Toro's Running of the Bulls Market Blog

Traveling. Open Post.

I will be traveling next week.  Feel free to post all things markets here. 

I will resume posting when I return.

Option ARM Debacle

From The Wall Street Journal

Defaults on a popular form of mortgage that gave home buyers a choice of how much to pay each month are rising and could rival those on subprime loans, potentially causing more trouble for investors and banks.

Nearly $750 billion of option adjustable-rate mortgages, or option ARMs, were issued from 2004 to 2007, according to Inside Mortgage Finance, an industry publication. Rising delinquencies are creating fresh challenges for companies such as Bank of America Corp., J.P. Morgan Chase & Co. and Wells Fargo & Co. that acquired troubled option-ARM lenders.

Option ARMs typically were made to borrowers with higher credit scores than those getting subprime mortgages. But many of these borrowers were stretched thin even when they were making payments, and are particularly vulnerable to a weakening economy and falling home prices. Borrowers can face payment shock when they must begin making payments of full interest and principal.

Often, these loans were taken out without full documentation of borrowers' incomes and assets, and the reported incomes were often overstated, analysts say. Option ARMs are concentrated in areas such as California and Florida that have seen some of the biggest home-price downturns.

Option ARMs, which have been largely abandoned, give borrowers multiple payment options, including a minimum payment that often was less than the monthly interest due. Borrowers who made the minimum payment on a regular basis often saw their loan balances grow, also known as "negative amortization." And with home prices falling, more than 55% of borrowers with option ARMs owe more than their homes are valued at, according to J.P. Morgan Securities Inc.

As of December, 28% of option ARMs were delinquent or in foreclosure, according to LPS Applied Analytics, a data firm that analyzes mortgage performance. That compares with 23% in September. An additional 7% involve properties that have already been taken back by the lenders. By comparison, 6% of prime loans have problems. Problems with subprime are still the worst. Just over half of subprime loans were delinquent, in foreclosure, or related to bank-owned properties as of December. The nearly $750 billion of option ARMs issued from 2004 to 2007 compares with roughly $1.9 trillion each of subprime and jumbo mortgages in that period.

Nearly 61% of option ARMs originated in 2007 will eventually default, according to a recent analysis by Goldman Sachs, which assumed a further 10% decline in home prices. That compares with a 63% default rate for subprime loans originated in 2007. Goldman estimates more than half of all option ARMs outstanding will default.

Astonishing.

Exchange Traded CDS

Saw this as a note from Howard Simons on RealMoney.

CDS contracts trading in volumes greater than the underlying bonds outstanding provide information to the market and allow for more efficient pricing.

The rejoinder at this point is, "Didn't that get AIG into trouble?" Yes, and that was true for the municipal monoline insurers (remember them?) as well. The answer is with central clearing and margining of outstanding CDS, you can support almost any volume of contracts. The futures industry has done this for years; only a small fraction of contracts ever go to delivery, but the remainder used for purposes of price discovery, risk management and speculation do not wreak havoc.

A derivatives market limited to the size of its underlying asset will collapse immediately. Whatever benefits existed from CDS, such as institutional investors being more willing to hold various corporate and municipal bonds, will disappear as well. Provide for centralized clearing and margining and everything should function just fine without Congressional interference.

More on Peter Schiff

Peter Schiff has been taking a lot of heat the past few days for his performance, as we noted a few days ago.  The Wall Street Journal has picked up on the story.

Peter Schiff predicted a collapse of the U.S. financial system. The bust-up he didn't foresee was the one that made mincemeat of investors who took his advice in 2008.

Mr. Schiff's Darien, Conn., broker-dealer firm, Euro Pacific Capital Inc., advised its clients to bet that the dollar would weaken significantly and that foreign stocks would outpace their U.S. peers. Instead, the dollar advanced against most currencies, magnifying the losses from foreign stocks Mr. Schiff steered his investors into.

Investors open accounts at Euro Pacific to take advantage of Mr. Schiff's investment advice, which generally involves shunning investments in dollars. Individual returns can vary. Some investors may like gold-mining stocks, while others prefer energy-focused stocks.

Most had one thing in common last year: heavy losses. A number of investors said their Euro Pacific portfolios lost 50% or more in 2008, worse than the 38% drop in the Standard & Poor's 500-stock index last year. People familiar with the firm say that hardly any securities recommended by Euro Pacific brokers gained ground in 2008. ...

In his 2007 book, "Crash Proof: How to Profit from the Coming Economic Collapse," he recommends that investors pile into gold, commodities and overseas stocks that spit out steady dividends. ...

In 2008, investors nervous about the state of the U.S. economy who were impressed by Mr. Schiff's track record poured money into Euro Pacific, nearly doubling the number of accounts to 16,000. But many did so at the worst time possible, much like investors who piled into Internet stocks as the dot-com bubble peaked. ...

(Note the herd piling in at the top?  The herd gets out at the bottom too.)

One of Mr. Schiff's biggest forecasts was that many overseas economies would "decouple" from the U.S., gaining strength even as the American economy struggled. Instead, overseas stock markets plunged as much or more than U.S. stocks in 2008 as the global economy skidded. Prices for commodities also tanked, torpedoing another favorite investment theme of Mr. Schiff's. After last year's losses, his firm has about $845 million in assets.

Early last year, Richard De Gennaro, a retired Harvard University librarian, put $100,000, about 15% of his assets, into a Euro Pacific account that included Canadian Oil Sands Trust, which focuses on crude-oil projects in Canada, and the India Capital Growth Fund, which holds investments in companies that do business in India.

Both investments took big hits in 2008, compounded by the fact that the Canadian dollar and the Indian rupee fell 18% and 19%, respectively, against the U.S. dollar. The 83-year-old retiree's account is now worth about $37,000, a 63% plunge. Mr. Schiff "goes around saying that he was right," says Mr. De Gennaro. "He was right about one thing and wrong about everything else."

Among investors who turned to Mr. Schiff's firm just as his strategy began to falter, Brian Kullberg, a design engineer in Portland, Ore., says he started to worry about the state of the U.S. economy in early 2008. He put $70,000 into a Euro Pacific account, hoping it would benefit as the U.S. economy and the dollar weakened. By late January 2009, his investment had shrunk to about $25,000.

Ouch.

Bankers' Bonuses

President Obama took a shot at the amount of bonuses bankers paid themselves for bringing the global economy to the brink of collapse.  EconomPic graphically illustrates who much Wall Street has paid itself over the years.

Obama's comments unnerved the market, and as an investor, I would rather he not have made them.  As a citizen, however, I agree.

Demolishing Marx's Labour Theory of Value

Every once in a while, I'll meet up with a dogmatic Marxist on the Internet who has spent his entire education (they are always students) studying Marx for 15 hours a day, every day, who will tell you that capitalists are evil because they exploit workers and all that.  For anyone who is interested, this is an old piece by Brad DeLong on the fallacies of Marx's labour theory of value.

Analogies to The Great Depression are Misplaced

I think references today to The Great Depression are misplaced.  Two recent articles note the differences between today and the 1930s. 

First, from The Telegraph

[I]t is not yet like 1933. That second leg down was the result of "liquidation" policies by a Dickensian leadership blind to the dangers of debt deflation. By then the Gold Standard had degenerated into an instrument of torture. It forced the Fed to raise rates from 1.5pc to 3.5pc in October 1931 to stem gold loss, with predictable results for shattered banks.

It is worth glancing at the front page of New York Times on Monday March 6, 1933 to see what the world looked like three days after Franklin Roosevelt moved into the White House.

The newspaper splashed with the story that FDR had closed the US banking system – invoking the Trading with Enemies Act – and ordered the confiscation of private gold. From left to right, the headlines read: "Hitler Bloc Wins A Reich Majority, Rules Prussia"; "Japanese Push On In Fierce Fighting, China Closes Wall, Nanking Admits Defeat"; "City Scrip To Replace Currency"; "President Takes Steps Under Sweeping Law of War Time"; "Prison For Gold Hoarders". ...

Roosevelt took over a country where the economic machinery had completely broken down. The New York Stock Exchange and the Chicago Board of Trade had closed. Thirty-two states had shut their banks. Texas had restricted withdrawals to $10 a day.

Few states could borrow on the bond markets. Illinois and much of the South had stopped paying teachers. Schools closed for months. An army of 25,000 famished war veterans squatting in view of Congress had been charged by troopers of the 3rd US cavalry with naked sabres – led by a Major George Patton.

Armed farmers threatening revolution had laid siege to a string or Prairie cities. A mob had stormed the Nebraska Capitol. Minnesota's governor was recruiting Communists only for the state militia. Lawyers attempting to enforce foreclosures were shot. More than 100,000 New Yorkers applied to go to the Soviet Union when Moscow advertised for 6,000 skilled workers.

We forget how close America came to open revolt. Eleanor Roosevelt feared the country was beyond saving. Her husband kept the faith. He channelled the anger against Wall Street, diffusing it. "The practices of the unscrupulous money-changers stand indicted in the court of public opinion," he began his presidency.

The Fed was an ideological deadweight. Bowing to pressure from Congress it began to purchase bonds in mid-1932 to boost the money supply, but then recoiled, before retreating into pitiful self-justification. A third of the rescue funds in Hoover's Reconstruction Finance Corporation had been embezzled.

The environment is very different today.

Today there has been no such failure of US institutional imagination, even if, as George Soros argues, the Treasury's policies have been "haphazard and capricious".

The twin blasts of fiscal and monetary stimulus have been massive. In short order the Fed has slashed rates to zero. It is now conjuring money out of thin air on an industrial scale, buying $600bn of mortgage bonds to force down the cost of home loans, and propping up the commercial paper market to avoid mass corporate default. Ben Bernanke, a Depression junkie, is proceeding with a messianic sense of certainty. The wash of money should ensure that the next 18 months will not mimic the cascade of disasters from late 1931 to early 1933.

I do not agree entirely with the reading of history of The Great Depression at Popular Delusions,  However, the author does point out several salient facts about The Depression.

[T]he crash on Wall Street and the credit crunch it created caused an abrupt halt to those international capital flows and turned a US scarcity of liquidity global. Then, as now, liquidity masked a multitude of sins and its sudden flight revealed an underlying financial fragility few had hitherto guessed at. 

First up were the Austrians. The capitalisation of their banking system had been weakened by the inflation of the 1920s while a consolidation aimed at strengthening the system in fact weakened it and made it more concentrated. The focus of the crisis, the troubled Credit-Anstalt was larger than all of its competitors combined. By May 1930, what had started as a nervous withdrawal of funds by foreign investors unsure of Austria's banking health became a full-blown run and in June the authorities put in place capital controls to restrict the flood of gold leaving the country. 

Now the global panic was on. If the Austrians could withhold gold, so could her Eastern European neighbours and soon there were bank runs in Hungary (where Credit-Anstalt had branches), Poland, Czechoslovakia and most importantly given the political consequences of the slump there, Germany, which came off gold in July/Aug 1931 (Kindleberger suggests part of the panic's contagion was caused by some American investors not realising that Germany and Austria were different countries). 

Britain was the next country to come under fire, succumbing to the new financial reality (and blaming speculators) and leaving the gold standard in September 1931 and this was a cataclysmic event. Although financially weakened by WW1, the perception until then remained that Britain was the economic, financial and political leader of the world - if Britain could come off gold, anyone could, including the United States. 

And so the financial storm again struck the American shores from which they'd originated as the 1929 Wall Street crash returned, boomerang like, to threaten the heart of the US financial system anew. The Fed raised its discount rate from 1.5% to 3.5% to counter the panic by attracting gold flows and, for better or worse (probably worse since the action triggered a further liquidity squeeze and another round of banking failures), managed to stay on the now considerably smaller gold/exchange standard (at least for another few years). 

One of the reasons I think it important to understand these events more clearly is because globally (and in strictly economic terms) the events of 1931 marked the high watermark of the crisis. The countries which came off the gold saw their economies recover soon afterwards. ...

FDR's election helped trigger a third round of banking collapses when he came to office. After winning the 1932 election he hinted without ever confirming that he would take the US off gold. But he wasn't to be inaugurated until March 1933. For four months there was no one in charge and the uncertainty and fear that yet another government would devalue it's currency against gold as most of the Europeans had just done caused another panic as investors rushed for the exits. While the US remained on the gold standard, gold still formed the basis for the banking system's reserves which formed the basis for the economy's outstanding stock of credit, so the sudden gold outflow caused another sharp contraction in the money supply, another wave of banking collapses and another nosedive into recession ...

There is currently a credit crunch, though it has eased somewhat over the past month.  However, the government and the Fed are working madly to unfreeze it, unlike during The Depression when the Fed and the government were late in addressing the credit contraction, even raising interest rates during the Depression to stem the outflow of gold.

Thus, I think the analogies of The Depression to today are incorrect.

Harvard Whacked

Harvard's losses are probably greater than advertised.

Harvard Management Co., which runs the world's largest endowment fund, has had until recently an incredible record. Over the past six years, it succeeded in more than doubling the notional value of Harvard's endowment to $36.9 billion in fiscal 2008 (which ended on June 30) even after paying for about one-third of Harvard's operating expenses. So its recent loss of $8.1 billion from July 1 to Oct. 31, 2008, came as a stunning blow. Yet this huge loss, as staggering as it sounds, might be only the tip of the iceberg of illiquid investments. According to a source close to the Harvard Management Co.,the damage, if the fund's illiquid investments are realistically appraised, may be closer to $18 billion—or more than twice the amount previously reported.

Harvard's asset allocation? 

• 18% hedge funds
• 13% private equity
• 11% emerging market equities
• 11% foreign developed market equities
• 11% US equities
• 9% real estate
• 9% timber and other agricultural land
• 8% oil and gas
• 5% inflation-indexed bonds
• 4% US bonds
• 2% foreign bonds
• 2% high-yield, i.e. "junk" bonds
• -3% cash

Cash was the best performing asset in the fourth quarter.

By my estimation, about half of Harvard's assets are in illiquid assets.  Sales of illiquid assets have collapsed.

One major player in the private equity business tells me that Harvard had tried this fall to sell its private equity stakes at 30 percent to 35 percent discounts but could find no buyers even at those prices. It's also possible that Harvard will have to meet "capital calls" on its private equity investments that would sap even more capital.

Endowments, pension plans, insurance companies and other large pools of institutional capital invest along asset allocation guidelines.  Asset allocations guidelines implicitly assume liquidity will always be available, i.e. an investor will be able to sell assets when needed to pay liabilities.  Liquidity is assumed in all financial models, including asset allocation models.  However, as Harvard - and the whole world for that matter - is discovering, liquidity is not always available.  That is a problem if you need liquid funds for expenses.

Many endowments and pension plans tried to emulate the success of Harvard and Yale by moving into illiquid assets.  They have found that illiquidity is a cost, and the risks of such investments were under-stated when they were putting together their investment plans.

My guess is that many of those same funds will move out of illiquid assets back into boring old stocks and bonds over the next several years.

We Do as We Do, Not as We Say

We in the United States and the Western nations will see our stature diminish in international financial markets as we do not take the medicine we recommend to others when they are in the midst of a financial meltdown.

Sitting a few time zones away from the Davos gathering, former Malaysian Prime Minister Mahathir Mohamad spares a dry chuckle at the fall of the once mighty Western financial giants and masters of the universe.

“They were doing everything that [multilateral agencies] were counseling developing countries not to do to stay out of crisis,” he said about the parade of Western banks that have crumbled over the last six years due to heavy leveraging and bad assets. “They were greedy … and now people are having a big laugh.” ...

“They told us … there was a bubble [in asset and currency prices]. They told us not to increase borrowing. They told us to cut back government spending. Its advice they ignored in [their] own economies,” he said to an appreciative audience of Arab businessmen who have their own gripes about what they see as American and European hypocrisy, especially when it comes to foreign policy in the Middle East.

I certainly do not blame them for seeing us as hypocrites.

New Home Sales Lowest on Record

Yesterday, we noted that typical bottoming behavior was occurring in the housing market as existing home sales rose from the month before as banks blew out foreclosed properties at fire-sale prices.

However, that does not mean the bottom is in.  Rather, it is the beginning of the bottoming process.  The actual bottom is probably several months away.

Evidence that home prices will remain under pressure over the neat term was today's news that new home sales in December were the lowest on record.

Sales of new homes in the U.S. fell in December to the lowest level on record, creating an unprecedented glut of unsold properties that casts doubt on any recovery in the industry this year.

Purchases dropped to an annual pace of 331,000, lower than all 70 forecasts in a Bloomberg News survey, Commerce Department figures showed in Washington. Other reports today said orders for durable goods slumped for a fifth month and a record number of Americans were collecting jobless benefits.

The collapse in demand for homes means builders are still constructing a surplus of properties, and signals more pressure on prices. The intensifying crisis will make it harder for President Barack Obama to arrest the industry’s decline with proposed tax breaks and steps to slow mortgage foreclosures.

“Builders are slashing production, but it’s difficult for them to keep up with sales that are falling so fast,” said Nigel Gault, chief U.S. economist at IHS Global Insight, in Lexington, Massachusetts, who at 345,000 had the lowest estimate of economists surveyed. “New homes are getting cheaper, but you can’t get credit so you can’t buy.” ...

Unadjusted for seasonal patterns, only 23,000 Americans bought new homes last month, with just 2,000 purchases in the Northeast region. ...

The median price of a new home decreased 9.3 percent from the same month the prior year to $206,500, the lowest in five years. Sales of new homes were down 45 percent from December 2007.  ...

New-home purchases, which now account for less than 10 percent of the market, are a timelier indicator than existing sales because they are based on contract signings. Sales of previously owned homes, which make up the rest, are compiled from closings and reflect contracts signed weeks or months earlier.

Getting ‘Clocked’

“The new-home market is getting disproportionately clocked relative to the existing-home market,” Stephen Stanley, chief economist at RBS Greenwich Capital Markets Inc. in Greenwich, Connecticut, said before the report. “New home sales have taken the bulk of the hit.”

Sales of existing homes in December unexpectedly rose 6.5 percent, the National Association of Realtors said Jan. 26. For the full year 2008, existing home sales fell 13 percent.