit markets (particularly in high yield). Investors always think they can get out before the house caves in. Among the many lessons of 2008 is how quickly liquidity can dry up when everyone heads for the exits. Investors ought to heed this lesson as they ponder chasing this rally in credit higher.

Thursday, October 15, 2009

VIX Index - Where's the Fear?

The VIX (volatility index) has officially receded to pre-Lehman levels. The market has firmly transitioned from fear to greed.

Friday, October 9, 2009

F.H.A. Problems Raising Concern of Policy Makers

The New York Times ran an article today highlighting the mounting problems lurking in the FHA ("FHA Problems Raising Concern of Policy Makers"). The article also contained a skematic demonstrating how the most recent mortages are the most distressed. Specifically, more than 20% of all FHA mortgages underwritten in 2008 are in default (see below).

I have included below some key quotes/takeaways from the article. While I am convinced that the FHA will end up requiring a bailout from the federal government, it is striking to me how so many of our politicians are deluded into thinking this program is actually serving a valuable function.

David H. Stevens [Head of the F.H.A]…acknowledged that some 20 percent of F.H.A. loans insured last year — and as many as 24 percent of those from 2007 — faced serious problems including foreclosure, offering a preview of a forthcoming audit of the agency’s finances.
• It appears destined for a taxpayer bailout in the next 24 to 36 months,” Edward Pinto, a former Fannie Mae executive, said in testimony prepared for the hearing. Mr. Pinto, who was the chief credit officer from 1987 to 1989 for Fannie Mae, went further than most housing analysts and predicted that F.H.A. losses would more than wipe out the agency’s $30 billion of cash reserves.
• The government is giving as many people as it possibly can the chance to buy a house or, if they are in financial difficulty, refinance it. The F.H.A. is insuring about 6,000 loans a day, four times the amount in 2006. Its portfolio is growing so fast that even F.H.A. backers express amazement.
• The number of F.H.A. mortgage holders in default is 410,916, up 76 percent from a year ago, when 232,864 were in default, according to agency data.
• 7.77 percent of the portfolio is in default, up from 5.6 percent a year ago.
Got to love this asinine comment from Barney Frank: Barney Frank, the Massachusetts Democrat who is chairman of the House Financial Services Committee, said in an interview that the defaults were, in essence, worth it. “I don’t think it’s a bad thing that the bad loans occurred,” he said. “It was an effort to keep prices from falling too fast. That’s a policy.”
• Kenneth Donohue, the inspector general of the Housing and Urban Development Department, who is also F.H.A.’s watchdog said the drop in reserves was “a flashing red light” that the agency was not taking seriously enough…”He noted that if private lenders had raised their down payment requirements in the last two years, it raised the question, “what does the F.H.A. think it is doing by asking only 3.5 percent?”
• Chaz Fullenkamp, an automotive technician in Columbus, Ohio, got an F.H.A. loan even though he was living on the financial edge. “If I got unemployed, I’d be wiped out in a month or two,” he says. Thanks to the F.H.A., however, he is better off than he used to be. Mr. Fullenkamp used F.H.A. insurance to buy a house this spring for $179,000. The eager seller paid the closing costs and also gave Mr. Fullenkamp $2,500 in cash. He immediately applied for the $8,000 tax rebate. Even taking his down payment into account, he came out ahead. “I knew in my heart I could not really afford the house, but they gave it to me anyway,” said Mr. Fullenkamp, 22. “I thought, ‘Wow, I’m surprised I pulled that off.’ ”

Thursday, October 1, 2009

Higher Downpayment for FHA Loans?

In a moment of apparent sanity by our elected officials, Congressman Scott Garrett (Rep-NJ) proposed a bill today that would raise the FHA’s minimum downpayment from 3.5% to a whopping 5%. The bill would also eliminate FHA financing of closing costs (apparently the legal and title fees are too much for many homebuyers to shoulder).

While hardly a meaningful deterrent from the speculative lending helping to inflate the housing market, the bill suggests to me that at least some legislators are waking up to the disaster that is the FHA. It will be interesting to see if the bill gets passed, though the pessimist in me says that the majority of folks in Congress will not want to do anything to disrupt the “nascent recovery” in housing.

The market has been due for a correction for a multitude of reasons, not least of which is a 60% run off the bottom. However, anything that results in a tightening of mortgage credit (i.e. higher downpayments for FHA loans, allowing the $8,000 new home buyer tax credit to elapse) or represents a lessoning of the government’s influence in the overall economy remains the most critical factors to monitor as investors gauge the sustainability of this liquidity driven rally.

For those who haven’t read it yet, I would definitely take a read of Fed Governor Kevin Warsh’s op-ed piece in last week’s Wall Street Journal (“The Fed’s Job Is Only Half Over”). While Warsh generally tows the party line that the economy remains very fragile and the Fed will likely need to maintain its accommodative stance for some time, he does suggest that the Fed should begin to plan its exit policy. While very subtle, it is the first time I have distinctly heard one of the Governors hint at a potential tightening by the Fed.

You be the judge based on these three paragraphs:

Today, even more than usual, we should maintain considerable humility about optimal policy. Financial market developments bear especially careful watching. They may impart more forward-looking signs of growth and inflation prospects than arithmetic readings of stimulus-induced gross domestic product or lagged composite readings of inflation. For example, the level of asset prices and associated risk premiums, and gauging their trend and durability, will demand careful assessment.

In this environment, market participants and policy makers alike should steer clear of ironclad policy prescriptions. Nonetheless, I would hazard the view that prudent risk management indicates that policy likely will need to begin normalization before it is obvious that it is necessary, possibly with greater force than is customary, and taking proper account of the policies being instituted by other authorities.

"Whatever it takes" is said by some to be the maxim that marked the battle of the last year. But, it cannot be an asymmetric mantra, trotted out only during times of deep economic and financial distress, and discarded when the cycle turns. If "whatever it takes" was appropriate to arrest the panic, the refrain might turn out to be equally necessary at a stage during the recovery to ensure the Federal Reserve's institutional credibility. The asymmetric application of policy ultimately could cause the innovative policy approaches introduced in the past couple of years to lose their standing as valuable additions in the arsenal of central bankers.