PJSC Commentaries

Daily Bankruptcy Review (DBR): The Emperor’s New Clothes: Current Edition

Mon, 05 Mar 2012 15:21:00 GMT

by Anders Maxwell

Capital markets are hitting new highs. As distressed investors reflect on the underlying crosscurrents, a major puzzlement is the contrast between the rosy outlook implied by rising indices and a harsh reality on the ground. In a similar market rally propelled by hype a decade ago (in that case, a ‘dot.com’ revolution), Peter Bernstein, the respected investor and market commentator, reflected on Hans Christian Andersen’s classic tale, The Emperor’s New Clothes, as an allegory to understanding the risks of an inevitable reversal in such markets. Just as Andersen’s tale of a conspiracy of falsehoods woven and maintained by influential, knowledgeable and respected authorities undone in an instant by a child dispelling the myth that the king wore any garments, so markets are eventually disabused of outlandish assumptions relied on to justify unsustainable prices.

Humorously suited to the analogy of a naked emperor parading in public, the S&P 500 has risen 7 percent since January 1, approaching a post-crash high. Still more impressive in light of the continued malaise in Housing prices and level of mortgage delinquencies, the S&P Homebuilder Index is actually up 15 percent. Not to be outdone, the Dow Industrial Average is approaching a four year high. Turning to credit markets, US Treasuries are at record lows across the yield curve. As a result, US corporate bond performance has actually outpaced Equities with high grade spreads ranging around 180 basis points and yields declining from over 5 percent to 3.8 percent over the past year. Notable given the inherent risk, since the first of the year, junk bonds as reflected in Moody’s Single-B Bond index have declined in yield from 8.4 percent to 7.4 percent, representing a 7 percent gain in price.

Judged by these headline figures, US capital markets have had a stellar start to 2012. But akin to the hoped for gains from the unscrupulous weavers’ clever ruse of a precious garment visible only to the virtuous and intelligent, markets are reaching new highs while economies treads water, facing tremendous uncertainty. Challenging the market’s premise of improving business, the global economy is now forecasted by the World Bank (“Global Economic Prospects”, January 2012) to expand more slowly than projected as recently as 8 months ago and in an environment the Bank describes as “characterized by significant downside risks and fragility”. In the US, personal consumption and corporate investment remain weak, as households continue to repay debt and companies build cash positions. Housing activity, the single most significant element depressing recovery, remains under pressure due to price erosion which is likely to persist given record delinquency levels.

The divergence between market perception and reality is explained by a latter day version of the weavers’ imaginary robe, US monetary policy. Effectuated by an ‘influential, knowledgeable, and respected authority’, the Federal Reserve, this policy is being emulated by central bankers in Europe, as well as Japan. Just as the weavers’ clothing for the king, this purported financial elixir has generally drawn approbation, flatteringly referred to as “Quantitative Easing” (QE), or “zero-based money”. Unprecedented in scale, QE is ballooning the Fed’s balance sheet. An unambiguous signal of the depth of concern by policymakers, interest free money poses systemic risks from the misallocation of capital and an eventual unwind of the Fed’s position. Rather than a cure all, QE places huge burdens on the economy. The resulting compression of interest rates distorts investment and consumption, generally encourages borrowing and over leverage, impairs the value of fixed income securities putting pressure on savings and underfunded pension liabilities, and shifts capital to higher yielding and riskier investments. Moreover, the Fed’s policy represents an outright subsidy paid for by the taxpayer to benefit major financial institutions in the form of an artificially low cost of funding. This subsidy equates to a transfer of wealth that far exceeds the recent mortgage settlement.

In fact, rather than an elegant solution to the economy’s plight, QE has left the US on the edge of a classic “liquidity trap”. The Fed’s massive intervention in the markets is depressing returns below acceptable thresholds. This confronts investors and corporations with little alternative but to hold cash or other nonproductive assets in order to preserve capital. This tendency is deflationary, risking a cascading of asset prices only confronted previously in the Great Depression. With the realization that equity prices are too high and debt too cheap to effectively allocate capital, analogous to the impact of the child’s cry that the emperor has no clothes, markets will revert to realistic and sharply lower levels. In the past, such reversions have proven to be electrifying in speed and breathtaking in magnitude.

Daily Bankruptcy Review (DBR): Where Capital Goes to Die

Sat, 14 Jan 2012 02:32:00 GMT

By Anders J. Maxwell

Market wags have characterized a succession of money losing investments with the above anthropomorphism. In the mid-'90's, this unflattering sobriquet was applied to venture capital; 10 years ago, to airlines; and recently, Japan. If this dubious distinction—“where capital goes to die”—was fitting for investment in Japan, consider prospects today, here in the U.S.A.

U.S. equity market indices have been treading water since 2000, but there are startling and more ominous similarities to Japan. Both economies experienced bursting bubbles due to inflated equity and real-estate values, and dysfunctional, nearly insolvent banking systems. Extending longer-term trends of increasing public and private debt, the ensuing economic collapse has been magnified and prolonged by this leverage. Taking into account total net indebtedness, debt as a percent of Gross Domestic Product is of similar magnitude for either country.

Such high debt burdens impinge on economic recovery, limiting the effectiveness of fiscal policy traditionally relied upon to stimulate growth coming out of a recession.

However, the two nations diverge in their respective ability to market the debt necessary to fund massive government deficits. Based on high historic savings rates, Japan's debt is almost entirely funded domestically. In contrast, lacking household savings, the U.S. is increasingly dependent on international bond investors—principally China and Japan. This seems imprudent given China's divergent ambitions and the competing demands on Japanese savings from post-tsunami reconstruction. An additional cause for concern is that since 2008's meltdown, the Federal Reserve has become the largest holder of U.S. Treasurys, funding its purchases by running a printing press, in lieu of capital-market support.

The best measure of the sustainability of these levels of national debt is the underlying growth in Gross National Product. At first glance, while the Japanese economy has grown at only a 0.9% average annual rate since 1990, when its asset bubble burst, the U.S. has expanded at 1.7% the past 10 years. Comparing these often-cited statistics, however, is not meaningful. A severe downturn overtook the U.S. only after 2006 and since that time, our economy has slowed to a 0.5% annual growth. Now roughly half the rate of Japan's growth, by this measure the U.S. will be seriously challenged to manage its debt load.

Recognizing the limits placed on fiscal spending by ever-growing deficits, with the U.S. economy mired in recession, the Federal Reserve adopted the Bank of Japan's controversial reliance on open-market purchasesof a variety of government and mortgage securities. So-called “quantitative easing,” this direct intervention appears an abject failure in Japan. Nevertheless, the Fed has pursued this tactic on a grand scale, resulting in its balance sheet ballooning to $2.8 trillion. This intervention inflates money supply and risks destabilizing the currency, while the intended consequence of zero interest rates presents a paradox. Depressed rates misallocate credit by force-feeding marginal investment, while the accompanying increases in credit standards freeze out overextended borrowers dependent on refinancing schemes to avoid or remedy default.

In spite of such unflattering comparisons, most market commentators continue to insist the U.S. is beyond so called “Japanization”—the risk of stagflation and the prospect of our own “lost decade.” This insistence seems justified solely contrasting a growing U.S. population (albeit at declining rates) primarily based on immigration, in contrast to Japan's decline. These demographics may impact years in the future, but are of little import in 2011. Other arguments raised are entirely subjective, ranging from accounting standards, work ethic and varying perceptions of central bankers.

Much more significant is the current global economic environment teetering on the edge of renewed recession, which exposes the U.S. economy at a critical juncture to additional risk. Furthermore, while the Japanese real-estate bubble centered on commercial-property speculation, and thus left personal consumption largely intact, in contrast, the U.S. housing implosion—compounded by personal borrowing that Japanese consumers historically avoided—is proving much more intractable.

The U.S. economy continues in a malaise, confronting major headwinds including an overextended household sector, which is overinvested in housing, a banking system in denial of embedded losses, and a global economy grappling with fundamental imbalances. In addition, the U.S. government bond market is highly dependent on China's support and a diminished investment capacity in Japan. With a presidential election next November, there is no prospect of government action that might otherwise ameliorate this confluence of adverse circumstances.

It's time that investors add the U.S. to the notorious list of investments characterized by probable loss - “where capital goes to die.” Securities of every stripe are implicated. Given the inflated value of U.S. equities and deflated bond yields, adjusting portfolios appears overdue.

Daily Bankruptcy Review (DBR): Future Shock

Sat, 14 Jan 2012 02:32:00 GMT

By Anders Maxwell

In his 1970 bestseller, “Future Shock,” sociologist Alvin Toffler put forward a thesis that individuals would be increasingly overwhelmed by the accelerating rate of social and technological change, popularizing the phrase, “information overload.” Forty years on, the U.S. economy itself is in Future Shock.

The credit crisis triggered by an overbought and overleveraged housing market has resulted in the worst recession since the 1930s Depression. Without due appreciation for the complexity and scope of an economic decline propelled by housing prices, in response government has pursued conventional fiscal stimulus coupled with an unproven and controversial monetary initiative, dubbed “quantitative easing.” Now, three years after the trauma of a failure of such iconic corporations as Lehman Brothers and AIG, rather than sustainable recovery, the U.S. economy continues to be dogged by faltering demand and systemic overleverage. How capital markets assimilate the impact of these pervasive issues will define risk and frame investment opportunities looking forward.

To appreciate the magnitude of the impending changes, interest rates have moved in one direction—down—since 1980. Following former Federal Reserve Chairman Paul Volcker’s effective stand against inflation, over this period, equity markets have been in a prolonged rally. At the same time, total debt, including government, corporate, as well as household, has grown more than tenfold, twice the rate of growth of gross national product. Reflecting the extraordinary effects of the Federal Reserve’s quantitative easing, adjusted for inflation, real rates of interest are now negative. Yet, measured by at least three key indices—unemployment, consumer confidence and housing—there is cause for concern the economy is poised for a “double dip.”

Given current conditions, interest rates have nowhere to go but up. The traditional prescription for reinvigorating the economy, government’s ability to spend its way out of the current stall, is seriously compromised by excessive deficits. By elimination, policymakers are left to extend a reliance on open market purchases of U.S. Treasury bills (and the occasional GSE mortgage-back). Signaling the magnitude of these market interventions, Federal Reserve purchases this spring have exceeded 70% of the new issuance of Treasury bills. Of further concern, this $14 trillion Treasury market is now dominated by three holders, the Fed, China and Japan, representing 26% of total U.S. debt.

However viewed, the Fed’s ability to continue its quantitative easing on such a scale will be challenged by the central banks of China or Japan as either responds to their respective domestic political and economic demands. This portends a curtailment of this level of U.S. bond holdings. Highlighting this prospect is the extraordinary capital demands represented by the March 11 “Great East Japan Quake and Tsunami,” with a rise in interest rates increasingly likely as a result.

As capital markets confront the inevitability of rising rates, the U.S. faces a sea change reflected by the crosscurrents underlying the current economic malaise. Declining housing values and compromised monetary policy are a cause for concern, seriously constraining potential remedial action. However, much more consequential are equity market valuations, which are estimated by Smithers & Co. as 60% overvalued measured by such standard ratios as market value-tonet worth and adjusted price-to-earnings. Furthermore, contrary to the view of Wall Street research that U.S. corporate balance sheets continue to strengthen, data from the Fed and the Bureau of Economic Analysis show net debt-to-equity at record levels adjusted for inflation. Propelled by corporate stock buybacks which, in turn, have been fostered by artificial liquidity from quantitative easing, inflated equity valuations, when magnified by corporate overleverage, substantially increase the likelihood of a major correction.

As though these issues are not concerning enough, looking forward, a recent white paper from the McKinsey Global Institute, “Farewell to Cheap Capital? Implications of Long-Term Shifts in Global Investment and Savings,” based on emerging market infrastructure demand, projects a material rise in interest rates, regardless of how governments manage deficits or the Fed’s burgeoning inventory of Treasury and mortgage securities.

Wall Street, it appears, has found little cause for alarm, at least prior to 2012’s election. This presumes Washington can manage the federal budget and, much more problematic, reverse prevailing trends so that U.S. households resume deficit spending to support GNP at least until the election. This seems wishful thinking, at best. Not only is the secular bull market over, but the buyers of Treasurys are under siege. Moreover, there is growing evidence of anemic performance of U.S. business in faltering sales. Coupled with high corporate leverage, markets are precariously balanced, poised for a major step down in a bear cycle. Overwhelmed and disoriented, the economy is, indeed, in Future Shock. Deep value investors are advised to focus on defensive credits, buttress hedges, and marshal liquidity in anticipation of the opportunities dislocation always yield.

Daily Bankruptcy Review (DBR): The Great Housing Depression

Sat, 14 Jan 2012 02:33:00 GMT

By Anders J. Maxwell

Traditional business cycle theory holds that housing leads the economy in and out of recession. This reflects the industry’s historic sensitivity to interest rates. While housing clearly led the recent downturn, having peaked by early 2007, this economic bellwether continues to plumb new depths.

Gauged by financial markets, however, the economy appears on a road to recovery. A Viewpoint article last spring (“Housing and the Economics of Sand Castles,” May 19, 2010) expressed the opinion that while financial markets were already enjoying a dramatic resurgence from the lows reached in 2008, this would prove transitory, based on a receding wave of liquidity earlier set in motion by the Federal Reserve, and further declines expected in housing.

A year later, that point of view has proven correct, at least related to housing. Home prices measured by Case- Shiller have continued downward; single-family starts were at an annual rate of 392,000 units in February and new sales reached a seasonally adjusted annual rate of 250,000, both record lows. Indicating this housing depression will continue, inventory for sale (including foreclosures) is estimated at 5.3 million units, propelled by foreclosure rates hovering over 12%. At current sales rates, this represents over two years’ inventory, a figure likely to increase, reflecting tightening lending standards and generally weak consumer confidence.

Further challenging capital market values have been a series of geopolitical shocks, including a destabilized Mideast and resulting triple-digit oil prices, a disrupted Asian supply chain following the Japanese earthquake, and growing tensions over record trade imbalances. Add to this volatile mix the contraction likely due to the looming fight over government deficit spending, and security valuations should have collapsed.

But that’s clearly not the case. In sharp contrast to the gloom in housing and construction, over the past year capital markets have continued to rise. Having gained nearly 80% from a trough in 2009 to last spring, equities measured by the S&P 500 are up an additional 10% the past year.

This sustained financial market rally reflects what traders refer to as “market technicals,” rather than a meaningful reflection of the economy. The renewed effort in the second half of 2010 by the Fed to maintain zero real interest rates and expand open market security purchases, which now exceed $1.5 trillion—dubbed “Quantitative Easing 2”—has markets awash in liquidity. The Fed’s interest-free lending and persistent intervention explain the dramatic recovery in equity markets, a resurgence in banking profits, and, recently, a small, but discernible, improvement in employment.

Reconciling these crosscurrents between rising financial asset values and declining housing holds the key to the economy’s future. Capital markets are indicating a significant improvement, while housing prices raise the specter of renewed contraction. Which of these two key barometers reasonably portends the future is clear.

The market in traded public securities continues to be inflated by the Fed’s ongoing quantitative easing. The magnitude of this unprecedented intervention is reflected in the Fed’s burgeoning balance sheet from purchases of government and mortgage securities. Underpinning bloated market indices, corporate profits are of dubious quality, due in large measure to nonrecurring cost-cutting and the extraordinary profits afforded the banking sector by the Fed’s interest-rate holiday. Given such tenuous supports, unemployment can be expected to remain elevated and growth in consumption lackluster.

Meantime, the primary cause of the “great recession”— systemic overleverage — has actually worsened and challenges our credibility with the international creditors on which the U.S. is completely dependent. While U.S. households have gotten the message and reduced borrowings 4% since year-end 2007, government debt has actually increased nearly 60%, resulting in a 13% expansion in the economy’s total debt.

Looking forward, the prospect of a continued depression in housing matters considerably more to the economy’s health than a Fed-induced market rally. Due to anemic real incomes, as well as depleting home equity, consumer spending, which comprises 70% of GDP, will continue to sap growth. Acknowledging the economy’s precarious state, “QE2” seems destined to be followed by a “QE3.” This is akin to pushing even harder on a string. Lacking demand, excessive liquidity leads to further distortion in prices and misallocation of capital. Evident from recent experience, this also encourages more debt financing, setting the stage for the next “subprime” train wreck.

In conclusion, inflated market indices are grossly misleading. Housing retains its position as the harbinger of things to come. Housing prices are down 30% from the peak in 2007 and starts are at 50-year lows. This grim leading economic indicator is flashing crimson, signaling another step down in a broadening bear market.

Daily Bankruptcy Review (DBR): QE2…Road to Hell…the Sequel

Sat, 14 Jan 2012 02:33:00 GMT

By Anders J. Maxwell

U.S. equity and bond markets have now retraced their steps and are fully recovered from the precipitous fall of 2008. The financial markets’ rebound is in stark contrast to the “real economy.” September’s headline-grabbing jobless rate remains at 9.6%, with the Commerce Department estimating that one in five Americans are either un- or under-employed. The erosion in housing prices continues to impair household net worth, dampening consumer spending. The related collapse in new construction magnifies this depressing effect. More fundamentally, the issue dogging the economy remains too much leverage. Aggregate indebtedness stands at 350% of GDP, a burden imposed previously only at the height of the Second World War.

This fall’s breaking story has been the controversy over the Federal Reserve’s anticipated open market initiative. Referred to as “quantitative easing,” or “QE,” the argument hinges on three points: what’s the theory; does QE work, and what does it mean for credit markets and distressed investors?

This Is “Easing”?
A current preoccupation, quantitative easing was introduced as a part of the stimulus applied by the federal government to stabilize markets in the aftermath of Lehman Brothers’ collapse. An extension of the traditional central bank’s open market monetary activity - frequently referred to as “printing money” - QE has been considered a last resort and applied in those exceptional circumstances where short term rates are deemed so low as to leave conventional levers ineffective. The only applicable example of QE prior to 2008 had been the Bank of Japan’s actions in the period 2001 to 2006. QE involves direct purchases by the central bank of long-dated securities with the stated objective of stimulating corporate investment and consumer demand. Less benign is an implied goal to raise the specter of future price inflation in order to defuse deflationary expectations perceived as depressing consumption. This hoped for inflation also affords the prospect of benefitting leveraged financial institutions, out-of-the-money homeowners, and a deeply indebted U.S. Treasury. This benefit comes, however, at the expense of creditors, those on fixed incomes and anyone holding US dollars.

Reflecting the discrepancy between rejuvenated financial markets and depressed employment and personal income, the Fed has raised the likelihood of moving forward with another round of easing, dubbed “QE2.” However well-intentioned, should the Fed go down this road, the U.S. economy will suffer further dislocation and anemic performance. This conclusion reflects three fundamental flaws of QE: it doesn’t work; it has unintended negative consequences; and, most significant, it portends incalculable long-term economic loss.

In the first instance, the root cause of the current malaise is the overdue process referenced above of deleveraging banks and consumers’ balance sheets. By its nature, this depresses economic growth. The premise of QE is that central banks can still “prime the pump.” Given the size and complexity of contemporary global credit markets, this basic tenet has been disputed for over a decade by Peter Warburton, the U.K. economist, and as recently as October 19 by economist Joseph Stiglitz. More to the point, there is nothing in either the Bank of Japan’s experience or our own since 2008, to suggest QE works. It certainly wasn’t QE that ameliorated the housing crash, but rather the Treasury’s takeover of Freddie Mac and Fannie Mae.

Second, there are demonstrable risks to a central bank tampering with capital markets. China’s Commerce minister framed a major concern this week in a remarkably blunt statement to Reuters, “Because the United States issuance of dollars is out of control and international commodity prices are continuing to rise, China is being attacked by imported inflation.” Recognizing this critic is the largest holder of the Treasury’s debt, it seems imprudent to ignore China’s objections and continue to run the presses. Another risk is that the Fed already holds over $2 trillion in mortgages and long-dated Treasuries. Clearly, additional purchases only increase the uncertain impact on markets of this inventory overhang.

Third, and most concerning, is that regardless of the selectiveness of the Fed’s purchases, such intervention disrupts markets, misallocates investment and, in so doing, places in question the country’s future economic prosperity. In the current environment, with consumers repairing balance sheets and business flush with working capital, plying markets with more liquidity is truly “pushing on a string.” Nowhere are the attendant risks more apparent than the current high yield credit bubble.

Bubble Trouble
The liquidity flood resulting from the Fed’s largesse to date, and the market’s anticipating more to come, has propelled high yield issuance. Junk spreads are at pre-Lehman levels, while yields are back to records set mid-decade. This is particularly disconcerting given heightened volatility and issuer risk. Moreover, for the first nine months of 2010, high yield issuance has exceeded previous full-year records! Most of this volume reflects corporate borrowers refinancing bank loans in public markets, rather than growth. Substantiating a degradation in credit quality, controversial “covenant-lite” and “PIK toggle” structures are again in vogue. More troubling, the current week’s calendar includes a dozen or more issues, in aggregate providing over $3 billion, to fund dividend recaps. This preponderance of high cost financing to cash out equity has historically been a clear bellwether of a market top. Based on history, we are no more than months away from this bubble bursting.

Back To Basics
While waiting for the bubble to pop and a new wave of selling, where’s the opportunity for value investors? In light of the Fed’s apparent predisposition to disrupt markets, distressed investors should consider a strategy to offset this risk by targeting those tradable assets least prone to credit market manipulation. Characteristics of qualifying assets are those which are fixed in supply (to avoid future excesses), reasonably free of both anti-competitive practice (that is, manipulation), as well as speculative derivatives (futures and options). This approach may be reflected in the renewed interest this year in real estate assets. In any event, given the inevitable dislocation as the economy continues to stumble, distressed investors, traders and advisors will have ample challenges and opportunities in the months ahead.

Daily Bankruptcy Review (DBR): Beware Zombie Credit Markets

Sat, 14 Jan 2012 02:37:00 GMT

By Anders J. Maxwell

The movie “28 Days Later” is a chilling portrayal of a future where an uncontrolled virus turns society into a wilderness populated by zombies. Now, nearly 28 months since the onset of 2008's “great recession,” this science fiction thriller seems an apt metaphor for U.S. capital markets.

Equity market gyrations have dramatically increased during the current recession. Key indices have swung wildly with both the Dow Industrial and S&P 500 indices' variance mirrored in an unstable Volatility index. U.S. equities are struggling to find direction, confronted with extraordinary, and often contradictory, economic indicators. The once popular presumption that equity markets are always efficient in their valuations or accurate barometers of economic activity has been discredited. Increasing attention and emphasis is due credit markets.

Following the height of the market's crisis marked by Lehman Brothers' bankruptcy, U.S. credit markets afford a stark indication of the economy's direction and attendant risk. Three marked changes are evident: (1) a steady decline in private lending and borrowing; (2) the shuttering of the Asset Backed Securities (ABS) markets; and (3) the federal takeover of the mortgage market. Taken together, these developments reinforce the pervasive impact of systemic deleveraging and reregulation of markets and raise the specter of huge deferred mortgage losses, further depressing the economy.

Contracting Private Credit Generally anticipated, a substantial decline in private credit is apparent in recent Federal Reserve data, with both financial intermediaries reducing assets and nonfinancial corporations and households cutting borrowing. Corporate downsizing and lower growth has become the “new normal” (as characterized by Bill Gross). Of greater impact as a proportion of GNP, household deleveraging and faltering consumption driven by declining home prices is the subject of a recent commentary in Daily Bankruptcy Review, “Housing and the Economics of Sand Castles.” Both trends portend a weak economy the balance of 2010.

ABS Lockdown The securitization market is adding another damper. While a relatively small segment of a $35 trillion credit market, ABS (excluding mortgages) are tremendously significant in setting market pricing on a broad range of asset classes. Characterized rather philosophically by the Financial Times as confronting an “existential crisis,” the ABS market has actually hit a wall. New issuance effectively ceased by 2008. A casualty of fundamental flaws ranging from fallacious bond ratings, controversial structures, opaque pricing and outright fraud, the integrity of this pivotal segment of the credit market is held in doubt. It remains to be seen how this once key market fares in the future. The deep freeze prevailing reflects a ground swell of political support for re-regulating markets. Clearly overdue, reregulation inevitably raises the cost of corporate lending, bond financing and consumer credit.

Socialized Mortgage Markets The most consequential structural change in credit is the federal takeover of the mortgage market. The Federal Reserve, in concert with the half-dozen emergency liquidity facilities comprising the Treasury's TARP program since the third quarter of 2008, has acquired $1,250 billion in mortgage-backed securities. When added to the mortgage assets of Fannie Mae and Freddie Mac - the GSE's effectively wards of the state - the federal government now has a controlling interest of 45% in the $14 trillion residential mortgage market. Given the ongoing decline in housing values nationally, the potential losses realized by the U.S. taxpayer on these securities could add significantly to current estimates of the federal deficit. More to the point, this speculative portfolio of mortgages represents a major overhang depressing real-estate prices, new construction and, in turn, the general level of economic activity. The very real prospects for loss on these securities is highlighted by this week's estimate by the Center for Responsible Lending that 9 million homeowners - representing one in four residential mortgages - are likely to be foreclosed on by 2012!

Deleveraging and reregulation of credit markets are generally acknowledged risks some 28 months since the recession's commencement. It is far from clear, however, that the risks of a zombie mortgage market of overvalued inventory are appreciated. Similar in key respects to the dilemma confronting the Bank of Japan following the bursting housing price bubble in the late 1980s, the Fed now holds mortgage securities with imbedded and unrealized losses. As these losses are forced through foreclosures and liquidations, expect further and prolonged housing price declines. As referenced previously, a further drop in this key household asset's value lowers aggregate consumption with overwhelmingly negative effects on the economy. The potential magnitude and duration of decline is suggested by Japan's land price index (land is used as a measure of residential value as Japan is prone to earthquakes making land more significant than house value) over that country's “lost decade.” A similar pattern of escalating property value and subsequent collapse is evident to date in the U.S. A comparison with the Case-Shiller Price index at the corresponding point in the housing cycle presents the possibility for significant declines in prices beyond the 30% pullback to date, bringing with it the prospect for a period of economic weakness extending well beyond 2010.

Daily Bankruptcy Review (DBR): Housing and The Economics of Sand Castles

Sat, 14 Jan 2012 02:37:00 GMT

By Anders J. Maxwell

May's capital markets are up blissfully, albeit after some extraordinarily volatile trading. Equity and credit markets are climbing to new highs from the current business cycle's low point in the second half 2008. The S&P 500 is up 34% in the past 12 months. High-yield bond prices have recovered from 50 to par. Corresponding bond yields have fallen from 23% to 8%. In short, this reversal is stunning. The financial press has naturally characterized the rally as presaging a meaningful recovery in the economy.

However, as these indices are hitting new highs, capital markets seem detached from reality. Two closely watched measures of economic activity - retail sales and manufacturing purchasing orders - are flashing warning signals. The International Council of Shopping Centers' index of monthly sales is projected down as much as 3% in April, while the ISM manufacturing index rose only slightly. It's speculated that the small ISM increase reflects supply chain restocking and accelerated orders in front of expiring tax credits, rather than sustainable demand. With retail spending accounting for about 70% of GDP and given that unemployment now hovers at 10% - a post-World War high - under the best of circumstances, consumption would be expected to remain anemic and weigh on markets.

What then explains the current elevated level of valuations, rather than the real economy, is the extraordinary expansion of the Federal Reserve's open market purchases (including $14 trillion of residential mortgages) and the Fed's ballooning balance sheet. These monetary initiatives account for the unprecedented level of liquidity reflected in the money supply, and record low interest rates.

Buttressing concerns over market valuations, based on any conventional metric - whether looking at price-to-normalized earnings, price-to-dividends, price-to-book, or price-to-sales - equity multiples on trailing results are well above long-term averages. Buyers, therefore, must be assuming growth in earnings exceeding 20% this year and next, completely at odds with sales growth projections for the S&P 500 of 5.5% this year and 7% next. Thus, whether on trailing results or unsubstantiated bullish forecasts, valuations are stretched to the limit.

There is clearly a sharp contrast between market perception and economic reality. The resolution as to where the economy is going has been housing and its banking companion, mortgage finance. This continues to be the case.

In due course fiscal and monetary props provided by the government will be eclipsed by the sheer weight of weak employment and faltering household incomes, in turn, depressing consumption, which drives the economy. More immediately, however, the broad-based collapse in housing - gathering momentum since 2007 - provides an unambiguous harbinger of what's ahead.

February marked the fourth straight monthly decline in new home sales - to the lowest rate since this series was initiated in 1963. Annual housing starts remain at record lows, around 600,000 units. Beyond these dismal production numbers, over one in four mortgages - roughly 11 million homes - are estimated to now exceed house value, reflecting 'negative equity' exceeding $800 billion. With homeowners seriously considering abandonment when value falls below 75% of their mortgage, it's forecast by Core Logic that between 5.1 and 7.4 million homeowners are likely to default this year.

The housing picture is bleaker still considering that the source of over 90% of mortgage financing since late 2008, the Federal Reserve, effective March 31 withdrew from its program of open market mortgage purchases. This certainly can't be expected to help housing.

The end of the Fed's “quantitative easing” leaves housing primarily, if not exclusively, dependent for mortgage finance on the two government-sponsored enterprises: Freddie Mac and Fannie Mae. Together, the GSEs hold over half of all U.S. mortgage loans outstanding and accounted for 75% of residential lending in 2009. Both Freddie and Fannie survive today based solely on the largesse of the U.S. taxpayer. The federal government has advanced $130 billion to these entities. Following continued losses in the first quarter of 2010, GSE advances are expected to increase $19 billion, totaling nearly $150 billion this quarter.

Given these financing conditions, however Congress eventually resolves the future of these floundering agencies, it is clear that mortgage financing rates will have to rise, credit tighten and home sales remain under pressure.

Reinforcing the negative impact of a dysfunctional mortgage market, also stalling homebuilding and depressing prices, is a looming inventory of vacant homes. This reflects foreclosure rates now exceeding 12%. Based on 60-day delinquency rates around 7%, foreclosures seem certain to remain high. Based on these record rates and overhang of unsold inventory, there is every indication that housing prices will continue to weaken. In fact, prices dropped for the fifth straight month in February with the S&P Case-Shiller index falling 0.9%. This 20-city index is now 30% below its peak in 2006. The impact on the economy of this deterioration in housing may yet prove overwhelming. Well-documented by economists Karl Case, John Quigley and Robert Shiller, changing housing values drive consumption. As the continued decline in home values and net worth weigh on consumption, another period of economic contraction (and, correspondingly, fall in market values) seems preordained.

Given these self-reinforcing declines in home prices, decreasing home equity, rising delinquencies and foreclosures, coupled with a mortgage market in conservatorship, housing values are certain to depress spending for the foreseeable future. The foundation of U.S. GDP is consumption. As this lags, the economy will suffer and currently inflated capital markets are certain to see valuations drop.

Just as housing imploded once markets recognized the corrupting influence of free credit, so capital market values are destined to erode as surely as any castle built of sand.