Oil's Well That Ends Well?

I have mentioned a couple of crazy notions on Urban Digs regarding a slowing world economy and increased unemployment actually being a positive for the U.S. You can read about it in my pieces World Economies - The Tide's Going Out and Oh Behave! Inflation.

I know you may be skeptical, but the self reinforcing cycle of higher oil prices, tapped consumers, mortgage defaults and a weak dollar, to me was economic kryptonite. It was necessary for this cycle to be interrupted to avoid dire consequences and I now believe that it just might have been. I can be a little bit of a conspiracy theorist. I love to quote an old institutional stock broker of mine, who had previously been an ATF officer. He used to say "just because I'm paranoid doesn't mean someone isn't following me." I don't actually believe that the interruption in the vicious cycle has been rigged despite the jawboning against speculators. I think it's more a case of supply and demand finally overcoming financial players.

It is now becoming the consensus view that world economies are slowing. David Malpass, former economist for Bear Stearns, was talking about it this morning on CNBC, and the big reaction to Dell's earnings on Friday, clearly underscores world stock markets' worries regarding the remaining leg of earnings support being kicked out. The slowing world economy makes oil and other raw materials cheaper, and it makes other nations stop raising interest rates. It is already making some nations lower them. This does a lot to allow the Fed to cut again if need be, without causing U.S. bonds to be dumped, driving up longer-term interest rates.

The reason I think that the vicious cycle may have been broken, is that we are now entering territory in the commodity price decline where the question of short-term correction versus long-term correction is coming into view. Witness the chart below on oil:

In this chart from StockCharts.com, you can see the 200-day moving average on crude at $111.17. As of this morning oil was getting creamed and trading at $108. If oil in fact closes below the 200 day, on a big breakdown of this nature, it portends future, longer-term weakness. I don't mean much lower oil prices. I simply mean a much longer healing process before oil can make any attempt at the old highs. Just for anyone who is overly focused on Hurricane Gustav, expectations of a more serious outcome may have helped prop up oil and the disappointment of bulls may be making the sell-off that much more dramatic, but commercials should be stepping in to buy big time around the 200-day moving average, if they are strongly bullish at these levels. I'm not a bear on oil, I just think its roll in inflation may be pulled off the table for the next 12 months or so. Note that the CRB Index, which has a very significant weighting in oil, and is a measure to which many big passive institutional investors index their commodity bets, broke its 200-day moving average a couple of weeks ago.

So the good news is bad news on world economies and commodities? I am not here to tell you that the economy and markets are going to get better soon. In fact, I think we are in a long-term deleveraging cycle, which I will be writing about soon, and which portends very poor growth in the U.S. for at least a couple of years. Check the chart on debt to GDP from Noah's piece Peak Credit & What That May Mean if you want to scare yourself.

I've asserted before on Urban Digs that banks need lots of time and a steep yield curve to heal their balance sheets (at least those that will survive). If world growth slows and we have more unemployment it will certainly hurt, but it's a slower decline, during which many resources and investor dollars will be marshaled to try to forestall a banking debacle and depression and profit from the avoidance of the same. So the not-so-bad news is that soaring oil and an imploding dollar are a very quick trip to the poor house that we may have squeaked by.

From the Blogosphere:

The developed world economy has slowed

Crude oil, gold, copper lead decline in commodities in London

Oil falls as demand concerns re-emerge

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SF Fed President Yellen Talks Dovish

A: I'm taking some time off from real estate this month and watching all that is happening in the stock market & credit world. A little disclosure, I did re-activate my trading account to get a more real time look at what is going on daily in the equity markets; screenshot at bottom of this post of my trading software and what I see (mapping keys right now so positions are minimal for testing). Some breaking statements from SF Fed President Janet Yellen, to me, hints at the reality that a RATE CUT is more likely than a hike as the next move. UD readers know that I have been in the dovish side for a while now, after acknowledging that wage inflation and an expansion in the money supply is not the type of inflation that is threatening us this time around. Rather, its credit/housing deflation that pose that biggest threats to our economy.

For much of 2007 I was focused on how commodity price inflation was not being measured properly and that our fed would be stuck in between a rock and a hard place with rates, due to soaring commodity prices and a weakening economy. I thought a rate hike campaign was inevitable at some point, but just unsure of its start date. But towards the end of the year and into early 2008, I got way more serious about the effects of deflation on our economy and got more dovish; specifically, credit & housing deflation occurring at the same time as soaring commodity inflation. For the past few months, I have been purely dovish in regards to future fed policy, expecting a rate cut and not a hike, likely in response to a market event.

Let me go into what Yellen just stated first, and explain how this fits perfectly into the school of thought that I have been in for most of 2008.

"Q3 GDP WILL NOT HOLD UP"

"FED POLICY MUST BE CALIBRATED TO PUSH THROUGH THE SUBSTANTIAL HEADLINES OUR ECONOMY IS FACING"

"FALLING COMMODITY PRICES HELPING THE FED"

"CREDIT CRUNCH IS DEEPENING"

"NO EVIDENCE OF WAGE PRICE SPIRAL"

Does this sound like a hawkish fed to you if this mindset is shared among other fed members, specifically, voting fed members? Yellen is an alternate voting member of the fed. Her comments perfectly fit into the thought process that ultra high commodity prices and a very weak dollar is NOT the environment hoped for to proceed with stimulative monetary or fiscal policy. And I think monetary policy will have to be stimulative as we face the economic after-effects of this year long credit hurricane and 3 year housing slowdown.

Almost a month ago, I wrote 'A Thought on the Dollar' and stated very clearly where I stand:

"By giving the dollar a boost without actually hiking rates in US or cutting rates in Eurozone, it will give our fed MORE FREEDOM TO CUT RATES should our economy continue to deteriorate down the road.

Ben wants to inflate, and in my opinion will not hike rates as long as there is housing/credit deflation, unemployment is rising, and the financial sector remains under distress. Hiking rates now will be counter-productive to fixing the financials/credit markets (which is so crucial for a housing recovery to take place) and an orderly unwind of toxic securities.

An outcome supported by this way of thinking, is if our fed does indeed cut rates as their next move (who knows when), and if Trichet holds rates at 4.25% for the foreseeable future. Should this happen, then the fed orchestrated it wonderfully..."

I stated my dovish stance on AUG 5th, when almost everyone else out there was still betting on a rate hike as the next move.

"In meantime, I think the fed is talking tough about inflation and may have to cut rates before raising them should the credit markets / housing markets continue to deteriorate OR if an event occurs to stabilize markets before trading re-opens; so I'm more on the dovish side while I see Barry Ritholtz on the hawkish side."

Lets see how this plays out. My money is on an inter-meeting rate cut in co-ordination with intervention to an 'event', to alleviate the shock to the tradable markets before opening. I just dont see the cut coming at a planned meeting. What I would consider an 'event' would be similar to the rescue of Bear Stearns. The most likely events we face are to rescue the GSEs, failure of another top IB such as Lehman or Merrill, failure of a top bank such as WaMu or Wachovia, and such.

We know some big names will fail and the world as we know it is in the process of changing. Lets get it on already!!

Trading Software: I was an equities trader at Tradescape from 1998-2004, after following the tradable markets from the ripe old age of 13; a $250 failed investment in SGI got me hooked. The company was bought by E-Trade, taken private, and now operating as LightSpeed Trading. I find the software fine for the active trader and ticket prices are about $6 per 1,000 shares (or ticket as I call it). I'll vouch for the software for any traders out there who are unhappy with their current trading systems.

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Surprise! More Jobs Lost & Unemployment Surges

A: Well, not a surprise actually. Anyone surprised by this report simply has decided to keep their head in the sand, to hold on to hope. That's OK, as long as you don't make extreme tradable bets based on this hope. As I have discussed over the past few months here on UrbanDigs, the likely next fed move will be a CUT, not a hike, as the fed futures traders and mass media led us to believe. Today's surge in unemployment, downward revisions in past jobs data, and continuing shedding of US jobs, puts the spotlight back towards economic growth. As a result, fed futures are now in the process of shifting their bias towards a rate cut, from bets on a rate hike previously to combat commodity inflation.

First the news, from Bloomberg:

Payrolls fell by 84,000 in August, and revisions added another 58,000 to job losses for the prior two months, the Labor Department said today in Washington. The jobless rate jumped to 6.1 percent, matching the level of September 2003, from 5.7 percent the prior month.

In late July, I had the privilege of speaking at the Inman BULL vs BEAR (link to summary of what speakers said) debate with amazing bloggers such as Bill from Calculated Risk, Yves from Naked Capitalism, and John Williams of Shadowstats. The video of this debate from about 6-7 weeks ago is at Inman Videos.

Those at the debate were a bit taken back by the negativity bias of the panel, but instead should have been appreciative to get such unbiased, real-time forward looking opinions on the state of the macro economy, credit markets, and housing market. Attendees heard first hand my thoughts on the near term which included the following statements:

a) massive credit deflation/contraction
b) deteriorating jobs market / rising unemployment
c) strapped consumer from commodity inflation makes for a perfect storm
d) pipeline pressure for Case Shiller Index
e) no 'V' shaped recovery in housing
f) years of deleveraging process / overly optimistic wall street CEO's to instill confidence
g) GSE's ability to fund themselves short term
h) no wage inflation

We are at now now. The story is the same, and to me it seems pretty clear how it will end. John Williams hyper inflation may come, but it will be as a result of all the intervention that our government & fed are likely to do as this cycle continues.

Over the past few months, everyone was expecting a rate hike to combat the inflation problem. Right now, we do not have the TYPE OF INFLATION THAT OUR FED WILL RAISE RATES FOR. If we had wage inflation and a rapid expansion of credit/money supply, then yes, our fed will aggressively raise rates. But we do not have this. Mish has been the poster boy for this mis-understood dynamic for a while now, and his blog GlobalEconomic Analysis is a daily must read; no matter how gloomy it may seem!

Readers should understand the environment we are in. Unfortunately, this is the process that we must go through to eventually see the light. Lets not delay it, lets not postpone it, lets use judgment on any bailouts, lets let those companies that should fail, fail, and let those who took unprecedented risk using too much leverage be punished and not let the taxpayers foot the bill. This story is not yet over.

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The Path of Deleveraging: Quantitative Ease Please!

How about some help with the heavy lifting Uncle Sam?

I've been contemplating this piece for quite a while, but with so much focus on inflation and the weak dollar decimating consumer purchasing power lately, I've written more on why inflation was the wrong bugaboo to be afraid of. I am going to declare temporary victory on the inflation question, despite what the ECB may think. I'll address "the great confidence game" of whether the threat of U.S. debt default causes hyperinflation and a third-world-type currency crisis here in the U.S. when the time comes....and at some point it may, but I'm not currently in that camp though I know that many are.

Yesterday, Bill Gross of Pimco (aka The King of Bonds) put out an investment strategy piece which was viewed as significantly more negative than in the more recent past (it may have even helped in the 300 point+ rout in the stock market). Now Gross is known on the street for talking his book and for sometimes being early, as he was on the housing crisis. He suffered poor relative performance for a year due to his bearish economic bet, before blowing the doors off everyone else when he was proven right. In fact, this makes perfect sense, because he is driving an oil tanker, he has to be early, and since he controls so much money, when he wants to change his bets it may behoove him to talk his book up to help generate demand for the other side of his trade. In his piece Gross enumerates what happens in a delevering cycle (and I thank him for doing my piece for me, but much more succinctly).

1) Risk spreads, liquidity spreads, volatility, term premiums – they all go up.

2) Delevering slows/stops when assets have been liquidated and/or sufficient capital has been raised to produce an equilibrium.

3) The raising of sufficient capital now depends on the entrance of new balance sheets. Absent that, prices of almost all assets will go down.

Gross goes on to explain what these three points mean and in the process he reminds us of some things that we already know in our guts but may be prefer to ignore. These are my interpretations.

Throwing out the baby with the bathwater - When people get burned in one asset they often sell other assets that have not yet been decimated in order to meet margin calls or just raise cash.

Relative value trading - investments with yield that get cratered increase in yield, which makes yields on other stuff look kind of thin in a "risky environment" this leads to mark downs across related assets. The risky stuff gets hit much harder and the spreads between assets rise, but everything sees it's risk premium rise.

Insurance policy prices rise - this is where the volatility part comes in. Those who would sell you you an insurance policy that would put a floor under your losses get nervous about the extreme swings in value (mostly to the downside), euphemistically called volatility and they raise the price of insurance policies/hedges.

What's left that we can sell? - With a prohibitively high cost of hedging risk, people have to worry a lot more about whether they can sell an asset that declines in value, rather than whether they want to. This is liquidity risk. Assets that are more liquid go down less, than the more illiquid ones, but liquid assets get dragged down, too, because they can at least be sold.

Standing Back - If all of this "negative feedback" isn't bad enough, eventually those who are not over-levered and have capital to invest become risk averse because they keep trying to call a bottom too early and continually get their fingers burnt. Pimco admits to being too early buying certain assets, along with many other smart investors. This general risk aversion is what keeps fresh capital from coming in and helping stop the deleveraging feedback loop.

Gross finishes his letter by calling on the government to get involved before risk aversion really sets in for good. How would this work? Gross' prior August letter dedicated quite a bit of space to the problem of the fed cutting interest rates but costs of mortgages going straight up anyway and pressuring housing prices further. Noah and I have commented on the incredibly pernicious impacts of this many times in the last few months. Here is a chart from Pimco's August investment letter, showing the impact of the Fed's rate cuts on the cost of borrowing for home mortgages.

It is and has been obvious to all that the Fed is "pushing on a string."
Ben Bernanke is known for his work on Japan's lost decade and one of the strategies that Japan nearly had to enact, when they had held interest rates at zero for several years and still couldn't stop the deflation, called quantitative easing. This is when the government actually goes out and buys debt, boosting prices, providing liquidity and easing volatility (they have already done a half step towards this with the "loan facilities" provided to banks and the Street). Uncle Sam could effectively do the same thing by just helping consumers get mortgages more easily, thus cushioning the housing market so those with cash can and do come in to buy houses and all the securities associated with housing. Either way it's on the government's tab. My guess is that they will do both. The question is just what is the most efficient policy mix to stop the asset deflation and de-levering (margin call) cycle.

Gross includes an ominous warning to the Feds with the following chart:

This composite chart of U.S. housing prices, stocks and bonds, shows the significant negative wealth effect now underway due to the effects of deleveraging. he notes that this magnitude of combined decline has not happened since the Great Depression and that this is what separates this financial crisis from prior ones where markets were hit. Gross provides some levity in his letter with commentary about his fascination with Jim Cramer and the idea that there is always a bull market somewhere. However, he makes a sharp point that as of now, as evidenced by the commodity rollover, there is nowhere for investors to run.

Pimco's flagship fund, Pimco Total Return, has gotten $15 billion of new money year to date, according to today's Wall Street Journal. The recent commentary is signed Booyah Hank? as if addressed to Hank Paulson (no doubt treasury would have to print a bunch of money to back up the Fed's efforts at quantitative easing and would have to help convince the government to intervene in the housing market in a big way). Is Gross sending a message to the Feds? I'll buy, but only if you buy first? A lot of smart money along with FWFs, private equity players and hedge funds might be tempted to follow his lead if Uncle Sam steps up....there is of course the eventual bar tab. Like I said, more on "The Great Confidence Game" in a future post.

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Freddie Overstated Capital Cushion / Bailout Imminent

A: First week of football, bailout of Fannie & Freddie, ahhhh the excitement. And man, how pathetic am I. Anyway, here is the latest and its not surprising. Both Fannie & Freddie for whatever reason have been marking their assets to model, not to market. When Merrill sold off their distressed assets at a reported 22 cents on the dollar, arguably 5 cents on the dollar, it issued in price discovery for what these distressed assets were currently worth on the open market. The ricochet of mark downs were not occuring at the GSE's, making their books appear at first glance to be stronger than they really were. I wish I had an intern to help me research all this for more visual discussions on these very important topics.

Via NY Times, "Loan Giant Overstated the Size of Its Capital Base":

The government’s planned takeover of Fannie Mae and Freddie Mac, expected to be announced as early as this weekend, came together hurriedly after advisers poring over the companies’ books for the Treasury Department concluded that Freddie’s accounting methods had overstated its capital cushion, according to regulatory officials briefed on the matter.

The details of the deal have not fully emerged, but it appears that investors who own the companies’ common stock will be virtually wiped out; preferred shareholders, who have priority over other shareholders, may also wind up with little. Holders of debt, including many foreign central banks, are expected to receive government backing. Top executives of both companies will be pushed out, according to those briefed on the plan.

Just amazing. Price discovery continues, mark to market write downs will continue, as the cycle progresses to the next stage. As I stated July 28th:

"This is how the cycle goes. A frozen secondary mortgage market leads to forced sales of assets that would not otherwise be sold. As firms stack their toxic holdings into the imaginary accounting blanket of Level 3 assets (which I told you back in NOVEMBER of 2007 would become a household phrase), some firm has to ruin the party and forcibly sell their bad holdings for a bad price in the bad open market that is not really very open anymore. And then, have the audacity to sell more shares and dilute current shareholder value. How dare they! And now, we get a fresh new glimpse at the price that the frozen marketplace will currently pay for assets that I both don't want to own or sell. Sweet, thanks, great job Merrill Lynch. Now I need to MARK DOWN my bad assets to the low level that you just sold them at! Damn bastards."

Freddie's capital cushion appeared better and was overstated because the marks on their toxic holdings were not updated as of the latest discovery trade. When you update them to the new value of the bad assets, the capital cushion becomes too low.

Welcome to free market capitalism, or lack thereof. The full details on the bailout is imminent. If market is to rally on this announcement, we probably will NOT get any event rate cut. An event rate cut is my phrase for the fed acting to sooth the markets that are reacting to a very negative event. You would think this would classify, but financials will likely surge and credit spreads likely will tighten significantly on this news without any cut. We'll see.

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Conservatorship: Markets Futures Reaction

For this historic announcement, here is the markets pre-open reaction via the futures:

DOW --> UP 225, or 2%
S&P --> UP 27.60, or 2.22%
NAZ --> UP 36, or 2.05%

GOLD --> UP $10
OIL --> UP $2.15, or 2%
*check futures here
*check gold here

Seems about right for this announcement as systemic risk is perceived to be removed, certainty added, confidence rises and stocks go up. I would also expect to see dollar weakness & commodity strength, spreads to significantly tighten, new money to come into mortgage market for short term, reversal in ABX's and CDX's, steeper yield curve, and a financials led equities rally. But beware the irrational stock market and their perceptions of confidence restoration on this big news!

Not sure about lending rates because in today's environment, appetite for jumbo loans will still be tight and there are so many fees built into the rate these days its hard to tell how much the end result will be for the individual borrower. So, lets keep it on the markets for now, and see what happens with lending rates.

It will be interesting to see how long all these micro rallies last on this specific announcement. How low will dollar go? How high will commodities come rally? How far will beaten down financials come back? How long will the general bounce last? How long will the general euphoria last? When does reality set back in? How many more firms will have to be bailed out?

Let us not forgot that the environment is such that Treasury had to step in and take action on the GSEs to prevent a systemic financial crisis; that they viewed to be inevitable. Who can we trust? How does this change rising unemployment? How does this change the strapped consumer? How does this change the continuing spread of defaults to higher quality debt classes? How does this stop home prices from going lower? How does this allow the strapped consumer to suddenly be able to pay their mortgages/rent and continue to spend? It likely doesn't. It simply prevents a very serious and catastrophic event from occurring, if nothing was done.

Troubling thing I see is a lack of destruction for the lowest two classes of the investment totem pole, the common shareholders and preferred holders AND the announced 10% annual portfolio reduction order starting in 2010; by that time who will be buying mortgages if its not these guys? Then again, why should we believe it!

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NY City Rental Property - As Good As T-Bills - NOT!

The following article spotlights an NYC real estate investment issue with implications for the quality of life in New York and therefore residential real estate values.

Just a quick follow up to my piece from June NY Rental Property As Good As T-Bills. Last year investors were touting New York City multi-family rental properties as being as low risk as T-bills, but with upside. The upside was to be generated by "repositioning." In many cases, this was code for throwing out rent-controlled/stabilized tenants and capturing the arbitrage versus free market rents. Both of the suppositions embedded in this strategy have been called into question recently.

I pointed out that a backlash was brewing in the city and in Albany, where several bills were introduced in the state Senate to tighten up regulations and prevent landlords (read: hedge funds) from significantly increasing turnover in their properties. Secondarily, costly, over-levered and often ill-conceived condo projects which are topping off in a soft demand environment are all of a sudden being forced to go rental, causing a spike in supply (see Crain's article cited below). Couple the increased supply, albeit modest, with the soft economy and evidence of a slowing in rental rate increases and even declines are emerging.

Last weekend's Barron's features an article "Out of Control - Investors in some huge New York apartment complexes face big losses and defaults, as quick conversions to market rents proves to be a fantasy." The article spotlights a couple of very large New York City residential building deals, done using very high degrees of leverage, which are imploding. In particular, it focuses on the Tishman deal for Peter Cooper Village and Stuyvesant Town, a historic top marking kind of deal in the spirit of AOL/Time Warner. According to Barron's, "When the landlords arranged financing in 2006, they projected that rental income would triple, to $336 million, by 2011. To reach that goal, rents would have to double from their current average around $1,800 a month - an unlikely scenario." Unlikely seems to be an understatement as of the current environment, yet the buyers heaped on a reported $400,000 of debt per apartment. The article discusses three other similar deals that are in trouble and in every case the debt service reportedly exceeds the properties' annual operating income. I hope these guys have deep pockets.

According to a recent study by Guild Partners, other players in the middle market multi-family apartment market in Manhattan, Brooklyn and Queens weren't much smarter than the big hedge fund/opportunity fund boys. On average buyers paid $200,000 per unit for apartment buildings in these boroughs year to date in 2008, up 163% from $75,938 in 2003. On a price per square foot basis the increase was an even more dramatic 201% from $114.39 to $344.73. At the same time the reported expense ratios of the buildings acquired declined from 37.6% in 2003 to 30% thus far this year, implying very little juice left to squeeze out of profits from lower expenses. Indeed, we can all surmise that expenses will be going up with energy costs on the rise and the tax environment likely to turn less friendly. Cap rates paid (the ratio of income to price) declined from a more reasonable 6.9% in 2003 to 5.3% thus far this year. With bank loans becoming more expensive, the implication is that any of these transactions entered into on a leveraged basis also generate initial negative returns to equity. Translated this means that you are borrowing at 6% plus and investing in an asset throwing off 5.3% or so and it actually costs you out of pocket money to hold the asset (note that this has not been lost on banks and lately the amount of leverage available has plummeted - maybe too late). Spending money each month to hold a real estate asset can all be fine when you expect rents to double and expenses to stay flat or fall. The calculus gets a lot tougher when these factors go upside down on you. As in any overheated market, transaction activity went crazy in the last few years, with 293 transactions in 2005, up 357% from 2003 and 89 year to date (for a run rate of 133), still on pace to exceed the slower 2006 period (when a big run up in rates clipped demand).

A significant setback for multifamily investors in New York City does not bode well for quality of life. Building owners in financial straits tend to let maintenance problems build up. At the same time it becomes harder for landlords to push up rents when living conditions are deteriorating. Note that according to The Real Deal, complaints to the Division of Housing and Community Renewal alleging that landlords are overcharging for rents or not renewing leases as required have climbed 37% over the last 18 months. In some neighborhoods this situation can actually result in a significant backslide in quality of life and crime. Problems in the rental market are an issue for real estate buyers in New York City and declining rents certainly could make the buy versus rent decision swing towards renting. Just make sure your rental building isn't going bust, you might have some problems getting hot water.

From the Blogosphere:

Condo glut Builds - Owners Cut Prices, Switch to Rentals

Manhattan Rental Market Finally Feels the Headwinds

Fear of Defaults After a Flurry of Apartment House Sales

Rent and Lease Complaints by Tenants Spike

Landlords, Residents Debate Loophole for Rent Controlled Evictions

Tenants Gain Right to Sue Landlords for Harrasment

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Massive Deleveraging Across All Classes

A: Oil is down 2%, Gold is down 2.5%, stocks are down and Lehman Brothers looks like they are seriously wounded and bleeding to death on the sidewalk. The big guns were used up to bail out Fannie/Freddie and it is VERY UNLIKELY that the fed/treasury will bail out any big bank or IB after what they just did to rescue the GSE's. We are entering a very serious phase of the unwind/deleverage cycle. As Jeff previously said, this is where we find out who has been swimming naked.

In September 2007, Jeff stated:

"SKINNY DIPPERS GET CAUGHT:

As the asset rolls over, the ripple effect of the tide going out starts. This is the part where you get to see "Whose Swimming Naked" and has hidden bets. It could be a hedge fund like Amaranth who was supposed to be diversified, but had a massive bet on Natural Gas prices so large regulators would have forbid it if they knew about it (but it was done through an online market outside their ken) or a European bank which was making big fees running an off-balance sheet conduit that borrows short, lends long and is leveraged....OUCH."

A real-time visual of LEHMAN trading as of right now is below. This is what I look at when I trade, and shows you the inside market. The stock is down about 30% on 82 million shares traded so far.

This is what happens. Capital raising talks fail, stock gets pummeled, crisis of confidence occurs, money is pulled from firm, and a very big problem is at hand. Washington Mutual is also getting very close to the danger zone. I highly doubt the fed/treasury will bail out a firm right after they pulled off the biggest bailout in the history of our country. This truly is a historic time that will be in all the history books when all is said and done.

On a side note:

US Treasury Credit Default Swaps Increase To Record (Across The Curve)

The cost of protecting against losses on Treasuries rose to a record on concern the U.S. government faces higher liabilities with its rescue of mortgage companies Fannie Mae and Freddie Mac, credit-default swaps show.
Contracts on U.S. government debt increased 2.5 basis points to 17 basis points, according to CMA Datavision prices for five-year credit-default swaps at 12:05 p.m. in London.

Central Banks At Risk of Sinking Along With Banks (via NakedCapitalism from Guardian)

A year into the global financial crisis, several key central banks remain extraordinarily exposed to their countries' shaky private financial sectors. So far, the strategy of maintaining banking systems on feeding tubes of taxpayer-guaranteed short-term credit has made sense. But eventually central banks must pull the plug. Otherwise they will end up in intensive care themselves as credit losses overwhelm their balance sheets.

The United States Federal Reserve, the European Central Bank, and the Bank of England are particularly exposed. Collectively, they have extended hundreds of billions of dollars in short-term loans to both traditional banks and complex, unregulated "investment banks"....

If central banks are faced with a massive hit to their balance sheets, it will not necessarily be the end of the world. It has happened before – for example, during the financial crises of the 1990s. But history suggests that fixing a central bank's balance sheet is never pleasant. Faced with credit losses, a central bank can either dig its way out through inflation or await recapitalisation by taxpayers. Both solutions are extremely traumatic.

Before you get excited about the Fannie/Freddie bailout lowering lending rates by 1/2 point, understand the reason WHY these firms had to be rescued by our government and the environment that we currently are in. The bailout was the lesser of two evils and had to be done to avoid a systemic financial crisis that would have come if no action was taken. It will be a VERY volatile few months ahead to say the least! Buckle up!

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Mortgage Market Update: The Bailout's Affect on Rates

Who would ever think that one day, these two would fail?

Although the bailout wasn’t a huge surprise to many people, it is still shocking to see just how many bad loans were written causing the entire US economy to crumble.

Here are my thoughts on the bailout:

1. Whenever the government steps in, they usually impose some guidelines of their own - usually not anything good for the consumer. Variables such as down payment, reserves after closing, and saving trends will probably be more closely looked at.

2. Higher premiums will most likely be charged for all future loans. These will be passed on to the borrowers and will increase the cost to borrow money.

3. A requirement for a combination of lower Debt-To-Income and Loan-To-Value ratios in order for the loan to be sold to either Fannie or Freddie. This will be done to manage risk as well as to bring in more revenue, via a higher premium, for the “riskier” loans.

4. An introduction of a program for international/foreign borrowers that will allow for the loan to be sold off to Fannie and Freddie. Currently international borrower loans are held on the bank’s portfolio as the GSE’s would not buy them.

5. LOWER RATES.

Yesterday, the first business day after the bailout, almost all conforming rates saw at least a 50bps movement in rate, and after a $1 Billion capital cash infusion it sure does show. Thanks Mr. Paulson!

Here is what I am quoting as of today on conforming loans:

30 Year – 5.75% @ 0 points, 60 day lock.
5/1 ARM – 6.00% @ 0 points, 60 day lock.
5/1 ARM I/O – 6.00% @ 0 points, 60 day lock.

Jumbo rates actually increased due to the lack of trading and the illiquidity with the MBS.

Here is what I am quoting on jumbo loans, as of today:

30 Year – 7.50% @ 0 points, 60 day lock.
5/1 ARM – 7.125% @ 0 points, 60 day lock.
5/1 ARM I/O – 7.625% @ 0 points, 60 day lock.

I would like to leave off asking all of you a question that’s been on my mind for the past week:

With the current state of the economy, would you agree that since commodities such as oil and metals such as gold, are coming off their highs, that investors will consider looking back into the Mortgage Backed Securities market as a place for lucrative investment?

Granted there is still major uncertainty, not to mention a huge amount of risk in mortgages, but it sure doesn’t look like equities and currencies are that attractive right now either…

What do you think?

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Off To Europe

I'll be heading to Europe for two weeks, back on the 25th. I made a promise to my wife to stay away from the computer, trading, real estate, and this blog while on vacation. So, hopefully Mortgageman, Toes, and Jeff can find time to keep up some content while I am away. By the way, conrats to Christine Toes who just moved over to Corcoran! She is a solid, savvy, ethical and service oriented broker whose business is strong no matter how the market is doing. Good luck Christine!

I wonder if WaMu & Lehman will be alive in their current form when I return?

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News That Catches the Eye

Bill Gross caught lightning in a bottle with his huge FNM, FRE bet. Whether Mr. Paulson was reacting to Gross' note of last Thursday or not, the bailout enriched Pimco Total Return holders handsomely. According to the Financial Times, on Monday the fund jumped 1.3% or $1.7 billion, it's biggest one-day rise ever against the Lehman Aggregate Bond Index. I guess that's why he's the king. Now the question is: Is he gonna sell the rally?

All eyes have been on Lehman Bros. as of late. But I am sure many noticed where Kerry Killinger was relieved of duty as skipper of Washington Mutual. What may have been under-noticed in the same press release is that Wamu signed a memo of understanding with the Office of Thrift Supervision, requiring them to submit plans and projections regarding the company's future business model and earnings. This sounds like they are on Double Secret Probation, but instead of it being Dean Wermer they are in trouble with it's the Feds, and they won't just be kicked out of their house (like many of their mortgage customers), they could be expelled altogether. With $307 billion of assets per the FDIC, the hangover from this toga party could be ugly. On the bright side, the bank couldn't be on the FDIC's list of problem banks yet, because those banks only have assets of $78 billion.....phew!

We speculated on Urban Digs long ago that there was trouble afoot in commercial real estate, and not just Florida and Nevada condotels. See stories here and here. It is interesting indeed that Lehman's latest mark-to-market losses of $7 billion include $1.7 billion of commercial real estate mark-downs.

The bailout seems to have helped Fannie a bit. The firm raised $7B in a monster debt sale that priced with spreads 70 basis points above comparable treasuries. According to Bloomberg, this is reportedly the lowest premium for it's two year paper since June. How this impacts mortgage rates, and more importantly availability, remains to be seen.

Oil can't seem to catch a bid no how. Neither OPEC nor IKE have been able to cause an uptick. Oil is now well below it's 200-day moving average. But as Urban Digs readers know, when a chart slices through a strongly up-trending 200-day moving average, there is a natural tension for a hard bounce back.....even if the pattern is turning into a major top. Gas up those SUVs. You've been warned.

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Media Hops on 'Rate Cut' Wagon

A: Last post, I promise. Also, I will get back to posting on Manhattan real estate when I get back to work after my vacation; I needed some time of from real estate after sealing all my deals and selling my exclusive listings. So, don't worry to those who were disappointed with the main focus being on the credit crisis, process of deleveraging, bailouts, etc..There is a reason I talk about that stuff here, and its because it is so damn important!

I've been dovish on future monetary policy for many months now, even after the aggressive rate cutting campaign by our federal reserve to forestall adverse economic effects and the credit crisis. The main reason is that the biggest threat to our economy is deflation, not inflation. A powerful combination of housing deflation & credit deflation, among other things, resulted in a seizing up of the secondary mortgage markets causing sooooo much pain for those holding assets tied to mortgages. One of the end results of all this was the extinction of MEW, or Mortgage Equity Withdrawal, as a growth driver for our economy. I discussed MEW back in June:

"When I see reports that mortgage equity withdrawal (MEW) is down 60% from Q1 2007, courtesy of Calculated Risk, I see the credit machine for growth broken. MEW is that little thing homeowners do to pull out money from their homes equity and spend it; so yes, down 60% year-over-year is noteworthy."

Yea, we don't hear about homeowners pulling out equity from their homes anymore to pay down other debts, or to spend! And with house prices way down, and loan-to-value ratios way UP as a result, most banks won't allow you to pull out equity anymore if it's too risky for them. Besides, most banks are fighting to repair their balance sheets right now and forced to raise dilutive capital. The process will continue and we are YET TO SEE THE MAIN STREET ECONOMIC AFTER-EFFECTS of credit deflation!

As unemployment rises, wages stagnate, credit contracts, houses deflate, and shadow banking system continues to see major losses, the fed is going to have to be stimulative. Think of it this way, at some point unemployment is likely to rise above 6.5% and GDP will go negative, whether in a preliminary report or in a backward revision. Either way, we will probably hear calls from the fed to cut rates to stimulate and inflate. The full effect of this 13 month long CREDIT TSUNAMI is yet to come on main street.

From CNN Money's article, "Fed's next move could be to lower rates":

The central bank is likely to keep its key interest rate at 2% at its September 16 meeting but expectations are growing for a rate cut before year's end. If the Fed does so, it would mark a dramatic change in the central bank's assessment of the economy. As recently as the Fed's last meeting in August, Fed members indicated that their next move would be to hike rates at some undetermined point in the future in order to fight inflation.

With the commodity bubble bursting, inflation expectations are likely to fall significantly in coming reports. But that doesn't really matter because the type of inflation that usually spurs aggressive rate hikes, is wage inflation and an expansion of the money supply/credit. We have neither, and instead, are experiencing stagnating wages and a contraction of credit. As commodities fall, the fed's ability to cut rates to battle the economic after effects becomes OK again.

Its a dose of tough medicine for an economy BUILT ON CREDIT! Ain't deleveraging a bitch! I would not be surprised to see fed funds rate go to 1% to 1.5% in the next 6-8 months. I am going to stand by my gut feeling that the first rate cut will likely be in response to a very negative event, such as a failure of a major IB or bank. Clearly, Lehman & Washington Mutual top the list as of today, and with the Fannie/Freddie bailout behind us, I seriously doubt the fed/treasury will come in and save the day again for wall street bigs. Moral hazard is already a very serious problem and at some point, they will have to let the free markets, or what used to be the free markets, take care of themselves.

Enjoy all!

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Manhattan RE: The Sky Is Not Falling, People!

I rolled my eyes when I saw the cover of the NY Times Real Estate section on Sunday, "Foreclosure Makes Its Move on Manhattan." Are they serious? The Times has clearly run out of things to write about. We all know negativity sells papers, but this article was really a stretch. If you actually read the article, it says that ONE in FIFTY THOUSAND apartments in Manhattan are in foreclosure. Foreclosures jumped from 52 to 93. The sky is not falling, people!

Two good lessons can be learned from the article. You shouldn't pull equity out of your HOME to start a business or to invest in your business. It can be a quick way to go under. The article also reinforced an oft-repeated statement of one of my favorite financial gurus, Suze Orman. You should have SIX to TWELVE months of living expenses in reserves in case something negative happens in your life - divorce, disability, job loss. Besides those lessons, take this article with a grain of salt.

I attended the Real Deal New Development Forum last night. Although the panelists felt that we may be in for more short term pain, the consensus was that:

A) we are near the bottom, and
B) the fundamentals of NYC real estate are still strong for the long term

Although foreign buyers may only be getting a 20% discount on real estate, with the 421-a expiring & the difficulty getting financing on large projects, there's not much new development in the pipeline. So the supply that hugely exceeded demand in places like Miami and Las Vegas is just not going to happen here. Larry Silverstein reminded the audience that by 2010, another 200,000 people are projected to move to NYC, and by 2030, the city will house over 9 million people.

Andrew Heiberger suggested that people are moving back to NYC because living in the burbs is getting more expensive. The increase in oil and gas prices has caused heat & hot water costs to escalate. Commuting to jobs in the city isn't cost-effective with $4/gallon gasoline. Crime is low. There are more 5 year old children in Manhattan than there ever have been, indicating that families are staying here and moving back here.

Barbara Corcoran said that she worried in the past when Wall Street was down, or the Japanese stopped investing, or for various other reasons. But she has learned over the past 30 years to "never worry about NYC." (She also admitted that she was wrong about Red Hook being the next big thing but that Astoria is looking promising!)

The panelists agreed that Wall Street is going to have more layoffs. However, globalization has really hit NYC and there is a lot of wealth out there, both foreign and domestic. NYC is still "cheap" in comparison to the real estate in London and Paris. So Wall Street does not impact real estate values as it did in the past. If someone in finance is laid off and sells anything, it's more likely to be their Hamptons house, not their primary residence.

The panelists also said that if your after-tax payments are less than what you would pay to rent, then you should buy. This is why I am buying another apartment. The rent I was looking at was $3,000 for a one bedroom and to buy a similar apartment, my payments will be $3,200. After tax-deductions, my payments will be $2,200! To me, it's a no brainer if you are going to be in NYC for 3 to 5 years. Mortgage rates just took a nosedive and I could not be happier that I am buying at this time. I can't remember if it was Charles Kushner or Bob Knackel who said last night something to the effect of "when there is fear in the market, that is when fortunes are made."

Could prices dip a bit this fall because there is more inventory on the market? I don't have a crystal ball. But I have a lot of buyers out there looking every weekend, just waiting for the right deal. If prices dip even a little bit, they are going to pounce.

I had a buyer say to me over the weekend, "Christine, StreetEasy says that 400 new apartments have come onto the market in the last two weeks!" I said, "But how many of them are 2 bed, 2 bath, pre-war doorman co-ops in the west 80s in your price range? Three. So I don't think you need to worry about it." Sure, if you are looking for a post war doorman studio, alcove studio or one bedroom in a non-prime location from $350K -$575K, it looks from some of my customer searches that about 50 new apartments just came onto the market, which is great for buyers! Now they have more to choose from. But for unique properties like lofts, anything pre-war, an apartment with a terrace, great light, stunning views, in a prime location, beautifully renovated, or with something otherwise special about it, it is still going to do well. These apartments are not a dime a dozen.

If you have the money, stop putting it in someone else's pocket by renting. Buy something you love. Buy something that makes you happy. Find a seller that needs to sell and make an offer that you will be comfortable with even if the market comes down a little bit. Buy something because you need the tax deduction. The press is almost always going to write negative articles about real estate because that's what sells newspapers. I know you hear this from me ad-nauseum, but in Manhattan, time IN the market is more important than TIMING the market.

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Fed 'Engineering' Lehman Sale This Weekend

A: I didn't know the fed's mandate was too orchestrate and engineer deals? Did you? Oh well, I guess it fits under the criteria of price stability, as in, stock prices will get killed if Lehman fails!

Not on vacation yet and Lehman's funeral service has already been announced. Well, ok, not a funeral service, but close. I believe Lehman has about 20,000 employees (verification?), who were on the receiving end of about $9,500,000,000 of bonuses last year! Today, Lehman could not find a buyer on its own or raise billions in capital, and so, the fed/treasury will have to facilitate a sale so as to avoid counterparty disruptions, financial instability, and risk of a systemic crisis in our system. Ain't deleveraging a bitch!

Its a very sad story and final chapter for this very old firm. The result of this will be tons of lost wealth, mainly held by LEH shareholders and employees who own stock options, and a likely shedding of half the work force. It's amazing that it appears a combination of a few firms will have to work together to buyout the firm. Very telling of the severity of this credit crisis, deflation, toxic assets, and the environment in general. Geez, who would have though that leveraging 30:1 could have such horrible ramifications?

I spoke about Lehman's problems on this site for about 10-12 months now, so it should be no shock to those who 'get it' and read this site. For those out there keeping their head in the sand, or choosing to view the bright side because doom & gloom ain't their cup of tea, it's time you wake up to the reality that this is the worst credit crisis since the great depression! More bailouts to come and the next Big 3 in my view are WaMu, Merrill, and Wachovia.

The markets have become 'used to' bailouts these days and I just don't see how this is a good thing. At some point, the markets will be forced to handle shocks on their own. For individual stories, I'm sorry, but I just can't feel sorry for someone who earned a million dollar bonus, on top of a very high six figure salary, who now finds their stocks options worthless and job at risk. This is what comes with playing the big games on wall street with the big firms, earning the big salaries. I'm not saying you deserve it, I'm saying this is the risk that comes with high reward if your firm is on the wrong side of bets in a very tough environment. As I said in January in my piece, "Bonuses: It's 2009 That Will Hurt More" :

"The derivatives trade of securitizing loans and selling them off in pieces on the secondary mortgage markets generated billions in revenue for these banks & brokerages. Now that the housing bubble popped nationally, risk has been re-priced, secondary mortgage markets are not functioning properly, liquidity dried up for mortgage backed securities, and the announcement of billions in losses and potential insolvencies, THE GAME IS OVER! How will these banks and brokerages generate the kind of revenue that they got used to generating the past few years? "

Put yourself back into time & place when I stated this; Bear was still alive & Lehman stock price was trading at $62! I knew the revenue model going forward for wall street firms was broken, and that toxic assets would ultimately cause tons of pain for the big firms. One of the reasons Lehman got in trouble, outside of their highly toxic holdings, was their future prospects for generating revenue! This is a wall street problem for many firms, and we have not even seen any regulation yet resulting from government intervention; trust me, its coming. Wall street will have to wait to see how the industry is regulated, to devise a new financial innovation to replace the securitization model of bundle, re-rate, and sell that is all but dead. I just don't see how things will ever go back to the way they used to be after this credit bust cycle.

For 2009 wall street bonuses, I would expect them to be down about 50% from 2008 levels. OK, now Im off!

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TILT!!!!!!

APOLOGIES FROM NOAH & ALL OF US AT URBAN DIGS
MARKETS WENT TILT & SO DID WE (disk overload).

Lehman evaporated into market history yesterday. Frankly, they went out with a whimper rather than a bang. The analogy I used with my partner yesterday morning was that when Bear Stearns went down the Feds showed up with fire trucks and brought out the big hoses to put out the fire. They did this because Bear was a huge counterparty in the under-regulated over-the-counter derivatives market. The Feds did not know what might happen as a result of a major dealer and counterparty, not being able to make good on contracts that helped other folks hedge out their risk. In the Lehman case, the Feds pulled up in fire trucks, took to the trenches that had already been built around the firm in the aftermath of the Bear debacle, and pumped a bunch of water into the trenches to keep the fire from spreading, but they let it burn down to the ground.

This approach seemed to work and briefly re-injected fear of moral hazard into the market. This was proved out in spades by Merrill Lynch's jump into the arms of Bank of America, before their house caught fire. It wasn't until around 2 p.m. that the markets started to fall apart. The culprit was AIG who reportedly turned down an offer from a group of private equity firms for a capital injection. Brokerage firms are not very transparent in terms of their assets and liabilities, but insurance companies are the ultimate in black boxes in my opinion, and one with a big credit derivatives business fuggedaboutit!. According to CNBC, there is potential for a federal role in the bailout of AIG. There is reportedly going to be no private capital solution. That's how scary AIG's black box is. Word of this pushed the market briefly into positive territory after opening with a thud following yesterday's 500 point decline.

The feeling that dominoes are falling is pervasive. The risk of a systemic rash of failures is real. We are on the verge of an environment where investors and financial institutions pull money from debtors causing them to fail, with the connection to fundamentals becoming tenuous. But don't let me fail to mention....FUNDAMENTALS SUCK!

On the positive side the VIX has gone ballistic indicating the kind of acute fear, which usually is a peak in uncertainty and often sets up a rally. In this case the question is, does it set up a long-term buy?

I have been hopeful that the underlying real estate market issues would begin to benefit from easier comparable statistics and the second derivative (the rate of change of the rate of change) in residential real estate could at least start to turn positive. But the infernal feedback loop of institutional failures, layoffs, securities markdowns and real estate financial constriction has got the economy in a bear hug.

The realization of this is credit collapse is being reflected in money market spreads. 3 Month LIBOR OIS spreads widened to 116 basis points overnight. The treasury Dollar/Eurodollar spread blew out to 175 basis points, the widest spread since March.

Sometimes it's best to admit that you have no idea what to do and not to make big financial decisions. I am in that camp for now. I certainly would not be buying real estate in New York City until the smoke clears a bit.

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Post Modern? Bank Run

The only thing we have to fear is fear itself — nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance.

Franklin D. Roosevelt 1932

My partner jokes that he has never seen me and Paul Krugman in the same place at the same time - so maybe we're the same guy. I'm not sure how I came to have so much common ground with the "liberal" economist, but our views of the unfolding of this crisis have been similar for some time. The Princeton economiser, buddy of Helicopter Ben Bernanke and Op-Ed Columnist for the New York Times wrote an editorial the other day calling the current phase of the credit crisis a "postmodern bank run."

What he meant is that in a panic over whose balance sheets they can trust, financial market players are pulling credit from each other and causing liquidity crises for institutions that might have actually muddled through this crisis had they had time to liquidate certain assets, raise capital etc. Although it may be debatable, several commentators have likewise commented that Lehman didn't have to go under.

Obviously, Krugman is spot on when one considers the collapse of AIG, the pummeling of Morgan Stanley and roughing up of even the hallowed Goldman Sachsin the last couple of days. We have moved from a credit crunch to a liquidity crisis, where leverage equals death - or at the very least dismemberment.

But what about those "old fashioned" bank runs? As you know, Noah and I have pulled no punches with our readers here on Urban Digs. I wrote a while ago about money market mutual funds "breaking the buck" (note that yesterday this issue returned) and at least in comments talked about moving money to a Fidelity muni money market fund months ago. (I figured muni funds couldn't own any toxic corporate paper and even a municipality that gets in trouble still has the power to tax. Plus I figured the vaunted Fidelity would make good if the $1.00 line in the sand were ever crossed, if only for reputational purposes.) But today I went a step further. I moved money above the FDIC insured amount out of Citibank into a local savings bank with very good capital ratios, that I know is a conservative lender. These guys are so conservative that when you move money into their bank they won't let you touch it for 30 days, as an anti-fraud measure. It's inconvenient to be sure, but as I left the bank it dawned on me that this kind of caution is exactly what I want from my bank these days. I had been thinking about doing this for months, really just to institute what I consider as a generally safe practice, but also due to the incredible credit mess.

This morning I talked to a friend who had just opened an account at Chase. He was moving money from a small bank that had received some negative press regarding its large exposure to GSE preferred stock. According to my buddy, the Chase branch was jammed and apparently most of the customers were doing exactly the same thing my friend was doing. In fact, they were running low on account opening packages. The man in the street isn't stupid and the natives are getting restless. We have seen what can happen when fear results in "frantic phone calls and mouse clicks, as financial players pull credit lines and try to unwind counterparty risk" as Krugman writes. But don't rule out the possibility of the little guy getting the same idea, especially if a Washington Mutual were to fail. Bloomberg News reported this afternoon that Wamu put itself on the block a couple of days ago.

Now I for one have never made money betting on the end of the world, and I believe that it is times like this when the Vix goes crazy and debt spreads go bonkers, which are usually great long-term buying opportunities. But having worked for a hedge fund, I also appreciate the need to hedge against the worse-case scenario. Be careful out there!

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Ginormous Stimulus = Ginormous Rally

The Fed, ECB, Bank of England, Swiss National Bank and BoJ plan to pump $180 billion into the world financial system. That on top of the more than $230 billion pumped into various markets by central banks so far this week (not to mention the massive bailout fund apparently being worked on by Congress, the Fed and the Treasury department). Amazingly (tongue firmly implanted in cheek), some of this money managed to get into the stock market. Hmmmmm! Let's flash back to the early 1990s. The banking system is on the ropes; many graybeards who were in the markets then will tell you that most of the major banks were bankrupt (on a mark-to-market basis). There were no loans being made. The fed lowered rates like crazy and held them there, and still banks really weren't able to lend. In fact, this is when and why the Commercial CMBS market was born (some good background info here). The lower interest rates could not be transmitted as increased money supply to the economy due to the banks acting as bottlenecks. There were, however, two key ways that lower rates were able to help the economy. The steep yield curve allowed banks to borrow from Uncle Sam at low rates at one window and walk around to the back door and lend the government back the money at a high rate. After a couple of years bank balance sheets were in better shape and they could start to lend again. The second and more immediate impact from lower rates was a huge refi wave. Rates hadn't been this low since the sixties and people took advantage of this to lower their interest costs.

Back to present day. We all know that banks aren't lending, and I can tell you from my own business that banks continue to back away from more areas of lending. First it was construction loans, non-recourse loans even for investment properties, and now it's commercial property loans (I'm generalizing, as we can still find some willing to lend, but it's a trend).

Unfortunately, there is very little consumer refi opportunity. Anyone who wanted to refi a mortgage on a property they have owned for a long time, and have decent equity in, was able to do so after the dot com collapse when 30-year fixed mortgage rates got down into the low fives and briefly into the high fours (if I remember correctly). With plummeting residential real estate prices and stricter lending standards, putting lots of cash in consumer pockets through refis is unlikely. Eventually, there may be an opportunity for commercial building refis as banks who will lend can earn unbelievable spreads vs. their cost of funds. (Many loans made in recent years were for five-year terms and will be up for refi in the next couple of years anyway.) Many of the loans outstanding today are variable rate and keyed to LIBOR. If the world's central banks can figure out how to wrestle LIBOR lower it would also help cash flows of companies and individuals.

Come to think of it in the case of the early 1990s, there was one more place where the creation of money manifested itself and that was ........the stock market. The wealth effect of a stock market fueled by lower rates and P/E multiple expansion, eventually helped corporate earnings and household wealth expand too.

I don't know where all the money being sprayed around the world financial system will go, but it will end up somewhere. We know much of it will be destroyed over the next few years as bad debts melt it away. With most of the transmission mechanisms for getting money into the economy broken, a ban on short sales in the offing and massive liquidity being pumped out, it's possible that some of it could find its way into stock markets, which might respond with a mystical levitation act. (Of course gold levitated too, proving you can fool most of the people all of the time, but there will always be some gold bugs who know the dollar is really worthless.)

It just gets weirder and weirder.

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Second Order Effects: Money Funds Cascade

A year or so ago when the sub prime crisis was still new we started to see "The Tentacles of the Credit Beast" extending into places that were unexpected. As we have all witnessed, in the last week or two the credit beast that looked like maybe it was being vanquished, came back with a vengeance, bigger and stronger than ever. It tore through Fannie, Freddie and Lehman, it scared Merrill off and then devoured AIG in one bite. With each feast it seems to get bigger and stronger. Now it's getting to where it appears that the government is literally having to make a last stand to stop it. As noted in my recent piece Post Modern? Bank Run, I was worried that with AIG evaporating in the course of a couple of days and the possibility of Washington Mutual - with it's branches on every corner - going under, consumers could get the hint and start to really worry about their savings. A bank run is what government officials are most worried about because it's a panic in which all confidence falls away and things run amok.

We may have gotten closer to a bank run than people realize. But it's not your corner bank where the run is happening. It's money market mutual funds and in some ways it's worse than a bank run....where at least their is FDIC insurance in place. Now, I want to state upfront, as I am sure you all know, the US government has announced that it is taking steps to backstop money market funds. The following quote was made Friday by the Federal Reserve according to Reuters.

One initiative will extend non-recourse loans at the primary credit rate to U.S. depositary institutions and bank holding companies to finance their purchases of high-quality asset-backed commercial paper (ABCP) from money market mutual funds, This should assist money funds that hold such paper in meeting demands for redemptions by investors and foster liquidity in the ABC market and broader money markets.

Additionally, the treasury had already announced that it would use the SEC's Exchange Stabilization Fund, which had assets of about $50B to help prevent any money market fund from breaking the $1.00 per share mark. Recall that money funds always trade at $1.00 per share. They normally hold super safe short-term paper and only a once has a money market mutual fund "broken the buck", in other cases where funds were likely to the fund company has put its own money in to shore up the fund, as not doing so would be a huge black mark to their brand. These funds are supposed to be as safe as a bank account. In fact, they are so safe that Americans and U.S. companies have about $2 - $4 trillion sitting in these funds, depending on how you count it. (Please note that the ratio of money market assets to the stabilization fund is about the same as the ratio of bank deposits to the FDIC insurance fund today....not that that gives a lot of confidence.

So why did the government immediately run out to back up money market funds after the Primary Fund, the oldest money market mutual fund broke the buck? A run on the funds began. The number of redemptions at Putnam Investments $12.3 billion Primary Fund was so great, that they were forced to liquidate the fund, rather than stabilize it with their own money. This was unprecedented! Legg Mason stepped up and injected $630 million into three of its money market funds. This brings the total they have pledged to support their money market funds this year to $2B.

According to Reuters:

Since Tuesday, money market funds have faced heavy withdrawal from jittery investors who favored short-term funds that own only Treasuries. "As a result of this shift, other money market mutual funds have apparently attempted to sell large volumes of agency discount notes, further reducing liquidity in this market,"

Money market funds reportedly saw record redemptions this week of $42.2 billion. So why is this such a big deal? A few points.

If a fund falls from $1.00 to 93 cents, your loss is small. But if everyone tries to get out at once, it can further weigh down the value of the securities they are having to sell into the currently illiquid markets and the last people redeeming can lose a lot more.

As I just learned today, in many cases, like the municipal money market fund I own, the borrowers actually have letters of credit with banks backstopping their ability to pay back short-term funds. If the system grinds to a halt due to liquidations, banks may be severly hurt in addition to the likely defaults by borrowers.

Additionally, most of the paper that money funds buy is short-term debt used by corporations to run their everyday business. If this market shuts down, perfectly good companies could be hit with a liquidity crisis. Many corporations also keep their cash in money market or money market like institutional funds - one of which run by Bank of New York "broke the buck" this week. Corporations reportedly have a couple of trillion dollars in these funds and if they pull this money it could have equally horrible ramifications.

Bond kings Pimco had this to say about the situation and government response:

``They're putting up a firewall,'' said Paul McCulley, managing director at Pacific Investment Management Co., which oversees $830 billion including money funds. ``It's the ultimate nightmare to have a run on the money markets -- that is truly the Armageddon outcome -- and they're not going to allow that to happen.''

How do ya like them apples?

Hold onto your hats! and please don't run out and redeem those money funds.

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High Water Mark & Hedge Fund Bonuses

The hedge fund format is a great business model. You collect a 1-2% fee on the money under management ostensibly to pay for office expenses. Although when you're running a billion dollars or more.....you can do the math. Then you collect 20% of the profits generated each year, your so-called performance fee or carried interest (in venture and private equity parlance). Most funds require that partners keep the bulk of their net worth in the fund at start-up (although, like anything else, exceptions are made) and a substantial amount of the annual performance fee is also required to be re-invested in the fund. This is to make sure partners have skin in the game and maintain it there. Believe me, when things go wrong it hurts. A neighbor of mine was partner of Amaranth and when their natural gas trading position took down the whole firm a couple of years ago, he lost the majority of his net worth. From what I know he had nothing to do with the energy team.

But there is a wrinkle that most hedge funds have in their charters that those who are not close to the business may not be aware of. It's called the high water mark. If a hedge fund loses money in any year, a fund that has a high water mark policy (and I would say that the majority do) must earn back the money they lost....or get back to their high water valuation mark....before they can start earning their performance fee. In the vast majority of cases this performance would be measured after the 1-2% management fee. Interestingly, the math is against the losing hedge fund manager. If you are running a $200 million fund and it falls 12.5%, your assets go down to $175 million, but to get back to your high water mark of $200 million you have to make 14.3%. Oh, and that's before adding back your 1 - 2% management fee....OUCH! In the past, many hedge funds that lost over 15% would close their doors, because the managers would potentially have to work sans performance fees for a couple of years to get back to the high water mark. I know the world's smallest violin is playing, but check out these statistics. Apparently it's a symphony.

According to the Wall Street Journal this morning, as of July 31, just 10% of hedge funds were receiving performance fees from their funds. Translated, this means the funds are under water and in fact according to the survey of 4,000 funds by Eurekahedge quoted in the article, 82% to 90% of funds were below their high water mark, depending on strategy. Frankly, with markets being insanely volatile and prior winning strategies like being long commodities and short financials being turned on their heads, it is unlikely that performance has gotten much better since.

The money that hedge fund workers take home as bonuses does matter to the New York City economy and frankly it's hard to say how many live within their generous salaries, or depend on bonus payments to pay for "essentials." Like anywhere else, people grow into their incomes, whether they are totally predictable or not. Hedge fund bonuses have undoubtedly had a big impact on the high-end New York City real estate market. That positive impact is sure to be on the wane until those high water marks are made back.

From the Blogosphere

Exposing the Hedge Fund Industry's Soft White Underbelly

Hedge Fund Performance Poor in August

Not All Hedge Funds Will Suffer

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Faith-Based Investing: Let Us Pray Congress Comes Through

Disdain for the bailout plan floated by Paulnenke was evident at the Senate Banking Committee meeting. Many questions regarding moral hazard, oversight and effectiveness were asked. Importantly, senators showed some significant resistance to the idea that this plan needed to be approved pronto and implemented yesterday. (Maybe they need time to attach a bunch of pork and giveaways to it?)

So why did Paulnanke announce the need for an immediate $700 billion bailout? It was the markets' loss of faith. Why were Congressman non-plused by the plan?....loss of faith. What has turned this debacle into a threatening implosion has been the slow but steady erosion of investor confidence in the functioning of markets and the ultimate losses being hidden by opaque financial companies. Of course, the more arcane, complex and opaque the issues are, the greater the loss of faith. Even Paulnanke have lost faith. They lost faith in the credit default swap markets ability to continue functioning under the failure of a major dealer - that was evident in the Bear Stearns bailout and again in the AIG LBO.

Merrill Lynch leaping into the arms of Bank of America was the ultimate statement regarding investor confidence. Here is a firm that potentially took the ultimate low water mark haircut on its questionable assets, and stayed solvent, yet they still ran to safety due to the fear of investor flight from leverage.

Goldman Sachs and Morgan Stanley lost faith that investors wouldn't pull the plug on their levered balance sheets. Frankly, I don't think it was a statement about the quality of the assets on their books, although no one really knows.

A recent quote from the New Yorker underscores how this crisis has moved from a residential mortgage meltdown to a flight from leverage and loss of faith.

“Lehman’s assets were not significantly more toxic last Monday, when the company filed for bankruptcy protection, than they had been a week earlier. And, technically speaking, the bank may not even have run out of money, since it had access to an emergency liquidity line from the Federal Reserve. What Lehman did run out of was credibility. It couldn’t remain a going concern because creditors and customers no longer trusted it. Why would they, when its stock price had fallen nearly 80% in the previous week? The less faith the market had in the possibility of Lehman’s survival, the more remote that possibility became.”

The biggest blow to faith and confidence came with last week's run on money market funds, and I would still not rule out a run on banks, if faith is not restored, before some of the larger impending bank failures hit.

What the market needs now is a big confidence booster shot. So far in this crisis we have received some small ones:

Jeffrey Gundlach, CIO of Trust Company of the West was reportedly buying beaten up Alt A mortgages back in April. He recently made a conference call presentation for fund holders and potential fund buyers in which he avers that he has continued to buy severely discounted paper that he believes will pay off handsomely, even with extremely dire loss assumptions, saying "I am not terribly concerned that we might have a short-term negative performance movement from the non-agency positions we have bought because they are way below fundamental value. They are very very likely to deliver very high returns even under a draconian pessimistic case."

Jim Tisch, CEO of Loews Corp. (the investment holding co. - not the hardware stores) recently reported that his company started buying select sub prime assets back in July, through its CNA Financial insurance and surety unit.

Distressed investor/private equity firm Lone Star Funds bought Merrill's toxic portfolio, in July but, hey, they paid cents on the dollar when financing is taken into consideration.

Bank and savings & loan insiders were buying more stock in their own institutions over the summer than at any time in 20 years. However, there's no denying the fact that some of these guys are the same dumb-asses that got us into this mess.

John Paulson of Paulson & Co. (not related to Treasury Secretary Henry), whose hedge fund made billions shorting sub prime, has been raising a fund to invest in battered banks. The fund was expected to be open by year-end.

Rockefeller & Co. is also raising a fund to invest in insurers, banks and brokers under the moniker Rockefeller Global Financial Services Recovery Fund LLC.

As of today Warren Buffet is investing $5 billion in Goldman Sachs - on an IQ or Ivy League degrees per dollar basis, probably one of the all-time great value buys. Plus Warren negotiates his usual, no one gets as good a deal as the Wizard, preferred stock structures.

At this point it would be helpful if the government could come up with a plan addressing several key issues. The first is mark-to-market accounting's failure in yielding good data on solvency. The second is the lack of oversight by bank and securities regulators and an indication that these guys are on the job, but not set to make things worse by forcing asset sales willy nilly. The third, a backstopping plan for saving banks that just need time to ride through high but manageable loan losses. Lastly, an orderly liquidation plan for those zombie institutions that are just dead men walking.

So in the unforgettable words of the Jerky Boys "Say yer prayers" that Washington will get er' done in short order.

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I'm Back & BIG Thanks To Jeff!

Jeff, you did a GREAT job covering the carnage that occurred while I was away. Of course, as always, I leave when all the action happens. When I was a equities trader at Tradescape, I was notorious in the firm for stepping out during the day when something crazy volatile happened, and taking vacations when big news hit and markets moved wildly.

Clearly, I kept my signature through the years!

Anyway, just landed and I need a few days to get caught up with existing business and to digest all the news and happenings that occurred in the past 12 days.

I'll be back next week with thoughts, and posts about how Manhattan real estate seems to be adjusting to the wake up call. I'll also discuss the sharp rise in inventory that I see took place in the past 3-4 weeks, and the noticeable surge in price reductions from the weekly average over the past 6 months.

Noah

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Recapitalize & Steepen; Markets Paralyzed

A: Alright, so I've read all the articles, read all the bloggers, and its clear there are very strong views on the flaws of this recapitalization plan that easily could exceed some $700,000,000,000. I'm more interested now on what the general theme is here. In my humble opinion, the goal is to recapitalize and strengthen the banks, period! Yea, Im sure there will be clauses inserted in the plan to help foreclosures, and work with struggled homeowners who might fall into foreclosure, but the main goal of this plan is to get the balance sheets fixed, the revenue generator for banks back running again, so that the lending can resume. Period. To do this, it seems first you recapitalize, then steepen the yield curve.

I'm so upset about all this bullshit you have no idea. I just know that the marks the future committee will be granting these toxic assets will be WAY HIGHER than true market value at the current time. But this IS the plan and those who mentioned write-ups will probably get them.

We are beyond what he said / she said at this point. We are beyond whether or not Paulson / Bernanke PUBLICLY acknowledged the health of our banking system at this point (behind closed doors, well then, that's a different story). We are beyond who dunnitt, at this point. I'm not saying I like it, I'm not saying it's right, I'm saying we are in dangerous territory, and Bernanke and Paulson know it. Their hand is revealed. The end game is either AWFUL or it's A BIT LESS THAN AWFUL w/ BAD SIDE EFFECTS. We will likely see the latter.

As Yves over at NakedCapitalism.com argues a recent NY Times article about the plan's intentions:

Vikas Bajaj of NY Times states: A big challenge for Treasury officials will be deciding whether to buy the troubled investments near the values at which the banks hold them on their books. That would help minimize losses for financial institutions.

Yves Counters: Huh? How can Bajaj not understand what this program is about? First, it is going to pay above, in fact considerably above, current market prices for the illiquid (frankly, often dud) assets. There is no point to this exercise otherwise. The banks are free to sell now at market price, but they aren't willing to. Hence the government is stepping in, paying over the mark.

Yves is spot on. The entire point to this plan, as I read it before revisions are made public, is to buy distressed assets at prices SIGNIFICANTLY ABOVE current marks that the free market today is willing to pay! By paying a great price for these junk assets, the banks:

a) get the toxic off their balance sheet AND
b) recapitalize

What you need to know is this, the markets are 'paralyzed' right now, as confirmed to me by an asset manager and a CDS (Credit Default Swap) trader. All eyes and trigger fingers are on what is to come. And as the waiting goes on, credit market indicators out there that we all use to check in on the fear level, or risk aversion, are going nutz. Something is going down, that is for sure! Oh, and by the way, you know we will eventually get economic data reflecting the past few troubled months here, so get ready for that too!

My bet is that a mega-revised plan packed with little add-ons to quell the public outrage will go through, banks will be recapitalized because they have to and our gov't will likely not stand idle, and you will see a steeper yield curve (above right is current US treasury yield curve); which is what they want to happen because it gives banks more chances for profits. The steeper yield curve this time around doesn't paint the rosy high growth / inflation from growth picture that it normally does. This time, we have significant negative macro forces at play that will likely result in higher longer term yields, at the same time our fed continues to battle a serious near term slowdown; hence the steepness.

Massive treasury issuance to fund all these programs/bailouts could eventually lead to longer term hyper-inflationary concerns, all dollar negative. For now, its about stopping a deflationary spiral. I guess I can imagine a world where this recapitalization plan fixes everything, and global investor confidence is fully restored, and no more failures occur, and the global economies don't slow down anymore, and the dollar ignores the national debt and account deficits (recall the Debt to GDP / Peak Credit discussion)....yea, I guess I can imagine that kind of world. But imagination usually doesn't translate into reality.

I expect the long end of the curve to see higher yields, and the short end to stay low as the fed will likely ease in response to a major event or very bad macro economic data. John Jansen over at Across The Curve, a great bond site, reflects in his post "Blank Check" and I agree:

Peter Orszag is head of the Congressional Budget Office and he testified before the House Budget Committee on Wednesday. He also testified that he expects the $700 billion authority, assuming it passes. to be fully utilized during fiscal 2009. I believe that the 2009 fiscal year will begin on October 1.

That is an enormous amount of borrowing by the Treasury and does not count funding of FNMA and Freddie Mac or purchases of MBS by the Treasury. Unless the economy heads into a serious contraction, very serious, current yields on 10 year notes and 30 year bonds will increase. We will be drowning in a sea of Treasury spittle.

Exactly. Only thinking out loud folks, this site is simply an open journal for me and others to blab on. Let's see how this Sunday evening looks in what is now a regular pre-global markets opening ceremony of rescues! It's a sad time for America.

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Breaking: Gov't Brokered Deal For JPM & WaMu

A: Waiting for details, as this news breaks. Can't find any release online yet, as I saw it past the CNBC screen. Apparently the government has pulled a Bear Stearns like transaction and helped broker a deal for JP Morgan to buy WaMu's deposits. Details to come.

The financial sector is changing very quickly and it seems Bank of America & JP Morgan are now the top two sharks as we head into the new world! Strange how eerily quiet things have been around Citigroup? Their balance sheet was a mess and they haven't announced write-downs in a while. The treasury recapitalization plan, if/when it goes through, I'm sure will rid many toxic loans from Citi's books, but it's clear that Citigroup is in no position to be the big shark that swallows the little guys in this wall street restructuring due to their overleveraged, toxic holdings that are restricting the company's buying power.

In other news, the latest is that the Treasury Rescue Talks have "Cratered"!

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WaMu Fails...Manhattan Real Estate Poll

A: No surprise here folks that the biggest US thrift has now failed. I have been discussing WaMu's problems for almost a year now. For fun, please take a moment and vote on where you think Manhattan real estate is headed, via a poll designed by my friend/colleague/fellow blogger Peter Comitini, who works at Corcoran.

Please take a moment to vote on where you see Manhattan real estate TWO YEARS FROM now. Peter asked me to put this on the site in an attempt to get a larger pool of votes, so we can try to gauge general perception. Thanks.

With this Washington Mutual failure, I am a bit concerned over mass consumer confidence now of our banking system. Main street is notoriously LATE to waking up to reality, and even though the blogosphere has got this credit crisis RIGHT for the past 12 months or so, and tried in every way to warn people about the likely events to come, I am sure there will be plenty of people that still will be surprised at this news. It is not suprising at all, rather, expected. Wachovia is probably the next big one to go, although their highly troubled portfolio doesn't kick-in until next year and into 2010, with their toxic option arm portfolio. I seriously worry about more bank runs as bank after bank after investment bank fail.

Only two weeks ago, I stated:

"For those out there keeping their head in the sand, or choosing to view the bright side because doom & gloom ain't their cup of tea, it's time you wake up to the reality that this is the worst credit crisis since the great depression! More bailouts to come and the next Big 3 in my view are WaMu, Merrill, and Wachovia."

Well, Merill & WaMu now do not exist anymore in their previous forms. Wachovia is the last one left of the Big 3 I worried about. That does NOT mean its over, rather, expect many more small bank failures to come and bailouts to expand to other troubled sectors; mainly auto's & airlines.

Crazy times. Markets set to drop big time on the open.

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Manhattan Inventory Surges; Confidence 'Shaken'

A: Here is the 1-Month chart of Manhattan real estate inventory. In short, supply shot up about 14.13% in the past four weeks, as wall street underwent reconstructive surgery sending shockwaves to general confidence. Real estate is 'ALL ABOUT THE BUYERS'. That is where it all starts, buyer confidence. Buyer confidence is comprised of many variables, mainly including job security, affordability, and near term prospects for the asset. Clearly, the public dismantling of wall street and the end of the wall street business model (the game is over), has shaken confidence not only in buyers, but in sellers alike. Here are the charts.

Items to NOTE:

1-MONTH INVENTORY ---> Up 14.13%
PRICE REDUCTIONS 1-MONTH WEEKLY AVERAGE CHANGE ---> Up 818%
*price reductions and contracts signed data are collected and displayed as a weekly average to show you the trends without the spikiness that results from minimal activity over weekends. The initial sharp rise up is probably a temporary anomaly, but a continued sustained trend up will tell us that sellers have gotten considerably more nervous as events unfold on wall street

This is quite a move in a short period of time; and it is worth noting since during this time we had the following events:

a) Lehman Brothers declare bankruptcy
b) AIG taken over by the Treasury
c) Merrill Lynch selling itself to Bank of America
d) Fannie Mae / Freddie Mac put into Conservatorship
e) Washington Mutual fails / JPM buys toxic assets, deposits, and branches

Simply unbelievable. The effect of these events and the headline blitz that came with it is directly shaking buyer & seller confidence. We must monitor if this trend continues as we head into a weak 2009 bonus season that is likely to see a dropoff of 50% or so in issued bonuses. In addition, we must be wary of the media shock that is likely to come when the first year-over-year significant decline is reported for Manhattan real estate. As I said before, I expect this to come in 4Q of 2008, or 1Q of 2009, in my piece back in July, "Preparing For Price Reports w/out New Devs":

While it was fine to see Manhattan average prices rise 17% due to closings at these high end buildings, it certainly won't be fine when reality takes OUT this temporary anomaly and prices show a drop of 15%! This of course did not happen yet, but it will as the quarter with the upside (4Q of 2007) is compared with the future quarter that doesn't include these high end sales anymore.

As with the seasonal component for BLS inflation data, new developments and condo conversions have skewed the price data significantly HIGHER! I urge you to watch out for this concept: WHAT GOES IN WILL EVENTUALLY COME OUT!

I'll be on top of this and report to you here on UrbanDigs as things change in our local marketplace.

To view charts, click on the CHARTS tab in the main panel above the most recent post. When you get to CHARTS page, you will have options for data at the top to select between TOTAL INVENTORY, PRICE REDUCTIONS, CONTRACTS SIGNED & NEW LISTINGS (see below). Once you have the chart, you can select the time frame above the actual chart.

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The Hazard of the Rescue

A: We are hours away from the finalized plan being made public, but a draft of the plan is up on Calculated Risk. Here is my problem with the recapitalization plan; it is punishing mark to market behavior that some firms decided to do to act in the best interest of their shareholders; to strengthen the position of the firm. Those firms that kept marks at the model price, hesitant to update from price discovery, will snake their way out of very ugly mess, rescued by the TARP plan. Lets look at Merill Lynch, the fire sale of what used to be $30Bln in assets back in July, some to Lone Star at about 22 cents on the dollar (arguably 5 cents), their sale of Bloomberg stake, and their ultimate sale to Bank of America. Props to Mr. Thain for acting in the interests of your shareholders; Mr. Fuld, well, how do say it, lost his game of 'chicken' with the markets.

This TARP (Troubled Asset Relief Program) is a recapitalization plan for the banks, with add-ons, oversight, and limits attached to it so as to quell public outrage over the perception of another wall street sector wide bailout. It's really a recapitalization plan of our banking system. The core of the plan is to:

a) buy distressed assets from banks balance sheets
b) buy these assets at marks HIGHER than the current market was willing to pay
c) recapitalize the banks so that lending can resume
d) jump-start private sector interest in the distressed secondary mortgage market to facilitate deleveraging at higher marks

There will be add-ons in the package for homeowners, foreclosures, oversight, transparency, CEO caps, ownership stakes, etc..as demanded by Congress as Senators fear the risk of their jobs for voting on this package. The perception is, this HAS TO HAPPEN. Its a lesser of two evils. Either we do this and things get REAL BAD or we do nothing and things get REALLY REALLY REALLY BAD. Which do we choose? It seems the ultimate ramifications of this package are being put on the back burner for now, as Mish points out, this could very well lead to a rise at the long end of the curve, meaning higher rates for borrowing across the board.

What kills me is when I look back at the actions of Merill Lynch, a firm that made the tough choice to sell toxic assets to the market at super distressed levels & their Bloomberg stake, so as to rid themselves of toxic assets, raise capital, and position the firm to weather the rest of the storm ahead. In both announcements, MER stock traded higher in the days after.

With fire sales, comes price discovery that ricochets through to other firms' holding similar illiquid toxic assets:

"When Merrill sold off their distressed assets at a reported 22 cents on the dollar, arguably 5 cents on the dollar, it issued in price discovery for what these distressed assets were currently worth on the open market. "

Now, back to the rescue plan. Look at the name of this plan, TROUBLED --- ASSET --- RELIEF --- PROGRAM!! The logic is to buy troubled assets that the current market values at close to nothing, offer relief to these handcuffed lending institutions, recapitalize, and get that bank lending again! Right now, credit markets are paralyzed waiting for action.

To do so, the troubled assets that need to be off-loaded MUST be removed at prices HIGHER than what the current market is willing to pay! Think about it, these guys can sell for 5 or 10 cents on the dollar right now if they wanted to, but they don't want to because it will HURT them, not HELP them. If they could sell at say, 35 or 40 cents on the dollar, well they can withstand that kind of shock for already marked down distressed assets, take the hit, clean up their balance sheets, restore investor confidence, raise more capital, and start lending again. It's all about where they could sell those junk assets at!

In comes the Treasury. The very prospect of $350Bln - $700Bln coming in to buy distressed assets, on its own will have the effect of bouncing the secondary mortgage market from levels say a month ago. That is very important. So when time comes for the committee in charge of buying distressed assets to 'pull the trigger', the market is likely to be significantly higher already. In addition, there will be other players fighting to get in on the action too, jumping on board the gravy train. I can see the explanation already for paying high levels for these distressed assets, "...we paid the price that the market placed on these assets at the time of our purchase". Yea right, of course you did, AFTER your plan rallied interest for these assets!

I shouldn't be so surprised, because again, this IS the plan. There is no point to it if we were going to pay super low prices that the market was valuing these assets at BEFORE this plan was first conceived. But that is the sales pitch we will get from the backers of the rescue package. That we, the taxpayer, are buying super distressed assets at super fire sale prices, and there is a very good chance we make money on this trade in X years. Yea right. I don't buy it. It stinks. It stinks real bad.

One hazard of this rescue is that it punishes firms like Merrill Lynch for their behavior of selling assets at fire sale prices when they had to. Too big to fail? What a great business model these days and down the road.

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Citi Buys Wachovia: It's 'Not A Failure'

A: Umm, sure, ok, whatever you say! Citigroup is the winner of the Wachovia buyout talks and agrees to take on as much as $42,000,000,000 of losses from Wachovia's $300+ Bln portfolio of toxic mortgages. After that, the FDIC will take on losses in exchange for preferred stock and warrants. This action was deemed by the FDIC as 'NOT A FAILURE'. With Wachovia stock trading down some 94%, to $0.75/share, shareholders can enjoy some relief that this is NOT a failure; it just feels like one!

Amazing. Not a failure! Give me a break, puh-lease! Here is the news via Bloomberg, "Citigroup Agrees to Buy Wachovia's Banking Business":

Citigroup will absorb as much as $42 billion of losses on Wachovia's $312 billion pool of loans, the Federal Deposit Insurance Corp. said today in a statement. The FDIC will take on losses beyond that amount in exchange for $12 billion in preferred stock and warrants.

Wachovia is the latest casualty of a financial crisis that drove Lehman Brothers Holdings Inc. and Washington Mutual Inc. into bankruptcy and led to the hastily arranged rescues of Merrill Lynch & Co. and Bear Stearns Cos. The purchase gives Citigroup about 3,300 branches and offices in 21 states. Wachovia will continue to own the A.G. Edwards Inc. brokerage and the Evergreen mutual-fund family.

Wachovia is the largest holder of option ARMs, ahead of Washington Mutual, the Seattle-based lender that collapsed last week. Option ARMs allow borrowers to skip part of their payment and add that sum to their principal. Monthly payments increase after five years or once the loan balance reaches a predetermined limit, usually 110 percent to 125 percent.

For the average option ARM borrower, payments will rise 63 percent, or by an additional $1,053 per month, when their rates reset, according to a Sept. 2 report by New York-based Fitch.

Thats it folks, I'm OUT OF FAILURES! They all happened. Now what the hell am I going to do?

No seriously, it appears that we are nearing the end of the shotgun marraige SHOCKS for the major American institutions. That is not to say we wont see more failures, but the big ones happened already. To date, here is a list of the MAJOR failures OR bailouts OR buyouts due to this credit crisis:

1) Lehman Brothers
2) Bear Stearns
3) AIG
4) Merrill Lynch
5) Countrywide Financial
6) Wachovia
7) Washington Mutual
8) Indymac Bancorp

Did I miss any? There are 12 more smaller ones on the FDIC Failed Bank List for 2008 already. Expect many more smaller ones in the next 12-18 months. Its now time for the next sector to show its ugly face (maybe home builders, maybe airlines, credit card companies, auto industry), hedge funds and global banks to show who is swimming naked.

Just another downward credit cycle? I think not! The landscape is changing, and after this nuclear credit war is over and the smoke clears, we will be back to simple banking with heavy regulation on all the complex derivatives and securitization methods that assisted in getting us into this mess in the first place. The credit boom is over and we likely have already reached PEAK CREDIT. This means years of deleveraging, and credit contraction until we hit equilibrium.

No more craziness, and as I said in the last Inman conference, the reason we will not see a 'V' shaped recovery, is that the system of credit that is needed to fund that type of recovery, simply will not be there. This will be an 'L' shaped process with prices reverting closer to their historic means. The likely BIG 4 surviving banks that will shape our future, as MH23 points out in a comment on the previous post, are JP Morgan Chase, Bank of America, Wells Fargo & Citibank. These Big 4 officially classify as too big to fail at this point and will be the main lending institutions that shape the next decade!

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BREAKING: House Fails To Pass Rescue Plan

A: Wow. Logged on to my trading system I will tell you the markets are totally insane right now. Trading is so hectic, quotes are completely tied up. Gold soared. Dow got as low as 620 I believe, down about 450 right now. Rush into Treasuries. Right now, Dems are trying to convince 11 Republicans to SWITCH their vote.

More to come as I have a feeling this convincing of 11 more votes, will go on for a while

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Mortgage Market Update: WE NEED LIQUIDITY!!

Rates are stable from Friday's close, currently at around 6.25% on 30 Year Fixed Conforming mortgages and a whopping 7.875% on JUMBO 5/1 ARM's.

While the DOW is down close to 450 points due to the rejection of the much anticipated rescue plan, the treasuries are rallying and their respective yields are plummeting. I see this as good news for conforming mortgage rates but an absolutely horrible prediction for unsubsidized loans.

There is barely any liquidity in the secondary mortgage market, and with the most recent upset from congress and the Wachovia "failure", I do not think banks will be in the business of lending un-securitized loans for much longer.

Risk aversion is first and foremost in present day economy and it's still not over. Stay tuned!

ON BEHALF OF ALL MORTGAGE PROFESSIONALS: WE NEED LIQUIDITY!!!

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Latest Freeze: PMI.

With the real estate market crumbling apart and credit markets grinding to a halt, I'm beginning to suspect that Private Mortgage Insurance is going to be the next sector of home finance to get a dose of their own medicine.

CnnMoney writes that PMI applications for August '08 were down 32% year over year. That is a HUGE drop, and signifies major uncertainty in the mortgage insurance sector.

For those that don't know, let’s start off with what PMI is and how it works:

PMI is given to qualified borrowers who seek more than 80% financing from the lender. Once PMI is issued, the premium for the insurance is passed on the borrower and is paid back monthly. The calculation for the premium is based on your risk profile, usually ranging from 50 to 75bps of the loan per year. For example a $500,000 loan with great credit and 90% financing would have a monthly premium of roughly $208.33 ($500,000 * .0050/12).

For years PMI was never a concern from an underwriting standpoint, however more recently it has been getting tougher and tougher to get approved; PMI companies now have two sets of guidelines, one for properties in a declining market and another for stable market properties. Of course each guideline has its respective premiums.

See here, here, and here for examples of PMI underwriting guidelines.

My most recent confrontation with PMI, and one of the reasons why I am writing this post today has to do with a couple from Brooklyn who are purchasing a 2 family home in Mill Basin (a very nice area in Brooklyn, NY), and are putting 10% down toward the mortgage. They are my clients and we have come to a point where the file is clear of any outstanding underwriting conditions, the commitment has been issued, and the only item left to obtain is PMI.

Last week I received a call from my underwriter letting me know that they cannot obtain the coverage. I freaked out and called all the mortgage insurance companies myself only to find that NOT ONE COMPANY WANTED TO PROVIDE THE INSURANCE.

I was shocked! The clients are purchasing a 2 family home at 90% financing, with a loan amount of $619,000 (Agency-Jumbo), and they cannot get financing?!? They have a 781 and 783 FICO score!!! I got through to an underwriter from one of the PMI companies and was told that due to the declining market of NYC (including Manhattan), they will not insure a home with that high of a loan amount. Minimizing the risk exposure, eh?

Having no choice, I had to place the borrowers into an FHA program. FHA will provide its own PMI but it will be extremely expensive, in this instance 1.25 points up front and 55bps/year in Mortgage Insurance. Unfortunately, my clients had no choice; it was either they take the new loan or lose their 10% down payment.

In conclusion, if you are getting PMI, please make sure your lender orders and approves the insurance BEFORE the commitment is issued! It is getting very tough out there people and my clients and I had to find out the hard way, I don’t want any of you going through the same pain.

If the commitment is issued and your lender cannot obtain PMI coverage, you hold the risk of losing your down payment. Make sure you consult with your attorney regarding the infamous mortgage contingency clause!

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