Friday, August 27, 2010

California Job Losses & Retirement Costs

Here is a great chart from today's Wall Street Journal showing the huge disparity between California job losses in the private sector vs. public sector. Since the beginning of 2008, California's private sector has shed nearly 1.2 million jobs, while employment in the public sector has remained essentially flat.

The op-ed piece ("Public Pensions and Our Fiscal Future") also suggests that the California's state government will spend over $6 billion this year on retirement benefits (more than on education), with this figure expected to grow by 15% next year! If these stats aren't dire enough, the annual cost of servicing California's retirement obligations is projected to grow to $30 billion within a decade (more than 5x today's level).

I am not sure what to say other thank goodness I don't live in California!

Wednesday, August 25, 2010

New Home Sales Hit New Cycle Low

New home sales declined by a sharp 12.4% in July to an annualized pace of 276,000 units. The July figure breached the low of 281,000 set in May, which represented the first month after the expiration of the tax credit (when we saw a 32% swoon in new home sales). Since in my June 23rd post, I predicted that May would represent the cycle low, a bit of humble pie is in order. However, I continue to believe that we are in the midst of a healthy bottoming process and that while the month to month trends may contain some volatility, the housing market should be in materially better shape 12-18 months from now. Further, while not receiving much attention in the press, the number of standing units continued to hit a cycle low in July, with only 209,000 units for sale (down 64% from the peak in June 2006).

While the housing ETF (XHB being one of the better proxies for the industry) is down around 8% since my June call, most of the builders are up today, despite the abysmal new home sales number. The industry has proven quite resilient despite the drumbeat of bad news and relentless calls for a double dip in housing. As demonstrated by the early 1990s housing downturn, most of the stocks bottomed 6-9 months before the turn became clearly evident in the reported data. Given the magnitude and duration of the current downturn, I would expect a similar pattern to play out in the current cycle. Investors who share my view that housing will be on much firmer footing in mid-late 2011, will be well rewarded by building positions in today’s environment, particularly when considering that the litany of bad news has driven most builder stocks to trade below book value and off 70-80% from their 2005/2006 peaks.

My bullish view on builder stocks is predicated on the following key themes (and of course I would welcome any points that undermine my view):
- Builders have spent the last several years building substantial cash hoards and deleveraging their balance sheets. Even the most speculative homebuilders (HOV, BZH, SPF) have addressed their debt maturities through 2013, leaving them significant runway to weather a protracted downturn.
- Unlike private builders who finance their operations through construction financing from regional lenders, the public builders finance their business from the unsecured bond market (which has been white hot as of late). Since regional banks have substantially reduced the financing they make available to land development and construction financing, the publics should be in a materially better position to take share exiting the downturn.
- The public builders have substantially reduced their fixed costs and several have turned the corner on profitability or remain within spitting distance of doing so (DR Horton being the clear leader). Achieving profitability with housing starts under 600,000 leaves them well-positioned to earn meaningful returns when the market returns to natural demand (something closer to 1.2-1.5mm housing starts). While it could take a few years to get there, the longer that we build at 1/3 of this level, the more significant the reversal will be when animal spirits kick in.
- In my own personal opinion, the US government is unlikely to cede control over the critical role it plays in supporting the housing market. Repeated comments made by Geithner and other top administration officials lend credence to this view, particularly as the fate of Fannie and Freddie gains more public attention. While I am not necessarily supportive of the government’s strong hand in guiding the housing market (and readers of this blog know full well of my concerns over the Federal Housing Administration), my own personal views are irrelevant in determining how I invest. In the eyes of government, meaningfully altering the current system of mortgage finance seems too dangerous given the precarious state of our economy and mounting concerns over deflation. Obviously, if any change occurs that substantially alters the role of the GSEs in the housing market, than I would most certainly have to reevaluate my favorable long-term view on housing. As John Maynard Keynes famously said, “When the facts change, I change my mind. What do you do, sir?” Any investor worth his salt has to reassess his or her investment thesis when the facts change and I reserve the right to do so.
- Valuations are just too compelling to ignore. Despite being the most liquid they have ever been, the public builders trade around book value, even when considering that their balance sheets have contracted by over 2/3 since the peak of the cycle. Whereas book value was a very dubious measure to evaluate the industry in 2005/2006/2007 (since the balance sheet reflected land bought at the top of the cycle), builders have collectively taken billions of dollars of impairments to more appropriately reflect current market values of their land inventory. Even with order trends remaining abysmal, most builders have stopped taking large impairment charges, reflecting greater confidence in the quality of their asset base. Similar to low book values, most homebuilders are trading at 3-6x normalized earnings. As an example, DR Horton generated an average EPS of $3.90/share from 2004-2006. At a current price of $10/share, this equates to a PE multiple of a mere 2.7x. Even assuming that normalized earnings for DHI will be half that level, one can buy one of the best builders at 5-6x normalized earnings. The mounting concerns in the housing market, coupled with the heightened volatility of the stock market, will undoubtedly result in sharp swings in DHI’s stock (as evidenced by its November 2008 low of $4.34/share). However, there is a little dispute that DHI will remain a leader in the housing market and will disproportionately benefit when the industry inevitably bounces back.

In summary, I believe that one should start buying when there is blood in the street. While I concede that this call may be early (and perhaps painfully so if we have another sharp downturn in the stock market), I am comfortable saying that valuations have gotten low enough where investors are being well compensated for having to endure whatever volatility may occur over the coming months and quarters. The opportunity to make 2-3x one’s money with minimal risk of permanent impairment rarely presents itself to investors. I firmly believe that this dynamic exists with the higher quality builders.

If one has a greater disposition for risk, then perhaps going down the quality spectrum could be appealing (BZH and HOV fit in that category). The ability for these companies to weather a downturn beyond 2-3 years is far from certain and so one should invest in this subset of the industry more carefully. However, I strongly believe that all the public builders that have managed to survive up to this point will avoid bankruptcy, and so the opportunity to make even more than 3x one’s money could be justified for those with a high tolerance for risk. Happy investing!

Tuesday, August 24, 2010

Kyle Bass Interview on CNBC

Below is a great interview with Kyle Bass of Hayman Capital (one of the best macro investors in the game). In addition to talking about the massive structural problems in the European banking system, Bass gives a great overview of his short thesis regarding Japanese government bonds. With a debt to GDP ratio exceeding 200%, government expenses more than two times receipts (40 trillion of revenues vs. 97 trillion of expenses!), and a domestic savings rate approaching zero percent (as retirees begin to draw down on their savings), Heyman believes Japan is fast approaching what he terms a "Keynesian endpoint."

If I am lucky enough to ever run my own hedge fund, betting against Japanese governemnt bonds would unquestionably be one of the first trades I put on. With 10-year JGBs under 1%, this represents one of the most assymetric bets since derivatives on the ABX allowed investors to bet against the US subprime market.

Friday, August 13, 2010

Manhattan Condos Embracing FHA

Here is a pretty crazy article from Bloomberg ("Manhattan Luxury Condos Embrace FHA in 'Game Changer') on how developers in Manhattan are trying to get the FHA to back mortgages in their properties. Amazing how an institution created during the height of the Great Depression to make homeownership affordable for low income families is now supporting the NYC luxury real estate market.

Nationwide, the FHA insured 21 percent of all mortgages made in the second quarter, or $71.4 billion worth of loans, according to Geremy Bass, publisher of the Inside FHA Lending newsletter. That’s close to the $79.5 billion total value of all FHA-backed loans in 2007.

The agency’s backing of luxury condos “doesn’t look good,” said Andrew Caplin, a professor of economics at New York University who co-wrote a paper titled “Reassessing FHA Risk.”

“Manhattan wealthy people -- is this really who the FHA was set up to support?” he said in an interview.

Caplin testified before Congress in March, arguing that FHA may need a taxpayer bailout because the agency relies on overly optimistic assumptions on unemployment, home prices and loan performance to predict losses.

Nine percent of all FHA-insured loans were 90 days or more past due or in the process of foreclosure in the first quarter, compared with 7.4 percent a year earlier, data from the Washington-based Mortgage Bankers Association show.