Friday, November 30, 2007

Real Rates Low


I may have spoken too soon. Real rates are already pretty low, only 0.25% from as low as they went in March, 2004, when Fed Funds was at 1%.

Chart 1. US Treasury 10-yr TIPs (inflation protected bonds) - last at 1.61 on Nov. 29th. [click to embiggen]
Free Image Hosting at
src: US TreasuryDirect


What's interesting is that the implied real rate is lower than the observed rate.

Despite the tax-advantage of muni bonds, they are trading at the same or better yields as treasuries. Without reviewing the data series, there are only a few times in history when that has been the case, I'd guess.

This suggests (a) an expected decline in inflation (CPI) to around 2.3% from the 3.5% most recent read; (b), a rise in nominal rates on bonds; or (c) some combination of the two. [update: or (d), a continued fall of real-rates on TIPs to even lower levels]

The most sensible is (a). However, if that turns out to not be true, then nominal rates are too dear, right? In fact, the CPI is not likely to fall, I don't think, that much. [Nor are real rates likely to skid so much further, without a full-blown recession.]

It's a continuation of the conundrum, in a way.


What's a clear piece of confirm evidence that these yields are too dear is the relative price to municipal bonds, that also come with a AAA rating. Despite the tax-advantage of these bonds, they are trading at the same or better yields as treasuries. Without reviewing the data series, there are only a few times in history when that has been the case, I'd guess.

I don't know any ETFs that hold muni bonds, however... I suppose one would want to sell treasuries to buy munis.


How good are the 5-yr TIPs as a funding source? I don't know how many of these bonds are available for borrowing (or at what price), but at 1% yield (or less, this week), it seems like the chances of a price rise would be slim...

Its Probably Time to Become a Dollar Bull

There are lots of reasons to dislike the dollar.

However, my heresy is telling me that it is probably a good time to become a dollar bull.

It's probably a little early, but early is better than late, most often...

Smalltime folk don't need a fancy futures account for dollar trading. There is an ETF! Some financial innovation actually does benefit the little guy.

No Recession, Just Slow Growth, So Far

Today, the Commerce Department estimates that personal incomes were up about 2.4%, at an annual rate. Also, spending did not trail off more than income (of course, these numbers don't tell the whole tale, but they are ... indicators).

That's about in-line with the forecast put up here for slow 2008 GDP growth (see below) and its personal consumption component. All the same, the real consumption and income figures were slower than my expectations - enough to be worrisome.

Inflation ticked up a bit.

Sounds like a good recipe for inflation-protected bonds, right, which have been going gangbusters for a couple of months now. They may have just a bit more to go.

It's going to be a rough go in the first quarter. Wall Street is going to have to get used to a slow growth economy.

But for now, Santa has a nice hat. Leading indicators are soft, but not flashing deep or harsh recession. In fact, activity levels seem high, outside residential construction, so folks may not even "feel" a slowdown, much. It's a pinch, not a slug, so far.

Naked, Financially Speaking

Morgan Stanley goes to the bench and comes up with a sales guy to help it manage risk...

Eh, it's their capital.

Meanwhile, it's still a bit of a question mark of how MS and Merrill, not big distributors of subprime, ended up with so much subprime and CDO exposure.

Was it all puts on CDOs or bonds?

Was it credit default swaps (CDS) that physically settle? If so, that's a big, bad trial for the credit derivatives market - all derivatives markets have problems when there is illiquidity in the underlying ... It's not just continuous hedging. Sometimes it is the ability to get rid of a position that you end up with through exercise.

Was it providing liquidity to clients (i.e. being nice)? It seems unlikely, but there has been a lack of conspicuously large investors - pension funds, mutual funds - who have recognized CDO losses, right?

More to be written in the saga, no doubt.

Thursday, November 29, 2007

More Problems with "Free Markets"

Two words: collective action.

Sometimes, it makes economic sense, even when a cartel is not implied.

Check out the Atlanta Mortgage Consortium, that helps banks avoid "excess" foreclosure costs while simultaneously helping them to spread the risk of continuing to lend. The consortium buys up the property at a "market price", one that may even keep the lender whole compared to a foreclosure/liquidation price. The property is then re-mortgaged, to the same or to a new lender, but the loan risk is shared among the consortium of banks.

Basically, they act like a clearing house for lender foreclosures.

What incentive do banks have to participate? Says one with first-hand experience:

Leadership, lender cooperation — not competition — can get us through this crisis. This is a challenge for the financial community and American families caught in "interest only" and high-interest loans. It is not the problem for all taxpayers.

Ugly Lenders or Successful Market Innovation

While the book on the free market and financial innovation is being written about sub-prime lending, comes a view that lenders may have pushed people during re-finance into subprime loans (or similar terms) to make money.

I suspect from anecdotal evidence that this allegation is not wholly untrue.

The notion that is evocative, that the innovation ultimately brought more or as many existing borrowers down into a new category of finance, rather than expand the set of borrowers altogether...

Do Your own Economic Forecast ...

Revisions to GDP data for third quarter suggest that you can bump up the estimate for net export growth substantially, up another $10-20 billion or so.

A draw in inventories (and declines in durables, nondurables) - a cut in production, is to be expected in a slowdown, so this confirms that with these data. I don't really have a big loss in jobs associated with that, however (apart from what is expected in construction industry) humm....

Investment, including residential investment, mostly at rates expected.

Table. NIPA 1.1.1, 1.1.2
Revisions: Revisions to percentage contribution to growth; growth, and revision to growth:

Percent change at annual rate:Chng
Gross domestic product14.91
Personal consumption expenditures-0.232.7-0.3
Durable goods-0.044-0.4
Nondurable goods-0.171.9-0.8
Gross private domestic investment0.795.95.1
Fixed investment0.17-0.41.1
Equipment and software0.097.21.3
Change in private inventories0.62---
Net exports of goods and services0.4414.63.6
Government consumption expenditures and gross investment0.023.90.2
National defense0.0210.10.4
State and local0.012.10.1

Foreclosures Level Off, Reposessions Up

A least one tracker of home mortgage foreclosures says that the rate is not increasing, but leveling off. At the same time, banks are taking up the property (a.k.a. "collateral") at significant rates to re-sell it.

Foreclosure filings for October rose 2% from September and 94% from a year earlier, but foreclosure activity in general appears to have "leveled off" since peaking in August, a foreclosure-listing service said.

According to RealtyTrac Inc., default notices for October dropped nearly 9% from a year ago. "Some of the efforts on the part of homeowners, lenders and advocacy groups to find alternatives to foreclosure may be starting to have an impact," said RealtyTrac Chief Executive James J. Saccacio. He added, however, that bank repossessions during the month jumped nearly 35% -- "evidence that more homeowners who enter foreclosure are losing their homes."

RealtyTrac, Irvine, Calif., said 224,451 foreclosure filings were reported in October, compared with 219,850 in September and 115,568 a year ago. Nationally, there was one filing for every 555 households [0.18%] during the latest month as credit pressures and tumbling home values continued to hurt homeowners. By contrast, there was one filing for every 566 households in September and one for every 1,001 households in October 2006 [0.10%].

It's probably too hard to translate these default rates into specific portfolio default rates, but at least it gives a sense that it is not one in four mortgages that are in default, or something! The rising repo rate will give politicians a run.

Meanwhile, the next thing to find out is the so-called "severity" or what the banks are getting in liquidation for their collateral. That's the MOST important figure, economically, although it is not intuitive. Severities greater than 30% are ... approaching the wall, so to speak, versus where some conservative folks ration their risk.

Separately, dealJournal noted yesterday that subprime debt ticked up and is trading at 20-cents on the dollar, for ABX indexes (run by, which, from what I gather based on other reporting, are mostly the 2006 vintage debt (some say that may be the most 'vulnerable' year of mortgage originations). It's sounds crazy, but 20-cents is a lot better than zero. Something tells me that to be a vulture for this debt is going to be quite profitable ...

The original Brady debt traded that low, didn't it (I honestly don't remember), and most of those bonds turned out to be good risks to take, difficult as it always is to stomach it.

Wednesday, November 28, 2007

Expectations Market for Home Price Declines

The CME futures markets on the Case-Shiller home price indexes predict the following home price declines for these markets and for the national, composite average:

Table 1. Contracts by year-month, at last traded price.

Las Vegas-3%-5%-7%-8%-10%-12%-13%
Los Angeles-2%-4%-6%-7%-8%-9%-11%
New York-3%-5%-7%-8%-9%-11%-12%
San Diego-2%-4%-5%-6%-8%-10%-12%
San Francisco-2%-4%-6%-8%-10%-13%-15%

These suggest that those who are worried about massive declines (20%+) in the upcoming year, due to foreclosures in their home markets or whatever, can still successfully hedge against that further decline.

Those who just want to hedge against a non-specific, generalized fall have less opportunity in the long-term contracts and would need to look toward rolling near-term contracts over.

These are not heavily traded contracts, presently, although interest may pick up.

This note is for informational purposes (commentary) only. Don't buy or sell anything just based on this or any other note here.

Welcome to Conduit Hell

Tripped Up, While Just Passing Through

Fortune continues its series on ... how banks and brokers screwed themselves in the process of passing along junk credit.

Money quote (pun intended):

None of this would have been a dire problem for Merrill if it hadn't gone from simply manufacturing CDOs and reaping fees to becoming a huge investor in the CDOs it created - getting high on its own supply, you might say.

The hellishness of "the liquidty put"
What's in the pandora's box?

Here's my stylized summary.


In the old days (1980s), there was the novel creation of mortgage-backed securities (MBS), now often called residential-MBS or (RMBS) for precision. These were fancy new securities that promised to behave like tried-and-true, mostly, at higher yields. When rates rose, they didn't. Merrill Lynch took the largest ever single-day trading loss in history, at the time, in its mortgage business on its mortgage desk. Today, the RMBS market is 'well understood' and functions to the benefit of all involved. A great deal of the collateral for MBS is provided by Fannie and Freddie, who buy up "conforming mortgages", as defined by their regulator, and provide a backstop to help sell them on. This middle-man role keeps money flowing to home seekers and lowers the costs to them, when it works well.

Shortly thereafter, the collateralized-mortgage obligation (CMO) was created. These were just a re-package of the re-packaged, MBS stuff. CMOs are not securities, per se, they are conduits, or legal entities that buy assets and sell participation in those assets' returns, in one way or another.


In the mid and late 1990s, Wall Street had a spin with 'sub-prime', in the form of manufactured housing lending. This was a chance to try to price low-credit risk high enough to cover the costs of it. Luckily, the amounts stayed low, because ... well, the margin for error was not large, and folks took a bath, eventually, as the eagerness to book fee revenues ... (I don't know where the market for this stands today).

In the late 1990s, the CDO was "invented", as a way to get to higher yields, again promising the same performance as tried-and-true. The "traditional" CDO, if such a thing exists, has about 80% "good stuff", 10% medium-good (maybe alt-A mortgages), and 10%, "sub-prime". Unlike MBS, the "stuff" can be most anything.

Some of the credit agencies even slapped, reportedly, "AAA" ratings on these securities (I cannot confirm this). If one pretended that sub-prime defaults were limited to, say, 10% of 10%, or 1% of the total CDO value, it would all be good, even moreso since 10% would never be hit by all geographic locations at once (and 1% was small compared to 11% annual interest rates charged, too boot). By the end of 2006, delinquencies - not defaults! - on subprime debt had climbed to the 15-20% range. By mid 2007, some portfolios had been sold at 20% discounts, suggesting, perhaps, that no one was willing to pay for the 'other stuff' given its uncertainties, even if it had likely value.

It appears that even the agencies, Freddie and Fannie, got involved in buying alt-A and subprime credits. [I will check the proportions for you when I get a chance.]

There is more.


If you buy up stuff and re-package it for sale, it can balloon your balance sheet and cramp your style (and growth). The "answer" is to create a legal entity to put the stuff off balance sheet. These are "SIVs", special investment vehicles, or "SPVs", for special purpose vehicles. They can also be "hedge funds", which are special legal vehicles for certain types of investors.

They have no capital requirements (that I know) and little regulation, certainly not bank regulation, directly. Some of the structures may have capital ratio requirements, by design, as may be suggested by HSBC indicating this week that it would rather put assets on its balance sheet than recapitalized because of a decline in value.

Anyone can try to set-up an SIV to get into the game. The big banks all have them, reportedly, as well as most if not all the big brokers. (Even the mortgage bond-insurance firms may have been tempted to get involved as well. So far, I don't know any insurance companies that took a spin.).

According to Fortune, you run an SIV like a Broadway show. Someone, a producer, gives upfront money (for a fee), you hired someone to direct the show (buy "stuff" AND carve it up into structured products to sell), then you sell tickets (get investors to buy the carved-up stuff). It appears that some of these SIVs run like mini-banks, in which the upfront money stays in the conduit, refinanced in the short-term commercial paper market.

Whether these SIVs, also called "CDOs", stuck to the 80/10/10 formula, no one knows for certain. There is some indication that they may have, from prior sales that came in at 20% discounts.

there is more

The producers appear to have also 'sold tickets' that could be returned. "Attaching liquidity" is something that has been done a long time, as a way to enhance a bond enough to entice buyers. This is done by offering to buy-it-back (giving a put to the investor), if something adverse occurs, like a credit downgrade in the next 24 months or so, say.

According to Fortune, these return tickets appear to have been part of what happened to Merrill Lynch. Someone should have been keeping track of how many were sold ...

there is more

If the tickets sold were 'put' back to the SIVs, you can see the problem. Suddenly, you have to raise financing (sell new tickets) or sell assets (stop producing the show).

It appears that something of both is going on. The inter-bank markets and the commercial paper markets suggest that people are worried that these SIVs are being financed in the money-markets (short-term, ahem!). I don't know how much of that is true. Also, some of the assets appear to have made their way onto the balance sheets of some companies, say, Merrill Lynch.

It's not clear (to me), whether "stuff" was returned directly to Merill or to the SIVs (in the end, some of the "stuff" may just be contracts, rather than securities, I'd guess, but I don't know). But you can see the issue. When it comes back, it needs to be financed (or financed again)... AND marked to market.

We appear to have a variety of cases. Goldman's hedge fund took in additional capital to keep financing the assets and to avoid fire-sale. Merrill appears to have used its own balance sheet. Bear Stearns appears to have sometimes worked without providing recourse, simply liquidating its hedge funds, leaving the investors holding the bag, this summer.

there is more

Whether or not stuff stays off balance sheet, sooner or later it has to be marked-to-market and the realized losses (if any) must be recognized - in whole or in part, and over time.

There are two big problems.

Almost no one wants to buy subprime, so there is probably no traded market value. A 20%-35% haircut might estimate the losses outside of the "good stuff" inside a CDO, based on a ultimate default and recovery assumptions, that will play out over the life of the loan, but most significantly, it would seem, in the next few years. [update: the market is trading now, well below that, indicating that people are not willing, perhaps rightly so, to 'pay up' for scenarios that may not be as bad as expected.]

The second part is potentially just as large. Prices on the good stuff have fallen, not just related to a flight-to-quality and sensible repricing of risk, but also to legitimate worries about recession (loss of employment) and adverse (and stupid) loan terms (resetting interest on low-credit loans) leading to record level delinquencies and defaults. That might be 10-25% on 80%, or a 8-20% "hit", which is just as large as the credit-related hit on subprime.

there is more

As life went along, a non-cash or derivatives market for CDOs developed AND took flight.

In this case, you don't have to take up financing (find a producer), getting your hands dirty with cash up-front.

In a synthetic CDO, you just reference the securities prices in question, like a futures contract might or like a credit default swap (CDS) might do. Oh, yeah, I think these are all off balance sheet risks, too, but I'm not 100% sure.

Derivatives markets are a good thing, but they have to be well capitalized. Many of the well developed derivatives markets trade several times the notional value of the cash markets, meaning that they can grow fast, and require adequate growth in risk capital. (see chart for growth estimates)

One can hedge the risk in regular-way credit protection on a corporate or municipal bond, say, with pretty good success. Well see how well people hedge away mortgage credit risks, including subprime risks. Also, we'll see who was on the "wrong side". So far, it seems like Goldman was ahead of the curve in using derivatives protection, but someone had to write that protection...

The overall CDO market might be $2 trillion. I could guess that synthetics might be one-third to a half of that. A 20% mark-to-market loss seems steep to me, on this, but if OAS spreads have doubled on a 20-year instrument, it might be right. That could get one to $200 billion dollars, spread out over the combination of market makers and investors, in some unknown set of proportions.

Of course, if the general level of rates falls and credit spreads tighten, too, some of that could get offset. If rates fall as part of an expectation of a growth slowdown, however, it's not at all clear that the price of credit will fall alongside. Spreads could simply widen...

Whatever the case, it is still possible to at least estimate a floor.

The emergence of synthetic deals has clearly boosted the CDO market. The market is dominated by synthetic deals, and today 75% of CDOs issued are synthetic CDOs. This marks a clear evolution in the CDO market. In fact, the two most recent products, single tranche CDOs and ABS-backed CDOs, now account for, respectively, 66% and 25% of the synthetic CDO market. The market is moving toward "on demand" credit risk, where an investor can specify a product’s risk/return and the bank originates the "raw material" (bonds, ABS, etc.) and then distorts the risk/return ratio of its portfolio and delivers a new product to its client.

The development of the synthetic CDO market on the back of the CDS market is having a tremendous impact on the credit market, reorganizing the credit value chain. The development of the credit derivatives market and especially CDOs has had a tremendous impact in the positioning of banks in the risk management value chain," says Pierron. In the medium term, regional and smaller banks will concentrate on sourcing risk (especially via loans), while brokerage houses and investment banks will focus on deal structuring. The distribution will be shared between various players, from large banks to insurance companies, he adds. - pic link

Tuesday, November 27, 2007

The Roof Over Your Head, Formerly Known as Piggy Bank


The Case-Shiller home price indexes came out today, for period ending September.

There is not an accelerating decline overall, but the slip did broaden in the month, as a few more cities in the composite showed a fall than had earlier (in fact, all 20 of them fell in the period for the first time, some just slightly).


Among the major markets, New York, Boston, and Washington, their was a decline in the rate of fall. San Francisco, which has been moving down very slowly, showed a downtick. Chicago did as well, but that market did not have nearly as much a run-up as did the other majors. Last month's sharp figure for Los Angeles did not repeat.

Phoenix, which is not a large part of the overall national market, put in a pretty bad number, if there is follow-through on it. A retirement destination, this has been one of the hot markets in the past fifteen years.

I don't have the geographical patterns of mortgage delinquencies (or defaults) and sub-prime lending. The notion that foreclosures are going to greatly accelerate the home-price decline is not in the national numbers, right now.


Markets like Miami, Tampa, Los Angeles, and San Francisco, that have had the largest run-ups, might be vulnerable to forced selling (foreclosure). Other markets, in the so-called non-coastal areas, might be subject just to the general credit and economic woes of working out the exuberant lending practices of the Bush era.

Non-"Recession" Economy Selling at "Recession" Prices

Discounting a significant recession seems way overblown.


One has to really believe that the U.S. consumer is going to not just stop spending more, but actually retrench, in order to get to negative growth for the full year next year.

Plugging in a calculation for an oil-related retrenchment and a continued, harsh, steep fall in residential construction, one gets to flatish growth (including even a significantly negative contribution from inventory investment).

On my figures, one would have to see year-to-year negative growth in (real) consumer spending in excess of 2%. Such numbers didn't occur in the last two slowdowns, even in the early 1991, when things were looking more bleak, in many ways. (PCE, personal consumption expenditures, haven't been negative since 1980, when it dropped just slightly for the whole year...).


Oil is acting like a "financial variable", these days, divorced from supply and demand. Speculation here continues to be a significant downside risk.


Guesses: For financials, it may be when the first quarter prints without "special charges", probably as soon as 1Q08.

For the market as a whole, probably sometime in the same period, as more data comes in that the consumer is not retrenching, fast and furious.

At that time, one might guess that the value of stocks, as measured by the broad S&P500, might move from a "lower" range of, say, 1370-1460 to an "upper" range of 1460-1562 (or higher, depending ...).


David Wyss, who has been tracking this stuff as long as anyone, these days, looks at the "wealth effect" on consumer spending and comes up with numbers not to far from my own:

Overall, we expect real consumer spending to slow to 2.2% in 2008, down from 3.0% in 2007. The saving rate will tick up to 1.5% from this year's 0.8%. Consumers aren't likely to stop, but they will tap the brakes.

We expect a total drop in existing home prices of 11% (they're already down 4.4%).

How much housing wealth translates to consumer spending remains unclear. Even correcting for the direct effect on consumption caused by the imputation of spending and income on owner-occupied housing, estimates range from near-zero to 5% of increases in home prices will be spent each year. At the high end, the impact would be a two-percentage-point rise in the saving rate, and an equivalent slowdown in spending.
On my figures, a sharp 2% rise in the savings rate alongside a sustained oil impact would lead to negative growth ... a gradual rise, not so much.

Interesting Chart from S&P

Irrationality in the Financial Stocks?

Amidst the uncertainty, there are glimmers of rationality.

For Citibank, for instance, throw in a known amount of capital raising and a likely restructuring charge, and one can come up with a price that fits, rather tightly.

We now know that dilution due to capital raising is going to be $7.5B rather than the $6B in my estimate, or about 30-cents a share more.

We can guess at a $1.5 billion dollar "restructuring charge" in Q4, which is about 20-cents after-tax. (It's doubtful it will all be realized, I'd guess...).

Credit is more expensive, now, and this will cause a mark-to-market loss of some kind. This is really hard to estimate, because there may be offsetting amounts gains. What's more, if the price of credit is near its high, now, then some amount of these charges will reverse next year or so.

Baking all those in, one comes down to a book value of $21.12, which might equate to a stock price of $29.57, fairly conservatively put. Citibank closed at $29.76 yesterday ...

Monday, November 26, 2007

2008 - The Economic Slow Lane or the Off Ramp?

Do you do an economic forecast of your own? If not, consider that it is easy and worth it.

Martin Wolf puts up a great piece on the economic outlook - in three points:

The latter is “the great unwinding”: the re-import by the US of the stimulus it imparted to the rest of the world between 1996 and 2004, when its domestic purchases grew faster than GDP and the current account deficit exploded upwards.
Yet the [retracement] is still modest: US households still ran a financial deficit of 2.3 per cent of GDP in the second quarter of 2007. Moreover, household savings rates remain very low, at 2.5 per cent of GDP in the second quarter of 2007. Further correction in both is probable.
But exports are only some 12 per cent of GDP. They must grow by considerably more than 10 per cent a year, in real terms, if the contribution of net trade to the rate of growth is to be as much as 1 percentage point. It is likely to be much less.

So, how strong is 'domestic demand' in the U.S.'s key trading partners, China, Canada, Mexico, and the EU and how much do they want what the U.S. is exporting? humm....

Sunday, November 25, 2007

Housing Bubble Snapshot

-1990 episode was fairly concentrated, with some markets 'stalling' while others dipped.
-2007 episode, so far, has been both more uniform and mixed. More markets have dipped, but some have also leveled out this year.

Table 1. Peak-to-Trough comparison, 1990 Real Estate "Bust" to 2007 Real Estate "Adjustment". (markets that started a decline prior to December 1994).

Los AngelesJun-90Mar-9669-27%Sep-06Aug-0711-6%
San DiegoJul-90Mar-9668-17%Nov-05Aug-0721-9%
New YorkSep-88Apr-9131-15%Jun-06Aug-0714-4%
San FranciscoJun-90Feb-9444-12%May-06Aug-0715-5%
Dallas - TXOct-89Feb-9452-8%Jun-07Jul-0710%
Seattle - WAJul-94Dec-945-1%Jul-07Aug-0710%
Minneapolis - MNNov-94Dec-941-1%Sep-06Aug-0711-4%
Tampa - FLSep-94Nov-9420%Jul-06Aug-0713-11%
Cleveland - OHNov-94Dec-9410%Jul-06Apr-079-5%
Portland - ORNov-94Dec-9410%Jul-07Aug-0710%
Miamino drop--Dec-06Aug-078-9%
Phoenix - AZno drop--Jun-06Aug-0714-8%
Las Vegasno drop--Aug-06Aug-0712-8%
Denverno drop--Aug-06Mar-077-4%
Detroit - MIno drop--Dec-05Jun-0718-13%
Atlanta - GAno drop--Jul-07Aug-0710%
Charlotte - NCno drop--Aug-07Aug-0700%

*items shaded lightly indicate markets in which a downward trend started, but has stopped, either as a permanent trend reversal or as a hiccup.

Seven markets really entered into price declines in the 1990 episode. Housing starts bottomed in January, 1991 (below 1 million units). The Fed raised rates in 1994, when the other markets listed slowed.

Only the three California markets had long, slow declines. The New York and Boston markets peaked first and actually started up circa 1991.

Prices did "bounce" a bit after the falloff that started in the early 1990s, mostly. Not surprisingly, the market with the steepest per-period run-up, Los Angeles, also had the largest decline. An 18-month, post-correction bounce trims the peak-to-trough loss to 22%, however. Four of the other markets came around 12%, with the last two closer to 5%.

Annualized, all of the price declines come out to 4-6% (see next table).

Table 2. Peak-to-Peak comparisons and rise at annual rates

to now
Phoenix - AZ--Jun-061389%11%9%
Tampa - FL20%Jul-061409%11%9%
Las Vegas--Aug-061409%10%8%
Seattle - WA5-1%Jul-071518%9%9%
Minneapolis - MN1-1%Sep-061417%8%7%
San Diego68-3%Nov-0511614%7%6%
Portland - OR10%Jul-071516%7%7%
San Francisco44-4%May-0614710%7%6%
Los Angeles69-5%Sep-0612613%6%6%
New York31-6%Jun-061827%5%5%
Detroit - MI--Dec-051324%5%3%
Atlanta - GA--Jul-071514%5%5%
Charlotte - NC--Aug-071523%4%4%
Cleveland - OH10%Jul-061393%4%3%
Dallas - TX52-2%Jun-071604%2%2%

The current episode, on closer inspection, also has some concentrations, if one considers the peak-to-peak growth in prices: Miami, Pheonix, Tampa, Las Vegas. Assuming that a "normal" growth in prices might be in the range of 3-7% for most regional employment and income dynamics, the price drop need to bring returns back to the averages. Over the next three years, Miami and Tampa, for instance, might need further price drops in the 15-20% range to get back to "normal" returns. Three of the other markets are in the 10-15% range. The remainder could stay flat and returns would be be "normalized" either right now or in the next 2 years.

Altogether, without a rising rate environment and based solely on "normal" levels of return, it doesn't look like a housing crisis is in the works, except in some markets that will correct further.

Of course, a recession (weak income dynamics) could force price falls to be less gradual and have greater amplitude, but those would be compounding cyclical factors, not "bubble" factors. However, many of these factors were also present in the 1990s slump.

In fact, a similar fall in prices, peak-to-trough, comes up with a duration of the episode about equal to the prior one, passing from peak-to-trendline-growth in just about 3 years, or sometime in 2009.

Chart1. House prices on a log-level scale. The current downturn could very much look like the prior one - down somewhat, but not sharply, followed by a period of flat, if there is an underlying uptrend in prices, as shown.
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The only way to really scare yourself is to imagine that the trendline re-based at the end of the 1990s, say, as a result of the end of the large decline in mortgage rates to a new, lower level. Such a re-basing suggests that most of the "gains" in the 2000s might have been not driven by the fundamentals.

Re-basing, however, is not supported by an economic model of the fundamentals driving the housing market, outside local supply and demand and cost-of-construction increases.

A basic, consumption-based model, without sophistication, suggests that the trend series growth analysis has some underpinnings.

Chart 2. A consumption-based model for growth in house prices
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src: all data from Census Bureau surveys

Both the model and the trend series suggest an overall price decline of maybe 8-11%.

Most of the stress will therefore come on the payments side, the credit part of the market, as part of rate-resets or income uncertainties (cyclical unemployment). A 10% decline will wipe out the equity of those with loan-to-value less than 90%, and drag out the time it will take the markets to clear and tighter credit standards will keep such people from moving on to new housing.

data: Case-Shiller indexes, through August 2007. There are other indexes for housing prices than these and other methodologies. Some market participants, like FannieMae, do not have exposure to all segments of the markets, because they are limited by the dollar amount of so-called "conforming loans".

Saturday, November 24, 2007

Just the Numbers: Week 47


Clinton falls a bit, but her numbers remain solid.

Huckabee has moved up, both in Iowa and nationally, while Ron Paul has leveled off. McCain continues to show no movement.

As the races start to look increasingly binary, these numbers start to get ... boring.

The Senate races haven't shown much movement. Collins (ME) dipped slightly, to lowest point yet, but maybe not 'statistically significant'. Coleman continues to be well bid in Minnesota. Sununu is in a dead heat, so far. For all the talk, McConnell's numbers don't change.

Giuliani is on the move in the FL and NV primaries.

Romney contracts tick up noticeably in South Carolina and New Hampsire. He is now even with Thompson in those states, so the Thompson candidacy, which this blog mused might well hobble Romney in the South, appears to not be having that impact (or any impact).


One could make some money (circa 15%) betting against Edwards to win in Iowa.

If you think that Obama will bring it home, there is a huge payoff in the parleys for betting both Obama-Giuliani and Obama-Romney (85%). Buying the Obama-for-President contract still pays just over 90% ... !

Everyone assumes that Obama can win the General, if chosen, but that chicken seems counted too soon (to me).

Next PresidentPr (%)Chg
2007 Week 47: Dems debate on CNN with few impressed by the questions asked. Clinton campaign under considerable pressure to show she has experience and can handle the heat. McClellan dishes up the Wilson-Plame WH cover-up.
GOP NomineePr (%)Chg
DEM NomineePr (%)Chg
SenatePr (%)Chg
Next ExecutivePr (%)Chg
DEM VP NomineePr (%)Chg
DEM VP NomineePr (%)Chg
President ParleyPr (%)Chg
src:; bid-ask are not points, but spread as a percentage of the bid. Polls comparison, via RealClearPolitics.
IMPORTANT DISCLAIMER: this is just an informational note and not a solicitation or recommendation to buy or sell securities and there is no guarantee implied and people can lose all money on all investments. Numbers are believed to be correct, but do your own math and make your own conclusions or consult with an advisor before making any decisions.

Caucus/CandidatePr (%)Chg
Iowa Caucus
New Hampshire Primary
South Carolina Primary
Florida Primary
Nevada Primary

Tuesday, November 20, 2007

Striken Bond Portfolios Enter Earn-Out Period

I did a little looking at Freddie (FHLMC), who rocked the financial markets, today.


The big picture runs ... o.k.

  • Big mortgage bond holders, like FHLMC, probably move into a period of "work out" in 2008. It's likely that there will be more credit losses to go. But these portfolios are still making money. Earnings will offset remaining credit losses, leaving flat income for the year.
  • The return to sanity of the pricing of risk will lead to some market-based losses. However, if the Fed eases some more (huge amounts, not required), then these will be ... mostly manageable, a moderate net drag.
  • If the peak of problems with foreclosures and workouts occurs in 2009 (or sooner), the markets will be looking beyond that, most likely, in late 2008 or early 2009, at the first signs of positive news.

From this point, the risk one is getting paid for is that the housing markets end up worse than than expected, because 'what is expected' got baked into the numbers today. Freddie, who are as good as any, I guess, are estimating that things end up worse than the last downturn (1991), so they are hardly being rosy. For them to turn out "wrong" from here on out would mean a fairly quick and radical worsening of the home markets.

Housing hasn't simply stopped nor has lending.

However, the high oil prices could put strain on the low-end of the market, for sure and dull economic growth enough to create a one-thing-leads-to-another problem. In short, bumpy is not out of the question.


Congress ought to remain vigilant, keeping on top of the regulators to make sure that all significant institutions have adequate capital plans.

Forcing almost everyone to shrink their balance-sheet all at once is not a great idea. (You'll notice that some of the thrifts appear to have skipped the problems and will benefit from that handsomely).

Some temporary relief of capital requirements is in order, coupled with other means, in a sort of 50-50 partnership to keep the credit market from 'standing still', rather than growing, if there is business to do.

I know that sounds weird, but it works. And it doesn't really let anyone off the hook for bad decisions. It just makes coping with them easier.

Hello? Congress! Wake UP

So, today FreddieMAC does the right thing.

Faced with a choice between drips and drabs, they massively provision for credit and mark-to-market now, in ways that are probably going to reverse.

This penalizes them because of a whopping capital adequacy requirement.

So, instead of Congress going on break and instead of stupid policies of expanding the GRE's into million dollar loans or more, temporarily lift the capital requirements, for pity's sake.


Monday, November 19, 2007

Grrr...missed this move in real rates

TIPS "win", apparently, among bond asset groups (not sure these are completely apples-to-apples, but it's what you can buy, so it doesn't matter, from that perspective). TIPS are the Treasury's inflation-protected bonds.

Chart 1. Exchange funds tracking the bond market:

Real rates have been falling faster than nominal rates ...

Chart 2. Real rates on the Treasury's 5-yr tips

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1. If you missed this (like me), then there is not that much more to go, right now, I wouldn't guess, so no point piling on, it would seem, absent an ready-Fed (unless you think the world is going to continue melting into next year - and some do).
2. This is why the dollar has been under sustained pressure, lately.

Thursday, November 15, 2007

Why some financials are attractive now


Take Citibank. Can we guess how low "low" is?

Without double-checking the data, here's a quick calculation:

It's worth $25/share, based on it's "book value".

There are about 5 billion shares issued.

Suppose they take even $15 billion more in write-downs (20% of a $70 billion exposure, say). That would be $3 per share, which would bring "book value" down to $22/share. Bear in mind also that they have already done about $10 billion ... (I don't know if that is in the $25/share figure, however).

If you don't believe that their business is changing dramatically because of all this, you can slap a 1.5 multiple on that, which isn't too aggressive for a big bank. That would equate to a $33/share stock.

Last year, the company made over $5 billion a quarter.

Even if they used all of that to pay for write-downs, handled a significant growth slowdown (trim even up to 25% of earnings or $5 billion), and covered the dividend (just under $10 billion per annum), it would seem they have earnings power to avoid going into massive negative quarters, while you hold their stock.

You end up with a flat-ish stock, based around $33/share that pays a whopping 6% in dividends, at current prices (about $34.-$35). At the end of that period, valuation could go up to old levels, giving a huge gain.

This may be why superior, value folks, like Bill Miller, are interested in the long-term potential of the major bank stocks.

The risks are that they have other big problems develop. Maybe some charge-offs in the credit-card business, in buyout-loans, or plain mortgaged-backed bonds. They also appear to be paying a price already in the borrowing markets, but that will just pinch their slightly and slowly earnings, which we've already accounted for, and could easily reverse with proper attention.

[BE SURE to do your own calculations, checks, and make your own decisions about what to own or not ... If you don't, just got to, say, and just-do-it.]

Update: The bulk of the charges are not in the $25/share figure, as of this press release. The other important consideration is that these charges should be considered after-tax. Therefore, the net change is not much: subtract $7B for the charges already announced and add $5.5B for tax considerations, for a net of $1.5B, or about $0.31/share, which, in turns, lowers the $33 figure to $32.50, which is a point statistic, but probably near a lower bound.

Here's a quick summary:

7 Billion after-tax announced
9.5 Billion after-tax to go ($15 Billion pre-tax)
10 Billion in dividend payment for 2008
26.5 Billion needed
15 Billion in net earnings for 2008, assuming 25% slowdown
10.5 Billion hit to equity or about $2/share

$23/shr approx equal to $33 stock price, conservative calculation (but not super pessimistic).

You Can't Take It With You

One of the "economic faithful", Brian Reardon, comes out with this, in the NRO, on the estate tax:

To its very core, the death tax is bad public policy. You don’t know when you’ll pay the tax. You don’t know how much the tax will be. And you don’t know if your estate will have the liquidity necessary to pay it when it comes due.

Not to be glib about those who have an "estate" big enough to be subject to the taxes, but after you are dead, you don't care when you will pay, how much, or if the liquidity exists. Same goes for those who say that people should have the choice. I agree. Spend, donate, or "recycle" the money while you are alive. Lord knows, you can't take it with you.

As an aside, best quote from yesterday's session: "The meek shall inherit the earth. But, they must do so on a stepped up basis."

Wednesday, November 14, 2007

Can Robert Rubin Be Wrong?


Paul Krugman and Greg "No Comments" Mankiw don't like what Robert Rubin has to say about the relation between national savings and the trade balance.

I have my own un-orthodoxy:

Higher savings, should lead, eventually, to higher growth rates. That may well support higher real rates of interest. One way or another, this usually leads to improvements in the terms of trade, but not the trade balance. (Technically, high-yielding currencies should depreciate, but they don't always).

I'll take a stab at this:

A US functionary recently asked me if I knew any way that a lower government deficit could lead simultaneously to a stronger dollar and a lower trade deficit without causing a recession. When I said no, he was disappointed: his superiors were insisting that he produce a report asserting that it could.
A small, labor-equalization tax might do the trick. It's sort of like forced savings that reduces the deficit and lowers consumption, without causing a recession...

So, for instance, if the labor-cost differential was 85% and a small tax cut that down to say, 50%, it would still be immensely profitable to invest capital alongside overseas labor ...

Rather bullish in a risky time

I'm not sure the economy is past its vulnerabilities, but it does seem that the financial markets have gotten ahead of themselves.

We'll see what happens, but if I had to bet, it would not be to be contrary right now, which is what has been working. It would be to look for a small, but meaningful, breakout, in the very short run.

There is a flow of good news going on alongside some of the worries in the financial stocks. I terribly mis-read the basing in those stocks as die-hards trying to protect their investments in technical ways.

The consumer is not dead yet, despite the wealth effects from the housing market and all else.

Tuesday, November 13, 2007

All eyes on the dollar

The short, sharp reversal in the fate of the U.S. Dollar the day before yesterday was an indication that the U.S. may not have pulled off the biggest, stealth competitive "devaluation" in recent memory.

Once it becomes clear whether the US is headed for a significant slowdown or recession, expect the trends to reverse [meaning, that reversal may be the shape of things to come]. Until then, probably more of the same, although waking up everyday to the USD down another 0.25% is probably not likely to continue without a period of consolidation.

Meanwhile, it appears, this morning, that the death of the US consumer has been much exaggerated.

These are good trading markets - it's hard to see a trendline emerge decisively in any short order. However, these good numbers coupled with 'manageable' inflation figures might be the excuse for a "Santa Claus" rally that the markets so desperately want.

The Euro block, with rates on hold:


Saturday, November 10, 2007

Just the Numbers: Week 45


The race tightened among the top four contenders.

Ron Paul has a fantastic fund-raising set, and moves up in the numbers, to his highest level yet.

Thompson continues to skid.

In an apparent mimic of "The West Wing", Huckabee improves his lead as the VP who can 'talk the language' of the Conservative Right.

Giuliani doing amazingly well in Florida.


Nothing new this week.

Next PresidentPr (%)Chg
2007 Week 45: Contentiousness heats up as Dem Candidates use debate forum to bust out from behind Hilliary. Kucinich slammed with UFO question. Huckabee becomes media darling, sort of. AG Mukasey is in the news on torture and sworn in. Obama revels tax plan for the middle class. Congressman Rangle's tax plan gets play from GOP trying to re-brand itself. Giuliani wins endorsement of Pat Robertson, shoring up support against Romney, who has Bob Jones III, president of the fundamentalist Bob Jones University, Robert R. Taylor, dean of the university’s college of arts and sciences, Dr. John Willke, who helped found the National Right to Life Committee.
GOP NomineePr (%)Chg
DEM NomineePr (%)Chg
SenatePr (%)Chg
Next ExecutivePr (%)Chg
DEM VP NomineePr (%)Chg
DEM VP NomineePr (%)Chg
President ParleyPr (%)Chg
src:; bid-ask are not points, but spread as a percentage of the bid. Polls comparison, via RealClearPolitics.
IMPORTANT DISCLAIMER: this is just an informational note and not a solicitation or recommendation to buy or sell securities and there is no guarantee implied and people can lose all money on all investments. Numbers are believed to be correct, but do your own math and make your own conclusions or consult with an advisor before making any decisions.

Caucus/CandidatePr (%)Chg
Iowa Caucus
New Hampshire Primary
South Carolina Primary
Florida Primary
Nevada Primary