Wednesday, May 30, 2007

Ni hao, can you spare me a dime?

It was reported today that 80% of all U.S. government notes with a maturity of between 3 - 10 years are held by foreign investors. EIGHTY PERCENT. Historians stated that not since the 19th century when the railroad systems were being built have foreigners funded so much U.S. debt.

Does this represent the efficient globalization of capital markets or is it a cause for concern. Should something be done. Senator Clinton has apparently raised the idea of legislation that puts limits on the amount of debt that foreign investors can hold. In a market with global liquidity, such a move would likely be received with as much market enthusiasm as Thailand's ill conceived and failed market intervention some months ago. That being said, it's an issue that deserves attention, and at least Senator Clinton has raised it.

Is the debt being used to rebuild aging infrastructure, secure water and energy sources through this century, aggressively address environmental issues or rebuild the primary and secondary educational systems of the country. We know the answer is no to that. It's being used to fund the consumption of consumer goods produced by our investors, to fund the expenditures of a Congress that is always looking to that next election, and to fight a war. One should note that this situation is not a result of the foreign investment. It is simply funded at a lower cost due to the access to global liquidity.

Is America taking out a giant no down payment, teaser rate subprime loan to support its lifestyle. Not yet one would hope, but our priorities seem to need addressing. Is it possible that what will be an interminable election season could have some candidates actually discuss issues like this. All the promises will be made but will the trade-offs be discussed.

WSJ subprime story

Today's Wall Street Journal's lead right article entitled "Subprime Aftermath: Losing the Family Home" focused on a middle class Detroit neighborhood that was suffering from the pressure of interest rates and the likelihood of defaults due to subprime lending. It was a series of personal stories that were touching and sad. They are for certain tragic for those involved. There were multiple tales such as: the woman whose 56 year old husband died and she couldn't afford the mortgage payments; the small businessman who stretched for his dream house and couldn't keep up with the payments when the interest rates reset as contracted; the family who signed up for a loan with a margin of more than 9% over LIBOR, the bank funding rate, primarily to make discretionary improvements to their house; and the high school principal who fell behind on payments due to a teacher's strike and due to the fact that she had fallen significantly behind over the years in paying her property taxes. All of these stories are compellingly told, but they are not really the fault of subprime lending. Why that comment?

One by one: the death of working spouse can put financial pressure on any family; overly stretching to buy anything, a house, a car, a vacation or whatever can be a financially unsound decision; agreeing to pay an exorbitant interest rate that's right there in the contract in order to redo a kitchen and other improvements is irresponsible; and not paying taxes or having some reserve finances when one has a reasonably good job is also irresponsible. They are sad stories but they are stories that can happen in any economic or market cycle.

Apart from the sad stories that make no real point, there are two issues raised that are or should be troubling. First, most of the people who took out subprime loans in the neighborhood that was profiled already owned their houses and had substantial equity. They took out the loans because they were marketed to them and they could use them to make improvements to their homes and pay off other debt. In other words, they owned a home and were financially solvent, but to some degree stretched on their credit cards. In order to maintain and improve their lifestyle, they stepped back into the financial jeopardy that characterized an earlier stage of their lives. This is troubling on many levels, but the concern is that this is could be just the beginning of a trend that has negative economic, social and political impacts. The stretched consumer tries everything to keep up appearances, and for some it fails. Second, the role of some mortgage brokers in the subprime market was not the same as in the prime market. In the prime market, a mortgage broker is often a member of a community who is viewed as a human E-Loan. He, or she, will get the best deal for you in the market and will ease the process for you. In the subprime market, some mortgage brokers were hustlers, presenting themselves as a trusted advisor in the prime market model, but taking advantage of unsophisticated borrowers. There can be and are a few crooks in any business, or any Congress, church or whatever, but in the rush for volume it is likely that some mortgage companies had a no questions asked approach to their brokers as long as they produced. It was more than a "few crooks". While those mortgage brokers and companies did not represent the majority of the market, they apparently were far more prevalent than was widely known as long as the housing market continued to rise. They should be held accountable for their actions and states should look at regulatory options for the future.

Everyone sees the advertisements all the time: flat screen television, no money down and no payments for 12 months; new car, lease for three years, no money down, $239 a month; 0% interest for six months on all balance transfers, no fees and maximum interest rate of 9.9% if your card account is in good standing; or finest quality suits, buy one for $199 and get a second one free, and for a limited time two free ties and two free dress shirts. The subprime lending market has been just another part of this consumer culture that has helped many people realize their goals. The marketers tempt consumers to go to the absolute edge of their ability to pay, and many are taking a step too far. When a mortgage goes wrong, however, it's especially serious. You can live without your flat screen, a new car, an extra credit card or extra suits, but you need a place to live.

Thursday, May 24, 2007

Home cooking

Bad day in the market, but look what's up today. CTX, HOV, and KBH, housing stocks that were mentioned in a 4/11 post. It's been modest, but in the Greenspan induced concern about global value, perhaps investors see value at home, in homes.

Greenspan sell-off

There are many reasons for profit-taking in the equity markets and a reappraisal of values. Today's sell-off is not because of that. Alan Greenspan, former Fed head, is choosing to use his considerable influence to impact the securities markets. There has, to the best of our knowledge, never been such a role taken by a retired Fed governor, and the celebrity of such an Alan/Andrea nexus

To the point. Greenspan yesterday said that the Chinese equity markets would eventually correct in a significant manner. That may be a good assessment, but it is not news. The New York intellectual, part of the late '40's and 50's Ayn Rand inner circle, has clout beyond any Fed role. While aging, the leadership of equity departments at firms like Neuberger Berman(now owned by Lehman) and Third Avenue Value(and many more) listen to him carefully. In libertarian New York, the largest capital market in the world, his opinion is really important. His point is not news. China is going through an equity bubble in its own equity markets which are not, and can not, be widely held outside of China. China is gearing toward the 2008 Olympics and almost every nation on earth wants them to succeed, because for China it is a coming out party that must succeed at all costs. Face saving deal big time. No problems from North Korea, no precipitous action on Taiwan, trade concessions with the U.S. in slow motion progress, it's in place for a couple of years. After that, it's not economic risk that's the issue, but political risk. If enough progress can be made in the interim on economic risk, the political risk diminishes. Go Hank Paulsen. Please shut up you self serving attention seeking Chuck Schumer.

Back to the point. China and the U.S. are in a symbiotic relationship that is beneficial for both(to be tackled in another post). A contributor, Doug Kass, described the China/Blackstone deal as bubble meets bubble. That may be a reasonable perspective, but it's not correct. China is an emerging market which will go up and down with more volatility than an established market, of course. On the domestic front it seems to be ahead of itself. Blackstone, a leader in the U.S. private equity market, is making rational decisions based on financial analysis and when access to capital markets pulls back they will pull back. There is nothing magic or mysterious here. China will participate in Blackstone's results and their own market.

The U.S. equity market is trading on earnings and growth prospects. Barring other factors mentioned in a prior post, it will continue to do so. China is an important part of the global economy, but their domestic stock market is not. Step back, and the issue is whether there is a bubble in some sectors of the U.S. markets. That's the issue. On a P/E basis assuming a slight positive bias to the future, there does not seem to be a problem. On an individual stock basis, some lucky folks are making a lot of money on individual stock picks. That luck may not continue but there is no immediate reason for market stability to be in doubt, Greenspan notwithstanding.

Monday, May 21, 2007

An incredibly significant event for the equity markets

Yesterday there were announcements of acquisitions with values of $27.5 billion for Alltel and $37 billion for two Italian financial services companies. The biggest number, however, was a $3 billion investment. That is China's new State Investment Company's agreed upon investment in Blackstone Group, the U.S. private equity giant that is planning an IPO for later in the year.

With over $1.2 trillion in foreign exchange reserves to be invested, China to date has limited itself to reinvesting in China and investing in the debt securities of other governments. Now China is liberalizing its rules to allow its Central Bank and its investment arms, as well as major financial services institutions, to diversify investments to equities in other countries. This allocation to equities could both improve their returns on their reserves and extend China's economic clout in a meaningful way.

The model for China is the Government of Singapore Investment Corp., or GIC. GIC has for the last two decades been a significant player in global equity markets and a major client of the largest U.S. investment banks. They participate with research and investment acumen that rivals any major U.S. asset management company and have meaningful investment returns.

The U.S. equity market has more depth and greater transparency than any other equity market in the world. While the market has been on what seems at times to be an almost implausible bull run over the last several years, P/E ratios are still reasonable, especially compared to a market like China(of course). The U.S. currency is a bargain. So the table is set. China's initial foray is a passive private equity investment into non-voting shares of Blackstone, but the potential for capital flows into U.S. equities is huge.

We look at the fixed income yield curve and for more than two years have seen an inversion that allows money market investments or short term CD's to yield more than a 10 year treasury. Economic growth continues at a modest pace and the forward predictive power of the fixed income market seems to be in question as a result of the demand for fixed income securities by China and other global export driven emerging economies. Could the same phenomenon now come to the equity markets. Could a U.S. centric approach to equity valuation be trumped by inflows that measure value with different metrics. In other words, is it possible that the next step in the equity markets is a huge rise driven by a new source of investment. Could the U.S. equity market become a mirror image of the U.S. fixed income market and defy traditional analysis.

The widening of China's investment approach will not happen overnight, but once it gets started and its new China State Investment Authority is fully functional it will likely evolve more rapidly than anyone will predict. All things being equal, meaning no geo-political disaster, no serious U.S. consumer meltdown, and no dysfunctional capital markets event, the impact of China's investment change will be material.

This may be the most important equity market news of 2007.

Sunday, May 20, 2007


testing 124

Waiting for a Car

Kizziah to man in line - This line is incredibly long.

Man in line - (with slight stutter) Everything happens for a reason.

K - Where are you from?

MIL - Upstate Michigan. I work in a penitentiary there.

K - You here with family?

MIL - Yeah, my wife and daughter are out there waiting for me.

K - Is your daughter looking forward to Disneyland?

MIL - Well, sort of, but she's older, trying to figure out what to do with herself. I want her to go into the service. There are too many options out there today for a 17 year old. I served 20 years in the Marines, seven of them in Vietnam. I liked the service, saw the world, got an education and had a lot of fun, except when I got shot up.

K - Got shot up?

MIL - Everything happens for a reason.

K - So you now live in upstate Michigan.

MIL - Yeah, we live in a town of about 250 folks and there are two businesses, the prison and the casino on the Indian reservation. Lots of people I work with like to go to the casino, spend a hundred dollars for dinner and gambling. Me, a good night is a hamburger and a movie, twenty dollars, that's enough for me. I'm cheap, but that's what I like to do, that and washing the vehicle.

(Kizziah did not choose to ask what kind of vehicle and having missed his cue they waited for a long time before the man in line finally spoke)

MIL - What kind of work do you do?

K - I work in banking, at Chase in New York.

MIL - Chase, yeah, they have our mortgage. Used to have a Visa card too, but a few years ago I came down here and charged $2500 on the card. It never came through. After a year I called the 800 number and they said don't worry about it. Now I didn't mind, but something was wrong. So I got a MasterCard instead, and cancelled the Visa. Everything happens for a reason.

K - Well, that worked out ok for you.

MIL - Where I live is on a farm where one big family has been making maple syrup for 200 years, tapping the hardwood. That's great for them but, you know, my family, if we're within 500 miles of each other that's too close. But overall , I think things are much better today than before. I'm really encouraged. Just remember the '60's and '70's. I'm encouraged. Things are much better.

K - Why?

MIL - It's the people.

K - The people?

MIL - They're less arrogant. Look at this line. We got hundreds of people waiting two hours for a rent a car. People wouldn't have done this 20 years ago. What's it like where you live?

K - I work in New York City but live in a small town in the suburbs where my children can walk to town and the storekeepers know them. It's good.

MIL - Everybody wants that, a place where you can go to town and buy a pop and say put it on the old man's account. That's not going to happen anymore because of automation. It's changing everything.

K - (after a pause in the conversation) So you don't like gambling.

MIL - Not gambling in a casino.

K - Gambling is something I've never gotten into. I just don't see the point.

MIL - But you know that you gamble every day no matter what you do. I think the same as you about going to a casino, but I said that to a fellow the other day and he asked me if I have a 401-K. I knew what he meant. I made 13% off my 401-K last year and that's ok. In 1978 I bought Chrysler at 7. That's when they were having all those troubles and a friend of mine said they'd be ok. Bought 5000 shares. That was ok. Bigger things than that happen all the time. I was here in Orlando in 1971. Look around you. Land prices have probably gone up 10 times since then. Wish I'd thought about it at the time. Everything happens for a reason.

MIL - (after another pause) Do you go to Central Park. Is it big?

K - I work near there.

MIL - My sister lives in an apartment that has a view of Central Park. She owns it, but she rents everything else. She's in the ad business. She doesn't have a man right now and she and her girlfriend went to Switzerland just for the weekend to go skiing. People do different things I guess.

K - (another pause) It's been more that two hours now. This is not right. Something's wrong, I mean look at this line.

MIL - (stutter returns) I like it. It's well organized. Just look at this line.

K - But I've got a 3 year old and a 9 year old out there in the heat and we've been up since 5:30am.

MIL - Isn't somebody with them.

K - My wife, but she's tired too. I hope the three year old falls asleep.

MIL - No way. She's just flown on a big bird to a strange place. She's awake. She'll stay awake.

K - (agitated) But something's wrong here. This is not right. This is incompetence.

MIL - I sort of like it, you know it's like being at the park already.

K - (more wired) But it's incompetent. Do you think I can get a cab from here. I can't wait any longer.

MIL - Sir, you can do anything you want, but you're over halfway there. And just look at this line. It's like a maze and they've got video monitors all around us. It's really well organized don't you think.

K - (no response)

MIL - Let's time the people in line. Causcasian male in plaid shirt will be at the counter in fourteen minutes. Watch the heavy guy in the brown shirt, twenty minutes.

K - What about us?

MIL - I'd say 1500 hours.

(Kizziah and the man in line continue to talk, time passes and at exactly 3pm they reach the counter)

K - You were right.

MIL - Well I guess that by now you know my response to that.

Friday, May 18, 2007

Politicizing the Sub-Prime Mortgage Problem

It started a couple of months ago. The delinquency rate of sub-prime mortgages was rising and foreclosures were beginning to spike as well. In a televised comment, Hillary Clinton authoritatively and sternly blamed predatory lending as the culprit. Barney Frank soon followed with the same comment and a promise to tackle all participants in the predatory lending schemes. They took advantage of what is primarily a market issue and turned it into a political issue, as well as setting the table for one of the Democrats' key funding bases, the trial bar.

To state categorically that predatory lending is the primary reason, or in Clinton's case the sole reason, for the sub-prime mortgage problems is absolutely incorrect. That said, predatory lending is an important issue to address and there are certainly going to be many examples of excesses and misrepresentations by mortgage brokers and mortgage companies. As a percent of the overall problem, however, it's small. The real issue is a cyclical peak in the competitive risk taking of mortgage lenders and the desire to participate in a hot housing market by borrowers. It's the top of a credit cycle in the sub-prime market.

Not to belabor what may be obvious, but the attributes of this cyclical peak are as follows: sub-prime mortgage companies compete with each other to attract borrowers; they loosen terms and lower down payments to build their originations; in a housing market with rising prices over the previous seven years, it works; they sell their originations to banks that package and distribute them to investors eager to take the risk for a higher yield, which leaves the mortgage companies with room on their balance sheets to lend more; market interest rates rise, housing prices stop rising, and the music stops. At the top of a credit cycle, the primary culprit is overly aggressive and optimistic lending, which could be called stupid lending. More than 50 sub-prime mortgage companies have now declared bankruptcy, including some of the largest. Bankruptcy means that the executives who run these companies lose all of the value of their equity, and their options and restricted stock are now worth zero. Their equity shareholders lose all of their money as well. Again the obvious---predatory lending would seem to imply that someone is a winner who is taking advantage of others, but these firms are not winners.

So what is happening on the borrower side of the equation. For those that find themselves with rate resets higher than they can pay or who find that they cannot count on refinancing their way out of a problem because their house is no longer rising in price, it's a painful problem. It does not, however, mean that they have been defrauded or cheated. It is likely that the great majority of people at some point stretch to buy a first house, or stretch to buy a bigger house for a growing family or to buy a house in an area with better schools or safer streets. Unfortunately when a market turns, as the housing market has, it hurts people who are unlucky enough to have bad timing.

The distress that this leads to can be a political issue, as government can look for ways to give aid to those in trouble and step in as a financer of last resort. Government can and should look at the problem and determine if there are ways that it could have been avoided. To attack the entire industry with a blanket assault about predatory lending should not be the government's role, but it is obviously the role of the opportunistic and cynical politician(this phrase can be applied in a bipartisan manner).

What's next? More of the same on this predatory lending theme no doubt, with the trial bar suing everyone in sight that facilitated the housing market's growth and the growth in home ownership that had taken place in the Clinton(Bill) and Bush administrations. Regulations are now being proposed that will stifle the market further(any borrower with a credit score below 660 should be sub-prime is part of the proposals, which is a really terrible idea) and Christopher Dodd in the Senate is coming up with some legislation that will almost certainly interfere with the market further. Unfortunately these actions are likely to exacerbate the problem in the foreseeable future.

Here's a prediction about what else is next. As background the WSJ had an article on Tuesday entitled "Lenders Get Tougher" that detailed how lenders are tightening standards and qualifying for a mortgage is becoming harder, in some cases even for applicants with good credit. So it can be almost guaranteed that before the presidential election in November 2008 there will be some politicians who attack the mortgage industry for denying credit to the middle class, creating onerous requirements, fees that are too high, documentation that is too burdensome, and in Clinton's case(Hillary), if she stays true to form, there may be the umbrella charge of red-lining(discriminating against minority neighborhoods). Red-lining, like predatory lending, is a problem that should be addressed when it occurs but it will not be the driving force behind tightened mortgage standards. Market forces will be, just as they created this painful correction.

To end on an upbeat note, a quote from Fed Chairman Bernanke, who understands all of this, from his comments yesterday, "Regulators must walk a fine line in using their authority to prevent abuses while avoiding actions that would close the market for borrowers". Bernanke favors using increased disclosure and supervisory guidance instead of new rule-making.

Wednesday, May 16, 2007

Fed hit by Bush Brownie moves

Yesterday President Bush nominated two new members of the Federal Reserve Board to fill recently opened vacancies. Unless these individuals are brilliant beyond their resumes, they would be barely qualified, if qualified at all, to serve on the critically important overseer of our financial system. Are they trained in and experienced in economics, capital markets, or finance? No, it seems not, but certainly they must be good people. They do have backgrounds in banking, which is a plus, and not in horse jumping competitions. One is experienced in corporate trust services for a bank and global operations for a credit card company. This is really beyond a stretch. Bank operations has nothing to do with finance or economics, and the understanding of capital markets is focused on mechanics. Of course it's not lightweight experience, but it's in processing which means technology, legal issues, and managing white collar factories. It is really totally unrelated to the Fed's mandate. The second nominee is a career banker in small banks at the EVP level. That kind of banker is a relationship person and an administrative person who understands credit and deposits. She no doubt has excellent experience, but for the Federal Reserve?
(They are both living in Virginia so let's hope they were not chosen because of Robertsonian or Falwellian loyalties)

Falwell dies

Jerry Falwell died yesterday. An extensive front page obituary in the NYTimes detailed his leadership of the "Christian" right, his founding of the "Moral" Majority, his enormous following at his church, and the development of his Liberty University into a major college. The obit highlighted the devotion of his followers and Falwell's power on the national political scene. What this obituary, and all others it seems, failed to include is the fact that the foundation of Falwell's "ministry" was a repugnant racist appeal from the pulpit in the 1950's and '60's.

Using television like many evangelists of that time, in the late 1950's and throughout the 1960's Falwell covered southwestern and southern Virginia with a style of "preaching" that was a constant attack on black people and any effort at integration. Using every possible way to attack with the exception of the n word, Falwell used scripture to "prove" that the races should be separate and that they were unequal. In a time when billy clubs and hoses were being used on men, women and children in Birmingham, Jackson, Selma and Danville, he inflamed passions and built his church. He was a talented speaker, but so was Hitler. Jews and even Catholics were by no means immune from his biblical admonitions, but they could repent and join the true church of his Lord and Savior Jesus Christ.
It was sickening to watch this man at the time, and amazing that he would rise in this country to a position of such influence and power. It is more amazing still that this background is completely overlooked, presumably for some political correctness related fear that the "Christian" right will be insulted if this man with such a heinous background is not honored.

Of course one could say that he changed, that his "ministries" aided many people in education and rehabilitation, that there are black people in his church and at Liberty University today, and that's the proof. Some of that is true. But one could also say that he had just milked the race issue for all it was worth and needed to go on to bashing gays and women in order to keep filling his coffers and feeding his ambition. Everyone can have their own opinion on that, but there can be no debate on the facts of his behavior in the '50's and '60's, and it is completely overlooked.

As reported in the Danville(VA) Register and Bee today, Falwell, as recently as 1997, was in Danville for a speech at the all white Westover Christian Academy and in 1999 for a sermon at The Tabernacle, that former bastion of racist preaching where, in 1967, I heard the preacher use the n word repeatedly from the pulpit and refer to Martin Luther King as the devil, and much more. The son of that preacher was quoted today as saying "Falwell has been a brother in Christ with me for many years".