This post is a bit of hard post for me because it is going to sound ultra-bearish. So if you want to avoid a really bearish blog entry, then this is the one to avoid. If you want to know why I am bearish, then this is the blog entry to read. I want to add a disclaimer here. I don’t really know if the market will go down, but what makes be ultra bearish is that the pieces are not adding up. For the past three weeks while writing this blog entry, whenever I ask other folks about my problems and disconnects they nod and say what be is what be. I also wanted to wait to until the Bush administration officially unveiled their plan before commenting. (Mish does a good job of covering the plan (1,2), and thus I will avoid discussing the plan in detail).
The core of the problem is that we have a valuation problem. I have had discussions with people who pointed out that at the beginning of the market crisis marked to market was the wrong thing to do. Though here we are in December and we are still facing the same problems. Though one company has started marking to market.
MIAMI – Home builder Lennar Corp. formed a land investment venture with Morgan Stanley Real Estate to acquire, develop, manage and sell residential real estate, with Lennar selling properties valued at US$1.3 billion to the venture for $525 million.
With more details being:
Miami-based Lennar said it was selling the sites to a venture led by the real estate arm of Morgan Stanley. The deal includes raw land as well as partly and fully developed homes for $525 million.
Lennar is keeping a 20% stake in the venture and will continue to manage the projects.
Some might argue if you look closely at the deal Lennar still wins and is still in the deal. Though think of it as follows. You are a baker and you have a bakery. You then sell your bakery to some financial company for 40 cents on the dollar, but say you will still manage it, and keep 20% ownership. What is the real deal here? I am tempted to believe that the baker is selling to ease its credit worries and is delegating the stress to somebody else. The baker is saying, "I have some real problems, and I want somebody else to figure this out." Thus I am tempted to believe that Lennar is making the smarter move.
Let’s assume that Lennar did a marked to market at the bottom of the real estate cycle. This means that there is a 60% discount. Though some are saying that the marked to market discount is even higher.
U.S. mortgage assets in collateralized debt obligations have lost so much value that the top classes of the securities may be worth as little as 20 cents on the dollar in a liquidation, Barclays Plc analysts said in a report.
Has this discounting occurred at the financial market level? No, and that’s a problem. I feel the market has neatly avoided this issue using the following two techniques.
- The products are marked to maturity. Thus the value of the products will actually be determined once the product matures. The financial market is completely convinced that Mr Market is wrong and they are willing to wait until the products mature. (Additional note after I first published this article on my personal blog: UBS has taken another 10 billion dollar hit, but I don’t believe this is marked to market, more likely marked to maturity. Get ready for more bad news "time to time.")
- Bond insurance companies. There were companies that improved the value of a bond, by providing insurance. This worked when things are good. But there are rumblings that some ratings of the bond insurance companies need to be reduced. The ramification of that would be a tidal wave of repricings because a single company that provided insurance touches oodles of other bonds. This not a ratings company problem, but the fact that the rating of a bond centralized to a few companies.
The feeling that I am getting is that the market is holding its breath and hoping that all of this blows over. I am getting the feeling that everybody is starting to relax a bit, and thinking that they can delay this "Armageddon" to a later day. I think the idea is that by delaying this decision Mr Market could be proved wrong. After all, in the LTCM debacle, I did blog that those who lost big in LTCM blamed the market for not behaving properly.
So how can Mr Market be made to behave properly? Two things; Fed cutting interest rates to "zero", and the government bail out. What makes me suspicion are comments like the following made by Dan (did not catch his last name) a big fund manager on commenting on the bail out plan on CNBC.
This is a good policy from a social viewpoint.
Though the question to Dan was if this could distort the price of borrowing.
Yes, and it is government intervention and it is intervention in a supportive manner.
You have to ask yourself, why would a fund manager managing billions upon billions approve of government intervention? These funds are fighting the government on most things that would regulate them, and here is a fund manager saying that intervention is a supportive action? And why would Paulson a market type of guy approve of market intervention? And did you catch what Hillary wanted to do? In this upcoming election year everybody is jumping over themselves to do the most that would avoid a recession in the short term. I am skeptical that they would have done this had this not been an upcoming election year. In contrast Rick Santelli who is not a fund manager, but bond commentator is completely against this plan, and has been arguing how much all of this stinks.
Put the dots together, if the government freezes interest rates, and bails out mortgages then the fund manager does not have to mark to market, and can use the mark to maturity value because they can assume at maturity Mr Market will have be "righted." This stinks and I don’t think it will work.
Ok, say you agree with the market intervention, and agree lowering the interest rates, is that going to help? I don’t think so because the problem is that people cannot afford the properties they have. In a previous blog entry I wrote about how the real problem is that the real estate market is wrong in the first place. In that blog entry I did a rough calculation indicating that the people were going over their affordability levels to start off with.
Let’s assume for the moment that freezing the interest rates and cutting interest rates would help them, would they be out of this mess? Maybe in the short term, but not the long term. What if one of them looses a job? What if an accident happens? What if they have to buy a car? This couple has no cushion and thus any change to the worse will cause them to the loose the house anyway’s. To make matters worse all of this works so long as the economy is expanding, and so long as there is growth. When there is no growth, and wage cuts then they will loose the house again.
I am jumping the gun and condemning the couple on their ability to pay. But having experienced these sorts of things first hand, whenever you stretch yourself you are asking for trouble. Therefore even with government intervention, and low interest rates there is no increased likelihood that people can keep their houses. The only real surefire way I know that they can keep their houses is if their mortgage payments were lower. And that means lower priced housing, and that means marked to market.
Ok, let’s assume for the moment that a government bail out will work, cutting interest rates helps, and the economy keeps growing. The problem there is that you need everybody else on this planet to consume, which is happening. Though what is happening to the commodity prices? They are going sky high and keep going higher. This is part of the conundrum that the economy is in. If the economy grows and everybody is consuming then commodity prices go up and there is inflation. The result is inflation, of which the ECB is particularly concerned with. Yet in the US, which has a depreciating currency there is no inflation (wink, wink). The problem with inflation is that the purchasing power of the consumer goes down, unless wages go up resulting in more inflation.
So to sum it up yes I am pointing out all of the things that could go wrong. But what bothers me in this situation is that I don’t have to try hard to find things that could go wrong. No matter which way I do my thought experiment I have a higher probability of being a bear than a bull. This is why I am ultra-bearish.
As Marc Faber said it best:
There was a global boom, but there will also be a global bust!
Where does this all end up? I did some calculations, and these are pretty bearish… 8 to 15 years before the equity market recovers. Yeah that sounds depressing, and that is why I warned you at the top of this blog entry that I was ultra bearish. Does this mean that the market will drop, and we will have a bear market? No, not at all. Who knows maybe this is the basis of a bull market. Though, I am not willing to put money into the hopes of a bull market. I would rather sit this one out and be proved wrong. And you know what, I actually want to be proven wrong on this blog entry!!!!