Alright Bernanke, Enough with the Rate Cuts

Do you get the feeling that FOMC Chairman Ben Bernanke is lowering interest rates more because that is what the markets want, and less because it is actually helping the problems we have in the housing and credit markets? The debate has long been whether or not the mortgage crisis will be contained or spread into the rest of the economy and cause a recession. With third quarter GDP growth coming in at 3.9%, the highest rate since early 2006, it is clear that the economy is a lot more than just the housing market.

While GDP growth should slow meaningfully in Q4, it does appear the mortgage problems are contained. Unless rate cuts will help stabilize the housing market, which is not a likely result, I don’t see the need to go ahead with them just for the market’s sake. After all, commodities like gold, oil, wheat, corn, etc are soaring. The result will be higher prices for consumers, which we have already begun to see as companies like FedEx, Colgate, and Procter & Gamble are all raising prices to maintain their profit margins and stock prices.

In the face of apparent inflation pressures, interest rates could ultimately be headed higher, which would make the recent cuts even more baffling. It’s true that the government’s inflation data doesn’t seem to jive with reality, and maybe that will reduce the likelihood that rate increases are in our future, but when press release after press release announce price increases from major manufacturers due to record commodity prices, it’s hard to deny inflation is real.

So what will cure the housing market’s woes if rates cuts won’t do the trick? Honestly, just the laws of supply and demand. The housing market is still falling with no signs of stability in sight. As long as delinquency and foreclosure rates continue to rise, and home prices continue to fall, the credit market issues (loan losses and asset backed securities writedowns) will continue. The value of loans won’t stop falling until the performance of such loans improves, or at least stop deteriorating.

Rate cuts won’t help because they have no direct impact on home prices or mortgage delinquency rates. This will be apparent when we see fourth quarter loan performance continue to get worse, not better. As home inventories are worked off and more home owners refinance into fixed rate loans, the markets will eventually stabilize. It will take time though. I don’t know when, nobody does, but hopefully we can get there by the end of 2008.

As for whether the housing market weakness has spread to other areas, this debate obviously will continue. From third quarter earnings season we see that the weakness has really been contained to home builders, mortgage lenders, banks and investment firms that own securities backed by mortgage loans, and companies that provide insurance for mortgages and mortgage backed securities. It is my belief, and many will certainly disagree, that consumer spending is not as bad as some would have you think, and the fact that growth in spending is lackluster has much more to do with the face that real wages have been stagnant for years, and not because of the housing market. In addition, the fact that consumers are staying current on all their other monthly bills, even when they are delinquent on their mortgages, shows that the housing market’s issues really are fairly well contained.

As for policy moves, I think actions should be focused exclusively on stabilizing the housing market. While pleasing to the markets, I don’t see any direct impact on housing from rate cuts. Just imagine how great it would be if we could get back to a “normal” housing market. People would have to get used to not making much money on their homes (real estate returns historically don’t outpace inflation), but the credit markets would stabilize and corporate earnings could resume their growth trend. Even a flat housing market would be welcomed by investors, to say the least.

Full Disclosure: No positions in the companies mentioned

Countrywide Predicts Trough, Shares Soar 24%

Gauging the outlook for pure mortgage lenders like Countrywide (CFC) is a tough game and one that I am choosing not to play. The company is predicting that the third quarter was the trough and profits will return in Q4 and 2008, but nobody really knows for sure. Delinquency rates are still rising at CFC, standing at 7.1% as of September 30th, up from 5.7% three months before.

Until there are signs of stability and that stability hangs around for a while, I’m not going to bottom fish in mortgage-related companies like pure lenders or mortgage insurers. Honestly, those stocks are down so much, trading far below even recently slashed book values, that I think eventually there will be plenty of upside without even needing to time the bottom of the cycle.

Until then, I continue to like the bigger diversified banks with fat dividend yields. With these stocks yielding more than treasury bonds, I think you can justify buying low and being patient, knowing that calling a bottom is essentially impossible. I would, however, start making a list of the kinds of stocks you might want to target when things start to rebound. You won’t be able to time a purchase perfectly, but there is no way that most of the home builders, mortgage insurers, and big lenders won’t survive and be consistently profitable when the markets get back to some sort of more typical environment.

There will be money to be made, but I’m not comfortable jumping into pure plays just yet. Hopefully by sometime in 2008 things will stabilize and we’ll have a better idea of what “normal” conditions look like. At that point, making bets will be much more prudent.

Full Disclosure: No position in Countrywide at the time of writing

Should We Cheer or Jeer Bernanke and the Fed?

A reader asked if I would share my thoughts on the views expressed in a Yahoo! Finance article written by Wharton Professor Jeremy Siegel on Thursday regarding the Fed and whether or not it should be flooding us with rate cuts.

The piece, entitled Don’t Blame the Central Banks — Thank Them, was well written and sought to comfort readers that coming to the aid of the banking industry is a good thing and could potentially help avoid a recession. Opponents of the Fed’s recent rate cut point to the fact that it is a bail out, and contributes to a moral hazard problem.

From my perspective, I think it is important to differentiate between a bail out and a Fed that provides additional liquidity and reduces the discount and federal funds rate. I am firmly against a bail out of any kind because it rewards (or at the very least seeks to reduce the negative repercussions from) poor decision making by the private sector. I agree that moral hazard is a real concern.

We live in a nation that is fueled by incentives. In most cases, people make decisions based on the incentive structure that is present at the time. If we bail out lenders who made stupid loans as well as the borrowers who were so eager to borrow money than they couldn’t afford to pay back, then nobody will learn from their mistakes and they will be made again and again, at the expense of taxpayers.

An important point to make, however, is whether or not the Fed’s actions thus far should be considered a bail out. Surely the Congress and President Bush could sign into law some sort of plan that essentially bails out troubled lenders and borrowers, but let’s focus on what our central bank has done so far. As Siegel points out in his article, the Fed has taken the lead in increasing the level of available liquidity. It allows those who want access to capital but can’t get it due to short-term market inefficiencies to have ways to get it. Our market-based economy will be better suited when we can eliminate, or at least sharply reduce, a liquidity crisis.

In my view, this is not a bail out. No borrowers are having their loans forgiven and no lenders are getting reimbursed for unrecoverable loans. When you have market participants providing capital into a market based system, and the system temporary stops working (i.e. capital becomes scarce), I applaud the Fed for stepping up in their role as a lender of last resort. We can argue how much of an impact it has had thus far, and will have in the future, but I have no doubt it is helping in some measurable way.

What I find interesting with this mortgage crisis so far is that the companies that have filed for bankruptcy (there have been more than 50 mortgage lenders go under so far) and the companies that have stopped making new loans, have fallen upon hard times due more from a lack of liquidity than loan defaults and property foreclosures. Interestingly, most home loans are being paid on time. As of August 31st, the nation’s largest mortgage lender had 95% of its loans being paid on time. Other lenders have seen their loan portfolios perform even better than that (delinquency rates at another banking institution company discussed last week on this blog are 50% below those of Countrywide).

Now, that is not to say that there isn’t a problem. The sub-prime sector of the market has seen delinquent rates reach more than 20% at some of the more careless lenders, and many of them are no longer in business as a result. I just hope that the actual performance of these loans is what ultimately causes the lenders to sink or swim. If you made bad loans, you deserve to go face the consequences, with no help from anybody.

However, companies whose loans are performing okay also found themselves teetering on the brink due to a lack of capital in the marketplace. If the Fed can provide liquidity to maintain an orderly market, I think they are doing the right thing. That won’t have any impact on how many loans are defaulted on, and I think that is what should determine how much money these firms lose and whether or not they can continue to stay in business. The might lose a lot of money in the short term, but very few can argue that isn’t justified based on the lax nature of their lending standards in recent years. What I’d prefer not to see is a lender be forced into bankruptcy due to lack of liquidity, only to see their loans bought up by third parties who actually recoup most of the outstanding money.

I am all for the Fed’s aiding in the liquidity crisis, but let’s make sure the people who lent money to people who couldn’t pay it back don’t get bailed out, even if that means a family has to give up their house in the process. If they can’t afford the house, I see no reason to fight hard for them to stay in it when they can move into another one (or rent) they can afford.

So Much For That Theory

If you want to know just how difficult it is to predict short term market events, such as interest rate moves, just look at what happened over the last two weeks. I wrote back then about how the futures market was pricing in a 50 basis point rate cut and postulated that the odds of no cut or only 25 basis points appeared to be much higher than the market was indicating. It turns out that neither the market nor my contrarian view two weeks ago turned out to be right.

By the time the Fed meeting came around yesterday afternoon, the market was only expecting 25 basis points, which I obviously agreed with. Then out of nowhere we get a 50 basis point cut, the bulls were ecstatic and the shorts got burned big time. The end result was a 336 point jump on the Dow, the biggest single day point gain in about 5 years.

Rather than try and predict why the Fed did what they did, or what they will do in the future, let’s focus on what yesterday’s action does. First and foremost it was a positive symbolic move that the Fed does have the market’s back. We can argue if such a role is in their official job description or not, but that’s another conversation entirely. I’m not sure why they waited so long if they thought a dramatic 50 basis point cut was needed, but maybe they are hoping decisive action will prevent further deterioration that would require more cuts in the future.

An important point regarding rates is the effect on the housing and mortgage markets. Remember, for all of those home owners who will desperately be trying to refinance their adjustable rate mortgages into fixed rate loans, this rate cut won’t help them. Fixed rate mortgage rates are based on long term bond rates, not the Fed Funds or Discount rate. The move will help those with variable rate home equity loans and credit card debt (which are generally based on the Prime rate), but I don’t think a half a point change in rate, or even a full percentage point if we get more cuts later on, will dramatically alter the ability of consumers to pay their bills on time.

The main problem with the housing market is supply and demand and overly excessive pricing. Despite press reports to the contrary, most people can get a mortgage if they want to buy a house. For those sub-prime borrowers who can’t get a loan, now isn’t the time they’ be looking for one anyway (they have already gone down that road). Instead, they will either be forced pay their mortgage, refinance into a fixed rate mortgage (which the banks can make a profit on and therefore are willing to offer), or lose their home and begin renting again.

So what will really help the ailing housing market? In my view, above all else, it’s reasonable pricing. Not only can most people still get loans, but another myth out there is that you can’t sell your house. Well, that’s not really true. What is true is that you can’t get top dollar for your house or always make a profit on every property that you purchase. However, if you price your home competitively, you will find buyers.

Want proof? How about what Hovnanian Enterprises (HOV), one of the larger home builders in the country, did recently. HOV just completed a 3-day sale on their homes, which they dubbed the “The Deal of the Century,” where they slashed prices by up to 25% or $100,000 in an effort to get rid of inventory. The results were beyond impressive. Hovnanian either sold or received deposits on 2,100 homes in just 72 hours. That compares with 2,539 homes sold in the entire quarter ending July 31st!

Now, some press reports compared these numbers directly to gauge the sale’s impact, which is not correct given the 2,100 number was gross sales and 2,539 was a net sales figure. If you use HOV’s most recent cancellation rate of 35% you get net 72-hour sales of 1,365 homes. But still, the implications are very strong. If you price your homes aggressively as HOV did, there are plenty of willing buyers. By doing so, Hovnanian sold more than 6 weeks’ worth of homes in only 72 hours.

Full Disclosure: No position in HOV at the time of writing

Fed Fund Futures Could Be Setting Market Up for a September Sell-Off

You would think that with everything Fed Chairman Ben Bernanke has said publicly thus far regarding the current turmoil in the mortgage and credit markets, the market might be at least somewhat doubting that a Fed Funds rate cut is coming later this month at the next FOMC meeting. After all, Bernanke came out and said the Fed is not responsible for bailing out lenders and consumers who made bad decisions in a loose lending environment. Quotes like that should at least temper people’s expectations a little bit that a rate cut this month is essentially guaranteed. Well, that does not appear to be the case.

As of late Wednesday, a 25 basis point cut was fully priced into the market and there was a whopping 72% chance of a 50 basis point cut also priced into futures quotes. Given the actions we have seen from the Fed thus far (namely choosing to inject liquidity rather than lower interest rates for consumers) and the words they have chosen in public speeches in recent weeks, I have to take “the under” on the Fed Funds futures bet.

Now, that is not to say that there won’t be a rate cut. That could surely happen, and you could justify it several ways. It just seems to me that the Fed wants to try every other option they have at their disposal before giving in with a rate cut, which many see as bailing out people who made ill-advised decisions and thus contributing to a moral hazard issue.

Because of that, I think saying there is a 100% chance of a cut this month is overly optimistic for interest rate bulls. And a 72% chance of a 50 basis point cut is even more aggressive. Right now, I’d put the odds of a cut of any magnitude between 50% and 75% based on what Bernanke has said and done so far.

I bring this up not because I think people should speculate in the futures markets, but because it’s important to understand what is currently priced into the marketplace. If we don’t get a cut later this month, which I think is certainly more probable than the markets currently are telling us, then stocks are going to sell-off. That is what we open ourselves up to when the market prices in something as a certainty even though there is still an undeniable fact that nothing is certain about the September FOMC meeting.

And even if we do get a cut of 25 basis points, we could still see the market not react positively because more than half of people right now expect 50 basis points (who knows what that number will be at meeting time). Just be aware that the risk-reward trade off right now in the short term doesn’t appear all that favorable as long as you assume two things. One, the fed fund futures market accurately gauges what the market is currently pricing into prices. And two, the market will be reacting to interest rate speculation and action in coming weeks.

Don’t Blindly Follow Carl Icahn (or anyone else for that matter)

From the Associated Press:

BONITA SPRINGS, Fla. (AP) — Shareholders of WCI Communities Inc. elected billionaire Carl Icahn to the board of the struggling homebuilder on Thursday, more than four months after management rejected his $22-per-share takeover bid. Icahn and WCI clashed for weeks over Icahn’s proposed takeover and control of the board, each urging shareholders to support their candidates, before settling recently on the compromise approved Thursday. WCI nominated three of its candidates, plus Icahn and two of his candidates. Three additional directors were nominated jointly by WCI and Icahn. Icahn companies control more than 14.5 percent of WCI.

That’s right, Icahn wanted to buy WCI for $22 per share. The stock currently trades at $9. That boneheaded bid lands him a board seat because of his 15% stake in the company. But hey, if I was a shareholder and he bid $22, I’d vote him on the board too.

Seriously though, I bring this up because many investors blindly buy stocks that billionaires like Icahn and Buffett get involved with. Although they make a lot of money, they are human too, so they make mistakes just like the rest of us. As a result, do your homework even if you want to follow a great investor into an investment. If your research yields a strong reason to buy (which would likely not have been the case with WCI) then at least you have less of a chance of making a mistake.

Full Disclosure: No position in WCI

Inventory Levels Suggest Housing Market is Far from a Bottom

There are undoubtedly a bunch of contrarians tying to find a bottom in the housing market, but I don’t see any evidence that a rebound is anywhere in sight. The key metric here is home inventories. Without a drawdown in the inventory of unsold homes, prices will not stabilize, let alone begin rising again.

The July report from the National Association of Realtors shows single family home inventories jumping more than 2% year-over-year to nearly 4 million units. Not surprisingly, sales for the month dipped to a five-year low and prices fell 0.6% from last year.

Including condos, inventories soared 5.1% to a record 4.59 million units, putting total inventory at a 9.6 month supply. It’s going to take a long, long time to work through that much supply, so don’t expect the housing market to stabilize anytime soon.

Sub-Prime Mortgage Weakness Not Spreading to Other Credit Products

Below is an excerpt from the first quarter earnings press release of a consumer lender that serves lower end customers, including some who would be classified as sub-prime borrowers, but is not involved in the mortgage:

“Factors adversely affecting our first quarter results included lower than expected fee assessments due to lower than expected delinquencies.”

No, that is not a typo. For all of those people who were expecting the sub-prime mortgage mess to spill over into other areas of credit such as credit cards and student loans, it appears the worries (and subsequent share price declines) were unfounded. Delinquencies were lower than expected!

It might seem baffling to many, but this is pretty good evidence that the sub-prime spillover effect is being greatly exaggerated, a theory I first rejected a month ago in a piece entitled Most Financials Dragged Down with Sub-Prime Lenders.

Renting versus Buying a House – A Contrarian View

I’m often posed with the question, “Given that interest rates are low, why shouldn’t I buy a house instead of throwing money away by renting?” In recent years, buying a home has been all the rage. With interest rates around 6% for a 30-year fixed mortgage and the housing market booming, I’ve been amazed at how many people who have no real need for a house (young singles) have bought one.

As someone in the investment management business, whenever I am asked my opinion about buying a house, I look at it from two perspectives. The first one ignores the financial aspect (assuming the buyer can afford the home) because if you are getting married and starting a family, there are reasons to buy a house that have little to do with return on investment or anything like that. However, for those single people out there who don’t have a true need for a house of their own, I suggest looking at the possible purchase as an investment and running the numbers accordingly.

I have made many spreadsheets for people to determine if buying a house makes sense financially. In the vast majority of cases it does not, as you can usually earn a higher return investing in a bank CD (let alone the stock market) than you can on a house, even after considering the benefits (mortgage interest deduction) and the costs (insurance, maintenance, taxes). The exceptions are cases where you rent out spare bedrooms and that cash flow covers a large chunk of your mortgage-related expense.

As a result, it is baffling to me when people will choose to take money out of their high yield savings accounts, investment accounts, and even their IRA or 401(k) plans in order to fund a house purchase. The common reason given is “renting is just throwing money away.” While this sounds logical (your rent check isn’t going toward the purchase of any asset), you have to look at it from a return on investment point of view.

A Smart Money article published last Wednesday entitled “Why Rent? To Get Richer” outlines the case for renting very well. I suggest those of you faced with the “rent versus buy” dilemma give it a read.

Full Disclosure: No position in a house at the time of writing

M&T Bank Preannouncement Shows Alt-A Mortgages Not Immune

Was anyone else surprised that news of a first quarter profit warning from M&T Bank (MTB) hardly had any effect on the market and received fairly little attention on Wall Street? One of the arguments we have heard from many Alt-A mortgage lenders is that the sub-prime mess is confined to that part of the spectrum, and Alt-A mortgages (given to home buyers with high credit scores but without verification of income, etc)are doing okay so far. M&T’s warning directly contradicts that view.

For those of you that missed it, M&T Bank (a regional bank in the Mid-Atlantic) projected first quarter earnings of $1.50 to $1.60 last week, far below consensus estimates of $1.86 per share. The culprit: Alt-A mortgage loans, which make up 30% of the bank’s mortgage portfolio. The company was forced to repurchase non-conforming loans and also decided to not sell some new loans due to inadequate pricing and a lack of bidders.

This news did hit MTB shares, which fell about 10 percent on the news, but very few others were affected. Other mortgages lenders heavy into Alt-A offerings such as IndyMac Bancorp (NDE) have come out publicly saying their mortgages are performing fine. The news from M&T, hardly an aggressive lender, show that the odds are good that Alt-A mortgages will become a problem for mortgage lenders as well as more diversified regional banks who make these types of loans.

This trend should continue to show up in first quarter earnings reports when they begin rolling in over the next month or so. As a result, playing the regional banks for a trade going into earnings season seems to be dangerous from the long side. Opportunities to get long may present themselves later, and companies highly levered to Alt-A may be good shorts heading into earnings, but I’d be cautious on the regionals heading into the upcoming reports. A good way to hedge existing positions would be to sell out-of-the-money calls to generate some additional income.

Full Disclosure: No position in MTB and short NDE at time of writing