Gold vs DOW & 'Don't Fight The Fed'...yet!

A: Sorry for the off-topic discussion here as I got some motivation to talk about this topic from a client I chatted with earlier in the day. In this case, one of my clients was bullish on equities since the fed started cutting rates because of the old mantra 'Don't Fight The Fed'! "That old saying can hurt you if you follow it too soon...", I tried to explain. I brought up my feelings about rate cuts (as I discussed last year as well) and what that tells us, and also the effect it has on our currency and commodities that are priced in the resulting weakening dollars. I told her to compare a chart of stocks vs gold over the past 5 or 6 months, a few weeks after the fed first started to cut the fed funds rate. While this is not your normal situation, it still shows you the basic conclusion! When the fed cuts and they say the bias shifted towards growth concerns, chances are you should wait to not fight them!

The fed's first rate cut was on September 18th, from 5.25% to 4.75%. Since then, we have had 4 additional rate cuts totaling an easing of 1.75%, or 175 basis points. We currently stand at a FFR of 3%, and it certainly appears to be going lower. During this time, I have had numerous discussions and arguments about why this is not good for stocks.

First off, let me say this: If you are going to follow the mantra of 'Don't Fight The Fed', be VERY cautious with the timing of any investment decisions when the fed is EASING! Why?

When the fed cuts the funds rate, it is doing so because there are perceived risks with economic growth that require stimulus. Stocks generally trade on near term profit expectations and confidence; lets say 6 months out. The accepted valuation models for whether the stock of a corporation is cheap (lack of confidence and low expectations) or expensive (plenty of confidence and high expectations), is the P/E ratio! Now, if the fed is cutting rates because there are risks to economic growth, and stocks trade on confidence and profit expectations, then chances are you will see pressure in stock markets as the fed eases. The more the fed eases, the higher the perceived risks to economic growth by our monetary policy setting body. In this cycle, hindsight shows that the fed was a bit late but aggressive so far with rate cuts. Stocks are now seeing pressure to profits and are re-adjusting equity prices to be more in line with lowered profit expectations.

A side-effect of aggressive fed easing is inflation; especially in commodities. Every time the fed cuts rates and/or economic data comes in weak, our currency goes down. Commodities that are priced in US dollars, in turn, get more expensive. With the case of gold, a few other dynamics are contributing to the metals latest attractiveness; gold is widely viewed as a safe haven & inflation hedge play. This was perfect for the environment that was in place when the fed first started cutting rates in mid September; fed easing + uncertainty about economic risks + fed fueled inflation.

The uncertainty element comes from a combination of so many forces at once; housing deflation, de-leveraging, seizing up of secondary trading markets, major credit-related losses, commodity inflation, and a weakening US economy. Its a perfect storm. But if you do not believe me, just look at the charts and you will see the re-allocation of money a few weeks after the fed started their rate cuts:

Since October:

GOLD ---> up $234/oz or about 31%

*DJIA ---> down 1,517 pts or about 11%
*does not include Friday's fall of 2.5%

These are the moves that happened a few weeks AFTER the fed started cutting rates. So be very cautious how you put your hard earned money to work in any environment when the fed is known to be aggressively easing because the economy is expected slow; which we knew in this latest easing campaign. 'Don't Fight The Fed' nah! Perhaps it should be, 'Don't Fight The Fed YET' instead!

When the fed tells us that they are no longer biased towards 'risks to economic growth', it will be a sign that inflation is now the focus and rates are likely to head higher in the near term; a good time to start observing the mantra of 'don't fight the fed' as the full effects of the easing cycle work through the system. That is when the US dollar will probably bottom and some speculative commodity trades will take their profits off the table.

PS: Something to keep in mind. Another way our currency will rebound is if our fed EXITS a rate easing campaign and STARTS a rate hiking campaign at the same time foreign central banks deal with the lagging slowdown that is a result of largely the same issues we are facing and our economic slowdown. It's widely accepted that the US economy leads the world economies; so our central bank will generally be AHEAD of other central banks. If Europe is to see a lagging slowdown, their ECB will likely cut rates and focus on growth concerns; and that could occur as our fed is nearing the END of our rate easing cycle! The combination of expectations of US rate hikes at the same time foreign central banks are easing, should certainly cause a rebound in the greenback and a slowdown in commodities that are priced in dollars!

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The Million Dollar "Mansion": What $1M Buys In NYC?

I am working with a few $800K - $1.05M buyers these days. None of them has the time to do any work on an apartment, so they want something new. None of them wanted to go through the scrutiny of a co-op board, or they didn't quite have the 20% down plus 18 - 24 months of assets in reserves to purchase in a co-op, so they needed something with no board approval. Adding to the challenge was that they all wanted to be below 34th street, which is, in general, more expensive than Midtown East and West and the Upper East and West Sides.

I joke about the Million Dollar "Mansion," because when you buy an apartment over $1M in NYC, you pay a "Mansion Tax" of 1% of the purchase price of the apartment. In a new development, the sponsor's transfer taxes somehow also "count," so usually you have to buy something under about $980K in order to avoid the Mansion Tax. Most New Yorkers find the tax to be ridiculous, because a million dollars does not buy a mansion in Manhattan.

So what does $1M buy you in a new development or condo conversion below 34th street these days?

It buys a one bedroom apartment. An approximately 750 - 1000 sq ft apartment. To make you more depressed, in buildings like the new "W" Hotel & Residence in the Financial District, a million dollars buys you 500 sq ft, but we're going to try to avoid the insanity in this post & focus on some semblance of normality. (If you can call it that!)

There really is a difference between a condo conversion & a new development built from the ground up. A lot of people say that you are paying a premium for buying in a new building and that it isn't worth the money, but in reality, you get what you pay for. Here are the buildings we looked at and my and my buyer's overall impressions.

The Charleston (225 E 34th St) is 90% sold (occupancy is immediate upon closing) and only has two apartments remaining for under $1M for sale by the sponsor. Both are about $1,000/sq ft, which is a fabulous value for a new, from the ground up development with a fitness center, roof deck, zen garden, and private storage that comes with each apartment. Apt 2K ($875K for 836 sq ft) is on the ground floor and has 131 sq ft of outdoor space, but not a substantial amount of light. It faces the "zen garden," so at least it is quiet. My buyers loved that there was a washer dryer in the unit, the bathroom wasn't cramped, and they much prefer open kitchens with a large breakfast bar to galley kitchens. They also loved the central air/heat, garbage disposal, 9'4 ceilings, and floor to ceiling windows. You rarely get these little luxuries in a rental building that is being converted to a condo. The second apartment (5B) we looked at was on a higher floor, also facing north, with a balcony and was less than $1000/sq ft (1005 sq ft with a 67 sq ft balcony for $960K). Sometimes when you buy at the very end of sales in a new development, you can get a relatively good deal. The developer just wants to sell out the building. He/she wants to stop paying the salespeople to be there, can stop spending the big marketing bucks, and can move out of the apartment that the sales office is in. I would say that at this time, the building is a really good value. The downside of the building is the location on 34th street next to one of the midtown tunnel exits. The apartments themselves are quiet, however.

Twenty 9th is being built on 29th street between Park and Madison, across from the site of the new Gansevoort Hotel. The sales office is not yet in the building but they have a model apartment so you can see what the finishes will be like. They had a few studios and quite a few one bedrooms on the market, but since they're over 50% sold, there wasn't that much left under $1M. Every one bedroom on the higher floors will be over $1M. A south facing one bedroom on the 5th floor came in at $950K and a north facing unit on the 10th floor (less light, less of a view on the low floor apartments on the north side), was $920K. The apartments also have washer dryers, an oven and an additional microwave/convection oven, an open kitchen with breakfast bar, & floor to ceiling windows. My buyers thought that the finishes were more luxurious and the building would be more high end than the Charleston, so 788 sq ft for $950K was reasonable (common charges of $611 and with the 421A tax abatement, taxes of $47). Above the 5th floor in some units, there is a window in the bath, and above the 10th floor in some units, there is a small, corner window, so you have a double exposure. The building will have a roof deck with BBQ and wet bar, fitness center, parking and resident's lounge. Occupancy is expected on the lower floors in mid-June to mid July and on the higher floors closer to the fall of 2008.

133 W 22nd Street had one apartment left at $1.005M and by the time my buyers got back to it, it had a contract out. There aren't many new construction buildings below 34th street and above the financial district with a pool. And the ones that are out there don't have anything under $1M. The pool at 133 W 22nd is a 25 footer, so it's not quite the lap pool you can find at the (farther north) Laurel, Sheffield57, or One Carnegie Hill, but at least it's a pool. Closings are anticipated in January 2009.

I thought it would make sense to bring my buyers by 205 Third Avenue because they really love the location. The building is on 18th street so is really close to Union Square as well as Irving Place & Gramercy Park. 205 3rd is a co-op building but the sponsor of the building is selling off the apartments he owns and is gut renovating them with finishes you would find in a new condominium. The apartments are a good value for the location. You can buy an 868 sq ft Junior - 4 (one bedroom with a dining area) with a terrace for $950K. Your total monthly charges including electricity are $1,150/month. But once a buyer gets used to seeing buildings with a washer/dryer in the apartment and a huge, gorgeous, brand new fitness center, roof deck, and resident's lounge, it is hard to move into an older building with 8'4 ceilings, laundry and a small gym in the basement, and an older lobby & hallways. I still think these apartments are a great value for someone who might not quite have the liquid assets in reserves to pass a strict co-op board but wants to live in the Village/Gramercy area. There is no board approval and you only have to put 10% down. Although you pay the sponsor's transfer taxes of approximately 1.8% of the sales price, you are still paying about 3% less in closing costs than you would be paying if you bought an apartment in a new condo building. Of course, when you resell the apartment, your buyer will need co-op board approval, and you have sublet restrictions that you wouldn't have in a condo.

I checked the A Building & The Oculus just in case, but they only had one or two small studios or ground floor apartments available. I have stopped taking buyers to The Gramercy (which was once my favorite downtown new development for entry level buyers), since the word got out that a McDonalds and a CVS are going into the commercial space in the building. Ugh. And we scoped out a resale one bedroom at Crossing 23rd, which is only about 2 years old, but the apartment had kind of an awkward layout. It was overpriced in comparison to what we had seen, even taking into account the 2% savings in closing costs you get when buying a resale condo.

One couple also wanted to see how much farther their money would go in the Financial District. Light and a view were important to them, though, so we skipped District, The South Star, and 45 John, and a few others that only had apartments in their budget on low floors where there would be another building or an interior courtyard less than 25 feet away. Since the buildings are so close together in the heart of the financial district, you usually don't have much light or a view unless you are on a really high floor. My buyers fell in love with the Setai (40 Broad), but the only available one bedroom was out of their price range at ~ $1.1M. There was one apartment left at The Exchange (25 Broad) but it faced a courtyard and didn't get much light.

We had a few apartments to choose from at 88 Greenwich on higher floors with open views and a peek here or there of the river. One apt (just over $1M) had 16 foot ceilings! My customers liked the iPod docking stations, wine rack & step stools built into the kitchens, personal trainer available for most of the day in the fitness center, the library, the resident's lounge, the roof deck, and the continental breakfast in the morning. They really wanted a washer dryer in the apartment and if they could have had a larger bathroom, they might have been sold. It was a great combination of price per sq ft, amenities, light, views, and finishes, and there are so many different layouts, the building doesn't feel "cookie-cutter" even though it is huge.

99 John, recently converted from a rental building, had two stunning and unique apartments for right around $1M. One of them had a slightly triangular shape, high ceilings (over 11 ft), an open view, fantastic light and SEVEN windows. When you walked in, the first thing out of your mouth was, "WOW!" I doubt that the apartment is even still available - the price per sq ft was fabulous. My customers had the same issues at 99 John as they did at 88 Greenwich, though - the bathrooms in a conversion are usually smaller than in a ground up development, and there was no washer dryer in the apartment.

At 99 John, even in the hallways that have been redone, I couldn't shake the feeling that I was still in a rental building. It's a little hard to explain, but the entryways to the apartments don't have a luxury condo feel. There are narrow planked wood floors instead of wide planked floors & shower rods instead of glass partitions. The resident's lounge had about 8 different design elements going on, so it just seemed a bit over the top for the size of the space. Still, it's tough to beat 970 sq ft for $955K in a gut renovated condo with light and a view!

Next up: Battery Park City

We stopped at 225 Rector Place. Since it isn't a pre-war building, the ceiling heights are lower, windows are smaller, baths are smaller, no washer dryers in the apartment (laundry on the floor). They loved that the building will have a POOL, though. And a few of the apartments in their price range had river views & fantastic light. Since BPC is on a landlease, the real estate taxes (called PILOT - "Payment in Lieu of Taxes") are higher than in the tax-abated buildings in the Financial District. For example, 99 John Street still has 6 years left on their tax abatement, so taxes are $120/month for a one bedroom, versus $650/month at 225 Rector. The taxes at 99 John will increase every 2 years, however. Also, when there is a pool involved, your common charges are higher. You might have $750/month common charges at 225 Rector and $500/month common charges at 88 Greenwich St. for a comparably sized apartment. Of course, it isn't just the pool, if a building has 600 apartments, your common charges are probably going to be lower than in a building with 300 units. The more apartments there are in a building, the more people to split the costs between.

The last stop on our trip was Visionaire, a LEED certified "green" building in Battery Park City. There were three lines of apartments that would have worked for my customers, and they were impressed with the quality of the workmanship in the building. No detail has been spared. And it is always nice to feel that you are helping the environment. 5% of the building's power will run on solar power and electric bills are expected to be 40 - 65% lower because of the way the building was designed. My customers were excited that the amenities included a pool, but felt kind of far from the subway, stores, restaurants, etc. The saleswoman at The Visionaire was unbelievably friendly and knowledgeable about the building.

So what did my buyers choose? I will let you know when the ink dries on the contracts! Until then, I'm keeping it a secret:)

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Why We Can't Trust: Thornburg Mortgage

A: In a sign of the times, jumbo mortgage lender Thornburg Mortgage is getting whacked as I write this because of deterioration in the value of their mortgage backed securities holdings. The losses are resulting in margin calls at the worst possible time. There is no market right now for these risky assets, except from vulture investors who will scoop up holdings at a high discount. But that is not the story here. Take one look inside Thornburg's Industry Expert Spotlight, as publicly displayed in the news section of their website, and you can see why we just can't trust what is told to us.

The news. According to Yahoo Finance's article "Thornburg May Be Forced Out Of Business":

Jumbo mortgage lender Thornburg Mortgage Inc. said Monday it may be forced out of business as it faces an additional $270 million in margin calls on top of the more than $300 million it was being forced to repay, or provide more collateral for, last week.

Thornburg said it has not met the majority of the most recent calls, but is working to repay them by selling assets or through the raising of additional debt or capital. If Thornburg is unable to meet the current calls, it said the result could materially affect its ability to continue to operate.

Margin calls force borrowers to repay loans or put up more collateral to secure them. Thornburg said the margin calls are "strictly a result of the continued deterioration of prices of mortgage-backed securities precipitated by difficult market conditions." The calls are not reflective of the actual performance of the securities, the company added.

LOOK AT WHAT I BOLDED! The margin calls are 'strictly a result of the continued deterioration of prices of mortgage-backed securities precipitated by difficult market conditions'. Now take a look at what their website states about their business model in mid 2007: Origination Strategies: Above The Fray; Thornburg Mortgage takes the high road on risk in its origination niche serving high-end borrowers.

Note that Larry Goldstone is Thornburg's President & CEO, as stated in this publication. WTF! If this is the case, then why the hell would they be forced into margin calls because "of the continued deterioration of prices of mortgage-backed securities precipitated by difficult market conditions"...? Didn't Goldstone state in that publication that..."...company isn't driven by what he calls 'gain on sale' model, referring to the business of providing mortgages and selling them to investors" and then state right after this that..."The Thornburg model is a throwback to the old-school way that mortgage lending occurred"?

If they are not driven by the so-called 'gain on sale' model of packaging up mortgages and reselling them to investors, why would they have to meet margin calls due to the continued deterioration of prices of mortgage backed securities? But if that doesn't light a flame under your a$$, here are some more tidbits from this publication:

* "We are risk managers before anything else, and there's a discipline required to being an effective risk manager" says Goldstone

* "In my own personal opinion, what happened in the subprime sector is history repeating itself," Goldstone says, referring to past real estate boom-bust cycles. "It's no surprise to me, I've been anticipating it".

A sign of the times. We STILL do not know who holds what, what IT is worth, and HOW much further the secondary mortgage market will deteriorate bringing up more margin calls like this one at Thornburg. The shame of this whole thing is that investors may have bought into TMA stock because they thought their model was safer, and their risk managers had the discipline to avoid this type of situation. After all, this is what was told to them!

Thornburg's stock price is currently trading down 54%!

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Keepin Our Heads Out Of The Sand!

A: Look, there are things going on out there that some people feel the need to discuss, some people just don't want to discuss, some people HATE hearing, and some people refuse to believe! Wishing and hoping is not going to solve this situation! Denial works for some people, but not for me. While I eagerly await for the light at the end of the tunnel to show it's first ray, it's good to see the equity markets wake up to what is going on and adjust expectations downward. If the damage lies before the light, then bring on the damage so we can get to the light! And lets continue to discuss these issues head on, which means keeping that head out of the sand!

Hey, guess who joined the club today? Mr. Bernanke!! In a speech to a banking group this morning, the fed chief seemed to acknowledge that the role of biased optimism needs to change to a role of crisis management. According to Yahoo Finance's article, "Fed Chief: Mortgage Crisis To Continue":

Federal Reserve Chairman Ben Bernanke called Tuesday for additional action to prevent more distressed homeowners from falling into foreclosure. "This situation calls for a vigorous response," Bernanke said in a speech to a banking group meeting in Orlando, Fla.

Even with some relief efforts under way by industry and government, foreclosures and late payments on home mortgages are likely to rise "for a while longer," Bernanke warned.

So, over the past few weeks the fed is now telling us that the coming quarters are going to bring us:

a) rising inflation pressures
b) weakening economy
c) rising unemployment
d) rising foreclosures
e) rising late payments on home mortgages

Man, what took him so long to publicly acknowledge all this? Bloggers have been discussing these concerns for 6-8 months already. If there is a sliver lining that I can think of, is that it seems we are going through the painful process that in my opinion we MUST go through to get out of this mess. It's one thing to watch all the data, indicators, fundamentals, etc.. and discussing the likely path; but it's another thing to experience the carnage. I think we are in the 4th or 5th inning of the painful process that we must go through. Eventually, all the stimulus we had thus far will put a floor on the down cycle. The problem is that the root cause of the problem (housing) is illiquid, takes time to reverse course, and was inflated through the use of leverage that was securitized by wall street. What I mean is, this will take time because of the self-fulfilling relationships of the individual problems we face...

HOUSING DEFLATION LEADS TO DEFAULTS/FORECLOSURES which leads to BROKEN CREDIT MARKETS which leads to MASSIVE WRITE DOWNS OF MBS which leads to CAPITAL RESTRICTIONS which leads to RISING LENDING COSTS + TIGHTER LENDING STANDARDS which leads to SLOWER GROWTH which leads JOB LOSSES which leads to FALLING STOCK PRICES which leads to NEGATIVE WEALTH EFFECT which leads to GO BACK TO BEGINNING!

The cycle feeds on itself. Remember this discussion back in late October of last year, "To Mr. Bernanke: BE STRONG", where I was concerned about commodity inflation & instead said to bring on the recession:

Gone are the days where bad bets are penalized by the tradable markets, because if they were it would cause financial distress to our economic system that maintains afloat from interventions from government and private institutions. That is why free market capitalism is NOT AT WORK HERE!

If it was, the markets would have to work themselves out and stocks of banks, lenders, and others who hold these assets would have corrected significantly more; and that is obviously not happening. We have become a society that fears recessions rather than understand them for what they are; healthy and normal disruptions in economic growth necessary to ensure longer term sustainable growth. We need to shake out the bad bets and weak players, let the markets fix themselves, and move on with the lesson learned.

Its not that I want the economy to weaken or stocks to go down, I don't, but I don't have much of a say into that now do I? Its the only way to cleanse the situation we created. Inflating us out of this mess has serious medium term ramifications, and should be a topic of conversation because it could affect all of us.

The markets are working, even if that means the marketplace itself is not working. The markets are currently self-correcting in the following ways:

a) seizing up of secondary mortgage markets - the very market where banks offload mortgage backed securities is dead. This is causing lending standards to be tightened, available capital to be restricted, lending rates to rise, risk to be re-priced, and losses to be booked on the bad holdings. Weak corporations will die and likely be taken over or declare bankruptcy. This is a self-correcting process as the industry adjusts to the way it used to be. You can't be a heroin addict for 5 years and expect to go through no withdrawal when you quit! Well, the credit markets are in withdrawal right now. Let the detox continue as we provide some minor painkillers (monetary & fiscal stimulus) to make the cleansing process a bit more manageable; and beware giving too strong of painkillers that will re-ignite the addiction.

b) housing deflation - the turnaround in housing is removing speculative players from the market who helped power the unsustainable boom. In addition, as housing prices fall banks are re-thinking to whom they will lend their capital to and at what rate. In short, the bullshit days of giving anybody a loan because housing goes up are gone! As housing deflation continues & lenders actions help correct the credit markets & clean the books, fundamentals should start to reverse course. These two forces, housing deflation/weak fundamentals & credit markets, are inter-related. It is likely that credit markets will normalize when housing fundamentals start to improve.

There will be great opportunities as a result of this cleansing cycle; so keep your eyes open. In the meantime, lets get more clarity on the depth of the crisis and watch for housing fundamentals to turn before we can start discussing the brighter times that lie ahead. We are not out of the woods yet by any means. Here are some of today's creditville headlines:

Bernanke Plan; Citigroup/Goldman Earnings Estimates Cut (via Bloomberg)

U.S. stocks fell, led by financial shares, after Federal Reserve Chairman Ben S. Bernanke urged banks to write down more mortgage debt and analysts cut earnings forecasts for Citigroup Inc. and Goldman Sachs Group Inc.

Citigroup fell $1.39 to $21.70. Merrill Lynch & Co.'s Guy Moszkowski said he expects $18 billion of credit writedowns related to the company's holdings of subprime mortgages, collateralized debt obligations, leveraged loans, bad consumer debt, real-estate lending and other investments.

Ambac Decides Against Splitting (FT.com)

Ambac, the troubled bond insurer, has decided against splitting in two as it completes a $2bn-$3bn recapitalisation, insiders said.

Under a recent proposal, Ambac, the second biggest bond insurer, or monoline, would have split its operations into a triple-A-rated municipal bond insurance business and a structured finance business with potentially lower ratings. A lower rating on the structured part of its business could have forced banks to reduce the value of guarantees on collateralised debt obligations and on derivative trades.

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It's All On Jobs Now

A: So we have had our fair share of failed auctions, margin calls, financial write-downs, fiscal & monetary stimulus, gov't sponsored targeted programs, and private sector bailout injections. It's exhausting. But the one thing we have not had yet, thankfully, is a rapidly deteriorating jobs market; but the radar is up. Of course its logical to expect it given the environment we have been in for over 8 months now, but the reports are always lagging and usually revised at a later time. To me, Friday's jobs report is going to be a big market mover IF the number beats or misses expectations by any significant amount. It's all on jobs now.

Jobs reports could be the final nail in the coffin for recession talk. If the unemployment rate unexpectedly jumps to 5.2% or higher, current expectations call for a 5% rate of unemployment, you are going to hear the media go nuts with 'recession is here' articles & the markets react fairly negatively; the combination of these two forces will hit consumer confidence in a way that just doesn't bode well for future economic reports. The messed up thing about following leading indicators is that we will see worsening economic data for a period of time AFTER the leading indicators normalize.

Here is a chart of unemployment rate since 1998, courtesy of the BLS. After the dot com bust, corporations cut back on spending and jobs ultimately bringing the unemployment rate to a high of 6.3% in June of 2003. That was about 3 years AFTER the top of the dot com bubble (back in early 2000), as the jobs reports lagged the stock markets and rapidly deteriorated from mid 2001 to mid 2003. Looking at the how the housing market, credit markets, and financial institutions have been performing over the past 8 months or so it is hard to argue that employment will be pressured. Unfortunately, this blogger expects some sharp upward pressure on the unemployment rate in the months ahead.

Lets play a bit and compare stocks to the unemployment rate since 1998, and see if we can see the relationship. The chart below compares the DOW vs UNEMPLOYMENT RATE over the past 10 years:

When I view this, I see a few things:

a) when unemployment really started accelerating in mid 2001, stocks corrected sharply.

b) in early 2003, stocks bottomed before unemployment topped out in mid 2003. For the record, the fed aggressively lowered the FFR to a low of 1% in June of 2003; about when unemployment topped out! Stocks started rallying 2 YEARS AFTER THE FED STARTED CUTTING RATES AND 6 MONTHS BEFORE THE LAST RATE CUT!When the fed started hiking interest rates (JUNE 2004 --> June 2006), stocks rallied about 20% during that period.

c) Unemployment has been slowly ticking higher since the low in early 2007; since unemployment is lagging, eyes MUST be on jobs now and probably for the next 3-4 quarters to see the reaction to the distress we have experienced thus far

On Friday we will get the unemployment rate and expectations are for 5%; the last report was 4.9%. What I don't know is which unemployment report (this one, or a report yet to come) will confirm what the fed is telling us when they say, "unemployment is expected to rise". The reason this is so important is the secondary effect it has on the consumer and on corporate strategy; as unemployment rises, confidence falls and the consumer gets more conservative while corporations cutback investments and look to cut costs contributing to the cycle.

ADD-ON (10:53AM): Forgot Non-Farm Payrolls on Friday too. Market expects growth of 25,000.

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Long Island City: Real(i)ty Check

In prior pieces I have been both an outspoken supporter of Long Island City (LIC) in the intermediate and long-term, and also a skeptic with regard to the significant supply of condo product coming to market in the near term. See my piece Spotlight Long Island City for a background. Today I want to revisit Long Island City, with the help of some input from a couple of local brokers and sources who are better informed and closer to the market than I am.

The press and blogosphere have been rampant with rumors of condos gone rental. According to an article in the Real Deal, "Developers become landlords, not by choice" one unfinished project, 512 Lofts at 5-12 51st Avenue, has gone partially rental. My pal Michael Stoler wrote recently in the NY Sun that:

One senior development director told me, Sales have dried up in Long Island City even for products in the best locations. Since October, we have only sold five units."

Other scuttlebutt suggested that even some of the most successful projects in LIC might be seeing some slowdown. According to Curbed, Toll Bros. 5SL had a one week sale on a particular unit, with a 3.4% price cut, followed by price reductions on 15 of 22 active listings. This was supposedly followed by prices being raised back up to prior levels as demonstrated by data from Street Easy. I have heard the Powerhouse mentioned as one property which appeared to have backed off from some higher than average prices, albeit for larger than normal apartments.

When I spoke with Eric Benaim of Nest Seekers, the only guy from a New York City real estate brokerage to open an LIC office, he offered a sunnier outlook and some explanation for the "gone rental" rumors. Eric has been a broker for 6 1/2 years, he's a Queens native, lives in LIC and has been dedicated to the market for the last 2 years. He opened up the LIC office for Nest Seekers a year ago on Vernon Boulevard. According to Eric, "People are taking a little more time to buy, but prices just won't go down." Condominiums like 44-27 Purvis street are having strong interest, with 20 - 30 people showing up to open houses on Sundays. The confusion over condo projects going rental may be being caused by rental availability in certain condo developments. For example, Eric reckons that 10% of the buyers at Arris Lofts, where he lives, were investors. These investors have since rented out their units....the developer has not gone rental. While the 20 or so units out of 237 units and 17 artist lofts that have rented may have generated some chatter, the magnitude of rentals is pretty small, and in part may also be indicative of the long waits owners had for the property to be built. According to Eric, at least one couple who were early buyers had twins while they were waiting for their unit to be delivered and put it up for rental, while they look for more appropriate space.

Darleen Krimetz of CITYVIEW Real Estate was the former VP of Sales and Marketing for the well known CITYLIGHTS building. She is still considered the expert on this property and is a top producer of resales there. Darleen also handles resales elsewhere in LIC and often shows new product to her clients for comparison. According to Darleen: "The market is still strong; with more product available, people are taking longer to make decisions. Resales have been turning over in 30 to 60 days vs. a typical 30 - 90 days, so they're back to normal, but the market is hanging in there. New developments have adjusted some prices which were getting high."

While it is apparent that sales velocity has slowed some in LIC, recent reports from the blogosphere suggest that new developments are still selling reasonably well. Curbed recently reported that Ten 63 Jackson Ave. has sold out 30 of its 37 units. Studios sold for around $375,000, 1BRs for $465,000 and 2BRs for $610,000, with an average sell-out price of $759 per square foot. According to LIQ City, One Hunters Point and Hunters View - both developed by Simone Development of Westchester - which started selling last October, have sold a combined 40% of their units. Curbed also recently opined that Crescent Club was in price increase mode on a couple of dozen units, which soon went to contract.

Still, rumors are circulating that the narrow windows seen being installed at 11-15 50th Avenue imply a "direct to rental" situation. The logic goes that condos have big windows, particularly when NYC views are an amenity, because owners pay the heating bills. Apartments are equipped with smaller windows, to keep this cost lower for landlords. The development had reportedly filed a Co-operative Policy Statement 1 (CPS1) with the state Attorney General's office, according to LIQ City, which allows general advertising of a development, without specific price information. An offering plan has supposedly not yet been accepted, further feeding the speculation.

Either way, the arrival of new tenants or new owners to LIC is seen as an overall net positive. One of the complaints about the area, from some but not all quarters, is that it's under-retailed. I pointed out the magnitude of this situation in my prior piece. According to Dan Minor, at the Long Island City Business Improvement District (LICBID):

It is very understandable that retail may be cautious until more tenants arrive in Long Island City and it's a bit of a chicken and egg situation

According to Eric Benain, demand for retail space is on fire and rents have rapidly escalated to the $55 - $70 per square foot range.

That said, the much-awaited and somewhat delayed arrivals of Duane Reade and The Amish Market to the Queens West waterfront complex (The Amish Market opening is said to be postponed until at least May) is seen as a big boost to the livability factor for potential new residents. Rumors continue to circulate that Starbucks will be "arriving" in LIC with a store in the Eastcoast building and potentially one on Vernon/Jackson Avenues. Other recent additions to the nabe, according to LIQ City include Ethereal (a women's clothing boutique), City Vet (pet care), BANY (Japanese fusion restaurant) and Ihawan (Asian Grill & Sushi Bar).

Bottom line: The things I like about LIC - one stop from Manhattan, neighborhood feel and great views- appear to continue to attract people to the area, which still holds lots of long-term appreciation potential. The necessary amenities are coming into focus, which I see as a big positive to the area moving out of the pioneering phase. My backbone still says there will be deals coming in this market as development continues apace while the economy cools. Savvy buyers should be keeping their eyes on the Pepsi sign and the buildings springing up beyond.

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Mortgage Market Distress Causing Rates To Rise

A: If you are watching CNBC or reading up on some headlines on Bloomberg, you probably can sense the fear level that is gripping the secondary mortgage markets! The problems have been bubbling under the surface for weeks and it seems that it can no longer be contained. The seizing up of these markets is causing companies like Thornburg & Carlyle to miss margin calls and receive default letters. The ugliness is a combination of fear, illiquidity, risk aversion, de-leveraging, and risk repricing; so expect sharp movements both up & down as the correction process continues. The unfortunate side effect is higher lending rates.

Have you seen the spreads between gov't backed conforming paper & 10 year treasuries! Even the safest paper is seeing risk aversion as a result of the credit turmoil. According to Bloomberg's article, "Agency Mortgage-Bond Spreads Rise; Markets 'Utterly Unhinged'":

The difference in yields, or spread, on the Bloomberg index for Fannie Mae's current-coupon, 30-year fixed-rate mortgage bonds and 10-year government notes widened about 7 basis points, to 223 basis points, the highest since 1986 and 89 basis points higher than Jan. 15. The spread helps determine the interest rate homeowners pay on new prime mortgages of $417,000 or less. The markets have become "utterly unhinged," William O'Donnell, a UBS AG government bond strategist in Stamford, Connecticut, wrote in a note to clients today. A lack of liquidity has "led to stunning air-pockets in price levels."

Investors are realizing that banks have little room to make new investments amid rising losses and a flood of unwanted assets, said Scott Simon, head of mortgage-backed bonds at Pacific Investment Management Co. The world's top banks have reported more than $181 billion in asset writedowns and losses, been stuck with $160 billion of leveraged buyout loans, and bailed out $159 billion of structured investment vehicles.

"Everything is telling you the financial system is broken," Simon, whose Newport Beach, California-based unit of Allianz SE manages the world's largest bond fund, said in a telephone interview today. "Everybody's in de-levering mode." Agency mortgage securities outstanding, which are guaranteed by government-chartered Fannie Mae and Freddie Mac or federal agency Ginnie Mae, total almost $4.5 trillion, about the same size as the U.S. Treasury market.

I discussed the effect on lending rates this two weeks ago in my post, "Inflation + Credit Crunch Means Higher Mortgage Rates":

"...this credit storm is now a full blown category 5 hurricane on so many levels and is hitting land at numerous points; analogy --> credit crisis is spreading! Put both these FACTS together and you will understand why lending rates are rising."

To the right is a 1-Month chart (courtesy of Bankrate.com) showing you 30YR Fixed Jumbo NY, 5/1 ARM NY, & FNMA 30YR MTG Yield. While the green & blue lines (the 30YR & 5/1 ARM respectively) seem to only slightly trend higher, take a look at the left axis and you will see that these yields have risen about 40 basis points & 50 basis points respectively over the past 4 weeks! Then look at what FNMA yields have done! These are the side effects of a secondary mortgage market in distress where risk aversion & fear are starting to effect even the safest paper out there.

All this is occurring as the latest round of housing data comes in and confirms what the credit markets have been deeply concerned about:

a) Home Foreclosures Hit Record High
b) Pending Home Sales Remain at Second-Worst Number on Record
c) Homeowner Equity is at Lowest Since 1945

As usual, the folks at the NAR put their car salesman spin on these disturbing numbers further eroding any credibility they have left. De-leveraging is a bitch and right now that bitch is taking over the cleansing process; it's quite a dirty job. As the credit markets continue to LEAD the stock markets, I am now starting to get more interested in the severity of the slowdown in future economic data reports that will reflect the turmoil that we have experienced over the past 4-6 months.

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The Mother of all Margin Calls: Leverage Bites

There was a great article in Thursday's Wall Street Journal about the fragile state of the markets called "Magnifying the Credit Fallout." It explains for the non-Wall Street audience how the $400 billion or so in mortgage losses could be causing such large reverberations, despite the fact that similar sums of money are often lost in equity markets on a daily basis, with no ill effects. The notable difference, the author highlights, is that these losses are taking place at banks and banks are levered about 10:1 - a leverage ratio that is much higher even than hedge funds. I have commented here before about banks' roles in money creation and destruction in a piece called Making Money out of Thin Air. The Wall Street Journal article points out that the losses at banks are resulting in a $4 trillion contraction in their lending capacity due to this high leverage - an impactful number to be sure. Importantly, this contraction is cascading down to other levered borrowers like mortgage REITs (At 12/07 Thornburg had assets of 18x their equity, while Carlyle was levered 36:1), hedge funds (many are down below 2:1 leverage, but some go as high as 7x and higher and several have begun to implode in the last couple of days), leasing companies (Financial Federal who reported earnings the other day has assets of 5x equity, but they fund themselves with long-term debt - obviously smart guys), etc, etc. But perhaps most importantly, the consumer is heavily levered in their real estate holdings. If you put just 10% down on your house, you're 10:1 levered on that investment. While people oftentimes have abundant additional assets too, my bet is this is a pretty good approximation of many such borrowers' overall "household leverage." FYI, the average homeowner has a historically low equity of 47.9% in their homes, which is nonetheless a much less levered position than that of many homebuyers of recent years.

Lately we have been hearing more and more about margin calls - Thornburg Mortgage REIT and a few hedge funds have felt the pain of dealing with a margin call when you are highly levered. For newbies, when an institution or an individual pledges a marketable security as collateral for a loan to buy another marketable security, the bank monitors the value of this collateral constantly. If the value of the collateral declines, the bank may ask for more collateral to be posted by the borrower....the infamous margin call. This will often cause the institution who borrowed money to have to raise new equity capital or sell positions to pay back the bank or boost collateral by some other means. This often happens at inopportune times and the institution often exacerbates its own situation by being forced to sell securities into a declining market.

A version of this scenario is currently happening to banks and I think it's instructive to think of the current situation in financial markets as the "Mother of all Margin Calls." Due to the transition in banking from making whole loans that a bank owns to maturity, to an environment where banks instead assemble packages of loans and sell off the pieces as securities, banking for most large banks has transitioned to an investment banking and trading business. As a result, they are falling increasingly under the purview of "fair-value accounting," which applies to marketable securities. See The Economist's article Mark it and weep for a primer on this subject. The result of the marking to market of mortgage backed securities, and recently muni bonds, collateralized loan obligations and CMBSs has resulted in banks' capital bases being hit hard by write-downs. It has exposed the problem that these most highly levered of all institutions' capital bases are actually much more exposed to market volatility than is comfortable for the financial system. So why the margin call analogy? In this case the margin lender to the banks is the Federal Reserve. The collateral level that the Federal Reserve requires the bank to maintain is called the regulatory capital requirement. So you can think of the stock offerings and sovereign fund investments the banks have been indulging in lately to boost their capital levels as reactions to the potential threat of getting a margin call from Uncle Ben Bernanke.

It is no wonder that banks are nervous about lending. They need to harbor their scarce and volatile capital, in case of future losses or just securities price declines. It's no wonder they are nervous about lending to each other - read about this phenomenon in the Economist' s When the rivers run dry.

So when will banks feel better about their positions and the security of their capital bases? They keep saying they have enough capital, but then they raise more. (I don't need to tell you they would never admit to being worried about their capital levels as that would be like yelling fire in a crowded theatre.) We all now know that their models for defaults on various securities have stunk so far. Since we are sliding into a recession, with tons of consumers levered 10:1, they are probably useless altogether. But eventually we will get through this and banks will feel better because:

1) They raise so much capital that the margin call issue becomes moot.

2) Real estate and other riskier debt securities have a huge rally.

3) The delinquency trend starts to visibly improve.

Let's think about each of these scenarios. The huge capital raise is a possibility, but let's face it, they have raised a lot and at least one sovereign fund is sounding like they aren't ready to pony up more money to save Citibank. I think a lot of the investors who bought the recent offerings by Citibank and Merrill actually bought into the "margin call" scenario and figured they could make a quick killing by helping relieve an acute but short-term liquidity squeeze situation. They probably aren't betting on a quick fix of this nature anymore. With regard to scenario #2, higher-risk debt securities could have a big rally if investors believed that they were very cheap even in a historically high default level scenario. Indeed, both Pimco and Wilbur Ross appear to feel this way about municipal bonds and their buying has helped support the market recently. However, my guess is that most of the buyers of this ilk are long-term investors, who can and need to be able to absorb short-term pain and by definition, use little or no leverage. This means they have to use much more capital to offset any selling by any entity receiving a "margin call." They can cushion the fall, but they probably can't stop it, or they already would have. With regard to the last scenario. The end to the delinquency trend seems nowhere in sight. Freddie Mac had this to say about the housing market and defaults on its recent earnings conference call:

The large decline in house prices in the fourth quarter has led us to increase the expected decline in our median house prices pass to approximately 15% peak to trough causing us to increase our expectations for expected default cost. While the relationship between house prices and defaults is clear, the forecast for expected defaults is not precise. This is particularly true in this environment as the rate of decline nationally is without recent precedent and the lack of correlation between unemployment and declining house prices is also unusual.

Of the total 15% decline in home price nationwide that Freddie expects, they have only seen 5 percentage points of it so far. That said, they feel that they have written down their portfolio enough, so that they will actually see a large amount of reversals of write-downs as the market improves. Let's hope they are right as Fannie and Freddie are the most levered of all financial institutions at 40:1....Woof!

Not much to be positive about regarding this liquidity crunch, it will take time and absorption of the many losses to come before conditions are likely to improve. The wheels of de-leveraging are in motion and they will likely have to travel many miles through this great unwinding before we see a return of normal liquidity to the markets and the economy. You can be sure regulators are thinking about these things and will be doing their part to move the unwinding along, by clamping down on the use of leverage anywhere they can. Same as it ever was.

From the Blogosphere

Carlyle Capital receives default notice after failing to meet payment demands.

Citigroup to shrink mortgage portfolio

Hedge funds stem exits as credit lines tighten

Long-Term Capital's Meriwether hedge fund loses 9% this year

KKR and Carlyle Funds in Deep trouble

Peloton lays blame on Wall Street lending crackdown for hedge fund liquidation

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Do Banks Need Tighter Regulations For Capital?

The answer to this might seem obvious these days. But with banks and the economy feeling the heat of the subprime mortgage mess, of course Congress and the Fed are weighing in. The real question, however, isn't regulation in of itself but what KIND.

Few anticipated that the value of mortgage loans, traditionally a mainstay of banking, would take a nosedive. As Fed Vice Chairman Donald Kohn told the Senate Banking Committee this week, "I don't know that we fully appreciated all these risks out there. I'm not sure anybody did."

Tuesday's Wall St. Journal included an article on the possible effects of Basel II (B2), proposed international standards for risk capital that - in theory - should help prevent the kind of massive write-downs by banks.

First, a little primer on risk capital: It's the amount of capital that regulators require banks to hold against their total assets. Typically it's based on a % of assets, which are categorized in terms of risk. So the riskier the asset, the more capital a bank has to hold aside in a reserve fund.

Why B2? One reason is set international standards for capital. Because each country has different accounting standards and capital markets, what might be considered 'equity capital' in Germany may not hold the same in the US. Keeping everyone on the same playing field would enable US banks to compete better globally.

Another reason is to allow the banks to assess risk levels specific to the type of asset, taking into account their own risk assessments and the opinions of credit rating agencies (i.e. Moody's, S&P), rather than adhere to regulatory guidelines that are more standard. After all, who would know better than the banks as it's their own business? Furthermore, B2 requires a safety net of capital for assets held off balance sheet. Theoretically B2 would enable banks to assess their capital reserves in a way that better reflects the underlying risk if their assets.

Some European banks have recently implemented B2 compliance; US banks have a couple of years to phase it in. The concern is that under B2 banks might underestimate how much of a capital cushion they'll need to absorb future losses. Another issue is the reliance on the opinions of credit rating agencies. Oh, and there’s the point that B2 doesn’t require as much monitoring of liquidity as US regulators would like.

Even under current US regulatory capital standards, banks are having trouble. This has Congress and regulators concerned that B2 standards would only exacerbate the situation, calling for further tinkering before banks implement the new program.

So here's what happened: banks valued their mortgage holdings as safer investments, only to find out the market didn't agree. Oops.

Ironically, hedge funds, that were previously thought of as a possible cause of the next big market bust, are lightly regulated in this regard. Of course many of them are feeling the same heat, so it calls into question the overall effectiveness of our current bank regulatory environment. Perhaps Congress and the SEC will pick up on this.

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Bedford Stuyvesant Townhouse Update

At the Urban Digs "bar night" two weeks ago, a few people asked me how my house in Bed Stuy turned out. Thanks for asking!

If you'd like to catch up on how / why I decided to invest my money in a two family house in Brooklyn instead of a one bedroom condo in Manhattan, please check out a few of my earlier posts:

A Broker's Search - Where To Buy
A Broker's Search Has Ended - Sort of
My Townhouse in Bed Stuy
Townhouse Renovation Tips

I am really happy to report that although it wasn't easy, my purchase on MacDonough Street in Bedford Stuyvesant, Brooklyn, turned out really well! Of course, none of my projections worked out as the "best case scenario" but none of them were "worse" than the "worst case scenario," either. I did my research & my numbers turned out to be almost "spot on."

I had hoped to have the construction finished by early December, but it was finished in mid December (NYC DOB permit issues set the work back by almost 2 weeks). I rented out the 3rd floor apartment for a Dec 15th move in, but had some trouble renting out the "owner's duplex" in the middle of the holiday season (which I was afraid would happen). The 2nd apt was rented out for a January 15th lease start.

I thought I would get about $1500 for the 1.5 bedroom and about $2550 for the owner's duplex, and my projections were very close. I offered a small credit for my tenants to postmark their rent by the 25th of the month before the rent is due. So far, my tenants have all sent in their rent early. I asked my tenants to sign leases that expire in the summer so that I don't have to worry about renting an apt out in the middle of the holiday season again. Summer rents are higher also, so my cash flow should continue to increase over time.

All in, I am covering the mortgage, taxes, homeowners insurance, heat & hot water expenses with the rent roll and I am slightly cash flow positive. Rates have actually come down since I purchased, so I will be working on a re-fi soon. As soon as I have paid off the $75K home equity line of credit on the house, I will be making more cash flow.

The project took time and money, though. I had hoped to spend $110K on the construction, but budgeted $130K "just in case." After 2 new kitchens, one new bath, two upgraded baths, painting, floors, new windows, upgraded electrical, two structural changes, a new closet, etc... When everything was said and done, I spent $135K. Part of that was my fault, though - I decided to add a washer dryer in the basement. In addition to adding the water line, there were additional expenses to convert the 110 power to 220 in order to support today's washer-dryers.

Of course, the heat stopped working in half of the house about 2 weeks after my tenants moved in. I tried to find someone through the grapevine to fix the problem because I prefer using vendors who are referred to me. Despite recommendations from other homeowners and brokers, it took me 2 weeks to find someone reliable to diagnose & fix the problem. The job was too small for my contractor's HVAC guys. One vendor that was recommended to me didn't do forced air gas heat. One vendor only did oil heat. One vendor kept saying he would go over and check it out and then never made it to the house, or arrived at the wrong time & the tenants weren't home. I offered to reimburse my tenants for space heaters. Finally, I Googled "boiler repair & Brooklyn" and just started calling numbers off of the internet. $1100 and half of a day later, the problem was fixed.

Buying a townhouse, renovating it, and getting it to cash flow is certainly not a "get rich quick" scheme, at least not in NYC. But if you are undertaking this kind of project as a 10 year (or in my case, longer) plan, I am confident that it will be more than worth your while.

Of course buying a one bedroom condo in a new development would have been a lot easier! But (so far!) my townhouse in Bed Stuy has been a hell of a lot more interesting. As a complete real estate addict (some would say "nerd"), I have to admit that it has been really fun.

My next adventure? I'm currently studying up on foreclosures:)

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What's A Fed To Do!

A: The fed came out on Friday, right before the scheduled release of the employment data, and announced up to $200 Billion in additional loans via the use of term auction facilities (TAF) and repurchase agreements. The interesting thing here is the changes to the repurchase agreements; extension of loans to 28 days + widening of allowed collateral requirements. Steve Waldman at Interfluidity, has an excellent piece (found via Naked Capitalism) that discusses what the fed may be quietly up to! Since 2.25% fed funds rate cuts thus far has done little to help normalize the credit markets, confidence, LIBOR, or liquidity in secondary mortgage markets, whats a fed to do?

First, some key elements of Steve Waldman's piece regarding the fed's announced stimulus actions on Friday:

The Fed announced that it would auction off $100B in loans this month rather than the previously announced $60B via its TAF facility. In the same press release, the FRB announced plans to offer $100B worth of 28 day loans via repurchase agreements against "any of the types of securities — Treasury, agency debt, or agency mortgage-backed securities — that are eligible as collateral in conventional open market operations".

The second announcement puzzled me. There are a couple of differences, then, between this new program and typical repo operations:

1. The loans are of a longer-term than usual. Ordinarily, the Fed lends on terms ranging from overnight to two weeks in its "temporary open market operations". The Fed will now offer substantial funding on a 28 day term.
2. The Fed is effectively broadening its collateral requirements by collapsing what are usually 3 distinct levels of collateral which are lent against at different rates to a single category within which no distinctions are made.

Until the current crisis is long past, I think it unlikely that any large bank will default and stiff the Fed with toxic collateral. Why not? Because for that to happen, the Fed would have to pull the trigger itself, by demanding payment on loans rather than offering to roll them over. Since TAF started last fall, on net, the Fed has not only rolled over its loans to the banking system, but has periodically increased banks' line of credit as well. In an echo of the housing bubble, there's no such thing as a bad loan as long as borrowers can always refinance to cover the last one.

The distinction between debt and equity is much murkier than many people like to believe. Arguably, debt whose timely repayment cannot be enforced should be viewed as equity. (Financial statement analysts perform this sort of reclassification all the time in order to try to tease the true condition of firms out of accounting statements.) If you think, as I do, that the Fed would not force repayment as long as doing so would create hardship for important borrowers, then perhaps these "term loans" are best viewed not as debt, but as very cheap preferred equity.

What we are witnessing is an incremental, partial nationalization of the US banking system. Northern Rock in the UK is peanuts compared to what the New York Fed is up to.

You may object, and I'm sure many of you will, that our little thought experiment is bunk, debt is debt and equity is equity, these are 28-day loans, and that's that. But notionally collateralized "term" loans that won't ever be redeemed unless and until it is convenient for borrowers are an odd sort of liability. Central banks are very familiar with the ruse of disguising equity as liability. Currency itself is formally a liability of the central bank, but in every meaningful sense fiat money is closer to equity.

The entire piece is a great read, but it's interesting to see the collateral requirements widened to include agency debt & agency MBS. It seems we will be seeing more of these types of moves for the next few quarters as commodity inflation pressures the aggressiveness of future rate cuts. That doesn't mean we have no room left for rate cuts, but lets be honest here: RATE CUTS THUS FAR HAVE HAD NO EFFECT ON CONFIDENCE OR EASING DISTRESS TO THE SECONDARY MORTGAGE MARKETS AND RATES! The bankrate.com chart to the right shows you how lending rates have risen as the fed cuts FFR.

So whats needed? You may not want to know what Paul Miller over at Friedman, Billings, Ramsey estimated ---> $1,000,000,000,000. According to Marketwatch.com:

Why are interest rates on 30-year fixed-rate mortgages rising even as the Federal Reserve slashes interest rates and yields on Treasury bonds fall? The answer is that the mortgage market is short of roughly $1 trillion in capital, according to Paul Miller, an analyst at Friedman, Billings, Ramsey.

The modern mortgage market works with lots of leverage, or borrowed money. Investors, including hedge funds and mortgage real estate investment trusts, buy mortgage securities, but finance a lot of their purchases with this leverage. FBR's Miller estimates that $11 trillion of outstanding U.S. mortgage debt is supported with roughly $587 billion of equity. That's a leverage ratio of 19 to one. This has sparked a de-leveraging cycle in which some highly leveraged mortgage investors have to sell assets to meet margin calls. Forced selling pushes prices lower, sparking more margin calls, which in turn produces more selling and even lower prices.

Since every rate cut is in essence a wasted bullet in a limited capacity gun, the fed knows it needs to pick & choose its next shots wisely. Personally, I think another rate cut will come soon and there is now a Goldman Sachs rumor floating around the markets that one may come today. I doubt that rumor as it is consistent behavior when stocks have had an ugly downturn and are now seeking a quick short-covering rally. The next scheduled fed meeting is May 18th, and I think the move will come then.

The credit markets (auction rate markets, secondary mortgage markets, corporate credit spreads, CMBX's, CDX's, ABX's, etc.) continue to LEAD the stock markets and the world for that matter; these are the markets to watch for signs of confidence and right now the credit markets are not reacting to rate cuts. So, any future rate cuts we get will be targeted as 'setting a floor' and easing the downturn that we are clearly in right now at the expense of commodity inflation. The actions that seem more effective right now are the TAF & repos. Your thoughts?

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Fed Acts! Targets Freezup in the Credit Markets

A: Wow, some big news today and what a timely piece yesterday, "What's A Fed To Do", discussing the ineffectiveness of fed rate cuts and the effectiveness of TAF & repos to heal what currently ails us. The fed pounced on what is working and announced today a new plan to lend up to $200 Billion in treasury securities to unfreeze the credit markets. The key element to the newly created TSLF, or Term Securities Lending Facility, is the 28-day hold period + the further widening of allowable collateral to be used. In addition, the fed has authorized increases in existing programs known as 'swap lines' with foreign central banks. All in all, a very targeted and effective move that is having an immediate effect.

The news from a variety of sources:

Yahoo Finance:

The Fed said it will make up to $200 billion in cash available to cash-strapped financial institutions.

"Pressures in some of these markets have recently increased again," the Fed said in a statement. "We all continue to work together and will take appropriate steps to address those liquidity pressures." The other banks involved are the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, and the Swiss National Bank.

In addition, the Fed has authorized increases in existing programs called "swap lines" with the European Central Bank and the Swiss National Bank.

Bloomberg:

The Federal Reserve plans to lend up to $200 billion of Treasury securities in exchange for debt including private mortgage-backed securities that have slumped in value as homeowners defaulted on their payments.

The Fed set up a new tool, the Term Securities Lending Facility, to lend Treasuries to primary dealers for 28-day periods, through weekly auctions. The Fed also said in a statement in Washington that it's increasing the amount of dollars available to European central banks through swap lines.

Here are some reactions I am seeing in the markets:

a) treasury yields are rising big time
b) equity futures are surging (short-covering will fuel the rally)
c) financials are surging on this targeted fed move
d) fed funds futures lower chances of expected total rate cuts to come

I would also expect this to have a narrowing effect on credit spreads over coming days, and that would be a very welcome macro reversal. Also, to be allowed to use debt including mortgage backed securities as collateral in exchange for the loan, is huge. However, there is something very important to understand here: THIS MOVE WAS TARGETED AT THE CREDIT MARKETS AND MEANT TO EASE THE DISTRESS & ILLIQUIDITY OF THE SECONDARY MORTGAGE MARKETS! It is not a cure all move and it will NOT prevent weakening economic data from coming out over the next few quarters. It will help where help is needed most on wall street, the credit markets. If there was a secondary mortgage market where MBS can be traded again, the process of cleansing the balance sheets of financials could occur at a faster pace so that we can return to a more normal lending environment.

For all those that believe that we must have a functioning credit market and a liquid secondary mortgage market if we are to start the recovery phase, me included, this move was aimed at achieving this. Equity markets were oversold and this probably will result in a sharp bear market rally over the coming days; we will not enter a new bull market until the financials balance sheets are cleaned, and the cleansing process for this is still ongoing.

The bigger picture here is that the fed seems to have found a tool that works, outside of traditional rate cut actions that have negative effects on the US dollar & commodity prices.

PHOTO Source: Denovobanks.com

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10-Year Trends: S&P 500 vs Fed Rate Cuts

A: For kicks, I just wanted to check out how the S&P 500 has performed when compared to fed actions over the past 10 years. I wondered if the relationship was clear. It was! Basically, if you SELL when the fed starts to cut rates and you BUY when the fed starts to raise rates, in the short-medium term you probably will do just fine! It's strange how a short term equity investment strategy may be as simple as this!

Lets get right to the 10-year chart:

S&P 500 Chart courtesy of MSN Money

Fed Funds Target Rate courtesy of Moneycafe.com

Its clear that substantial easing or hiking campaigns resulted in a subsequent selloff and rally respectively. Granted, when the fed started hiking in mid-1999 the time to sell was when the fed stopped hiking rates in mid-2000, and not at the next ease. If there is any relationship that is noteworthy here (which would be for periods of time where fed action is aggressive), its that if you buy when the fed starts a hiking campaign, you probably will have missed the majority of the pain that occurred during the slowdown period prior. On the same note, if you sell when the fed starts a new easing campaign (tricky part is realizing when fed action will be aggressive and drawn out), you probably are getting out before the slowdown hits full force! Also, the longer the period of PAUSE after a hiking or easing campaign seems to relate to the length of the current trend in the S&P.

Ok, thats done.

Relating To Todays Fed Announcement: Today's fed move probably means fewer rate cuts down the road. In my opinion, the hidden gem in today's announcement is the targeted nature of the shot that will limit pipeline inflation (geez, there's enough of that as is) by reducing the need to cut fed funds rates as aggressively as previously expected. That means the US dollar may not become as weak as expected and commodities priced in dollars may lose a dose of steroids (rate cuts) that they were betting on. If you want to get real crazy, what if we assume that international markets are lagging the US and they are about to enter a period of financial distress similar to what we have been through for past 4-6 months? Our currency could bounce further if foreign cb's start easing at a time when our fed found a way to limit future rate cuts. Ehh, just a thought with many if's.

Time will tell, as this is a more medium term idea (3-4 quarters) to be watching for; for now, we still have pain to go through waiting for the damaged economic reports to show the carnage left in the wake of the ongoing credit storm.

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States & Cities At Risk: Including New York

While many see the machinations on Wall Street as distinctly separate from the day-to-day realities of the real world, the worries or passions that are reflected in securities market moves are based on reality and market participants' concerns and hopes about future trends. Sometimes markets get it wrong and worry far too much about potential future outcomes, or put too much stock in them. Sometimes markets seem prescient and sniff out a new trend before Main Street has any clue it's coming. Rarely, but once in a while, market moves actually drive trends that are normally the impetus for price moves in those markets. We are in one of those strange times, when because of all the leverage in our economy, the tail is wagging the dog. (See my recent piece,The Mother of all Margin Calls)

In recent weeks, the municipal bond market has come under severe pressure due to the capital adequacy problems with monoline insurance companies (see my piece, Tentacles of the Credit Beast) , which insure municipal debt. As many have pointed out, municipal debt has performed very admirably over time, with low default rates. In fact, some municipalities are now wondering, why they ever used the insurance in the first place. However, fear over the efficacy of insurance on products that never really needed insurance, should not cause the kind of huge re-rating of municipal bond risk that it has in the market. According to the Financial Times:

Yields in the US municipal bond market have soared to historically high levels compared with US Treasury bonds, as investors respond to uncertainty over the fate of bond insurers and Wall Street banks withdraw support from the market.

This kind of move does not happen solely because of some arcane issues with bond insurance. Yes, I know that there are many investors who must sell bonds if they don't carry better than a particular credit rating. However, some investment committees can take short-term exigencies into account and override these rules. Additionally, other investors would come in to buy up bonds that those committees that can't flex their guidelines force their portfolio managers to sell, if this were the only issue. Note that smart guys like Bill Gross of Pimco and Wilbur Ross of W.L. Ross have been doing just that, but spreads would never have gotten to record levels if there wasn't some underlying increase in credit risk to these instruments.

So whatup with muni bonds? It's the economy stupid! As I noted in my 8 Predictions for 08, the real estate debacle is hurting state and municipal finances. By my count 16 states were already having budget issues coming into 2008, and I missed New Jersey, which is busy whacking its spending (Sopranos style) and contemplating big job cuts. Collection of real estate taxes and transfer taxes on real estate transactions are down. But revenue is now being further attenuated by falling sales taxes and eventually income taxes. In the meantime, home foreclosures are adding to the need for state-provided services of various kinds. According to Financial Week:

Twenty-one states face budget deficits in fiscal 2009, including 16 that are short at least a combined $30 billion, according to the Center on Budget and Policy Priorities.

These fiscal issues are also impacting cities, abetted by a trickle down impact of a lack of state funds. According to Reuters:

Revenues in one-third of American cities have declined over the past year because of a rise in housing foreclosures, the National League of Cities said in a report released Tuesday. Nearly two-thirds of the more than 200 cities participating in the poll said they have seen foreclosures rise, leading one out of three to cut funding for community programs. The cities are also grappling with growing demands for food banks and counseling, the report said.

Across the northern states, snowstorms have posed budget problems for cities from Milwaukee to Rochester to Wareham, Massachusetts. If these cities can't handle a little extra snow, imagine what's going to happen when the heavy stuff starts coming down. Margins for error in state and municipal finances are thin, because rapidly rising revenue allowed budgets and services to expand even as costs were spiraling upwards. Now that revenues are flagging, healthcare costs, fuel costs , pension costs and construction and maintenance costs are biting hard.

As I noted in my predictions for 2008, "state spending is $1.8 trillion annually and reportedly about 13% of the economy and state spending is going from a big booster of growth to potentially contracting." I think we can safely add municipal spending to the category of areas of the economy likely to disappoint. In some cases the disappointment could be large - for example Vallejo California, which recently narrowly averted bankruptcy. Of course, Vallejo, which has had problems since before subprime was put in the dictionary, and Jefferson County, Alabama (currently caught in a derivatives debacle) were in Warren Buffet parlance, "skinny dipping", before the credit crunch. But of course you only find out who is skinny dipping when the tide goes out and the tide is definitely going out on state and municipal government finances.

Please note that New York State and Gotham City are not immune. The State has an estimated budget deficit of $4.7 billion, but the news on New York City has been pretty good so far. The Independent Budget Office's annual report just came out and in testimony to the City Council, Ronnie Lowenstein had this to say about the outlook this year:

While the local economic downturn and the declines in tax revenue have dimmed the city’s fiscal picture, our short-term budgetary condition may not be as dark as one might expect. One reason is that so far this fiscal year business tax collections have not declined as much as previously projected. In addition, despite Wall Street’s huge losses, bonuses barely declined, bolstering personal income tax withholdings.

She goes on to note that a significant surplus is still expected for this year and that this surplus will help to plug holes in the 2009 budget. A deficit is expected to be forestalled until 2010, and the shortfall in that year is being estimated at a relatively modest $2.1 billion. Please note that these forecasts are based on the assumption of a relatively brief and mild recession. Among other areas where the outlook could go wrong are second order effects. According to the testimony:

There are a number of other potential fault lines for the 2009 budget and January Financial Plan. For example, the Mayor’s budget plan does not recognize the effects on the city of the Governor’s proposed budget. Another example is the planned conversion of a merged GHI and HIP to a for-profit insurer, which could cost the city $200 million or more a year in additional health insurance premiums for employees. A third example is stock market losses by municipal pension funds, which may force the city to substantially increase its annual contributions to the funds in the coming years.

The moral of this story is that major dislocations in financial markets, like muni bonds, don't happen on a whim or just because of mechanical market issues. There is always some truth behind a major move. In this case the truth is that state and municipal finances will have a negative impact on the economy and joblessness, and ultimately will feed back into weaker real estate prices in some places. The second chapter of the liquidity crisis is upon us and we are now going to start seeing the second order effects of it. Hopefully, the Fed's latest moves to give the credit markets an angioplasty will get the money flowing again and ease the severity of these second order effects.

From The Blogosphere

The Tough Choices Ahead

Taxing Decisions

Foreclosure Crisis Has Ripple Effect

New York City eyes deeper budget cuts in shortfall

The 2008 to 2013 MTA Capital Plan: Is There A Way Out?

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Fannie & Freddie go to Rehab

Rumor has it that last week the Federal Government was considering granting Fannie Mae & Freddie Mac (F&F) ‘explicit guarantees’ of its debt.

Bad idea and the government quickly denied it. But it brings to mind what these groups do and how they affect the markets.

Right now both F&F benefit from an ‘implied guarantee’ meaning that, because the two companies were chartered by the Federal government they’re able to issue debt at a lower rate than comparable corporate debt. Thing is, this ‘implied guarantee’ gives the impression that Congress would bail out F&F in the event of a default, at the taxpayer’s expense. Which is actually not the case.

On the surface the implied guarantee might make sense, given F&F’s contribution to the US housing market and the economy, by enabling wider homeownership and by adding liquidity to the mortgage market through packaging of mortgages into securities. Plus the fact that Fannie was originally chartered as a government agency under FDR in response to the housing issues of that day.

Problem is that today both groups are – surprise! – public listed corporations just like Citi, Merrill and Google, not government agencies like the US Treasury Department or the IRS. This means they should be held accountable to shareholders. And have a board of directors, and all of the other corporate governance-related activities that public companies get to do.

Problem is they hadn’t always been doing this very well. If you’ve been following the business news in recent years, both F&F have been plagued by internal control issues. Fannie’s was so severe that it had to undergo the largest restatement in US history. An investigation revealed accounting fraud initiated by former senior executives and aggressive lobbying on the part of senior executives as to render its regulator, OFEO ineffective, to say the least.

Sure, other companies have done this before but given the impact that FNMA has on the US – no, the world – economy, this is no small lobbying effort. The problem was so severe that the Wall St. Journal called FNMA the “Enron of the Beltway”.

Of course all of this happened before the housing market credit crunch. And FNMA has been cleaning itself up, having hired a new executive team, revamped its board, appointed bright people to its senior management ranks, and Congress has been making a point to hold the company more accountable for its actions.

But all of this has been fairly recent and, I suspect, is still in the process of being ironed out as it takes time to change the cult