Housing - The numbers only

Why are folks panicking about the housing market?
It has 2 parts, really:
1. Financial market turmoil not seen since the last financial S&L turmoil
2. Millions of people kicked out of their homes
Obviously, both add up to major economic consequences.

But how much of this is realistic and how much is just for the media circus?
To understand that, we need to understand what kinds of loans are collapsing and how much they represent.

WHAT IS THE DIFFERENCE BETWEEN ALT-A AND SUBPRIME
Answer: not much

Subprime – debt ridden, have no liquidity, and have a history of defaulting. Subprime have either a proven history of defaulting or will topple over if the winds change even slightly.
Alt-A – No documented income, stated income, or not owner occupied. The abuse of the stated income is quite rampant and often target speculators (second homes)

IT'S ALL ABOUT TIMING
Fannie Mae estimates ~ $3T in ARMs were written over the past 5 years (out of $10T since 2000). In fact, ARMs were 30% of all mortgages from 2004~2006 - higher in some markets like California. That's important because folks opt for ARMs typically because they can't afford the house at normal rates. Of the $3T in ARMs, almost all re-set in 2007 and 2008.

The average loan amount is $260K, but we’ll use $300K because of the California skewing. That’s 10M homes facing higher rates.

ZEROING IN ON THE ALT-A/SUBPRIME EXPOSURE
According to most estimates, the suprime and Alt-A share of the resets:
Subprime = 47% of resets or $1.4T (4.7M homes)
Alt A = 25% of resets or $800B (2.5M homes)

The Subprime default rate has risen to 15% and is still rising (Countrywide had 20% in August). That means at least $210B in loans will default.
The Alt-A default rate is now 5% (6% at Countrywide). That’s $40B in loans that will default.

A combined $250B in losses for 2007/2008. How well are lenders covered? Here are loss reserves so far:
Citigroup $11,000,000,000
Merrill Lynch $8,400,000,000
Barclays Capital £1,300,000,000
HSBC $3,400,000,000
Swiss Re $ 1,070,000,000
UBS AG $3,600,000,000
Deutsche Bank €2,200,000,000
Bear Stearns $1,200,000,000
Morgan Stanley $3,700,000,000
Lehman Brothers $700,000,000
Freddie Mac $3,600,000,000

Against $250B of likely losses in just 24 months, not even $45B has been put into loss reserves. Even if the homes can be re-sold for 50% of loan value, that’s $80B more that must be put into reserves ($250B * 50% - $45B).

A fraction of that exposure is also held by pension funds and insurance companies, but these companies are a major source of lending, so they might as well be considered lenders.

So it's two issues here: more creditor losses and a general shrinking of funds available to lend. Nobody can shrug off $250B in losses. And given that these funds are leveraged in the marketplace, the financial investing impact is at least $1 Trillion.

FORGET BANKS, HOW WILL PEOPLE BE AFFECTED
Go back to the home units that will enter default. The estimates are that 7.2M properties re-setting as Alt-A and subprime. If the default rates stay flat, almost 850K homes will be foreclosed on and re-enter the inventory stock. (For the 2 years 2007/2008)

How realistic is that? It’s actually on the low side: ~800K properties were already foreclosed on in the first 9 months of the year. There were ~450K foreclosures in the 3rd quarter alone. http://www.realtytrac.com/ContentManagement/pressrelease.aspx?ChannelID=9&ItemID=3567&accnt=64847
With ARM resets peaking in December, we might as well call it 1.5M homes for 2007. That’s ~3M homes for the period 2007/2008.

Of the 7.2M homes under re-set in 2007/2008, default rates seem to be ~40%. I think it’s higher, here’s why:
1. Pushing down that rate is the fact that not all foreclosed homes are these resetting loans.
2. Pushing it up is the fact that banks are being slow to pull the trigger on defaults. I would guesstimate that the true default rate is easily 60%.
3. Housing prices continue to drop, pushing out the likelihood of short sales and sales that would avoid defaulting

Also, notice how there are more filings (635K) to properties (446K). That’s indicative of the fact that most borrowers used multiple loans. In and of itself, that is proof that these folks could not afford the mortgage without tricking the system.

At 40% default rates, we will see a total 2.9M homes defaulting or $1.2T.
At 60% default rates, we will see 4.5M homes defaulting. That’s $1.8T in losses.
That’s millions of people tossed out of their homes.

Should you feel sorry for them? No way. First of all, under traditional borrowing standards, they'd be exactly where they are heading: renting apartments. Many others were gambling and lost. Others were simply living beyond their means. Or they took equity out of their house and blew it on cars and vacations.

Add it all up and you have millions thrown out of their homes and effectively removed from the consumer spending marketplace. You also have fortunes erased as individual speculators lose their investments. These are the fundamentals of a recession.

Adding to the pain of falling spending is the tightening of lending.

No amount of free ride on defaulting loans will restore the fortunes of investors and homeowners who can't even pay their property taxes. These folks will not suddenly feel comfortable enough to go out and buy new cars. They will be pinching pennies.

The scale of this is massive.

On the othe rhand, if you can weather the situation, this is a blessing coming your way. Anyone with cash and good credit will have an unparralleled opportunity to buy assets cheap.

To buy or not to buy

This is the second time in just a few months where the market has crashed and our STOP strategy did not work. I use STOPs for 2 scenarios.
First, stock specific bad news that gets me out with less damage.
Second, to take advantage of pullbacks. Basically sell and then buy back in a bit lower

The problem is that I have to be watching the market to follow through on the buyback. And I have been unable in October and November to have that daily focus.

So I missed the rally last week and at the same time we got hit with the sell off. On the other hand, I feel really really good about the strength of my picks.

Now, on the positive side, many of our stocks have recovered and more. ATW, for example, had earnings last week that, as I expected, would trump expectations.

Bottom line, I have confidence in my stock picking but my STOP strategy is not functional given some outside commitments. So for now, I am not going to use STOPs but I will offer them as guides for those who do use them.

As you can also see, I have not bought back in yet. Last week saw a very nice rally but I don’t know if this is a reversal or more of a response to overselling. The key motivator was interest rates but I suspect there was also an awareness that things were oversold. Does that translate into a bull market? Perhaps. But for how long?

I see 1 strategy here, based on interest rate cut expectations, proposed changes to the mortgage lending and the imminent earnings announcements.
1. Interest rates will be cut – This is already largely baked in to the current market. Limited upside
2. Interest rates won’t be cut – This would sink stocks. Huge downside.

The market expects an interest rate cut and indeed Bernanke seemed to feed that expectation last week when he said that the Fed needs to be nimble. What he is seeing is a massive liquidity crunch on a global scale. Did you know that inter bank lending rates have shot up an extra 0.5%. Banks are having to get cash to cover loss reserves, and they must borrow. Everyone borrowing at once makes for a run-up in lending rates. Dropping interest rates will help to ease the pain.

There are signs that under normal conditions, another rate cut is suspect.
* The economy is strong
*GDP is raging: Q2 was 2.8% and Q3 was raised to 4.9% from the previous preliminary 3.9%

* Forecasted growth through next year is 2%+

* Inflation is showing up. October CPI was 3.3% and 2.2% excluding food and energy. This is after very low interest all Summer and into Fall.
* Fed Governors are not supportive of a cut
*Gov Kroszner just said that he is against a cut. He also pointed out that October CPI surged 2.2% - the highest in a year. (It was 3.3% including food and energy). Cutting rates tends to be inflationary
*Fed Governor Plosser is also against a rate cut even if the economy starts to slow.
http://query.nytimes.com/gst/fullpage.html?res=9D01E1DF173BF934A35752C1A9619C8B63&n=Top/Reference/Times%20Topics/Organizations/F/Federal%20Reserve%20System
· The last cut was not unanimous
o Governor Hoenig voted against it
o Only 6 of 12 governors requested it
o Only 9 governors voted for it

The emphasis being on normal conditions. The last cut of 0.5% was not based on economic performance. It was entirely related to the banks’ liquidity crisis. That crisis has not gone and it has – in fact – spread to other countries.

Until this gets resolved, takeover and merger activity is on hold. And that’s a positive waiting to happen.

So the Fed may be willingto cut now to smooth the bank crisis and then reserve the right to reverse direction if inflation shows up. Naturally, it will but the Fed will do nothing. In fact, the crisis will only spread because the mortgage market is $1T in losses over the next year. Rate cuts ease the pain but nobody can swallow that much pain without suffering.

Another positive factor supporting stock prices is the potential of a proposal to the subprime crisis. On the face of it, any solution will calm the market. But don’t forget that at its heart is a political solution to a market problem. In other words, it won’t solve the problem but it will ease some of the pain. This being an election year, that matters to some folks.

A final positive factor is that the 4th quarter ends in 4 weeks. As I’ve pointed out before, funds tend to buy in as the quarter ends and visibility starts to improve.

The way to play it would be to be bullish for a week and prepared to jump out if Bernanke does not deliver.

I’ll post the current portfolio and performance later. In the meantime, we will be buying in today or tomorrow. Stay tuned.