Mortgage Crisis: Shark With an Appetite
I was in New York earlier in the week for the Value Investing Congress. Among the more valuable presentations were those of Sean Dobson at Amherst Securities and Whitney Tilson and Glenn Tongue of T2 Partners.
They were valuable because they helped frame where we are in the mortgage crisis, which has been the main shark in the water over the past couple of years. You should know where that shark is and whether or not it is hungry. The chart below shows you the ferocious fish may still have an appetite.
It shows you that we are past the viscous subprime crisis, when that shark chewed through the balance sheets of a number of banks and financial institutions, in some cases devouring them whole. However, it is not yet safe to get back in the water:
There are these other slices of mortgages that are not quite as risky as subprime that reset in the next couple of years. Years 2010 and 2011 face big resets in so-called Alt-A and Option ARM loans. What this means is more write-downs and more losses for banks and others who hold these mortgages.
Making all this worse is the fact that the housing has not yet recovered. The T2 duo made the case that the current "stabilization" of the housing market is a head fake. Mostly, it's due to huge government support of the housing market. But there is still a large inventory of homes out there. And with these resets coming due, we've still got a large amount of foreclosures on the horizon.
All the while, the unemployment numbers are still poor. The T2 duo calls the unemployment situation the "most severe since the Great Depression." The US economy has shed over 8 million jobs in this recession and unemployment - officially - is nearly 10%.
Plus, it's not like the average US consumer is in a good position to sail through this crisis. Household liabilities are still high, as this next chart shows:
US consumers need to save and rebuild their financial strength. This is why the savings rate is on the rise. This is why, for the first time since the 1950s, household credit debt declined.
As investors, it seems clear that any idea that depends on discretionary consumer spending - say, buying trendy new sweaters or watches or expensive shoes - faces some big head winds. Better to the stick with the necessities, I say.
Also, it looks like the bounce in the stock prices of overleveraged banks and financial institutions is premature. Most bank stocks should be sold, not bought. The bounce in home building stocks looks ridiculous in light of what they have to look forward to. The T2 duo actually recommended shorting the home building stocks through the iShares Dow Jones US Home Construction ETF (ITB). By shorting it, you make money when the stock prices of the home builders go down.
They made a compelling case, of which I will highlight a few things. Exhibit A would be the fact that the average new home has been on the market for 12.9 months. Exhibit B is that we have about 2-3 years of existing home sales just to absorb the vacancies that exist. According to T2, about 6% of all homes built this decade are vacant.
Exhibit C is that the home builders themselves have too much debt and too much inventory relative to their thin equity cushions. The home builders are in the position of trying to hold up a bowling ball with a sheet of paper...in the rain.
Lastly, the home builder stocks are almost universally expensive on a price-to-book basis, as this chart shows:
Stocks with lots of debt, too much inventory and an awful market don't deserve premiums over book value. Discounts are more like it.
So there you go. I like the idea of shorting the home builders. At the very least, I wouldn't buy one. I'd also stay away from banks and financial institutions that hold mortgage assets. American real estate is not worth zero, as Dobson said, but it can be worth a lot less than today's price.
I recommend staying with the sorts of companies that own essential assets and/or sell essential items. As I like to say, stick with what keeps civilization a going concern. And avoid any stock that is dependent on regular access to the credit markets. As we saw in 2008, a mortgage crisis can shut down the credit markets. We don't want to be held hostage by lenders in that situation, so stick with excellent financial conditions.
Regards,
Chris Mayer
for The Daily Reckoning Australia
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About the Author
Chris Mayer is a veteran of the banking industry, specifically in the area of corporate lending. A financial writer since 1998, Mr. Mayer's essays have appeared in a wide variety of publications, from the Mises.org Daily Article series to here in The Daily Reckoning. He is the editor of Mayer's Special Situations and Capital and Crisis - formerly the Fleet Street Letter.
Comment by christina on 7 November 2009:
Oh wow, that first chart is scary!! The masses love to go out and watch horror movies saying that "you will be on the edge of your seat and gripped by fear" If they love being into all that horrible negative stuff, well, they won't have to pay any more, this stuff is more scary than any Hollywood director could ever dish out
Comment by Dan on 7 November 2009:
The impact of the option ARMs will be determined in part by the interest rates which the US experiences now and during 2010/2011 when they reset, plus the willingness of anybody to go in and buy up the surplus housing (will the US allow foreign investment in this regard?). While still hard to quantify, it will still be big and people will once again be returning their keys to the bank and walking off to Walmart to buy a Chinese made family tent ( http://www.bloomberg.com/apps/news?pid=20601109&sid=aQ_ZgC75Zfyw ).
By 2012, we'll all be at the definitive side of it all, and as you say Christina, it does look pretty ugly for the US and those tied to its fate.
Comment by Dan M on 7 November 2009:
A small quibble - I don't think the US savings rate is increasing at all. Americans are not really saving, they are paying down debt, which is not nearly the same thing. Savings might be spent later. Paying off debt never results in money that can be spent later. Paid off debt is money that disappears from the economy, and only makes deflation worse. I'm not arguing that debt should be perpetuated, rather that I'd be happier to just see it defaulted on and get it over with.
It's a crazy world when something that should be good (increased saving) actually makes the situation worse.
Comment by murray on 8 November 2009:
Much as i'd like to see Sydney house prices fall i do not think what happens in the USA will have much impact on prices here (or even in Canada as another example)
the reason is simple
when things turn to doo-doo in large economies like the USA and Europe, many of those with money run away - to places like Australia
it only takes a small proportion of people running from a larger economy to have a substantial impact here
so i expect house prices to rise across the board
Australia has always dealt with economic threats by upping its immigration quota while at the same time making it harder for those who are least likely to have money to come
On the one hand we will see more and more of "lack of skilled workforce" and on the other "too many undesirables"
If things get much worse in the USA and Europe the situation will become more pronounced here
for those of us who own real estate it will be great but for those who don't, and their decendents, owning a home will become ever more unlikely
i'm sure if the average Australian understood what is happening there'd be a lot more anti-immigration rhetoric
but for Australia the situation is simple - we maintain a growth based economy even in the face of a falling world economy simply by maintaining an incoming stream of upper middle class families seeking a "safer" place - and bringing their typically 2-3 million in assets
m
Comment by Neverown on 11 November 2009:
Murray, you are bang on!! I have read the daily reckoning for the last 2-3 years and have listened to 'expert' opinion on how Australia's house prices are unaffordable and unsustainable and over valued and so on and so forth. The bubbgle is about to burst and reality is about to set in and greed will be punished.
It sounds wonderful in theory but i am now 29 my wife and i have 56k deposit and a DINK scenrario bringing in 112,000pa, we cannot afford to even buy a one bedroom unit in a 15 stroy block 12km out of the city.
August 2008 we made an offer on a propety at 279,000 in our apartment block but did't proceed as the (non-existant)GFC had started to ramp up and appeared to be coming at us hard. We then went to an Auction on an identical one bedder in our apertment blcok in July which sold for $358,000.
The latest Auction was for another one bedroom with a small rcess they call a study (same dimensions as the first 2) , on the 11th floor facing the city that went for 405,000 2 weeks ago. That is a literal increas of over 40% in the space of under a year. And if you think this is rubbish go and check your local real estate guide for unit pricing in melbouren 12km rduis in the last year
We are now priced way out of the market and will be renting for life, this government has made it quite clear that they will do nothing to improve the lives of those on the bottom rung. They are now focused on those in housing and realise how detramental the fragility of housing can be.
Rudd will pump as much money into it to insure it doesn't fail, house prices are going no where but up!!
Comment by dave on 11 November 2009:
...an unmanageable pace and scale of immigration is the mortgage bankers' wet dream...
Comment by Coffee Addict on 11 November 2009:
Neverown
What would you suppose the unit which sold for $358,000 will sell for if interst rates were touching say 12%?
While 12% may be a bit far fetched at the moment, what will happen when the when central banks finally let go of their free money policy? In your shoes I wouldn't dispair. Rudd has less control than he thinks he does.
cheers
Comment by Don on 11 November 2009:
For the record by the end of next year I will own my place in Melbourne and will probably move back there from up north. Hearing that prices have gone so crazy down there does not make me the least bit happy as it obviously prices out the young and struggling from having much chance at having their own place or if they do they will be up to their ears in debt for most of their life.
I agree with your assessment CA but I suspect that the government will just boost the first home owners grant and tweak other things to try and mitigate the pain by sucking more people into the debt trap. High unemployment however has proven to be something that the US government is struggling to turn around (despite almost zero interest rates) and I think that is where things will turn pear shaped for us. Immigration will only support prices if unemployment remains low or manageable.
Comment by Ned S on 11 November 2009:
DR seems to pander to people's deep underlying wish that central banks did not exist and that the world was a fair and reasonable place. But central banks do exist and the world is not inhabited (by and large) by fair and reasonable people - Just self interested ones. Such is Life - With the challenge being to learn to laugh at it - And at oneself.
Comment by gwizz on 30 November 2009:
Hooray! Ozzies build and buy the biggest houses on earth!(SMH 30/11/09)C'mon, we need 12 million more people living here to fill them. I sneezed and "heritage" fibro two-bedders in western Sydney flew past 400k (for KDRB into McMansions)That is the "genius of the market" at work, ain't it? (An old leftie has sneaked into your blog)