Manhattan Real Estate & The Dollar Rally

A: 'The weak dollar is powering Manhattan real estate by bringing in foreigners looking to take advantage of currency trends and buy prime Manhattan real estate on the cheap'. Does anyone else recall this statement made by brokers, real estate experts, and the media over the past few years? I certainly have. In fact, I wrote about this last year in my piece, "Does A Weak Dollar Accelerate Foreign Demand". But now that the greenback caught a bid, and has experienced quite a rally against other major currencies, what does that mean for us? Well, lets just break this down the numbers.

Back in November, I stated:

"As the US dollar falls against the Euro, it is more THEORY than REALITY that demand will accelerate when so much surrounding the macro environment has changed towards the negative! In short, there is no evidence that for every penny the US dollar loses against the Euro, 'X' number of additional buyers will pour into our marketplace.

I'm not saying there is not an attractive trade here. There is, and there has been for some time. Thanks to foreign demand, many of our new development inventory has gone into contract, in addition to many existing resales; especially the higher end. The element of foreign demand has helped keep Manhattan inventory at such tight levels, which in turn helped keep our marketplace shielded from the nationwide housing slump."

The discussion back then was simple. I made the argument that confidence trumps the currency trade and that Manhattan has already experienced the peak of foreign buying, which was one ingredient helping to keep Manhattan inventory tight as much of the nation's housing supply surged. Rear view mirror analysis doesn't help us, as we MUST always look ahead to stay ahead of the curve. So lets do some creative thinking here, as the dynamic of a weak dollar causing foreigners to buy is yesterday's news. If a weakening dollar made US real estate more attractive to BUY, a strengthening dollar will make US real estate less attractive to new foreigners seeking to take advantage of currency trends alone - If the dollar rally is sustained, it could also make foreign holders of US real estate more interested in selling, to take advantage of the local currency strength against their home currency!

Here is the math:

WEAKENING DOLLAR BEFORE THE PURCHASE

2 YEARS AGO (1EUR = $1.278)

500,000EUR buys $639,000 worth of US real estate

6 MONTHS AGO (1EUR = $1.56)

500,000EUR buys $780,000 worth of US real estate

**As you can see, the weaker the US dollar is against the EURO, the more house a foreign investor using Euros to buy the asset gets, simply on currency trends.

This weakening dollar trend has been ongoing for 7 years or so. In 2006, the trend really accelerated and the weak dollar trade for Manhattan real estate became front page news. It had an effect, and many foreigners stepped up and bought Manhattan property, mainly new developments and conversions. This ingredient to our buyer pool, helped to keep Manhattan real estate inventory tight, while outside markets saw supply surging.

Fast forward to today and the recent dollar rally, and lets do the same math using today's currency valuations compared to the low the dollar hit against the EURO in mid-July:

STRENGTHENING DOLLAR BEFORE THE PURCHASE

1 MONTH AGO (1EUR = $1.60)

500,000EUR buys $800,000 worth of US real estate

TODAY (1EUR = $1.466)

500,000EUR buys $733,000 worth of US real estate

**In the past 4 weeks as a result of the dollar rally, foreigners can now buy LESS house for their money.

So, we can see the change on new foreign buyer demand. As the dollar strengthens, US real estate becomes less attractive from a currency advantage standpoint, because they can buy less house than what they could have purchased in the past.

Now, lets proceed to foreigners who purchased real estate on the currency trade, and how the stronger dollar affects their asset from a currency standpoint. The simple translation is, as the US dollar strengthens, foreigners will have more incentive to sell and take advantage of the currency gains that their US asset has against their euros. The question is, can the asset be sold for a gain?

STRENGTHENING DOLLAR AFTER THE PURCHASE
**since the dollar only recently rallied, we must use a hypothetical example to explain to you the reality of how a stronger dollar affects a foreigners property in Manhattan

BOUGHT WHEN 1EUR = $1.60

500,000EUR buys $800,000 worth of US real estate

VALUE IN US DOLLARS IF 1EUR = $1.466

$800,000 US dollars now equals $545,000EUR (exchange rate of $0.6815 into EUR)

Get that? The above example reflects how much gain the foreigners US owned asset will now fetch in their own euros if they sold at the same price they bought; simply because of the rally the US dollar has had in the past few weeks alone! Now of course this is a hypothetical example because there is no way a foreigner could have purchased the asset at the very top 2 weeks ago, closed on the property, and then sell it at today's exchange rate; plus not calculating transaction costs. The purpose of this math is to simply show you that when the dollar rallies against other major currencies, it changes investment psychology & makes the foreign owned asset more attractive on the sell side to take advantage of the currency gain.

Now, this does not mean you will see a flood of foreign owned condos hit the open market here in Manhattan. Mainly because the purchases were done in the past few years and the EUR was valued lower at that time; so even with this recent dollar rally, there is not the above referenced currency gain. Other factors will determine whether a foreigner chooses to list their property for sale; such as weakness of their financial position, intention of flipping, or confidence in the asset's future value. But it does show you the dynamics of the currency advantage and trade that has enveloped Manhattan real estate in the past few years. The conclusion, a stronger US dollar has a two pronged effect:

a) it makes new foreign US property investment less attractive as a stronger dollar means they get less bang for their foreign money

b) it could make existing foreign property owners more attracted to selling the US owned asset to take advantage of any currency gain they may have from the time they purchased

A great currency discussion for the times.

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World Economies - The Tide's Going Out

It's open season on skinny dippers! As the tides go out worldwide, voyeurs are getting an eye full of who was swimming naked. It's all fun until someone has to mark-to-market. Investors all over the globe are facing a slowdown and now scrutinizing the risks they are taking at home, and questioning the returns they should be expecting in a low real interest rate environment that looks to be spreading. Note that real rates in the US and China are already negative.

Let's take a brief tour of the latest carnage in pictures and figures.

The Shanghai composite Index is an absolute bloodbath (excellent chart below from Bespoke Investment Group). Either you believe that markets are completely inefficient and express no actual information about the underlying company fundamentals, or something has changed radically in China. I'm not just talking about giving up some ill-gotten gains related to over-enthusiasm for the China investment theme and the Olympics. The 60% decline in this stock market, a give back of over 2/3 of a 502% up-move, is a shellackering you don't see very often. I will wager that millions of people in China are now sitting on losses, despite investing in a stock market that had underperformed the world for a decade before its meteoric rise. Why?

I personally believe that China has grown way too fast, as I opined in an April 2008 piece China Update - Olympian Challenges. In it I stated "Economic growth can be like heroin, though, you keep needing more and more and it gets pretty ugly when you get less. Due to imbalances in the Chinese economy, the country has grown to rely on high rates of growth." Folks appear to be more than a little worried about these imbalances. But regardless, China doesn't have to implode for Chinese stockholders or the world to notice, it just has to slow down.

Seperately, the first negative GDP quarter registered in the Eurozone since 2001 was reported yesterday. The linkage to the U.S. is definitely being felt here, but the Europe has it's own home grown problems as well, particularly in the countries that boomed in recent years. Here's a chart on growth in the biggest economies there from The Economist.

Check out this chart of the oil correction from Futures.TradindCharts.com. I say correction, because I am not making a bearish call on energy from these levels in this piece, although I had been expecting commodities generally to weaken for the last six months due to slowing world growth (so i was a little early).

The impressive thing here is how fast this freight train of a bull market has wilted. I am showing you a less dramatic-looking daily chart, so you can see that it took about 9 1/2 months for oil to rocket from $110 to $140, but only 4 1/2 weeks to give it all back. This smacks to me of a market which was run up by weak players, who all bolted as soon as it turned south. Is it any wonder? As Noah has mentioned here before, oil in particular and commodities in general were the last one way trade. Here's the vicious cycle players were depending on.

Higher oil prices (and commodity prices) sap consumer spending power; this pushes more homeowners into default on their rapidly imploding properties; which causes more losses for banks and tighter credit, further slowing the economy; the weak economy leads to a weaker dollar, which causes commodities and oil to inflate more. The Fed can't ease rates due to a weak dollar (and inflationary pressures that result from it), their easing isn't translated into lower borrowing costs anyway because banks can't afford to take on any more risk while their current loan portfolios are blowing up and the Fed can't raise rates to help cushion the dollar out of fear of killing the banking system and the consumer. PREFECTO! the ultimate one-way trade.

The only problems with this trade were: What if the entire world economy started to slow causing unemployment to rise, and the ability to pay higher prices evaporates? and what if high prices actually do what they are supposed to and kill demand? It's always a guess what the elasticity of demand for any particular item will be and necessities like food and fuel seem like things people might accept a big price hike on before they cut back their consumption. But, of course, besides demand destruction, there's always substitution and trading down, which we are seeing in spades. You can see the contrast between Macy's Q2 results wherein sales fell 3% and Wal Mart's. We have all heard about the switch from driving cars (gasoline) to mass transit (electricity/coal).

So what's the next great one-way trade? In my book there is none - there will be the occasional distressed fire sale, but it will take deep pockets and a very long-term perspective to participate here....no ETFs I'm afraid. It is going to be a long, slow grind for the imbalances worldwide to get worked out. I have always believed that the imbalances were worldwide, not just because of the scary things I was reading about the London commercial property market, the Spanish and Indian housing markets and Chinese fixed investments, but because money was incredibly cheap worldwide and when money is cheap people do dumb things....sort of like when alcohol is cheap. Now that money destruction has begun to spread around the world, we will find out just how far and how deep the "mal-investment" or mis-allocation of capital around the world went.

On the positive side, I don't see inflation expectations getting out of hand in this environment (see my piece Oh Behave Inflation - NAIRU to the Rescue). Additionally, with the US already facing up to its bubble and cutting rates significantly/monetizing the debt, the dollar will look somewhat more appealing than the currencies of countries that are just about to start cutting rates. Check the chart below of the recent dollar strength. I don't expect a straight up move and it should pull back from the recent pop, but I think the one-way trade is over.

So should we really be rooting for a global rout? It's not going to help our export growth and corporate earnings, but it's an improvement from the vicious cycle of dollar weakness/inflation/consumer devastation. The tide will come back in eventually, but until then, as the Brits would say, "Keep your swimming costume on!"

From the Blogosphere

Investors less worried about inflation - Merrill poll

The party is nearly over - Eastern European bubbles

The South Sea Bubbles Again

Economic slump hits Spain hard after 14-year boom

Japanese economy shrinks, adding to recession fears

Euro pinned down as euro area growth contracts

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Writedowns Hit $500 Billion Mark

A: Hardly news, but just maybe a wake up call. As I and many others have said since 2007, this is not just a subprime problem. What starts at the lowest level, eventually climbs to near prime and ultimately prime. What started out as a mortgage problem, quickly spreads to auction rate securities, HELOC's, credit cards, auto loans, etc.. This is an overall debt problem. This is credit deflation and assets are being marked down as price discovery continues. The cockroach theory is in full effect, so we should all expect the banking woes to linger.

From Bloomberg's, "Banks' Subprime Losses Top $500 Billion on Writedowns":

Banks' losses from the U.S. subprime crisis and the ensuing credit crunch crossed the $500 billion mark as writedowns spread to more asset types.

The International Monetary Fund in an April report estimated banks' losses at $510 billion, about half its forecast of $1 trillion for all companies. Predictions have crept up since then, with New York University economist Nouriel Roubini predicting losses to reach $2 trillion.

"It just keeps spreading from one asset to another, so it's hard to know when these writedowns will stop," said Makeem Asif, an analyst at KBC Financial Products in London.

For those looking ahead, check out Calculated Risk's reference to Clayton's take on the coming ALT-A problems:

Clayton's report suggests that we may have now seen the beginning of the end of the subprime meltdown, but we are only at the end of the beginning of the Alt-A wave that is following it.

According to Clayton, subprime delinquencies appear to have peaked in December of 2007, and subprime foreclosure starts may have peaked in January of 2008. The volume of foreclosures in process will remain elevated for a long time as these things work their way through lengthy foreclosure timelines, but the peak in FC starts is good news.

Unfortunately, Alt-A seems nowhere near its peak yet. Clayton's report, based on May data, indicates that both new delinquencies and foreclosure starts in Alt-A pools are still rising. Fannie Mae's recent conference call suggesting that Alt-A deteriorated even more sharply in July is yet more evidence that the Alt-A mess is still ramping up.

It wont stop there. Alt-a, then prime, then credit cards, then auto loans, then student loans, then lawsuits, then jail sentences, then regulation, and then we know what credit deflation and peak credit is all about.

If Roubini is right, we are about 25% through the writedowns. This is globally, so it very well may reach that tally when we look back at this history making cycle in hindsight down the road. As we live through, it will just seem like the problem that won't go away. I think the US will lead out of the mess though, just like we lead into it; with foreign banks/writedowns adding to the tally when we exit the cycle. The question is, when?

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Mortgages: The Raw Data

In these times of great confusion and virtually no forecast of the mortgage market, I thought it would be a great time to take a step back and look at what is happening, present day.

The mortgage market has experienced substantial change over the course of the past year and a half or so; Guidelines are stricter, underwriting is tighter, credit is scarce, and worst of all it’s not over yet. Some of these items may not be of great surprise to you as they usually make financial headlines at least once a week, but I wanted to touch on a couple of items that, in my eyes, need to be addressed:

1. Home Equity Products are virtually non-existent and even if they are available, they don’t offer too much benefit. There are many reasons for this, one of them being that home prices are falling all across the nation, making these products very risky investments on the secondary market from a collateral perspective. Even if a bank does offer a Home Equity product, it will limit them to very low CLTV limits and very high credit ratings. The days of 80/20 and 80/10/10 financing are LONG gone.

2. PMI is the solution. Since HELOCS and HELOANS are no longer available as a way to offer subordinate financing, full 90% or 95% financing is achieved using one big mortgage with Private Mortgage Insurance. In this instance a bank receives insurance from a third party to insure the note (since it is above 80% LTV/CLTV) and the premium for this is passed on to you – the borrower.

3. The GSE’s (Government Sponsored Entities) are struggling. This is never good for any person working with/looking for mortgages, the GSE’s raised the premiums they charge to secure loans, they are not willing to securitize as many mortgages as they did before, and they do not want to keep a lot of risky/toxic assets on their balance sheets. Who would?!?!

4. FHA – The temporary band aid. You will hear these 3 letters used more and more often than usual over the next few years. FHA or Federal Housing Administration is a government entity that uses more lenient guidelines to offer more people mortgages. There are many variables to this program but in a nutshell, they generally do not have a credit score requirement, you need to have stable income and must be able to prove it, and you need to produce various types of documentation to prove to the government that you are capable of repaying the loan. This all comes at a price and is not cheap. Doesn’t it remind you of that little mishap we all want to forget? Subprime?.

5. JUMBO Mortgages – Most banks are not able to get them off their books and therefore are not able to write new loans at decent interest rates. It seems like the mentality is that since there is no secondary market for JUMBO mortgages, the banks will have to take more of a spread to keep the loans in their portfolio. As a result I am currently offering 7.375% on a Jumbo 5/1 ARM @ 0 points.

This is just a small piece of the puzzle and is how I see the mortgage market present day. Almost every Fortune 500 company which at some point in time offered or continues to offer conventional mortgages, is reporting huge losses and we are certainly not out of the water yet. The outlook is to remain positive and hope for the best, the damage has already been done. And as Noah has said many times before, there is no such thing as free lunch.

Before I forget, I am MortgageMan. I am a loan officer at a major financial institution in the NYC area and have chosen to use an alias to remain anonymous. My goal will always be to give you a clear view of the current market status from a lender’s perspective. I will try to post consistently, and prioritize discussions when the market that I work in sees a drastic change; either for better or for worse.

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A Thought on the Dollar

In late February, I wrote a piece titled, "Sometimes We Get Lost in the Dark", as a change-of-pace discussion on what I thought described the state of our economy at the time. Thinking back now (when Bear Stearns was still alive), February was certainly a very dark and mysterious time for our markets as they navigated through unchartered terrain. I mean, who expected Bear was going to die of that quickly!

Today, I want to temporarily embrace an idea of what I think is going on with the recent dollar rally, seemingly sparked by a concerned Trichet in the Eurozone. It does have an orchestrated tone to it, and that's fine as long as you all know that I am not a conspiracy theorist or paranoid about such theories. However, I am a believer that there is a co-ordinated effort going on between our federal reserve and overseas central bankers to attempt an orderly unwind of global holdings of toxic waste. It is in nobody's interest that the system fail, and because of this very unique environment, I think the idea that specific markets (credit markets, currency markets, commodity markets, equity markets) are being targeted for orchestration to allow the mass unwind to proceed with minimal event-causing disruptions, is worthy of discussion.

Off the top of my head, I see the following interventions for the following markets:

Equity Markets

a) Paulson's backstop plan for GSE's allowing the treasury to buy preferred shares of stock for Fannie Mae & Freddie Mac, thereby placing uncertainty and more risk for those holding, and thinking of holding, short positions. It's hard to raise capital if your stock is below $5/share!
b) the temporary restriction of naked short selling for a selected number of companies

Credit Markets (rate cuts & facilities offered by fed)

a) 325 bps of fed funds rate cuts, 350 bps to discount window
b) $30 Billion for rescue of Bear Stearns
c) PDCF
d) TSLF
e) TAF & repos

Commodity Markets

a) talk of lifting moratorium on offshore drilling
b) talk of windfalls profit tax on oil companies that will limit research & development
c) US Senate proposal designed to curb commodity speculation (The Stop Excessive Speculation Act, recently blocked by Republicans)

Currency Markets (central bank dissenters & rhetoric)

a) dissenting votes on rate decisions
b) 'tough guy' act in issued statement
c) Trichet's recent comments on concerns over Eurozone growth

Thats what I want to discuss, that last one. The recent dollar rally (30-Day US Dollar Index chart on the right courtesy of FXstreet.com) seems to be sparked by comments from Trichet over risks of slowing growth. That statement changed the view that Trichet will hike rates another 1/4 point, and instead now gives the impression that rates are on hold and may go lower in the future. Massive short covering and new positions are being taken on the dollar, resulting in lower commodities across the board; which is what we wanted anyway right?

Lets put ourselves in their shoes? HOW DO WE STOP RISING COMMODITIES? As I said April 22nd, ANYTHING THAT WILL SUPPORT THE US DOLLAR:

I've said this so many damn times on this site: commodity inflation + housing deflation is NOT A GOOD MIX! Pipeline inflation is bubbling and we can expect future inflation data to be very troubling indeed.

The fix? Here's a thought: ANYTHING THAT WILL SUPPORT THE US DOLLAR! We MUST remove the speculative currency trade that has driven commodity prices higher; arguably there could be $30/barrel in speculative trade in oil as an example. Even if this means the fed changes verbiage to put their bias into the fight against inflation, then so be it! That would be interpreted by traders that future rate cuts are in serious doubt, the US dollar will be supported, and it would remove a good portion of the speculative trade in most commodities. It doesn't fix the supply problem that has resulted from fast growing economies like China & India, but it will help by removing the bets made simply on the premise of a weakening US dollar.

There is speculation in commodities, I have always stated that, and it wasn't only supply/demand forces driving oil to $145; speculation helped and a weakening dollar drove that as commodities were the only asset class working for the past few years. The $30 of speculative oil I discussed 4 months ago, is where we are right now with oil down about $30 from its high in only the past three weeks. Obviously this proves that speculative trading exists in the price of crude oil.

Thing is, I think we still have big problems ahead of us and a few big institutions that are going to fail. If that turns out to be true, the fed will have to cut rates to calm the tradable markets, probably before they re-open for trading again. If the US dollar was in the dumps, requiring $1.60 to buy one Euro, and with oil at $145 and gold at $975, there was absolutely no way the fed could afford to cut rates to deal with such an event. That would have driven oil closer to $175, gold closer to $1200, and the Euro closer to $1.75 against the dollar; think about that environment. That would have also made foreign holders of our debt very unhappy, and we do not need to deal with ramifications of that dynamic right now.

Things that make you go hmmm. So what do we do? Lets have a chat with Trichet and co-ordinate a change in public bias (lets not do anything about!), to fix some of the major macro problems that may come from surging commodity prices and a continued imbalance of currency valuations. If we, the fed, act tough on inflation, and you, Trichet, mention a blurb about slowing growth (which is happening so credibility won't be hurt), that could buy us a cushion!

It has a two pronged effect:

1) by giving the dollar a boost without actually hiking rates in US or cutting rates in Eurozone, it will appease foreign holders of US debt

2) by giving the dollar a boost without actually hiking rates in US or cutting rates in Eurozone, it will reduce speculative bets on commodities, and cause a correction in the price of commodities priced in US dollars

These are both welcomed events. But a third effect can be the bulls-eye accomplishment!

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. To me, this is the ideal situation for Ben Bernanke and it is this exact reason that I think a co-ordinated effort to cushion the dollar may be in place right now. Call me paranoid, but to slow down commodity inflation, or at least the perception of inflation expectations, without hiking rates is a major ingredient to soothe some of the problems we face! 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; that is, if there was a stealth co-ordination in the first place (I have to assume these guys are talking to each other, on the same team, and working together on the problems both face). Clearly, traders are covering dollar shorts and selling Euro longs, and pricing in either a US rate hike or a Euro rate cut. Lets see what happens next!

In conclusion, I think the fed knows that it needs bullets if unemployment continues to rise, the economy goes into a deeper slowdown, the credit crisis claims a big institution or two, or if housing/debt problems continue to accelerate and spread to higher quality classes. To be able to cut rates, the dollar needed some resuscitation and commodities had to correct. If the fed was forced to cut rates with $150 oil, and the Euro at its high against the dollar, the problems would be compounded and fed ammo wasted. With the dollar strengthening and commodities selling off, the fed has more legroom to do what they might have to do to invigorate growth and calm any spikes in distress in the credit markets. Time will tell if this scenario plays out, or if the US is really leading the world out of this mess (helped by tons of fiscal/ monetary stimulus) setting up a sustainable recovery for the US dollar and the proven burst of the commodities bubble. You know where I stand.

Related Currency Read from March 11th, 2008, discussing the impact of a more dovish ECB on our dollar:

That means the US dollar may not become as weak as expected and commodities priced in dollars may lose a dose of steroids (rate cuts) that they were betting on. If you want to get real crazy, what if we assume that international markets are lagging the US and they are about to enter a period of financial distress similar to what we have been through for past 4-6 months? Our currency could bounce further if foreign cb's start easing at a time when our fed found a way to limit future rate cuts. Ehh, just a thought with many if's.

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Fannie/Freddie Rescue Talks Intensify

A: Something that will affect all of us, when it happens. I use the word 'when', because quite simply, the only way these institutions are saved is if the US housing market has bottomed already and is in the process of recovery right now. I don't think anyone believes this is the case. Add in the fact that these two have taken very conservative mark downs on their toxic assets so far, when the tradable markets value these 'hard-to-trade' securities at much lower levels, and I get the feeling that the problems are being delayed, and not resolved. On quick view, I see that FNMA 5-YR spreads to treasuries has now widened to about 93 basis points, as investors appetite for Fannie credit risk diminishes. Should this spread widen to 125-150 basis points, we may have a problem on our hands.

First lets get to the charts. Below is a chart comparing 5-YR FNMA Agency yields to 5-YR Treasury yields; showing you the 93 basis points spread, about 10 basis points wider than yesterday:

*table courtesy of Vanguard Bond Yields

Second, here is a chart showing us the rise in premium (+21.9 basis points, or 10.55% since yesterday) required for credit protection (CDS) on Fannie Mae:

*chart courtesy of CMAVision Top 5 Widening Spread Movers

I do not have a bloomberg terminal, nor am I a credit default swap trader, so my access to this kind of information is very limited. However, I'll explain to you what I do know as I understand it and you can feel free to correct me or add to the discussion if you are more knowledgeable of these markets.

The CDS trade is the cost of buying protection in case of default. It is compared to zero. if the entity is riskless then the spread should be zero. If you are talking about the change then it's compared to itself on the previous day, same as a stock price change, only here a positive change is bad.

This means that to buy protection on Fannie's subordinated debt you have to pay 230bps per year (times the notional). So for a dollar of notional it will cost you 2.3 cents to insure, hence higher is implying greater probability of default and/or greater loss given default (lower recovery).

The conclusion from this graph is that you can tell there is not much appetite for Fannie credit risk and it's about as bad as it has been in the past.

Both Mish & Calculated Risk have discussion's on Freddie Mac's awful report issued yesterday:

From MISH:

Anyone following Alt-A mortgages knows that Freddie's claim is simply preposterous. Freddie has $130 billion in subprime and Alt-A loans. Somehow CEO Richard Syron wants us to believe the problem will go away if left on its own.

From CALCULATED RISK:

This graph from the Freddie investor's slides shows the default rates of Alt-As vs. the rest of the portfolio.

As we've been discussing, the 2nd wave of defaults it just starting, and Alt-A will be ground zero this time.

For those not in tune with the credit crisis, Alt-A is 'near prime' or those mortgages considered in quality to be in between subprime & prime. News reports of warnings inside Freddie Mac being ignored surfaced this week, and speaks volumes about this entire credit/housing downturn experienced thus far. In short, they wanted to keep the party going! Well, as in all long-lasting parties, the hangover will be great. From NYTimes.com:

The chief executive of the mortgage giant Freddie Mac rejected internal warnings that could have protected the company from some of the financial crises now engulfing it, according to more than two dozen current and former high-ranking executives and others.

That chief executive, Richard F. Syron, in 2004 received a memo from Freddie Mac’s chief risk officer warning him that the firm was financing questionable loans that threatened its financial health. In an interview, Freddie Mac’s former chief risk officer, David A. Andrukonis, recalled telling Mr. Syron in mid-2004 that the company was buying bad loans that "would likely pose an enormous financial and reputational risk to the company and the country."

But as they sat in a conference room, Mr. Syron refused to consider possibilities for reducing Freddie Mac’s risks, said Mr. Andrukonis, who left in 2005 to become a teacher.

"He said we couldn’t afford to say no to anyone," Mr. Andrukonis said. Over the next three years, Freddie Mac continued buying riskier loans.

Just unbelievable. Now, Bill Gross of PIMCO (who owns a ton of US Agency debt) is saying that the US Treasury will be forced to buy as much as $30,000,000,000 of Fannie/Freddie preferred shares to bolster investors confidence for the institutions. Why you ask? Simple. These two institutions borrow short & lend long. With their stock prices in the dump, they wont be able to raise capital so easily by selling shares. If they can no longer borrow short at reasonable rates, we have a very big problem. That is why I included a chart showing you the spread of FNMA 5-YR yields to 5-YR Treasury yields. In normal times, the spread is about 50 basis points. In distressed times, it rises as risk rises. Today, its around 93 basis points. If that rises above 125-150 bps or so, the credit markets as a whole will get very shaky and that is something we just do NOT want right now! Fannie & Freddie must be able to fund themselves and that means investors need to be willing to do so at somewhat reasonable levels!

We truly are at a crossroads and the existence of these two overly leveraged, overly exposed institutions are at grave risk. I wonder what the world would be like if Fannie & Freddie were nationalized, and shareholders wiped out? Thoughts?

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Fed Holds Rates Steady; Statement Mixed

A: Hmm, an expected decision yet confusing statement. As I read over this statement, I have to lean on the dovish (rate easing) side, as opposed to the hawkish (rate hike) side. It's hard to imagine the fed cutting rates when inflation threats remain and commodity prices have risen as far as they have, but if you look at the past few weeks commodity prices have come down fairly significantly. Lots of differing views on this latest fed decision and issued statement.

FED STATEMENT

Let me break it down by downside risks statements and inflation statements, to make it easier for us to review. Afterwards, I want to get into Ron Insana's interesting take after the decision, warning the fed that they are missing the boat on the bursting commodities bubble and the deeper slowdown that we are facing.

DOWNSIDE RISKS STATEMENTS

* Although downside risks to growth remain, the upside risks to inflation are also of significant concern to the Committee. (hmmmmmmmm)

* Tight credit conditions, the ongoing housing contraction, and elevated energy prices are likely to weigh on economic growth over the next few quarters.

* However, labor markets have softened further and financial markets remain under considerable stress.

INFLATION STATEMENTS

* Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities, and some indicators of inflation expectations have been elevated.

* The Committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain.

Fisher dissented and wanted to hike rates. Tough statement to break down. As CNBC had the economists and analysts break down this report, there were vastly differing views on whether this was a hawkish or dovish statement. It was very interesting to hear Ron Insana, whom I consider one of the voices of reason on the program, discuss:

a) the current bursting commodities bubble
b) the deeper recession
c) that the fed needs to cut rates and not worry about inflation that will ease as commodities tumble

Interesting. Certainly, the inflation that is out there is resulting from commodity inflation and is passing through to consumers in the form of higher food & energy prices. The inflation that most economists fear most is that of rising wage inflation and the money supply. There are so many definitions of inflation, that for this argument, we need to focus on the right ones.

Putting aside commodity inflation, I just do not see wage inflation or an expansion in money or credit. Do you? In fact, I see massive credit deflation out there and massive destruction of wealth in the shadow banking system; which ironically saw a massive build of wealth in the past decade to the tune of approximately $10 trillion dollars by early 2007. Boy how times have changed. Write-downs thus far in the banking system are around the $450 Billion mark and estimates range from total credit losses of between $1-$2 Trillion before all is set and done.

Should commodities continue to fall as Insana predicts, we could see a significant fall in inflation expectations as a result. My only problem with this is that if the fed has to cut rates aggressively to combat the deep slowdown, the US dollar will likely fall again and that could lead to a rise in commodities priced in dollars. But hey, he is Ron Insana and I am Noah Rosenblatt of Halstead Property! Time will tell.

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. Until then, I see continued pressure in the pipeline for housing, a rising threat to commercial real estate and the mortgages that back them as seen in widening CMBX spreads, rising lending rates, continued wide corporate spreads, and a tapped out consumer.

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Peak Credit & What That May Mean

A: Peak credit, sounds like I hit my limit on my credit cards! I guess its kind of true. For owners of home equity lines of credit, you may have noticed a decrease in your available credit line recently. Why is that? Because credit has peaked, and is now contracting! As banks work to repair their toxic balance sheets, capital must be raised and cash hoarded; that means less lending for us consumers. Peak credit, the idea that our system of borrow now & pay later has reached its pinnacle, is a scary notion. So lets figure out just how out of whack we actually went, before discussing what credit deflation may bring in our future.

Yves Smith, of NakedCapitalism, was one of the panelists with me on the Inman Bull vs Bear debate a few weeks ago. I recall her mention of total credit debt as a percentage of GDP, but didn't really think much about it until I got back from San Francisco. Looking back at the video of the debate, Yves stated on the panel:

(5:56 into the video) - "...right now we got a level of debt to GDP which is OUT of proportion, way out of proportion, right now debt to GDP is 350%...never been that high, the highest it was at the depth of the depression was 260%, and its only went above that level since basically 2000, we had a parabolic increase in debt to GDP, but this is at a level that is just not sustainable in the long term, so the question is...what's going to make this break?"

Interesting stuff. Below is a chart (courtesy of Austrianenginomics.com) that visually shows you what our total credit market debt is as a percentage of our GDP. Look closely and you will realize something very interesting when comparing the two spikes (the first starting after the Great Depression & the second from the past few decades as our economy was driven by debt & credit):

The use of debt in the 1930s was a direct response to the Great Depression! We used debt to get us out of the depression. Recently, we used debt for an entirely different reason: TO SUSTAIN ECONOMIC GROWTH! My two questions are, who are we going to borrow from this time to get out of this mess + how are we going to service our current levels of debt?

Yea, thats right. That huge runup that you are looking at above is the amount of debt that we have taken on to fund our growth for the past few decades. This is giving the term 'peak credit' a whole new meaning isn't it!

When you hear Mish discuss peak credit and credit deflation, now you know what he is talking about:

Peak credit has been reached. That final wave of consumer recklessness created the exact conditions required for its own destruction. The housing bubble orgy was the last hurrah. It is not coming back and there will be no bigger bubble to replace it. Consumers and banks have both been burnt, and attitudes have changed.

Some choose to call what is happening "credit deflation". In this regard "credit" is an unnecessary label. Deflation is about the contraction in money supply and credit. The conditions now are very similar to what happened in 1929. The primary difference is that prices of many goods and services (notably energy and food) have been rising.

So where does this leave us? Unfortunately, we are far from finding out as we are only in the beginning phases of credit deflation and credit destruction. The system that has drained every ounce of umph from available credit, is in fact, broken. That is why you are not seeing lending rates fall with the 325 basis points of fed easing seen thus far, and instead, seeing tightening lending standards implemented. It's a new world of tighter credit and higher costs of credit. For now, we still need to let the process unwind, delever, re-price risk, or whatever you want to call it.

That is what worries me. How bright is our economic future when the credit system is deflating, the cost of credit is rising, and we already took on huge loads of debt? Lets face it, we have been a society built on credit, and now:

a) credit is contracting
b) the cost of debt is rising

Unfortunately, I wonder how much more debt we can afford to take on for future stimulus and to bail out troubled institutions that are too intertwined to our financial system to allow to fail. On the consumer side, credit is not being dispersed the way you would hope; those that need credit, can't get it, while those that don't need it continue to get new offers via snail mail. Looking ahead, I see three endings to this story:

1) we continue to service the debt as rates rise
2) we pay off the debt
3) we default on the debt

Its hard to imagine the US defaulting on our debts, but its also hard to imagine that Fannie Mae and Freddie Mac may be nationalized by this time next year! The key element here are the foreigners holding massive amounts of dollar based assets; our debt. I would expect the bond market to be hit at some point, as treasury prices fall and yields surge; especially if foreigners slow down purchases of our debt or decide to dump some of their holdings in. The next big bubble to burst could very well be the bond market resulting in double digit treasury yields. This is not a new argument, but to me, is probably closer than some people would like to admit.

Back to peak credit, I think we have seen it. How we adapt is anyone's guess. One thing is for sure, is that the credit platform that we have gotten used to for the past few decades, has vastly changed, and psychology with it. There comes a time when we will have to pay off our debts, and like with our pesky credit card bills, paying off debt is no where near as fun as spending it!

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Oh Behave! Inflation - NAIRU to the Rescue

Bond guys have always been frowned on for being lovers of bad economic news....doom and gloom actually makes these guys bullish on their market - they're like Dr. Evil. The more people who lose their jobs the happier bond buyers are, unless it's bond market participants being laid off, oops, now there's a touchy subject. But seriously, bond owners receive a fixed payment for extending credit to others, who presumably use that credit to juice up their equity returns, which can increase with the success of their ventures. But the poor bond guy can only earn the coupon he has been promised and get back his principal. He has no upside. Not only that, if the value of money declines through inflation (or exchange rates) the poor bond owner actually sees the purchasing power of his money decline while he clips his coupons and waits for his capital to be returned. But if there is deflation, then he's in the catbird seat so long as it doesn't bankrupt his borrower. The bond owner clips his coupons, which keep going up in value versus everything else, and eventually he gets back his original investment, which has effectively increased by the amount that everything else has deflated over the same period. No wonder bond guys hate inflation and love unemployment. It's hard to have inflation with people being thrown out of work. With lots of workers around, who has the gumption to ask for a higher salary? For those thrown out of work, their consumption goes way down, freeing up goods for others to buy. This causes price increases to stay more contained than they otherwise would be or it might even make them decline. Makes sense to me.

This concept is embodied in an economic theory called NAIRU, which stand for Non-Accelerating Inflation Rate of Unemployment. You can read more about it here. The theory holds that there is a natural rate of unemployment that offers enough of a buffer of labor supply that the economy can grow at its full potential, without igniting an acceleration in inflation. Now the idea that increases in un-employment always have an immediate and direct impact on inflation (as calculated using the "Philips Curve") fell into dispute after the stagflation of the 1970s. But in a way this period actually caused people to rethink the NAIRU theory. It is now more often framed in terms of a relationship between employment and inflation where there is no absolute number below which one will see accelerating inflation, but rather a NAIRU that moves around over time. In an economy that has invested scads of money in labor saving industrial or computing equipment the NAIRU level declines, because productivity helps the economy produce more with more people employed, before wage growth needs to accelerate. In an economy that has strong unions, little investment in labor saving technology or capital equipment and cost of living adjustments (COLA) baked into the wage structure etc (as the US did in the 70s) the NAIRU level of unemployment is much higher. You have to throw lots of people out of work before expectations of future wage gains get squashed. This time NAIRU may have climbed for a different reason: growth in demand for commodities, outside the U.S.

So where are we now?

As you can see from the chart below, CPI is up significantly from the low of 1.069% year to year growth in June 2002, to the June figure of 4.901%. However, CPI is not really all that much higher than at the last economic peak of July 2000, when it was running 3.599%. Now we all know these numbers are junky and that the impact of price increases on our daily lives are much greater right now....but we will touch on this factor later.

Courtesy of Guild Partners

Note that unemployment bottomed at about 3.9% during the dot com boom, but never got quite that low during the housing boom. It troughed this time at 4.4% in March of 2007. In both cases the Fed got nervous about how low unemployment could go without sparking inflation (NAIRU). As is usually the case, the end of the recent boom was brought on by Fed rate hikes, which usually precipitate the upturn in unemployment, as the Fed engineers a slowdown or recession.

Courtesy of Guild Partners

The impact of rising unemployment on consumer price inflation during the dot com boom/bust cycle is quite vivid from the chart below. Now this is only one cycle, but I think you get the logic here and you can see the correlation. We don't have the July CPI number yet, so we can't see how it compares with the 5.7% unemployment just registered, which is the highest since December 2003. Please note that as Noah has described on Urban Digs before, the screwy seasonal adjustments the government makes means that recent inflation has thus far been under-reported in the headline numbers and will start to surge this summer as the funny stuff reverses. I believe that this time things will be slightly different in terms of unemployment's impact on inflation as much of the inflation we are seeing is beyond our control. For one, much of the inflation has been based on commodity price inflation, specifically energy-related commodity inflation - which now includes agricultural product inflation courtesy of the geniuses who brought you ethanol (food as fuel) subsidization. Also, the inflation pick up has been accompanied by and/or caused by a weak dollar. For this reason many feel that the inflation we are now seeing is completely out of the control of the Fed in that the higher interest rates needed to stabilize the dollar and quell inflation would send the economy into a depression.

Courtesy of Guild Partners

So let's talk about these two issues. On the commodity inflation side let's not forget the surge in metals like copper and steel as well as some construction materials like lumber that has occurred in addition to the energy spike. These commodities give us a bit of a laboratory to look at commodities that have been impacted by domestic demand and those that haven't. Check out this chart of copper (they call it Dr. Copper because it has an honorary economics degree). It is supposed to be a strong predictor of economic growth.

As you can see, copper, which is consumed all over the world and particularly in China, as they build out housing and their electrical grid, hit a peak in 2006. The big move that year was actually driven by a rogue trader in China who was caught massively short. (Note to traders: always get out/get short on the blow-off rally that results when someone else gets squeezed to death). It took copper a couple more years to make a nominal new high. It's still a bullish chart and commodity, but it really has not contributed to "inflation" for a couple of years. But it didn't fall out of bed, despite the fact that a lot of copper is used in construction of single family homes and the housing bust has trimmed US demand from this source. In contrast, take a look at lumber prices.

Lumber prices should be called US & Canadian lumber prices, as it is a largely domestic market, because it doesn't really pay to ship lumber around the world. See how lumber peaked, even before the housing market, probably just as the largest number of new homes were being framed out for sale in 2005. Now these commodities have their own supply demand stories, but they give you a feel for the fact that some can really be influenced by the US economy, while others are more global. Let's face it, the world has never been more global, so lack of US consumer demand for stuff, despite it being 30% of the total demand, doesn't automatically or immediately relieve price pressure on a global basis. However, when things get too expensive, it does kill demand. We have seen demand killing by gasoline prices for the last few months and oil prices have gotten hit pretty quickly. So while I think there will be a lag between unemployment rising in the US and a drop off in inflation, this time, I don't think the rules have been rewritten. Couple the increasing unemployment with a slowdown in foreign economies, which is causing the dollar to firm, and you can see where commodity inflation could start to fade. In order for this somewhat rosy scenario to play out, foreign economies must continue to slow, without US employment falling off a cliff by itself. This will be helped by US demand for overseas goods declining, while our exports continue to grow.

Bob Barbera is an economist whose work I used to read religiously. He has an amazing ability to point out the obvious, importantly it is usually only obvious to him because he actually does the work to scrub down economic numbers and see what they are really saying. In a recent piece that a friend forwarded me he opines "if it were not for improving net exports, U.S. output would have declined over the past three quarters. Deconstruct that contribution and you find that the big story is not booming exports - they rose at a 9% pace last quarter, equaling their growth rate over the previous two and a half years. The news is embedded in the import line. Real imports fell at an astounding 7% annualized rate. He goes on to mention that "Quite amazingly, average hourly earnings in July climbed only 3.4%, year-over-year, compared to a 4% year-on-year rise over the year ending in July of 2007. That is amazing because headline inflation rose by nearly 5% over the period. To what does the Fed owe this good fortune? Over the same period the jobless rate leapt, climbing to 5.7% from 4.7% one year back. Relax President Plosser, the leap for joblessness is keeping wages in check." Bob avers that the lack of wage inflation coupled with energy inflation is squeezing the purchasing power of U.S. households as never before.

So I find myself at least somewhat on the side of those bond market baddies playing Dr. Evil. Bring the unemployment.....just not too far or too fast and I'll be looking on happily....wearing my Nairu jacket of course.

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Commercial Sector At High Risk

A: The natural evolution of this credit cycle would be to assume a few things. One, that what started out as subprime will soon spread to near prime and prime; this is already happening. Two, that what started out in residential will soon spread to commercial; the topic of this discussion. And three, that the credit cycle is coming in waves. Looking at the CMBX indices, it appears that investor sentiment on the commercial sector and subsequent commercial mortgage backed securities, is deteriorating quickly. It appears the next wave, whenever that may be, will be related to the commercial real estate sector.

First off, all of MARKIT's CMBX spreads have widened dramatically in the past 6 weeks. Take a look at the CMBX-NA-AAA index for a basic idea of the widening spreads (NOTE: A rising line graph is negative and is a sign of deteriorating investor sentiment for commercial mortgage backed securities):

Up is down. Click the link above and you can check in on all the classes of CMBX indexes that Markit offers; lower quality indexes show an even more dramatic deterioration. This is one reason why Lehman Brother's health is being questioned; as they have significant exposure to commercial real estate, mainly the buyout of Archstone-Smith for $22.2 Bln, near the peak of the housing boom.

CORRECTION (Aug 6th @ 11:42AM): Archstone Smith is residential firm. It was NOT this purchase that gave LEH their commercial exposure. LEH does have commercial exposure, but not from this transaction. This was simply an ill-timed transaction that contributed to the company's overall exposure to the housing market.

Calculated Risk pointed out 7 weeks ago:

This deal was announced in May 2007, but wasn't closed until October - after the credit crisis started. I bet Lehman and their partners wish they had paid the $1.5 billion break up fee! The Archstone-Smith acquisition was a negative cash flow deal from the start. To cover the interest on the $16 billion in debt financing, there was a $500 million interest reserve created.

This suggests that Archstone is burning through the interest reserve very quickly. Not mentioned in the WSJ article was that Fannie Mae and Freddie Mac acquired a total of $9 billion of the $16 billion in debt. Something to remember if this deal really goes south.

The problem here is very similar to when the Markit ABX indices started to shit the bed exactly one year ago! Last July, most people didn't have a clue of the severity of problems those cliff-diving ABX indexes were trying to tell us! Here, I'll remind you; In my July 2007 post, "Macro Check: Rates Holding" I stated:

While it's not making the major headlines as it did a weeks ago, the subprime mess that led to a disruption in the MBS (mortgage backed securities) markets is not going away. This is leading to a level of uncertainty that the tradable markets hate most! It is leading to a rise in safe haven plays, like gold and other commodites, and is still yet to reveal itself on just how bad the problem is.

Barry Ritholtz over at The Big Picture has a great post on this topic titled, "WTF is going on in the ABX markets":

"Its one thing when we see that the BBB bonds -- the junkiest sub-prime crap in the Residential Mortgage Backed Securities (RMBS) universe -- getting shellacked due to foreclosures."

"But today, we see that the AA and even the AAA are getting whacked. It looks like either a fund is getting liquidated across all asset qualities -- or someone is panicking."

The ABX index measures the risk of owning bonds backed by home-loans to people with poor credit. Just take a look at some of the charts he posts to get an idea of the sharp moves in these markets. Crazy.

Now the CMBX indexes are starting to really go off. If recent history is any guide, we will start to see big time rising defaults in the commercial sector. CR is all over this dynamic with 483 mentions to the coming CRE Bust which he states is now here! I have to give credit where its due.

Looking ahead, FinancialWeek had an article last month about the I-Banks exposures to deteriorating commercial mortgage backed securities and guess the two firms that topped the list? BEAR STEARNS & LEHMAN BROTHERS! According to the story:

According to Fitch data, Lehman had $36 billion in commercial mortgage-backed securities in trading assets and commercial real estate loans held for sale, or 140% of tangible capital, as of the end of 2007. That was about equal to Bear Stearns' exposure of 143%, but once again much higher than Morgan Stanley's 44%, Goldman Sachs' 55% or Merrill Lynch's 80%.

Here too, Lehman has reduced its exposure to less than $30 billion, but the stress in the commercial real estate market is only beginning, and more is clearly on the way.

As you can see via the above-right chart, Lehman is right up there in the exposure to commercial real estate. The stock price (NYSE: LEH), currently down 6.75%, seems to show the 'no tolerance' trader mentality to over-exposed I-banks in this current environment. The bad news is, this has to happen as the cycle continues! The good news is, this has to happen for the cycle to end!

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Jobless Claims Surge: EUC Program is Blamed

A: Sorry for the lack of content lately, I'm just burnt out and trying to take some time off. Anyway, I wanted to just discuss today's data for a moment. First off, GDP came in below expectations but it was the negative revisions to 4Q 2007 that grabbed the headline. This could mean that the recession started at the end of 2007, but we won't get any official declaration until we are either nearing the end of the slowdown or out of it. More importantly, was the surge in jobless claims. There was an anomaly at work here called the Emergency Unemployment Compensation (EUC) program, so I want to just discuss this briefly so we can keep things real.

Now, readers of UD know of my beliefs in flawed government statistics. I mean, between the birth/death adjustment, the use of core instead of headline, and the seasonal component it is very hard to get a grip on what is really going on out there.

But when a headline shows a surge of 44,000 jobless claims to 448,000, we should read the fine print a bit. This time around, the Emergency Unemployment Compensation (EUC) program is being blamed for the surge (below via CTDOL.state.ct.us).

Q: What is the federal Emergency Unemployment Compensation (EUC) Program (also known as the Extended Benefits Program)?
A: EUC is a federally-funded program which provides up to 13 weeks of extended unemployment insurance benefits in all states to unemployed individuals who have already collected all regular state benefits or have expired benefit claims and meet the federal eligibility guidelines.

Q: When does the Emergency Unemployment Compensation program begin and end?
A: The program began July 6, 2008 and expires on March 31, 2009.

According to Reuters:

The number of first-time claims filed in the week ending July 26 rose by 44,000 to 448,000, the highest level since April 2003.

The Labor Department said much of this increase is due to an indirect response to the 2008 Emergency Unemployment Compensation (EUC) program. The federally-backed extension provides additional unemployment benefits for up to 13 weeks for people who have already exhausted their regular unemployment benefits.

Labor said that many people contacted about the program actually qualified for regular unemployment insurance instead of the extension under the EUC program, since they had since worked enough to qualify for a regular claim. As a result, initial weekly claims rose.

'It is expected that claims will be higher than anticipated for several weeks as a result of this effect, but should decrease as the states work through the pool of claimants from the 'reachback' period of EUC,' Labor said.

From my other sources (which will remain anonymous), I get this section of a report regarding the EUC program's affect on jobless claims:

Several states have indicated that they are experiencing increases in initial claims as an indirect result of the EUC program. this is because a number of individuals who had exhausted benefits previously (as early as 2006) and were notified of their potential eligibility for EUC qualified instead for a new regular UI claims.

States were required to notify individuals who had previously exhausted their UI benefits that they might be eligible for EUC. Before an individual can qualify for EUC, the state must verify that s/he is not eligible for regular UI benefits. Some claimants who worked temporarily or part-time following establishment of their previous claim might have earned enough to qualify for a new regular UI claim. in that case, they must be placed into the regular UI program (with a new benefit year) as opposed to EUC. These claims would be correctly reported as new initial claims in the regular program.

This should help explain the surge, and explain why the next few reports are likely to be a bit artificially high as well. However, the number of people continuing to receive unemployment insurance is up 185,000; so that is certainly a weak spot. Continuing claims for the week totaled 3.282M, the highest since DEC of 2003.

All in all, we continue to see a weak jobs market and negative revisions to GDP. No matter how you slice it, we are in a slowdown. Call it what you want, things are just soft. Given the phenomenon of credit deflation, housing pressure, weak jobs market, and pesky commodity prices, the consumer will continue to be pressured. The story continues.

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Deleverage Chapter 5: Price Discovery Continues

A: And the story goes on. Fresh back from the real estate conference, I come back to more deleveraging and more capital raising, which leads to ding ding ding ding ding...you guessed it ---> more price discovery! And you are the winner of a brand new WRITE-DOWN!!!

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.

Okay, Noah, get out of the first person.

Here is the news out of Bloomberg's, "Merrill Has $5.7 Billion of Writedowns, Sells Shares", which probably explains why the stock was down some 11% BEFORE the news was announced, (you shady shady marketplace, you):

Merrill Lynch & Co. said it will record $5.7 billion of pretax writedowns in the third quarter because of additional losses on the sale of collateralized debt obligations and hedging contracts with bond-insurers including XL Capital Assurance.

The New York-based firm said today in a statement that it plans to raise $8.5 billion by selling shares in a public offering. Thain has had to raise capital to stave off credit- ratings downgrades and satisfy regulators that the firm can withstand losses.

Calculated Risk wisely adds on:

Here is the info on the CDO sale: On July 28, 2008, Merrill Lynch agreed to sell $30.6 billion gross notional amount of U.S. super senior ABS CDOs to an affiliate of Lone Star Funds for a purchase price of $6.7 billion. At the end of the second quarter of 2008, these CDOs were carried at $11.1 billion, and in connection with this sale Merrill Lynch will record a write-down of $4.4 billion pre-tax in the third quarter of 2008.

Merrill Lynch will provide financing to the purchaser for approximately 75% of the purchase price

So, lets do the math:

VALUED AT $11.1 Bln and SOLD for $6.7Bln = a 40% markdown

Did I interpret this correctly? Please feel free to correct me if I'm wrong. As these 'super senior ABS CDOs' start forcibly trading, it will result in price discovery of a marketplace that is very illiquid at the moment, and give insight into the latest valuations placed on these hard to sell assets! And, MER will finance 75% of the purchase price? So, lets see here, lend to the buyer of your own distressed asset? Oh yea, I like this.

Expect more deleveraging, write-downs, and unwinding in our near future. The cycle continues, and this is NOT news. As prices are discovered, bad marks will spread to outside held illiquid holdings. Anyone shocked by this news, is behind the curve. The story will continue. The good news? This has to happen to get past it.

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Inman BULL vs BEAR Debate

A: As usual, the Inman Real Estate Connect conference was lively, entertaining, educational, and filled with young entrepreneurs showing off their advancing applications. It was great to see old friends again, and a pleasure to speak on the 2nd Bull vs Bear debate. I don't have video of the debate, yet, so I'll try to muster up some damaged brain cells (thank you Red Bull & Grey Goose for that) and point out some of the topics discussed. Overall, it was still biased towards the bearish side, however, not as bearish as January's panel. In other words, less bearish with glimpses of hope seem to pop up.

John Williams - Definitely the most bearish on the panel, discussed the concept of dollar destruction and hyper inflation. His serious tone clearly was interpreted by me that he is a true believer in government bent statistics on inflation and unemployment, and that the worst is yet to come. If the US dollar really does go to 'zero', and hyper inflation sets in, we may be in store for Zimbabwe style currency notes.

I disagree with the total dollar destruction and hyper inflation, mainly because I do not see wage inflation and rather, we are experiencing the side effects of commodity inflation (food & energy inflation) that arises when a central banks' primary focus is on reviving economic growth at the mercy of the local currency. The best medicine for high commodity prices IS high commodity prices that cause demand destruction and eventually a speculative trading reversal. In my humble opinion and as I stated many months ago, our dollar will get a boost as foreign CB's are forced to eventually lower rates to combat their own slowdowns right at the time our CB will shift their rate actions towards inflation fighting.

Yves Smith - Bearish, yet a realist. We have debt problems, trade deficit issues, state budget issues, etc., and Yves takes all this into account. The current account deficit seemed to be her main concern as fears arise that foreigners may slow down purchases of our debt, sending treasury yields surging. This is definitely a possibility although we need to see the AAA credit worthiness of our government be called into question, and further dollar erosion for this to become more likely. I don't remember the other topics Yves talked about, so I need to get the video of the debate to refresh my memory.

Bill from Calculated Risk - Fantastic on the panel and very down to earth. While he is putting the bottom of the housing downturn around 2010 - 2011, and recovery a few years later, he openly admitted his 'less bearish' stance on housing. In his words, "...there is a time element here. If you asked me in 2005 how bearish I was, I would have said much more bearish than I am today". Clearly Bill feels that we have experienced a good portion of the pain thus far, but likely to feel a bit more before its over. The contrarian in him seemed to come out as I got a sense that he is of the mindset that deals are to be had in the coming year or so, and investors' money is already being put to work buying distressed/foreclosed properties that are finally now CASH FLOW POSITIVE!

That is a very important element to clearing up inventory levels; a dynamic that must happen if we are to see a bottom. The following days existing home sales report confirmed what Bill mentioned, as it was revealed that a staggering 30% of all existing home sales were foreclosure purchases. Clearly, investors are finding value in homes priced at 40-50 cents on the dollar! I would be too!

Think about it this way, to pick the exact bottom you MUST buy while the asset is down & out, distressed, and the seller's fear/nervousness is still high. Only in hindsight will we see the bottom, which according to some law of physics, will mean you missed it!

Avram Goldman - This CEO of 12+ PAC Union GMAC realty offices was definitely the most bullish of the bunch. He is looking ahead to brighter times and seemed to believe that his markets have already bottomed, are seeing a reduction in inventory levels, and a pickup in sales volume. Certainly comforting statements.

I did question his rear-view mirror approach though about mid way through the panel, saying something to the extent that we still have a contracting credit system and rising unemployment that will put future pressure on housing affordability; thus we need to look ahead rather than behind us. I don't recall his response or if the moderator changed topics right after that. All in all, I thought Avram was a great addition to the panel and brought a more realtor/front line perspective to a heavily weighted economics led panel base.

Dottie Herman - I got the impression that Dottie was a bit more bearish than she was last January, but in true fashion, the most composed of the bunch in terms of the worst being behind us. She did discuss the problem of credit, but addressed the pass down of wealth from parents and grandparents as a saving grace to contracting loan availability and tighter lending standards that we are dealing with now.

I sense that Dottie sees some issues still on the horizon, but that with problems comes opportunity.

Noah Rosenblatt - Yours truly. I tried to spice it up a bit and fight with my fellow panelists to get a lively debate going. I recall questioning with Avram on looking ahead rather than behind us at lagging statistics, and I disagreed with John Williams hyper inflation statement. Yes, I see inflation out there, but it's commodity inflation coming at the same time as wage and credit DEFLATION! The amount of credit destruction is astonishing and the shadow banking system has seen hundreds of billions of dollars destroyed by deflating toxic assets, that are consistently being written down to lower values.

I mostly discussed the issues I see ahead of us as a crisis of confidence in our banking system and GSE's (a mention to the potential problem of raising money could be devastating), continued pressure on jobs, the credit markets, and wages; all which affect affordability of a home purchase. Combine that with surging commodity prices, and the consumer is tapped out. I just think that these forces will take longer to play out, thats all.

My one bright spot, was the possibility of rising sales volume resulting in a stabilization or even reduction of inventory levels in our near future (a must for any recovery in housing), as potentially easing the credit markets! This didn't happen yet, but certainly is a possibility as house prices fall further and investors' eyes for cash flow positive properties light up. I agree fully with Bill on that dynamic.

But all in all, I think we still have pipeline pressure in housing reports amidst rising defaults and foreclosures. We still need to get these distressed transactions through the system and into the reports, which means we have more downside pressure to go through. As the cycle continues, I get more excited and less bearish.

I put my expectations on a mid-late 2009 bottom (not proven until 2010) and the potential beginning of a recovery in house prices on a national level to 2011. However, the recovery will not be a new bubble as over-regulation kicks in and housing as an asset class in general is looked upon quite differently.

Hopefully the video will be made available soon, so we can see the depth of the topics I discussed here. For now, this is what I remember. I thought the panel was great, although it went on some doomsday tangents a few times in terms of our deficit and our weak currency.

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Did You Know...?

A: Heading to Inman Conference in SF tomorrow, so I will not be blogging for the next 4 days. For today, as I go over my bullet points for the BULL vs BEAR debate, I figured to post a 'Did You Know' article that goes over some of the things that most people probably didn't know. Enjoy and as always, your two cents and any corrections are appreciated.

1) $450,000,000,000 - The approximate amount of write-downs to date from the financial sector stemming from the subprime crisis and housing market downturn

2) $325,000,000,000 - The approximate amount of capital raising to date in the financial sector

3) $9,500,000,000,000 - The approximate amount of the National Debt (source)

4) $5,600,000,000,000 - The approximate amount of total residential loans that Fannie Mae & Freddie Mac either own or guarantee (source)

5) $900,000,000,000 - The approximate value of the Fed's portfolio

6) $450,000,000,000 - The approximate amount that the Fed used of its total portfolio to help ease distress in the credit markets

7) $985,000,000,000 - The approximate amount of US agency debt held by foreigners; mainly China, Russia, and the oil countries (source)

8) $230,000,000,000 - The approximate amount of Fannie & Freddie debt purchased by foreigners in the past year

9) $710,000,000,000 - The approximate amount of the global US current account deficit last year; or 5% of US GDP (source)

10) $1,000,000,000,000 - The approximate amount of foreign money the US must import each year to support the current account deficit

11) $14,300,000,000,000 - US GDP (source)

12) $411,000,000,000 - The increase in the amount of foreign-owned assets here in the US, in the 1Q of 2008 alone, following an increase of $380.4 Bln in the fourth quarter (source)

13) Between $1,000,000,000,000 - $2,000,000,000,000 - The implied total credit losses predicted by Professor Nouriel Roubini (source)

14) $1,300,000,000,000 - The entire capital of the US financial system; as stated by Professor Nouriel Roubini (source)

15) $53,000,000,000 - The approximate total amount of funds held by the FDIC (source)

Needless to say, the topic of foreigners continuing to purchase our debt is becoming a media favorite! Feel free to offer your thoughts, opinions, corrections, updates, additional sources, or anything else to get a better hold on some of the astronomical numbers we are talking about here!

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2008 Word of the Year: CRECESSION?

A: How great would it be to coin a new term for how I would describe this period of economic activity: CRECESSION! Its not a recession (yet), its not a depression, its not stagflation (as long as wages aren't rising we have commodity inflation, not wage inflation or a growth in the money supply), its CREDIT DEFLATION that will lead to a credit based recession! A crecession - here's my first draft at a possible definition!

Cre - cess - ion [cre-session]
- noun

a period of economic activity where available credit is contracting and the cost of credit is rising, leading to a disruption in the credit markets and difficulties for businesses that borrow short and lend long. The result will likely be a period of asset deflation leading to a lack of growth, rising unemployment, and rising commodity inflation due to pressure on the dollar

{Origin: 2008; by UrbanDigs}

Now, who do I call to coin this term; given that the definition probably needs refining? Seriously though, we are a society that thrives on credit and right now it is the very platform of credit that is being tested. The destruction of credit out there in the shadow banking system is enormous right now, and we still don't know how deep the rabbit hole goes. Things will change and the world as we used to know it is likely to be very different in the next few years. We will soon find out what its like to have lived through a crecession!

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Don't Look Now: Financials Leading The Rally

A: Oh what a difference a few days make! On Monday, with the Dow closing under 10,000 and what seemed like 6-7 weeks of constant selling, everyone I know in the hedge fund world and the credit world started to get a bit nervous! The VIX fear index rose to above 30, representing a great buying opportunity for those that are willing to take the risk and buy when most smaller investors are 'throwing in the towel'. I discussed the trading theory tied to the VIX seven days ago, as it reached the level where I normally would cover my shorts and start to get long beaten down equities. It is comforting to see the rally in the banks, as earnings estimates were taken down too low and stocks in big cap financials are seeing a short squeeze & value investors buying in on better than expected earnings reports. Will it last? Unlikely, unless housing turns around, defaults stop spreading to higher quality debt classes, and toxic assets get a bid and trade again at more favorable valuations; and I just don't see this happening.

Disclosure: This is a discussion, not investment advice! Readers of this site have learned that content I write sometimes has a trader feel to it; because that is what I am and that is how I view the markets. I am currently fully long equities and disclosed to you guys a week ago that I covered my shorts and started to get long about 2-3 weeks ago; building up the long position as stocks continued to fall. Turns out I covered shorts about 10 days early and should have waited for the VIX to hit 28 to start to flip the position.

Now that the disclosure is out of the way, I feel like I can openly talk about what I see going on here. I see another fierce bear market rally, as the financials lead the way. It is SO IMPORTANT that it be the banks and financials that lead the way in any rally; and it seems like they are doing so right now. However, and its a big however, I urge you to understand that this is a trading market right now, and in no way, shape or form has the dreary fundamentals changed in the past two days.

Why am I long? Because its a trade, thats why. I don't intend to hold these positions for that long, and my focus is still on the short side and when the next entry point for that play may be. The reason for this logic is that the forces that are taking control of the credit markets continue to be negative: housing is still under pressure, defaults are rising, foreclosures are rising, defaults are spreading to higher quality debt classes and fast, the jobs market is very weak, the securitization model on wall street is all but dead, more write downs of toxic assets as price discovery reveals most recent valuations, capital raising will continue and get harder at the same time, deleveraging continues, credit deflation, commodity inflation, etc..

None of this has changed, and we did get some confirmation of this in the past few days or so:

1. MERRILL is forced to sell core businesses to raise capital
2. MERRILL write down far exceeds estimates and gets a lowered credit rating
3. JP MORGAN CHASE admits that defaults in PRIME are rising fast
4. FANNIE & FREDDIE still in trouble and will have to raise capital; FREDDIE leaning towards stock sale
5. HOUSING STARTS continue to fall
6. HELOC credit lines are being cut off, as defaults are rising
7. BUILDER CONFIDENCE continues to decline

So, we really need to look at what is going on with an open mind; credit/housing deflation. We did get some good earnings reports from Wells, JP Morgan & Citibank; but this came on the verge of lowered estimates and beaten down stock prices. And the drop in the price of oil is helping too. But when I see the CEO of JP Morgan come out and say (via HousingWire.com),

"Our expectation is for the economic environment to continue to be weak – and to likely get weaker – and for the capital markets to remain under stress," CEO Dimon said in a press statement.

In a surprisingly short conference call with analysts, Dimon suggested that losses in JP Morgan’s prime mortgage book could triple in the foreseeable future as the credit mess moves out of subprime and into Alt-A and jumbo loans. "Prime looks terrible," he told analysts on the call. "And we’re sorry, and there’s nothing else we can say."

...I take notice. Take a look at this chart showing the rise of delinquency trends for JP Morgans Prime Mortgage portfolio, via HousingWire.com:

Nothing goes in a straight line forever, and this rally is likely nothing more then an oversold bounce in a bear market. I think it will surprise most how long this rally lasts, if the financials continue to squeeze the shorts and drive higher. But it does not change the overall macro picture and I urge you to be wary of the false hope that a significant stock rally may produce.

The monoline problem is behind us and it seems most of the residual write downs from that event have been taken. So we must look forward again and now it is all about one thing: the spread of defaults to higher quality debt classes!

I have discussed this at length plenty in the past 12 months, and I'm afraid the next 12 months will show just how deep the problem has spread to. The amount of leveraged loans and debt out there in the near prime & prime category far exceeds those in the subprime arena. So, we must question the value of securitized assets held on the books of the financials should the problems spread to these higher quality debt classes.

In the end, we need housing to show signs of stabilizing and defaults to stop spreading to higher quality debt classes before we can declare ourselves in the clear. Problem areas seem to be HELOC's, option ARMS, credit cards, cosi/cofi loans, other negative amortizing loans, auto loans, etc..

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