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Dangerously Close to a Money Panic by Martin D. Weiss Ph.D.

This is content from another blog that I thought my constituency would appreciate... Yes, it has an alarmist tone, and many of us already know much of what he states, but does make a compelling story when all put together. He also includes two very well known companies that I am probably going to put a concentrated short position on once I have finished my research.

With credit markets sinking into deeper turmoil ...

With more severe losses spreading to a wider range of financial institutions ...

And with the Fed's rate cuts thus far failing to stem the crisis ...

We are coming dangerously close to a money panic.

Few Wall Street analysts are talking about this in public. Fewer still understand its potential consequences. Many don't even know what a money panic is. But historians do. They realize that ...

A money panic is a stampede from greed to fear, risk to safety, buying to selling. Once set into motion, it can spin out of control, feeding on itself, wrecking havoc in financial markets.

Moreover, the data I'll share with you in this in-depth issue shows that, if not averted, a money panic could ...

• Threaten the solvency of major Wall Street firms like Bear Sterns, Goldman Sachs, Lehman Brothers, Merrill Lynch or Morgan Stanley.
  
  
• Increase the risk of future failure among large banks like Bank of America, Citibank, HSBC, JPMorgan Chase or Wachovia.
  
  
• Even force certain kinds of money market funds to break their solemn process of preserving your capital.

Welcome to the World of Dr. FrankenFinance!

Many of the large institutions that are the bellwethers of industry (certain industries, at least) are the victims of Dr. FrankenFinance. Due to the machinations of Doctorates of Philosophy (PhDs), who are much smarter than I am (academically at least), there has been an explosion of financial activity in the past decade. From off balance sheet structures to insured debt, to the securitization and sale of balance sheet liabilities, these doctors (known in today's parlance as financial engineers) have enabled companies to do what just a decade or two before had been considered impossible and just the stuff of fantasy. But wait, did they truly weave magic? Or was it the result of financial alchemy? Or was it just pure, old fashioned math? Well, whatever it was considered in its creation, it can now be now considered… A Monster!

Why a monster, you ask? Well, The Doctors' FrankenFinance have enabled corporate America (and corporate Europe and Asia as well, I just don't have the time to cover them in this blog piece), to bring to life certain aspects of the profit cycle that were heretofore non-existent. Examples of which are:

• profiting from assets that do not drag down ROA and ROI metrics (i.e., holding business assets off balance sheet);
• funding operations with "disappearing" liabilities (i.e., holding liabilities off balance sheet);
• creating the unlimited balance sheet by writing loans off of someone else's balance sheet (i.e., loan securitization otherwise known as OPM – other people's money); and
• using allegedly 3^rd party opinions from companies with highly conflicted interests in conjunction with insurance and guarantees from companies levered over 100x to sell junk bonds as AAA .

Yet, you see, these distortions of financial nature have truly indeed created monsters. Let's take a look:

• Off balance sheet accounting: When Dr. FrankenFinance takes things past the alchemical and into the mysticism of Voodoo, we get … Zombies. Lennar, the nation's largest homebuilder, is borderline insolvent. Click the zombie link to see my analysis. Long story, short – this would not be the case if they were not allowed to sock half of their debt away from investors' eyes. Or at least, investors would have had a chance to value the company accordingly. To make matters even worse, up until yesterday, the nation's largest bank (and itself a prime benefactor/recipient cum victim of FrankenFinance science, see below) has been issuing bullish buy reports on this company and its entire sector for months.
• More off balance sheet accounting: Citigroup, BofA, HSBC, JP Morgan Chase and all of the other major SIV (structured investment vehicle) vendors. The monster behind the madness of these guys' creations have come home to roost.
• Using other peoples money: The problem with this aspect of FrankenFinance is that it breeds irresponsibility. If you make loans and it ain't your money, you really don't give a damn who pays it back and who doesn't. These geniuses only considered the short term ramifications of such actions though. In the intermediate term, we get companies like... American Home Lending, Countrywide and Washington Mutual.
• Using allegedly 3^rd party opinions from companies with highly conflicted interests in conjunction with insurance and guarantees from companies levered over 90x to sell junk bonds as AAA: Here we have the Scary Halloween Tale of 104 Basis Points where we delved into the inner machinations and secrets of MBIA, and the subject of my next dark missive - Ambac Financial (which should be online in an hour or two).

Nouriel Roubini and Global Recoupling - Pt 2 of the Great Global Macro Experiment!

Roubini is one of the few renown economists that I can vibe with. He has been lockstep with me on my views of real estate recession, and he is also in agreement with my views on global contagion and re-coupling (more accurately, I never believed we decoupled in the first place). To get an idea of how I am investing my modest amount of money, read For those who feel the world has decoupled from the US economically - and in the financial markets, I bring you “The Great Global Macro Experiment” , for it explains how the US exported its proprietary brand of asset inflation and hyper-growth activity to the rest of the world. This is what got me into real estate investing, to begin with. The issue is, with every boom there is the requisite bust. This is what got me into shorting real estate. The opportunity lies in the fact that many, till this very day, fail to understand the extent of the upcoming real estate bust, and fail to understand the linkages that will export this bust to the rest of the world. It has already spread from residential real estate to mortgages and derivative finance. Commercial real estate is up next (reference my first post on this blog in September), then the large retirement funds, then the full blown export to the rest of the world via the realization after this Christmas holiday that the US consumer will no longer support the world's extra normal growth. Which financial market and economy is most bubbliciously inflated, and set to fall the most??? You smart guys have guessed it, the Asian economies being led by China. European financial an real assets are to be routed along the way. This graph from Calculate Risk gets the prize for the "picture is worth a thousand words" contest.

So, there you have it - an outline of my investment activity for the next fiscal quarter.

From the Roubini site:

This analyst started arguing against the "decoupling" hypothesis in the summer 2006;  see 12 Reasons Why the World Will Not De-Couple From the Coming U.S. Growth Slowdown…Or “Why When the U.S. Sneezes the World Gets the Cold”…and The Fairy Tale that the World Will "Decouple" from the Coming U.S. Recession...

I elaborated my views in the recent Global Recoupling Rather than Decoupling as the US Heads towards a Recession  While there I discussed how Europe will not decouple from the U.S. hard landing the argument holds a fortiori for China, Asia and other emerging market economies.

Paradoxically China is the one country that has, so far, decouple the most – both in real and financial terms from the U.S. but it will also be the first and most serious victim of a U.S. led recession. The decoupling of China is clear as its growth rate has not decelerated, in spite of the U.S. slowdown, and its financial markets have – so far – blissfully avoided (thanks in part to its financial system partially isolated via capital controls from the global one)  the turmoil and volatility that hit the US and Europe since the summer. But the reason for the Chinese growth decoupling is that, until recently the US slowdown was still modest (short of the coming hard landing) and it was not concentrated in private consumption but rather housing: China is mostly exporting low-priced consumer goods to the U.S. and the re-coupling of China will occur soon once the US consumer recession is in full swing. Thus, the biggest victim of a US consumer led recession will be the country – China - that, so far, has decoupled the most from the US.  And for China a fall in its growth rate from 11% towards 6-7% would be the equivalent of a "hard landing" as China – to maintain its social and political stability given its widening income and wealth inequality – needs to grow at least 10% a year in order to move about 15 millions poor farmers from the rural to the urban and industrial sector every year. No wonder that Chinese officials have started to express serious concerns about the current sharp slowdown in Chinese exports to the US, from an annualized growth rate of over 20% in Q1 to a rate of 12.4% in Q3 of this year ("If demand in the US drops further, Chinese exporters will be devastated by a rapid and continuous fall in orders," a Chinese official report said).

And once there is a sharp growth slowdown in China the next victims of this re-coupling will be East Asia and commodity exporters.

Quick note on increase in construction spending: not necessarily good economic news

Listening to CNBC this morning, I heard that residential construction spending has just increased, bucking the consensus and being lauded as good news. The home builders, who are the largest contributors to this index, are buried in debt and need to build in order to monetize the land they cannot sell for positive cash flow. This is their business, and they must build in order to try to make money.  I know it sounds counterintuitive to build houses when you currently have more houses than you can possibly sell, but from their perspective land is worth more with a finished house on it then it is in a raw condition. This is in their individual selfish interests. The problem is that adding more houses is negative for the homebuilding industry in general, negative for the economy since it adds supply to an oversupplied market that has slackening demand, and it steals wealth from homeowners by dropping the values of homes as supply increases further.

I am a contrarian along these lines, as in my viewpoints on share buybacks.

There is no recession, the economy is in fine shape, and business is strong!!!

I am so convinced of the title, that I have compiled a list to illustrate. Of course, I didn't include the home builders in this list since they have obviously been hit, and I didn't include the banks earnings (since they have obviously not been doing well), and I didn't include the mortgage insurers results (since they have been hit hard), and I didn't include the foreclosure rates (since those are dismal), and I didn't include REOs (with CountryWide becoming the largest holder of single family housing in the country), and I didn't include... Well, you get the message. So let's see what I did include in my compilation to show how far away from recession we are...

My team's latest forecast of real estate price trends  4 years forward (the entire table may not fit in this post, width-wise):

	3Q2007	4Q2007	1Q2008	2Q2008	3Q2008	4Q2008	1Q2009	2Q2009	3Q2009	4Q2009	2010	2011	2012
West	-5.30%	-4.90%	-3.90%	-4.10%	-3.80%	-3.10%	-2.70%	-2.30%	-2.30%	-2.00%	-2.50%	-3.10%	-2.20%
North	-4.10%	-3.80%	-2.80%	-2.10%	-1.80%	-0.90%	-0.80%	-0.70%	-0.30%	0.20%	0.40%	3.70%	4.10%
Texas	-0.80%	-0.20%	0.20%	0.30%	0.70%	1.30%	2.70%	5.40%	10.80%	21.50%	30.30%	24.20%	19.40%
Southeast	-6.00%	-6.20%	-3.90%	-2.60%	-1.40%	-1.20%	-0.40%	-0.50%	-0.60%	2.00%	-2.70%	-8.50%	-9.30%
Average	-4.10%	-3.80%	-2.60%	-2.10%	-1.60%	-1.00%	-0.30%	0.50%	1.90%	5.40%	6.40%	4.10%	3.00%

More than lower interest rates fueled the recent real estate boom

The credit innovation thing is what is perpetuated in the media - but for one it is not the innovation that caused the bubble. Innovation leads to liquidity which in, and of itself is good. What we had in the last bubble, was carelesseness, the ultimate moral hazard - otherwise known as OPM on the street (other people's money). You see, if it ain't your monies at risk, you are much less likely to care if the loans are good or bad. That is why the most popular buzzword in the media is a misnomer - "subprime". There was no subprime contagion, for subprime was never the problem of the bubble or the bust. If anything, it was subprime underwriting - not subprime loans. It was the careless underwriting standards borne by banks that did not have to face the consequences of just giving out money to anyone (at least past their one year risk retention stipulations, hence the popularity of 2 year ARMs). Thus, it is prime, subprime, alt a, alt b, and everything in between where the actual problems will manifest. Those who follow the media buzzwords or actually believe the BS of the ratings agencies who were compensated by the entities they were rating on a basis that was contingent on a favorable rating, are bound to be surprised by an apparent "contagion", again and again, and again, and again, and......

Before that lax lending standards really took off gentrification pushed up housing prices in the urban areas of the US where upper middle class commuters chose to live closer to the center of the metro areas (the inverse of what happened in the last major housing cycle that developed and propped up the price of the suburbs and exburbs). This is fundamentally sound, for price did not outstrip income. Of course there are several socioeconomic factors that come into play which are too complex to get into here (but I will get into them in other posts with fun models to download and play with :-) Gentrification led to sprawl (due, in part, to the displaced urbanites), and both were exacerbated by lower interest rates and flexible funding/easy credit, like jet fuel on smoking tinder. Once writing loans off of someone else's balance sheet became popular and combined with the great global macro experiment, then fundamentals ran amuck and cap rates dropped to the level of, or even below that of the risk free rates. Such a level is unsustainable (eventhough you have some investors who are still trying to push cap rates towards zero, I have seen large deals done at 2% with money markets yielding over 4%), hence where we are now.

It pays to have intricate knowledge of the markets from a local perspective, which is why I'm taking my time to take positions in the foreign (non-US) markets. I have intimate knowledge of some US markets, but that does not necessarily help me in the foreign markets. From what I have observed thus far, they are behind the US, but we will export our own brand of "burst" soon enough.

Okay, I have just recharged the batteries in my crystal ball: Back tested Home Price Trends - Historical and Forecasted

My analysts have performed a lot sell side research, and I am an industry outsider that thinks out of the box. I have never worked for the sell side, thus I think very differently. Hence we tend to come at things from differing angles. This is good. Diversity is good, even when it results in others disagreeing with my theses. When creating the pricing and forecasting engine for the Ryland model used in my last post, I noticed that the numbers appeared to be too optimistic, at least according to my grassroots investor's gut instincts. I know "gut instincts" is not very scientific, but regardless, I told the team to go back and check the numbers. It received a slight tweak, but my gut still told me something was off, despite the fact three smart and knowledgeable people scrubbed the numbers for 2 weeks straight. They used many sources for each city that Ryland built in OFHEO, CME, Case/Shiller, MLS, REOs, Foreclosures, etc. I then got the following email which created a spark:

You’ll love this:

“While fishing one day I was introduced to the recently retired president ( age 42) of Ryland Homes and his view was that the housing debacle in Florida is going to get much worse than the current state. He had conveyed the disturbing number of houses that would not be completed to a finished project currently being constructed and their internal projections of available buyers at higher interest rates and more importantly qualification standards. In his opinion the bottom is still years away there and most like the same in other areas of previously high appreciation above the norm. They are renting unsold condo's on the beach for 1% per year of asking price in an attempt to at least generate some type of CF until a sale might take place in an unbelievably overbuilt and overpriced market. He also thought that a 30% decrease in value from today's number ( already discounted from the top) is probable and the most important idea is that most in his industry are still in the denial mode vs the desperation mode necessary to make a true bottom.”

http://www1.investorvillage.com/smbd.asp?mb=2234&mn=77658&pt=msg&mid=3229300

Now, I just reviewed this guy's company so the numbers were fresh in my mind. In addition, I was pondering what could have been wrong with the analysts numbers. Empirically, the methodology was sound. So, I took their numbers and removed ALL government data, scrubbed them with market data only taking into consideration the foreclosure and REO rates (using proprietary algorithms), then back tested the results. Voila! Numbers that matched my gut feel, and more importantly numbers (or at least a methodology) that can be partially verified through back testing. Having just went through this exercise when the email above arrived prompted me to run the new numbers through the Ryland model. The result, whewww!!! No wonder all of those insiders are selling all of those shares. Things looked pretty bad with the ivory tower, conservative numbers. The more realistic grassroots numbers pushed through the Ryland model screams Bad News!!!  For the record, we have Miami dropping (32.07%) from this month to 2011. You see, Ryland management and I really do think alike. We're both selling Ryland stock and we're both forecasting similar numbers for real estate pricing. Hey, to agree with me, those Ryland guys must be pretty damn smart:-)

I will have my analysts thoroughly back test the results and refine the model even more, but in the mean time I think we are on to something. Let's take a look at what we have.

For the record, this data has yet to be adequately and fully adjusted for condos. This, and the filtering of new construction and investment properties, is the weakest component of the Case Shiller index (see my opinion on that topic here). YTD, condos have underperformed single family housing in 14 out of 24 Metropolitan Statistical Areas. Needless to say, the new construction is being heavily discounted. Also, keep in mind that most of the markets that did not participate in the bubble are still participating in the recession due to the fact that many homeowners used exotic financing for their homes, which ended up with a non-traditional, often unpleasant result of distress, foreclosure an REOs. A perfect example of this would be Detroit. In the graph below I have outlined the last 20 years of housing appreciation in the US for 10 metro areas. Click the picture to enlarge.

Notice the difference in intensity between the last residential real estate bull market and this most recent bubble. It is a BIG difference. Each market entered the  Boom, the Burst & eventually, the Recovery at a separate  and individual date, thus have been calculated and graphed accordingly. Residential real estate is very local. What is very different this time around is the severity of the bubble, and how correlated the markets are - not just across the US but throughout  the Americas, parts of Asia, N. Africa, & Europe as well. For more on how this occured, you can read “The Great Global Macro Experiment”

NY Housing Trends: Where is NYC Headed?

I have received a few requests regarding the NY metro area pricing trends. I don't predict the future, but I try my best to get a good grasp of the present. For those that didn't get to read the piece on Manhattan for the month of September '07, see Manhattan Real Estate is Falling. That's Right, I said it!!! And Beware Those with Short Term Memory.

As for the NY Metro MSA (which consists of the statistical MSA including Bronx, Brooklyn, Flushing, Jamaica, Jersey City, Mount Vernon, New York, Paterson, Staten Island, and White Plains) I will offer the following research.

Pricing

I have (personally) observed pricing pressure trending downward since the second half of '05 in Downtown (gentrifying) Brooklyn and Manhattan. Here are the empirical stats for the last 6 months for the statistical MSA (NY metro area). Click the graph to enlarge.

As you can see, pricing is trending downward and due to the macroeconomic outlook will probably trend downward farther and at a steeper pace. This is the case for higher priced homes (25th percentile), median (middle) priced housing, and lower priced housing (75th percentile). This includes attached, semi-attached, detached, and condo style housing.  Keep in mind, these are asking prices and not transaction prices.

Manhattan Real Estate is Falling. That's Right, I said it!!! And Beware Those with Short Term Memory.

When the residential real estate market falls hard, it falls. New York (Manhattan, too) is different from many other regions because it is denser, harder to build new supply, and has a generally richer demographic. Alas, buildings are still buildings, people are still people, and money is still money - Yes, even in NYC. Manhattan and Brooklyn have been on a tear during the boom. So much so that many actually began to believe that NY was somehow magically immune to real asset cycles. Developers have found a way around the supply issue as well. Just convert everything that stands into condos (NYC use to be a coop market). Those with short term memory must have forgotten the 90's, the 80's, and the '70s. NY residential real estate cycles reliably every ten years or so, give or take. Guess what. It's about ten years, and we have a free credit, cheap money, gentrification housing boom to make this cycle a doozy, both on the way up and the way down.

More on Short Term Memory

Prudential Douglas Elliman, a prominent NYC luxury real estate broker produces a monthly study as a marketing aid that recaps very recent property transactions. Now, if you follow the National Association of Realtors economists and reports, you should realize that those in the industry tend to run a bit, ahem, optimistic. Keeping that in mind, let me run down a highlight of the report for the month of September. Please keep in mind that the way things work in NY is akin to the following:

1. marketing time increase to point of sale (product stays on market longer to sell)
2. volume of sale decreases, as sellers refuse to lower prices to meet buyer demand
3. concessions are given that usually do not show up in public record (seller's concession, private paper held back, furniture/antiques included in sale, etc.)
4. publicly recorded prices finally drop.

By the time we get to point 4 above, the market has actually been slowing down and effectively dropping in price from an economic perspective from point 1, usually at least a year before. These facts are not reflected in statistics, and it will be hard to get realtors to admit it.

Low end luxury: Smaller units where luxury is not compromised, priced between $1 and $2 million.

• # of properties sold: 218 SIGNED IN AUGUST, 59 SIGNED IN SEPTEMBER (73% decrease, down sharply in September)
• Average price: $1,443m ($1,119/sf ….SLIGHTLY DOWN compared to previous report)
• Average Size: 1,277sf

Beware, even the strong rental market!

From the WSJ:

When the music stopped in the residential-real-estate market, speculators who got caught with unsold houses and condos began putting them on the market as rentals. This "shadow market" has made investors jittery about price-destroying competition for the real-estate investment trusts that own big apartment complexes.

For most of the country, though, it is a landlords' market, with vacancy rates falling and rents rising in many major cities. Despite a selloff in apartment REITs, the shadow market is really confined to real-estate disaster areas such as Florida, Las Vegas and Phoenix. That presents a buying opportunity for stock-market investors.

Be careful following this advice outside of the short term. Any significant amount of single family housing purchased at bubble peak prices cannot compete with apartment housing due to economies of scale, the significant management expense of dealing with actual separate physical properties, and most importantly, the negative cap rate that would entail due to acquisition costs. Single family homes are not significant threats, unless entire communities are actually rented out, which is unlikely. What will dent the low vacancy rate is the rampant condo build-out, much of which I feel will fall back as rentals. They will be highly unprofitable rentals since the developers (hence the bank) probably paid too much for the dirt underneath. Alas, better some money than no money at all. Much of the stuff will not be able to sell at anywhere near break-even. Since most construction mortgages have a rental fall back clause of some sort or fashion, I am sure this will, and has been used to a much greater extent due to the glut of condo building in the coastal areas and speculative spots such as Vegas.