Housing news: Bottom is falling out of the Bottom

The latest housing sales data was released and it's really bad - worst news in 40 years.

NEW HOME SALES DOWN
To begin with, August and September #s were both revised down. If you recall, the August preliminary data gave the market a bump up because it showed a sequential increase.
Well, guess what: it was actually a slowdown
Aug original 795K
Aug revised 711K

Sept Original 770K
Sept Revised 716K

October estimates are 728K, but we can expect that to be revised down next month

So in 2 months, 138K homes did not in fact sell. And another 191K homes were built during this time. Not counting the inventory from previous months, that's a combined 2 month total of 329K homes that were added to the market.
At $250K per home, that's $82B in unsold inventory in just 2 months.

But prices will stay flat, right? WRONG. October prices fell 5.5%.
But it won't happen in California at least. WRONG
According to CAR, Existing Home sales decreased 40% in October in California compared with the same period a year ago, while the median price of an existing home fell 9.9% to just under $500K

Even better: "Financing issues have dogged entry-level buyers since early 2007, but they spilled over into the middle and upper-tier markets in the last few months,’ said C.A.R. President William E. Brown. ‘The decline in sales at the upper end of the market contributed to a significant decline in the statewide median price as even well-qualified borrowers had difficulty securing financing.’”

Inventory of existing homes is now 16 months.

So we have surging inventory added to an already impressive inventory base. San Diego November escrow closings were just 5% of all listings!

Add to this the fact that foreclosures have doubled since last year nationwide and are rising.
Foreclosures will surge by April as the peak of ARM resets begins.
Oh, and lenders now expect 20% downpayment.

The pressure on prices is immense and growing. Considering that economic data is still strong, we are in for a very rough ride ahead as we move into a recession and people's finances weaken.

The secrect to remember is that nobody believes trends until they show up as publicly reported facts. Until th eimpact shows up in a company's quarterly report, it isn't a fact. I made this mistake exactly a year ago when I shorted a lot of housing and financial companies: I was too early. That is to say, th ereality was underway but it wasn't quite hitting the books.

With housing, it takes months before an actual foreclosure happens and then months before it shows up on the books as a distressed sale. So while we can see the mess today, it will be Jan-April when companies start losingthe ability to hide it.

Next summer is when the fear and panic hit. When California prices drop another 15%. Don't even think about buying before 2009.

Meanwhile, Lowes and Home Depot and Sears can't be shorted enough

Is it all about the interest rate cut?

In the past 2 days, the market has gone up 4%. Is this a turnaround because the market was oversold? Or is this just another sucker rally?

I hold subscribe to my theory that stocks rise beginning the last month of the quarter (December). So that creates an underlying desire to get back into equities.

But the trigger in this case was 3 things:
1. Critical 12,700 level
2. Citigroup got funding
3. Hopes that the Fed will cut rates in 2 weeks

While I am not driven by the technicals, the 12,700 mark was an important one psychologically. That was a 10% drop from the recent high, which is substantial. The market hit it and rebounded. That's a positive sign for now.

Citigroup's cash injection came from Abu Dhabi. Which is interestingbecause, back inthe 90s Citigroup was in a similar dilemna and it got a major cash infusion from Saudi Arabia. In any case, as I suggested a few posts back, foreigners are going to come piling back into the US market. For some we look cheap. For others, like China, we have critical technology.

So the Citigroup investment was a positive signal that money is out there and will come into the market. And that's what matters in the short term. In the long term, it's not a good sign that a major company is on the ropes so quickly. It was just August when Citi said they were fine and had no exposure to subprime loans.

Then we have the interest rate cut expectations. The Fed has room to make the cut. Certainly the past 2 quarters have shown strong GDP growth:
Q1 0.6%
Q2 3.9%
Q3 3.8%

Much of that growth was driven by exports and by increases in spending on inventories and durable goods. In other words - a weak dollar bumped up manufacturing. Over the next week or so, we will get better visibility to jobs, housing and manufacturing. And inflation. The market seems to be shrugging off the non-stop negative news about housing. Instead it focuses on whether soft inflation will allow for more rate cuts.

Putting on the Fed hat, this is what I would see:
1. Extreme distress in the credit markets requiring increasingly fsat attention
2. The last rate cut brought stability until more bad news came out regarding housing and financial institutions
3. Rate cuts must not drive inflation - current indicators are that inflation concerns exist.

Inflation is an area of conflict. Minutes from th elast Fed meeting and comments more recently suggest that inflation is not to be taken for granted and that Fed cuts may not happen if inflation looks set to increase.
At 3.5%, inflation is higher than last year's 2.6%.
ftp://ftp.bls.gov/pub/news.release/History/cpi.11152007.news
However, much of this comes from the early part of the year. The last 5 months have seen very low CPI.
And the Fed likes to strip out food and energy, which makes the CPI 2.2% for the last 12 months. Nevermind how absurd it is to strip out food and energy, which are plainly in a major inflationary mode. The Fed's decisions will be influenced by the adjusted CPI and it is trending low.

In other words: the Fed has room to cut.

An interesting point: the GDP surged while inflation dropped. I don't know why.

Back to the subject at hand: where is th emarket going.
In the short term, rate cuts will generate excitement and bump it up but let's be realistic. We are heading into a recession and the market never does well in a recession. The trend is Bearish with spots of Bullishness.

Factor in the fact that only afraction of th ehousing bubble bad news is out and we need to be careful. Are retailers really doing well? Are cars really selling? The economy is run by consumption and that is slowing down.

There are two ways to go.
1. Join the herd but carefully. The market wants to be excited and want sthe Fed to cut in a few weeks. That could be a 2 week run-up. You could profit by jumping in and selling quickly.
There is to much money sitting on the sidelines and it is burning a hole in some pockets. Folks want to play in the market. Europeans, Arabs and Chinese see a market that is down 10% on top of a dollar drop of 12% over the last year. Looks pretty cheap.

2. Wait for bad news. You won't have to wait long. The market will dive again.

Fannie Mae Tanking - Housing Part 2

As you know from recent news, Citigroup just sold 4.9% of itself in a desperate move to get cash.
Meanwhile, Fannie Mae is cutting its dividend and selling new shares.

Add it up and you see that top lending institutions are insolvent. What does this mean and why should you be scared.

Start with FNM. FNM is a very unique entity - it backs mortgages. If a homeowner defaults, FNM is required to buyback these loans at the original price, not the current value. Bearing in mind that FNM basically focuses on folks who couldn't normally get a loan, well, you get the picture. They backed bad loans and must now buy them back. In 1 year, FNM has movde from buying back $37M in bad loans to $670M.

Meanwhile, FNM has engaged in slippery accounting. They are not writing down the losses but, instead, are claiming that the losses can be recovered. If they are correct, no problem. But if they are wrong, then they are hiding the fact that they are now insolvent.

Recall that subprime loans are now trading at $0.30 to the dollar. The FNM and Freddy Mac backed loans have more support: they are trading at $0.70 per dollar. Combined, these two entities have $162B in guaranteed loans. If they are wrong and the market is right that 30% of these loans will never get repaid, then they will lose $40B. But they don't have that money.

The same is true of Citi - their debt to cash ratio is blown. The only way they and other banks like BoA are surviving is by using accounting tricks to hide the true extent of losses and forestall emergency help.

This is the match that will start the fire sale. As more and more properties become bank owned, pressure will build to sell them. At any price. A housing fire sale tend sto be different from a normal fire sale because housing gets handled slower. Repossessions can be delayed up to 6 months or more. And then the house must be sold. It could be 9~12 months from now before the tidal wave of dumped houses finally shows up in the housing numbers.

Meanwhile, governments will be in a bad place. The Fed will find that most financial institutions won't be paying taxes this year. Or next. That's 10s of billions of dollars in tax revenues that won't materialize. At the local level, governments that depend on housing taxes will be in for a nasty surprise. California's housing taxes add up to ~1.5%. With 100K houses already under default, that's ~$50B in property at $500K per house. Almost $1B in tax revenue that won't get paid. Assume that another 50,000 homes will default and you get the picture.

Instead of doing the honorable thing and firing a bunch of workers or renegotiating fat government union salaries, watch the states and municpalities up taxes and increase penalties. This wil lalso take at least a year to materialize.

Invest defensively. The day of reckoning is on the horizon but the stock market is still low-balling the impact.

What is the deal with all the banks taking write downs?

Takestock asks: What is the deal with all the banks taking write downs?

WHAT IS THE VALUE OF THE US MORTGAGE LOAN PORTFOLIO
WHAT HAPPENS IF THAT VALUE FALLS
HOW WILL OWNERS OF THOSE LOANS RECORD A LOSS

The mortgage value of US residential property is $10 Trillion. In 1998, US residential property was worth ~$10 Trillion. Today it is worth $20 Trillion. If you connect the dots, you realize that the value of housing is exactly the value of loans.

If defaults on those loans reaches 10%, that's $1 Trillion in losses. As long as the housing market stays strong, defaults can be covered by claiming the collateral (the house) and selling it. The lender recovers the loan one way or another.

Unless the housing market collapses. In which case there are losses.

When banks switched from being loan holders to being middlemen, they loosened standards. Mortgages were packaged and re-sold as CLO or CDO (collateralized loan or debt obligations). Banks made more money on loan processing - the more loans, the more money. The consequence of which was that banks and other lenders had looser and looser standards as they sought more and more loan activity.

Asset prices always rise when money is cheap. Housing prices rose as easy lending terms and low rates brought in investors and potential homeowners. Housing prices rose, and started to become self fulfilling - drawing in more investors and flippers.

Loan activity soared and with it the average value of each loan.

Meanwhile, the CDOs/CLOs were sold to investment houses, insurance companies, and foreign investors. An important thing to be aware of is that many of these CDOs/CLOs carried an interesting condition: loan writers had to buy back the CLO/CDO if the value fell.

Of the $10 Trillion in loans, $1.5T is held by the government (Fannie Mae and Fannie Mac). Of the remaining $8.5T, about $2T is subprime. As ARM's reset, borrowers began to default. And - surprise - that home is not worth as much anymore.

Today's defult rate on subprime is a movingtarget, but it's at least 15% nationwide. So ~$300B in CDOs will be written off. Ouch.
Except that these CDOs are currently trading for 25% of face value. In effect, $1.5 Trillion in loan value is gone. Now throw in Alt A and other tiers where defaults are also happening and we are looking at a $2 Trillion writeoff. (BTW that figure is about what Goldman Sachs recently said we'd be seeing.)

The consequence of these mounting losses is that Lenders aren't in the mood to provide easy money when they are looking at $2 Trillion in losses. That hurts hedge funds and others, and leads to a reduction in leverage. Put differently, M&A activity and general investment activity slows down.

Back to writedowns. If a company owns gold then the value of that investment is today's gold price. That's called marking to market - the act of assigning a value to an investment or portfolio based on the current market value. But not every investment can be so clearly valued. An investment in a start-up company, for example, could be worth the original investment, more, less, who knows. There may not be a current market for that investment.

Into that hole falls CDOs/CLOs. US accounting lets the owners of CDOs/CLOs to declare their value based on whatever the owner says it's worth. That $1B CDO could be worth $1.5B or $100M, but the owner gets to state the value. In a post-Enron environment, and with massive scrutiny, accounting firms are not going to play along with that game.

A mark to market approach would have subprime CDOs worth only 25% of original investment value. These CDO owners face massive losses and they want to play for time in the hope that this is just a fire sale and the current values will rise. A fine strategy, but it's not kosher if a company is going to report current value of investments.

Citigroup and JP Morgan recently tried an Enron-esque scheme whereby these CDOs could be shoved into a separate entity and then traded by - surprise - Citigroup et al. In essence, they were trying to create a market and manipulate the pricing higher by playing the role of buyer. They hoped that they could create a price that was much higher than the 25%.

That scheme went nowhere.

These entities are facing a very real scenario where the value of their investments is worth a lot less and they have to be honest about it.

How much less? The current view is that lenders will write off amounts that approximate default rates. After all, the loan still has value as long as someone is paying the interest and principal. That default rate varies, but it's at least 15% on subprime, or $300B. That $300B equals 1 Million residences. Or 500K residences at California prices. Interestingly enough, 100,000 notices of default have been issued this year in California.

So far, I think we've seen maybe $100B of writedowns. Which means there is a lot more coming. And that assumes that others won't default. I think that we are facing $2T in defaults and the associated downward spiral of the wealth effect.

Fear, Uncertainty, Doubt

The markets have been steadily falling for almost 4 weeks. Arguably, one could say that the markets have been falling even longer and that the end of October rise was a dead cat bounce.

With more bad news on the way, it will be hard to coaxe money back in. Short term, the environment is not a solid investing environment. Long term, I am bullish on a few sectors.

For example, the HSBC announcement of bad news is going to be followed by plenty more. And the GDP news this Thursday may not be as solid as expected.

I am also noting that the market crashed to a 6 month low in just a few weeks: a rapid 10% drop. That will shake out quite a few hands.

I am going to continue to sit and wait for a bit more. I am going to hone my list of stocks. I think the time to make a move is coming as we enter the last month of the quarter and of the calendar year.

Getting caught up

Apologies for being AWOL - too much happening in my personal life.

The last few weeks were, simply put, horrible for us. Because of the market panic we were stopped out of everything. Not necessarily a bad thing, but I was too busy to respond and jump in. We were, for example, stopped out of PCP.

In any case, my investing thesis will follow these guidelines
1. US heading to recession - Avoid any housing, financial, consumer, and IT sectors.
2. Financial institutions are still low-balling the extent of the damage - There is more blood to shed from the housing woes. They will cut back on IT spending for another two quarters.
3. Oil is where the money is to be made. There is no cushion between oil supply and demand.
http://www.eia.doe.gov/steo
Oil price rises have not been seen to cut into US demand yet. Moreover, a 5% drop in US demand will be offset by China, India, Russia, and other non-OECD demand. In other words, demand is flat to rising, even in a US recessionary scenario. Supply is rising slightly but it can not rise much because OPEC does not have the extra room.
Ongoing high prices will drive a lot of exploration and extraction.
4. Developing countries and infrastructurre will continue to grow.
5. US exports of agriculture products will boom

I think the US stock market will suffer from liquidity in the hedge funds and other funds.

My Wishlist

The stocks I am watching are

AGRICULTURE
AGU
AG
POT
tra
mos
cf

ENERGY
CAM
GSF/RIG
IO
NE
NOV
oii
sgr
fwlt
stp
wfr
atw
do


CELL PHONE
GLDN
VIP
MICC
nok


OTHER
mvl
pcp
pcln
syna
dsx
drys
ma