Tuesday, September 1, 2009

Multi Topic Links for Tuesday

Krugman longs for the days of Richard Nixon: No, Paul Krugman does not wish that Richard Nixon was actually in power again. However, what he does miss are the days when the relationship between the Democrats and Republicans was not so polarized that it was impossible to reach across the aisle and pass bi-partisan reforms. He also thinks it would be nice if we could go back to a time when large corporations did not have so much influence over policies:

We tend to think of the way things are now, with a huge army of lobbyists permanently camped in the corridors of power, with corporations prepared to unleash misleading ads and organize fake grass-roots protests against any legislation that threatens their bottom line, as the way it always was. But our corporate-cash-dominated system is a relatively recent creation, dating mainly from the late 1970s.

And now that this system exists, reform of any kind has become extremely difficult. That’s especially true for health care, where growing spending has made the vested interests far more powerful than they were in Nixon’s day. The health insurance industry, in particular, saw its premiums go from 1.5 percent of G.D.P. in 1970 to 5.5 percent in 2007, so that a once minor player has become a political behemoth, one that is currently spending $1.4 million a day lobbying Congress.

I believe the problem is that we need a lot of reforms and the current animosity between the parties suggests that nothing will get done unless it is forced. The financial crisis has shown the need for more prudential and thoughtful regulations. It is also clear that without the proper steps taken now the problems surrounding health care, climate change and Social Security may lead to unmitigated disasters. I’m not advocating any specific policies or reforms. This is not about pushing my personal political agenda. I just think it is unambiguous that a lot of government run and sponsored programs, regulations and initiatives are not working. But if the Republicans plan to fight every Democratic proposal tooth and nail and the Democrats automatically squash any Republican-sponsored legislation, then all we will end up with is a law making body that is completely ineffective (may be too late). When that is combined with Obama’s willingness to let Congress initiate all the needed reforms, it does not look like there is much hope for passing legislation that will serve to minimize the consequences of further crises or that will help the US out of the current economic and fiscal death spiral.


Admitting the inevitable: In this very sober article in the Telegraph, Ambrose Evans-Pritchard makes the argument that despite the rally in global stock markets, the worldwide recession is not necessarily over, a sentiment echoed by statements coming out of the IMF and Bank of International Settlements. These institutions are sounding the alarm regarding developing countries nearing the end of their ability to implement stimulus without causing lasting damage. But I would ask what the incessant stimulus has even really accomplished:

All that has happened over this crisis is that huge private losses have been dumped on society: but the losses are still there, smothering the economy. Taxes must rise. Debts must slowly be purged. "As long as economic growth relies on the state, you cannot talk about durable recovery," said European Central Bank member, Yves Mersch.

Nobel Laureate Paul Krugman said the US needs another fiscal blast for "political reasons", alluding to the Great Depression. It was Phase II from late 1931 to early 1933 that tipped half Europe into fascism and brought America soup kitchens. Although such a fate has been averted this time by government action, the Atlanta Fed says the true rate of US unemployment is already 16pc (not 9.4pc), worse than early 1931 levels. Official youth unemployment is 34pc in Spain, 28pc in Latvia, 25pc in Italy, 24pc in Sweden, Hungary, and Greece.

I have some sympathy with the Krugman view, but entirely disagree over methods. The key is to prevent a debt deflation trap – note that producer prices have fallen 8.5pc in Japan, 7.8pc in Germany, and 6.8pc in the US.

Specifically, all the US has done is tried to paper over losses and re-flate the bubble. We have thus avoided the necessary pain that comes with the clearing of excesses from the system. As a result, in the author’s view, the impact of the inevitable shift towards individual balance sheet repair may be felt for many years and be an impediment to future prosperity.


Surprise, surprise- the Cash for Clunkers program was a terrible way to allocate stimulus dollars: There has been plenty written about the problems with the Cash for Clunkers initiative. First, pulling forward demand for autos to temporarily boost sales and GDP is not a lasting solution to the woes of the automakers or the country. Second, the people who took advantage of this subsidy now have a car payment that they did not previously have, a fact that could limit spending in other areas or cause more stress on peoples’ already over-levered balance sheets. Finally, it appears that while it may have been good for the environment to get those gas guzzlers off the road, it was a terribly expensive way to do so:

Assuming the clunkers would have been driven four more years, the $4,200 average rebate removed 11.2 tons of carbon from the atmosphere, at a cost of some $375 per ton. If they would have been driven five years, the carbon savings cost $300 per ton. And if drivers drive their sleek new wheels more than they drove their old clunkers, the cost of removing carbon from the atmosphere will be even higher.

To put this in perspective, an allowance to emit a ton of CO2 costs about $20 on the European Climate Exchange. The Congressional Budget Office estimated that a ton of carbon would be valued at $28 under the cap-and-trade program in the clean energy bill passed by the House in June.

Even under optimistic assumptions, the carbon savings comes out to $300/ton versus the $20-$28 per ton as estimated by the European Climate Exchange and the CBO. So, when you combine the first two items mentioned above with the data regarding the cost per ton, the entire program is clearly not a winner when it comes to efficiency or efficacy. Hey, at least people have shiny brand new (mostly foreign) cars.


Euphoria regarding widespread earnings beats seems misplaced: Hat tip to The Pragmatic Capitalist for posting this commentary from David Rosenberg. The following data shows that even with earnings estimates falling throughout the first half of the year and many companies engaging in massive cost cutting, bottom line boosting initiatives, it still looks as through S&P earnings have fallen short of even June 2009 estimates.

When we look at our databases, we see that S&P 500 operating EPS for 2Q is now estimated to have come in around $13.94. Meanwhile, at the end of the second quarter, the consensus was sitting at $14.15; at the end of March, consensus estimates were at $14.84 and at the end of 2008, they were $19.92. So, where exactly was this “beat” in terms of earnings versus estimates? The second quarter came in 30% below what was being “projected” by Wall Street analysts at the end of 2008!

The third quarter has been cut already so many times that the hurdle is now $14.57. At the end of June, it was $15.05, on March 30, it was $16.68, and at the end of 2008, the third quarter estimate for this year was $21.11. So let’s get this straight — the S&P 500 has managed to advance 13% this year even though current quarter operating EPS has been pulled down by nearly 30% (and 45% since the end of September 2008). That would make Houdini blush. The year-over-year EPS growth expectation for 3Q swung from +32.3% at the end of 2008 to +4.5% on March 2009, to -5.7% at the end of June, to -8.7% currently. And the market is up 50% from where it was in March even though we had seen a 13 percentage point swing to the downside.

The lesson? Don’t get fooled into believing that the market is cheap because some big name companies beat operating earnings estimates. In fact, if you annualize the Q2 data of about $14, you get $56 in operating earnings for the S&P. This implies a not so cheap 17.8x P/E multiple despite the fact that the prospects for a rapid and strong recovery are incredibly shaky.


What’s the real deal with foreclosures? Hat tip to Zero Hedge for posting this link from CNBC. A lot of conspiracy theorists have been alleging that the big money center banks have been hiding foreclosures and the associated losses by either moving very slowly through the process or just outright not initiating foreclosure proceedings. This article asserts that these claims are largely inaccurate (as does a spokesperson from Bank of America) but does add that foreclosures are still a huge problem. Check out the chart below and the associated commentary:

Then I spoke with Ted Jadlos of LPS Applied Analytics. He says there is no clear evidence of purposeful accumulation by the banks of these foreclosed properties. They are, he believes, working through the huge onslaught of new defaults as fast as possible, but it takes time. He says they are selling REOs at a fast clip as well, within about three months of taking them as REO.

Then he offered the following very detailed chart of what's called "roll rates" or the rate at which troubled loans are moving through the system. Note the "average" is a four year average, and two of those years were the worst ever in the mortgage market, so as Jadlos notes: Just getting to the average isn’t saying all that much. We need to be close to the four year low to be fully entrenched in a meaningful recovery. Based upon foreclosure and REO timelines, it’s going to take at least 18 months to flush the system of our current problems. But to flush the problems in only 18 months, more problem loans need to leave the system relative to the new problem loans of today and tomorrow. That does not appear to be the case right now—we aren’t clearing faster than new problems are emerging.

The data to pay special attention to are the green (most recent 4 month average) and light blue (average) bars. These show the current magnitude of the roll rates as well as the average severity over the past four months. While it is a good thing that the light blue bars are lower than the green bars, the overall propensity for loans to continue to the next delinquency step without being cured or becoming current is startling. This seems to confirm the recently released data that suggests that prime loan cure rates have fallen to 6%. People are falling behind and are not able to get back up from a knockout punch. But yes, housing has clearly bottomed even though distressed sales make up 31% of total sales. If you don’t think there is a ton of inventory from foreclosures coming online, I have a house in Stockton, CA to sell you that I promise will double in value in 2 years.


Hussman makes the case that this recession is different: Expanding on a common theme of his, in this week’s missive John Hussman argues that stocks are not expensive if you assume that we are in the middle of a run of the mill post WWII recession. However, if this recession is more like those that have come after major asset bubble implosions and financial crises, then stocks are unequivocally not cheap:

The present situation is clearly and profoundly different from any post-war period, and was already preceded by weak intrinsic demand. The Treasury has run a deficit in excess of 7% of GDP year-to-date to maintain a still-negative growth in overall GDP. The economic expansion we've enjoyed since 2002 has been peculiar in its dependence on debt finance. The same basic story holds if one includes mortgage equity withdrawals and other forms of debt expansion. This will not be an easy situation to solve with an increasing number of homes now “underwater” relative to their outstanding mortgages, and with job losses continuing (above expectations at 570,000 last week).

What I really like about Hussman is that he positions his fund to benefit even if he is wrong about the state of the economy and the valuation of stocks. Usually hedging is associated with protecting against the downside. But Hussman has what he calls an anti-hedge on to protect him against the upside. This is a very sober-minded and pragmatic way to approach what are undoubtedly very difficult markets to navigate. It is also a good way not to get blinded by either the bull or bear case.

That's not to say that I will be correct in this instance, but our objective is to outperform our benchmarks (the S&P 500 in the case of the Strategic Growth Fund) over the complete market cycle, with a strong concern for defending capital. I believe that this objective is best served – at present – by continued skepticism that our economic difficulties have now been resolved. My view is not that the market will necessarily plunge or crash – only that the market returns that we presently expect are not substantial enough, relative to the risks involved, to accept more than call option-based exposure to market fluctuations. As always, we will continue to focus on disciplined stock selection underlying our hedged position.


Commercial real estate data you have likely never seen: I found this commentary from Contrary Investor on Zero Hedge. This is an absolute must read for anyone interested in commercial real estate (CRE). It is a discussion of the coming CRE crisis within the context of the lengths that the banks are going to in order to avoid taking losses on CRE loans and CMBS. The author also discusses the magnitude of the recent decline in CRE value as highlighted by a seemingly unbiased property index:

The NCREIF Property Index is a quarterly time series composite total rate of return measure of investment performance of a very large pool of individual commercial real estate properties acquired in the private market for investment purposes only. All properties in the NPI have been acquired, at least in part, on behalf of tax-exempt institutional investors - the great majority being pension funds. As such, all properties are held in a fiduciary environment. NCREIF requires that properties included in the NPI be valued at least quarterly, either internally or externally, using standard commercial real estate appraisal methodology. Each property must be independently appraised a minimum of once every three years. Because the NPI is a measure of private market real estate performance, the capital value component of return is predominately the product of property appraisals. As such, the NPI is often referred to as an "appraisal based index." At the moment there are roughly 6000 individual properties in the index whose value approaches $300 billion…

Although we do not detail the quantitative numbers in the chart, over the last four quarters (3Q 2008-2Q 2009) the index has recorded a 22.5% contraction in value. And just what does this infer about bank holdings of CRE loan paper? Thanks to the current Administration’s financial sector “don’t ask, don’t tell” policy for bank assets, we’re not going to really know any time soon. Good thing the US banks can simply move forward reporting record earnings and ignore the current inconvenient truth of declining CRE values, no?

And to be totally honest, value declines in the third quarter of last year for all property types were less than 1%. Meaning that 95% of the price damage you see in the table above has occurred since September month end of last year to the present. (Emphasis mine)

Yikes. Those declines look unprecedented, both in terms of severity and speed. Sure, maybe values will recover and cap rates will drop again if the Fed actually succeeds in creating another asset bubble. In that case the CRE loans that are coming due over the next few years will get rolled over or refinanced and everything will be just fine. But, assuming that perfect scenario does not come to pass, the very real truth is that banks and investors who hold whole loans or MBS could be in for severe losses. Plus, don’t forget the real estate companies like Tishman Speyer that bought properties at the peak, financed them based on wildly optimistic projections about rent increases, and now are going to be foreclosed upon. If you don’t think this dynamic is going to have negative impact on the financial system as a whole, I suggest you start investigating how to get all the below market units in Stuy Town up to market rent.


(Picture of Nixon courtesy of Businessweek.com)