Bullard Comment on Fed's Asset Purchase Program

Amazing how the quote below, uttered by Federal Reserve Bank of St. Louis President James Bullard to reporters yesterday, is propelling the markets to a near 2% move today. Just goes to show that so much of this rally is being driven by the market’s perception that the Fed will retain its accommodative stance for far too long.

"I have advocated to keep the asset-purchase program open but at a very low level, and wait and see what happens, and as information comes in about the economy we can adjust that program while the federal-funds rate remains at zero," Mr. Bullard told Dow Jones Newswires in an interview Sunday. He said "no decision has been made" about the program's fate.

While bubbles appear to be forming in every asset class outside of the US dollar, the Fed has done nothing to temper these concerns (some would even contend that this is precisely the Fed’s goal!) While the contrarian in me believes that a sharp reversal is in the offering (I am actually considering buying long-term treasuries as a portfolio hedge), the massive rotation out of the dollar could be sustained for some time, particularly with Bernake & Co. at the helm. Interestingly, the collapse in near-term treasury yields has now made the US dollar a cheaper funding source than the Japanese yen. With the dollar replacing the yen as the primary vehicle for the carry trade, the momentum underpinning the declining dollar may only be beginning, particularly as these carry trades are typically executed using substantial leverage.

The short-term impact of a leveraged short against the dollar can be self-perpetuating and I believe we are currently in the midst of this phenomenon. Hedge funds and other leveraged investors are buying any number of assets – junk bonds, emerging market bonds/equities, oil, and gold & other base metal commodities, etc. The assets may be different, but the funding source is essentially the same (i.e. the US dollar). While everyone is currently consumed by their investing acumen, correlations between seemingly uncorrelated assets have never been higher (in many cases approaching one). The momentum in the markets is not dissimilar to what we saw in the summer of 2008 and we know how that ended.

Again, while I remain invested in gold and believe the Fed’s policy of zero interest rates provides investors a license to speculate in risky assets, I am becoming increasingly concerned by the uniformity underpinning this thesis, particularly as leveraged investors enter the fray. Selling my gold today would be a mandate on the world’s central banks ability to heal their economies without stoking inflation – at this juncture, I remain far from convinced that such an outcome will play out. However, to the extent that central banks begin to withdraw the artificial stimulus underpinning this asset bubble (or at least give us a credible timeline for doing so!), Lumpy Investor will not be shy about reevaluating his year long bullish view on gold. Until then – gold $2000!!

With the FHA Help, Easy Loans in Expensive Areas

The New York Times (“With the FHA Help, Easy Loans in Expensive Areas”) continued to hammer home the problems mounting at the FHA in today’s paper. Some of the most compelling quotes/data points include the following:
· On Thursday, the Mortgage Bankers Association said more than one in six F.H.A. borrowers was behind on payments [14.4% of loans are delinquent; 3.3% are already in foreclosure]
· In 2007, fewer than 4,400 F.H.A. loans were made in California. The Economic Stimulus Act of 2008 helped change that by temporarily doubling the maximum loan the F.H.A. insured, to $729,750. The F.H.A. has insured more than 107,000 loans so far this year in the state, according to DataQuick.
· “If one of these higher-limit loans fail, that’s equivalent to two or three cheaper loans,” Mr. Donohue said. “You have to ask yourself, was the F.H.A. ever intended to address these markets?”
· “It was kind of crazy we could get this big a loan,” said Mr. Rowland, 27. “If a government official came out here, I would slap him a high-five.” “We were resigned to waiting another year,” said a second partner, Michael Bedar, 31. “Then we read about the F.H.A. I had never heard of it before, and couldn’t quite believe it. But it was the answer to our problems.” They put down about $33,000, split among the three of them [the purchase price on the building was $963,000]. “Everyone should have the chance to do this,” Mr. Kurland said.
· Everyone may get a chance. Representative Barney Frank, the Massachusetts Democrat who is chairman of the House Financial Services Committee, said in an interview that he planned to introduce legislation next year raising the maximum F.H.A. loan by $100,000, to $839,750. His bill would make the new limits permanent.

Robert Toll Blasts the FHA

Below is a verbatim quote from Robert Toll, CEO one of the most respected public homebuilders in the country, on the government’s FHA program. Toll was addressing a large crowd of investors at a UBS building products conference when he was asked to comment on the FHA.

How disastrous must the FHA be, such that Toll felt it prudent to warn about a program that is directly supporting his industry? So far, few people, outside of concerned investors and knowledgeable folks in the housing industry, have lamented about the problems at the FHA. The fact that Toll is now speaking up against the agency should serve as a clear warning signal to those folks in government who think they are doing a service to the country by artificially propping up the housing market via this broken federal program.


A - Robert I. Toll, Chairman and Chief Executive Officer: We had all sorts of inspectors and qualifiers and administrators that made it a big pain in the butt [ph] so Fannie, Freddie was around with the same limits of much easier financing, so why would you go FHA. Well, the reason you go FHA, FHA is the new subprime. What the government is doing is beyond belief in that once upon a time until that had its glorious days like a year and half ago. FHA did very small percentage of the business in the country. I don't know what the actual percentage, I bet it was 2 or 3% and today FHA is doing 30% of the business. And the reason is yesterday's subprime is today's FHA and whereas on a Fannie, Freddie you are talking 20% down you can go and get the last 10% if you struggle hard from another guy and give a combo rate. But on FHA you're talking 3.5% down. And now if you're doing business at $120,000 and you're given an $8,000 credit, and you're only making the guy put down 3.5, not only does he get the house but he gets some cash to walk away from the settlement table with. So yesterday's subprime is today's FHA and I think it's not --

Q: So it's potentially a train wreck again?

A - Robert I. Toll, Chairman and Chief Executive Officer>: It's a definite train wreck and --

Q: Because a lot of the guys --

A - Robert I. Toll, Chairman and Chief Executive Officer: The flag will go up within the next couple of months. It already has preliminary going up, bail us out, give us some more money.

Q: Right. I mean not you guys but again a lot of the publics have 60, 70% of their volume now coming.

FHA's Net Capital Ratio Falls to .53%

Late last week the FHA released its long anticipated annual update report to Congress. As expected, the report highlighted the significant financial duress within the agency’s portfolio. Specifically, the FHA’s capital reserve ratio fell to .53% vs. a 2% mandated level and 2008’s cushion of 3.22%. While the agency’s leadership continues to believe it will not need a bailout, most close observers of the housing market (including myself) see little chance of that scenario playing out. Even within the guts of the FHA’s report, the agency does concede that under certain pricing scenarios the agency will eat through its entire capital buffer (though this will be temporary as a robust housing recovery will enhance the agency capital position beyond 2011).

While absorbing the FHA’s losses will be relatively small, particularly when compared to the hundreds of billions of dollars needed to prop us Fannie & Freddie, my concern is how distorting the FHA’s involvement has become. Private commercial lenders have been shut out of the market since most are unwilling to match the lax underwriting standards and high LTV ratios available through the FHA. Government involvement has enhanced affordability for marginal buyers, but derailed the inventory & pricing correction needed to bring the housing market to a healthy equilibrium. How sustainable is a market that requires a maximum 3.5% downpayment, $8,000 tax credit, and artificially low mortgage rates (less than 5% at current rates) to entice the incremental household to buy a home? Obviously, not very. The longer we put off the day of reckoning the more painful the correction will ultimately be.

At the end of 2008/beginning of 2009, I was very encouraged that housing was quickly finding a bottom. While pricing and new construction were breaching new lows each month, the inventory was starting to clear and real buyers (not 600 FICO subprime borrowers or speculators) were finding their way into the market. Pricing was falling to levels where the rent vs. buy equation was just too enticing for judicious savers that sidestepped the madness of 2004-2007 to pass up. However, with the strong hand of government manipulating the market, that price/inventory correction has reached a grinding halt.

It could take some time for the government to withdraw its stimulus from the housing market, particularly with the 2010 elections quickly approaching. Politicians hate to disrupt the apple cart lest it interfere with their #1 goal of getting reelected. However, until housing reaches a point where it can stand on its own, the apparent “recovery” evident in the incrementally positive data remains highly elusive in my opinion.

World Gold Holdings - As of September 2009

The World Gold Council recently updated the gold holdings for every major country, including the IMF. While little has changed since the Lumpy Investor last published the Council’s findings on May 21st (see post for comparison), it is important to emphasize how underinvested the US’s largest creditors remain in gold. Specifically, China and Japan, which collectively hold $1.5 trillion of US Treasuries, have only 1.9% and 2.3%, of their respective foreign reserves in gold. Conversely, the leading Western economies, including the US, Germany, Italy, and France have between 65-80% of their reserves in gold. Across the 107 countries surveyed by the World Council, the average country has approximately 10% of their reserves in gold.



China has publicly expressed its concern over the US dollar and demonstrated its unease by purchasing 400 metric tonnes of gold earlier this year. While unlikely in the near-term, I see no reason why China wouldn’t seek to bring its holdings in-line with the world average of 10%. Assuming such an outcome, China would have to increase its gold holdings by approximately 4500 metric tons. With mine production at approximately 2500 tons per year and declining (see chart below), this would represent 1.8 years of annual supply just to get China on par with the rest of the world. Applying similar logic to other reserve rich/gold poor countries, including Japan (2.3% of reserves in gold), India (~6% after its recent 200 metric ton gold purchase from the IMF), Singapore (2.2%), and Russia (4.3%) could have a massively distortive impact on the price of gold.

While I doubt the conclusion of some analysts that such a scenario would drive gold in excess of $5,000, I see no reason why the yellow metal will not surpass its previous inflation-adjusted price of approximately $2,200/ounce hit in 1980. Given the unprecedented money printing and fiscal imprudence demonstrated by elected officials across the globe, such an outcome becomes more likely with each passing day.

The Lumpy Investor remains bullish on gold over the next several years, and while I am increasingly concerned by the growing consensus around that view (particularly with hedge funds and individual investors clamoring into the trade), the glaring underinvestment in gold by the world’s largest creditor nations, provides strong fundamental support for my thesis. Does that necessarily preclude us from seeing a short-term pullback in the price of gold? Most certainly not. There has been a massive shift out of the dollar and into risky assets, with gold an obvious beneficiary of this migration. Should the Fed begin to tighten, we will likely see a near-term snapback in the price of gold as the dollar-carry-trade gets unwound en masse. However, last week’s policy statement provides minimal evidence that the Fed views inflation as a risk, which would in turn lead to them raising short-term interest rates.

With the Fed's stamp of approval, investors have a license to speculate in risky assets, with gold being the most obvious currency. Until the Fed begins to show some backbone and/or foreign central banks reduce their negative rhetoric on the dollar, the Lumpy Investor will remain bullish on gold.

Pulte’s Reliance on the FHA

The quote below, taken from Pulte’s third quarter earnings call, demonstrates how critical the FHA has been to propping up the housing market. With its recent acquisition of Centex Homes, Pulte is the largest homebuilder in the US and an excellent proxy for the industry.

FHA loans were approximately 43% of loans funded from the financing line in the third quarter [Note: Pulte, like many public builders owns its own mortgage company] compared to approximately 34% in the second quarter of 2009. FHA loans in the quarter for Pulte, on a standalone basis represented 35%; in Centex it was 60%.

IMF Sells Gold to India, First Sale in Nine Years

The Reserve Bank of India became the latest central bank to stock up on its gold holdings, purchasing 200 metric tons directly from the IMF over the last few weeks. The transaction, equivalent to 8 percent of global annual mine production, accounts for almost half the 403.3 tons that the IMF in September agreed to sell as part of a plan to shore up its finances and lend at reduced rates to low-income countries.

Despite the sizable purchase, India’s gold holdings ($10.3bn) represent less than 4% of its total foreign exchange reserves ($285.5 billion) as of October 23, 2009. This is well below the 30-40% more reflective of developed country central banks.

While the pending IMF sale created a pull back in the price of gold in September, India’s sizable purchase suggests significant appetite on the part of foreign central banks eager to diversify their exposure to US dollars.

Even with China’s purchase of 400 metric tons earlier this year, bringing its reported gold holdings to 1,045 tons, the country remains way underinvested in the yellow metal, with gold representing less than 2% of its foreign exchange reserves. I wouldn’t be surprised if they take down the remaining 200+ tons the IMF intends to sell later this year.