Thursday, January 28, 2010

Foreclosure Filings on the Rise

The final foreclosure figures are in from RealtyTrac and they are not pretty to say the least. Foreclosure filings totaled 3.96 million in 2009, up 25.3% from the 3.16 million filings made in 2008. Since the housing market peaked in 2005, there have been a cumulative 11.5 million total foreclosure filings. Even more troubling is that monthly filings accelerated throughout 2009. This is partly attributable to suspension of many state foreclosure moratorium programs in the 2nd half of the year (particularly in California), but also reflects the steady rise in unemployment.

Monday, January 25, 2010

Here is an interesting chart from the New York Times showing the percentage of US treasuries purchased by China from 2002 through 2009. As suggested below, China purchased less than 5% of newly issued treasury securities in 2009 vs. a peak of 47.4% in 2006. As of November, China represented our largest creditor with treasury holdings of $790 billion, outpacing Japan with $757 billion and Britain with $278 billion.

While it seemed unfathomable at the beginning of 2009 that the 10-year would stay well below 4% even in the face of a $1.4 trillion federal deficit, hardly anyone (including your humble author) anticipated that American households and financial institutions would so dutifully fill the void left by the Chinese and Japanese. As noted in the following article "Debt Burden Now Rests on US Shoulders" domestic investors financed a remarkable 61% of US treasury borrowing last year. Whether domestic investors will continue to pile into government securities remains the biggest question hanging over the treasury market as we enter 2010.

Thursday, January 21, 2010

Number of Stocks Hitting New Highs on the Decline

While I hardly consider myself a “chartist” or technical analyst, I oftentimes look at the number of companies making new 52 week highs or 52 week lows to gauge the overall strength or weakness in the underlying markets. Whereas many fundamental analysts were urging caution during the March 2009 timeframe, an unusual number of technical analysts were getting massively bullish given the declining number of companies breaching new 52-week lows. Although the indexes were continuing to hit fresh lows, the breadths of the declines were rapidly diminishing. As suggested in the chart below, whereas nearly 1,900 companies hit a 52-week low in September 2008 (right around when Lehman collapsed), only 667 breached a new low on March 6, 2009 (when all the major indexes hit their cycle lows).

In a similar vein, despite the continued strength of the equity indices over the last 10 months (up until the last 2 days), the number of stocks hitting new 52-week highs hit a peak in October 2009. Technical strategists would argue that this suggests a market on the throes of a correction. If the last two days are any indication, they may be right.

Wednesday, January 20, 2010

Bank of China Orders Slowdown in New Loans

As widely reported today, the Bank of China ordered its credit officials to slow the pace of new yuan loans due to overly fast lending growth in January. Concerns over an impending slowdown in bank lending, which has been weighing on global stock market indices for the past few weeks (not just in China), contributed to a 2.9% decline in the Shanghai stock index on Wednesday. A data point cited by the Wall Street Journal (“Bank of China to Take Steps to Rein In Loans”) suggests that new loans in the first week of the year grew by a staggering 600 billion yuan ($88 billion) vs. new loans of 379.8 billion yuan in all of December.

Given the multitude of contrary indicators coming out of China over the last few weeks, I thought it helpful to summarize the most salient points:

- Both Chinese Premier Wen Jiabao and Wang Shi, Chairman of China Vanke (China’s largest property developer) have recently warned about the rampant level of housing activity in many of China’s largest cities. While carefully avoiding the use of the word “bubble”, both suggested that the current pace of building is not healthy or sustainable.

- Several studies have indicated that a large percentage of the 4 trillion yuan stimulus money (perhaps up to a third) has been directed into real estate and stock market speculation. As noted in my December 18th post, overbuilding appears to be plaguing many large cities, including Ordos, which remains virtually uninhabited despite the capacity to inhabit over 1 million people (A Must See Video on Ordos). Regional mayors have encouraged excessive building to meet aggressive growth targets - as suggested in the video "who wants to be the mayor who couldn't deliver 8% GDP growth".

- China’s regulators have quietly initiated the first stages of a tightening program, with the reserve requirement for big banks raised by 50 bps to 16% (starting on January 18th). According to estimates by Xing Ziqiang, an economist in Beijing at China International Capital Corp, the increase will remove 300 billion yuan of liquidity from the market ("China Raises Banks' Reserve Requirements to Cool Economy"). While modest relative to the China’s total GDP (~34 trillion yuan in 2009), the move is highly symbolic and indicates that further tightening is likely. In a similar vein, China’s central bank slightly increased the interest rate on its one-year bill by 8 basis points to 1.84 percent, further draining liquidity from the system.

- With the flood of new bank lending that occurred in 2009 (7.37 trillion yuan in the first six months and 9.2 trillion through November), the China Banking Regulatory Commission is rumored to have encouraged the nation’s largest banks to bolster their capital positions. China Construction Bank kicked off the fund raising, selling 20 billion yuan of subordinated bonds in December. According to a recent article (“China's Open Loan Spigot Augurs Ills”), China’s banks could be compelled to raise between 300 and 500 trillion yuan in 2010 to help cushion them from future bad debts.

While fairly benign when evaluated individually, the statements/actions are far more troubling when considered in totality. This fear is certainly validated by the market, which continues to sell off with the announcement of each tightening measure by Chinese regulators. Perhaps the biggest takeaway should be the impact on the US indices once Bernake and Co. decides to take away the punch bowl. If China, which is structurally and financially much healthier than the US, sells off at the whiff of a potential clampdown on bank lending, imagine how the S&P will react when the Fed ends its myriad of quantitative easing programs (and forget about actually starting to raise interest rates!).

It is also probably worth noting that while the US equity markets continue to hit new 52-week highs, the Shanghai Composite Index remains more than 9% off its August peaks. Could this be a harbinger of things to come in the US? At this juncture it is tough to say, particularly with the flood of new money hitting the market, but the recent spike in volatility is certainly disconcerting.

Although I hate to opine on the daily movements of the stock market, I think yesterday’s swoon can be partly attributable to the diminished prospect of a second stimulus package as Republicans increase their clout in Congress. As I have advocated in prior posts, support for the market is primarily being driven by an accommodative Fed and the prospect of continued fiscal support (no matter how inefficient and wasteful both may prove to be). Anything that suggests otherwise (i.e. Brown’s victory in Massachusetts, expiration of the Fed’s $1.25 trillion MBS buying program, the impending confirmation of Bernake, expiration of the homebuilder tax credit in April, etc.) will continue to weigh on the market.

Housing Data - December 2009

Housing data reported this morning was a mixed bag. On the negative front, housing starts declined by 4% (6.9% for single family) and came in 2.6% below consensus expectations. On the positive front, building permits were very strong, rising 10.9% month over month and 12.6% above consensus expectations. The higher building permit data (which usually precedes housing starts by a month or two) portends increased building activity over the course of Q1. An additional positive is that “houses under construction” continues to hit cycle lows, falling another 3.8% during the month. This suggests declining builder inventories, which should help stabilize end market pricing. Overall, the extended tax credit ($8,000 through April 30th) is clearly having a favorable impact on the housing market and should provide a nice tailwind to the reported industry data for at least the next 4-6 months.

Despite the steadily improving data, with single family housing starts up 27.7% from its February 2009 trough, its important to recognize that the industry is building well below natural demand (a good thing!) As indicated in the chart below, single family starts remain a staggering 75% below the 1.81 million level achieved in January 2006. While we are unlikely to ever recapture these cycle peaks, natural demand is at least 100% greater than current levels. While we continue to have signficant structural challenges to work through, a powerful rebound in housing remains a foregone conclusion given the depressed state of the industry. Removal of government stimulus by the middle of this year could result in a modest relapse (particularly if mortgage rates spike from current levels), but ultimately this will help work down the backlog of foreclosures that continues to build in the pipeline.

As I have stated numerous times, the fundamentals of the "new" housing market have improved dramatically over the course of 2009. Standing inventories of new homes for sale remain at 30 year lows and builders are now complaining about a deficiency of finished lots available to build on. As such, pricing has begun to firm and builders are slowly increasing their community counts in select geographies.

Conversely, the "existing" home market continues to challenge the industry, with inventories still an elevated 3.5 million vs. a more normalized level of 2-2.5 million. While down from a peak of 4.6 million homes for sale, the reported number likely remains artificially low given the backlog of bank-owned properties that are held off the market (and contribute to the supposed "shadow inventory" that weighs on the market). Until this inventory gets cleared it is difficult to proclaim the bottom of the housing market, but clearly we are well on our way.

Modest Changes Made to FHA

After a surge in delinquencies last year, The FHA announced stricter standards yesterday. The key changes include:

- The agency will increase up front mortgage premiums to 2.25% from 1.75%

- In order to qualify for the agency’s 3.5% downpayment program, borrowers must have a credit score of at least 580. Those with a lower score will have to pay at least 10%. However, this rule change will essentially have no bearing on the program since the average borrower score is around 700. A universal increase of the downpayment to at least 5% would have more appropriately addressed the negative equity situation challenging the program (note 14.36% of FHA loans were past due at the end of Q3 2009 vs. 9.64% for all loans)

- Maximum seller financing will be reduced to 3% of a home’s appraised price vs. a previous ceiling of 6% (will help remove the incentive to inflate appraisals)

- The FHA will more closely monitor the performance and compliance of participating lenders. This is in response to the Taylor Bean and Lend America disasters and the 15 lenders that are currently being investigated by the FHA for engaging in potentially fraudulent activities.

Overall, the changes seem like window dressing for the agency and are unlikely to have a major impact on participating lenders’ ability to provide credit to the FHA’s core constituency.

For those interested, the Wall Street Journal ran a good front page cover story ("Souring Mortgages, Weak Market Force FHA to Walk a Tightrope") rehashing many of the problems facing the FHA (which I have recounted in numerous posts). Although David Stevens, head of the FHA since July 2009, spends much of the article defending his organization, I think this quote is the most telling:

"We should not play this large a role," Mr. Stevens says. "It's not healthy for the mortgage-finance system, it's not healthy for the economy, and it's certainly not sustainable for the long term."

The chart below does a great job of zeroing in on the rising delinquencies and diminishing capital cushion affecting the FHA. Most fascinating to me is how quickly loans made in 2007 and 2008 are falling into arrears. Many of these loans were extended to at-risk borrowers who were refinanced into FHA-backed loans as a result of government foreclosure prevention programs. In effect, institutional investors were able to offset troubles in their own portfolio onto the government. With the redefault rates on many of these modified mortgages running in the 50-60% range, its highly likely the taxpayer will ultimately absorb the bulk of these losses. In affect, the FHA is serving as a backdoor recapitalization program for the nation's banking system.

Friday, January 15, 2010

Net Funding Requirements of the US Government

For those concerned about the government’s ability to finance its burgeoning deficit, this chart (courtesy of Deutsche Bank) should go a long way in confirming that fear. My only response to this chart is “wow – good luck.” Unless we retreat into a massive recession or the Federal Reserve announces additional programs to significantly expand its balance sheet (even after tripling it to $2.3 trillion in 2009!), its hard to dispute the view that rates are going materially higher. Layer on the costs of Obamacare, the increasing likelihood of an expanded stimulus program, and an overhaul of our energy system, and we are really setting ourselves up for a fiscal nightmare.

Tuesday, January 12, 2010

China Again Tightening Lending Requirements

In a bid to further tighten lending, China’s central bank increased the reserve requirement for the nation’s banks to 16%. The 50bps bump represents the first increase in the country’s reserve ratio since mid 2008 and suggests that officials may be setting the path for further adjustments. As highlighted by the Wall Street Journal (“China Cuts Amount Banks Can Lend, in Sign of Inflation Worries”), bankers expect Chinese authorities to target roughly an 18% increase in bank loans this year, slowing from the 30%-plus surge in 2009, with total new lending of around 7.5 trillion yuan compared to more than 9 trillion yuan last year.

I also noticed an off the run article yesterday (“China Cracks Down on Banks' Loan-Sale Practice”) that highlighted how China’s banking regulator is cracking down on banks selling loans to off-balance trust companies. Similar to the SIVs and securitization markets that artificially bolstered the US banks capital ratios, Chinese banks have recently begun employing these off-balance vehicles to mask their aggressive lending activities. One article I read suggested that approximately 734 yuan ($108 million) of bank loans were packaged into trust products in 2009, with 80% of it issued in the second half of the year. With the recent crackdown, only seven new trust products backed by banks loans have gone on sale this month, compared with 465 for the whole of December (see chart below). One can only imagine the quality of the loans that sit in these off-balance vehicles.

Tighter lending standards in China, coupled with several negative earnings surprises (i.e. Alcoa, Chevron, Electronic Arts), are weighing on the markets today. As I have suggested in prior posts, both the equity and credits markets (particularly the latter) have rallied too hard too fast. While sustained zero percent interest rates could provide further impetus to the rally, an argument supported by valuations and improving fundamentals is getting increasingly difficult to make.

October 2008 through July 2009 was a time of “sowing” new ideas and new investments. As we enter 2010, it is prudent to start “harvesting” those ideas. While one is guaranteed to miss the crest of the market (just as no one can catch the absolute bottom when building said positions), it is a very precarious investment thesis that relies on trying to get out before the music stops. This is particularly the case in the credit markets where liquidity can literally dry up over night. As the new issue backlog begins to massively build in the US and Europe, I think one would be absolutely crazy to enter the next few months fully invested (which I believe most credit funds are).

Monday, January 11, 2010

Adjusted Unemployment Rate Analysis

As reported last Friday, the nation’s unemployment rate remained constant at 10% in December despite an additional 85,000 reduction in non-farm payrolls.

While declines in the nonfarm payroll number are likely to have ended last month, simple math suggests that the unemployment rate should continue to increase as the economy improves.

As noted in the analysis below, the Bureau of Labor Statistics reports that approximately 1.9 million Americans have left the labor force since May 2009 (when the work force peaked at 155 million people). Since these people are assumed to have left the available labor pool, they are not included in the calculation of the nation’s unemployment rate. In my back of the envelope analysis, I calculate that December’s unemployment rate would have been closer to 11.1% had the government not assumed that nearly 2 million people left the labor force.

As the economy improves (hopefully!), many of these uncounted civilians will reenter the labor pool, placing pressure on the denominator of the unemployment rate calculation. Further, natural population growth in the United States suggests that the economy must create between 125,000 and 150,000 jobs per month to absorb those incremental Americans looking for work. As such, even if nonfarm payrolls turn positive, the employment rate will trend up unless we get a fairly pronounced recovery.

As noted in the chart below, it wasn’t until early 2004 that the economy began comfortably generating in excess of 200K monthly jobs. This was a full two years after the recession officially ended in November 2001. If the trajectory of the current recovery follows that of the last recession, it is highly conceivable that the peak in the unemployment rate may not occur until sometime in 2011. I hesitate to think what the employment rate will grow to if we have a double dip.

Friday, January 8, 2010

Comparison of 1982 to 2009

Here is a chart from a recent David Rosenberg research report comparing the onset of the 1982 secular bull market to economic conditions today. While tremendous liquidity (particularly into credit), artificially low interest rates, and modestly improving economic data could provide additional support to the market, the chart below provides convincing evidence that we are far from out of the woods.

Thursday, January 7, 2010

Chinese Decision on Rates Seen as ‘Turning Point’

China’s central bank raised the yield from its weekly sale of three-month central bank bills on Thursday; the first time in nearly five months (NYT – Chinese Decision on Rates Seen as ‘Turning Point’). While the .05% sounds very small, central bank tightening is highly directional, and today’s action is likely a harbinger for future rate increases.

While Chinese government and business leaders have begun to express concerns over inflation and seemingly speculative investments in real estate, today’s interest rate hike represents the first tangible move to tamp down the country’s bourgeoning money supply. Actions always speak louder than words and we saw a similar development in mid-2007 as China took aggressive actions to counter inflationary forces in its economy (though it took about 6 months for the stock market and economy to feel the full effects of their actions).

Today’s action by the central bank follows on public comments made by the CEO of Vanke, China’s largest property developer. The Wall Street Journal provided the following quote in a December 4th article (“Vanke Sees China Bubbles”):

Nationwide, "things haven't risen to a property bubble yet," said Mr. Wang, who founded his company 25 years ago and has built it into the biggest housing developer in one of the world's fastest-growing housing markets. But "in individual cities, and in some of the main cities, there is clearly a bubble. There's no doubt about that ... I'm very concerned." Mr. Wang said he fears the trend could "infect second-tier cities, which would be similar to the nature of the Japanese bubble decade" that imploded in the early 1990s.

The 58-year-old said he is, overall, "cautiously optimistic" about China's economic outlook. But he expressed concern about the prospect of continued inflation in asset prices next year because of the massive stimulus, which he said could prove hard to reel back in. "This kind of monetary expansion, which goes into fixed-asset investment, into infrastructure -- you can't just stop it by saying stop," he said.

While it is always difficult to identify a “bubble” and I will concede that there seems to be a “bubble” in the growing use of the word bubble, several data points support the view that housing is getting overheated in China. Firstly, home price/median income ratios are off the charts in China (~9x in Shanghai vs. 3x in the US). Also, banks and many companies have heavily gotten into the real estate business. The government has mandated that state-owned banks increase their lending and much of that is being directed into real estate – some press reports have indicated that up to a third of new loans has been directed to such activities. Common sense should leave one skeptical that a government controlled economy/banking system can effectively allocate 25% of GDP in 6 months (which represents the 1 trillion yuan of lending made by Chinese banks in 1H 2009 benchmarked against the country's 4 trillion yuan economy). Tremendous excess capacity is being built in all parts of the Chinese economy, with housing receiving the most attention.

Admittedly, China lacks the systemic flaws that devastated the US housing market. Chinese consumers are limited to borrowing 70% of the price of their houses (and less for second properties) and the irresponsible securitization of mortgages is non-existent in China. In fact, many Chinese investors are paying 100% cash for their homes.

However, as I have made clear to a few friends who have debated me on the topic, asset bubbles can still be inflamed with 100% equity. If my memory serves me correctly, I lost a ton on tech stocks in 2000/2001 and I am proud to say I didn’t use one penny of leverage!

Monday, January 4, 2010

The Year in Review for High Yield

With the conclusion of 2009, I thought it instructive to show how massively credit spreads have collapsed since peaking in December 2008. The spread to worst on the Credit Suisse High Yield index has declined to 647 bps from a staggering 1900 bps on December 18, 2009. Similarly, the yield to worst on the index has declined to 8.8% from over 21% in late 2008.

The compression in spreads led to an approximate 57% increase in the broader high yield index with CCC’s (the real dregs in high yield land) returning over 100%. For distressed bonds that traded at 10-15 cents at the market nadir, many have risen by a staggering 500-600%. Needless to say, it has been an unbelievable year in credit.

As demonstrated in the charts below, yields have returned to late-2007 levels (around the time of the equity market peak in October 2007) and spreads have compressed to levels last seen in June 2008 (right before the market really started to blow out in July 2008). While history suggests that we could see some further spread tightening, particularly if the economy continues to heal, high yield credit will be a much more difficult place to earn a living in 2010. In my opinion, for those with a more bullish orientation, the equity markets offer a much more compelling risk reward proposition. This will be even more the case if inflation begins to surface.