Tuesday, December 30, 2008

Home Prices Continue to Slide

The latest Case/Shiller data is still pointing towards more decline in the housing market. According to the index, home prices have retreated back to early 2004 levels.

The peak in the market was in early 2006, so far the market has dropped about 23% from those highs. Based on the supply of reserves held at the Fed (see post from last week) and the level of residential mortgage rates, neither lenders or borrowers believe the bottom is in sight.

Household creation seems to be at a secular norm, so I can't see how the market can correct itself in less than 3-4 years. The Center for Economic Policy Research published a paper a few summers back that stated that home price declines were the major cause of default, not interest rate increases. The recent data prove that to be the case.

My humble guess: another 20% decline from current levels is needed to clear the market. This would point to a bottom during the 3rd quarter of 2009 and represent a 40% drop from the 2006 peak.

Friday, December 26, 2008

Pop Vox in 2009

Thanks to all for reading and sharing comments since I started this blog in September.  I hope that this has provided some helpful nuggets of info and opinion.  For me, it has proved to be a wonderful outlet for my ideas and observations, a great way of thinking out loud.

For the New Year, I would like to really get this blog going in terms of new "posters" and more commentary by readers.  I have received some constructive criticism on site design and content and I would welcome more. 

Thanks again.

Nothing Changes on New Year's Day

Happy holidays to all and best wishes for 2009. It has been a year unlike few living have witnessed before. Alas, 2009 has been set up for an impressive encore of capital dislocation and volatility.

The expansion of TARP participants has reached preposterous proportions. The loans that were granted to General Motors and Chrysler were funded by the TARP. In addition, the following corporations have applied for bank holding company status so they can participate as well. As you recall, Goldman Sachs and Morgan Stanley converted to bank holding companies a ways back to save their skins. Oh, don't forget about AIG. TARP funds were used in that rescue too.

- American Express: conversion complete, awaiting $3.5 billion in funds

- GMAC: conversion approved this week, potential $6 billion in funds available

- Genworth Financial: in the process of acquiring a bank and converting thereafter

- Hartford Financial: in the process of acquiring a bank and converting thereafter

- Lincoln Financial: in the process of acquiring a bank and converting thereafter

- Protective Life: in the process of acquiring a bank and converting thereafter

- CIT Group: conversion approved, potential $2.5 billion in funds available

- Discover Financial: conversion approved, potential $1 billion in funds available

Is this really what the TARP was intended for? There is no penalty for making a poor business decision. All a company needs to do is file some paperwork and the taxpayer pays the bill.

Monday, December 22, 2008

Pushing on a String Revisited

Through several posts, I had mentioned that the availability of funds did not imply the use of funds. Unless the Federal government is going to make all of the economic decisions, it is incapable of insuring that the money supply is replenished to the same extent to which it is being depleted by bad loans.

The first graph depicts the ratio of total reserves to required reserves. A bank makes virtually no money holding on to reserves. In theory, they would rather make loans than just let the reserves sit with the Fed. For the last 20 years, the ratio has been about $1.03:$1.00 (banks held only 3 extra cents in reserves over the stated minimum).

The second graph contains the same data, but includes the last few months. The number is astonishing: $12.10 to $1.00 as of November and about $16 to $1 currently.

Unintended Consequences

Why are yields so low in the Treasury market?  Focusing on the longer dated maturities (10 - 30 years):

-   Continued flight to quality.  Treasuries are backed by the full faith and credit of the Federal government, i.e. its ability to tax citizens.

-   Slowing economy.  Whether we wind up with disinflation or deflation, the future purchasing power of the earned interest and principal SEEMS to be safe.  You can think of a risk free bond yield as a combination of an inflation component and a growth rate of the economy component.  Neither one seems to be poised to move higher in the near term.  The market is becoming more confident in that assumption, so they are buying longer dated bonds.

-   Mortgage market hedging.  This is the big one.  A mortgage payment is composed of both principal and interest.  The string of cashflows is impacted by current mortgage rates because of the motivation to refinance.  As rates fall, the value of outstanding mortgages increase slightly.  But if the rates fall too much, refinancing activity will cause the prepayment of outstanding mortgages and erode the value of a bank's portfolio.  To hedge this risk, mortgage holders need to acquire securities that will continue to add value if rates fall to compensate them for the underperformance of the mortgages.  Please drop me a line if you would like to discuss this topic further.  It has the potential to really damage balance sheets in this environment.

Sunday, December 21, 2008

Ireland Bank Rescue

Back in an October post, I mentioned the size of the external debt relative to the GDP of several countries.  Ireland's external debt is almost 10 times its GDP.  The real estate speculation on the Emerald Island made the U.S. market seem prudent.

As a result, the Irish government is taking control of Anglo Irish Bank Corp. and is injecting 2 billion Euro worth of capital into Allied Irish Banks & Bank of Ireland each.


Above is the TARP capital infusions versus current stock market capitalization for the financial companies that have participated. I have included American Express, even though they have not received the funds yet. I continue to harp on this one because it is a clear example of the difference between the stock market and Federal government valuations of this sector. Nobody can compete with the sweet deals that the banks are getting. Aside from small market mergers, the ever changing landscape will not allow for a significant deal without a government backstop.

Similar story above. More and more financial companies are getting on board with issuing government backed debt, preventing the bond market from doing its job.

This just keeps getting worse. According to the latest data, home equity is only about 45%. The recovery in our economy has no chance unless the housing market bottoms. Any attempt to delay it only introduces additional risks.

Friday, December 12, 2008

U.S. Auto Makers

The inability of the car makers to make money is not a recent phenomenon. A combination of union policies and government regulations created a pseudo command economy type industry that could not adjust to dynamic competition. I don't remember voting my approval for any of this, I do not want to receive a bill to keep a zombie company running.

30 Year U.S. Treasury Bond Trades Below 3% Yield

Hits 2.989% in Tokyo trading.

Thursday, December 11, 2008

Largest Bankruptcies of 2008 (so far)

Please click on chart to expand. General Motors Corp. has about $60 billion in assets & Ford Motor Company has about $72 billion in assets.

Although not one of the larger failures this year, KB Toys filed for bankruptcy today. This is a sad day for me, my first Monopoly set was purchased at a KB toy store in Brooklyn.


Dec. 11 (Bloomberg) -- Senate negotiations for a U.S.automaker bailout plan collapsed, in a blow to General Motors Corp. and Chrysler LLC, which may run out of cash early next year.

“It’s over with,” Majority Leader Harry Reid said on the Senate floor in Washington. “I dread looking at Wall Street tomorrow. It’s not going to be a pleasant sight.”

Equity futures are pointing to a 3.00% - 3.25% drop in overnight trading. Asian equity markets are down between 3% and 5%. Crude is down about 4%, gold is down 1%. The US dollar is at its weakest level versus the Japanese yen in 13 years.

On a totally separate note, I really think that Yo La Tengo is one of the most underrated bands of the last 20 years. Also, I DID NOT bid for the Illinois Senate seat.

Fear Factor

A few months back, I was of the opinion that gold and oil would decouple. Since gold is typically thought of as an inflation hedge, the two commodities usually rally and fall together (higher oil prices lead to inflation and vice versa). My premise was that the economy would slow down due to credit constraints, yet the instability in the financial markets would prompt gold to rally (or at least stay flat). The below graph tracks the price of one troy ounce of gold versus the price of one barrel of crude oil: this tells us how many barrels an ounce of gold will buy.

The bulk of the recent upward move in this graph has been the amazing drop in the price of crude oil. Gold has been moving a bit higher over the last few days, but is still 20% of its 2008 highs. OPEC and other oil producing countries are in a bind because they need anywhere from $50 - $75 per barrel to balance their budgets. Cuts are imminent, so this ratio may retrace in the near term. However, the case for buying gold remains unchanged. I would not recommend shorting gold and buying crude at this point. I have recommended to some readers over the last few days buying the Canadian dollar and selling out of the money puts on gold. Both trades benefit from a continued commodity bid in the short term.

Tuesday, December 9, 2008

A Little Bit of a Rehash

I apologize for going over some of the same material, but there were some interesting updates today:

The above graph tracks the issuance of corporate debt by financial institutions as part of the TLGP. SunTrust joined the party today, issuing $2.75 billion of 3 year bonds. This brings the industry total to $49.475 billion. KeyCorp plans to issue as well, it looks like $500 million - $1 billion of 3 year bonds. I take issue with this because we STILL have no price discovery. The FDIC guarantee is the major reason these bond sales are taking place, I get it. However, by not allowing the market to price the companies as stand alone entities, we have no idea how far along these companies are in the recovery process. Without market discipline, these companies are not motivated to continue their purging of bad assets and reorganizing.

The above table tracks the amount on money the Treasury Department has invested (TARP) in financial companies and their corresponding market capitalization. SunTrust was active is this space today as well, announcing that they will seek an additional investment of $1.4 billion (the total in the table includes this amount). In addition, they are continuing with the liquidation of their stake in Coca-Cola.

The above graph charts a little bit of history that was witnessed today. The top part of the graph charts the 90 day Treasury Bill rate (white line) and the 90 day commercial paper rate (orange line). The 90 day T-bill rate hit 0% today, an unprecedented event. It is an example of how risk averse institutions have become. In fact, shorter term T-Bills traded today with a NEGATIVE yield. Yep, buyers paid to lend money to the Federal Government.

Commercial paper is a short term debt instrument that corporations typically use to finance payrolls and other short term cashflow deficiencies. The bottom part of the graph tracks the difference in yield that corporations have to pay over T-Bills in order to run their businesses.

Monday, December 8, 2008

Demographics and Interest Rates

When I was back there in seminary school, I came across a journal article entitled " The Fisher Theorem - An Illusion, But Whose?"
The authors of the article proved their thesis by constructing several regression equations that predicted the yield of corporate bonds and inflation using only U.S. population data. They separated the population into "consumers" (aged 15-34 & 65 and older) and "savers" (aged 35-64). Their results were quite interesting in that the prediction strength was quite high.
I have recreated their analysis in a less robust fashion, but I think the point is clear:

The above graph tracks the ratio of consumers to savers versus corporate bond yields. As the the growth in the number of consumers outstrips the growth in the number of savers, yields rise because producers of goods are chasing funds that are in lower supply. Conversely, as savers grow faster than consumers, there are more funds available for producers. The forecasts from 2009 and beyond are based on the Census Bureau's population projections.

The above graph tracks the model projected yield level (black line) versus the observed yield.

Update: FDIC Backed Debt

One of the more popular government programs of late is the TLGP (please check the 11/28/08 post for more details). The borrowing burden for banking companies has been lessened by this program since the debt is issued with a AAA rating. The interest expense on these bonds is significantly lower because, in essence, the tax payer will back issuer.

The graph below details the amount of issuance under the TLGP as of last Friday. The total is $46.725 billion.

Friday, December 5, 2008

Another Bank Failure

The FDIC closed another bank today (it was on my bad bank list). It was a small bank in Georgia, less than $300 million in assets. As I have mentioned before, it is important to not just track the number and size of bank failures, but also the ratio of FDIC costs to asset size. Yet again, the FDIC will take a loss that amounts to 30% of a bank's assets. There is no legitimate oversight of our banking industry.

Wednesday, December 3, 2008

Carry Benefit

The above graph (click to expand) tracks the benefit of owning the 5 year Treasury Note. Typically, buyers of Treasuries borrow the money needed for the purchase. This borrowing is collateralized by the Treasury security it self. Since this is a collateralized loan and the collateral is of high quality, the borrowing rate is typically quite low.

I took the yield of the 5 year and subtracted the borrowing cost for a 1 month loan. The average benefit is about 95 basis points (0.95%) and it is currently 99 basis points.

What this ignores is the potential underlying price movement of the Treasury note, but it does provide some context for the current price action.

Monday, December 1, 2008

Thanks Ben !!! Largest Declines: Dow Jones Industrial Average

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Hmmmm, Why Would Ben Want to Jawbone Treasury Rates Lower?

That's a whole mess of issuance for a December.

Ben Bernanke To Replace Steve O As New Jackass

"Although conventional interest rate policy is constrained by the fact that nominal interest rates cannot fall below zero, the second arrow in the Federal Reserve's quiver--the provision of liquidity--remains effective. Indeed, there are several means by which the Fed could influence financial conditions through the use of its balance sheet, beyond expanding our lending to financial institutions. First, the Fed could purchase longer-term Treasury or agency securities on the open market in substantial quantities. This approach might influence the yields on these securities, thus helping to spur aggregate demand."

Ben Bernanke auditions for MTV

Right, buy Treasuries because........NO ONE ELSE CAN BORROW BUT THE TREASURY BEN!!!!! They don't need your help to issue more debt. Treasuries have been trading at essentially 0% in the repo market, you can get PAID to borrow money for some Treasury issues and fail to delivers have sky rocketed. And Treasuries need another buyer........

Should U.S. Treasury Debt Be Downgraded?

As I have mentioned before, debt plays an important role in a capitalist society. The lag between production and sale is managed effectively by debt issuance. In addition, exogenous lags (weather delaying shipments, holidays/seasonal adjustments, etc.) in distribution are mitigated.

Debt does need to be paid back at some point. Interest is charged as well, the amount of which depends on the length of the loan, collateral and the perceived ability of the borrower to pay back the principal in the first place.

In looking at the debt of the U.S. Government, there seems to be no intention of ever paying back the "money" it owes.

The debt of the General Fund is closing in on $11 trillion dollars. This figure includes debt held by other government entities (Social Security trust funds hold about $2.3 trillion). The debt has doubled in the last 10 years and has grown at an annualized rate of 9.3% since 1974. In that time span, the debt outstanding increased every year.

In 1974, the debt could be measured at 33.2% of nominal GDP. This year, it hit 69.5% of GDP. GDP is a proxy of the potential tax pool for the government. Since 1974, government revenue has averaged 18.3% of GDP. This figure has been quite stable, ranging from 16.3% to 20.9%. So, debt outstanding has been growing relative to GDP, while revenue based on GDP has flatlined.

In 1974, for each additional dollar of debt outstanding, $4.52 of GDP was created. In 2008, a dollar of debt got us 46 cents of additional GDP.

This year, the Treasury agreed to strengthen the guarantee that Fannie Mae and Freddie Mac operated under. Although not an explicit guarantee, the Treasury acknowledged the importance of the orderly operation of the mortgage market and concluded that it was in the best interest of the economy to facilitate trading in these securities. The potential exposure to the government is $6.7 trillion.

The FDIC resembles a drunk trying to stand on one foot while buying a hot dog at the Papaya King window in the rain. I reviewed their position in 2 posts last week.

The TARP will require increased debt issuance as well. In addition, Congress is discussing another stimulus bill on the order of $500 - $700 billion.

On November 3, the Treasury announced that debt issuance would total $550 billion in the 4th quarter of 2008. DC has outdone itself, doubling the previous record (1st quarter of 2008). The only ray of sunshine is that nominal borrowing rates are quite low, good news for debt service. By the way, the interest on the debt accounts for 17% of the annual budget. Another way to look at it: 39% of individual income taxes go to paying the interest expense of the debt.

The U.S. has become reliant on foreign governments to purchase debt. Their patriotic duty is to protect their own county, not ours. While I agree with the position that liquidating their holdings would cause dramatic losses, they could seek higher yields or stronger trading positions to continue buying. Either way, the tax payer is compromised.