The Lumpy Investor

Pharmasset - Interesting Merger Arb Candidate

2011-12-11T19:57:00.000-08:00

Though I usually shy away from merger arb candidates for fear of getting run over by the proverbial steam roller, Pharmasset's trading price ($129/share) relative to Gilead's all-cash offer of $137 has recently piqued my interest. Pharmasset is one of the leading biotech companies developing a drug to treat hepatitis-C, one of the fasting growing markets in the healthcare arena. Unlike other experimental drugs on the market which must be used with alpha interferon, a type of drug injected once a week that can cause severe flulike symptoms and other side effects, Pharmasset's drug candidate, PSI-7977, is the first all-oral treatment regimen, which does away with the need for interferon. Rather than rehash Gilead's investment thesis for acquiring Pharmasset, I would point readers to this article from the NY Times DealBook "Gilead to Buy Pharmasset for $11 Billion" for background on the company and the hepatitis-C market.

Gilead has recently announced a tender offer to acquire Pharmasset's outstanding shares (click here for details). The tender offer is slated to run through January 12th, with Pharmasset investors receiving cash shortly thereafter (usually takes 1-3 business days). As such, investors can set themselves up to receive an approximate 75% annualized gain by buying Pharmassset's shares today.

While financing risk often explains a sharp discount to the offer price, Gilead's offer is not contigent on financing. Further, the company recently raised $3.7 billion by tapping the bond market, which when combined with more than $2 billion of cash on its balance sheet, will provide Gilead with ample capital to effect the tender.

So why is Pharmasset trading well-below the offer price given the high likelihood of the deal closing within the next month? Firstly, I think investors are spooked by the massive premium that Gilead offered for the company. At approximately 90%, the downside risk is very signficant should the deal not go through. While I think this is a very low probability, particularly since Gilead raised its offer multiple times before winning over Pharmasset's board, merger arb specialists are undoubtedly taking into account the pre-deal price when assessing their downside exposure.

Secondly, at ~$10 billion, Pharmasset's sizable market cap likely explains some of the gap. There is simply not enough merger arb capital out there to absorb the supply of paper being sold from long-term Pharmasset holders (who rightfully sold out of their position when the deal was announced). This is particularly the case as we head into the end of the year when investors naturally become more risk-averse. Last thing a trader wants is for a merger arb position to blow up in his face as he is wrapping up the year, particularly since the transaction won't close until after the new year.

Finally, the last reason (and perhaps the most pressing concern for risk arb) traders is an unusual provision in the agreement, called a "Key Product Event". To avoid me misinterpreting the provision, here it is in its entirety:

A “Key Product Event” is any serious adverse event that (i) is determined by an independent safety review committee overseeing the safety of the relevant clinical study to be directly related to PSI-7977 (not predominantly related to any compound with which PSI-7977 is coadministered) and to have: (a) resulted in death; (b) been life-threatening; (c) required inpatient hospitalization or prolongation of existing hospitalization; (d) resulted in persistent or significant disability or incapacity; (e) resulted in a congenital anomaly or birth defect; or (f) required significant intervention to prevent permanent impairment or damage and (ii) (x) results in the FDA’s placing a clinical hold on the development program of PSI-7977 or (y) is likely to result in a significant delay in the development timeline of PSI-7977 as of the date of the Merger Agreement.

The key point to note is that efficacy is not enough for Gilead to pull out of the deal - the drug must have resulted in death or be life-treatening. While I am not a scientist and certainly not in a position to render any opinion on Pharmasset's drug, one has to have faith that Gilead has done substantial diligence on this issue before committing to buy the company (and raising its offer 3 times before finally winning the prize).

My own personal view is that short sellers are grasping on this issue to try and push the stock down. After rising to as high as $135 after the deal was announced, Pharmasset's shares have steadily declined to $129, providing a huge windfall for put buyers that bought near-term puts following the deal's announcement. With that said, I think the fears surrounding the Key Product Event are creating a very compelling risk/reward for those investors willing to look past the noise created by short sellers.

If anybody has anything intelligent to add to the discussion please feel free to drop me a line. Hopefully, I am not missing the steamroller as I reach for a couple of nickels:)

Thanks,
Lumpy

Update on Norilsk Nickel

2011-11-04T07:20:00.000-07:00

After two harrowing weeks of waiting for the tender to go through, I am pleased to report that the cash finally hit all three of my accounts this morning. While there was much skepticism on whether the tender would go through (not least by yours truly!), I am actually surprised at how seamlessly the process transpired. Save for some concerns that the government would review the tender (at the behest of Rusal, who stood to lose the most from it going through), there were really no major hiccups to report. The Company closed the tender as expected on October 28th, announced the results on Nov 2nd, and started distributing funds last night.

As I indicated in my previous post, the biggest concern I had was that the tender would attract so much interest that there would be an oversubscription by odd-lot holders (i.e. those holding less than 1,000 ADRs). However, the proration factor turned out to be nearly 11% vs. the Company’s intention to purchase 7.7% of its shares outstanding. As such, there was never really any threat of odd-lot holders not getting paid out in full.

Based on the handful of comments I received on the post, it sounds like there are some fortunate individual investors who decided to hold their nose and take the plunge on an attractive risk reward. Congrats to all and let’s hope we can get in the middle of another fight between a pair of Russian oligarchs in the near future!

For all those interested, here is a great article ("Bread Line or Stock Sale") from the wall street journal that shows the difficulty most Russians faced in tendering their shares. Unlike us fortunate Americans who simply had to place a 3 minute call to instruct our broker to tender our shares, most Russians had to tender their shares in person. The article talks about the massive "bread" lines of people that formed to take advantage of the "once in a lifetime" offer. Unfortunately, many they didn't make the October 28th cutoff.

One for the Little Guys?

2011-10-27T12:28:00.000-07:00

A common refrain from many individual investors is that the “markets are rigged” or “there is no way to beat the professionals so why even try.”

However, I learned about an investment opportunity two weeks ago that only a small fry investor like me could fully take advantage of. It all started when my brother-in-law, who works for one of the premier option market makers, received a firm-wide email alerting him to an opportunity in Norilsk Nickel. Norilsk is a $40 billion market cap Russian-based metals and mining Company.

The email indicated that Norilsk (ticker NILSY on the pink sheets) was conducting a tender offer for approximately 7.7% of its shares at a substantial premium to its then current trading price of approximately $20 share. More specifically, the tender offer price is $30.60/share, representing a 50+% premium. While not unusual in its own right, the fascinating part of the tender offer is that individual shareholders who own less than 1,000 shares will not be prorated in the tender. As such, assuming the Company follows through on the tender, an investor could pocket approximately $10,000 in less than two weeks time just buy tendering their shares!

For a large institution holding several hundred thousand shares, this offer hardly seems that appealing. While they will likely be able to tender a small portion of their shares (perhaps ~5%), the vast majority of their position will not be accepted and as such they have to be primarily focused on the fair value of the Company (which presumably is around $20/share). Given that most of Norilsk shares are held by very large shareholders, the Company’s share price has hardly moved since the tender was announced, despite the fact that the offer contemplates a 50% premium to the pre-tender price!

Ever the opportunist, and recognizing a compelling risk/reward when I see it, I purchased approximately 1,000 shares in three separate trading accounts. Tomorrow is the day of reckoning as the Company will officially close the tender and presumably announce the results thereafter. As I see it, the key risks are the following:

The Company decides at the last minute to pull or delay the tender

The Company lowers the offer price, since they see no reason to reward mostly individual shareholders with a 50% premium

So many small shareholders pile into the trade that even the non-prorated class ends up getting prorated (i.e. not all of my 3,000 shares are accepted for tender)

The government challenges the tender (this is a separate issue that is not worth going into in this email – safe to say, this issue has likely been taken off the table given recent comments from the Russian government)

While there is a distinct possibility the tender offer fails to go through, I still think this is an incredibly attractive risk reward that frankly I have not seen available in a very long time. In a worst case scenario, the tender offer is pulled and I end up owning stock in a $40 billion Russian metals Company.

While not my intention to be long NILSY, most of the more bearish analysts think the stock is worth $18. In a worst case scenario, assuming it trades down to this more pessimistic view of fair value, my maximum short-term paper loss would be $7,500 [(my purchase price of $20.50 - $18.00) * 3000 shares]. My upside, assuming the tender is accepted is $30,300 [ ($30.60 - $20.50) * 3000 shares]. If you assume there is an 80% chance of the tender going through, that provides an expected value payoff of $22,740 (.8* $30,300 + .2 * -7,500). Certainly not fool proof, but a compelling risk-reward in my play book.

I look forward to reporting back on the results of the tender! Knowing my luck, something bad will happen between now and tomorrow, but given the massive run in the market today, I feel even better about my downside.

For those interested in reading more about the tender offer, please follow this link: http://nnbuyback.com/home.html

China's Ghost Cities and Malls - Excellent Video

2011-08-09T22:29:00.000-07:00

Here is a great video documentary ("China's Ghost Cities and Malls") I came across as I continue to dig into the housing and real estate bubble infecting China. Having carefully studied the market for the last 2+ years and documented many of my most salient findings on this blog, it’s painfully obvious to me that China’s housing market is a classic bubble. Nonetheless, the opposition to this view remains fierce, with many noted investors and economists downplaying the potential fallout from a correction (even if they concede that the real estate market is stretch) and so it behooves me as an investor to continue to dig for information that supports my thesis.

The video, which was put together by SBS Dateline (Australian TV) in March 2011, is about 14 minutes long so it requires some investment of your time, but definitely worth listening to. There are at least 3 major cities profiled in the documentary that are virtually unoccupied, but have the capacity to support millions of people. It’s kind of eerie to see the camera pan across these cities and show high rise building after high rise building with virtually no tenants.

Perhaps the most telling statistic in the video is that there are approximately 64 million empty apartments in China. Despite this overcapacity, the government recently mandated that 36 million affordable homes be built over the next five years, including 10 million in 2011 and another 10 million in 2012.

I also found the story on The South China Mall in Dongguan, China to be particularly fascinating. The mall, which was completed five years ago, is nearly three times the size of the Mall of America in Minnesota. As detailed in this May 2005 New York Times article ("China, New Land of Shoppers, Builds Malls on Gigantic Scale"), the mall has 150 acres of palm-tree-lined shopping plazas, theme parks, hotels, water fountains, pyramids, bridges and giant windmills. The mall also has a 1.3-mile artificial river circling the complex, which includes districts modeled on the world's seven "famous water cities," and an 85-foot replica of the Arc de Triomphe. Despite the mall’s world class architecture and its relatively close location to Shenzhen and Guangzhou (two major Chinese metropolises), the video vividly details how the mall is a virtual ghost town, with a large chunk of the mall unleased and seemingly no customers to be found on its premises.

While I will readily concede that I have never been to China and my thesis rests squarely on third party research and information, the multitude of articles written and videos produced over the last few years, provides compelling evidence that the growth in China’s real estate market remains unsustainable and enormously damaging to the global economy when it inevitably corrects.

Over the last few weeks, investors have faced unsettling news from all corners of the world. Whether it is the debate over the debt ceiling in the US, the potential contagion fears from a sovereign default in Europe, the dangerous consumer bubbles forming in Brazil and India, or the overall slowing economic growth throughout most of the developed world, investors have a lot to be concerned about. However, in my opinion, nothing is as dangerous or potentially destabilizing as the real estate bubble forming in China. So many companies, from equipment manufacturers to commodity producers to Chinese state-owned banks will be severely impacted by a slowdown in Chinese fixed investment.

While it is difficult to predict when the correction will occur, and history suggests that the Chinese government will do everything in its power to keep the charade going, the fissures seem to be developing by the day.

Already, we have learned that traditional banks have severely curtailed their lending to the real estate sector ("Chinese Property Firms Getting Squeezed"). As such, lending has moved to the “shadow banking system” in the form of trust companies, which have more than doubled their lending to real estate developers over the last quarter vs. traditional banks, which reduced their loans for property development by 75% in 2Q (see chart below).

As we saw in the US during our own housing bubble, the migration of lending from traditional banks to an unregulated and unaccountable shadow market, represents the last leg in what we all know will end badly for these unsuspecting trust company investors.

Anemic GDP Growth Showing Evidence of Double Dip

2011-07-31T12:20:00.000-07:00

For all those concerned about the prospect of a double dip recession, this chart unfortunately gives strong credence to those fears. Essentially it shows that every time year-over-year GDP growth dips below 2%, a recession always follows. With the release of Q2 GDP on Friday (which showed a paltry 1.3% annualized growth rate), the year-over-year growth rate is dangerously close to this 2% threshold. Given the downward revision to Q1's GDP growth from 1.9% to an anemic 0.4%, future revisions of Q2 GDP could very well show that year-over-year growth is trending well below the 2% line in the sand.

Brazil's Consumer Debt Bubble

2011-07-13T18:37:00.000-07:00

While investors' attention is rightfully focused on the European sovereign debt crisis, the escalating property bubble in China, and the tenuous debt ceiling negotiations occurring in the US, the consumer borrowing binge happening in Brazil represents another consequence of the easy monetary policy of the US Federal Reserve and a grave threat to the global economic recovery.

As highlighted in this recent Financial Times article, "Credit To Redeem", the consumer credit bubble occurring in the Brazilian economy is on par with the real estate and credit bubble that led to the US's undoing in the summer of 2007. This paragraph from the article says it all:

"Part of this inflation has come from rapid credit growth, particularly consumer borrowing. Observers such as Paul Marshall and Amit Rajpal at Marshall Wace, a London-based hedge fund, argue that Brazil is at risk of a full-fledged consumer credit crisis. Retail borrowers are on average spending one-quarter of their disposable income on debt servicing, compared with only about 16 per cent in the US. Defaults are rising. Serasa Experian, a credit monitoring agency, this week said its index of consumer delinquencies rose 22 per cent between January and June, the biggest increase in nine years."

While the central bank is forecasting credit growth of 15 per cent this year, no one agrees on how much debt households can bear. “What’s the limit that people can pay in terms of interest charges plus amortisation? When it’s getting to a third of their income, it’s pretty high,” says Mr Volpon.

In another FT artice, "Brazil Risks Tumbling From Boom to Bust," we learn of the remarkable borrowing rates faced by consumers.

The average rate of interest on consumer lending has jumped from 41 per cent in 2010 to 47 per cent most recently in May 2011. This rise from an already elevated level reflects the cumulative effect of tightening by the Brazilian central bank in order to contain inflation.

The consumer debt service burden, which stood at 24 per cent of disposable income in 2010, is now slated to rise to 28 per cent in 2011.

While the Brazilian central bank has aggressively tightened monetary policy, including raising interest rates to a global high of 12.25%, the bank's actions to date have had minimal impact on the growth in credit. Further, the raising of interest rates has resulted in a 40% increase in the Brazilian real and attracted significant foreign investment flows, which have only exacerbated the country's challenges.

While always difficult to predict the top of a bubble, its very clear that the credit binge occurring in Brazil is unsustainable and will end in tears. Add this to the list of risks facing investors as we enter the second half of 2011.

S&P Lowers Outlook on US Government Debt

2011-04-18T19:51:00.000-07:00

In a strong wake up signal to our elected officials, S&P lowered its outlook on the US's long-term credit rating from stable to negative (though retained its AAA rating). As demonstrated in the chart below, outside of the Japan with a gross debt/GDP ratio of 220%, the US leads all developed nations with a ratio of 92%.

Given that the US deficit should exceed $1.5 trillion this fiscal year, its laughable that both sides of Congress declared victory when agreeing to spending cuts of a paltry $38.5 million last week. While spending in Washington remains unrestrained, the discipline of the bond market will most certainly force action should Congress not get more serious about reducing our deficits.

S&P's announcement should serve as a shot across the bow for government officials who think that "deficits don't matter," particularly with the planned expiration of the Fed's QE2 program in June.

Oil Exports by Country

2011-03-08T05:54:00.000-08:00

Here is a great chart from this morning's WSJ that breaks out oil exports by country. As suggested in the chart, Libya exports 1.5 million barrels/day of light sweet crude. While Saudia Arabia has stated that they would draw on their spare capacity to address any shortfalls in Libyan production (which is estimated to have dropped by 1 million barrels/day), Saudian Arabian oil is much heavier than Libayn oil and could not be handled by the many refineries that process Libyan oil. As such, many of these refineries that can only process light sweet crude would have to turn to a limited number of other countries for supplies, including Nigeria and Algeria, themselves the subject of growing unrest.

Oil Markets and the Arab Unrest

2011-03-06T11:42:00.000-08:00

With the price of a barrel of Brent crude around $115 (and peaking at $120) and West Texas Intermediate crossing $100, I thought this article from the Economist ("The Price of Fear") provides an excellent overview of what is going on in the oil markets.

Clearly, pricing is going up because of an increase in demand, particularly in the emerging world:

“World demand grew by an extraordinary 2.7m b/d in 2010, according to the International Energy Agency. It will probably keep growing by another 1.5m b/d this year and the same again next, as the rich world recovers and demand surges in China and the rest of Asia.”

However, it’s also worth noting how seamlessly the developed world has been able to cope with higher oil prices over the last thirty years and how out of whack energy intensity remains between the developed and emerging world.

“America’s economy in 2009 was more than twice as large in real terms as in 1980. Yet over that period America’s oil consumption rose only slightly, from 17.4m b/d to 17.8m. Europe actually used less oil in 2009 than in 1980, even though its economy had grown... America’s economy, though about three times the size of China’s, uses just over twice the amount of oil that China’s does. But oil intensity in emerging countries has also been falling in recent years, as manufacturing has become more efficient and less energy-intensive service industries have increased their share of the economy.”

In the short-term, there is no reason to believe that oil can’t take out its 2008 peak, particularly if social unrest begins to spread to the major oil exporters (Saudia Arabia, Iran, etc.). However, a sustained period of high oil prices remains unlikely in my opinion given the likelihood that elevated prices will throw the global economy back into recession (as we saw in the summer of 2008). Further, high oil prices will undoubtedly spark a new innovation wave that further reduces oil intensity throughout the world (not just in developed countries). The latter could take some time to play out, but human ingenuity should disprove those market commentators who confidently predict $200-$250 oil over the coming year.

Covenant-Lite Loans are Back

2011-02-05T14:34:00.000-08:00

One would have thought that the meltdown of the leveraged loan market in 2008 would have left a lasting impression on participants in the industry. However, the recent flood of money into the loan market has resulted in a diminution of credit standards comparable to what we saw in late 2006/early 2007. As demonstrated in the chart below, covenant-lite loans have represented 26% of all new loans issued year-to-date in 2011, nearly identical to the 25% level hit in 2007, and more than 5 times the percentage seen in 2010. While the sample size is fairly small ($8.8bn YTD 2011 vs. $100 billion in 2007), hearing the words “covenant-lite” and “PIK-Toggle” enter the lexicon of credit investors scares me tremendously.

With rates and covenants so remarkably favorable to borrowers, it is only a matter of time before the LBO machine begins to ramp up into overdrive. Supply is what broke the back of the last LBO bubble - I have little doubt that it won’t do the same this time.

Over the last year, I have been highlighting the mounting excesses in the credit markets. Admittedly, my fears have not been borne out and credit investors would have been well-served by ignoring my concerns (generally, a pretty lucrative trading strategy:). However, not in my wildest dreams could I have imagined that at this stage in the recovery, we would still be talking about zero percent interest rates “for the foreseeable future.” The Global Food Index just breached its 2008 highs and oil is flirting with $100/barrel and yet our esteemed Fed Chairman sees no evidence of inflation in the economy. How many countries have to endure mass riots over parabolic food rises before Bernanke will abandon his unyielding reliance on the heavily manipulated CPI numbers?

With rates across the entire yield curve kept artificially low, perhaps this can go on for some time. Bernanke’s comments on Thursday talking down any inflationary pressures in the economy have given investors a license to speculate. However, I have no doubt that when the Fed begins to tighten, this mini-reincarnation of the 2007 credit bubble will quickly be snuffed out.

Companies Stock Up Ahead of Price Increases

2011-02-02T19:13:00.000-08:00

Here is a good article from today's WSJ ("Companies Stock Up as Commodities Prices Rise") that highlights the self-fulling prophecy of higher prices. With the price of rubber, cotton, spices, and other commodities rising to new highs over the last few months, anxious customers are accelerating their inventory purchases to try and get ahead of additional price increases. Similar to what we experienced in mid-2008, when panicky restaurant owners drained Costco shelves of bags of rice, scared businesses are accentuating the inflationary spikes by collectively buying far more than the underlying demand in their businesses would suggest is necessary.

Its difficult to say how long this could go on - and zero percent interest rates are certainly not helping - but unless end market demand truly picks up, its hard to justify this frenzied activity. In 2008, we had a good 3-4 months where it seemed like everyday the price of most commodities was moving higher. However, as Jim Grant is fond of saving, "the cure for high prices is high prices" and you can be sure that at some point high prices will break the back of this inflationary pressure.

As can be expected, the Fed's head is firmly buried in the sand and it remains highly unlikely that they will raise interest rates anytime soon. With home prices trending lower and unemployment stuck at 9.5%, Bernanke can care less that copper and rubber prices have tripled since early 2009. However, no matter how clueless the Fed, they cannot repeal the laws of supply and demand and any investor chasing this commodity spike higher ought not to forget what happened in August 2008 when reality finally took hold in the market.

This anecdote from the article perfectly captures the frenzied behavior of businesses across the country:

John Anton, Anton Sport's founder, saw the price of cotton shooting up, and decided to act. Last month, when his T-shirt suppliers warned about the fourth price rise in six months, he borrowed $300,000 through his home-equity line of credit and bought more than a year's supply. Mr. Anton typically has about 30 boxes of shirts on hand at one time, but now has more than 2,500.

"It just kind of clicked that I can borrow at 2.45%, and if cotton is going to go up between 10% and 12%, why wouldn't I do this?" Mr. Anton said. Cotton prices rose 92% last year, and are up 22% this year.

Mr. Anton, the T-shirt seller, bought mountains of shirts after receiving letters in January warning of an imminent price increase. One supplier's letter, a copy of which was reviewed by The Wall Street Journal, urged customers to "wrap up most of your pending orders and buy at the best possible prices."

"What's exciting here is we can now go to somebody like McDonald's and say: 'We have a price that's going to beat everyone around,' " Mr. Anton said. "At this point, I don't know if I'm the smartest guy in the room or the dumbest. But I can't see prices returning to where they were anytime in the near future."

China Unveils Trial Property Tax in Two Cities

2011-01-30T15:46:00.000-08:00

Since I was traveling in Germany last week, I missed a key development in the Chinese housing market. Two cities, Chongqing and Shanghai, introduced property taxes to help curb speculation and rising home prices ("China Unveils Long-Awaited Property Tax"). Although mild by most developed country standards, the introduction of the tax, coupled with an increase in minimum downpayment requirements for second homes from 50% to 60%, sends a strong signal that Chinese officials are serious about containing speculation in the market.

In Chongqing, the city levied a real-estate tax on villas owned by individuals — usually luxury, stand-alone homes — and on newly purchased high-end homes at three rates: 0.5%, 1%, and 1.2%, depending on market transaction prices. Separately, the Shanghai government said it would levy a temporary 0.6% real-estate tax on homes and may cut the rate to 0.4% for properties whose transaction prices are below certain—unspecified—levels. Both taxes were positioned as "trials" and could be modified depending on how they impact their respective housing markets.

As noted in prior posts, I believe one of the biggest factors driving the speculation in China's housing market is the minimal carrying costs of holding real estate. With bank lending rates below the rate of inflation and a general aversion to investing in the stock market, real estate has historically served as a store of wealth for many Chinese.

Admittedly, past efforts to contain house prices have had minimal effect and some may believe (rightly) that the announced property taxes are too small to have any great impact on the market. However, its always difficult to identify the straw that breaks the camel's back and last week's announcement convinces me even more that Chinese officials will continue to take incremental actions until home prices (particularly at the high end) begin to respond.

China's Inflation Starting to Spike - Investors Beware

2011-01-03T13:14:00.000-08:00

As indicated in the chart below, China’s inflation rate rose to 5.1% in November from 4.4% in October. Though down from the 8.5% rate that existed in early 2008, the spike in prices is clearly starting to worry Chinese government officials – hence the two interest rate hikes over the last ten weeks. Even more concerning, is that food inflation is running well into the double digits, and though food accounts for only one third of the CPI, it accounts for 75% of the increase. As an example, soybean oil, a key ingredient in Chinese cooking, rose approximately 25% last year, with most of the gain coming since July (“Cooking Oil's Surge Shows How Inflation Hits Chinese “).
While Chinese officials are hesitant to slow down the economy, the recent spike in inflation will force their hand. Just as we saw in 2006-2007, it may take some time for interest rate hikes to work their way through the Chinese economy, but inevitably they will work their magic. Given the rebound in the commodity and equity markets, investors seem to be ignoring the residual effects of China’s deliberate attempt to engineer a slowdown. With many industrial and agriculture commodities making parabolic moves over the last few months, I think it is prudent for investors to start taking off risk.

While the easy money policies of the US Federal Reserve are starting to coax people back into equities, the 2011 theme for most of the developing world is one of tightening. China, Brazil, India, and Australia are among the largest economies that have recently raised interest rates and more are coming. As an example, in Dilma Rousseff’s inauguration speech yesterday (new Prime Minister of Brazil), she specifically mentioned controlling inflation as one of her top priorities. I think it is fair to say that when inflation becomes a key theme in an inauguration speech, investors should take notice – I know I certainly am.

China's Real-Estate Frenzy

2010-12-28T09:58:00.000-08:00

Here is a good op-ed in today's Wall Street Journal ("China's Real-Estate Frenzy") that highlights the growing real estate bubble forming in China. After experiencing a modest correction during the summer, pricing and activity appear to be back in an upswing. However, as yesterday's 25bps interest rate hike demonstrated (building on the first 25bps hike in October), Chinese government officials are slowly waking up to the realization that they need to do something before things get really out of control. One interesting point highlighted in the article is that there are no property taxes in China. As such, the carrying costs for holding an empty apartment are negligible. In order to curb speculative activity, I think Chinese officials should implement some sort of property tax, even if modest.

Here are some other good highlights from the article:

Last week I sold an apartment in Beijing for more than 2.5 times what I paid for it five years and three months ago [more than a 20% IRR!]. When I asked the buyer why he was optimistic about real estate, he explained that land was limited in Chinese cities and government policies would keep the market going up.

Housing prices in the U.S. peaked at 6.4 times average annual earnings this decade. In Beijing, the figure is 22 times.

In the past, when China could depend on growing export markets, technocrats in Beijing were able to keep speculative frenzies in check with periodic crackdowns...But this time nobody is listening. Local governments and banks have set up off-balance sheet vehicles to conceal loans and keep the spending boom going. Fitch Ratings estimates that not only did banks exceed the central bank's 7.5 trillion yuan ($1.1 trillion) cap on lending for this year, they made an additional three trillion yuan of these shadow loans.

When a government loses control of monetary policy, inflation follows. A few months ago, only the scariest "China bears" predicted 6% inflation for next year; now the People's Daily is admitting it may reach those levels "in some months."

Germany Not Immune to Europe’s Contagion

2010-12-23T09:16:00.000-08:00

Here is a good article from today's FT ("Germany not immune to Europe’s contagion") that highlights the mounting pressures facing Germany. Although on a standalone basis, Germany should be fine, its banks are highly exposed to contagion risks in Europe's periphery. The article posits that if Spain should default, German yields (which are currently under 3%) could rise sharply higher. Further, German CDS spreads have recently hit new highs (excluding the time period surrounding Lehman's bankruptcy) and the ultra-safe swiss franc has been steadily climbing against the euro. Here are some of the highlights from the article:

The very idea that Germany could be caught up by contagion from the eurozone debt crisis seems risible. Its benchmark interest rates, those for 10-year Bunds, trade below the equivalent levels for the US, UK and France.

Yields of just shy of 3 per cent for 10-year money hardly smack of trouble. Inflation is unlikely to cause problems soon, unlike in the UK and potentially in the US thanks to quantitative easing. It also enjoys a sizeable current account surplus, meaning it is not at the mercy of foreigners for financing, unlike many in Europe. In short, its bonds are still seen as the safe haven of at least the eurozone.

Nonetheless, the whispers are starting against Germany. Yields have risen by more than half a percentage point since their lows in October. Unlike the corresponding rise in US yields, which many see as the result of higher growth expectations, few are touting higher output as a reason for Bunds spiking.

Instead, the markets are firmly putting the blame on the prospect of contagion and in particular the fear that Germany could end up coughing up to bail out most of the so-called periphery of the eurozone.

Pimco, one of the world’s largest bond investors, which by chance is owned by Allianz, the German insurer, has for several months privately been warning that German yields could shoot up once the price of the various European rescue schemes are factored in. Germany’s exposure should remain manageable if the crisis stays restricted to Greece and Ireland (and probably poor Portugal, the next in line for a bail-out).

But the 50-100 basis points question for Germany is what happens to Spain. Should it need a bail-out – and its yields continue to hover close to euro-era highs – then Germany is on the hook for tens of billions of euros more and its yields could well shoot up.

China's Inflation Is A Monetary Phenomenon

2010-12-08T05:38:00.000-08:00

Here is a good chart from todays WSJ (“China's Inflation Is a Monetary Phenomenon”) highlighting the growth in China’s M2 since 2002 and the recent surge in food inflation. As demonstrated in the chart below, M2 growth peaked last November at approximately 30%. Given that inflation generally lags M2 growth by 12-18 months, we are now only starting to see the effects of last year's massive lending binge work their way through China's CPI data.

A big theme for the year ahead will be how aggressive China and other emerging market central banks are in tamping down inflationary pressures that are clearly bubbling up in their economies. Should central banks accelerate their recent tightening measures, we could see global economic growth fall well short of the more bullish forecasts starting to gain sway with investors (though the lagging effect of these actions suggests this will be more of a 2H 2011/1H 2012 problem).

For a similar article on the inflationary pressures building up in Brazil see another article from today's WSJ - "Inflation Dilemma Looms for Brazil's Rousseff."

On the campaign trail, Ms. Rousseff promised to lower Brazil's sky-high interest rates. But in order to tamp down inflation, Brazil's central bank is getting ready to raise rates, not lower them, economists say. Central bank directors are meeting Wednesday to discuss potential rate increases. Many Brazilian economists expect the country to boost its 10.75% interest rate—among the highest in the world—by the end of January at the latest....

Inflation picked up as Brazil's government took on more debt to boost spending after the global financial crisis. The stimulus helped Brazil weather the downturn. But two years later, the stimulus spending has juiced up Brazil's natural growth rate of around 4.5% to a China-like 7%, creating inflation along the way.

"The inflation issue requires a policy response," says Marcelo Carvalho, who follows Brazil at BNP Paribas in São Paulo.

Brazil's Finance Minister Guido Mantega, who is set to remain in his job once Ms. Rousseff takes office, said this week that the federal government will introduce a series of inflation-fighting spending cuts.

Eurozone Bond Spreads Blowing Out

2010-12-01T20:23:00.000-08:00

Here is a great chart from yesterday's Financial Times highlighting the growing credit crisis in the euro zone. The bottom left graph clearly demonstrates how credit spreads have blown out over the last few months. As investors turn their attention to the next dominoes to fall, Spanish bond yields have risen to approximately 300bps wide of German yields. Even more concerning is that Italian bond yields have blown out to 210bps wide of German yields (the highest spread since the euro came into effect). While Ireland and Spain both entered the credit crisis with very low government debt to GDP ratios (less than 30% for Ireland and less than 50% for Spain), the FT reports that Italy's sovereign debt to GDP will be about 118% by year end. On the positive front, Italy's banks remain far healthier than those in Ireland and Spain, though the country faces significant refinancing risk in 2011, with Eur300bn of total debt (sovereign plus bank) maturing during the year. Out of this 300bn, approximately 1/3 of it is due in the first three months. While equity markets continue to rally in the US, investors ought not to dismiss the contagion risks spreading throughout Europe.

Spanish Banks' Dependence on Wholesale Financing

2010-11-23T19:31:00.001-08:00

This chart from a September 30, 2010 Economist article (“Two Cheers, Three Tiers”) sums up the significant risk building up in Spain’s banking system.

As suggested in the chart, Spanish banks’ loans as a percent of deposits have leapt to approximately 130% over the last decade. This 30% gap has been filled by wholesale financing, which tends to be much less sticky than retail deposits (think Lehman or Bear Stearns, which faced a massive run when their access to the capital markets dried up essentially over night). While the larger and healthier Spanish banks have been able to access wholesale financing (albeit at higher rates), the vast majority of the country’s financial institutions have been shut out of this market. As such, the country is in the midst of a severe deposit war, with the Economist suggesting that “banks are trying to claw share from the beleaguered cajas by offering rates as high as 4%. Higher funding costs are squeezing net interest margins, which fell by 6.4% in the first half of the year for the banks and by nearly a quarter for cajas.”

While drawing too many parallels to Ireland may be a bit premature, its important to note that Ireland’s bailout was precipitated by the rapid loss of retail deposits from the nation‘s largest banks. As an example, Allied Irish lost €13 billion ($21 billion) of deposits since the beginning of the year. Investors fearing contagion to Spain should monitor carefully the deposit levels in the country’s banking system.

As if the deposit war isn’t concerning enough, the Economist concludes the article by commenting “that banks still have €323 billion of exposure to property developers, which for some is close to four times their core capital.”

Japan's Demographic Timebomb

2010-11-20T19:23:00.000-08:00

Here is a great picture from a recent Economist article (“Into the Unknown”) showing the rapid shift in Japan’s population from 1950 to 2055. From 1955 to 2005, the steadily increasing population of working age people (reflected in the pyramid shape of the left most schematic) and rising productivity of its workforce propelled Japan to become the world’s second largest economy. However, over the next forty years, the working age population is forecasted to shrink so quickly that by 2050 it will be smaller than it was in 1950 (dropping from a high point of 87mm in 1995 to less than 50 million by 2050; see second chart). Similarly, over this timeframe, Japan’s population, currently 127 million people, is expected to fall by 38 million or nearly 30%! By 2050, four out of ten Japanese will be over 65.

As the population ages, the nation’s pension system is becoming increasingly strained. When public pensions were introduced in the 1960s, there were 11 workers for every pensioner. Now there are a mere 2.6, compared with an OECD average of four.

Finally, Japan’s rapidly aging population has resulted in a substantial reduction in the nation’s savings rate. Once above 20% of disposable income, the ratio has dropped to about 2%, and the Economist posits that it could go negative over the next few years. Given that 95% of the government’s debts are financed by domestic savings (primarily banks, pension schemes, and insurance companies), Japan could be forced to seek external financing to sustain its huge public sector debt. Rates would undoubtedly rise under this scenario given that Japan currently borrows at a paltry 10-year rate of 1% from its risk-averse populace.

Given all these facts, its not terribly difficult to sympathize with the bearish thesis surrounding Japanese government bonds.

Sovereign CDS Spreads Widening in Europe

2010-11-11T05:26:00.000-08:00

European sovereign 5-year CDS spreads are blowing out this morning, with Spain at 285bps (+58.5bps), Portugal at 495bps (+78bps), and Ireland 605bps (+65bps). As of now, concerns seem contained to the Euro zone, but I think it is only a matter of time before we start seeing the residual effects spill over into the United States. US treasuries in the belly of the curve (2-5 years) remain well bid, as investors try and front run the Fed’s $600 billion quantitative easing program, but the yields on the long-end of the curve (particularly 30-year treasuries, where the Fed will only do marginal buying) have blown out over the last few days. Yesterday’s weak $16 billion auction of 30-year treasuries could serve as the canary in the coal mine for investors who have been piling into fixed income over the last 18 months.

Spain

Portugal

Ireland

Here are a few recent articles from the WSJ that address mounting concerns in the Euro zone.

Spain’s Bank Mergers Suddenly Drying Up
QE2 Off its Course: Yields Are Going Up
Ireland’s Next Blow Could be Home Loans

Systemic Risks Posed by ETFs

2010-11-09T09:44:00.000-08:00

Here is a great report published by Harold Bradley and Robert Litan of the Kauffman Foundation warning about the potential dangers caused by the explosion of ETFs. The authors conclude that the growth in ETFs and ETF derivatives poses more of a systemic danger to the financial system than the advent of high frequency trading. At 84 pages, the report is highly detailed and fairly technical, but definitely worth a read for those interested in learning more about the subject. While I am by no means an expert into the inner workings of the financial markets (at least as it pertains to high speed algorithmic trading), all I could think about as I was reading this report was that we could be facing another October 1987 type-meltdown should regulators continue to ignore the rapid growth in the ETF market.

ETFs have proliferated around the globe at an astounding pace, from roughly ninety at the beginning of this decade to about 450 at the end of 2005 and more than 2,300 today, with another 1,000 or so in the regulatory pipeline (see chart 4).

But there can be too much of a good thing if taken to extremes,and this is now happening with ETFs. From an asset base of about $75 billion a decade ago, ETF assets now approach $1.2 trillion, with trading reaching an astounding $18.2 trillion last year. ETFs have been morphing in new and unexpected ways. Simply put, we will argue here that ETFs and the derivatives built around them have become the proverbial tail that wags the market.

As more ETFs are created, the risk grows that in the event of a future market meltdown triggered by any number of possible causes the rush to unwind the ETFs will aggravate any sell-off. Indeed, some creators of ETFs may not be able to honor their obligations. If those institutions or holders of ETFs are deemed sufficiently important or interdependent with other financial actors, the U.S. government could be forced again to make the agonizing decision whether to come to the rescue, as it did with AIG and a number of other large enterprises during the financial crisis of 2008.

Reevaluating Gold

2010-10-04T15:53:00.000-07:00

Ever since I began this blog in late 2008, I have been an advocate for investing in gold. While the massive support provided by the Fed in the wake of the collapse of Lehman Brothers helped forestall a complete financial meltdown, I thought the unprecedented monetary stimulus injected into the system would ultimately prove inflationary (admittedly this doesn’t seem to have played out yet, though the recent rise in gold and other industrial commodities suggests we may not be too far off).

With a near 60% return over the last two years, I think it is prudent to reevaluate my thesis and consider the merits of maintaining a position. The rampant media attention given to gold’s ascent above $1300/ounce suggests that my thesis is hardly unique and that the yellow metal could be migrating into bubble territory.

As an unrepentant contrarian, I always grow nervous when my thesis is shared by the broader investing community. Asset prices tend to climb a wall of worry and I am afraid that we are reaching a point where even the most hardened skeptics have thrown in the towel (See the A1 Section of the September 28th WSJ "Gold Vaults to New High."

Despite a growing unease, little has changed since my original purchase, and I intend to hold my position for the time being (hopefully, you can sense the waning lack of conviction in that statement!). Underlying my thinking are the following points:

1. Central banks across the globe continue to aggressively counteract strength in their currencies. The Bank of Japan is selling yen in order to hold down its currency. The US Federal Reserve gave a clear indication in its last statement that it stands ready to support the economy should evidence of a double dip begin to take hold (i.e. “QE2” – whatever form that will come in). Never mind that a second dose of stimulus implicitly proves the ineffectiveness of the first round (when the Fed purchased $1.75 trillion of treasuries and mortgage backed securities); Bernanke and crew remain willing to do whatever it takes to avoid a deflationary debt spiral and I believe they are willing to err on the side of too much stimulus rather than too little.

Just as investors doubted Paul Volker’s ability to arrest the pernicious inflation of the late 70s (a battle which took over 2 years to win), the common refrain from today’s “experts” is that Bernanke is fighting a loosing battle. Talk of the US mirroring the path of Japan is almost as prominent as talk of gold being in a bubble.

While I believe the Fed’s campaign may ultimately undermine the US dollar’s status as a reserve currency (hence my investment in gold!), I have read the transcript of enough Bernanke speeches to know that he remains committed to the task at hand. Until the Fed takes its foot off the accelerator, it’s difficult to turn bearish on gold. Conversely, once the Fed credibly lays out an exit plan, I will be the first to exit my position, no matter how much money I end up leaving on the table.

2. Despite less media attention given to the situation in Europe, the PIIGS remain in deep financial distress. The situation in Ireland can only be described as a crisis, with the Irish government estimating that up to €50 billion may be needed to stabilize its banking system. Even more staggering, the country is anticipated to run a deficit of more than 30% of GDP this year!

On the other side of Europe, Greek CDS spreads suggest that default is highly likely despite China’s commitment to buy up to $5 billion of the country’s government debt. Even credit default spreads in Spain and Portugal have edged up over the last few weeks, with investors skeptical that announced austerity measures will be enough to get their fiscal houses in order. While this would have been front page news in May, concerns over the PIIGS have receded to the background, as US investors focus squarely on the improving macro data. Despite the best September for the stock market since 1939, little has changed in Europe and investors ought not to forget the fears that existed earlier this year.

3. The mounting problems in the $2.8 trillion municipal bond market are slowly starting to play out. While a discussion of this issue will have to be saved for another post, suffice to say that the recent default by the city of Harrisburg (which was forced to be bailed out by the state of Pennsylvania) will be the first of many defaults by a municipal borrower. Just as the bankruptcy of New Century in April 2007 served as the canary in the coal mine for the subprime debacle, so too will Harrisburg’s default for the municipal bond market. I wouldn’t be surprised if we begin talking about a TARP for state & local governments as we enter the next stage of the credit crisis.

4. As mentioned before, while the market experienced a strong September, this move was hardly confirmed by financial stocks (many of which hit 52 week lows during the month). This lack of confirmation from the leading financials is eerily reminiscent of 3Q 2007, when the stock market seemingly ignored the mounting problems in the credit markets to rally to all times highs in October 2007.

A slowdown in trading activity, flattening yield curve, declining loan growth, and potential for another wave of home price declines/foreclosures, suggests a very challenging environment for the banks over the next few quarters. While the Obama administration is currently taking a victory lap with the apparent success of the TARP program (which is estimated to ultimately cost US taxpayers less than $50 billion), the stalled rally in financials suggests that we shouldn’t quite yet break out the “Mission Accomplished” banners. This is particularly the case as the heightened regulations emanating from the new financial bill begin to take effect.

5. Surplus countries, primarily China and India remain underinvested in gold (with less than 5% of their assets in the yellow metal). While China talks publicly about their commitment to both the euro and the dollar, I have to believe that behind closed doors they are growing increasingly nervous about their currency holdings. Should China and India step up their purchases of gold over the next year, the move from $800 to $1,300 may only be the beginning.

In summary, while gold is on the throes of becoming a crowded trade, I don’t think we have reached the euphoric stage that often characterizes market tops. Similarly, I contend that the fundamentals underlying my original thesis (as noted above) remain firmly intact and that there is still decent upside from today’s levels. As long as central banks remain stubbornly committed to seemingly unending monetary stimulus and competitive currency devaluations ("Beggar the World"), gold should continue to climb to new highs.

2010 - 2018 High Yield Maturity Schedule

2010-09-27T15:27:00.001-07:00

This is a great chart from Knight Libertas highlighting the maturity schedule for high yield and leveraged loans over the next 8 years. While 2010 and 2011 looks manageable ($110bn due through 2011), maturities start to ramp up thereafter with $147bn due in 2012, $245bn due in 2013, and a staggering $405bn due in 2014. As demonstrated in the chart, the lion’s share of the 2014 maturities are comprised of leveraged loans used to finance the wave of borrowing undertaken by PE firms in the 2006 and 2007 LBO wave. While the massive inflow of capital into credit could continue for sometime, I suspect we will hear more and more about this “maturity wall” as late 2012/early 2013 approaches.

Momentum Stocks Getting Bid Up

2010-09-20T14:42:00.000-07:00

While most equity market indices are up only a few percent year-to-date, momentum stocks with strong growth outlooks (particularly in the tech sector) have outperformed significantly. As an unrepentant value investor, this has been a source of deep frustration to me since most of these stocks hardly seemed like bargains going into 2010.

As demonstrated in the table below, I have selected a basket of 10 stocks that loosely fit the parameters of a “momentum growth” stock. The ten stocks include F5 Networks, Netflix, Akamai Technologies, Finisar, Salesforce.com, Citrix Systems, Riverbed Technologies, NetApp, VMWare, and Acme Packet.

Nearly all are up over 50% year-to-date, recently hit fresh 52-week highs, and have business models that fit squarely into the portfolios of managers seeking growth. Unlike the bubble years of 1999, when nearly any tech stock with a “.com” at the end of its name was bid up to ridiculous levels, these 10 stocks have strong competitive positions within very attractive secular growth markets. And most importantly - All are profitable and generating decent free cash flow.

My only contention (and of course the most critical determinant to a value investor) is the massive multiple these companies trade at relative to current and 1-year forward earnings estimates. As an experiment, I am going to pretend that I purchased $10,000 of stock in each one of these ten companies as of the close of 9/20/10. If a similar experiment had been performed at the end of 2009, one would be up 111% year-to-date.

It will be interesting to see how this basket of stocks performs 6 months out when I will evaluate the results on my blog. I honestly have little conviction on how things will turn out, but the value investor in me thinks that most will be substantially lower.

Now I always like to say that I passed on Google when it came public at $85 (and I evaluated it pretty extensively pre-IPO) so my opinion on growth stocks should be taken with a healthy dose of skepticism. However, the disconnect between growth and value seems more extreme than at any point since the waning days of the tech bubble. Perhaps this experiment will lend some credence to this view (or once again make me eat my words!)

I look forward to reporting back in March of next year.

Brazil's Farming Revolution

2010-09-01T16:04:00.000-07:00

The Economist ran with a great feature story last weekend on the tremendous growth of the Brazilian agriculture economy (“The Miracle of the Cerrado”). While it is a fairly in-depth article, one of the more fascinating takeaways is highlighted in the chart below. With only 50 million of its 400 million hectares of arable land currently being utilized, Brazil has significant spare farming capacity to help feed the world’s growing population. In fact, Brazil has as much spare farmland as the next two countries together (Russia and America). Given that the world’s population is anticipated to rise from 7 billion to 9 billion by 2050 (in addition to a doubling of the urban population over that timeframe), Brazil’s agricultural economy will play a vital role in feeding this growing population, which will require a 50% increase in grain output and a 100% increase in meat production.

In addition to being blessed with significant spare farmland, Brazil is awash in fresh water. According to the UN’s World Water Assessment Report of 2009 highlighted in the article, Brazil has more than 8,000 billion cubic kilometers of renewable water each year, more than any other country. Brazil alone (population: 190m) has as much renewable water as the whole of Asia (population: 4 billion).

I would encourage everyone to follow the link to the article (see above) to get a more comprehensive overview of the topic since my amateurish summary leaves a lot to be desired.

California Job Losses & Retirement Costs

2010-08-27T11:20:00.000-07:00

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!

New Home Sales Hit New Cycle Low

2010-08-25T08:44:00.000-07:00

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!

Kyle Bass Interview on CNBC

2010-08-24T19:34:00.000-07:00

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.

Manhattan Condos Embracing FHA

2010-08-13T10:01:00.000-07:00

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.

Bonds Soar to Rare Heights

2010-07-30T05:54:00.000-07:00

Yields on investment grade bonds have shrunk to less than 4%, the lowest level in more than 6 years, and just 1.7% points above treasuries (see front page article on the WSJ – “Bonds Soar to Rare Heights”). In a sign of the times, McDonalds raised $450 million in 10-year debt at 3.5% this week, a record low yield for a US corporate borrower for at least 15 years. Commonweath Edison Co., the electric utility owned by Exelon, sold 4% mortgage bonds at the company’s lowest 10-year coupon since the 1950s.

While concerns of a double dip recession and the reemergence of deflationary fears continue to gain more traction, I believe the stampede into credit will have profound consequences if sustained for much longer. Committing new capital to fixed income at today’s paltry yields could only be justified if one believes we are heading for a Japanese style debt deflation. While I am staying on the sidelines (though maintaining a position in some floating rate debt funds), clearly I am in the minority given the billions of dollars of new money flowing into fixed income funds each week.

Anybody skeptical that the Fed would tolerate a bout of severe deflation should read comments out this morning from James Bullard, the President of the Federal Reserve Bank of St. Louis. Here is a snippet from a research paper released today.

“The U.S. is closer to a Japanese-style outcome today than at any time in recent history,” Bullard said, warning in a research paper released today about the possibility of deflation. “A better policy response to a negative shock is to expand the quantitative easing program through the purchase of Treasury securities.”

Another Solid Month for California Housing Market

2010-07-09T07:00:00.000-07:00

While housing activity on a national basis has declined sharply over the last few months due to the expiration of the $8,000 new homebuyer tax credit, California data for the month of May continues to reflect steady improvement. Given that California led the rest of the country into the housing downturn, it is encouraging to see the region showing concrete evidence of a bounce off the bottom. Notwithstanding the encouraging data from May, June and July will likely show a falloff in activity (similar to the rest of the country), but it is important to put in context the level of healing that has emerged over the last year (see accompanying charts for evidence). Barring a significant decline in the economy, it seems highly unlikely for California to retest the lows in activity and pricing that reflected the state’s housing market in the dark days of early 2009.

As indicated in the chart below, May home sales in Southern California were up 7.2% year-over-year with Los Angeles, Orange County, and San Diego up 12.3%, 22.1%, and 19.6%, respectively. Unit prices were also strong, up 22.5% year-over-year and 7% vs. April 2010. Since bottoming in April 2007 at $247,000, median home prices in SoCal have risen by 23.5% to $305,000. Though prices have risen smartly off the bottom, they are still down 40% from the peak, with pricing in the inland empire down well over 50% off the top.

Similar to Southern California, the Bay Area continues to show significant evidence of a rebound. May home sales were up 11% year over year, with the higher end regions (San Fran, Marin County, Santa Clara) up well over 20%. The trends in pricing were even more encouraging, with prices up 20.1% year-over-year and up 10.8% vs. April. Since bottoming in March 2009 at $290,000, home prices have risen by a sharp 41.4% to $410,000 in May 2010. While mix has undoubtedly padded that figure, all regions tracked by Dataquick have seen pricing up by double digits off the bottom.

Illinois Stops Paying its Bills

2010-07-06T14:49:00.000-07:00

Here is a must read article from the NY Times ("Illinois Stops Paying Its Bills, but Can’t Stop Digging Hole") that highlights the fiscal mess brewing in Illinois. The mounting deficits facing most of our states (with California, NY, and Illinois being the most egregious) presents the gravest threat to the long-term health of our country. Anyone holding muni bonds in their portfolio should think long and hard about the wisdom of this decision after reading the linked article.

Here are some of the key paragraphs from the article:

For the last few years, California stood more or less unchallenged as a symbol of the fiscal collapse of states during the recession. Now Illinois has shouldered to the fore, as its dysfunctional political class refuses to pay the state’s bills and refuses to take the painful steps — cuts and tax increases — to close a deficit of at least $12 billion, equal to nearly half the state’s budget.

Then there is the spectacularly mismanaged pension system, which is at least 50 percent underfunded and, analysts warn, could push Illinois into insolvency if the economy fails to pick up.

States cannot go bankrupt, technically, but signs of fiscal crackup are easy to see. Legislators left the capital this month without deciding how to pay 26 percent of the state budget. The governor proposes to borrow $3.5 billion to cover a year’s worth of pension payments, a step that would cost about $1 billion in interest. And every major rating agency has downgraded the state; Illinois now pays millions of dollars more to insure its debt than any other state in the nation.

The state pension system is a money sinkhole and the most immediate threat. The governor and legislature have shortchanged the pensions since the mid-1990s, taking payment “holidays” with alarming regularity.

The state’s last elected governor, Rod R. Blagojevich, is on trial for racketeering and extortion. But in 2003, he persuaded the legislature to let him float $10 billion in 30-year bonds and use the proceeds for two years of pension payments.

That gamble backfired and wound up costing the state many billions of dollars. Illinois reports that it has $62.4 billion in unfunded pension liabilities, although many experts place that liability tens of billions of dollars higher.

Time to Start Nibbling on Housing Sensitive Stocks

2010-06-23T08:30:00.000-07:00

With new home sales down 32.7% in May, the housing bears are once again gaining an audience with the media. While there is little doubt that housing remains in the doldrums, I am getting increasingly bullish at today’s levels and believe that investors with a longer-term time frame (at least 1-2 years) should think about dipping their toes into housing related stocks. The 30%+ declines in many homebuilders over the last few months provides an attractive entry point for those willing to look past that bevy of seemingly bad news over the last few weeks.

Firstly, the huge swoon in May largely reflects the falloff in activity post the expiration of the $8,000 tax credit on April 30th. Homebuilders aggressively built inventory in the first four months of 2010 in anticipation of pulling would be buyers into the market. As such, we saw new home sales increase by 12.1% in March and 14.7% in April, so naturally we were going to see a steep decline in May. Admittedly, 33% was worse than most pundits expected, but I firmly believe that May’s print will represent the trough in this brutal 5-year housing downturn. To put the 300,000 new home sale in context; this is 8.8% lower than the previous lowpoint (329,000 annualized homes sales in January 2009 – two months after the first tax credit was slated to expire) and a staggering 78.4% below the peak number set in July 2005.

Secondly, the standing inventory of new home sales continues to hit cycle lows (see chart below). In my opinion, this represents a more critical data point to gauge the health of the housing market, since the actual sales number has been significantly distorted by the expiration of the tax credit. May inventories were down 26.7% year over year, 62.7% from the cycle peak hit in June 2006 (nearly one year after the peak in new home sales), and lower than any level since data was first recorded in 1970. So while it is difficult to gauge when sales will pick up with any vigor, the low level of standing inventory suggests the industry is in a substantially healthier position and could realize some unexpected pricing power when things inevitably begin to pick up. A good article in today’s Wall Street Journal ("Beaten Down Markets Finds New Fans") highlights the rapidly declining inventory of finished home lots in several of the nation’s most overheated housing markets. Rising land prices inevitably serves as a precursor to higher home prices.

Affordability also should provide another floor on both pricing and volumes. With a peak to trough decline of 33% in home prices (see chart below) and mortgage rates under 5%, today has never been a better time to purchase a home for those waiting patiently on the sidelines. Further, the government remains extremely supportive of the housing market through its 1) commitment to keep long-term interest rates down (however, distortive these actions may prove to be); and 2) its backstop of the mortgage program through the FHA and GSEs. My firm believe is that the government will continue to flood the market with liquidity should evidence of a double dip begin to gain more traction. Multiple speeches given by Bernake suggest that he will do whatever it takes to stabilize the economy no matter how damaging said actions are on the federal balance sheet.

In conclusion, while concerns in housing have begun to resurface, I think the structural rebalancing that began in June 2005 is nearing its final stages. As with any market, the tendency to overcorrect is highly probable and investors should expect significant volatility over the coming quarters. However, my bias is always to invest when valuations have troughed and fundamentals have meaningfully improved. The upside to today's dismal new home sale number is that the data could hardly get any worse; given how difficult the housing space space has been for the last 5 years that in and of itself is cause for celeberation. For those with a longer-term time frame, investments made at the bottom of the cycle should prove prescient in years to come.

China's Share of Global Demand by Commodity

2010-06-18T13:55:00.000-07:00

Here is a great chart I pulled from a recent BHP Billiton presentation that shows China’s share of global demand by commodity. Amazingly, China accounts for 63% of metallurgical coal demand (key ingredient in steel production), 56% of iron ore consumption (again, key raw material in steel production), 39% of aluminum demand, 36% of copper consumption, and 35% of global nickel consumption.

Long Beach Container Shipments Showing Healthy Growth

2010-06-16T14:55:00.001-07:00

Data on container shipments into the Long Beach Port in California provides an excellent snapshot into the overall economy, particularly as it relates to trade with Asia. As indicated in the chart below, inboard container shipments have experienced significant year-over year growth, with May 2010 shipments growing nearly 27%. Since bottoming in February 2009 (one month before the equity markets bottomed), shipments have grown by a staggering 77%, though remain well below the peak levels of 2007, as evidenced by May 2010 shipments which were still 16.4% lower than May 2007 shipments.

However, for those bullish on the US economic recovery, data from Long Beach certainly helps support that view.

Spain's Monthly Funding Requirements - Watch July!

2010-06-16T06:42:00.000-07:00

As demonstrated in the chart below, Spain faces a substantial funding gap in July, with 25 billion euros maturing during the month.

The country plans to access long-term capital on Thursday with the sale of 4% bonds due 2020 and 4.7% bonds due July 2041. Not coincidently, several press reports have come out suggesting that Spain is in discussions with the ECB and IMF regarding a bailout. Though Spain has vehemently denied these reports, a disappointing auction on Thursday could expedite said discussions. A seize up of interbank lending in Spain has already forced Spanish banks to borrow record amounts directly from the ECB. According to the FT, Spanish banks borrowed €85.6 billion from the ECB last month, more than double the amount lent to them prior to the collapse of Lehman and up from €74.6 billion in April ("Spanish banks break ECB loan record"). In my opinion, given Spain’s devastated economy and weakened banking system, it is only a matter of time before the country directly taps emergency loans from the ECB’s €440 billion stability fund.

However, as a true cynic, I believe talk of an IMF bailout of Spain has been purposely leaked in order to encourage investors to participate in the upcoming auction. Hank Paulson’s analogy about having a bazooka in dealing with Fannie & Freddie serves as a useful illustration in understanding the tactics employed by the ECB in attempting to avoid a direct bailout of Spain. Here is Paulson’s quote:

To Senate Republicans worried they’re being asked to write a blank cheque for federal support to mortgage brontosauruses Fannie Mae and Freddie Mac, Treasury Secretary Henry Paulson offered an intriguing analogy on Tuesday: “If you’ve got a squirt gun in your pocket, you may have to take it out. If you’ve got a bazooka, and people know you’ve got it … you’re not likely to [have to] take it out.” In other words, give me an unlimited line of credit and I probably won’t have to draw on it. But give me X billion and force me to come back for more in three months after that hasn’t worked, and you’ll persuade people the U. S. government is powerless. Then where will we be?

More on the China Property Bust

2010-06-04T13:27:00.000-07:00

As demonstrated in the chart below, April home prices in Beijing rose by a staggering 95% year-over-year vs. a nationally reported figure of 12.8% (though dividing total sales value of homes—384.6 billion yuan ($56.3 billion) in April—and the floorspace sold (72.4m square metres) yields growth of nearly 18%).

While there is little doubt that home prices are set to decline in China, low levels of personal and government debt should help lessen the damage from a property bust. As highlighted by the Economist (“China’s Economic Boom Can Survive a Property Bust”), the ratio of mortgage debt to GDP is only 15.3% in China, compared with a peak of 79% in America. The article highlights the example of Hong Kong’s late 1990s property bust to demonstrate that huge equity cushions should mitigate substantial damage to China’s banking system (unlike in the US and Europe). More specifically, in Hong Kong, where regulators bar mortgages of more than 70% of a home’s value, prices fell by almost half in the three years after the Asian financial crisis, yet mortgage delinquencies peaked at 1.4%. Finally, while mortgage books have grown by more than 70% for certain Chinese lenders, mortgages represent less than 20% of loans for most big banks, and loans to property developers account for perhaps another 8%. As such, banks have substantial capacity to absorb losses in the property sector, even if prices decline on the order of 25-30% (which is a distinct possibility given the massive run up we have seen).

While local government debt represents another distinct threat to the overall economy, particularly since they are heavily reliant on the property sales to fund their budgets, the article suggests these concerns may be somewhat overblown. According to Vincent Chan of Credit Suisse, land sales and property taxes should account for less than 17% of their revenues this year. Further, even if one uses an aggressive estimate of the debt carried by these local entities (11.4 trillion yuan as per calculations done by Victor Shih of Northwestern University), total public debt to GDP would be a manageable 50% of GDP, hardly alarming for an economy growing at over 10% in nominal terms and possessing $2.5 trillion of foreign currency reserves.

China's Property Market Slowing Down Sharply

2010-06-04T10:13:00.000-07:00

Further evidence is emerging that China’s property market has begun to slow, as suggested in the chart below (see: China’s Property Market Freezes Up”). As discussed before, the Chinese government implemented several measures in April, including raising minimum downpayments on second homes to 50%, to help cool the market. On average, the number of residential property transactions in the four weeks after the curbs were unveiled is down 40% compared with the four weeks before the measures, according to figures covering 24 major cities from real-estate consultancy Soufun.com. The sharp slowdown comes as Beijing considers additional measures to push down prices, including imposing new taxes on residential property (though I suspect this will be reconsidered in light of the sharp slowdown already impacting the market).

Similar to the beginning stages of the US property bust, real estate agents and local investors are dismissing the slowdown as a short-term phenomenon. While they recognize that business has slowed, one gets the sense they view the dip as a buying opportunity. This quote from a Chinese real estate agent captures the complacency of the average Chinese person about the potentially serious consequences of a protracted property bust.

“What’s really dampened the market is the uncertainty. That overhang is what’s driving everyone to wait,” said Kevin Yung, executive vice president of IFM Investments Ltd., which runs the Century 21 real-estate agency franchise in China. “We think this could last another three to six months,” he said, a rough forecast shared by other industry executives. “We think prices are going to come down, probably by about 20%, but it will happen over time because this adjustment is driven more by policy than demand” he said.

Warren Buffett Comment on Muncipal Bonds

2010-06-03T09:41:00.001-07:00

Warren Buffett famously called derivatives “financial weapons of mass disruption” way before anyone realized the systemic danger they posed. Regarding municipal debt, I think the following statement spoken at yesterday’s Financial Crisis Inquiry Commission will prove equally as prophetic:

“If you are looking now at something that you could look back later on and say, ‘These ratings were crazy,’ that would be the area,” Mr. Buffett said about state and local government bonds. “If the federal government will step in to help them, they are triple-A. If the federal government won’t step in to help them, who knows what they are.”

Strategic Defaults Threaten Housing Recovery

2010-06-01T05:47:00.000-07:00

One of the biggest concerns weighing on the housing recovery remains the threat from “strategic defaults” by underwater homeowners (estimated at 25% of US households). With the backlog of foreclosures overwhelming the capacity of banks and mortgage servicers to deal with them, many homeowners are able to live rent free for months and potentially years on end. As suggested in the chart below, the average time it takes for a defaulting household to actually lose their property through a foreclosure has increased 75% since 2008 from 251 days in January 2008 to a staggering 438 days as of April 2010. The most egregious state is New York where the average homeowner spends 561 days in foreclosure, following closely by Florida at 518 days. Understaffing banks, government pressure to offer modifications, and incessant legal challenges have allowed millions of homeowners to live rent free, which in my opinion is creating an artificial boost to consumer spending, despite persistently high unemployment. With $2,000 or so freed up from not having to pay one’s mortgage, much of that money is being directed into other parts of the economy.

Some great quotes from a New York Times article (“Owners Stop Paying Mortgages, and Stop Fretting”) on the subject include the following (note how easy the profiled people are able to rationalize walking away from their contracts):
- More than 650,000 households had not paid in 18 months, LPS calculated earlier this year. With 19 percent of those homes, the lender had not even begun to take action to repossess the property — double the rate of a year earlier.
- One reason the house is worth so much less than the debt is because of the real estate crash. But the couple also refinanced at the height of the market, taking out cash to buy a truck they used as a contest prize for their hired animal trappers. It was a stupid move by their lender, according to [the homeowner] Mr. Pemberton. “They went outside their own guidelines on debt to income,” he said. “And when they did, they put themselves in jeopardy.”
- Foreclosure has allowed them to stabilize the family business. Go to Outback occasionally for a steak. Take their gas-guzzling airboat out for the weekend. Visit the Hard Rock Casino. “Instead of the house dragging us down, it’s become a life raft,” said Mr. Pemberton, who stopped paying the mortgage on their house here last summer. “It’s really been a blessing.”
- In Pinellas and Pasco counties, which include St. Petersburg and the suburbs to the north, there are 34,000 open foreclosure cases, said J. Thomas McGrady, chief judge of the Pinellas-Pasco Circuit. Ten years ago, the average was about 4,000. “The volume is killing us,” Judge McGrady said.
- About 10 new clients a week sign up, according to Mr. Stopa, who says he now has 350 clients in foreclosure, each of whom pays $1,500 a year for a maximum of six hours of attorney time. “I just do as much as needs to be done to force the bank to prove its case,” Mr. Stopa said.

Leveraged Loan Index Declines for First Time Since December 2008

2010-05-28T09:49:00.000-07:00

The leveraged loan market is poised to post its first loss since December 2008, with the benchmark S&P/LSTZA Leveraged Loan index down 2.33% for the month. While modest relative to the equity markets, the index had posted 16 straight months of positive performance and has risen over 50% from its December 17, 2008 trough. Unlike the equity markets, the leveraged loan market generally shows a great deal of stability so a 2.3% decline represents a meaningful change.

As I have reported on several occasions, the loan market has gotten very pricey, with leveraged buyers driving incremental demand. Many hedge funds have employed total return swaps (“TRS”) to leverage their positions (essentially, borrowing a meaningful portion of the purchase price from investment banks). With LIBOR less than 50bps and current yields of only 3-4%, the only way to generate mid-teens returns (the hurdle for most credit funds), was to employ meaningful leverage in one’s book. An improving economy and significant liquidity in the credit markets enabled leveraged buyers to outperform the market. Many of those trades are breaking down and should continue to do so as credit spreads widen.

While we have gotten a bit of a reprieve over the last few days, liquidity in the market remains very low and suggests that a great deal of caution is warranted as investors look to bargain hunt. As is often the case, a slowdown in liquidity generally precedes true price discovery in the credit markets and I firmly believe that the worst is far from over. While we could get a bounce in credit over the next few weeks given May’s sharp selloff, rallies should be used as opportunities to lighten positions rather than increase exposure.

Another data point that should signal caution is the sizable outflows in high yield we have experienced over the last three weeks. Last week we saw a massive $1.4bn exit from the high yield markets, on top of a cumulative $2bn withdrawal over the prior two weeks. Cumulative year-to-date inflows are now only $534mm vs. the nearly $4bn we had seen before problems in Greece began making front page headlines.

Here is a good chart from BofA that shows the weekly flows into high yield since late last year. With the exception of two weeks of declines in Mid-February, we have experienced consistently strong inflows into the riskiest parts of credit.

China Reviews Eurozone Bond Holdings

2010-05-26T14:00:00.000-07:00

As discussed in my post on May 11th (“Foreign Exchange Reserves by Currency”), a big trend over the last several years has been an increasing shift in foreign currency reserves from the US dollar into the euro. From 2004 to 2009, the euro’s share of foreign currency reserves has increased from 24.0% to 27.4%, while the US dollar’s share has declined from 66.9% to 62.1%.

Not coincidentally and as reported by the Financial Times today, China has begun to review its sizable holdings of eurozone debt, which the article suggests could be as high as $630bn (~25% of the country’s total reserves). While the US may benefit in the short-term as China reallocates some of its reserves to dollar-denominated assets, I continue to believe that gold will ultimately be the biggest beneficiary as the yellow metal represents a paltry ~1.5% of the country’s reserve assets (as opposed to the dollar and the euro which collectively account for 95% of the country’s reserves).

Here are a few key paragraphs from the FT article:

China, which boasts the world’s largest foreign exchange reserves, is reviewing its holdings of eurozone debt in the wake of the crisis that has swept through the region’s bond markets.

Representatives of China’s State Administration of Foreign Exchange, or Safe, which manages the reserves under the country’s central bank, has been meeting with foreign bankers in Beijing in recent days to discuss the issue.

Safe, which holds an estimated $630bn of eurozone bonds in its reserves [the country’s foreign exchange reserves totalled $2,447bn at the end of March, up $174bn in just six month]., has expressed concern about its exposure to the five so-called peripheral eurozone markets of Greece, Ireland, Italy, Portugal and Spain.

Any move by Safe would mark a significant change in direction, as Beijing has been trying to diversify away from the US dollar in recent years by buying a greater proportion of assets denominated in other currencies.

Another Spanish Bank Fails

2010-05-25T11:40:00.000-07:00

As I reported on April 4th 2009 ("Spain Bails Out First Bank" - hard to believe over one year ago!), the bailout of Caja de Ahorros Castilla La Mancha (known as CCM) by Spain’s central bank, served as the canary in the coal mine that significant problems resided in the country’s banking system. This was particularly the case for the nation’s cajas (small, mutually owned banks controlled by depositors, employees, religious organizations and politicians), which had grown their market share from 10% to nearly 50% and continued to lend aggressively in 2006 and 2007, even as Spain's larger banks pulled back.

Over the weekend, we received another data point highlighting Spain’s troubled banking sector, when the central bank took over a Church-controlled savings bank, CajaSur. While the bank accounts for only .6% of the nation’s banking assets, future takeovers and forced mergers are imminent. In fact, yesterday four savings banks – Caja de Ahorros del Mediterraneo, CajaStur, Caja Extremadura, and Caja Cantabria – signaled their intent to eventually merge their operations. By consolidating, the banks are likely to receive financial support from Spain’s central bank, which will be necessary to sustain their operations.

Leading Indicator Surveys Flashing Red

2010-05-20T12:40:00.001-07:00

Two leading indicator surveys suggest that the rebound in the US economy may be stalling (perhaps explaining the significant decline in the equity markets over the last few days). The ECRI Weekly Leading Index declined by 2% for the week ending May 7th, the lowest weekly decline since October 17, 2008. While this index has periodically declined from week to week over the past year, the 2% drop is significantly greater than any posting since the market bottomed last March (see 1st chart below).

In a similar vein, the Conference Board’s Monthly Leading Index survey experienced its first decline in April, falling a modest .1% (see second chart). While relatively small, the decline represents the first negative data point since March 2009 when the index fell .2%, only to be followed by a sharp rebound in April. Given that the market bottomed on March 9, 2009, most people view this survey as a remarkably prescient reading on were the market and economy are heading. While leading indicator surveys provide little insight into valuations and underlying fundamentals for individual companies, the fact that both surveys are flashing negative warning signs ought not to be dismissed by investors.

Shanghai Property Sales Hit Five Year Low

2010-05-19T10:27:00.000-07:00

Homes sales in Shanghai fell to a 5 year low last week as measures put in place to curb real estate speculation in China appear to be gaining traction. According to Bloomberg, (“Shanghai Home Sales to 5 Year Low”) sales of new homes from May 10 to May 16 fell 16 percent to 60,000 square meters from the week before, the lowest level for the same period since 2005. Despite the sharp fall in volumes, average home prices in Shanghai rose 21 percent to 24,833 yuan per square meter during the month. Price increases in Shanghai are exceeding the national average, which rose 12.8% in April as reported last week by China’s National Bureau of Statistics (see chart below).

While difficult to draw too many conclusions from one week’s worth of data, the sharp falloff in Shanghai property sales has certainly spooked the market, with the country’s main stock index down 21% year-to-date, over 25% from its peak in August 2009, and nearly 10% in May alone. Chinese property developers and commodity sensitive equities have been getting crushed as well.

An ATM That Dispense Gold

2010-05-14T05:35:00.000-07:00

While I have been advocating gold for some time and continue to believe it represents an appropriate hedge in one’s portfolio, pictures like the one below suggest we could be setting the stage for a massive bubble. As frightened Europeans turn their rapidly depreciating euros into hard assets, we will likely see continued upward pressure on the price of gold.

Though it feels good to be riding the wave, at some point central banks will be forced to stop speculative runs on their currency. Though I believe we are months and perhaps years away from such a situation playing out, investors chasing the rally in the yellow metal ought to pay close attention to the commentary emanating from the world’s major central banks. With pledges to keep interest rates at zero, endless guarantees afforded to private sector banks, and incessant money printing, central banks are clearly communicating a message that forestalling a deflationary debt unwind remains priority number one. As such, investors are acting perfectly rationally by selling currencies and buying gold.

However, I am under no illusion that buying gold is a one way bet. Personally, I think we breach the previous inflation adjusted gold price of $2200/ton before central banks feel compelled to defend their currencies (particularly the United States). Again, that day may be some ways off, but at some point inflationary forces building in the economy will force the hands of the supposed protectors of fiat currency.

Foreign Exchange Reserves by Currency

2010-05-11T13:02:00.000-07:00

Here is a great chart from the IMF that shows a breakout of foreign exchange reserves by currency. The key takeaway from the data is that the euro has increasingly grown its share of foreign exchange reserves over the last five years. As of Q4 2009, the euro accounted for 27.4% of foreign currency reserves vs. 24.0% in 2005. Conversely, the dollar’s share of foreign currency reserves has shrunk from 66.9% in 2005 to 62.1% as of Q4 2009. Collectively, the two currencies account for 89.4% of total foreign reserves, with the pound (4.3% of total), yen (3%), and other miscellaneous currencies accounting for the remainder.

Given recent events in the euro zone, I would imagine we see a reallocation away from the euro into the dollar, yen, and hard currencies. Perhaps the biggest beneficiary will be gold, which as I write this post is making new all time highs.

As I have suggested in prior posts, most Asian nations (China, Japan, India, Taiwan) remain grossly underinvested in gold relative to their Western brethren. China is the most glaring example of this with less than 2% of its foreign exchange assets in the yellow metal. Conversely, the US, Germany, France & Italy all maintain gold in excess of 65% of their total reserves. While China is unlikely to get to this level anytime soon, even a relatively modest move to 10% would require the purchase of 4,500 additional tons or nearly two years of total global production (note: annual production of gold is approximately 2,500 metric tons). The implications of this strategic move on the price of gold would be massive.

Greek Bonds Yield Snap Back After EU Bailout Package

2010-05-10T08:12:00.000-07:00

As I highlighted on April 23rd, the recent blowout in Greek’s government bond yields presented a good trading opportunity for those investors willing to bet that the EU and IMF would not let their troubled neighbor default on its near-term debt. While the long-term implications from today’s €750 billion bailout remain extremely troubling, the fact of the matter is that France & Germany have been consistently resolute in their commitment to stand by the PIIGS. In engineering one of the biggest short squeezes in modern day history, Europe has sent a clear signal to those pesky hedge funds that they better not consider “attacking” the euro again. Anybody who thought they were bluffing is not feeling so good today.

As indicated in the chart below, Greek two year bond yields have snapped back from 17.3% on Friday to 7.1% this morning. The increase in price from 79.60 of par on Friday to 95.10 today suggests an overnight gain of 20%. Anybody courageous enough to go long Greek bonds last week would be wise to close out their position given the uncertain environment that lies ahead. While the EU’s commitment significantly diminishes the near-term probability of a default, last week’s footage of riots and anarchy suggests the difficultly Greece will have in implementing the austerity measures needed to secure continued EU and IMF funding.

The most important takeaway from the last two years is that governments remain unwilling to let insolvent institutions fail. Whether it is underwater homeowners, overlevered US banks, or profligate European countries, governments have proven time and again that avoiding the consequences of failure usurps the importance of containing moral hazard. It is unfortunate that an investing thesis predicated on “shaking hands with the government” has proven the winning strategy over the last few years. However, the important point is that this can’t go on indefinitely. Governments simply can’t go on assuming the risk of too big to fail banks or countries before investors begin to lose faith in the currencies that underpin these economies (hence my long-term bullish view on gold).

Thee only difference between Greece and California is about 2 years. Just as irresponsible European countries have been able to borrow at artificially low rates thanks to their association with the EU, so too has California been able to borrow in the municipal bond market at rates that severely understate its standalone risks. However, as Greece has shown us last week, there is no rule against sovereign states or nations going bankrupt.

Implicitly, investors must be assuming that the US government would never let its largest state default. However, as the world’s eighth largest economy, California is simply too big for the US to assume its obligations without the dollar/US treasuries coming under severe strain. Investors ought to keep this in the back of their mind as they celebrate the sharp rebound in today’s markets.

Slowdown in Chinese Copper Demand?

2010-05-04T15:10:00.000-07:00

Here is a good article from the Wall Street Journal ("China Slowdown Pounds Copper") highlighting the recent declines experienced by copper. The article cites a report issued last Friday by the International Copper Study Group which suggested that Chinese demand for copper could drop as much as 13% in 2010 vs. 38% growth in 2009.

With approximately one third of the world’s refined copper consumed in China, the recent 10% decline in the metal’s price should serve as a cautionary data point to those who think China’s Q1 2010 GDP growth of 11.9% is sustainable. This is particularly the case as China takes repeated measures to cool its overheated property market. In addition to raising the minimum downpayment for second homes to 50% in early April, the Chinese government just yesterday raised the reserve requirement for big banks by 50bps to 17% (the third increase since the beginning of the year). Higher lending standards could result in tighter credit for manufacturers and construction companies, which in turn could dampen demand for the red metal.

It is always difficult to judge how these measures will ultimately impact the broader economy, but based on the recent downdraft in China’s stock market (~13.5% YTD), investors appear to be taking a cautious a view (one that I sympthasize with).

Europe's Web of Debt

2010-05-02T19:50:00.000-07:00

Here is a great chart from the New York Times highlighting the interconnectedness of the major EU economies. Perhaps the most interesting takeaway from the schematic is that Greece's debt of $236 billion pales in comparison to that of Spain ($1.1 trillion) and Italy ($1.4 trillion).

European Banks Exposure to Greece

2010-04-28T20:05:00.000-07:00

As suggested in the chart below, French banks have the greatest collective exposure to Greece, holding nearly $79 billion of the country's bonds. In second place are German banks with $45 billion of exposure. As such, while the Eur30+ billion committment from the ECB is being couched as a "bailout" of Greece, a more appropriate characterization would be a bailout of the major French and German banks (hence my belief that a large rescue package is imminent). Not coincidently, France has shown little resistance to the bailout. In order to appease their rightfully angry citizens, German government officials have made a big public stink about the proposed bailout, but they too will eventually come around.

Given the absurdity of bailing out the profligate Greek government to save its own banks, one has to ask why the ECB doesn't just directly inject capital into the German and French banks who will undoubtedly be hurt most by a Greek debt default. While the merits of this path should be explored, I suspect the ECB is concerned about the knock on effects that will undoubtedly spread to Portugal and Spain should they allow Greece to twist in the proverbial wind (particularly as Portugal and Spain have recently received downgrades from the major rating agencies). By bailing out Greece, the ECB will send a message to foreign creditors that the region intends to stand by its members, thereby giving Portugal and Spain breathing room to get their own fiscal houses in order.

While this may be the intention, I remain highly skeptical that Portugal and Spain (and eventually the UK) will avoid a similar fate as Greece. With negative GDP growth forecasted for at least 2010, double digit budget deficits, and structurally high unemployment (particularly Spain which is approaching 20%!), it is only a matter of time before foreign creditors turn against both countries. Most analysts suggest a bailout of the PIIGS could cost the European Central Bank 600 billion euros (~8% of the region's GDP). Such a scenario would gravely impair the ECB's balance sheet rendering it an almost impossible solution. While a bit premature, I think it is only a matter of time before a breakup of the EU begins to seep into the public dialogue. The problem is simply too big and too widespread to fix in the absence of several large defaults.

Ironically, I think the US will be the biggest short-term beneficiary of the contagion spreading in Europe. While our long-term fiscal situation remains far from perfect, it certainly looks a lot better compared to the PIIGS! Since capital has to go somewhere, much of it will likely find a home in the US. With excess capital flooding into the US, real interest rates should remain low, helping to forestall our own day of reckoning. I suppose this is the upside to Europe's woes, but it will only make the fallout from our own debt binge that much worse when the bill inevitably comes due.

GreeK Government Bonds Continue to Blowout

2010-04-23T06:00:00.000-07:00

As concerns over Greece’s fiscal situation continue to mount, the country’s bond yields have blown out over the last few days. At nearly 9%, Greece’s 10 year government bonds yield 585bps points more than that of German sovereign debt (see charts below). Most perplexing about this continuing spread widening is that the EU and IMF have collectively pledged over €45 billion to help bail out the country. As such, I would attribute much of the rapid decline in Greek bond prices to technical factors relating to European banks dumping their holdings for fear of having to come clean to the investment community on their exposure. While Greece has continued to increase their estimate of their 2009 fiscal deficit (currently at 13.6% and climbing), I find it highly unlikely that this would be enough to deter the EU/IMF consortium from standing by its pledge to help. If they did, the contagion risks for other PIIGS nations would be felt immediately (particularly Portugal).

Many investors fear that bondholders will be forced to take a haircut, though Dubai’s recent bailout of Nakheel creditors (with funds that were previously received from its neighbor, Abu Dhabi) shows the pains that sovereign nations will go to in order to remain in good stead with external creditors. When fears over a Dubai World default gripped the investment community last fall, the holding company’s Nahkeel subsidiary bonds plunged to between 50 and 60 cents on the dollar. However, last month Dubai announced that maturing bonds would be paid in full, resulting in a huge gain for those hedge funds willing to bet that Dubai World wouldn’t let its troubled subsidiary go.

While Greece’s fiscal situation is untenable and requires severe austerity measures to bring under control, the recent plunge in its government bonds presents a good trading opportunity for those investors willing to bet that the EU and IMF will stand by their commitment.

On a somewhat related point, I find it ironic how on one hand the German government is lambasting Goldman for selling it subprime bonds backed by troubled US homeowners and on the other hand they are about to write a huge check to bail out Greek pensioners. In a world marked by overlevered consumers and their equally irresponsible governments, there appears to be no easy choices for German savers.

China GDP Grows 11.9% in Q1

2010-04-15T05:44:00.000-07:00

More evidence of China’s overheated economy emerged yesterday with the release of the country’s Q1 2010 GDP estimate of 11.9%. This is the highest reading since Q2 2007 when GDP grew by an impressive 12.6%. In a statement by the country’s State Council accompanying the GDP release, the agency noted “the problem of excessive increases in housing prices in some cities is particularly acute.” This follows on the release of the March property-price index which rose 11.7%, accelerating from February’s 10.7% rise. While concerns are mounting that China will begin raising interest rates, official readings of broader inflation were only 2.4% in March, below Beijing’s target of 3%, suggesting that rate hikes may not be imminent.

Though I firmly believe that China has all the makings of a growing asset bubble (i.e. debt-fueled growth in property prices, an overheated banking system, fixed asset investment approximating 30%), without the government taking decisive steps to prick the bubble, it’s exceptionally difficult to call the top. One of the most dangerous corners of investing is shorting a bubble that has yet to run its course (think tech in 1997/1998). While Lumpy Investor will continue to report on the mounting bubble forming in China, I will do so from the sidelines. Headlines like this: “Time to Deal? Carlyle Raises $2.55 Billion In Asia Fund” suggest to me that we many only be in the early innings of the China saga. Private equity funds are lemmings and I can assure you that every other mega buyout fund is plotting their strategy on how to benefit from the “Asia Miracle.”

The only thing I can say with reasonable certainty is that the longer the insanity takes place, the more painful the reckoning will be when rationality inevitably reemerges.

Mortgage Rates Starting to Creep Up

2010-04-08T15:02:00.000-07:00

With the conclusion of the Fed’s $1.25 trillion MBS program last month, mortgage rates have quietly started to rise. Rates for 30-year fixed mortgages rose to 5.21% last week, the highest rate in nearly eight months. While rates are still low by historical levels, the quick rebound off the December lows (when rates bottomed at 4.71%), could derail the slowly improving housing market, particularly with the planned expiration of the new homebuyer tax credit on April 30th.

Getting Toppy In Leveraged Loans

2010-03-15T10:11:00.000-07:00

One of the greatest investing opportunities that emerged during the height of the credit meltdown in Q4 2008 was the implosion of the leverage loan market. While individual investors can’t access individual loans (since they usually trade in million dollar increments), several closed end funds issued by the big bond managers exist that exclusively comprise these floating rate bank loans.

One that caught my eye in late 2008 was the Blackrock Floating Rate Income Strategies Fund (FRA). While I have traditionally shied away from investing in open or closed end mutual funds, a few things really made closed end funds extremely attractive during the late 2008 timeframe. Firstly, bank loans were trading at 60 cents on the dollar. While individual security selection may have yielded better results, as an individual investor I didn’t have the capital to buy into this market. Buying a basket of high quality bank loans at 60 cents on the dollar seemed good enough.

Secondly, and more importantly in my opinion, an exodus from risky assets, drove the valuations on closed end funds to double digit discounts to net asset value (NAV). In fact, in November 2008, when I began to build a position in FRA, the fund was trading at a remarkable 20% discount to its NAV. Assuming the average security in the portfolio was trading at 60 cents on the dollar, I was able to purchase a basket of secured bank loans at 48 cents on the dollar!

While the credit meltdown left much to be concerned about, bank loan recoveries in bankruptcy have averaged in excess of 80 cents. As such, I felt my margin of safety was sufficiently wide, even under the most dreadful of circumstances. Add in a current dividend yield of 18% paying monthly distributions and I considered FRA a once in a lifetime opportunity.

So what happened? From a purchase price of approximately $8.50, FRA last traded at $16.35 for a 105% gain. Throw in $1.52 of cumulative dividends received since December 2008 for an additional 18% of income, and the total return equates to 123%.

While the appreciation in a reasonably safe security has been remarkable, all good things must come to an end. From a nadir of 60 cents on the dollar, the average bank loan now trades in excess of 90% of its face value. Even more concerning, FRA’s 20% discount to NAV has now turned into a 14% premium. As such, by buying FRA one is buying a portfolio of bank loans in excess of par. While a rebound in LIBOR could validate this premium (since bank loans typically pay interest that is indexed to 3 month LIBOR), I am always concerned when closed end funds trade at a premium to par. This is particularly the case with FRA given the spike relative to its NAV has only occurred within the last few weeks (see chart below).

As suggested in prior posts, the easy money in credit has unquestionably been made. While I will concede that I may be early, I strongly believe that the credit markets have crossed over from being incredibly undervalued in Q4 2008 to reasonably valued in Q2 & Q3 of 2009 to firmly overvalued as we exit Q1 2010. New issue deals oversubscribed by 5-6 times, closed end bond funds trading at double digit premiums to NAV, tens of billion of dollars of monthly inflows into credit funds (i.e. performance chasing), compression of spreads to well below pre-Lehman levels, and growing concerns about inflation, have all heightened my cautious view on the credit markets. Perhaps we get another 150-200 points of spread compression (implying 12-15% of upside on the average high yield bond), but too many uncertainties exist for investors to hold out for this last bit of upside.

New Issue Market is White Hot

2010-03-10T06:43:00.000-08:00

New issuance for the corporate bond market remains white hot, with several deals getting priced over the last few days. As I follow the building products space, I thought it instructive to highlight some of the deals that have been completed in my coverage universe. Notably, two leading suppliers, Masco Corp (owner of Behr paints, Kraftmaid cabinets, Delta & Peerless faucets, Milgard windows and several other leading brands) and Building Materials Corp of America (#1 roofing manufacturer in the US) tapped the bonds markets this week.

As evidence of the exuberance greeting the new issue market, I am told that both deals were approximately six times oversubscribed, with many investors coming away empty ended. Both bonds priced with a mid 7’s coupon and immediately priced up a point or so in the secondary market (further evidence of an ebullient market). As a point of comparison, Masco’s investment grade bonds traded in the high 70s in December 2008 providing investors a compelling 14% yield (nearly double the level currently implied by its new issue). Even more compelling, BMCA’s junior term loan (the piece of paper just refinanced at par as per the new bond deal) traded at 45 cents on the dollar at the depths of the market in December providing a remarkable 25.5% yield. This is even more striking considering that roofing had record years in 2008 and 2009 as asphalt prices collapsed (key input for roofing) and price increases implemented in 2008 were maintained.

While I am hesitant to call the top of the credit markets (particularly, since it could go on for some time), it is very evident that massive inflows into bond funds are compressing yields to unsatisfactory levels (or at least according to my discriminating standards). Investors have tired of earning zero percent yields in their money market & savings accounts and are moving billions of dollars per week into bond funds. This demand is overwhelming the supply of new paper and driving yields back to 2007 levels.

With quality deals like Masco & BMCA oversubscribed by 6x, it is very clear that we could be in the beginning innings of a renewed credit bubble. However, the new issue market is rapidly gaining steam and will eventually break the back of this technically driven rebound in credit. Sometimes I feel like the guy who was talking about a tech bubble in 1996 or a housing bubble in 2003, but I have little doubt that the credit markets have climbed to unsustainable levels. The only point I can make with relative certainty is that the longer this credit mania endures the more painful the reckoning will be when rationality finally creeps back into the market. Until that point, I would be more inclined to be a buyer of equities vs. debt since companies will be much bigger beneficiaries of cheap credit than their mindless lenders.

Analysis of InteractiveCorp Spinoffs

2010-03-05T10:34:00.000-08:00

Spinoffs represent one of the greatest opportunities for diligent investors, particularly when the spinoff occurs prior to a meltdown in the equity markets. No better example illustrates this point than looking at the four entities spun off from InterActiveCorp (Ticker: IACI) on August 8, 2008. While each of the four companies: Ticketmaster (now part of Live Nation), Interval Leisure Group, Home Shopping Network, and Lending Tree declined between 75% and 87% from their initial spin-off price, all have been at least four baggers off their respective lows. Home Shopping Network has been the real star, appreciating by a staggering 1800% off its $1.44 low hit on December 8th, 2008.

Return of Staple Financing for LBO Deals

2010-03-04T19:59:00.000-08:00

It is quite shocking to me that less than one year after the complete demise of the credit markets, investment banks are reportedly offering aggressive "staple" financing deals to faciliate a new round of LBOs. As reported by the Wall Street Journal ("Equity Firms Cheer the Return of Staple Financing; Critics Don't"), Interactive Data Corp, Michael Foods, Hillman Group, and Bresnan Communications have all received staple financing packages in the 5.5x-6.0x debt/EBITDA range. While all four are quality companies that should attract ample interest from prospective investors, the indicative leverage levels harkens back to the 2006/2007 timeframe when purchase multiples were driven to unsustainable valuations due to leverage provided by the selling investment banks. Admittedly, 6x is less than the 7.5-8x that existed at the absolute peak of the LBO boom, but still represents a level well north of historical averages (~4.5-5x).

As I have commented in past posts, I firmly believe that the credit markets are far more overvalued than the equity markets. The compression we saw in spreads last year was due to robust inflows into credit and a lack of new incremental supply (i.e. most of the new issuance volume was due to refinancing). With several large LBOs announced over the last few weeks, including the four mentioned above, the supply part of the equation may finally be tested as we progress through 2010. Should inflows begin to moderate, the technicals of this new supply could force a widening in spreads, particularly if the Fed begins to tighten (though probably unlikely for the remainder of 2010).

China Curbing Lending of Local Governments

2010-02-26T07:04:00.000-08:00

As suggested in this February 25th Wall Street Journal article ("China Feels the Pinch From Tighter Credit"), Chinese central bank regulators are curbing lending to the country's regional governments. These actions, along with a myriad of other policy iniatives including raising the reserve requirement twice this year, prohibiting lending by state banks for the last week in January (after 1.4 trillion yuan of new loans were extended - 20% of the 7.5 trillion yuan target for the entire year), and eliminating the practice of banks selling loans to off-balance trust companies, all reflect increasing concern by government officials that China's overheated economy needs to be restrained.

While local governments are generally prohibited from incurring debt, most set up local companies to take on outside financing. Comforted by their land holdings and an implicit guarantee from the central government (sounds similar to how Fannie/Freddie were able to access cheap capital!), many of China's largest banks lent freely to these investment companies to finance significant infrastructure development.

As noted in the article:
Estimates of the total debt accumulated by investment vehicles set up by local governments range from six trillion yuan (around $878 billion) widely cited in the Chinese media, to the 11 trillion yuan calculated by Northwestern University professor Victor Shih. Those sums—on the same order of magnitude as all the official debt of China's central government—have drawn high-level concern.
Liu Mingkang, China's chief bank regulator, followed up in a nationwide conference call with bank executives on Jan. 26, telling them to "fully assess and effectively guard against risks from local government financing platforms."
The Shanghai Securities News reported Wednesday, citing unnamed sources, that banks had been ordered to stop issuing new loans to investment vehicles that are backed only by local governments' future revenue and have no registered capital.

While most skeptics of a potential Chinese credit bubble point to the country's ample foreign currency reserves and relatively low level of government debt to GDP, it is important to realize how much debt resides "off-balance" in the form of loans to these local investment companies (which as noted before have the implicit guarantee of the federal government). The first evidence of a deflating credit bubble will be when one of these regional governments can't roll over their debt. Many will point to the "excesses of this one local investment company" and give the standard refrain uttered at the beginning of the suprime meltdown that "the blowup is isolated and will not spread to the rest of the economy." However, as the events of 2007-2009 taught us, bad loans from one sector of the economy inevitably restrict lending to other seemingly healthy parts of the economy as banks work to restore their capital reserves. The systemic problems caused by China's highly concentrated quasi-government banking system will only heighten the spread of this contagion.

A February 9th op-ed piece in the Wall Street Journal Asia edition ("China's 8,000 Credit Risks") by Professor Victor Shih does an excellent job explaining the mounting problems of China's regional investment companies.

Historically Low Mortgage Spreads

2010-02-22T08:59:00.001-08:00

Below is a great chart courtesy of David Rosenberg of Gluskin Sheff showing the historical spread of 30 mortgages to treasuries. Historically, this spread is 150bps, but now stands at a measly 20bps. As discussed several times on this blog, the huge compression in mortgage spreads to treasuries reflects the Federal Reserve’s $1.25 trillion MBS buying program, which is slated to end by the end of March. While the Fed could decide to extend the program or use Fannie & Freddie as a backdoor conduit to support the mortgage market (since both organizations now have more flexibility on when they have to shrink their balance sheets), the prospect of higher mortgage rates seems very likely as we progress through 2010.

Japan Displaces China as Largest Holder of Treasuries

2010-02-16T12:19:00.000-08:00

Japan overtook China as the largest foreign holder of US Treasury debt last month. China reduced its holdings of treasuries by $34 billion in December and now holds $755.4 billion of US government debt. Conversely, Japan added to its holdings by $11.5 billion during the month, ending the year with $768.8 billion of treasuries in its portfolio.

In the article, “Japan Reclaims Title of Top Treasury Holder”, The WSJ highlights the mounting concerns that China’s waning interest in US treasury debt could have for our ability to finance our growing deficits.

The purchasing behavior of China has been troubling to some analysts and potentially to a U.S. government that is seeking to borrow a record amount this fiscal year. The latest shift would seem to reinforce market worries that China is tiring of its role as a key creditor to the U.S. amid rising budget deficits and tensions between Beijing and Washington.

While fiscal problems in Europe could provide a short-term boost to the United States, particularly from “safe haven” buyers, the long-term threat from declining support from China (seeking diversification) and Japan (as the country inevitably shifts from a creditor to a debtor nation) should be the cause of great concern for investors.

Another Rise in FHA Default Rates

2010-02-10T13:43:00.000-08:00

In its latest report to HUD, the Federal Housing Administration disclosed that its default rate (loans more than 90 days delinquent) increased to 9.12% as of December 2009 vs. 6.82% in the prior year. More specifically, 531,671 of the 5.8 million loans insured by the FHA were in default, a staggering 66% year-over-year increase. As expected, Florida led the pack, with the state comprising 16 of top 25 most delinquent MSAs. Michigan had 4 cities in the top 25 and New Jersey had 3. The MSA with the highest default rate was Punta Gorda FL, with nearly 23% of its FHA-insured mortages at least 90 days or more in arrears.

Foreclosure Filings on the Rise

2010-01-28T09:45:00.000-08:00

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.

2010-01-25T18:35:00.000-08:00

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.

Number of Stocks Hitting New Highs on the Decline

2010-01-21T12:02:00.001-08:00

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.

Bank of China Orders Slowdown in New Loans

2010-01-20T18:52:00.000-08:00

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

2010-01-20T06:14:00.001-08:00

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

2010-01-20T05:12:00.000-08:00

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.

Net Funding Requirements of the US Government

2010-01-15T08:06:00.000-08:00

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.

China Again Tightening Lending Requirements

2010-01-12T13:13:00.001-08:00

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).

Adjusted Unemployment Rate Analysis

2010-01-11T08:51:00.000-08:00

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.

Comparison of 1982 to 2009

2010-01-08T11:42:00.000-08:00

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.

Chinese Decision on Rates Seen as ‘Turning Point’

2010-01-07T06:20:00.000-08:00

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!

The Year in Review for High Yield

2010-01-04T06:34:00.000-08:00

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.

Leverage is Back in the Credit Markets

2009-12-30T06:31:00.000-08:00

Last night I had dinner with a friend who works as a bank loan trader for a large and distinguished credit-focused hedge fund. We were chatting about the wild ride the credit market has taken over the last two years and commiserating how difficult it will be to make money in 2010 given how much spreads have narrowed since the depths of the market swoon last December.

In casually noting how difficult it is to get excited about bank debt trading at close to par (vs. 40-60% of par one year ago) with skimpy spreads and LIBOR close to zero, my friend told me his fund is now employing what is called a Total Return Swap (“TRS”) to juice their returns. Essentially, a TRS is a form of financing provided by an investment bank that allows an investor to lever their returns (i.e. if a security is trading at 80 cents on the dollar a hedge fund could finance some portion of this purchase to turn a low return investment into one with a mid to upper teen yield).

At the height of the credit bubble in 2007, levered purchases of bank debt were fairly common and contributed to the madness. However, this mountain of leverage came crashing down in 2008 when the trading levels of most securities fell below the face value of the debt issued to finance their purchase (akin to the price of a home falling substantially below the value of its mortgage).

As my very crude example below demonstrates, the use of a TRS can help juice a security with an otherwise paltry 5% current yield into a highly attractive 15% clipper (admittedly, the use of 80% leverage is probably high, but certainly existed at the height of the credit bubble). Since my firm never employs leverage in any of our purchases, much of the bank loan market has now been rendered off-limits to us.

Should liquidity in the credit markets remain robust and the economy continue to heal, many of these investments will pay off handsomely. However, it’s quite disconcerting to me that not only is leverage quickly coming back into the system, but that it is the leveraged buyer is who driving the sharp rebound in asset prices. Does the memory of investors extend beyond one year or is 2008 sufficiently in the past that we are ready to go back to our old ways?

Another somewhat related point – how perplexing is it that investment banks are willing to lend to hedge funds (who are using the cash to drive asset prices higher), but most Main Street businesses who operate in the real economy still can’t get a loan.

Investing Outlook and Strategy for 2010

2009-12-23T07:02:00.000-08:00

Here is an article from the FT confirming that large hedge funds are betting on inflation. Obviously, there is nothing earth shattering in this article since Robertson has been touting his “steepner trade” since Jan 2008 and Paulson is the largest holder of the GLD (in addition to marketing a new gold focused fund), but thought it was interesting to point out how funds are positioning themselves to make money in 2010.

In reflecting on the market bottom that we hit in March 2009, if you had told me that the high yield index would be up 55% this year, leveraged bank loans up a similar amount, the Nasdaq up 40+%, the S&P up 60% from its March lows, gold at $1100 (having crossed $1200 along the way), I would have thought it nuts to see the 10-year at only 3.7% (and around 3% for much of this rally!). This goes to show you the incredible effectiveness of the monetary experiment initiated by the Fed. Essentially, quantitative easing (primarily through the Fed’s $300 billion treasury purchase program and $1.25bn agency-backed mortgage program), has kept the back end of the curve fairly low, even with a powerful rally in risky assets. One can chastise the Fed for its involvement in the financial system and dispute the long-term merits of such action, but in no way can one debate how successful it has been in the short-term. The ponzi-esque nature of the Fed’s actions are legendary (i.e. buying unwanted assets in the open market to keep their yields low and allow the treasury to fund our fiscal deficits at rock bottom rates), but even Madoff’s investors felt great in the beginning years. However, based on the recent rise in the long end of the curve it’s unclear that our creditors will remain as committed to us as Madoff’s unwitting investors were to him.

Rapped up in this “inflation” trade is actually a very bullish view on the economy. Assuming the Fed keeps rates negligible for some time, which is my own personal opinion (hardly differentiated, but certainly confirmed by Bernake’s extensive work on the failings of the Fed during the Great Depression), we could see a fairly powerful rally in the stock market for the early part of 2009. As forceful as the rebound has been off the March lows, the individual investor has remained almost entirely on the sidelines. This is confirmed by the persistent negative fund flows into equity mutual funds. March represented a capitalization of sorts on the downside; the pervasive skepticism that has greeted the current rally is hardly reflective of market tops.

I routinely like to call a bunch of friends in the industry to take a very informal poll of their mood and that of their firms. I like to say that everyone was a micro bottoms up investor in 2004-early 2007 and ignored (except John Paulson and a few other astute investors) the macro clouds hanging over the global economy in 2005/2006. Well in October 2008 to March 2009, everyone all of a sudden became a “macro investor.” Concerns over the systemic risk of the banking system, the Fed’s irresponsible involvement in the financial markets, and the death of capitalism dominated the conversation. Such “boring” things as single digit PE multiples off of cyclically depressed earnings and free cash margins in the double digits (for even unlevered companies) all of sudden became irrelevant in the context of the impending doom of the financial system.

As we emerged from the depths of the March lows, massive amounts of skepticism greeted the market rally. People conceded that asset prices were extremely cheap, regretted that they hadn’t bought more, but also doubted the sustainability of the rally. The “green shoots” sprouting in the economy (i.e. house price stabilizing in California, inventory liquidations abating at most large companies, credit worthy borrowers accessing cheap credit) were either ignored or outright dismissed by those seeking confirmation of their bearish bias.

As I stand here now in December 2009, I can sense a clear shift in the mood of my fellow investors. Skepticism is melting away as people are simply tired of being bearish. The macroeconomic concerns that dominated the conversation over the last twelve months are being replaced by “M&A is back”, “companies still look reasonably priced on historical metrics”, “which companies stand to benefit from China growing 10% next year.” In short, all the discussion topics that would have served investors well in March; ones that I found so hard to engage people in less than a year ago, are only now beginning to resurface.

While the individual investor still remains on the sidelines, the hedge fund community has clearly embraced this rally. Until the former joins the party, I think we could see a continued rally in the market, perhaps materially so. Improving economic data that will most surely surface in the early part of 2009 will only confirm this increasingly bullish disposition. However, as an unrepentant contrarian, I think investors should not so easily dismiss the “macroeconomic” views they so diligently added to their investing toolkit at the bottom of the market. An improving economy will have the perverse effect of encouraging the Fed to extricate itself from the economy. This is particularly the case as it relates to housing, which I have repeatedly pointed out since starting this blog, has been on an improving trend for much of 2009 (do in no small part to the strong hand of our government).

The Fed’s decision on whether or not to extend the $1.25 trillion mortgage-backed security market (set to expire at the end of Q1) will serve as the seminal data point on the sustainability of the market rally. Should they let this program expire, the impact on mortgage rates, housing, and the banking system will be immediate. The reverberations of this in the overall economy could take a few quarters, but under such a scenario I think 2010 could end up disappointing a lot of investors as we exit the year. On the flip side, should the Fed maintain its overall accommodative stance by keeping rates low and extending many of its liquidity programs, we could see a sustained rally for some time. At some point, the reckoning will have to come, but I doubt it will happen in 2010. If 2009 has taught me anything, it’s to never doubt the short-term impact of a massive Fed-induced monetary experiment.

Bernake and Co. unleashed every weapon in their arsenal to prevent another Great Depression. As long as they continue their fight, and Bernake’s academic background leaves little doubt that he remains committed for the long haul, it remains pointless to fight the Fed. The ramifications of sustained monetary stimulus will be inflation, which underpins the short treasuries/long gold thesis dominating the investing strategies of many hedge funds going into 2010. I remain in this camp, though I concede I derive little comfort from the growing consensus forming around this thesis. A sharp reversal in Fed policy will warrant a reassessment of this investing strategy, though I think investors will be well-served by maintaining a strong bias to equities and gold as we enter 2010.

Job Openings - Leading Indicator of Job Growth?

2009-12-20T14:40:00.001-08:00

While the employment picture remains grim in the United States, the number of job openings has increased by over 4% since bottoming in July 2009. As a leading indicator, this provides a bullish data point for the employment situation as we close the books on 2009.

A few points explain the spike in job openings. Firstly, the increase in listings reflects the normal frictions that occur in the labor market as companies prepare for an increase in employment. After all, you need to post a job offering before actually hiring someone. Secondly, with the pool of unemployed workers in excess of 15 million, companies are rightfully being very discriminating in who they seek to hire. Most executives remain suspicious of the apparent rebound in the economy and want to make especially sure they have a need for additional workers before adding to their payrolls.

However, I believe a third factor is having the greatest influence on job openings without a commensurate increase in employment. Simply put, the administration's repeated extension of unemployment insurance is making out of work Americans more selective in what jobs they are willing to settle for. As explained in this very enlightening NY Post article ("The Stimulus for Unemployment") if you subsidize something (i.e. unemployment) you get more of it. Extending unemployment benefits from 26 to 79 weeks has removed the ballast of necessity for many unemployed folks. Why settle for anything less than ideal when the unemployment check keeps rolling in?

With the benefit of hindsight, the administrations's worst case assumption of 9% peak unemployment used in the bank "stress tests" seems patently laughable. This has been the source of much ribbing by investors and economists alike. Ironically, it may be the administration's actions regarding unemployment insurance that resulted in such a sizable divergence from their original estimates. As suggested in the referenced NY Post, the government's forecast may not have been too far off if it left the labor market to its own devices.

China's Empty Cities

2009-12-18T07:12:00.000-08:00

A good friend alerted me to the video below, which demonstrates the incredibly inefficient capital investment taking place in China as a result of its 4 trillion yuan stimulus program (~US$600bn). The video features the city of Ordos, intended to hold over 1 million people, but which remains virtually uninhabited.

The story of Ordos reminds me of the unoccupied homes on Dubai's palm-shaped islands. 60 Minutes did a great two-part segment on the country in August 2008. Here is a link to the video: A Visit To Dubai Inc.

While I remain convinced of China's long-term growth potential, there is little question that the government has fomented a massive investment bubble that will undoubtedly end very badly. While there are innumerable data points to support this view, a few stand out. Firstly, average Chinese home prices are nine times median household income, on par with the peak levels reached at the top of the US housing market in even the most speculative cities (more normalized levels should be ~2.5-3x income). Secondly, the volume of property sales has risen by 85% in 2009 and prices of new apartments in Shanghai have risen by nearly 30%.

While concerns over Dubai and Europe's "PIGS" dominate headlines, China scares me infinitely more. Dubai has public and private market debt of approximately $60-$80 billion depending on which source you believe (Dubai World, where much of the troubled debt resides, comprises just $25 billion of this total). On the other hand, Chinese banks unleashed over $1 trillion into their domestic economy in the first six months of 2009 alone! On an annualized basis this equals approximately 50% of GDP. After forcing them to aggressively lend earlier this year, the Chinese government is now encouraging banks to shore up their capital bases. Such a dramatic change in direction should not be dismissed lightly. (see: Chinese Banks Study Plans to Boost Capital).

Lending by government decree has undoubtedly contributed to the country's 8-9% GDP growth, but one has to question how efficiently such capital was invested. While there is little tangible data to support this assertion, most pundits speculate that a good chunk of this lending (perhaps a 1/3) was directed to real estate and stock market speculation. The video below provides some convincing anecdotal evidence to support this claim.

More Evidence of a Bottom in Housing

2009-12-16T06:41:00.000-08:00

While housing activity will likely remain subdued over the next year as inventory in the existing home market gets whittled down, the data below provides convincing evidence that the new home market bottomed earlier this year. From the peak in September 2005, housing starts hit a trough in April 2009, some 79% below its peak levels. Subsequent to that time period, total starts have risen a healthy 19.8% and single family starts an even more robust 35.0%. While permits and housing starts have firmly rebounded, homes under construction continue to hit new lows in November 2009, suggesting the new home market could experience a rebound in pricing over the next year, particularly if mortgage rates remain at rock bottom levels.

Is Gold a Good Long-Term Investment?

2009-12-01T13:04:00.000-08:00

Here is my response to a friend’s comment that “gold is a good long-term investment”.
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I am not sure I would ever hold a commodity “forever” and I disagree vehemently with your statement that gold is a good “long-term” investment. The nature of commodities is that high prices ultimately choke off demand and/or result in increased supply. Gold seems to be in the sweet spot of the cycle since annual supply continues to decline (despite the higher prices) and demand remains very strong among investors and central banks. However, nothing suggests that this dynamic will last indefinitely.

Remember gold was in a secular decline from 1980 to 1999 so while it has risen a lot since 1999, it will come back down hard at some point. It could take 5-10 years (frankly, I have no idea), but there is little doubt that it could come crashing down. The near consensus global view forming around gold's preeminence as a store of value should only serve to spark your interest in how best to short it. There is still much skepticism around its recent run; as such it could continue going higher (hopefully, materially so since I remain long through the GLD and options on the GLD). However, there will come a time where even the most ardent skeptics throw in the towel and the most strident bulls bask in their fleeting fame as TV personalities (many of which are already coming to the fore). At that point, I hope I am smart enough to spot the cracks in the bull case. Usually, it’s the most levered buyers who serve as the canary in the coal mine. To the best of my knowledge (albeit limited), I don’t think the current bull market in gold is being driven by the leveraged speculator and so the “foolishness” that characterizes most bubbles has yet to surface.

Every time a speculative bubble gets underway, I always try and call the top and every time I am always way too early. However, without fail no matter how high things go they always end up materially lower than ever I thought possible. So my point is that even if gold goes to $2,000, $5,000 or whatever, once investors’ faith is restored in paper currency, gold will decline precipitously. It is hard to imagine a world where paper currency reclaims its spot as a favored store of wealth; then again, it’s always difficult being a contrarian when others are getting rich riding a speculative wave. While the comment that investors will one day come to value paper currency again seems asinine given the ubiquitous money printing and fiscal deficits being run by nearly every developed economy; I can assure you that asserting in 1999 that gold would breach the $1,000 level seemed equally as preposterous.

The only thing I would blindly hold forever is the equity of an excellent company. Give me an early stage Coke, Disney or Microsoft and I will give you every ounce of gold residing in my portfolio (no matter what the concerns surrounding inflation are). There is absolutely no better way to generate long-term wealth than buying and holding the stock of great companies residing in countries undergoing secular growth. No matter how high gold goes, nothing will shake my conviction that equities remain a far superior long-term investment.

Bullard Comment on Fed's Asset Purchase Program

2009-11-23T08:15:00.000-08:00

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

2009-11-20T05:38:00.000-08:00

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

2009-11-18T15:31:00.000-08:00

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%

2009-11-17T15:43:00.001-08:00

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

2009-11-11T06:38:00.000-08:00

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

2009-11-04T15:20:00.000-08:00

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

2009-11-03T07:56:00.000-08:00

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.

Weekly Railroad Data - Still Negative

2009-10-28T10:25:00.000-07:00

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.

America's Growing Short-Term Debt

2009-10-27T13:28:00.000-07:00

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.

Lend America Faces Probe for Alleged Fraud on FHA Loans

2009-10-25T12:55:00.000-07:00

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.

A Top of the Market Quote From the Chairman of CIC

2009-10-23T12:50:00.001-07:00

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.

VIX Index - Where's the Fear?

2009-10-15T12:37:00.001-07:00

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

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

2009-10-09T13:02:00.000-07:00

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.’ ”

Higher Downpayment for FHA Loans?

2009-10-01T12:26:00.000-07:00

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.

FHA - Leverage Ratio Exceeding Bear Stearns

2009-09-30T07:13:00.000-07:00

As indicated in the chart above (courtesy of yesterday’s WSJ), the FHA’s leverage ratio has increased from a modest 14: 1 in 2003 to an expected 50:1 by the end of 2009. This far exceeds Bear Stearn’s 33:1 leverage at the time of its rock bottom sale to JP Morgan. While the FHA continues to insist that they won’t need a federal bailout, similar to the claims made by Fannie and Freddie prior to their government takeover, a mere 2% loss rate would wipeout the FHA’s capital position. Given that its loan delinquency rate (more than 30 days due) exceeds 14%, a national unemployment rate slowly creeping towards double digits, and the agency’s subprime like borrowers (who only have to come up with a mere 3.5% to qualify for a loan) I remain highly skeptical that the agency will avoid seeking some sort of federal assistance.

While yesterday’s Case Shiller index provided yet another positive data point for housing (only 2 of the 20 regions in the index posted sequential declines in housing), it is important to emphasis how dependent housing has become on the government. As I indicated in my prior post, the FHA’s market share has increased from a mere 2.7% in 2006 to approximately 25% today (and 40% in August alone!). The agency insures approximately $750 billion of mortgages today from $410 billion in 2006. Even more concerning is the projected growth in the agency’s portfolio, which is expected to exceed over $1 trillion by the end of next year. As a point of reference, Fannie and Freddie collectively insure approximately $5 trillion of mortgages or half all of all home mortgages.

Remember how fragile this housing recovery is the next time you see those shady infomercials encouraging you to refinance into an FHA loan. However, instead of some faceless pension fund in Japan taking a loss on its portfolio of securitized subprime Countrywide mortgages, US taxpayers will be left holding the bag from these busted FHA loans.

Japan's Demographic Time Bomb

2009-09-30T06:05:00.000-07:00

This weekend’s Barrons featured a very grim article on Japan’s demographic time bomb (Is the Sun Setting on Japan?). Although I have always appreciated the structural debt & population challenges facing the country, I never really understood how grave they were. Some scary data points from the article include:
- Japan's gross national debt now equals 217% of its gross domestic product, compared with 81.2% for the often-maligned U.S. and an average of 72.5% for the G-20 nations (the 19 largest economies, plus the European Union), according to the International Monetary Fund.
- The latest United Nations median forecast estimates Japan's population will fall from a current 127 million to just 101.6 million by 2050 (a decline of 20%), while the U.S. count will rise from 317 million to 404 million.
- The number of Japanese of prime working age (15 to 64), which totaled 83 million in 2007, is likely to tumble to 49 million in 2050, while the over-65 cohort jumps from 27.5 million to nearly 38 million. This implies more than 77 elderly dependents for every 100 workers by 2050, compared with just 33 per 100 now.
- Japan's household savings rate—more than 20% in the early 1970s—has dipped to about 3%. That's less than U.S. households' 4.2% as of July.
- Japanese businesses are highly inefficient and shielded from domestic and foreign competition by complex regulations. Output per man-hour in Japan trails that of the U.S. by approximately 30%.

While many pundits are encouraged by the strong victory of the Democratic Party of Japan (DPJ) in last month's national elections (which has promised to implement badly needed structural reforms to the country’s ailing economy) it will be extremely difficult to overcome the demographic tsunami facing the country. If you are not a Barron’s subscriber and would like to read the article please send me an email and I will be more than happy to forward along.

Government Involvement in Housing Market

2009-09-18T13:45:00.000-07:00

As noted repeatedly over the last few months, several recent data points suggest the housing market has begun to improve off the unprecedented lows reached in April. Seasonally adjusted housing starts are up 25%, standing inventory of existing homes has been whittled down to 9.4 months (vs. over 11x months at the peak, though well above the 4-6 months indicative of a healthy housing market), and pricing has begun to firm, with the Case Shiller Index posting its first sequential monthly increase since July 2006. Although some regions of the country continue to experience declines (Vegas and Phoenix being amongst the most troubled), the recovery has generally been broad based, with some of the hardest hit markets (southern California, western Florida) demonstrating the strongest hints of recovery.

While a stabilization in the housing market is encouraging, investors must realize how critical the government’s role has been in driving this improvement. Firstly, the $8,000 tax credit for new homebuyers has significantly brought forward demand. This is particularly the case in California where residents also benefited from a $10,000 state-specific tax credit (though the program’s funding was exhausted in July). Further, mortgage rates have been artificially suppressed thanks to the Federal Reserve’s program to buy $1.25 trillion of mortgage-backed securities and up to $200 billion of Fannie & Freddie debt securities by year-end. With a combined $810 billion expended to date on these two programs (see below), the Fed has kept conforming interest rates below 5.5%. Low mortgage rates and 30% peak to trough declines in home prices have resulted in off the charts affordability. However, once these spending programs are exhausted, we are very likely to see mortgage rates creep up. Even a 50-100 bps widening could have a meaningful impact on the housing market, particularly as unemployment moves towards double digits.
Despite the one-time tax credits and government orchestrated effort to suppress mortgage rates, no federal program has been more distortive than the Federal Housing Administration (FHA). Created during the Depression to help minority and poor households realize the promise of homeownership, the FHA has become the government’s vehicle to prop up the housing market. With required downpayments of only 3.5%(much of which will be recouped through the $8,000 tax credit), the FHA has essentially taken the place of subprime in providing financing to at-risk borrowers. In 2006, the FHA insured 2.7% of all loans in the United States. Year-to-date, the agency has provided a government guarantee for 23% of all new mortgages and nearly 40% in August. Many of the public builders suggested in their most recent earnings calls that between 40% and 75% of all their buyers received FHA-insured mortgages last quarter. In fact, when combined with Fannie and Freddie, the government is now insuring close to 90% of all home mortgages and probably close to 100% for all new home buyers (see chart below)!
Several recent articles have highlighted the problems festering in the FHA. In fact, this morning the Washington Post ran an article suggesting that the FHA could breech its minimum capital ratio of 2%. Further, some 7.8% of FHA loans at the end of the second quarter were 90 days late or more, up from 5.4% a year ago. Even more perplexing is that the agency has never operated with a chief risk officer and has only recently sought to fill the position (even AIG Financial Products, Countrywide, and Lehman had chief risk offers!).

While the government will likely continue to support the housing market through the FHA, particularly with the 2010 election around the corner, I would be extremely wary of the headlines suggesting that the housing market is on stable footing. Just as Fannie, Freddie, and later subprime massively distorted the housing market over the last decade, so too has the FHA.
I will continue to report on this organization and Ginnie Mae (the government agency whose primary function is to guarantee mortgage backed securities comprised of FHA-insured mortgages) over the coming weeks and months. While I will also continue to highlight the improving trends in housing, it is always with an eye towards the government’s overarching influence that my enthusiasm will be vastly tempered.

Rapid Growth in e-book Sales

2009-08-28T05:32:00.000-07:00

Great chart above showing the steep rise in e-book sales since the end of 2008. E-book sales were $37.6 million in Q2 2009, rising 45.7% from Q1 2009. In June alone, e-book sales were $14mm or 1.5% of the month’s overall book sales of $942.6 million. While still a tiny sliver of the overall book publishing market, sales are set to rapidly rise over the coming year with several new products in the pipeline including a new wireless reader by Sony (launched on August 25th), Apple’s highly anticipated tablet (hopefully released by Q4 2009, but more likely in early 2010), and Plastic Logic’s 8.5 x 11 inch touchscreen device (sometime in 2010). Further many of the new product launches, including Sony’s new Reader Daily Edition, are using a more open approach, allowing for easier use of content across multiple platforms. The leading open format appears to be EPub, created by the International Digital Publishing Forum, and utilized by Sony’s new device.

China's Underconsumption

2009-08-14T04:45:00.000-07:00

Great chart from the Economist showing how little Chinese consumption comprises of the nation's GDP -approximately 35% vs. nearly 70% in the US. In fact, despite signficant growth in the nation's economy over the last decade, consumption as a percent of GDP is actually down from 49% in 1990. With over 1.3 billion people, a robust and growing economy, maturation of the country’s financial system, and the government’s increasing focus on expanding its social safety net for its aging populace (which discourages saving and permits a higher level of consumption during one’s most productive years), the Chinese consumer remains the most compelling investment story of our generation.

NY Law Firm Sees Big Reduction in Rent

2009-08-02T19:06:00.000-07:00

The following WSJ article provides a pretty scary datapoint about the state of NYC commercial real estate market. According to the piece, the law firm Orrick, Herrington, & Sutcliffe, recently signed a lease in the CBS Headquarters building located at 51 W. 52nd Street in the low-mid 70s per square foot vs. $120-$140 per square feet for equally comparable real estate at the top of the market in 2007. Further, the landlord agreed to contribute $150 per square foot of improvements, allowing Orrick to move into the location with essentially no out of pocket expenses.

The article also quotes a Reis study that suggests that the vacancy rate in Midtown Manhattan has spiked to 10.6% vs. only 5.9% pre-Lehman (enough to fill 6 1/2 Empire State Buildings) and rents have fallen by 7.2% over a similar time period.

While evidence continues to mount that the worst of the recession is behind us, particularly in the lower end of the residential real estate market, Orrick's experience suggests that the commercial real estate downturn has only just begun.

http://online.wsj.com/article/SB124882179252188243.html