Surmountable mortgage mess

I’ve been watching the housing and mortgage markets with great interest for years.

When working for my former employer (2002-2005), I watched (but didn’t follow) as he doubled- and tripled-down on investments associated with the housing market.  As his employee, I worked hard, struggling to understand the individual investments, but never fully got my arms around them.  I knew enough to be very cautious, but that was all. 

Now, after watching the boom and bust over the last decade, I believe I have a much better understanding of how the housing, mortgage and financial markets work (or don’t work) together.  I’ve watched, researched, studied, invested and blogged on the subject over the last six years (my blogs from the spring, summer and fall of 2007 are particularly revealing of my concerns). 

So, it was with great interest that I read an article in the Wall Street Journal today, The Mortgage Hangover.  I highly recommend it to anyone who sincerely wants to understand the boom and bust of the housing and mortgage markets over the last decade (and not just looking for evidence to confirm one’s conclusions beforehand).  The article is not perfect, but it does a great job of highlighting many of the important details.

Specifically, it describes how the mortgage market was distorted over the last decade in the Bronx.  You may think that Bronx real estate has nothing to do with Florida, Nevada, California or Colorado real estate, but it does.  In fact, I believe it represents a microcosm of all U.S. real estate.

The problem started with well-meaning politicians who wanted everyone to have a home.  That problem was exploited by real estate and finance workers who were heavily incentivized to take things to the brink (which was the inevitable result of bad policy).  When those problems led to collapse, the same well-meaning politicians tried to prevent the resultant suffering.  Once again, those efforts are creating new problems instead of solutions.

The good news is that the mortgage and housing problems can be fixed.  It requires that housing and mortgage markets be allowed to reach clearing prices (where free buyers and sellers agree to exchange without any distorting incentives from politicians).  When that happens, housing and mortgage markets can begin growth afresh. 

I’m not saying the process will be pretty, but it will happen.  The destination will be the same no matter how well-meaning those who disagree.  The only question, now, is how quickly or slowly we get there.  Policy can impact the duration of the pain, not its intensity.

The bad news is that politicians and voters are unlikely to take the fast approach.  This is unfortunate, because U.S. economic and employment growth are unlikely to recover until the housing market recovers.  The longer we put off clearing prices in the housing and mortgage markets, the longer until employment and our economy truly improves. 

Mortgage and housing markets need not wallow in freakish misery.  Recovery, both for those markets and the U.S. economy, could start soon.  But, with continued meddling in housing and mortgages, recovery will take much longer and be much less robust.  It’s time to face the inevitable, hold our noses, and take our medicine.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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Surmountable mortgage mess

“Are we there, yet, Dad?”

The stock market seems to be finally reflecting economic weakness. The bond market reflected it some time ago, but the stock market only now seems to be coming around.

The question now is: how much farther do we have to go?

I’ll be the first to admit, I don’t know. But, I do have an opinion on whether we’ve reached bottom, yet, or not.

It seems hard to imagine that the fallout from a steeply declining housing market and the seizure of credit markets will wash out in less than a year.

Remember the wash-out that resulted from the dot.com bubble? It took from 2000 until 2003 to really hit bottom and turn back up.

Does it seem reasonable to expect the stock market to hit bottom so soon and with so little damage when housing and credit markets are much bigger pieces of the economy than technology? I don’t think so.

No, I think we still have some way to go.

First, the subprime mess will continue to spread. A lot of floating interest rate mortgages will reset, and a lot more people will punt their homes to lenders. Credit card debt, auto loans, etc. will also fall apart as credit markets further reflect housing turmoil. That, by itself, will take another year or more to work out.

Next, credit markets will have to absorb all those losses and downwardly spiraling asset prices. That will take another year or so.

Then, a bunch of politicians and lawyers will ride to the rescue, further highlighting the misdeeds of the housing and credit markets. That will take another year or so, too.

In my opinion, we still have at least a couple of years to go on this.

That doesn’t mean stock prices won’t hit bottom beforehand. They usually do.

That also doesn’t mean there aren’t good investments to be found. I’m finding some outstanding bargains now and expect that list to grow over the next year or two.

My goal is to be greedy when others are fearful and fearful when others are greedy. The latter kept me out of the housing and credit down-spiral. The former is what I’m looking forward to, but I don’t think others are quite fearful enough, yet, to call the bottom.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

If a shoe falls in the woods, and no one is around to hear it, does it make a sound?

In an earlier post, I brought up what could knock down credit markets. One issue was the availability of credit, which has been the subject of much pain and anguish, recently. The other two issues were interest rates and employment.

In the news today, the employment report for the month of August looked dreadful. For the first time in 4 years (when we were stumbling out of the last recession), payrolls tracked by the Labor Department shrank instead of climbing.

Could this be the result of financial service firms laying off workers in an attempt to adapt to current credit conditions? Could these laid off workers then have trouble making their home payments, thus promoting the negative spiral of home price declines, credit defaults, financial market troubles, and more layoffs?

I certainly think so. In fact, I believe this is the beginning of the other shoe dropping. I also believe the Fed will react as it always does, by lowering interest rates in an attempt to “jump-start” the economy.

This will, in time, lead to higher interest rates on longer dated bonds as foreigners demand higher rates to compensate for the dropping dollar. The dollar will drop further as more and more market participants realize the Fed will lower interest rates by printing more dollars (in other words, creating inflation).

How bad will this get? I don’t know, but lower employment and higher interest rates will make current housing problems look tame by comparison.

It’s a good time to avoid companies with lots of debt. It’s a good time to avoid investments related to the housing market or its financing (although a bit late).

More importantly, it’s a good time to be invested in securities that will benefit from this fallout. It’s a good time to have some cash that can be invested as the market goes down.

If inflation is a concern, it’s a good time to consider investing in tangible things (other than real estate) that are hedges against inflation. It’s not a bad time to consider foreign investments that may be hedges against inflation, too.

It’s also a great time to consider those companies that will fair best as we emerge from our credit market problems and into another growth up cycle.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Clampdown on risky mortgages

The Wall Street Journal had an interesting article today by James Hagerty and Ruth Simon titled “Lenders Broaden Clampdown on Risky Mortgages.”

In it, they highlighted that “Jittery home-mortgage lenders are cutting off credit or raising interest rates for a growing portion of Americans.”

As they say, “This worsening credit crunch threatens to put further pressure on the housing market.”

The mortgages being effected aren’t just subprime, but also included so-called Alt-A loans, a category in between prime and subprime. This illustrates how the credit crunch impacting the subprime market is spreading to other markets.

The articles quotes Thomas Lawler, a housing economist in Vienna, Va, who said the credit squeeze “will further crimp the effective demand for housing, and will make the late summer home-sales season even worse than the dismal spring season.”

Also, American Home Mortgage Investment stopped making loans earlier this week and said late yesterday it would cease most operations and lay off over 6,000 employees. Accredited Home Lenders Holding is almost in as much trouble after auditors said its “financial and operational viability” is uncertain.

In other words, the so-called “contained” credit market squeeze continues to impact more and more markets and businesses. It’s my guess that it will take years for this situation to fully work out and that players in the credit markets will see record stress before it’s all over.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Beware the Black Swan

I’ve been babbling for several months now on this blog (and, as my wife can attest, for several years before that) about the risk of low probability, high impact events–what Nassim Taleb refers to as Black Swans–particularly related to the housing market.

It seems that chicken may finally be coming home to roost in the housing market and the markets that rely strongly on the housing industry.

Before I crow too loud about the malaise that is occurring, I must freely admit that I did not place any money-making bets on this decline. Quite the contrary, all I did was try to stay away from such a risk.

In staying away, I missed out on the huge run-up that has occurred in mortgage lenders, mortgage insurers, bond insurers, home builders, etc. This made me look pretty stupid in the short run, but right now I’m quite happy I don’t own any companies in these industries.

Will these industries face a total collapse or a financial crisis? I have no idea. The odds are against it. But, like all Black Swans, I want to avoid such negative, low likelihood, high impact events.

I don’t have to be able to predict when they will happen or how bad it will get, I simply have to stay away from risks I cannot accurately assess or that do not provide sufficient compensation for their risk.

I will be very interested to see how bad such housing related markets get, but I still don’t think I’ll be participating there for quite some time. After all, because it seems to be a Black Swan, I don’t know how bad it will get, and so I’m staying away until I understand what’s going on.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Interest rates

For those of you not paying attention, the bond market has had an amazing month and a half!

If you are thinking to yourself, “What does the bond market have to do with anything, I buy stocks,” hold on to your hat.

Bonds are frequently used as the discount rate or the base rate from which discount rates on stocks are computed. This is most prevalently seen in the Fed Model, but is also the way almost every finance textbook used in business school starts.

If bonds drop in price, and their yields go up (as has happened lately), then stock prices should go down (all things being equal, and they never are). By how much? I’ll get to that below.

Back on May 2nd, the 10 year yield on US Treasury bonds was 4.64% and the 3 month yield on US Treasury bills was 4.87% (according to Value Line’s May 11 Selection and Opinion). Today, according to PIMCO’s website, the 10 year is yielding 5.30% and the 3 month is yielding 4.72%.

This is a massive change! The 10 year’s yield jumped 0.66% and the 3 month’s yield dove 0.15%. Because the bond market has such a huge impact on all discount rates in the market, this is a huge change!

For those of you thinking the stock market’s recent sell off has taken account of such a discount rate change, think again. The DJIA was at $13,211.88 on May 2nd and closed at $13,295.01 today, a 0.63% increase. All things being equal (assuming estimates on company earnings haven’t changed), the DJIA should be at $11,566.60–down 12.45%! Instead, it’s at $13,295.01, implying that earnings estimates for the DJIA have increased by 14.95% in the past month? I doubt that.

I’m NOT suggesting the Fed Model is correct or that stock prices should move precisely with bond yields, but I am suggesting that the stock market, and perhaps other markets, have not taken full account of recent bond price and yield movements.

Also, how do you think bond price moves will impact mortgage and housing markets? A 30 year mortgage on a $300,000 house should go up around 7% per month (or $130) based on this bond price change. Does it seem like that’s been figured into market prices for home builders and mortgage companies? It doesn’t seem like it to me.

As usual, I’m making no assumptions about what will happen in the market and when, but I do find recent bond market moves disturbing.

Perhaps bond prices and yields will go back to where they were, vindicating recent stock market moves. Perhaps fundamentals are improving just as quickly as bond prices are dropping and this justifies no move in prices.

I can’t predict what will happen much better than the next guy, but I am scratching my head and wondering what other people in the market are thinking.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Inflation and Valuations, Foreign Investors, Lead into Gold, The Many Faces of the Housing Market

Several market commentators have been highlighting that low inflation has historically corresponded with high valuations, thus implying current valuations are justified by low inflation. John Hussman, in a recent article, takes this notion to task.

Just because high valuations have corresponded with low inflation in the historical record does not mean it’s a great idea to invest now. You should be focusing on future returns, not data on current conditions. In fact, as Hussman shows, low inflation and high valuations tend to indicate weak future returns. Perhaps we should all drive by looking out the windshield instead of at the rear view mirror.

Most investment commentators are paid to get gullible people to buy stock now…Now!…NOW!!! Don’t be confused into becoming a lemming by such blather.

John Mauldin’s latest weekly letter had some delightful information, too.

First, Mauldin highlights the influence Sovereign Wealth Funds may have on markets going forward. Specifically, China’s recent $3 billion investment in BlackRock may be an indication of things to come. Can you say falling US dollar?

Next, Mauldin does a great job describing how the financial engineers of Wall Street are turning lead into gold. Specifically, he shows how such rocket scientists can turn non-investment-grade subprime loans into 95.8% investment grade securities. Do you think they’ll stay investment grade if the underlying assumptions prove to be based on a too short historical record?

Finally, Mauldin raises some questions about recent positive housing data and how such information may impact the US economy. Are housing statistics really good indicators of what is happening in the housing market? Did new home sales jump based on fundamental demand, or because new home prices are lower than existing home prices? If the economy’s growth over the last 6 years has been due to mortgage equity withdrawals, what will happen if home prices decline? And, how would this be impacted if unemployment were about to rise as forecast by Paul McCulley at PIMCO?

Just some good commentary to consider…

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.