Tuesday, June 30, 2009

Joel Greenblatt Q & A

Gurufocus posts a good Q&A with remarkably skillful investor, creator of Value Investors Club and all around nice guy Joel Greenblatt. Here are two of the highlights:

Question 10. Could you share your thinking about the relationship among long-term earnings stability, long-term ROE/ROIC and valuation levels (PE, PS)? How do you think about the dynamics of these three variables when valuating a company? (grol1971)

JG: When doing in depth analysis of companies, I care very much about long term earnings power, not necessarily so much about the volatility of that earnings power but about my certainty of “normal” earnings power over time. My goal is to buy a company at a low multiple to normal earnings power several years out and that the company earns good returns on capital at that level of normal earnings.

Question 11. What type of things would you look for in an annual report that your typical investor might not pick up on? Do you feel there is a need to do a DCF analysis of a company? (cyrano)

JG: I look for obvious things when looking for bargains, not something terribly obscure. So, if a company has two divisions, one that earns money and one that loses, I might speculate on what the company might be worth without the money losing division, but that wouldn’t involve higher mathematics or special sleuthing talents. A DCF analysis is potentially a useful reality check to see what kind of growth rate, earnings and discount rate would justify the current price. However, I usually just look at a simple multiple to normalized earnings. If I can buy something at a very low multiple and I have confidence in the earnings stream, I don’t have to calculate a DCF to know whether I want to buy it.

[Hat Tip: Manual of Ideas]

T Minus 2 Days Until California Issues IOUs - Wells Fargo And Bank Of America Will Not Commit To Accepting Schwarzies

Get ready, Schwarzies are coming!

We are only two days from California issuing its own currency in the form of IOUs (dubbed Schwarzies by TILB) and we could hardly be more excited!

Schwarzenegger Scrip: we can almost taste it.

Yet, shockingly, until California gets the ratings agency granted credibility to pay off old Schwarzies with new Schwarzies (something akin to the crime Bernie Madoff received 150 years for... and the famous helicopter drop Dr. Ben Bernanke is regularly lauded for), some folks actually seem a bit timid about accepting Schwarzies.

"Who are these Schwarzie hating traitors," you might reasonably ask.

Well, your friendly neighborhood bankers at Wells Fargo and B of A - California's two largest banks - seem a tad bit hesitant to embrace the idea. As if California's mortgage default rate needed another reason to tick up...

B of A had this to say on the matter:
“Any action pursued by the state, such as issuing registered warrants, will require much greater specificity about rates, timelines, terms and many other variables for banks to determine ability to support such actions,” said BofA spokeswoman Colleen Haggerty in Los Angeles. “Speculating on a plan before the Legislature and governor have completed budget negotiations is premature.”
Ha! Is B of A pretending like it actually does credit work on borrowers and underwrites loans? Where was that discipline when it counted?

In any case, I think if we learned anything from the Hartmarx and Chrysler debacles, it is that if our president deems you strategically important (for instance, you either employ 40,000 unionized democrats or you make his suits), resistance is futile; it is not up to the lending bank to make decisions about who gets loans or how defaulting borrowers are treated.

What's that you say? The Obama Administration has refused California's requests for the federal government to help it with loan guarantees or otherwise bailout the state's finances? Now, that just seems mean. Unless, of course, you believe in conspiracies...

You may have noted that so far we have only quoted one of our two friendly neighborhood bankers on the matter of Schwarzies. Have no fear, Wells Fargo issued an equally banal statement on the matter.

However, a little more digging will show Wells Fargo's true opinion on the matter. In a recent speech at Stanford, Wells CEO John Stumpf said the following:
"The state of California is in financial ruin,” Stumpf told those attending a statewide microfinance lenders’ conference at Stanford University. “The budget deficit in California is staggering.”
Not exactly the words you want to hear from one of the largest potential cogs in the Schwarzie circulation system...

Stumpf went on to talk about the economic situation for California's citizens and corporations.

Stumpf said the recession is taking a toll on some of the loans made to creditworthy borrowers who lost their jobs and fell behind on payments.

“Today we’re charging off loans to people we should have made loans to,” said Stumpf, reiterating that the bank avoided many of the exotic mortgages offered by rivals.


On the national economy, Stumpf said this is his “third rodeo” or downturn. He pointed to the deep recession of the early 1980s when the prime rate hit 21 percent and the struggling economy of the late 1980s that counted most the nation’s largest thrifts and major banks in Texas among its casualties. He says the economic fallout from the dot-com bust and Sept. 11 terrorist attacks was significant but not as harsh as the earlier recessions.

“This one feels different,” Stumpf said. “It feels different in the respect that the whole world is in recession.”
Welcome to a world where economic realities, put off for decades by politicians and citizens that believed in Tooth Fairy Economics*, come forth in a burst of killjoy that makes everyone play the hand they were actually dealt.

[Hat Tip: JC-FL]

*Okay, TILB is officially copywriting the term Tooth Fairy Economics

...or, perhaps not. We had never heard the term before writing it just a moment ago and were so pleased with its goodness that we were fully prepared to laud self congratulatory genius heapings upon ourselves. However, we subsequently Bing'd it and found out some dude named Tom Woods at Campaign For Liberty
used the phrase last February. Two comments: 1) as much as we want to assume he's some lucky deuchebag and keep the phrase for ourself, we love the ideals of Campaign For Liberty; and 2) we still are claiming it for our own. This is like when two scientists make an advancement at the same time and both claim credit for it...oh, dammit.

Nix our cliam. It is his even if it should be ours. He bettered us by four months.

Damn you Tom Woods and your enviable creativity and pursuit of liberty (this guy atually wrote a book that has a forward by Ron Paul; TILB considers that a major portion of a complete life).

Credit where credit is due. We bow to you, Tom Woods.


Liberty Quote Of The Day: George Washington

First President George Washington understood the dangers of big government and its natural desire to grow and wreak havoc on its people when not appropriately constrained.
"Government is not reason; it is not eloquence. It is force. And force, like fire, is a dangerous servant and a fearful master."
- George Washington

Monday, June 29, 2009

Equality Of Outcome vs. Equality Of Choice

Dr. Thomas Sowell, who has defined political society (and to a certain extent, society at large) in two buckets: the Constrained vision and the Unconstrained vision, gives a wonderful interview to the Hoover Institute. We believe that the Unconstrained vs. Constrained vision can be summarized simply as equality of outcome vs. equality of choice. We pick the latter.

In a bit more depth, the Constrained view is that man is flawed and that those flaws are generally fixed as part of human nature. As such, we need a government that is constrained in its powers in order to reflect and protect against the fact that flawed people (i.e., humans) will run the system and that history has shown power corrupts and that corrupt people are often drawn to power. In essence, that because there is no political messiah and that even if there were a perfect leader he/she would someday die and those powers will inevitably fall into corrupt hands, we must build a system that sustainably and structurally separates powers.

The Unconstrained view is that man's flaws are generally man-made and solvable. To the extent we have had flawed societies in the past, it is because we have not tried hard enough, had an expansive enough vision, or perhaps simply had the right leaders. That government should be as powerful as it needs to be in order to improve the lot of its people through dictum. That improved leaders can solve many of human nature's problem through the implements of their leadership and thusly that human nature can be changed (that it is not fixed). In essence, there are political messiahs and we must seek to find these benevolent, perfect leaders in order for their vision to improve human nature.

Some of the highlights include:

* Defense: Sowell's statement on why defense spending deserves a priority position within broader governmental spending, "[that] recognizes that you must survive before you do anything else." This is a classic Constrained vision of the world, which is that history shows that nations will war, thusly disarmament is not a sound approach because it imperils survival.

* Intellectualism: Why do modern intellectuals adhere so strongly to the Unconstrained vision? Dr. Sowell postulates that "they imagine that good people like themselves can make this thing go, that if it hasn't worked in the past it's only because we haven't had the right people [leading]. In other words, communism would have worked if it hadn't been for Stalin." In essence, that we have had the wrong leaders and that the collective decisions of humanity lead to worse outcomes than the targeted decisions of a select few.

* War and Peace: "You can take this back to the Federalists when they said, 'why do we think the thirteen colonies would make war on each other if they're not united,' and the answer was, "because that's what countries have always done. It's not just war, It's poverty. It's crime. All of those are things that people with the unconstrained vision feel needs explaining." He goes on to say, [paraphrasing] that that is what people with the Unconstrained vision feel needs explaining (the "why" of why do wars, crime and poverty happen), whereas Constrained vision people say these are natural outcroppings of man's nature and that we should focus on creating a structure that is most likely to sustain peace, law and order, and morality rather than trying to "cure" man of his nature.

* Obama: On why Obama represents the most clear view of the Unconstrained vision in the history of American politics. "Even FDR pulled back on some things. But Obama...he really does have the Unconstrained vision; which is an elitist vision. It says, 'I know what is best to be done and I will do it.' When he says, 'I will change the world,' you realize this is a man that has actually accomplished nothing other than advancing his career through rhetoric. It remains me of a sophomore in college who thinks he can run the world." As Charlie Munger so wisely and frequently says at the Berkshire Hathaway annual meetings, I have nothing to add.

* One bonus quote from Dr. Sowell, which explains why we here at TILB effectively chose None Of The Above this past November, "people ask me why am I going to vote for McCain rather than Obama, I answer that it's because I prefer disaster to catastrophe." Indeed.

Dr. Sowell goes on to apply this to modern politics, the judicial system and more.

Watch, enjoy, learn.

[Hat tip: @mymoneyshrugged

Liberty Quote Of The Day: Calvin Coolidge

President Coolidge, in TILB's opinion, is a massively underappreciated president. We largely attribute this to the fact he was president during a time of peace and prosperity - in essence, an environment that was uneventful from the standpoint of historians. We argue that is the sort of period we should study and aim to replicate, but heroes are not made during times of happiness and Coolidge was an understated man to begin with (relative to most presidents, at least).

In the short quote below, we see President Coolidge grasp the nature of incentives and the dangers of government believing it can craft success through dictum.

Don't expect to build up the weak by pulling down the strong.

Do Not Mess With Obama's Threads - Hartmarx Prevented From Liquidating

President Obama's suits are made by unionized Illinois-based Hartmarx. Not surprisingly, as a high cost producer of an expensive and easily deferable purchase, Hartmarx went bankrupt a month or two ago.

Hartmarx senior lender, Wells Fargo's Wachovia subsidiary, has been pushing for liquidation as the highest recovery approach. Despite this being a small, anything but strategic business (other than to the President's outward appearance), the political pressure surrounding it has been unusually pitched. Wells finally capitulated after the new buyers begrudging through a few more million dollars Wells Fargo's way, though Wells is still losing 28 cents on the dollar.

Here's some pertinent coverage from Dow Jones:

Judge Bruce W. Black of the U.S. Bankruptcy Court in Chicago signed off on the transaction at a hearing Thursday, solidifying the results of a Wednesday auction at which Emerisque and SKNL had emerged victorious. The pair had served as the lead bidder, offering $128.4 million in exchange for the assets of Hartmarx.

"Consummation of the sale of the acquired assets at this time is in the best interests of the debtors, their creditors, their estates and other parties in interest," Black said in court papers filed Thursday. [emphasis added]


In the days leading up to the company's bid-procedure hearing, where it sought approval for the rules governing its auction, Wachovia Capital Finance Corp. filed a formal objection to Hartmarx's stalking-horse pick. The bank said Emerisque's bid, then valued at $119 million, was unacceptable, as it would leave the lenders $50 million short of full repayment.

Last-minute weekend negotiations before the hearing yielded a higher bid - $128.4 million - and support from the lenders. Details released at the time indicated that the majority of the new bid - an $83.964 million payment representing 72% of the balance on Hartmarx's bankruptcy loan as of May 8, and a $5.5 million junior subordinated secured note - would go directly to Wachovia. Emerisque and SKNL also were set to assume liabilities estimated to be worth more than $33.5 million.

Hartmarx's workers [i.e., the "other parties in interest" referred to by Judge Black] had vigorously thrown their support behind Emerisque and SKNL's bid and denounced creditor Wells Fargo's push for liquidation as hypocritical, considering the bank had received taxpayer funds under the Troubled Asset Relief Program. Some national and local politicians also threw their voices into the mix, with lawmakers like U.S. Sen. Charles Schumer leading rallies alongside workers at various Hartmarx plants.

[HT: Pitchbook PE and CM]

Sunday, June 28, 2009

PPIP Faltering Before Ever Getting Launched: Shocker

The Journal, in its ongoing USA, Inc. series, discusses what many of us have assumed for a long time: banks cannot afford to sell so-called "toxic" assets at prices that generate acceptable returns to buyers (TILB last discussed that reality here). This, despite an incredibly generous financing proposal from We The People. That is how far reported bank balance sheets have diverged from reality.

That discrepancy is the real story here, but it continues to be completely unreported: selling these assets, even after a massive credit rally and with subsidized non-recourse funding, still generates a loss to the seller that is so big banks cannot afford to take the hit.

The implication, of course, is that bank balance sheets do not remotely reflect market realities. As such, we can expect the drag of realized losses to be an anchor on bank earnings reports for the foreseeable future. Green shoots, though.

Anyway, here are some highlights from the WSJ.
The government's plan to enable banks to dump troubled assets is facing troubles of its own.

Markets initially rallied when Treasury Secretary Timothy Geithner announced in March a two-pronged plan to offer favorable government financing to entice investors to buy bad loans and toxic securities from banks.

But that initiative -- called the Public-Private Investment Program, or PPIP -- has lost momentum. Big banks worried about having to sell at fire-sale prices while small banks feared they would be shut out. Potential buyers balked at the risk of doing business with the government, concerned that politicians might demonize them for making big profits.

The program's problems threaten to stymie efforts by struggling smaller banks, in particular, to clean up their balance sheets. That in turn could hinder efforts to revive the nation's economy.

A look at why the program has stumbled underscores how difficult it has been to solve one of the economy's biggest problems: Mountains of bad debt sitting on the books of the nation's banks. As those loans and securities lose value, they are saddling the banks with losses and constricting their ability to lend.


The slimmed-down program will focus not on bad loans, but on toxic securities, which are a problem for a relatively small fraction of the nation's banks. That is bad news for hundreds of smaller banks burdened with growing piles of defaulted loans. [TILB comment: once again small banks get the wide end of the shaft] These banks are less able to tap capital markets than their larger rivals, so they have been eager for U.S. help unloading loans as a way to bolster their capital cushions. Many of them can face big problems if just one or two large loans go bad. Seventy banks, most of them community institutions, have failed since the start of last year. Analysts are bracing for hundreds of lenders to collapse in the next few years.


During the last banking crisis, nearly two decades ago, the government established the Resolution Trust Corp. to sell off the bad loans and securities of banks that had failed. Many experts credit the RTC with helping defuse that crisis.

This time around, efforts to rid banks of soured assets have sputtered repeatedly. In late 2007, federal officials helped cobble together a plan for a bank-financed fund to buy securities held by bank investment funds, but the effort was aborted. In 2008, the Bush administration established a $700 billion program to buy banks' soured assets. Partly because of the complexity of valuing those assets, the U.S. abandoned that plan, instead opting to directly pump taxpayer money into banks.


On March 23, when Mr. Geithner unveiled PPIP, the Dow Jones Industrial Average surged nearly 500 points, or 7%, its biggest gain since October, on hopes that the program would nurse the banking industry back to health.

Many bank executives were skeptical about whether the program could succeed. Even before it was announced, some had grumbled that federal officials weren't consulting them, and instead were crafting the initiative with input from would-be investors. Some banking executives say they warned that they would be loath to sell at the kind of prices investors were likely to demand.

Executives at Citigroup Inc. shared those concerns, according to people familiar with the matter. While the New York bank was sitting on at least $300 billion of risky loans and securities, selling them at discounted prices would require painful hits to its already thin capital ratios, these people say [TILB: "already thin"? Didn't you see the stress test results - Citi almost qualified as well capitalized!].

Some Citigroup executives had a different idea: Maybe they could turn a profit by bidding on their own toxic assets at discounted prices, using government financing, according to the people familiar with the talks [TILB: If this had happened, I would have fucking moving out of the country.]. Other big banks also talked about setting up distressed-asset units to snap up troubled loans and securities, including from their parent companies, with taxpayer financing.

FDIC Chairman Sheila Bair later publicly shot down the idea. Citigroup declined to comment.

Meanwhile, many small-town bankers hoped the program would help them unload the bad assets -- generally loans to finance commercial real-estate projects -- that were hurting their balance sheets. Some potential buyers had surfaced before PPIP was announced, but they were offering such low prices that few banks could afford to sell the loans without severely denting their capital cushions.


When PPIP was announced, big-name investors were intent on figuring out how to profit from it. Raymond Dalio of giant hedge-fund firm Bridgewater Associates, which oversees $72 billion in assets, initially expressed interest in participating. But within days, he was blasting it, saying buyers and sellers would have difficulty agreeing on pricing and fund managers that profited would be exposed to criticism from politicians. The way PPIP is set up "makes us not want to participate and it makes us question the breadth of interest that we will see in the program," he wrote to clients.


In conference calls with bankers and investors, FDIC officials emphasized that PPIP was critically important to cleanse banks of their bad assets. "I think you know the stakes are very high with this," Ms. Bair, the FDIC chairman, said during a March 26 call, according to a transcript. "We need this program to work." [TILB: On to Super SIV v6.0, or whatever number we are at]


Next month, the FDIC intends to use PPIP for a far narrower purpose: to auction loans the agency has seized from failed banks. Eventually, it hopes to resuscitate the loan-buying program so that smaller banks can benefit from it.


Many banking experts contend that the financial system won't fully stabilize until banks get rid of their bad assets.

Mr. Segal, the bank adviser, complains that federal officials have cited recent capital raising by big banks as evidence that "the system is OK." That may be true "for the top 15 or 20 banks," he says. "But for everybody else, there really needs to be more attention paid." [all emphasis added by TILB]

Liberty Quote Of The Day: Thomas Jefferson

From the original libertarian and a true intellectual giant, we bring you Jefferson's sobering understanding of the nature of debt and taxation and their inevitable consequence:
We must not let our rulers load us with perpetual debt. We must make our election between economy and liberty or profusion and servitude. If we run into such debt, as that we must be taxed in our meat and in our drink, in our necessaries and our comforts, in our labors and our amusements, for our calling and our creeds...[we will] have no time to think, no means of calling our miss-managers to account but be glad to obtain subsistence by hiring ourselves to rivet their chains on the necks of our fellow-sufferers... And this is the tendency of all human governments. A departure from principle in one instance becomes a precedent for[ another]... till the bulk of society is reduced to be mere automatons of misery... And the fore-horse of this frightful team is public debt. Taxation follows that, and in its train wretchedness and oppression.

Saturday, June 27, 2009

Five Bank Failures: Most In One Day In Over A Decade

Since at least 1993, when the tail end of the massive S&L crisis was finally waning, we have not seen a failure wave the likes of which we are seeing now. Most of the S&L failures were tiny institutions.

Yesterday evening, the FDIC buried five banks, as this fairly comprehensive article states. Mid way into 2009, we have reached 45 failed banks, averaging approximately two per week and the FDIC deposit insurance fund, as we discussed a year ago, is nearly depleted (down to about $14 billion).
The FDIC estimates that the cost to the deposit insurance fund from the failure of Community Bank of West Georgia will be $85 million. [Neighborhood Community Bank's] failure will cost the fund $66.7 million. The failure of Horizon Bank is expected to cost the fund $33.5 million, while the closure of MetroPacific Bank will cost the fund about $29 million. Mirae Bank's failure will cost the fund $50 million.
As long time readers know, one of our favorite back of the envelope metrics for tracking the severity of this crisis is to measure losses as a percentage of reported assets. As mentioned in the same TILB from a year ago, losses were averaging 20% of assets in mid-2008. Let's look at how this week went. From the Yahoo! article linked above:
Community Bank of West Georgia had $199.4 million in assets and $182.5 million in deposits as of May 15. Neighborhood Community Bank had $221.6 million in assets and $191.3 million in deposits as of March 31. Horizon Bank had $87.6 million in assets and $69.4 million in deposits as of March 31. MetroPacific Bank had $80 million in assets and deposits of $73 million as of June 8. Mirae Bank had $456 million in assets and $362 million in deposits as of May 29.
Community Bank of West Georgia: $85mm of insured losses / $199.4 mm assets = 43%
Neighborhood Community Bank: $66.7 / $221.6 = 30%
Horizon Bank: $33.5 / $87.6 = 38%
Metropacific Bank: $29 / $80 = 36%
Mirae Bank: $50 / $456 = 11%

So, four of the banks were in the 30% or greater range and one - Mirae (the largest bank on the list) was an 11% loss. The four high loss banks were in-line with recent failures and Mirae is a very positive outlier. Mirae is such a big outlier in a trend that has been persistently worsening that we postulate Mirae would not have been forced to fail yet except the FDIC had an eager buyer lined up. In general, the FDIC is not failing banks until the bank will generate losses of 25-30% of assets. This means the failed banks are probably in a negative equity position of about 10-20% (call it 15%), then the FDIC makes up that hole plus a margin to return the bank to well capitalized and to compensate the buyer for risk of further deterioration.

As we have said so many times, there are probably many hundreds of banks (possibly into the thousands) that have an equity position somewhere between being adequately capitalized and the failure threshold of 15% negative equity. We at TILB expect the Failure Train is just now leaving the station.



Thursday, June 25, 2009

The Countdown To Schwarzenegger Scrip Is On: T Minus 7 Days

This Journal article simply mentions in passing the fact that California is contemplating issuing its own currency (oh, excuse me, "IOUs") beginning next Thursday July 2nd, but we here at TILB are a lot more excited about this than the average bear.
The setback for Democrats came the same day state Controller John Chiang warned that he will begin issuing IOUs on July 2 to local governments, private contractors and state vendors if lawmakers don't come up with a solution. Such a move would likely further damage California's credit rating, already the lowest among the 50 states [emphasis added]
It has been since the 1913 evil of the Federal Reserve Act that any entity other than the Fed has legally offered a new currency in the U.S. California seems poised to do change that next week, though they'll pretend IOUs issued in mid- to small- denominations are something other than currency.

We suppose technically this is Chiang's Change or something like that but we strongly prefer referring to these as Schwartzies.

We can hardly contain our glee! Perhaps California will watermark the IOUs with The Governator's profile and instead of In God We Trust, it puts in a classic pithy 80s style Schwarzenegger quote like, "I'll be back" or "Have a seat". Perhaps, in homage to the likelihood of getting 100 cents on the dollar, "Hasta la vista, baby..."

Liberty Quote Of The Day: Abraham Lincoln

Honest Abe gives us a great quote about the power of planning, preparation and effort.
If I had eight hours to chop down a tree, I'd spend six hours sharpening my ax.

Wednesday, June 24, 2009

Liberty Quote Of The Day: Alexis de Toqueville

We here at TILB will be loosely rolling out a new (somewhat) daily posting that simply highlights a favored quote about liberty, effort, and other noteworthy topics called our Liberty Quote of the Day.

Our first quote comes from Alexis de Toqueville's great Democracy in America:
Democracy and socialism have nothing in common but one word, equality. But notice the difference: while democracy seeks equality in liberty, socialism seeks equality in restraint and servitude.

Federal Reserve Chairman Ben Bernanke Quietly Seeks Increased Powers

According to this NY Times article, The Helicopter is working behind the scenes in search of increased powers for the Fed and thusly himself.

Of course, this is akin to the head of your municipal water company poisoning the water supply, then providing a questionable version of an antidote that at best postpones the pain but doesn't cure the illness asking for greater control and freedom over the water supply in order to protect its users from man-caused dangers in the future. Nobody would ever contemplate allowing that to occur. It is absolutely insane. And yet, this seems to have a better than 50:50 likelihood of occuring with our money supply and financial system oversight!
But behind the scenes, he has been a forceful proponent of giving the Fed more power, both defending his management of the economic crisis and arguing that more authority would help the agency act more decisively to reduce the chances of a recurrence, according to interviews with lawmakers and officials from the Fed, the Treasury and the White House.

Despite criticism by some lawmakers that the Fed failed to anticipate the problems that led to the crisis, Mr. Bernanke has told associates that such critics fail to recognize the extraordinary actions taken by the central bank over the last year.

Mr. Bernanke believes the Fed’s actions have played a major role in averting a possible second Great Depression, according to government officials who know his thinking. Those steps, the Fed chairman has told these people, demonstrate that the agency is up to the larger task assigned to it by the Obama administration.

Mr. Bernanke has one important champion — President Obama. On Tuesday, the president reinforced his preference for an enlarged role for the Fed in a news conference at the White House.
As we have addressed several times, including in one of our favorite posts on the nature of indebtedness, the Federal Reserve System (inclusive of fractional reserve banking with demand deposits considered core deposits available for long-term lending) holds the largest helping of responsibility for the crisis we find ourselves in today. It is damning enough that we have continued to allow The Fed to operate virtually unfettered and unchecked, but to actually contemplate expanding its mandate is beyond sanity.

Monday, June 22, 2009

Fannie And Freddie Looking At Allowing 125% LTV Refinancings

We here at TILB are revolted by this Bloomberg news story:
Fannie Mae and Freddie Mac may get permission to begin refinancing mortgages with loan-to-value ratios above 105 percent as the Obama administration seeks to boost participation in its anti-foreclosure programs.

“We’re actively considering how to structure a program that makes sense over 105 percent,” Federal Housing Finance Agency Director James Lockhart said yesterday. He said a ratio of 125 percent “is a number” that’s on the table, though “not necessarily the number we’re going to end up with.” [emphasis added]

President Barack Obama’s Home Affordable program announced Feb. 18, sought to help as many as 5 million Americans who may owe more on their mortgages than their homes are worth. Fannie Mae and Freddie Mac have refinanced 80,000 loans under that program, Lockhart told a National Association of Real Estate Editors Association conference in Washington yesterday. He didn’t say when the loan-to-value ratio could be raised.[emphasis added to highlight yet another failed policy...thankfully]


Home Affordable has been “seeing a slowdown” as mortgage rates increase, Lockhart said. The average rate on a typical 30- year fixed loan was 5.38 percent in the week ended yesterday, according to Freddie Mac. The rate is up from a record low of 4.78 percent at the end of April.


Expanding the program to a 125 percent loan-to-value level may benefit about 10 percent of borrowers that have loans backed by Fannie Mae or Freddie Mac, according to Mahesh Swaminathan, a mortgage strategist for Credit Suisse in New York. He said an additional 4 percent of borrowers with Fannie Mae or Freddie Mac loans are further underwater.

“If home prices decline further, this bucket” of underwater borrowers could expand, he said.

A drop in values has left about 20.4 million of the U.S.’s 93 million houses, condos and co-ops with mortgages higher than the properties are worth as of March 31, Seattle-based real estate data service Zillow.com said in a report May 6.
We didn't highlight it, but there's also some useful color on how Treasie Mae and Feddie Mac intend to manipulate warehouse lending as well.

Unless the government also chooses to forgive mortgage balances when an owner chooses to sell, refi'ing someone at a 125% LTV (that is still worsening!) is like trapping them in that house forever. You want to see the housing transaction market dry up? Make it so the seller literally cannot sell because you have financed them a mortgage so big that no buyer will pay enough to cover it.

Ironically, the prospective buyer - as a taxpayer - will be paying the would be seller to keep said house off the market via We The People's support of Fannie and Freddie. An odd and horrible arrangement.

As we've said in prior posts, such as this one on the nature of indebtedness, the solution to the housing crisis is not cheap credit nor broadly available credit (in fact, those will worsen and lengthen the crisis). No, the solution is to allow prices to fall to a point that brings buyers off the sidelines as has happened in Southern California and the Inland Empire.

It is important to recognize that in a world where buyers purchase things based on monthly payments, if we combine artificially low interest rates (i.e., artificially low monthly payments) with unnaturally available credit to borrowers and the owner owns the property on the basis of those low payments, that buyer essentially owns long interest rate duration risk and most likely has no idea.

For example, if in order to afford a given bouse price, you require a 4.75% mortgage rate and four years later rates have risen and you need to sell it to another monthly payment slave based on a 6.5% mortgage, you stand to get crushed.

In essence, the U.S. government is setting new borrowers up to get absolutely destroyed. They will have stabilized nothing if the stabilization requires rates to be held below their natural level.

We need prices to reset and transactions to pick up in order to move homes from weak hands to strong hands and give the new owner a sound base to build on.

Happy green shoots!

China Dominates The Metals Market: Copper, Aluminum, Nickle, Zinc And More

From The Bloomberg, we can see that China has absolutely dominated the global metals markets for the past several months as they've stockpiled like crazy.

See the year over year changes for the most clear indication - imports have absolutely skyrocketed and exports have basically gone to zero (and you can imagine demand is down enormously, so this truly is a stockpiling).

China has already announced that its stockpiling program is coming to a close. We suspect we am not the only interested observer over the next few months:

The figures are in metric tons. Percentage changes are from the year-earlier period.

May % Change YTD % Change

Imports 337,230 258% 1,403,456 130%
Exports 160 -99% 1,121 -98%

Imports 259,095 2,414% 737,250 1,143%
Exports 258 -94% 4,052 -84%

Imports 95,631 398% 412,239 656%
Exports 10 -100% 4,188 -88%

Imports 25,418 43,333% 110,095 1,902%
Exports 1,729 -46% 5,947 -80%

Imports 25,032 127% 78,995 37%
Exports 411 -45% 2,019 -21%

Imports 3,360 160% 12,579 100%
Exports -- -100% 57 -85%

Friday, June 19, 2009

Paul Tudor Jones Speech On Failure

A week or so ago, legendary trader and UVa alum Paul Tudor Jones gave the commencement speech to a ninth grade class at The Buckley School (an all boys school). He talks to them about Failure and the difficulties it presents but also its importance as a motivator and learning tool.

It is an excellent read.

As we so often do, TILB brings it to you first (see Ackman's GGP pitch and Ira Sohn notes).

Paul Tudor Jones - Failure Speech June 2009

Thursday, June 18, 2009

Cantillon's Letter To Clients Discussing Its Decision To Shutter Hedge Fund Business

William von Mueffling of Cantillon wrote a letter to his LPs describing why Cantillon is closing its hedge fund business in order to focus on long only. Deal Breaker has the complete text of the letter here.

von Mueflling discloses nothing Earth shattering in the letter and really provides no rationale other than to say, "we have found ourselves covering a large number of shorts in the Cantillon World and Cantillon Europe hedge funds (the 'Funds'). This is likely to continue and therefore the Funds' portfolios in the future are not likely to exhibit the characteristics that we have always targeted for the Funds."

Cantillon has always had monthly liquidity and as such does not have some cliff of investors waiting poised to redeem upon some lock-up expiration. von Mueffling has always been a bit of an enigma and this furthers that view.

We are not really sure what this signifies. Perhaps his cessation of shorting calls an interim market top as capitulations by prominent investors often do. We shall see.

Maine Forbids The Use Of The Word "Squaw", "Squa" Or Derivations Thereof

Hilarious. We didn't even know the word "squaw" was controversial, but as of tonight at least one of us here at TILB is heretofore referring to his wife as his squaw.

At least nothing important is happening for politicians to focus on. I'd hate for them to be distracted from their core business of speech control.

Excerpted from the WSJ:
The lane in question, on a woodsy bluff overlooking the ocean, was once called Squaw Point Road. Maine banned the word "squaw" from place names in 2000, in deference to Indians who consider it racist. Names such as Squaw's Bosom Mountain and Little Squaw Brook quietly receded into history.

Competing signs for a contested road in Stockton Springs, Maine.

But residents here played Scrabble with the spelling instead. They renamed the road Squawpoint -- then later, Squa Point and Squapoint, complying with the letter of the law but not with its spirit, critics say.

The resistance prompted the state into action again. This month, Maine lawmakers amended the law to ban public place names that include "the designation 'squa' or any derivation of 'squa' as a separate word or as a separate syllable in a word."

Lesley Cosmano, a retired Chicago schoolteacher who moved here with her husband in 2005, finds the amendment ridiculous. "This means birds can no longer squawk, people can't squabble" and town squares might be outlawed, she says, in her dining room with views of Penobscot Bay -- namesake of one of Maine's largest Indian tribes.

On Saturday, Stockton Springs residents will vote on a new town ordinance drafted by Ms. Cosmano and her allies. If passed, the ordinance will let them rename the road again. They've already picked a new handle: Squall Point Road. Ms. Cosmano stresses the Norse origins of the word "squall" and cites strong winds that batter the coast here.

Wednesday, June 17, 2009

Confiscated U.S. Bearer Bonds "Clearly Fakes" Says U.S. Spokesman

I can't lie, I'm a little disappointed.

Also, what in the hell were these numnuts thinking? Did they think someone would simply accept bearer bonds with face values of half a billion dollars without at least trying to verify them?

From Bloomberg:
U.S. government bonds found in the false bottom of a suitcase carried by two Japanese travelers attempting to cross into Switzerland are fake, a Treasury spokesman said.
"They're clearly fakes," said Stephen Meyerhardt, a spokesman for the U.S. Bureau of the Public Debt in Washington. "That's beyond the fact that the face value is far beyond what's out there."
Italy's financial police last week said they asked the U.S. Securities and Exchange Commission to authenticate the seized bonds, with a face value of more than $134 billion. Colonel Rodolfo Mecarelli of the Guardia di Finanza in Como, Italy, said they were probably forgeries.
Had the notes been genuine, the pair would have been the U.S. government's fourth-biggest creditor, ahead of the U.K. with $128 billion of U.S. debt and just behind Russia, which is owed $138 billion.

Baupost's Seth Klarman Gives A Speech Detailing Why Most Investment Managers Fail

Hat Tip: Advisor Perspectives
Below are some excellent notes about a keynote speech Baupost's legendary Seth Klarman gave to the Boston Security Analysts Society last week.

He discussed several timely topics including the short termism of most investment professionals and why the incentive system is set-up to drive them in that silly direction:
Klarman first addressed a fundamental conflict within the investment management industry that he said is at odds with investor objectives.

Investment managers, such as pensions and endowments, exist in perpetuity and should be focused on long-term wealth creation. Yet performance is almost universally evaluated using short-term results – managers are compared using quarterly, monthly, or even daily returns, creating extreme short-term pressures. “Managers who do well in the short term are rewarded with more assets,” he said. “Those who do not do well in the short term often don’t survive to see the long term.”

“Money managers know the Sword of Damocles is poised to fall on them next,” he added, which forces them to sacrifice long-term wealth creation to pursue short-term gains.
Klarman talks about how he addressed this at Baupost by being as selective about his clients as they are about him.

Of course, he also addressed the current rally which he said perfectly fits the description of a classic bear market rally. While fitting the description does not definitively mean it is a sucker's rally, it improves the likelihood. In the end, it does not concern him one way or another as he endeavors to focus on what he can control, which is making sure he maximizes the price to value gap.

As to his macro worries, he stated he's put on "massive" portfolio protection via rate caps and swaptions. He also agrees with TILB's long-time worry that TIPS will not provide satisfactory inflation protection as the people that pay you are the same people that measure inflation - they cannot be trusted.

Finally, he talks about the government's actions creating the "mother of all moral hazards."


Seth Klarman - Why Most Investment Managers Have It Backwards 6-09

Cash For Clunkers

Yet another ridiculously dumb piece of legislation has passed The House and is en route to the Senate, where hopefully (though not likely) some quotient of intelligence will prevail upon them and they will nix it. Here is the essence of the bill (from Bloomberg):
Consumers would get $4,500 vouchers if the new car they are buying gets 10 miles-a-gallon better gas mileage than the model they are trading in. For light trucks, the improvement must be 5 mpg better than the older model.

For a $3,500 voucher, the improvement for cars must be 4 mpg or better, and for light trucks, 2 mpg. The trade-in vehicle must be no older than a 1984 model and get 18 mpg or less in combined city/highway fuel economy.

New passenger cars purchased with the vouchers must get at least 22 mpg in city/highway fuel economy, and light trucks must get at least 18 mpg. Domestic as well as foreign models sold in the U.S. qualify.
Sadly, all of us fools that responsibly purchased fuel efficient cars in the past will be punished for our transgressions as we will not be eligible for this giveaway and we will pay our neighbor for having been wise enough to own a fuel inefficient car.


How many times will We The People pass legislation that rewards the behavior the government is seeking to "correct"?

Of course, on top of the ridiculousness of this subsidy that we have already described, it will not end up having much long-term benefit for the auto industry. Instead, its impact will primarily be to pull demand forward from the future rather than to create much sustainable new demand, thus hurting the auto companies next year and beyond when - shocker - demand that would have existed naturally is not there (it was brought forward to 2009).

Further, one aspect of the "that which is not seen" portion of this sort of legislation is the demand destruction it will cause to other industries as consumers respond to unnatural forces and redirect their increasingly scarce resources toward new cars of all things and away from everything else causing a negative impact in those industries that consumers would have spent money on had their demand not been manipulated by the government. That negative impact elsewhere, which will go unseen by virtually all of society (including those soon to be damaged companies as they won't be able to grasp what happened to them), will offset whatever short-term positive the auto industry receives.

Cash for Clunkers is a massively misguided piece of legislation on so many fronts.

At least, we presume, the government will take ownership of these "clunkers" and destroy them in order to prevent them from spewing forth their foul pollution ever again.

"No," say you?

You say they'll sit effectively as subsidized inventory on dealer lots or be chopped for parts to extend the lives of other similar clunkers? You mean these clunkers will provide cheap competition to new unsubsidized cars in the future?

Strange times, we say.

Or, as a friend of TILB said with more than a hint of sarcasm:

They will not sit on lots. Nor will they be recycled (as if they were really concerned about the environment), b/c that would further F the steel makers [note from TILB: recycled steel being a competitor to integrated steel manufacturers]. And as we know, the steelmakers are a union bunch. Therefore, trade in the clunkers, create new demand for new cars, destroy the clunkers, create new demand for steel!! It's brilliant.
Now we're cooking with fire! He's done a fantastic job of thinking like an elected official. Let's put on our Congressman Cap and extend this line of thinking.

Perhaps next, in order to solve the scourge of global climate change and to stimulate steel demand (and the whole steel and aggregates value chain!) as well as embrace the jobs provided by the strategic construction industry, we will let people and firms trade in their clunker houses and buildings. We The People will pay 50% over the market value then destroy buildings and rebuild them to LEED standards - just imagine how productive we'll be, plus we'll solve the mortgage default crisis, AND we'll save the Earth from human contamination at the same time. A trifecta of epic proportions!

Awesome plan!

Now that we think of it, this works for every industry - sorry boys, but TILB will be out of pocket for a bit. We are off to Washington to share the good news. TILB has got this "economy" problem licked!

Tuesday, June 16, 2009

The Fed Holds Nearly One Billion Dollars Of Extended Stay's Recently Bankrupt Credit

This was first reported a few weeks ago, but since Extended Stay has now officially filed, we thought it was important to review the fact that the Fed, through its Maiden Lane I (Bear Stearns) portfolio, holds nearly one billion dollars (face) of Extended Stay credit. Given the Fed has been holding that aggregate Maiden Lane I portfolio at only a modest discount to par, we suspect they have not yet revalued this POS.

The WSJ article linked above states:
Creditors who are not so lucky include some of the country's biggest banks and possibly U.S. taxpayers since one of the lenders was Bear Stearns, whose stake was assumed by the Federal Reserve after Bear collapsed in March 2008. As a result, the Fed had $744 million in face value of various junior classes of the debt on Extended Stay; it also held $153 million in the senior debt that was packaged and sold as bonds. A New York Fed spokeswoman declined to comment.
While the senior debt may have a decent recovery, depending on how it was structured, the bulk of the Fed's holding are in junior classes which are massively at risk.

Now that We The People are one of the major pre-petition creditors in a sizeable bankruptcy (with CRE implications, no less), it will be interesting to see how We behave.

Our long held conviction here at TILB has been that the next sector to be attacked under our Grand Unified Conspiracy Theory framework would be healthcare. However, perhaps we will backdoor our way in to the CRE or hotel and leisure industries first.

We already run the Lincoln Bedroom seven star resort, why not pick-up 680 properties around the country as well?

Kirchner Rebuts Bill Ackman Of Pershing Square Re: GGP (General Growth Properties)

Thomas Kirchner of Pennsylvania Avenue Event-Driven Fund (PAEDX) has written a rebuttal to Bill Ackman's presentation on the merits of GGP that he gave at the recent Ira Sohn charity conference.

The crux of Kirchner's rebuttal is: NOI will be worse than Ackman expects, Ackman uses a flawed cap rate, Pershing uses faulty assumptions about the likely cost of GGP's debt (if it's successfully extended), and that dilution is likely which Ackman does not account for. Here is Kirchner's statement on Ackman's 7.5% cap rate:
Like most valuations, Pershing Square’s lives and dies with its cap rate assumption. Ackman contends that GGP should trade at a 7.5% cap rate, 100 bps better than Simon Property Group (SPG). 7.5% cap rates are not what malls trade at these days, if they trade at all. SPG itself trades at an implied 8.5% cap rate, and Pershing Square thinks that this cap rate discounts the risk of bankruptcy of SPG. Therefore, reasons Pershing Square, GGP should trade at a lower cap rate, resulting in a higher valuation. The problem with this argument is that it can be applied to GGP as well: if the maturity of the debt is extended by 7 years as proposed, the market will discount a potential liquidity squeeze at the new maturity date of the debt. In addition, we believe that an 8.5% cap rate for SPG only shows that SPG is overvalued. If we apply a more realistic cap rate (9%, in our humble opinion) to GGP, then the upside for the equity looks much less appealing. And we haven’t even mentioned dilution yet, which we will address in a moment. After dilution, the equity looks pretty close to fair value to us.
We at TILB think Kirchner was kind not to simply laugh at Pershing's 7.5% cap rate assumption. In fact, to rely on Simon's 8.5% cap in a market in which Simon has issued sub notes that were priced to yield 10.75% is lunacy.

In the end, Kirchner agrees that GGP equity likely has some value, though limited. In the footnote it is disclosed that Kirchner owns "securities" in either or both of GGP and Rouse (a wholly owned GGP subsidiary) which implies that Kirchner is a creditor.

So it seems that at least one creditor is laying the grounds for a battle over who will receive the economics of GGP. Obviously others are like-minded, despite Ackman's wishes that they simply obey his commands. We certainly look forward to an enjoyable fireworks display.

Hat tip: Manual of Ideas


What do you think? Green shoots for GGP equity or zombie equity?

Monday, June 15, 2009

C.B. Richard Ellis Moves CRE Office Cap Rates To 12%


CBRE was/is supposed to be the "asset light" real estate company. All the upside but limited downside...

Well, they just priced sub notes to yield 12% for eight years. All of this (plus some fresh equity the company recently raised from Paulson & Co.) is basically going to be used to term out some existing maturities.

That is expensive capital for simply refi'ing and paying down some of what's already in place.

We at TILB are not sure where "office" cap rates should be, but given the high perceived quality of the CBRE franchise and the nature of its underlying business economics, that same 12% feels like a reasonable starting point.

Of coursen that implies virtually all CRE REITs are zeros...

Happy green shoots to you all!

Sunday, June 14, 2009

Nationalizing Healthcare At Only $120,000 Per Person!

HT: to ZeroHedge

Good news, dear reader, it appears a mere $600 billion in incremental tax increases are coming.

Even better news: that's just to pay for health care, much less the debacle that's going on now - forget the $2 trillion deficit we would have anyway.

Luckily, the plan is simply to further soak the rich (how wet can somebody get before they are thoroughly soaked?) and have five million people subsidize three hundred million.

Obama has pledged that health-care changes won’t add to the deficit. To accomplish that, he’s proposed getting about $600 billion by reducing tax deductions available to the wealthy, and by trimming Medicare payments to insurance companies.
He goes on to state that he understands that number is too big and there will have to be cuts. If past is prologue, he'll cut some nominal amount and then stomp for approvale at his grand achievemnt.

Or, as the good folks at Zerohedge state it:

Additionally as Obama has pretty much staked his political career on only raising the taxes of those who make over $250,000 per year. That's what - 4, maybe 5 million Americans? So, $600 billion divided by 5 million, that makes... oh, about $120,000 in tax increases per person.
I'll note that is before those same people pay for the deficit/debt that already exists.


Someday, perhaps, Atlas will indeed shrug as even his capable shoulders can only bear so much burden. TILB mourns for America...

Friday, June 12, 2009

Mortgage Reset (And Recast) Wave Coming: Whoo, Whoo! Here Comes The Pain Train!

As a follow-up to our post yesterday that the Option ARM reset/recast wave is upon us, I thought our loyal readers may appreciate seeing an updated version of everyone's favorite graph: the monthly mortgage reset/recast chart. It shows that the pain train for ARMs and Option ARMs is just now leaving the station (yellow and light blue).

For those that were hoping yesterday's green shoots news that month over month foreclosure filings declined 6% (despite being the third biggest month for filings ever), you should take that news in the context that we are basically right between two reset humps. The first hump was the subprime reset wave which exploded during 2007 and 2008. We are now at a comparative lull (though still an absolutely high level of resets) before the pace simply explodes from the $20-25 billion a month today to $35-$40 billion a month for two years starting in Q3 2010. Don't worry though, the economy will be robust by then, personal balance sheets will have been repaired, house prices will have recovered, and this will largely be a non-event. Oh, and the Fed will keep benchmark rates low so that the then floating mortgage payments will stay manageable for the ensuing 23-25 years.

Happy green shoots to you all!

Mortgage Reset Wave

Many thanks to our friends at Credit Suisse for continuing to aggregate this data (it's basically a data dump from Loan Performance and the agencies).

Thursday, June 11, 2009

Amherst Securities F's JP Morgan In The A

Amherst is an outsourced mortgage research shop that lots of smart non-mortgage hedge funds rely on for research and advice.

This WSJ article is pure genius. Anyone who doesn't think Wall Street banks wouldn't do the same exact thing given the chance are fooling themselves. If the JPM guys had been smart, they would have utilized the exact same strategy (buying the underlying mortgages at the end) and make sure they were not paid off but instead defaulted.

Some highlights below:

A canny trade by a small brokerage firm in two markets at the heart of the financial crisis has left some of the biggest players on Wall Street crying foul.

The trade, by Amherst Holdings of Austin, Texas, was particularly galling to the big banks because it turned what they believed was a sure-fire profit into a loss.

The burned banks include J.P. Morgan Chase & Co., Royal Bank of Scotland Group PLC and Bank of America Corp. Some banks have reached out to two industry trade groups about Amherst's actions, and the groups are reviewing the transaction, according to people familiar with their thinking. "It's all-out warfare" between the banks and Amherst, said a senior banker at one firm that lost money.


The trade involved credit-default swaps and securities backed by subprime mortgages. The original securities had been sold by Lehman Brothers and were backed by $335 million of subprime mortgages mostly on homes in California made at the housing bubble's peak in 2005, according to the prospectus.

Following a wave of refinancing and defaults, only $29 million of the loans were left outstanding by March 2009, half of which were delinquent or in default, according to a performance report by Moody's Investors Service.

Believing the securities would become worthless, traders at J.P. Morgan bought credit-default swaps over the past year from Amherst, according to people familiar with the matter. Credit-default swaps act like insurance, paying off the buyer if securities are hit by losses. Other banks including RBS Securities, which is the U.S. investment-banking arm of Royal Bank of Scotland, and BofA also bought swaps on the securities from different trading partners.

The banks had to pay up for the protection, similar to a person buying insurance on a beach house just before a hurricane. They paid as much as 80 to 90 cents for every dollar of insurance, the going rate last fall according to dealer quotes, expecting to receive a dollar back when the securities became worthless over the coming months.

Traders can buy credit-default swaps on securities they don't own. At one point, at least $130 million of bets had been made on the performance of around $27 million in securities, according to a person familiar with the matter.

In late April, traders at some banks were shocked to find out from monthly remittance reports that the bonds they had bet against had been paid off in full. Normally an investor can't pay off loans like that but if the amount of outstanding loans falls to less than 10% of the original pool, the servicer -- or company that collects mortgage payments from homeowners and forwards them to investors who own the securities -- can buy them and make bondholders whole.

That's what happened in this case. In April, a servicer called Aurora Loan Services at the behest of Amherst purchased the remaining loans and paid off the bonds.

Although Amherst won't provide specifics and won't comment on its arrangement with Aurora, it doesn't deny that it took this approach. (Aurora says it is a subsidiary of Lehman Brothers Bank, but not part of the Lehman Brothers Holdings bankruptcy filing.)


When the bonds got paid off, the swaps became worthless, meaning the banks effectively forfeited what they had paid for the insurance. J.P. Morgan lost millions, while RBS and BofA suffered minimal losses, said people familiar with the matter.


Since the mortgage securities were valued at just $3 million or so in the market, well below the $27 million they were redeemed for, traders believe Amherst entered into an uneconomic transaction to profit from its swap positions.

We here at TILB love this stuff. WSJ continues its streak of excellent reporting.

Mark Haines Of CNBC And Barney Frank Have a Cat Fight

Barney Frank decides to participate in an interview on CNBC about executive compensation. When people actually challenge the logic of his approach, Barney's cat claws predictable decend.

Mark Haines and CNBS win the ensuing catfight by taking the moral high road...not that being on a higer moral plane than Barney Frank represents much of a challenge.

The fireworks begin with Haines questions around 4:45 or so:

Option ARM Reset Wave Threatens Housing Rebound

A Bloomberg exclusive.

Some highlights (lowlights?) below. Whitney Tilson's ubiquitous mortgage presentation cited.

What's crazy is the talk about a 73 year old lady, Shirley Breitmaier, who's mortgage payment is skyrocketing from $98/month (which I'm sure was the minimum allowable payment) to $3,500. That's in paragraph one. About half way into the story we find out her mortgage was a $313,000 loan.

So, $98 was insanely low and she was/is clearly neg am'ing massively ($98/month actually equates to 3/8s of 1% annually!). Her loan is particularly lax as it allows her to neg am to 145% (so nearly $450,000) of the original loan balance though most Option ARMs cap that amount at 115-120% of the initial balance. Also, her loan was a re-fi as she's lived in the house for decades, which makes it a sad human story (hopefully she had fun with all the money).

People often get very angry at the lender in these cases, but forget that the borrower in a re-fi got a huge amount of cash and chose to do something with that money. I have sympathy, but it's limited by this fact.

The rational outcome for all sides is for her to deed the house back to the mortgage holder now and let them deal with the problem before housing values plummet further in exchange for them not crushing her credit standing:

June 11 (Bloomberg) -- Shirley Breitmaier’s mortgage payment started out at $98 when she refinanced her three-bedroom home in Galt, California, in 2007. [does anyone else find the name of this town ironic? - TILB] The 73-year-old widow may see it jump to $3,500 a month in two years.

Breitmaier took out a payment-option adjustable rate mortgage, a loan popular during the housing boom for its low minimum payments before resetting at higher costs later.

About 1 million option ARMs are estimated to reset higher in the next four years, according to real estate data firm First American CoreLogic of Santa Ana, California. About three quarters of those loans will adjust next year and in 2011, with the peak coming in August 2011 when about 54,000 loans recast, the data show.

Option ARM borrowers hit with unaffordable monthly payments are another threat to the housing recovery and the economy, said Susan Wachter, a professor of real estate finance at the University of Pennsylvania’s Wharton School in Philadelphia. Owners who surrender properties to the bank rather than make higher payments for homes that have plummeted in value will further depress real estate prices and add to the inventory of properties on the market, she said.

“The option ARM recasts will drive up the foreclosure supply, undermining the recovery in the housing market,” Wachter said in an interview. “The option ARMs will be part of the reason that the path to recovery will be long and slow.”

More than $750 billion of option ARMs were originated in the U.S. between 2004 and 2008, according to data from First American and Inside Mortgage Finance of Bethesda, Maryland. California accounted for 58 percent of option ARMs, according to a report by T2 Partners LLC, citing data from Amherst Securities and Loan Performance.


Shirley Breitmaier took out a $315,000 option ARM to refinance a previous loan on her house.

Her payments started at 3/8 of 1 percent, or less than $100 a month, according to Cameron Pannabecker, the owner of Cal-Pro Mortgage and the Mortgage Modification Center in Stockton, California, who is working with Breitmaier. The loan allowed her to forgo higher payments by adding the unpaid balance to the principal. She’ll be required to start paying principal and interest to amortize the debt when the loan reaches 145 percent of the original amount borrowed.


Breitmaier, who has been in the home for 45 years and lives with her daughter, now fears she will lose the off-white stucco house that’s a hub for her family.

I wish the government would bail us out like the banks and the car businesses,”[emphasis added by TILB - and out politicians wonder why people hate them] she said. “I’d like to go from here to the grave next to my husband.”


“This loan is a perfect example front to back, bottom to top, of everything that has gone wrong over the last five to seven years,” Pannabecker said. “The consumer had a product pushed on them that they had no hope of understanding.”


“The problem is, real estate values went down,” Paul said. [not the shit-poor underwriting standards, of course - TILB]

Option ARMs typically recast after five years and the lower payments can end before that time if the loan balance increases to 110 percent or 125 percent of the original mortgage, according to a Federal Reserve brochure on its Web site.


Refinancing is impossible in many states given the nationwide drop in prices. In California, the median existing single-family home price dropped 37 percent in April to $256,700 from a year earlier, according to the state Association of Realtors.


The delinquency rate for payment-option ARMs originated in 2006 and bundled into securities is soaring, according to a May 5 report from Deutsche Bank AG. Over the past year, payments 60 days late or more on option ARMs originated in 2006 have almost doubled to 42.44 percent from 23.26 percent, Deutsche Bank said. For 2007 loans, the rate has climbed from 10.1 percent to 35.25 percent. [emphasis added]


“There’s a level of hopelessness to the phone calls now,” said Brown [a borrower advocate].

Anyway, great article. Bloomberg's been on this story as well as anyone, so kudos to them.

Happy green shoots!


Let us know what you think about the debacle in housing!

Wednesday, June 10, 2009

Bob Rodriguez Of First Pacific Advisors (FPA) Has Been Busy Warning Us All

What follows is the transcript of a speech Rodriguez gave at the Morningstar conference a week or two ago (hat tip: TD and CM). It is an absolute must read.

For those of you that don't know Rodriguez, he has one of the best mutual fund track records out there and he and his partners have done it by maintaining healthy skepticism, employing vision out beyond that typically employed, and by taking less risk, not more.

Rodriguez also recently published this OpEd in Barron's titled V-Shaped Recovery Outlook Is In Vain in which he raises the critical question of who will finance all the debt the US intends to take. For those of you that read our debunking of Irving Fisher's Debt-Deflation prescription, you know the second half of it was dedicated to addressing this issue and identifying it as the challenge of our times.

Anyway, Rodriguez's thoughtful Morningstar speech is below. I'll summarize his view (and ours) as beware of strangers bearing gifts. When our government proposes to intervene in order to "solve" our problems, it generally creates a problem of at least equal size and it leads down a road toward treachery and despair. Read it and learn.

May 29, 2009
Robert L. Rodriguez
Partner and Chief Executive Officer

Good morning.

I want to thank Morningstar for this honor of speaking to you today. We go back a long time, beginning in 1986, when Don Phillips became the very first analyst to cover my two funds, FPA Capital and FPA New Income. I am deeply grateful for having been selected three times for the Morningstar Manager of the Year award and being recognized for my work in both equity and fixed income management.

For those of you who do not know, I will be taking a sabbatical beginning next year. My trusted partners, Dennis Bryan and Rikard Ekstrand will assume leadership of FPA Capital Fund while Tom Atteberry will do the same for FPA New Income. These three outstanding managers are here today should any of you wish to meet and speak with them. Having a high degree of confidence in them as well as FPA, I will be leaving all my personal investments in the various funds and will retain my equity ownership in the firm. Many executives say they have confidence in their associates but few demonstrate this in such a tangible way. I will return 2011 in a supporting role. My decision to take a sabbatical has nothing to do with the current tumultuous market or my health. More than six years ago, I discussed this as a possibility. I consider this step part of the process of succession planning and execution.

This will complete my 39th year in the investment business, 35 of these being as a money manager and analyst, with 25 at FPA. It has been a wonderful experience, though a humbling one at times. I believe I have found success because I have been deeply aware of the need to balance the human emotions of greed and fear. In a word, DISCIPLINE. As a board member on the University of Southern California’s Student Investment Fund program, I tell our students that discipline is a key attribute to becoming a successful investor. I stress that, without a strong set of fundamental rules and a core philosophy, they will be sailing a course through the treacherous investment seas without a compass or a rudder. I also emphasize the importance of integrity and tell them that they can spend a lifetime building their reputation and, if they are not vigilant, they can lose it in a day.

I have always maintained my professional and personal integrity. I have never wavered, despite having paid some very high prices. It seems as though it was a lifetime ago in 1986, when I had few assets under management, and the consultant to my largest account insisted that, if I wanted to continue the relationship, I had to pay to play. I was shocked, dismayed and speechless. Though this would probably have never become public, if I had agreed, how would I have ever lived with myself? By not agreeing, it meant that I would lose nearly 40% of my business. When I was fired shortly thereafter, this termination compromised my efforts in the raising of new money for nearly six years because I could not say why. Despite the pain and humiliation, there was no price high enough for me to compromise my integrity. With the subsequent disclosures of improprieties at this municipal pension plan, the cloud of suspicion over me ultimately lifted. I not only survived, I prospered.

I relay this short story because it conveys some beliefs that will run throughout my speech today entitled, “Reflections and Outrage.” I will make some comments and observations about our industry, the government and then provide a brief financial market forecast. These are my honest opinions for better or worse.

The Mutual Fund Industry
Let’s be frank about last year’s performance, it was a terrible one for the market averages as well as for mutual fund active portfolio managers. It did not matter the style, asset class or geographic region. In a word, we stunk. We managers did not deliver the goods and we must explain why. In upcoming shareholder letters, will this failure be chalked up to bad luck, an inability to identify a changing governmental environment or to some other excuse? We owe our shareholders more than simple platitudes, if we expect to regain their confidence.

Diversification effectively failed as a strategy. All asset classes, other than cash, gold or Treasury securities, lost money. If Morningstar will allow me a small transgression by quoting Lipper Research, “Equity funds posted their worst one-year return in Lipper’s 49-year-old database.” It didn’t matter whether they were U.S. diversified equity funds or world equity funds with declines of 37.5% and 45.8%, respectively--so much for decoupling. This is a concept we never subscribed to at FPA.

For the record, my own fund, FPA Capital, was not a stellar performer either. It was down 34.8%, although it did outperform the average diversified domestic equity fund and mid-cap value fund. In my latest shareholder letter, I discuss the reasons for this lousy performance and attempt to explain why I believe it is only temporary versus other types of performance declines that appear to be more permanent.

The same criticism can be leveled at fixed income managers as well, since domestic and world income funds lost money last year. Only Treasury and GNMA bond funds provided positive returns. Our bond fund, FPA New Income, however, did perform extremely well by achieving a positive total return, our 25th year in a row during our management, and its widest performance differential versus its peers.

Did the industry try and prepare for this tsunami of a credit debacle? I don’t think so. Whether in stocks or in bonds, it seems as though the same old strategies were followed--be fully invested for fear of underperforming and don’t diverge from your benchmark too far and risk index tracking error. The industry drove into this credit debacle at full speed. If active managers maintain this course, I fear the long-term outlook for their funds, as well as their employment, will be at high risk. If they do not reflect upon what they have done wrong in this cycle and attempt to correct their errors, why should their investors expect a different outcome the next time?

Investors have long memories, especially when they lose money. As an example, prior to FPA’s acquisition of FPA Capital Fund in July 1984, the predecessor fund was a poster child for bad performance from the 1960s era. Each time the Fund hit a $10 NAV, it would get a raft of redemptions since this was its original issue price and investors thought they were now finally even and just wanted out. This trend eventually stopped in late 1987, twenty years after the Fund’s founding. I believe investors will react in a similar fashion after this market collapse.

During the 1998-2000 performance derby races, a head long rush into speculation took place when growth stock “investment” managers chased Monopoly money-like stocks called “dot com” and other types of technology stocks. The fear of being left behind by not owning them was quite evident and I was utterly shocked and dismayed by their capricious actions. Where was their discipline? What were they thinking and did they ever consider how they might destroy their client’s capital? At the time, I referred to dot com company valuations as, “not only discounting the future but also the hereafter.” Did these managers learn anything and have they reflected upon what went wrong and how they would change their investment management for the better? The academic community wrote very little on this period but an original thinker and my late friend, Louis Lowenstein, did so in his paper, “Searching for Rational Investors in a Perfect Storm.” I recommend it. Why should individual investors and others trust managers who threw investment caution to the wind? This type of recklessness undermines the basic justification for active investment management versus simply being invested in Index funds.

While technology stock and growth stock investing hysteria were running wild, we did not participate in this madness. Instead, we sold most of our technology stocks. Our “reward” for this discipline was to watch FPA Capital Fund’s assets decline from over $700 million to just above $300 million, through net redemptions, while not losing any money for this period. We were willing to pay this price of asset outflow because we knew that, no matter what, our investment discipline would eventually be recognized. With our reputation intact, we then had a solid foundation on which we could rebuild our business. This cannot be said for many growth managers, or firms, who violated their clients’ trust.

We also did not run with the herd in 2005 and 2006, and thus, FPA New Income’s assets declined from $2.1 billion to $1.6 billion. This process began in 2003 when we deployed an extremely defensive portfolio strategy whereby we would no longer buy any intermediate or long-term Treasury bonds because, in our opinion, they were devoid of any investment merit. We considered the monetary policy being implemented by former Federal Reserve Chairman Alan Greenspan to be insane and that it would create another bubble. Little did we know how big it would become. Because of the low yield environment, new types of securities were created to meet the demand for an enhanced yield. We did not chase yield by purchasing these highly complex, purported to be high-quality, securitized alphabet soup labeled securities created by propeller heads. Reaching for yield, in a low yield environment or because of competition, always leads to disaster, as reflected by the carnage in so many bond and money market funds last year.

It would be unfair of me to level criticism just at growth managers. Many value managers have a lot of explaining to do as well, given last year’s poor performance, driven largely by an overweighting in financial stocks. How did they miss the greatest credit excess in the modern era? How could we have a pandemic breakdown in loan underwriting standards and so many managers miss it? What were they doing in their research? After the collapse of Bear Stearns, I reviewed the changes in portfolio holdings of many value managers and saw additions to their holdings in Fannie Mae, Freddie Mac, AIG, and Washington Mutual, to name a few. What were they thinking?

In contrast to these actions, our firm expressed the view, in our March 30, 2008, website commentary, “Crossing the Rubicon,” that we had crossed over into a new financial system and new era that required great caution since a new set of economic ground rules was being created and the shape of the playing field could not yet be determined. Because of the changed nature of our financial system, we felt that a significantly higher hurdle rate had become necessary for most financial stock and bond investments. For the industry in general, rather than demonstrating caution, it seemed as though each week another “expert” was calling for a bottom in financial stocks. If portfolio managers and analysts cannot recognize the greatest credit blow-off in the last 80 years, when will they? What new procedures and policies have they implemented at their firms to address this new environment and protect them from making similar mistakes in the future? I believe these are questions that must be answered in order to regain and retain investor trust.

I am not without shame. I wrote about my worst investment failure, Conseco, in FPA’s first website commentary in 2002. My failure was in not recognizing the breakdown in its underwriting standards that led to lending excesses. I analyzed what critical variables I had missed and discussed my errors openly in my shareholder letters and other public communications. Both Tom Atteberry and I served on the creditor’s committee rather than take the easier road by saying, “It’s a loss and a waste of time, so let’s move on to the next investment.” Out of this bankruptcy, we developed a template that could be applied to the credit excesses that were to come later, but on a far wider scale. By being totally open about my failure, I believe it has enhanced my personal credibility.

Having the courage to be different comes at a steep price, but I believe it can result in deep satisfaction and personal reward. As an example, FPA Capital Fund has experienced heavy net redemptions since the beginning of 2007, totaling more than $770 million on a base of $2.1 billion. My strong conviction that an elevated level of liquidity was necessary, at one point reaching 45%, placed me at odds with many of our shareholders. I estimate that approximately 60% left because of this strategy. One relationship withdrew $300 million because my policy upset their asset allocation model. We have been penalized for taking precautionary measures leading up to and during a period of extraordinary risk. Though frustrating, in our hearts, we know that our long-term investment focus serves our clients well. I believe the words of John Maynard Keynes as expressed in his book The General Theory of Employment, Interest and Money (1936), are reflective of our investment style. He said, “Investment based on genuine long-term expectations is so difficult today as to be scarcely practicable,” and “It is the long-term investor, he who most promotes the public interest, who will in practice come in for the most criticism wherever investment funds are managed by committees or boards or banks. For it is the essence of his behaviour that he should be eccentric, unconventional, and rash in the eyes of average opinion.”

We are again running contrary to the consensus, shifting course in our equity investment strategy in a way many would consider to be high risk. We deployed more capital than at any other period in the last 25 years, late last year and early this year, with 67% directed into energy stocks. This added to FPA Capital Fund’s hefty energy exposure that existed prior to the market collapse. Over 50% of the Fund’s equity investments are currently in energy. You may read more about our rationale in the March shareholder letter. We have skewed our research toward companies that will benefit from what I believe to be the beginning of a “New World Order.” In my opinion, the old economic order began at the end of WW2 and ended in 2007. Mercantilist nations in Europe, Asia and other parts of the world operated with the strategy of having a cheap currency that made their exported goods attractively priced for a financially sound and unleveraged American consumer. With the recent collapse of the American consumer’s over-leveraged balance sheet, a new era has begun. Foreign countries will have to restructure their economies to emphasize domestic growth so as to offset the structural reduction of U.S. demand for their exports. China has already begun this process. If my outlook is correct, many sectors of the U.S. economy will be negatively affected. Active managers will have to make some hard choices as to how they deploy capital going forward.

I believe superior long-term performance is a function of a manager’s willingness to accept periods of short-term underperformance. This requires the fortitude and willingness to allow one’s business to shrink while deploying an unpopular strategy. Additionally, in the low return changing world I foresee, a well diversified mutual fund of U.S. stocks will likely have a harder time outperforming the stock averages and index funds, as a result of its higher expense ratio. A more focused strategy will be necessary to excel. If active managers continue to adhere to their old practices, we should see a contraction in the active mutual fund management universe over the next five to ten years. First Pacific Advisors plans to be among the survivors.

Government and the Credit Crisis
What a mess we are in. There is little question that this is the worst economic contraction since the Great Depression. It is worse than a recession but not as bad as the Depression. I have a new word for it, “repression.” From its beginning, I have been of the opinion that this is not a normal recession and that the economy would not respond to typical economic policy stimuli. This idea was expressed in my September 2007 shareholder report.

I wonder why so much credibility is bestowed upon many of our government officials. Former Federal Reserve Chairman Greenspan expressed on several occasions that a bubble could not be recognized before it occurred. In his remarks before the Office of the Comptroller of the Currency in 1999, he said, “Collapsing confidence is generally described as a bursting bubble, an event incontrovertibly evident only in retrospect.” 1 Apparently, he couldn’t recognize the internet bubble, but when it popped, he attempted to stabilize the economy from its negative effects by implementing a misguided and unsound monetary policy that instead initiated the greatest credit and asset bubbles since the Depression. While Alan Greenspan was in Shanghai in May 2007, the BBC News reported that he said the Chinese stock markets had risen to levels that were “unsustainable” and that they were overvalued. 2 Then, while he was in London in October of that same year, Reuters reported he said, in response to a question about the Shanghai stock market, “If you ever wanted to get a definition of a bubble in the works, that’s it.” 3 How is it that, as the Fed Chairman, he cannot recognize a bubble in the U.S., but as a private citizen, he can travel more than 6,000 miles from Washington and recognize one in a foreign country?

Chairman Bernanke also has his difficulties recognizing bubbles. In a June 2004 interview with The Federal Reserve Bank of Minneapolis, not yet Federal Reserve Chairman Bernanke said, “I think it’s extraordinarily difficult for the central bank to know in advance or even after the fact whether or not there’s been a bubble in an asset price.” 4 While in October 2005, according to The Washington Post, Mr. Bernanke “does not think the national housing boom is a bubble that is about to burst.” 5 I guess the housing bubble was just too small for the Fed to recognize.

It appears that neither of these Fed Chairmen could recognize the two greatest U.S. bubbles in the last 80 years. In contrast, at FPA, we identified excesses in Alt-A securities back in the summer of 2005 and extended that analysis into subprime and other sections of the credit market. I asked a major savings and loan CEO why he thought we were seeing unexpected deterioration in our Alt-A mortgage pools that was materially different from our experience of the last two decades. His response was, “Fraud.” Upon further investigation, we concluded there was a widespread breakdown in underwriting standards and that this was leading to a blow off in the real estate market as well as other segments of the U.S. economy. In contrast, Fed Chairman Bernanke, in both April and June of 2007, said that there would be no contagion from the subprime credit debacle. Not to be outdone, former Treasury Secretary Paulson affirmed this view in August while on a trip to China. This is not Monday morning quarterbacking on my part since these conclusions were detailed in my shareholder letters as well as in my June 2007 speech, “Absence of Fear,” that I gave here in Chicago to the local chapter of the CFA Society. At FPA, we also wrote extensively on the growing bubble in the stock market in 1999 and 2000 and said that valuations were far in excess of those that preceded the 1929 crash.

Why am I detailing these errors in analysis or judgment? It is because of the extraordinary actions and policies that have been implemented by the Fed, Treasury, the Congress and the Executive branch to address this credit and economic crisis. Let me make my viewpoint perfectly clear, my trust has been severely shaken in the Federal Reserve, the Treasury, the Congress and the Executive branch of government in their collective judgment as to what is required and appropriate for a fundamentally sound long-term economic recovery. Incorrect analysis, obfuscation and political posturing have brought me to this realization. Since the beginning of this credit crisis, both the Fed and Treasury have assumed that a collapse in available liquidity was its cause. At FPA, we concluded it was a capital destruction crisis and that the supply curve of credit in the U.S. had shifted to the left with the demise of the structured-finance market. We also believed that overly optimistic business plans for both depository and non-depository financial institutions had further compromised their balance sheets. Many of these institutions were acting like hedge funds, in disguise, as my associate, Steven Romick, so eloquently detailed in his December 31, 2006 FPA Crescent Fund shareholder letter.

The regulatory agencies and the federal government were complicit in laying the groundwork that allowed many of these credit excesses to develop prior to this economic crisis. Had they done their job effectively, the economy would not have been pushed to the brink of collapse. The “too big to fail” doctrine, that was allowed to develop over the years, reduced the number of viable regulatory options available to deal with this crisis. Given this history of laxity, I am dubious of the federal government’s ability to properly identify and prescribe the appropriate economic and regulatory responses. As we noted in our July 30, 2008 website commentary, “Disgusted and Betrayed,” “It was only on July 10th that Secretary Paulson said that ‘the lenders (Fannie and Freddie) have sufficient funds’ before the House Financial Services Committee. On that same day, the Office of Federal Enterprise Oversight, which regulates both Fannie and Freddie, said that ‘both are adequately capitalized.’ Finally, Senator Chris Dodd in a July 11 news conference said, ‘These institutions are sound. They have adequate capital. They have access to that capital.’” On September 7, 2008, the Federal Housing Finance Agency announced the decision to place both of these institutions into a conservatorship that resulted in the debt and mortgage-backed securities being effectively guaranteed by the U.S. government. The Office of Management and Budget now projects that they will need an additional $92.2 billion by September 30 and this is supplementary to the $78.8 billion already received. Both companies have an emergency capital commitment from the Treasury for $200 billion each. For years we were told these agencies were private companies with only limited access to the Federal government’s balance sheet. We clearly must exercise extreme caution and skepticism when listening to our government officials.

At FPA, we fundamentally disagree with these “rescue” programs since we believe our impaired financial system is being distorted by protecting inefficient and questionable business enterprises. These programs reflect a philosophy of DWIT—Do Whatever It Takes—to stabilize the economy now. Maybe I should call it DimWit? In my opinion, a perfect example of unwise policy has been the economic support of the automotive industry, especially GMAC. At the end of last year, the U.S. Treasury invested $5 billion in GMAC senior preferred equity with an 8% yield. These new funds allowed the company to resume auto lending to support the sale of GM cars. With an 8% cost of capital, new loans were made with rates as low as zero percent. FICO scores were also lowered from 700 to 621, just one point above what would be considered a sub-prime loan. Aggressive lending practices like these are what got GMAC into this mess in the first place. This illustrates how a policy that is meant to help may actually have an unintended consequence that undermines the competitive capability of a more prudent lending institution.

Misguided measures to re-stimulate consumer borrowing, beyond just getting the system functioning, are highly questionable. The combined collapses of stocks and housing prices have pummeled the U.S. household’s net worth by an estimated $12.7 trillion, according to the Federal Reserve, while ISI International estimates it to be in the area of $14 trillion. This net worth destruction is the most severe since the Great Depression. We have a news flash for the government, creating new credit programs for a consumer who was spending almost $1.1 trillion more than they were earning in spendable income, according to MacroMaven’s estimate, will be a non-starter. More leverage is not what they need. Encouraging the consumer to take on more debt is like trying to help a recovering heroin addict lessen his pain by providing him with more heroin.

A dramatic rise in the U.S. personal savings rate will be required to begin the mending process of the consumer’s balance sheet. I expect the U.S. personal savings rate will rise from 2% to 8% this year and remain at an elevated level for the foreseeable future. This process should increase savings by approximately $650 billion annually. An increase of this magnitude, in such a brief period, is unprecedented, other than during WW2, when it rose from 12% to 24% between 1941 and 1942. Assuming some earnings on this incremental savings and a partial recovery in the stock and real-estate markets, it will likely take ten years for the consumer’s net worth to return to its pre-crisis level.

Governmental programs deployed to stabilize and grow the economy appear highly risky, especially those involving an unprecedented Federal intrusion into the private capital system. They have been implemented in an ad hoc fashion with little predictability and consideration for their long-term effects upon the economy. President Obama said in his speech of January 8, 2009, “that only government can provide the short-term boost necessary to lift us from a recession this deep and severe. Only government can break the vicious cycles that are crippling our economy.” [emphasis saddeningly added by TILB] I respectfully disagree with this statement since it flies in the face of 121 years of economic history prior to the establishment of the Federal Reserve System. During that period, economic volatility was far greater than that which we have experienced since WW2, but the economy did recover and grow, without governmental intervention, from several recessions and depressions.

I expect little bang for the buck from the latest economic stimulus plan since most, if not all, of the anticipated positive economic effects will be offset by an increase in personal savings and a reduction in U.S. exports. The plan’s focus attempts to renew personal consumption while supporting housing. Though well intentioned, in my opinion, it is based on rear view mirror analysis in that it does not consider the likelihood that we have entered a new world economic order. If the American public is willing to accept a prolonged period of expanded government spending as a percentage of GDP, possibly in the range of a mid- to high twenty percentage proportion versus a typical 19% to 21%, the U.S. economy will face an even more protracted period of substandard economic growth than it otherwise would. A more viable solution, requiring less government, would be to encourage a transformation of the economy so that exports represent a greater portion of future GDP than their current 12.9%. A shift of approximately five percentage points could possibly accomplish this transformation. As an example, rather than offering consumers an $8,000 credit to purchase a new or existing home, it would have been far more beneficial to redirect this spending to job retraining as well as stimulating employment hiring in industries that are more export oriented. With proper incentives for investment, we could unleash the entrepreneurial spirit of the private sector. Our foreign trading partners will not wait for a recovery in the U.S. consumer’s balance sheet to rekindle their own export growth. They will direct a portion of their fiscal spending into new areas that enhance domestic economic growth, thus, reducing their export dependency. We should not be wasting precious financial resources on industries like housing and autos that will not be beneficiaries of this new trend.

My confidence is being undermined by this new financial system and era. The House of Representatives responded to the voices of the mob, when it voted 328 to 93, to punitively tax AIG employees in an ex post facto fashion. Many of these employees committed to aid in AIG’s corporate restructuring and expected their employment contracts to be honored. Another example is the repeated attempts by Congress to pass cram down legislation that would allow a first mortgage to be restructured in bankruptcy court. We placed a halt on the purchase of new mortgage-backed securities until this issue is settled. On May 6, the Senate passed safe-harbor mortgage legislation that would limit or prevent mortgage servicers from being sued, should they modify loans under government anti-foreclosure initiatives, by owners of mortgage-backed securities. We smell conflict of interest here since the five largest residential mortgage servicers, who control approximately 67% of this industry, are large recipients of TARP funds. They own billions in second mortgages and home equity loans whose values could be enhanced, if only the first mortgages are restructured; thereby, giving priority to a junior creditor’s standing.

Chrysler’s bankruptcy reveals further conflicts of interest. The four largest senior secured lenders to the company had previously received $90 billion in TARP money. It looks as though they rolled over to allow the President’s plan to move forward. To see junior creditors gain superiority over senior creditors is a bad precedent. It turns upside down the absolute priority rule that is a basis of bankruptcy law. Given this outcome, this new potential political interference risk raises a serious issue in our minds in lending to corporations with high union workforce representation with large legacy employee liabilities. At the very minimum, we will require a higher return to compensate us for this risk. It is all about the sanctity of contract in bankruptcy. As a side note, it was not the hedge funds that forced Chrysler into bankruptcy, it was the company and its unions that created a non-competitive enterprise that drove it down the road to bankruptcy. In a recent WSJ article, an unnamed administration official is quoted as saying, “You don’t need banks and bondholders to make cars.” 6 Such statements do not instill confidence in capital suppliers. The latest GM settlement proposal extends this adverse trend. Mr. President, you may have won these battles but the true cost of your “wins” will not be known for several years. Your mission to save a few thousand automotive jobs upends a history of prioritization of lender claims in bankruptcy. You are placing at risk fundamental elements of contract law. In the long run, your strategy will likely cost this country dearly. For the record, I do not, and have not, had any domestic automotive company debt in my bond fund for two decades and thus, I have no conflict of interest on this topic.

The President talks about the concept of “sacrifice” in connection with the Chrysler bankruptcy and the economic crisis. We do not see it demonstrated by our elected officials. My associate, Steven Romick, highlights in his latest shareholder letter that, “Congress recently gave themselves a 2.8% pay raise. We would have preferred something more akin to FDR’s first 100 days when he cut $100 million, including a 5.6% reduction in congressional wages, as part of “A Bill to Maintain the Credit of the United States Government.” 7 Private sector employees and business owners have suffered cuts in their incomes and profits so why should not our elected representatives and other governmental employees experience this pain as well? Why shouldn’t they sacrifice too?

We have to be careful about what is meant by “sacrifice.” As Alexis de Tocqueville said, “A democratic government is the only one in which those who vote for a tax can escape the obligation to pay it.” Given the extreme progressivity of the U.S. tax code, a small proportion of Americans are the ones who really pay for government but most Americans fail to realize it. According to the WSJ editorial of April 13, 2009, by Ari Fleischer, “Everyone Should Pay Income Taxes,” he states that the Congressional Budget Office estimates that those who earned less than $44,300 in 2001, approximately 60% of the country, paid 3.3% of all the taxes, and that by 2005 their payments had fallen to less than 1%.” This is not a healthy trend, if our democracy is to survive.

This brings me to my last point in this tirade against our federal government and its unsound policies and that is that our federal debt growth is out of control. In my September 2008 shareholder letter, I estimated that incremental new Treasury debt issuance for 2009 could be in the range of $2.5 to $3 trillion on a base of $10 trillion. For the six-month period ended March 31, 2009, Treasury debt outstanding grew by $1.1 trillion. New programs announced by the Treasury, the Fed and a much larger budget deficit total approximately $3 trillion more than my initial estimate range; thus, I believe my forecast will prove to be sadly optimistic. I also believe we will see follow on programs that will add to this total.

I estimate that by the close of 2011, Treasury debt outstanding will be between $14.6 and $16.6 trillion and that the U.S. debt to GDP ratio will rise to between 97% and 110%. By comparison, the highest ratio ever attained was 121% at the end of WW2. Furthermore, my estimates do not include entitlement liabilities or the effective guarantee of trillions of dollars of Fannie Mae and Freddie Mac obligations. Treasury debt service will likely rise by 50% to 100% above the present $450 billion rate and this is with interest rate levels near record lows. A critical question is, “How do we finance all this debt?” Assuming consumers save an additional $650 billion in 2009, we will still be more dependent on foreign sources of financing. Should foreign investors retain their present amount of Treasury debt ownership and then let it increase proportionally to our debt growth this year, additional purchases between $719 and $862 billion are required versus last year’s $724 billion. This appears doubtful, given the deterioration in their domestic economies along with rapidly declining exports. To make up the difference, the Fed will be forced to print an additional $800 billion to $1.5 trillion of new money to buy these bonds. Unless Americans increase their personal savings per my estimates and foreign investors boost their Treasury ownership by 39% to 57% between 2009 and 2011, the Fed could be forced to print additional money. This possibility may unnerve some of our trading partners, particularly the Chinese and the oil exporting countries.

Restricting debt growth will be difficult, if not impossible to do since it will require the Congress making unpopular decisions while unemployment remains elevated. In a similar fashion, the Fed will find it tricky to retract the excess liquidity it has created as well as eliminating the various asset purchases and guarantee programs it has established. I do not have confidence in the government’s ability to execute these policies, given the history of the regulators, the Congress and the Executive branch choosing to ignore the excessive growth that took place at both Fannie Mae and Freddie Mac, while looking the other way on numerous other financial institutions, including AIG and the investment brokerage firms. For over three years, Fannie and Freddie operated with excessive leverage and without public financial statements while the government twiddled its thumbs. In contrast, FPA saw these problems three years ago and made the difficult decision to place all of these companies on its investment restricted list. We would not reward bad behavior. I do not see government rising to our standard.

What gets me is that this outrageous size and continued growth in debt and off balance sheet entitlement liabilities is effectively stealing from our children and future generations. As Thomas Jefferson said, “Loading up the nation with debt and leaving it for the following generations to pay is morally irresponsible” and “To preserve independence, we must not let our rulers load us with perpetual debt.” These sentiments ring true today except with our elected representatives. Who is to blame for this tragic set of circumstances? We are. If we, as citizens and providers of capital, do not attempt to exert control and discipline over our government, who will? At FPA, we will not lend long-term money to this irresponsible and fiscally inept government nor will we to other irresponsible borrowers. We are exercising nothing less than our fiduciary responsibility.

My financial market outlook is rather cautious. I believe the recent stock market rally is nothing more than a bear market rally. It is being driven by some highly optimistic expectations. A narrowing in credit spreads is encouraging some “experts” to express the view that the worst of the credit crisis is over, especially with the economic stimulus plan benefits yet to come. Many economists are forecasting an end to the recession by year end, and I have even seen one anticipating a “V” shaped recovery. If my previous comments about the stimulus plan prove to be correct, these forecasts will be wrong. With a continuing weak economy, particularly among consumers, corporate earnings growth will disappoint. Over the last four years at FPA, we have argued that both reported corporate profits and profit margins were unsustainably high. This assessment has proven to be correct for financial-service companies and now we believe this process is extending to non-financial corporations. We estimate that at their peak, corporate profit margins were approximately 30% higher than previous peaks. With a return to more normal profit margins and substandard economic growth, I expect the stock market to be price constrained for the next ten years. This analysis tends to support my estimate that it may also take ten years for U.S. consumers to rebuild their balance sheets.

The fixed-income market faces many challenges that include an explosion in Treasury debt issuance and a return of energy price inflation, within three to five years. In light of this, FPA New Income’s portfolio remains defensively postured, with a short duration that has averaged approximately one year or less for the past six years. I view the Treasury market as being in bubble territory with foolish leaders at the helm of our economic ship.

It appears that we have seen the worst of this credit crisis in the sense that we went over a waterfall but the river is still flowing south. The bulk of the economy’s credit problems are still to come, as charge-offs on trillions of dollars in loans remain to be recognized.

The credit markets are gradually reopening but they are still supported by massive federal programs and guarantees. We do not know the costs of these actions that will have to be paid by future generations of Americans. In the short run, the 1979 Chrysler bailout looked like a winner, but from a longer term viewpoint, did we accomplish anything? Government economic interference can and will cause a price to be paid; hopefully, it will not be a large one, but I doubt it. We are in the midst of a Grand Experiment that entails high risk while the nation is in its most leveraged position in history. There is little margin for error.

It is my hope that I have provided you with some new insights and have prompted you to consider how your actions or inactions could personally affect the financial risks facing our country. I believe this crisis has reawakened a sense of budgetary responsibility that has lain dormant in Americans these past two decades. As Americans, we should demand the same of our government. We, as an industry that allocates capital, bear a responsibility to compel our government leaders to return to prudent fiscal management. If they do not, long-term capital should be withheld, as we have done at FPA for the past six years. We must demand this of our elected representatives and if they do not adhere to a strict fiscal discipline, they should be kicked out of office. If we fail at this responsibility, I fear our nation will travel down a dark and treacherous road.

Thank you again Morningstar for giving me this opportunity to share some opinions and insights at this conference.

Happy green shoots to you, kind TILB reader!


Let TILB know what you think.