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Wednesday, September 17, 2008

A Blast From the Past... How the Housing Crisis Will End (Revisited)

This piece is simply an updated version to a piece I published back on March 5th 2008 titled 'How will it end'. Despite the fact we are much deeper into this financial crisis; the root of the problem has not changed, and that is the US housing market.

As an interesting exercise consider that in March 2007 the total value of US subprime mortgage market was estimated at USD1.3trn; now lets combine that with the fact that 12% of these mortgages have or are in the process of defaulting. What this implies is that the total value of subprime mortgages effected by these foreclosures equals USD156bn. Now compare that to the cost of write-downs (~USD517bn) and the Fed's bailouts (USD85bn just for AIG)... Of course no one, including the Fed, could have possibly predicted the detrimental wide-spread effect the housing crisis would have on the global economy; my point is solely to demonstrate how a small piece can have a very significant impact on the entire picture in an over simplified manner.

Here it is with updated data and some small changes!

We are continuously being barraged with mixed news concerning the housing crisis. One day we hear signs are pointing towards a bottom; the next housing numbers came in much lower than expectations. So we raise this question: What indicators should we be looking at to truly signal a recovery in housing?

With this question in mind our analysis focused on creating the stages we believe would be necessary to facilitate a recovery. We were able to define 7 chronological stages which need to occur in order for the crisis to end. Additionally, the progress for each of the stages can be measured by several key indicators. The stages we outline below are meant to help to average investor better understand how a recovery will most likely unfold, and includes indicator that anyone with a basic internet connection will be able to easily access.

Our stages and key indicators to watch:

1. The number of defaults from subprime borrowers needs to drop substantially. This will help to stabilize growing inventory levels. Key Indicator(s): RealtyTrac foreclosure data (monthly) & MBA foreclosure data (quarterly)

Subprime ARM mortgage resets continue to be the primary driver behind subprime foreclosures (July 2007-November 2009)

Foreclosures as a percent of total mortgages continue to rise...
Source: Bloomberg

2. Banks need to lower lending standards for home mortgages. This will allow existing and new home sales to increase and prices to stabilize. Key Indicator(s): Fed Senior Loan Officer Survey, mortgage rates, Case Shiller Home price index (monthly), & New and Existing home sale prices

However, lending standards have tightened across all mortgage types according to the Senior Loan Officer Survey
Source: FRB

30Y fixed mortgage rates have fluctuated but remain elevated especially when considering the recent rate cuts ...
Source: Bloomberg

3. Once people are again able to buy homes we will see a reduction in inventory levels. When this occurs demand will rise for new constructions. Key Indicator(s): New home sales data (monthly) & Existing home sales data (monthly)

But for now increased foreclosures and tighter lending standards have caused new home sales to drop
Source: Census

The recent crisis has begun to negatively effect the housing affordability index
Source: Bloomberg

4. The rise in demand for new construction will first show up in building permits. The rise in building permits will lead to our next step... Key Indicator(s): Building permits data (monthly)

But, building permits have shown no signs of a sustained recovery
Source: Census

5. Very soon after the rise in building permits we will see an increase in housing starts. Key Indicator(s): Housing starts data (monthly)

However, with permits still depressed, starts have shown no signs of recovery
Source: Census

6. The increase in starts will lead to an increase in construction spending. Key Indicator(s): Construction Spending (monthly)

As you can see from this chart, this is not yet the case
Source: Census

7. Finally, residential investment begins to rise and the housing crisis is over. Key Indicator(s): Residential Investment via GDP release (quarterly)

Residential investment continues to be a drag on real GDP growth
Source: Bloomberg

Essentially, this crisis is occurring due to a substantial increase in the supply of houses through subprime foreclosures, and a decrease in demand to buy houses through harder to get mortgages. As more homes enter the market and less people are able to acquire mortgages to by them the price drops. Hence, the first major step in a recovery for the sector will be a slow-down in the number of foreclosures, which has likely been pushed back until second half 2009. Secondly, and equally important banks need to reduce lending standards to allow qualified buyers to purchase new homes. These two actions combined will begin to reduce the inventory of homes on the market and stabilize price. Once the amount of inventory of homes for sale begins to drop, we will see demand for new constructions begin to rise. This will first show up in the building permits index, followed by housing starts, and finally private construction spending. All in all, this will not be a fast process, with the reduction in foreclosures and lowering of lending standards being the hardest hurdle to overcome.

Currently, the primary driver for subprime foreclosures are interest rate resets. When these borrowers we first given their mortgages they were given low teaser rates which would eventually reset into higher adjustable rates. Meaning some mortgage holders who were paying USD1,200 a month for their mortgage in November could be paying USD3,200 a month in December. For a lot of these borrowers it has been nearly impossible to pay the new amount and they have been forced to default. On a positive note, based on available market information we should see the number of resets for adjustable rate subprime mortgages peak sometime in late spring/early summer. However, it is tough to estimate the lag time between mortgage resets and actual foreclosures, which prolong this situation. The deteriorating employment situation in the US will add additional downward pressure to this indicator. All in all there is no quick easy fix on the housing front, and we will likely have to deal with these conditions for quite some time.

Investment Idea:
Once a the market starts showing signs of a sustained recovery we feel that US home builders could significantly benefit. US homebuilder stocks have been pounded since the housing crisis first began, and will be poised to make a recovery as demand for new homes eventually rises. However, as we said this could take some time, but it will happen. I currently hold a long position in ITB, a US home builder ETF.

Tuesday, September 16, 2008

My Thoughts on the Next 24 Hours...

These are very interesting times... At this point in time, after passing up some deals which could have saved AIG, I wouldn't be surprised if we saw at least part if not all of AIG being bought at bargain basement prices by one of its major competitors. I think it will be tough for them to find financing any other way, especially after the recent downgrades. However, I haven't been following the industry too carefully, so it would be tough for me to speculate on an appropriate suitor (list could include ING, Allianz, AXA, etc...). Nonetheless, I am rather glad I haven't taken on any new long positions in the sector recently. Something else we should all be paying close attention to is the effect these failures have on the CDS market, this could open up a whole new bag of worms. I recently read an article which stated that PIMCO alone currently guarantees USD760mn of AIG debt.

As for the Fed, I would be surprised, but not shocked, if we saw the Fed move 50bps today, however they will almost certainly switch to an easing bias in the statement and very likely modify and extend some of the current lending schemes (i.e. changes to the discount window and/or TAF, accepting more assets as collateral, possibly even allowing the Fed funds rate to trade well below target over the next couple of weeks, etc...). I don't really believe a rate cut would be the right course of action, liquidity is the issue not price. However, psychologically it may help the market. All in all the Fed's announcement will likely bring some calm to the market, which could easily be undone by an AIG collapse. We will all get a much better idea within the next 24 hours, as it has been reported an AIG deal would need to be completed by Wednesday. Currently, I am staying on the sidelines, but monitoring the situation closely. Finally, I did notice that the financial sector ultrashort ETF is trading nowhere near its July highs, which I found somewhat interesting. I am not very familiar with this fund, so if anyone has some insight on this please feel free to email me.

As an aside, and as I mentioned was a possibility in my previous post, China has begun easing monetary policy. This could be an important factor once the market does start recovering. Many of China's issues were self-inflicted and reversing policy could have a big impact as investors (eventually) become a bit less risk adverse.

UltraShort Financials ProShares (AMEX:SKF)

Source: Bloomberg

Sunday, September 14, 2008

A Quick Look at Global Sub-indices (& An Aside on China)

A while back I created an excel file that tracks the conditions of global sub-indices. Essentially, I took over 600 sub-indices from around the world and I broke them out by best and worst performing over the past 6 months, P/E and P/B ratios, and dividend yield. I extracted the 15 best and worst performing indices from each of these categories and consolidated them in the chart below . I am eventually planning on using this data to look at global trade ideas or to spot mis-pricings between markets. All in all I extracted this data form Bberg last week and I hope you enjoy the data. I will follow up with a more detailed analysis on markets that may look attractive after I conduct further research.

As an aside, given the recent economic data out of China (inflation, IP, exports, etc...), I anticipate the government is closer to moving towards a more accomodative monetary policy. The shift will likely include reductions in reserve requirements and an easing of lending standards. It is also possible, but unlikely at this point in time, that we could see a rate cut before the end of 2008. Any action by the government to stimulate the domestic economy should have positive effects on Chinese markets. I currently hold an upward bias towards some of China's housing, health care, and financial names. (Please see earlier posts for more details).

Top and Bottom 15 Global EQ Sub-Indices by 6M performance, PE, PB and dividend yield

*Source: Bloomberg