Big Ben Holds Rates, Market Throws Party

The FOMC did almost exactly what we expected, it held rates at 5-1/4 percent. The market however did something that I did not expect, it decided to celebrate. Check out the chart to the right see what I mean. Most major market indices were up over 1.5% on the day yesterday, so the rally left few behind. You can read the statement in its entirety here. I could break the press release down myself, or I could just point you towards the Wall Street Journal Online's analysis which I feel is very much on point. Please note how important each word is in the FRR. A slight modification of wording can actually move the markets. Read on below:

Source: The Wall Street Journal Online
http://online.wsj.com/public/resources/documents/info-fedparse0703.html

Are You a Member of the Pigou Club?

Late last year Greg Mankiw, a professor of Economics at Harvard University, wrote a Wall Street Journal article that he dubbed the "Pigou Club Manifesto." It is called the "Pigou Club Manifesto" after the late British economist Arthur Pigou(1877-1959). Pigou is perhaps best known for developing the concept of negative externalities. He felt that properly levied taxes on producers and consumers of products with negative externalities help align the incentives of interested parties with those of the negatively affected third parties. Mankiw's article argues for an increase in the tax on gasoline consumption. Imagine paying an extra $1.00 per gallon every time you go fill up your tank. Doesn't really make you too excited does it? Well I must admit upon first hearing this I was a little taken aback as well. But, after a quick review the policy seems to make good economic sense. Check out Professor Mankiw's article in its entirety here. The article is actually a quick read but I included a quick excerpt below to whet your appetite:

Campaign consultants aren't fond of this kind of proposal, but policy wonks keep pushing for it. Here's why:

The environment. The burning of gasoline emits several pollutants. These include carbon dioxide, a cause of global warming. Higher gasoline taxes, perhaps as part of a broader carbon tax, would be the most direct and least invasive policy to address environmental concerns.

Road congestion. Every time I am stuck in traffic, I wish my fellow motorists would drive less, perhaps by living closer to where they work or by taking public transport. A higher gas tax would give all of us the incentive to do just that, reducing congestion on streets and highways.

Please check out the rest over at Greg Mankiw's blog here.

Source: N. Gregory Mankiw
"The Pigou Club Manifesto" October 20th, 2006
http://gregmankiw.blogspot.com/2006/10/pigou-club-manifesto.html

Two Huge Mortgage Recast Waves

Credit Suisse put together a chart showing all adjustable rate mortgage recasts in the US. I think this chart clearly illustrates how much danger the real estate market is in. The first big wave on the chart is the result of subprime mortgages recasting/resetting. The subprime lending meltdown has thus far largely been with the subprime mortgage companies. Everyone has heard of the big public lenders like New Century and Accredited Home Loans but most people don't realize that roughly 41 lenders have gone out of business since late 2006. The ones that remain have tightened up their lending standards or stopped doing subprime loans entirely. The real casualties of this whole affair are the subprime borrowers. There are roughly $17.5bb of subprime recasts this month, but that number quickly doubles to $35bb in 8 months. It is going to be a slow, painful unraveling as all of these underwater (assuming home prices remain flat or negative) subprime borrowers realize that they can no longer get "no doc" subprime loans.

But, the subprime loans aren't the only problem, just the most immediate. Most of that fallout will occur in the next 2 years. The next big wave of recasting loans will be the option ARMS and Alt-A ARMS. We haven't even begun to talk about these loans yet because the worst will not hit for another 4 years. But, if you assume that the subprime fallout hits real estate prices fairly hard you have to figure that the default rate during the second wave could be even more deadly. Unless the real estate market miraculously turns around and starts to rise many of these borrowers will have to dig themselves out of a mortgage that may be anywhere from 5 to 20% larger than the FMV of their home. Remember this is what happened to homeowners in Japan that bought in during their 1980's real estate boom and subsequent bust. Some homeowners who bought homes in Tokyo 20 years ago are still underwater!! In fact the chart to the right shows that real estate prices in Japan have fallen for close to 17 straight years. I don't write this to scare people, but I do want to note that whenever there is a bubble someone gets stuck with the bill. In this case I have a feeling it won't be contained to just subprime lenders.

Source: Irvine Renter
Irvine Housing Blog
http://www.irvinehousingblog.com

Source: Wikipedia
Japanese Asset Price Bubble
http://en.wikipedia.org/wiki/Japanese_asset_price_bubble

Merrill Lynch is Bearish on the Economy

I wrote a few weeks back about Alan Greenspan's recession prediction. Well it seems that Alan isn't the only one predicting a recession these days. Merrill Lynch issued a research report last week that came to the same conclusion. You can read the report here. They are urging Bernanke to cut interest rates this year to avert a recession.

The bottom line of all this is that it is becoming increasingly likely that a decline in home prices could lead to a recessionary environment. Therefore, following the leading housing indicators will be very important this year. As an investor facing these economic predictions remember that there is no replacement for a disciplined multiple asset class investment strategy. Don't let predictions scare you into changing your portfolio allocations. Not even Alan Greenspan and Merrill Lynch can see the future.

Blackstone Group Going Public?

Rumor has it that Blackstone Group plans to go public, selling a 10% stake of its management company in an IPO later this year. This would be a huge initial public offering and the founders, Stephen Schwarzman and Peter Peterson, could split upwards of $4 billion dollars. Not a bad payday for two guys who started the firm with $400K in 1985.

But why on earth would a private equity firm go public? Don't these guys thrive on taking public companies private? Don't they regularly lament the street's focus on quarterly earnings targets? Just this year Schwarzman, who may control upwards of 40% of Blackstone, had this to say about going public:

"I think the public markets are overrated," he told a panel at the annual Super Return private equity conference last month. When referring to the efforts of a rival that pursued an offering a year earlier, he added: "To divert yourself like that and then take on that cost is really not worth it."

So why do it, and why now? Well to start out, Blackstone isn't just a private equity firm. Of their $64bb under management, only $28bb is in private equity. The rest is hedge funds, debt funds, restructuring funds, real estate funds etc. They are by all means a diversified asset management company. And though this isn't a pure liquidity play you can imagine that Schwarzman, who is the 73rd richest American according to Forbes, is salivating over having a couple extra billion to invest.

This would also be the second large private asset management firm to go public this year following Fortress Investment Group, and it could be the beginning of a trend in the space. Keep in mind they are only selling 10% of the firm, they will still retain much of the control. The real danger is that though they are only giving up 10% of the equity they will be giving up 100% of their secrecy in the process. Stay tuned for more information on how the deal will be structured. It certainly will be interesting to get a peak inside a company known for its secrecy.

Is Real Estate a Good Investment?

I've had a lot of people ask me whether or not residential real estate is a smart investment. Of course the question is usually couched liked this: "I only invest in real estate because it is the best investment, don't you agree?" Because I'd rather not ruffle too many feathers I usually just respond "it depends." The bottom line is that we just experienced a decade long real estate boom. No one wants to listen to anyone say that residential real estate should just be a home, not a retirement plan and certainly not the place to keep your entire nest egg. Three years from now I suspect this will be an easier conversation.

Instead of giving you my own long winded thesis on home ownership I will just refer you to a couple of charts and a great article from David Crook. Mr. Crook (great name eh?) is the Editor of the Wall Street Journal Weekend Edition and is the author of a great book entitled "The Wall Street Journal Complete Real-Estate Investing Guidebook." He's a smart guy, I just wish more people would listen to what he has to say. You can and should read the article in its entirety here. To whet your appetite check out this graph from the article.


I always say why present a case with words when you can accomplish much more with numbers. Well below you will find two graphs. Click each one to enlarge.

This first graph shows the annualized rate of return to stocks and real estate over 5 years from 2001-2006.

This second graph shows the annualized rate of return of stocks and real estate over thirty years from 1976-2006.
Remember, investing is about strategic asset allocation, rebalancing and time invested. The last time I checked most assets move in cycles. Over the past decade real estate has boomed, which tells me that real estate returns should revert to their longer term average over the next cycle. However since you live in your home it is hard to "rebalance" it as a part of your overall portfolio and perhaps even harder to make unemotional financial decisions about it. Therefore real estate should be a part of your investment strategy/retirement plan, but it probably shouldn't be your entire investment strategy/retirement plan. Remember diversification across asset classes works because we simply can't predict which asset class will outperform over the next 5-10 year period. If we knew that then we would sell all of our other investments and buy that one asset and hold it for 5-10 years.

I would love to hear comments or suggestions.

Countrywide's Mozilo is Selling Out

Starting with the Wall Street Journal a week ago much has been made of the fact that Angelo Mozilo, the Chairman and CEO of Countrywide Financial Corporation, has been engaging in a bit of doublespeak as of late. On the one hand he and CFO Eric Sieracki have been vigorous defenders of Countrywide's financial position. Mr. Sieracki called the company a "well-conditioned athlete" -- whatever that means. Mozilo appeared on CNBC this morning and said he felt it was unfair that investors were lumping "diversified financial services companies" like Countrywide and Wells Fargo (anyone else think comparing CFC with WFC is a bit of a stretch?) in with companies like New Century, NovaStar and Accredited Home Lenders. He described those companies as mono-line subprime lending companies. On the other hand, Mozilo has been exercising options and dumping Countrywide shares like they are going out of style. See the graph below courtesy of the SEC:


In Angelo's defense he has been systematically liquidating shares for quite some time. However, you can notice just from glancing at the chart above that the pace has quickened in recent months. By my calculations he has liquidated $69,918,490 worth of Countrywide shares since the beginning of December 2006.

Countrywide is one of the lenders that will most likely survive the subprime meltdown. Only 10% of their loan portfolio is technically "sub-prime." Though 15% of their loans over the past 2 years are considered Alt-A loans. There will probably be plenty of volatility ahead for Countrywide and while the company will survive it may not survive as an independent company. The stock is off 19% on the year and is trading at a P/E multiple of 8. There may be a sale sign out in front of their Calabasas Headquarters in the near future.

Now? Now? Not Yet.

This turned out to be a fairly good description of the market today . . .

Courtesy of Immobilienblasen.