Do you Support a Congressional Bailout of Foreclosed Home Speculators?

As home prices decline and many overextended homeowners face foreclosure some are calling on Washington to step in with taxpayer dollars and bail them out. Keep in mind there are always foreclosures, many of which are caused by legitimate causes: loss of a job, serious medical issues etc. Unfortunately for those homeowners there are no government bailouts. However, this most recent wave of foreclosures has largely been caused by "speculators" who can't afford the home they bought but figured that if home price appreciation continued they could make a quick buck. Why should they get a bailout if the normal foreclosure victims never got one?

I for one do not support a bailout for two reasons. First, I think it creates a moral hazard problem. If the government steps in every time speculators take on too much risk the speculators will never learn their lesson. Second, I don't think that a spike in foreclosures is enough to derail the "real economy" and as a taxpayer I am willing to take that risk before I give my hard earned money to speculators.

Pimco's Bill Gross is one prominent investor who is pro-bailout:

``Why is it possible to rescue corrupt S&L buccaneers in the early 1990s and provide guidance to levered Wall Street investment bankers during the 1998 LTCM crisis, yet throw 2 million homeowners to the wolves in 2007?'' Gross wrote. ``If we can bail out Chrysler, why can't we support the American homeowners?''

Gross does have a point. The Federal government has engaged in or organized bailouts of the private sector in the past. But, this just goes to illustrate my point. If every constituency "expects" to be bailed out if they get into trouble what is to prevent them from taking on too much risk in the future? People have to fear the worst in order to prevent them from making mistakes in the present. Oh and by the way I also think that what Bill Gross mean to say is "if we can bail out Chrysler, why can't we support the American home speculators?"

If you agree with my sentiment I encourage you to check out and sign an online petition that can be found here.

Have Financial Earnings Estimates Fallen Enough?

In looking at the graph below ask yourself if earnings estimates for the financial stocks below have fallen enough given the fallout in the credit market:


Hat Tip: Bespoke Investment Group

Buffett and Griffin: Last Buyers Standing?

As the LBO premiums unwind and the buyout firms try and figure out how they can do blockbuster deals with uncooperative debt markets there is at least one buyer out there who can still do deals with a flick of a pen: Warren Buffett. Warren is sitting on a war chest estimated at some $50 billion that he would love to spend, but just hasn't found enough opportunities at the right prices. But, as the credit crunch claims more casualties and equity prices creep lower Buffett's time may be nearing. This is the latest from the WSJ:

The bond market has seized up, stocks are in turmoil, private-equity funds are sidelined and hedge-fund managers and lenders are hosting fire sales.

These are happy days for Warren Buffett.

"I can spend money faster than Imelda Marcos when things are right," he says, referring to the former Philippines first lady and renowned shopper.

For the past three years, Mr. Buffett's traditional bargain-hunting investment strategy has been partly stymied as debt-fueled private-equity funds and hedge funds drove asset prices out of his value-investing orbit.

The result: Today he's sitting on a war chest of nearly $50 billion in cash.

Now, with the shakeout in the subprime-mortgage market forcing the end of easy money and the distressed sale of assets -- such as Thornburg Mortgage Inc.'s sale yesterday of $20.5 billion of its top-rated mortgage-backed securities -- many see Mr. Buffett, the 76-year-old chairman of the giant Berkshire Hathaway Inc. holding company, as one of the last buyers standing.

But, Buffett isn't the only investor who stands to gain from the fallout in the markets over the next few years. There is one investor who started out as a convertible arbitrage specialist with just $4.2 million under management in 1990 who has grown his firm into one of the best alternative investment companies in the business, managing somewhere in the neighborhood of $15 billion in assets. His firm bought Amaranth's energy portfolio during its distress last year. He also bought Harvard-backed hedge fund Sowood Capital Management's credit portfolio when that hedge fund collapsed earlier this year. Most recently he bought some assets of struggling cash management firm Sentinel Management Group and even scooped up shares of embattled home builder Beazer Homes. His name? Ken Griffin. His firm? Citadel Investment Group. The name "Citadel" was chosen to suggest strength in times of volatility, which I guess is fitting in light of their recent activities.

As more and more hedge funds get themselves into trouble in the weeks and months to come I expect Ken Griffin will be busy snapping up assets at firesale prices and generating those 25%+ annual returns that the investors in his Kensington fund have come to expect.

Fed Cuts the Discount Rate

Before everyone gets all worked up about the Fed "caving" to Wall Street, lets review exactly what the Fed accomplished today. The Fed responded to increasing liquidity problems by reducing the rate it charges at the discount window by 50 bps. The discount rate is still 50 bps above the Fed Funds rate and lowering that rate is not nearly as significant as a change to the Funds rate. Here is a great explanation of the discount window courtesy of Greg Ip at the WSJ:

The discount window is a channel for banks and thrifts to borrow directly from the Fed rather than in the markets. Until a few years ago, the discount rate was set below the fed funds rate and loans were subject to numerous conditions.

Banks were reluctant to access the window because it was associated with a stigma usually reserved for distressed banks. A few years ago the Fed overhauled the discount window to try and alleviate that stigma; the rate was then set one percentage point above the funds rate and subject to far fewer conditions. In spite of that, discount window borrowing has remained paltry.

Discount lending averaged just $11 million in the week ended Aug. 15. Although that was up from $1 million in the prior week it was puny compared to the billions of dollars the Fed has regularly injected into the financial system through open market operations.

Fed officials hope that reducing the penalty rate associated with the window and lengthening the term of loans to 30 days from one further lifts the stigma and gives it a tool to supplement open market operations for reliquefying markets.

Yes, folks $11 million/day of lending through the discount window last week. The discount rate is virtually meaningless at those levels and it would be hard to construe lowering the rate as "caving" to Wall Street. In truth lowering the discount rate should only partially help to "reliquefy" markets (though it could save Countrywide) but perhaps more importantly, it signals to the markets that the Fed is moving away from its "inflation" bias. Until today all indications from the last Fed statement and the comments from Mr. Poole indicated that the Fed was still primarily focused on inflation. But, in the Fed's statement it did acknowledge that threats to growth have risen:

Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward. In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably.

So the Fed cut the rate at a window that has gone virtually unused and issued a statement that shows that it is not out in left field ignoring the potential fallout from the credit crunch. But, it didn't change the Fed Funds rate, nor did it hint at a future cut. The Fed still believes that this is primarily a liquidity issue though it is admitting that downside risks to growth have increased. Let us not forget that Bernanke is a prolific researcher of the Great Depression, which is acutely relevant to the current credit crunch:

``The relevance of Bernanke's work to today is that it helps him tread the fine line of allowing individual investors - - and firms, if necessary -- to fail while avoiding credit market gridlock,'' said Joe Mason, professor of finance at Drexel University in Philadelphia. ``The message from the recent interventions is that there is no gridlock.''

As Bernanke and the Fed strike the balance between orderly credit markets and the unwinding of years of cheap credit, we are left wondering if the potential collapse of Countrywide was a factor in today's shift. I was surprised by the quick turnaround in the Fed's stance on growth, and the psychological damage to markets of the top mortgage lender in the US going under cannot be ignored. It now looks far more likely that the Fed will find cause to cut rates before year end. The key will be if the hard economic data gives them the flexibility to cut if needed. If we receive low core PCE data and another uptick in unemployment the Fed will have the leeway to accomplish the cut without looking like it is bending too much to Wall Street.

The End of the Yen Carry Trade II?

I first wrote about the potential for a dramatic unwinding of the yen carry trade back on May 19th. Click here to read that post. In light of the significant dislocation in the credit markets and the dramatic fall in equity prices around the world it was worth checking back in to see how the carry trade is holding up. The carry trade is a cheap way to borrow a low yielding currency like the yen (0.5%) and buy a higher yielding currency like the US dollar (5.25%), Australian Dollar (6.5%), or New Zealand Dollar (8.25%) in order to capture the difference in yields. All is well and good of course until the trade unwinds, which can happen quickly as traders flood the exits in a panic. Well that panic might be upon us:

``The market is in panic mode,'' said Michael Woolfolk, senior currency strategist at the Bank of New York Mellon in New York, the world's largest custodian bank with over $20 trillion in assets under administration. ``It is a full-blown unwinding of the carry trade. This is just the beginning.''

Today the yen rose 3.5% against the US dollar. The yen is also strengthening dramatically against the other major currencies that are favored in the carry trade. Here's how the yen faired against other major currencies today.

The biggest change was the 8.837% appreciation against the Australian dollar and the 8.468% appreciation against the New Zealand dollar, both of which are popular carry trade currencies.

If we see a continued unwind in the carry trade that could be a bad sign for equities. We would see a more determined flight to quality situation and watch as short term treasury yields sink even further than they already have in the past week:
One way to play this would be to buy the yen ETF (EXY) which was up 2.25% today. I would stay away from (or short) the Powershares Currency Harvest ETF (DBV). That fund will get stung badly if the carry trade continues to unwind. I would also avoid most currency Etf's that are short the dollar, as I expect the dollar to continue to appreciate against the G-10.

>> Bloomberg Article
>> WSJ Article
>> Forbes Article

Uncertainty and Fear Grip the Markets

There is apparently more to fear in today's markets than there is to be excited about:

• The CBOE Volatility Index (VIX) has shot up in recent weeks and is approaching 30, putting it near where it lived from 1999-2003 during the bursting of the tech bubble.
• Subprime contagion has spread to Alt-A and A paper as measured by the ABX indices. It seems investors are fearing the worst for just about every mortgage backed loan. The ABX HE BBB Index, which tracks subprime paper, has fallen 60% since February. Meanwhile the ABX HE AAA is off almost 8% after flirting with 10% earlier in the year. This is a large drop for AAA rated debt.
• Our inverted yield curve whip-sawed over the past two weeks as investors snapped up short term treasury bills. The 3 month treasury bill is now trading at levels not seen since the beginning of 2006.
• Quantitative Hedge Funds have taken it on the chin in August. Goldman's Global Equity Opportunities fund lost $1 billion, over a third of its value in the first week of August. Goldman injected $2 billion of its own money into the fund to reduce its leverage but CFO David Viniar refused to call that move a "rescue." He insisted Goldman was being opportunistic. AQR Capital Management reported "shockingly bad" losses in its quantitative strategy, which lost 20% of its value in the first week of August. AQR, like Goldman, was able to raise an additional $1 billion even after the fall. The king of the hedge fund world, Jim Simons (pictured to the right), sent a letter to his clients announcing that RIEF was off 8.7% in August alone, after a bad July. So much for absolute returns.
  
• LBOs seems to be a thing of the past. I still remember the heady days back in Q1 when you couldn't go 24 hours without a few billion dollar deals. Instead we are seeing the LBO premium unwinding and the S&P now down for the year. The end of cheap money may well spell the end of the bull market, which at least in its final stages was fed primarily by cheap financing for LBO's and stock buybacks.
  
• Mortgage Lenders and REITs have gotten absolutely crushed. Countrywide is off 41% this month. Thornburg Mortgage is down 60%. NovaStar is off 76%. ECC Capital is off 66%. New Century is finally throwing in the towel and is down 65% this month.
• The Fed isn't budging on rates. While it will inject liquidity, it is serious about inflation. Just this evening Fed governor William Poole had this to say: ``I don't see any impact as yet on the real economy or on the inflation rate,'' he said in an interview in the bank's boardroom. ``Obviously, there could be an impact, but we have to rely on some real evidence.'' Poole says he will be watching monthly jobs, retail sales and industrial production data to determine his stance at the next Fed meeting in September.

Given all the headlines above, are you optimistic about strong stock returns?

Economic Data: Retail Sales, PPI, CPI

This is a busy week for economic data. Let's review the highlights thus far.

Monday - Retail sales

It seems the consumer is still holding up in the face of the housing recession and higher gas/food price. But, we also learned this week that retailers Home Depot and Wal-Mart are seeing declining sales in the coming quarter and are worried that a weak housing market could effect their results.

Tuesday - Producer Prices

Tuesday's report continues to show the importance of energy in overall inflation - something the Fed clearly is watching. The market largely ignores the PPI data these days, choosing instead to worry about the CPI numbers that came out Wednesday.

Wednesday - Consumer Prices

Year-on-year, the overall CPI was stood at 2.4 percent in July, compared to 2.7 percent in June. The core rate was unchanged in July at up 2.2 percent on a year-on-year basis. Inflation is clearly moderating and if this trend continues a rate cut in September becomes more and more likely.

Tomorrow the housing starts data comes out. Expect housing starts to be lower in July due to the continued overhang in housing supply. Consensus is for a roughly 4% decline to a 1.41 million-unit rate.

Commercial Building is a Weak Crutch

With residential building falling off a cliff, commercial building has been propping up regional economies around the country. Just this morning the WSJ featured an article about commercial construction supporting the economy in areas like Phoenix, Houston and Las Vegas. Unfortunately commercial building has historically been a weak crutch. First of all the commercial market just isn't as big as the residential one: "commercial construction can't offset all of the downdraft from weak housing. The residential market is much larger than the commercial market, and it plays a bigger role in the U.S. economy." Commercial construction has another weakness; it is dependent on financing and thus vulnerable to a liquidity crunch. If banks and other lenders start pulling back from all lending or if investors foresee rising defaults in commercial mortgage backed securities that could put a chill on the commercial construction boom.

The other thing worthy of note is that in a typical cycle commercial investment lags residential investment by roughly 5 quarters. In the graph below residential construction has been moved forward 5 quarters into the future. You may notice that residential investment has been falling over the last 5 quarters. Many predict that commercial market will soon follow, which would lead to a spike in unemployment and an increased chance of a rate cut.

Hat Tip: WSJ and Calculated Risk