A: Because its from Bloomberg, it seems to carry more weight! While this report is not surprising and shouldn't be surprising to anybody that is following the macro trends, it could be the start of a media induced effect on confidence. Lets get right into it.
According to Bloomberg's article, "New York City Real Estate Market Slows as Wall Street Cuts Jobs":
Manhattan apartment sales fell in January and February from a year earlier and new properties came to the market at the fastest pace since at least 2000, according to data from New York-based real estate appraiser Miller Samuel Inc. Transactions slid 6.4% to 3,250, while the number of condominiums, co- operatives and townhouses for sale at the end of last month climbed to 6,225; 15% more than at the start of the year.One of the reasons why I love working at a firm like Halstead, is because they tell it like it is! Greg Heym is the Chief Economist at Halstead and serves on the New York City’s Economic Advisory Panel. I had the pleasure of hearing him speak at the last Halstead semi-annual meeting, and let me say that he was dead on in terms of what is really going on out there; very refreshing to say the least!
JPMorgan Chase & Co.'s planned buyout of Bear Stearns, once the fifth-largest U.S. investment bank, is rattling buyers and sellers now, said Gregory J. Heym, chief economist for Terra Holdings LLC. The closely held company owns residential brokers Brown Harris Stevens and Halstead Property LLC.
"The amount of uncertainty, at least as long as I've been following the market, is unprecedented," said Heym.
Moving on, lets go back 3 months to Dec 27th where I offered you my specific predictions on the Manhattan real estate market for 2008:
"I expect inventory to build as we near summertime, as a result of a slower than normal bonus season, and wall street to deteriorate as we get more clues about whether we are in a recession or not. As wall street falls, so will confidence and demand on the buy side for Manhattan real estate products. At the same time, we will see more types of sellers contribute to inventory builds toward the end of 2008; speculators, foreign buyers flipping, second home's selling, and struggling buyers who bought a bit more than they can chew or whose job security has changed to the negative. I expect job losses to grow during the first two quarters of the year as a result of the credit crisis and hit to the financial sector, leading to what I described above."For all those that have been reading my stuff for the past 2 1/2 years, you know my passion for macro and telling it like I see it! You will NOT find fluff on this site and the goal will always be to offer unbiased front line reporting and opinions about the macro economy and Manhattan real estate! We need a more transparent marketplace and that is what I am spending much of my time on trying to accomplish!
The Streeteasy.com widget has been wonderful in keeping pace with Manhattan's TOTAL INVENTORY so far! The UrbanDigs charting tool is almost out of BETA testing and in 2-3 weeks you will be able to do more powerful searches and analysis on all four listing metrics: new listings, price cuts, contracts signed, & total inventory trends. It is very comforting to see appraisal guru Jonathan Miller's inventory # (6,225) come in pretty much in-line with our total inventory number of 6,280 as of today; although JM's # is from last month I think we were in high 5,000's at that time! It's clear that our efforts on accuracy have been paying off and Streeteasy's tech team deserves great credit for helping to make NYC real estate a bit more transparent!!
UrbanDigs Says: This is not news to UrbanDigs readers. We have seen inventory rise for the past 3 months and stay over 6,000 for about 2 weeks now. At this level, there STILL is not a glut by any means out there! Thats the key takeaway. What we must keep in mind is that inventory has dropped significantly as a result of strong sales volume for the past few years. We are now ticking up, but are no where near a level that warrants fierce seller competition; fierce seller competition is the phrase I used often here to describe a local re marketplace in distress! It's a metric to monitor as the full effects of the credit crisis reveal itself; economic slowdown & job losses which effect confidence. In my opinion it is all about confidence. While it seems the fed has averted a systemic financial meltdown and will do everything in its power to continue to do so, we are now entering a period of time where we will see the economic fallout from the credit storm. Our eyes will be open!
No not 'R'ecession! I'm talking about the other 'R' word: 'R'egulation! Every economic panic has raised questions about regulation, and the current market debacle is no exception. Especially in an election year. As I'm writing this, Congress is looking into overhauling our nation's oversight of financial institutions.
The danger is that Washington will come out with a knee-jerk-reaction piece of legislation such as Glass Steagall or Sarbanes-Oxley. The former came out of the Depression and legally separated commercial from investment banking broker/dealer activities, under the presumption that riskier financial activity would place consumer depositors at risk, a risk that was never verified as a cause of the Great Depression. As markets evolved over time the law didn't make sense and became counter-productive to US banks; after some wrangling Congress finally repealed it in 1999. As for Sox, having grown out of the Enron and Worldcom scandals while the SEC was asleep at the wheel, well, that's another discussion.
But some legislation has been beneficial, such as those that established the SEC, to provide oversight to the markets and encourage more transparency. And the Federal Reserve Act, that established the Fed, centralizing our nation’s money supply and creating a more effective means to control monetary policy that remains a model for central banking around the world.
So what's next? Well, right now we have an 'alphabet soup' of agencies providing a patchwork of oversight, including the following:
1. FEDERAL RESERVE - bank holding companies and banks that are members of the Fed, also manages monetary policy and issues securities for the US Treasury
2. OCC - part of the US Dept of Treasury oversees nationally chartered banks
3. OTS - also part of the Treasury dept, oversees thrift institutions
4. FDIC - insures consumer bank deposits
5. SEC - supervises public exchanges
6. NASD (Currently known as FINRA) - supervises securities dealing activities
7. OFHEO - part of the US Dept of Housing & Urban Development, supervises government-sponsored entities such as Fannie & Freddie
8. FHA - also part of HUD, provides housing loans for lower-income
...not to mention each state's banking department.
Ok, got that?
The issue is, places like Bear Stearns or Lehman Brothers don't undergo the same level of scrutiny as banks that accept deposits. And that's probably a good thing given their role in providing innovation in the financial marketplace. Yet they have come to play an increasingly crucial role in effecting liquidity in the marketplace, which includes banks. So when Bear falls, it rumbles through to potentially destabilize the markets, and ultimately the economy.
So what's the solution? What I'm afraid of is all of these calls by politicians for MORE regulation; if anything just to show the public that they're doing SOMETHING to address the issue...ugh.
A better idea would be more EFFECTIVE regulation. There must be a balance between protecting the interests of the public/economy vs. stifling financial innovation that can lead to unintended consequences (inability to compete in world markets, market illiquidity, etc.).
I like the ideas put forth by US Treasury Secretary Paulson and Senator Chuck Schumer of streamlining all of these various financial regulators. Today's article in Bloomberg is titled, "Paulson to Propose New Financial Overseers, SEC-CFTC Merger", and aims to give the fed more power:
Treasury Secretary Henry Paulson is likely to call for the creation of new regulatory agencies with broad powers over lending, the securities industry and business conduct, according to the draft of a study he commissioned.The UK did this by establishing the FSA; an independent body that regulates the financial services industry in the UK. As of now, although each agency applies the same regulatory standards, the system creates tremendous inefficiencies, and the taxpayers deserve better.
The report, which recommends more power for the Federal Reserve, also proposes combining the Office of Comptroller of the Currency -- which dates back to the Civil War -- and the Office of Thrift Supervision into a single banking overseer.
The real question is this - if Bear Sterns were subject to the same level of oversight as a bank like JPMorganChase, would all of its troubles have been prevented? Would the Fed therefore not have had to come in and move the way it did?
Or maybe Bear should have managed its own risk better, in which case no amount of regulation would have prevented the firm’s potential meltdown. Their story is not over yet and more will unfold. Until then, Congress should hold off on passing another law until the root causes are fully understood, so that more effective regulation could be applied.
According to a recent Bloomberg article, the body count on Wall Street has hit 34,000 in the past nine months as a result of the subprime market fallout. The article quotes Jo Bennett, a partner at executive search firm Battalia Winston International as saying, "The crisis is much worse than 2001, and we don't know how long it's going to last." It adds that the Securities Industry and Financial Markets Association showed 39,800 Wall Street jobs lost in 2001, and this number climbed to 90,000 in the next two years.
Bennett also opined that some firms have not fully disclosed their job cuts to avoid looking weak.
The job losses related to the subprime collapse are already impacting ancillary areas.
According to Jeanne Branthover, a managing director at Boyden Global Executive Search in New York, "This is filtering down to the vendor, the firms Wall Street was using are also feeling the pain."
A list compiled by Bloomberg of layoffs by firm from company disclosures as of 3/27/08 follows:
Please note that the Bear Stearns numbers don't include fall-out from the JP Morgan take-under and the Goldman Sachs numbers don't reflect the NY Post's recently rumored additional cuts. These job losses have significant implications fot the Manhattan office market, despite the lack of significant new supply coming on, similar to the 2001 experience....but that's the subject of a future post. For now, let's look at some of the data and projections on job losses and consider the implications for the residential real estate market.
According to the International Herald Tribune, "The New York economy is more dependent than ever on high Wall Street incomes, which have jumped by more than half since 2001, to an average $387,000, according to the city comptroller's office." As an example of the impact the Times cites a company called SeamlessWeb, which delivers food to Wall Street firms and is reconsidering hiring plans.
According to the New York Post: "Economists at the city's Independent Budget Office have calculated that for every job lost in the securities industry, there are eventually another four to five jobs lost across the city economy." The conservative Manhattan Institute Empire Center for New York State Policy released a study back in October in its Fiscal Watch publication, which predicted a less draconian loss of two non-securities jobs for each lost Wall Street paycheck. So depending on whose estimates you want to believe, 103,000 - 208,000 total job losses are already being baked into the pie, if the losses in the table above are the absolute total.
Below you can see a visual representation of New York City job trends and securities industry job trends historically. This excellent chart from the New York Fed only extends through 1999, unfortunately (I have inquired into getting an updated one). Note that in the 1970s and 1990 contractions on Wall Street, city employment ex-Wall Street rolled over slightly after Wall Street employment, fell faster or for longer than Wall Street employment and took longer to recover. This bodes ill for employment's impact on the city's real estate market, this time around.
Interestingly, the recent Manhattan Institute study echoed several themes we have been pointing to here at Urban Digs (see States & Cities At Risk) , like the knock-on effects of likely lower tax revenue and city budgetary issues. Below is a chart of what happened to city tax revenue after the dot com employment swoon, according to the NY Fed.
Check out this chart chronicling the super-charged growth in tax funding and spending growth in New York City during the upturn vs. the more mundane growth of other economic growth measures over the last decade. This has got be partially driven by real estate market impacts on tax revenue and something of a loss of spending discipline. The reduction in employment, coupled with lower real estate-related taxes, is an evil omen for city tax revenue.
As you can see from the chart below, which is also from the Manhattan Institute, the dot com downturn was not enough to stop the secular upturn in city funded operating expenditures as a percentage of personal income, which began out of the depths of the 1990 recession and Wall Street slump. According to the New York Fed: "Between 1988 and 1991, Wall Street employment fell 16 percent and real earnings dropped 12 percent. About one year into the securities industry downturn, the overall economy also faltered: from 1989 to 1992, total employment fell 9 percent and real earnings dropped 3 percent. Since the city recovered from that hangover and Wall Street employment recovered to 1987 levels around 1996, operating expenditures compared with personal incomes has been on the rise. This has undoubtedly contributed to a steadily improving "quality of life" in Manhattan and a virtuous cycle of increased prosperity and both income and real estate driven tax dollars to work with. The question is whether this downturn will reverse that trend.
Note that the Bloomberg administration briefly raised taxes after 9/11. They were taken to task for it by the the Manhattan Institute in prior studies, which suggested that when taxes are raised in New York City, jobs are lost. Tax cuts when they were forthcoming appeared to have helped boost the city's fortunes.
So keep your heads down, dodge the ax man.....and then look out for the tax man!
From the Blogosphere
Will Wall Street Cutbacks Hurt New York City Real Estate
Heads Rolling on Wall Street: Job Losses Starting to Rival Tech Bust
Job Cuts Shake Wall Street Nerves
A: I lied, I must talk about macro today after reading this article over at Interfluidity, Steve Waldman's blog via Macro-Man's analysis of the fed sponsored deal for the Bear buyout. Its strange, every time I think I get a grasp on what is going on here, I later learn I have no clue! PLEASE, SOMEBODY STEP UP AND EXPLAIN TO ME IF THE FED REALLY IS BUYING UP TOXIC MORTGAGE BACK SECURITIES AT HIGHER PRICES?
This is mysterious and warrants a discussion. I'm not sure where to start to make it simplest for all of us to understand, so bear with me for a moment.
Steve Waldman delves into what is really going on with the fed sponsored deal for the buyout of Bear Stearns over at Interfluidity; what we thought was a loan, isn't a loan at all:
It is not a loan at all. The Fed and J.P. Morgan are creating an investment fund, to be managed by BlackRock. The money that the Fed and J.P. Morgan will provide is startup capital for the fund. All of it is referred to as "loans", but that's facile.Lets revisit that last paragrah. Macro Man discusses:
The Fed's ownership stake will be $29 billion, ostensibly in the form of loans at "the primary credit rate, which currently is 2.5 percent and fluctuates with the discount rate". But, that is largely meaningless. If the investment company's assets turn out to be worth less than the principal and interest due the Fed, then the Fed's loan won't be repaid. If its assets appreciate, J.P. Morgan gets paid out, and the rest belongs to the Fed.
Essentially, the Fed will own this investment fund and the Bear portfolio outright. JPM's position is basically a call option on the fund's assets at $29B plus time-value whose value is capped at $1B plus time-value. (JPM is long a call option and short the same option at a higher strike price.)
The Fed can deny all it wants that it is considering purchasing mortgage-backed securities. That is the economic effect of this arrangement. The Fed is buying up mortgage-backed securities and other unspecified assets at "the value of the portfolio as marked to market by Bear Stearns on March 14, 2008."
Things just get curiouser and curiouser. Not only has JP Morgan managed to dig under the sofa cushions and find enough dimes to quadruple its bid for Bear Stearns....but the New York Fed has put its side of the deal (eg, the loans that guarantee some of the shite that Bear owns) into a SIV, of all things, to be managed by Blackrock. Sure, if things go belly up, JPM is on the hook.....for a whole $1 billion. Gee whillikers!There is fed statement disclosing the financial arrangement of JPMorgan Chases's Acquisition of Bear Stearns; here are the key terms that the above blogs are discussing:
The New York Fed loan and the JPMorgan Chase subordinated note will be made to a Delaware limited liability company (“LLC”) established for the purpose of holding the Bear Stearns assets.So, my question is: IS THE STRUCTURE OF THIS NEW LLC, SETUP BY THE FED & JPM, IN ESSENCE BUYING UP THE MURDEROUS MORTGAGE BACKED SECURITIES HELD ON THE BOOKS OF BEAR STEARNS?
The New York Fed loan and the JPMorgan Chase subordinated note will be made to a Delaware limited liability company (“LLC”) established for the purpose of holding the Bear Stearns assets.
Repayment of the loans will begin on the second anniversary of the loan, unless the Reserve Bank determines to begin payments earlier. Payments from the liquidation of the assets in the LLC will be made in the following order (each category must be fully paid before proceeding to the next lower category):
* to pay the necessary operating expenses of the LLC incurred in managing and liquidating the assets as of the repayment date;
* to repay the entire $29 billion principal due to the New York Fed;
* to pay all interest due to the New York Fed on its loan;
* to repay the entire $1 billion subordinated note due to JPMorgan Chase;
* to pay all interest due to JPMorgan Chase on its subordinated note;
* to pay any other non-operating expenses of the LLC, if any.
Any remaining funds resulting from the liquidation of the assets will be paid to the New York Fed.
If so, then this statement by 'a senior fed official' is not entirely true:
"The Federal Reserve is not involved in discussions with foreign central banks for coordinated buying of MBS,"Maybe there is no co-ordinated effort, but clearly the fed is taking some toxic paper on! Talk about moral hazard.
A: I want to take a brief break from macro and discuss something that all buyer's should take into account as they seek to put their hard earned money to work in a new home; the layout. I've noted many times before here on UrbanDigs.com in the buyers tips section the importance of putting your money into the permanent features of the property that likely won't change until resale: location, light, views, raw space. Obviously light/views is the only thing that may change should the property be next to a future development site. After these four permanent features, apartment layout is one of a few factors that I like to focus on to get the most bang for the buck. Let me explain.
When it comes to layout, I think of two things that are very important in the buying process: time line to own and resale-ability. As most people have budgets that should definitely be adhered to, one of the goals in the buying process is to get a property that is scalable to the buyers' needs. What I mean is, does the property allow room to grow? Having a 5+ year time line to own is a must, but having a property that allows the potential for a few more years is even better. In addition, does the layout appeal to the masses for resale?
After spending more than 4 years in the field with many different buyers, I have come to understand what the masses look for and are willing to pay a little extra for come bid time. In no particular order, here are the things to look for in getting a desirable layout for most price points:
1. Scalability - In my opinion, one of the more important aspects of a layout! Does the layout afford the owner the luxury of scalability to meet the future needs of more usable space? The easiest way to explain this is a JR4 layout that is capable of being converted into a makeshift but doable 2BR; by converting the alcove dining/office area into its own bedroom. The key to scalability is having a room that offers its own window, at least 100 sft or so, room for a closet, and its own HVAC unit. Having a scalable layout does two things: allows the owner to live in the property for a few more years should they desire to do so + offer the future buyer the same luxury at resale.
2. Wasted Space - Does the layout make good use of space? I find that layouts with long hallways or very large bedrooms but small living areas are much less desirable to the masses. While this doesn't mean that you wont get a good price for this type of product at resale, it does make it harder to do so. Overall, having space wasted in long hallways or large foyers seems to have the biggest impact on buyers.
3. Formal Dining Room / Dining Area - A key element, especially at higher price points. Does the layout offer a separate dining area or formal dining room. There is a big difference between marketing a 4.5 room 2BR over a Classic 6 with its own formal dining room! In the end, if you are going to spend top dollar for a family home, be sure it has the features that will appeal to families down the road; and that means having a clear room/area for dining allowing the living room to be used on its own devices.
4. Configurable - A bit less important. Does the layout allow for changes? Can you lose a closet here so that you can expand a bathroom there? Buyers like the idea of customizing a layout to meet their own needs; so whenever possible, having a layout that is customizable may appeal to that perfect buyer at resale who has the ability to see the ultimate potential of the property.
5. Split Bedrooms - I find that most of my two bedroom buyers prefer to have split bedrooms. Leaving reasons why out of this discussion, the idea of the kids being across the apartment is more desirable! Again, this is layout feature that is less important than scalability and wasted space; but figured to mention it anyway!
Well, there it is! The importance of the layout when it comes to plunking down hundreds of thousands of dollars for your new home! Remember, permanent features of location, light, views, and raw space remain a higher priority in the buying process for future profit potential. After this, try to fine tune your vision to find a layout that will be able to meet your needs for time line
to own (can you grow into this property and stay a few more years), and appeal to the masses at resale!!
Transformation: My JR4 Into A 2BR
What To Do With Your JR4
Room Count: A Shady Science
A: Why? Because she was dead on BEFORE any other analysts were! Meredith Whitney had the courage to say what others wouldn't and put out a research note warning of the writedowns and dividend cuts months before they occurred. Today, Whitney quadruples the loss estimates for Citigroup which comes one day after Goldman Sachs puts the total global subprime loss projection at 1.2 Trillion before all is set and done.
Back in late October, Whitney put out a research note on Citigroup; story via Forbes.com:
Citigroup (NYSE: C) dropped 7.5%, or $3.11, to $38.25 on Thursday morning after CIBC World Markets downgraded the stock on fears of an impending dividend cut.Hmm, Citigroup falling 7.5% to $38; seems like ancient history these days. So where is Whitney NOW after the entire financial sector has gotten beaten down? Well for Citigroup, she is revising her loss estimates up four fold!
In a research note, CIBC World Markets analyst Meredith Whitney downgraded Citigroup to "sector underperformer" from "sector performer," saying that a dividend cut may be on the horizon in order for the company to raise capital.
According to Bloomberg's article, "Citigroup Estimates Cut by Oppenheimer's Whitney":
Citigroup fell 3.3 percent in Frankfurt trading to $22.65 after Whitney predicted the bank will lose $1.15 a share in the quarter because of potential markdowns of $13.1 billion on assets including leveraged loans and collateralized debt obligations. That compares with her earlier loss estimate of 28 cents, Whitney wrote in a note yesterday to investors.This comes one day after teflon IB Goldman Sachs sees total credit losses around the globe reaching as high as $1.2 trillion; and $460 billion for US levered institutions.
According to the story via Reuters:
Goldman Sachs forecasts global credit losses stemming from the current market turmoil will reach $1.2 trillion, with Wall Street accounting for nearly 40 percent of the losses.We had our one week drug induced rally after the fed cut FFR & discount window and helped avoid a systemic financial meltdown by backing up a JPM buyout of Bear Stearns. The drugs are starting to wear off, and as usual, talk is now starting about the NEXT round of rate cuts. Oh when will the story end!
U.S. leveraged institutions, which include banks, brokers-dealers, hedge funds and government-sponsored enterprises, will suffer roughly $460 billion in credit losses after loan loss provisions, Goldman Sachs economists wrote in a research note released late on Monday.
Losses from this group of players are crucial because they have led to a dramatic pullback in credit availability as they have pared lending to shore up their capital and preserve their capital requirements, they said.
Goldman estimated $120 billion in write-offs have been reported by these leveraged institutions since the credit crunch began last summer. "U.S. leveraged institutions have written off less than half of the losses associated with the bursting of the credit bubble," they said. "There is light at the end of the tunnel, but it is still rather dim."
If there is one thing to take from what Whitney & Goldman is saying, its that we STILL don't know how deep this writedown abyss goes! I certainly have no clue how deep the hole goes, all I know is that it continues to be deeper than most like to admit. We are about to enter a period where more writedowns will come at the same time economic data shows the effects of the credit storm; after all the fed admitted that unemployment & inflation will rise as the economy slows. We saw today's weaker durable goods number and now we must brace for unemployment data and Q4 final GDP and Q1 advanced GDP that could very well mark the official recession call.
Profit potential at investment banks need to get adjusted as the game is over for many revenue generating models:
The derivatives trade of securitizing loans and selling them off in pieces on the secondary mortgage markets generated billions in revenue for these banks & brokerages. Now that the housing bubble popped nationally, risk has been re-priced, secondary mortgage markets are not functioning properly, liquidity dried up for mortgage backed securities, and the announcement of billions in losses and potential insolvencies, THE GAME IS OVER! How will these banks and brokerages generate the kind of revenue that they got used to generating the past few years?When the fed does what they are doing, you know regulation isn't far behind! While that is good for longer term sustainable growth without allowing for the same mistakes that were made in past few years, it will strangle profit potential.
In my view, future rate cuts will tell us how severe the recession will be. I would expect at least another 50-75 bps of cuts to the FFR over the near term, further weakening our dollar and boosting commodity prices. I hope that additional stimulus measures will limit the aggressiveness of future rate cuts. Should the fed cut more than this, or take the FFR below 1.5% or so, that is an indication that the recession is proving to be worse than original thought. How low will we go?
A: Sorry for the lack of content as I have been very busy over the past week or so; lets get back to work. The fed has showered the markets with stimulus since the Bear Stearns debacle and the huge $200Bn TSLF announced on March 11th that kicks in on Thursday. Thus far, the fed has poured over $478B worth of liquidity injections + expanded what may be used as collateral for these short term loans to ease the distress in the credit markets. Some Markit indexes show improvement BUT I am hearing the opposite from friends I know on the front lines. Bottom line, while some of the credit markets are seeing improvement, it is NOT across the board!
Lets be clear, there SHOULD be an easing effect given the amount of actions the fed took to avoid a systemic financial meltdown from a Bear Stearns bankruptcy, and to help ease secondary mortgage markets and credit spreads over the past two weeks. Watching Kudlow last night, I got this little tidbit regarding what the fed has done so far to address the credit crisis:
TSLF --> $200 Billion
TAF --> $100 Billion
REPOS --> $100 Billio
SWAPS --> $36 Billion
BSC --> $29 Billion
PDCF --> $13 Billion
TOTAL = $478 Billion
Why is this important? Well, the fed's TOTAL balance sheet is $879 Billion making the actions taken thus far 54% of reserved bank credit!
So what is seeing improvement?
a) mortgage spreads - yay for buyers!
b) IG (investment grade) spreads
c) CMBX spreads - chart on right showing improvement (down is improving)
What isn't improving?
a) junk bond market
b) HY (high yield) spreads
c) commercial paper
d) money market rates (added on @ 12:48PM)
I think this rally was a typical fed induced rally powered by short covering and the unwinding of hedged positions in commodities; it is not a rally of returned confidence, clarity, and certainty about the near term. It seems the fed has prevented a crisis, but they did pay a big price for that luxury! While it fixes a few problems, (and when I say fixes we are only back to where we were a month ago), it doesn't solve everything!!
I guess it depends on what credit market you look at! If you look at mortgage rates, yes you probably saw a nice drop in the past week or so; and rightfully so. If you are working on a trading desk in a junk bond market or high yield commercial paper, things are still very bad!
According to Bloomberg's article, "Junk Bond Losses Top $35 Billion, JPMorgan Sees":
High-yield, high-risk bonds are off to their worst start ever, and the biggest investors say there's no recovery in sight. While the Federal Reserve has slashed benchmark interest rates by 3 percentage points since September, it has been unable to get investors to increase their purchases of the riskiest assets. The declines are choking off financing for speculative- grade companies, boosting defaults. The debt is likely to "struggle" for months as the economy enters a recession, according to JPMorgan Securities Inc., the top high-yield research firm in Institutional Investor magazine's annual poll.Enjoy the fed drugs until they wear off because this credit crisis is ongoing, de-leveraging will continue, more corporate deaths will pop up, and the economic data will start to come in showing how deep the slowdown is getting. To me, this is a lot of unanswered questions. There will be a time to get excited, I just think its still a bit early for the credit markets.
Investors are demanding yields averaging 8.07 percentage points more than Treasuries, up from 5.92 percentage points at the end of last year, and a record low of 2.41 percentage points in June, index data from New York-based Merrill show. The spread reached 8.62 percentage points on March 17, the most since 2003.
Think of this. If the housing bubble burst caused the seizing up of secondary markets, which caused the debacle to the financials, which caused the credit crunch...what will happen when the recession actually hits? How can housing recover in a recession? The good news is we are closer to a bottom then we were 6 months ago. The bad news is that glimmers of hope are just that, glimmers of hope! We STILL do not know whether other securitized debt classes will cause trouble on wall street, the full effect of ARM resets, the full effect of foreclosures, and the full effect on the US economy.
When I see improvement across ALL credit markets, I'll report it to you and I will start to discuss clarity about the post credit / post housing recovery!
The Mother of All Margin calls has taken its first victim in the personage of Bear Stearns. Just like seeing Spitzer step down must make any wayward husbands have second thoughts about illicit activities, so should the brutality of Bear's sudden collapse make leveraged investors shudder. In both cases, the magnitude of the example is likely to cause changes in behavior. Advice from folks like Citibank's strategy team recently - yes the irony is thick - is to reduce portfolio exposure to leveraged investments. According to the sharpies over at Citi:
Steady growth, low inflation and rock-bottom interest rates encouraged economic and financial participants across the world economy to gear up over the past few years. Easy money encouraged many to buy a bigger house, a bigger car or a bigger speculative position. But now, any behavior that relied upon continued access to easy money is being dramatically reassessed. Leveraged banks must lend less, leveraged consumers must acquire or invest less, and leveraged speculators must speculate less.
Yes, they pay these strategist guys a lot of money to state the incredibly obvious, but hey, you have to pony up these days for the relatively few people with now valuable history degrees. Who else would be able to recall this quote from the July 23, 1990 issue of the New York Times? : ''Debt is not king anymore and equity is becoming the favored way to fund,'' said John Trygg, head of investor relations at U S West, the Denver-based regional telephone company. And the further commentary from this article written by Leslie Wayne:
For issuers, what lies behind these numbers is a psychology of fear. Corporations are troubled by the collapse of the ''junk bond'' market, the specter of Donald J. Trump's problems, the bankruptcy of many celebrated buyout companies and an economy that could be headed for rough times. ''Debt is becoming a four-letter word,'' said Richard L. Kauffman, director of equity capital markets at the First Boston Corporation.
Now if you think all of the writedowns that banks have taken on marketable securities scared them into tightening credit, and frightened customers into demanding less credit, wait until the actual loan losses hit, semi-permanently erasing capital from bank balance sheets. With the Fed's recent invention of the term securities lending facility, banks may be able to use the Fed as a warehouse for low-quality securities that they hope will eventually prove more valuable than their current mark to market prices, but they can't easily reverse write-offs of loans that go sour. Not only will loans that banks already suspect to be of poor quality go bad, but the slowing economy and surging job losses will bring forward a new slew of problem debts. I think it's safe to agree with the Citi strategizers that as in the early 1990s, debt will become a four-letter word again.
Just to get some perspective on the likely extent of the coming de-leveraging, let's look at some historical statistics, from the blog of Economist Paul Deng of Brandeis University:
Before the deleveraging came the leveraging. Take the U.S. The ratio of all sorts of debt to gross domestic product rose to 342% at the end of September 2007 from 160% in 1975. Through 2000, debt increased by 2.4 percentage points a year faster than GDP. But after the turn of the millennium, the rate accelerated almost to 3.7 percentage points a year.
If you agree with the supposition from my piece The Psychology of Asset Cycles, that after a period of out spending demand for an asset, you need to have a period of under-spending to get back to the long-term trend line, you will agree that the leverage cycle should work in a similar way. During the course of the cycle, the world will go from over-leveraged to under-leveraged, it won't stop at "just right". Deng the economist seems to agree with me:
In deleveraging, too, one thing leads to another. Start with a bank that has lost a few billion dollars on subprime mortgages. The bosses are likely to decide that troubled times call for higher capital ratios. That means calling in lines of credit. Some borrowers are forced to sell assets, pulling down prices. The banks then look at the value of their collateral and think: "Oh my god, it's not worth what we thought." They then cut their credit again -- giving another turn of the deleveraging screw.The following charts are lifted from Deng's blog, but appeared in a recent paper by David Greenlaw (Morgan Stanley), Jan Hatzius (Goldman Sachs), Anil Kashyap (University of Chicago), and Hyun Shin (Princeton) called Leveraged Losses: Lesson's from the Mortgage Market Meltdown, discussed by Fed Governor Mishkin in a recent speech.
The housing market was just the start. A series of debt mountains -- credit cards, car loans, LBO loans -- risk being leveled. The credit contraction strikes down financial arrangements that once looked solid -- from structured investment vehicles to auction-rate securities.
If the original debt helped fuel consumption, deleveraging will feed into lower economic activity. If the original debt fueled asset purchases, the consequence will be lower asset prices. There could be a dual effect because lower asset prices can make people feel poorer and less willing to spend money. This is especially the case with people's homes.
The chart compiles the equity capital to assets ratios of various financial entities (something I touched on with a couple of examples in The Mother of all Margin Calls). The paper goes a step further and attempts to quantify the reduction in liquidity that will take place as a result of losses and consequent forced deleveraging. It assumes a 50% capital loss re-coupment and a reduction of leverage ratios by 5% (I would argue that the latter assumption is optimistic and doesn't take into account the propensity for human beings to run to the other side of a listing boat in an emergency as opposed to running to the middle of the boat (credit here to my partner Jim Gannon for the perfect analogy). These data are shown in the chart below.
If you agree with me that the reduction of leverage will be worse than current projections, just slide your finger to the right of this chart and the reduction of debt supplied by U.S. financial institutions goes from $2 trillion to $3 trillion. Neat, huh?
Corporations seem to be lone market participants that stuck with the de-leveraging trend that began after the dot com bomb dropped. Corporate balance sheets are generally believed to be in very good shape. But even this supposition has recently been called into question, due to potential accounting ledger main. See the article Corporate Deleveraging May be Overstated for details.
The great de-leveraging seems to be starting to impact commodity traders as well. Is it availability of credit, or just the sense that the economic impact of global de-leveraging will mean lower demand for all physical goods. Hard to say, but this week's commodity liquidation can't be ignored as another signal of an overall caution regarding leverage. While I am not calling for a commodities bear market as some others are, one of my 8 Predictions for 08 was a correction in commodities and I'm sticking with that call.
Don't get me wrong. I am not calling for any more implosions like Bear Stearns either. In fact I agree with the historical analogy cited in this Street.com article by Doug Kass of hedge fund Seabreeze Partners:
The decade of the 1980s gave birth (and death) to an upstart brokerage firm, Drexel Burnham, which created, sold and traded high-yield junk bonds -- the turbo debt and foundation of the previous "decade of greed." After the insider trading indictment of Drexel's Denis Levine was followed by Michael Milken's demise, junk bond liquidity dried up, recession befell the U.S. economy, and, by 1990, default rates on high-yield debt more than doubled to over 10%. Drexel, forced to buy the bonds of its junk bond clients, depleted its capital and filed bankruptcy.
In much the same manner as Drexel did in the junk bond market, Bear Stearns emerged as a leader in a parabolic growing market -- mortgages. As we are now witnessing at Bear Stearns (as we did during the Drexel era), a brokerage's well-being relies, in large measure, on the kindness and confidence of strangers to accept its collateral and accept counterparty risks. That confidence is impaired swiftly when price discovery unveils a diseased portfolio of assets, which is further exacerbated by a high degree of leverage employed. This is especially true when the brokerage's business is not diversified and is narrow in scope -- Drexel (junk bonds) and Bear Stearns (mortgages).
I do believe, however, that much more prudent and "normal"use of debt will come out of this episode. We will get there through the normal cycle of over-conservatism and re-regulation. Same as it ever was. So for the final bit of irony, if I am right the world will be developing an aversion to leverage, just when long-term interest rates are likely to hit bottom for many, many years to come. I call these juxtapositions the poetry of the financial universe...check this chart - its a beauty!
From the Blogosphere:
Deleveraging will take its toll - but on whom is unclear
Bank's Squeeze out high-risk customers
Welcome to A Deleveraging World
DELEVERAGING - Gold & Commodities Teetering on the Brink of a Bear Market
Seeking Alpha - Citi & The Great Unwind
A: All commodities got destroyed the past two days in what appears to be a combination of liquidations, or the unwinding of speculative/hedged trades, PLUS the fed's new found methods of targeting the credit markets without the negative effects to the US dollar. Lets discuss.
YES, the fed cut its discount rate 100 bps and the funds rate 75 bps in the past week. But these are not normal times. In the past 9 days where we saw a bear get shot & killed, check out all the stimulus that the fed took to orchestrate an orderly liquidation and handover of BSC to JPM:
a) 3/4% point cut to Fed Funds Rate
b) 1% cut to discount window
c) $30B loan to JPM for the Bear handover that was NOT executed yet
d) $30B lending facility for primary dealers following the bear murder
e) $200B in a new TSLF, term securities lending facility, PLUS widening of allowable securities to be used as collateral
This is some serious action people! And it was targeted at the credit markets and maintaining an orderly financial marketplace as an 85 year old firm died out. In my opinion though, March 11th was the key date where the fed announced the TSLF that kicks in on March 27th.
Remember 9 days ago in my piece, "Fed Acts! Targets Freezup in the Credit Markets", when I stated:
"The fed pounced on what is working and announced today a new plan to lend up to $200 Billion in treasury securities to unfreeze the credit markets. The key element to the newly created TSLF, or Term Securities Lending Facility, is the 28-day hold period + the further widening of allowable collateral to be used. In addition, the fed has authorized increases in existing programs known as 'swap lines' with foreign central banks. All in all, a very targeted and effective move that is having an immediate effect.The money phrase is the last one: The bigger picture here is that the fed seems to have found a tool that works, outside of traditional rate cut actions that have negative effects on the US dollar & commodity prices.
The bigger picture here is that the fed seems to have found a tool that works, outside of traditional rate cut actions that have negative effects on the US dollar & commodity prices".
Now, the fed did still cut rates afterwards, but not as much as the market was expecting and now we are seeing a reversal of trades that worked as the bet was on a weaker dollar. I must admit, I got caught up in the gold selloff and lost some nice profits in the past few days. But that is why you use STOP LOSSES on your positions, especially if you trade frequently. You may not hit the top, but you also won't get killed on the downside.
The point here is that the fed may not have to ease as hard as some thought, and that is why you are seeing the dollar trades unwinding. The fed is throwing everything but the kitchen sink at this credit crisis and time will tell how effective they are. At this point, future rate cuts to me are an indication of the severity of the recession! If the fed has to cut FFR down to below 1.25%, or another 100 bps, then the recession is expected to be much deeper than originally thought.
Dick Bove (story via Marketwatch.com) courageously announced this morning that, "...the financial crisis is over, economic crisis is not". The hidden gem in that statement was that the banks have realized the worst of the hit, and without the banks, we just won't have any sustainable market rally!
Now lets see if the fed's new found sweet spot can really allow them to navigate through this slowdown without cutting the FFR that much more! That in itself will help the US dollar and allow commodities to correct down as the speculative currency trade unwinds; bringing down with it expectations of pipeline commodity inflation.
ADD-ON @ 5:43PM: In the post 9 days ago I also stated, "I would also expect this to have a narrowing effect on credit spreads over coming days". I meant to put a chart of the CDX index via MARKIT. To the right you can see that a few days after the March 11th announcement, the CDX.NA.IG Series 9 spread did come in, so lets see if it continues! In a February 23rd post, I discussed what the CDX index tells us; but in case you didn't read that, here it is again:
WHAT CDX.NA.IG SERIES 9 MEANS (as I understand it from contacts I know in these markets): NA stands for North American. IG stands for Investment Grade. Every 6 months dealers are polled. They vote names into the new index. We're now up to series 9. To be eligible for a vote you must have contributed end of day marks for X% of days in the last 6 months on the names in the old index; X being a lot. There are a bunch of indices, but the two big ones are HY - high yield, and IG - investment grade. 100 names are in each. You take the 100 names and average the credit spreads to get the CDS spread on the overall index. Bigger spreads = worse credit in the index as a whole. If HY (high yield index) goes from 500bps to 1500bps and IG (investment grade index) goes from 50 to 70bps you know the HY index is getting a lot worse a lot faster than IG in terms of credit quality. Those numbers are just arbitrary to demonstrate a point.
On Noah’s post last week about the Fed’s $30 billion bailout of Bear Stearns, one reader commented that the Fed was using taxpayer money to bail out the company.
It’s a valid thought; after all, why should the government – at the expense of taxpayers - have to pick up the tab to rescue some bank that got us into this rut as a result of the bad judgment of a bunch of rich guys? And meanwhile people are losing their homes and their jobs.
Much is being said about WHAT the Fed does, but not on HOW it does it. So what I’d like to do here is explain on a high level how the Fed operates and the impact on the US taxpayers. The reality is that it's less than people think.
For starters, when the Fed loans to a bank it requires the bank to back it up with collateral of at least 100% of the value of the loan. The collateral must meet certain liquidity guidelines and the amount depends on the collateral type (i.e. Treasury bills might only require 2% above the loan amount vs. AAA corporate bonds that might require 5%). This way if the bank defaults on the loan, the Fed is covered. Today’s Wall St. Journal includes a good article on how this works; subscription only though.
But if the collateral is gone? Well, then the Fed must run to Congress to fund at the taxpayer’s expense; but the likelihood of this would be remote.
So how does the Fed fund itself; for a primer click here for the structure of the Federal Reserve? Each Federal Reserve District Bank (there are 12 of them, plus the Board of Governors in DC) earns its own income from a spread through issuing Treasury securities and other activities it provides to banks in its respective district, i.e. money transfer services such as Fedwire. Because each Fed Bank is not allowed to operate for a profit, it must return all revenues in excess of operating expense to the US Treasury. So therefore you could argue that this is an indirect cost to the US taxpayers…though on the other hand it wouldn’t be spending anything it’s not earning in the first place.
Although the Fed has government oversight, it runs independently. This is done on purpose in order to ensure its actions are in the best interests of the economy and not politicians in Congress….and one of the reasons why the US is still considered to have the most solid financial system in the world.
So what does the Bear Stearns bailout mean for US taxpayers?
The loan that the Fed is extending to Bear - actually to JPM Chase for Bear - is secured by collateral, as noted above. If the collateral runs out the Fed must obtain funding from either borrowed funds (Treasury bonds) or – yes, you guessed it – US taxpayers. But the latter would be in dire circumstances and unlikely to happen.
Enough of the Fed…the real risk to taxpayers is new regulations permitting Fannie Mae & Freddie Mac to reduce their required capital reserves, allowing them to expand their mortgage portfolios. This actually places US taxpayers at GREATER risk than the Fed’s recent action, but doesn’t get as much notice. But that is another post for another day….
A: We are about an hour and a half from the fed's next rate cut. The question is not whether they will cut, but by how much. This horse agrees 100% with BR over at The Big Picture, which shouldn't be a surprise to anyone here, that they need to exercise restraint and cut only by 1/2 point; limiting the negative effects on the US dollar & commodity prices while acting nonetheless. By saving their bullets now, they will have more ammo to use as the economy weakens, housing continues to be a drag, and credit markets correct themselves.
Unfortunately, I do not think 1/2 point will be the move. I think they will cut 75 or 100 bps this afternoon as a 'shock & awe' offensive to limit the severity of the slowdown and give the markets what they want. I must admit in hindsight, Ben & company handled the Bear bailout wonderfully as they orchestrated an orderly liquidation and averted a complete financial meltdown. Putting my feelings aside of letting the free markets punish those that are weak and the vultures jumping in to grab whats left, the fed's actions avoided chaos that could have played out as a domino effect of Bear Stearns announcing bankruptcy. The move to bail out BSC does NOT fix the housing problem, it does not fix the expectation for rising unemployment & inflation, and it does not fix the expectation of weakening economic data resulting from the credit storm; hence the rate cut move that will come today.
On February 29th I published a post titled, "Credit Check: Running Out Of Bullets", where I stated:
"With future rate cuts likely resulting in further commodity inflation, I'm concerned that we are going to be running out of bullets soon and will have to deal with a period of financial stress without the fed's strongest weapon available to us."That was over two weeks ago. Two days ago, Bloomberg published their version of what I was discussing in their article, "Bernanke May Run Low on 'Ammunition' for Loans, Rates":
Federal Reserve Chairman Ben S. Bernanke may be running out of room to pump money into the financial markets and cut interest rates to rescue the economy.Barry Ritholtz discussed today on CNBC his feelings on the issue and is in the same camp that I consider myself a part of:
The Fed has committed as much as 60 percent of the $709 billion in Treasury securities on its balance sheet to providing liquidity and opened the door to more with yesterday's decision to become a lender of last resort for the biggest Wall Street dealers. The central bank has cut short-term rates by 2.25 percentage points since September and will probably reduce them again tomorrow.
"They're using up their ammunition on the liquidity and overnight interest-rate fronts," said Lou Crandall, chief economist at Jersey City, New Jersey-based Wrightson ICAP LLC, a unit of ICAP Plc, the world's largest broker for banks and other financial institutions.
"I believe that the FOMC should "man up," show some backbone -- cut rates by "only" 50 bps. They might find out what its like not to be at the Market's beck and call (girl). That should stabilize the greenback, and perhaps send food and energy prices lower (earning Ben the appreciation of consumers through out the country)."But I do not think it will play out this way; time will tell. In meantime, I urge you to maintain a clear head as you interpret the events that result from this credit storm. Bear market rallies are always sharp and filled with glimmers of hope; I believe this rally to be no different. Time will heal what ails us and it's clear the fed will take every step necessary to limit the severity of the recession and the pains of the de-leveraging process. Yesterday a bear was shot & killed but not before many innocent employees got their retirement plans wiped out. Whats next?
The unknown continues to be:
a) who holds what toxic assets
b) who is experiencing a liquidity crisis similar to Bear
c) when will foreclosures / defaults reverse course
d) when will credit markets normalize; credit spreads continue to narrow
e) effect on global markets
f) pipeline inflation
g) spread to higher quality / other debt classes
h) severity of job losses to come
i) severity of economic weakness
j) effect on local state budgets
k) spread to other markets (ars, muni's, etc)
l) effect on main street
Steps are being taken, but we are not out of the woods. This is not a daily fix, it is a quarterly to yearly fix rooted by housing that will take time to play out! We went from years of credit fueled leveraged bets to a complete STOP in a matter of months; we have been at this STANDSTILL since mid-to-late 2007 and we are yet to see the economic effects of this. The good news is, we must go through this to get out of it, so in my opinion and as I said over 6 months ago, BRING ON THE RECESSION!
A: Wow, wow wow! I thought it was a typo as it passed across Bloomberg TV. It wasn't! JP Morgan agrees to buy Bear for $2/share or $270 Million! Bear Stearns stock price closed at $30 on Friday giving it a market cap of just over $4B; nothing like losing $3.5B over a weekend!
Needless to say, shareholders of BSC are screwd! Employees holding company options are screwd! We are certainly in unprecedented times. The very idea that the buyout is at $2 per share makes me wonder how bad the books were as executives at JP Morgan and fed officials reportedly worked diligently this weekend to get a deal done before Asian stock markets open!
According to Yahoo Finance:
JPMorgan Chase says it will acquire rival Bear Stearns for $2 a share in a move aimed at averting spreading panic in the financial markets over tightening credit.Bear Stearns (NYSE: BSC) closed at $30/share on Friday and seem headed for a nosedive when markets re-open tomorrow morning. The article mentions that the deal was "aimed at averting spreading panic", but at $2/share, umm, what are we supposed to have faith in?
JP Morgan says the all-stock deal has received the required approvals from the federal government and the Federal Reserve.
The Fed will provide special financing to JPMorgan Chase in connection with the deal. The central bank has agreed to fund up to $30 billion of Bear Stearns' less liquid assets.
UPDATE @ 7:30PM: Futures JUMP as the fed cuts discount window by 25 bps and announces that the federal reserve bank of NY will create a new lending facility for primary dealers. Thanks to Calculated Risk for the speedy report as the rest of the world gets hit with this Bear news:
Federal Reserve moves:
1) The Federal Reserve Board voted unanimously to authorize the Federal Reserve Bank of New York to create a lending facility to improve the ability of primary dealers to provide financing to participants in securitization markets. This facility will be available for business on Monday, March 17. It will be in place for at least six months and may be extended as conditions warrant. Credit extended to primary dealers under this facility may be collateralized by a broad range of investment-grade debt securities. The interest rate charged on such credit will be the same as the primary credit rate, or discount rate, at the Federal Reserve Bank of New York.
2) The Federal Reserve Board unanimously approved a request by the Federal Reserve Bank of New York to decrease the primary credit rate from 3-1/2 percent to 3-1/4 percent, effective immediately. This step lowers the spread of the primary credit rate over the Federal Open Market Committee’s target federal funds rate to 1/4 percentage point. The Board also approved an increase in the maximum maturity of primary credit loans to 90 days from 30 days.
UrbanDigs Take: I understand the markets will like the fed discount window cut and lending facility, but what is good about any of this? Investment banks should wake up to a dose of reality on Monday. This fed move sounds very panicky to me; and I'm sure most traders who think like I do will agree. The TSLF that the fed announced on Tuesday, that rallied the markets over 400 points, doesn't kick in until the end of the month, hence this Fed Reserve Bank of NY deal goes into effect tomorrow; things that make you go hmmmmmmm! I guess the the secondary markets needed a boost ASAP, and couldn't wait another 2 weeks!
A: Boy oh boy oh boy; I go out on two early appointments and I come back to a fed sponsored bail out of Bear Stearns. I hope people start fully respecting what the credit markets are capable of by now! My gut reaction to today's fed sponsored bailout of Bear after the CEO denied rumors of a cash shortage; a surge of UNCERTAINTY & decline of CONFIDENCE! Tradable markets HATE uncertainty and rely upon confidence for future business decisions.
Here is a 5-DAY timeline of events surrounding Bear Stearns:
Bear Stearns DENIES Rumors on Liquidity After Shares Plummet (Bloomberg)
Bear Stearns Falls For 2nd Day on Cash Concerns (Bloomberg)
Bear Stearn's CEO Schwartz Says Cash Cushion is Ample (Bloomberg)
Bear Stearn's Falls To 5-Year Low on Capital Concern (Bloomberg)
Bear Stearns Gets EMERGENCY FUNDING From JPMorgan & Fed (Bloomberg)
Now, the kicker is that TWICE in the past 4 days that this rumor was floating around executives at Bear told us that rumors were FALSE, and that cash cushion was fine; THERE IS NO LIQUIDITY ISSUES AT BEAR! The response no is that 'all the deterioration occurred in the past day'. Yea right! Of course, the market cleansed the situation in its own way as a fed sponsored bailout of Bear just happened today; hammering BSC stock price!
While I understand that executives need to maintain investor confidence, but at what point will they realize that by cheer leading for their firms and avoiding the music they are doing themselves and the market as a whole a disservice! Why? THIS IS A CRISIS OF CONFIDENCE JUST AS MUCH AS IT IS A CRISIS OF CREDIT MARKETS, HOUSING, BALANCE SHEETS & LIQUIDITY!
What happened today proves one thing: we can't trust anything we hear! Markets HATE uncertainty & lack of confidence and we got a huge dose of both today! Which brings me to wonder who else is having these types of problems and require a fed sponsored bailout? Its rather narrow sighted to think that Bear is the last one! Isn't it? Some institutions that appear to be in for some rough times are Washington Mutual, UBS, and I'm sure a bunch of hedge funds out there who will ultimately be at the mercy of future margin calls.
Buckle up folks, this ride ain't over and you should certainly expect the unexpected as we see the damage left behind from this ongoing credit/housing hurricane! In meantime, the de-leveraging process is in full force and expect more forced liquidations of assets as the unwinding continues and Mr. Margin calls.
A: Big talkings going on from House Services Committee Chairman Barney Frank! Lets get to the rumor that is rallying the street but wait for an official announcement to discuss what any announced plan means. Clearly, the federal government believes they MUST do something aggressive.
According to CQ Politics:
House Financial Services Chairman Barney Frank , D-Mass., on Thursday proposed the federal government step up efforts to help struggling homeowner.Barney Frank & SBC Chairman Christoper Dodd, who say we are in a recession, are targeting PREVENTION OF FORECLOSURES as the next federal measure to stabilize the domino effect of the falling housing market. Lets wait for an official announcement before jumping to any conclusions, but clearly the markets are reacting to this rumor.
According to a broad outline released Thursday, the program would allow the Federal Housing Administration to provide up to $300 billion in new loan guarantees for “at risk” borrowers.
But lenders would have to make substantial write-downs of a loan’s principal amount — to no more than a home’s current market price — before the FHA would back the loan. And the new loan would be made on terms that a borrower could repay.
In exchange for taking a “haircut” on the loans, the existing holder of a mortgage would have “no further credit exposure to the borrower,” Frank’s summary said. The refinanced loans, with FHA insurance, would be easier to sell on the secondary market.
“This could potentially refinance between one and two million loans (and help these families stay in their homes), protect neighborhoods and help stabilize the housing market,” according to a summary of a discussion draft.
Rep. Frank Offers New Foreclosure-Help Proposal (Marketwatch.com)
Dodd, Frank Unveil Foreclosure Prevention Legislation (Bloomberg)
A: A good topic to discuss considering the environment and the fact that one of my buyer clients unsuccessfully bid over ask in a recent highest & best situation. When you are up against 'all cash' bids, what premium should that offer have over a bid reliant upon financing? The short answer is that it all depends on the seller's risk level and situation, the more creative answer in my opinion is about 2-3% of the purchase price. There is no formula for finding out what 'all cash' is actually worth in any given deal, but it is safe to say that in tough lending environments its value surges!
What sort of discount should a buyer offering all-cash in this environment expect? On the flip side, how much should an all-cash bid be worth to the seller? Here is a recent situation where an all cash bid took complete control over a multiple bidding situation; I'll discuss the basics with changed details to get to the point of the discussion.
I'm blessed with very savvy buyer clients who are mini-experts on their price point. This buyer was no different and knew a great deal when one popped up. So, going into the first open house (which was active) we knew a strong bid was the very least needed to get this deal. Not surprisingly, multiple offers came in the very next day including ours. We did our diligence, formulated how under-valued we felt the property was priced compared to comps and property condition, spiced up the terms of our final bid, and went for it!
In the end we bid about 5% over ask and just under what we perceived as market value for the apartment. But it was the altered terms of the deal that we focused on to put us on par with an all cash competitive bid that we were told was already submitted; a very tough task to accomplish when credit crunch headlines make front page news everyday. Here is what we did and what you can do if you ever want to strengthen your bid in bidding war situations:
a) provide a pre-committment letter instead of a pre-approval
b) provide credit score; especially if its very strong
c) offer to sign a no-finance contigency contract of sale
d) raise the down payment by 5% to lower debt/income ratio and ease board review process
e) flexible closing date
the standards: point out liquid assets after closing, debt/income ratio if deal were to proceed, attorney info, lender info, salary & employment info, and a little note that we had advised the attorney to do due diligence within 2 business days of full receipt of doc's!
Did it work? Unfortunately no. We lost to an 'all-cash' bid that was also over the asking price. OK, not the end of the world but certainly frustrating. At least we knew our comfort zone and made a strong play for the property. Which brings us to why we lost!
In my opinion, I think we were the highest bid! Of course I'm not 100% sure, but its just a gut feeling after hearing back from the broker.
TO COMPETE AGAINST AN ALL CASH OFFER THAT ALSO HAPPENS TO BE ABOVE THE SELLER'S ASKING PRICE, PROVES TO BE A VERY DIFFICULT TASK IN TIMES LIKE THESE! SO, YOU MUST BID A PREMIUM TO MAKE THE SELLER EVEN CONSIDER TAKING YOUR DEAL THAT INCLUDES SOME RISK!In normal times, I would say that an all-cash offer should gather 1-2% of the purchase price as a premium for providing the seller with the comfort of bypassing the loan & board approval process; although I have heard of all cash deals getting rejected by a co-op board, though it is not the norm! Let me explain using a similar over-ask multiple bidding scenario as we just went through with the numbers changed:
NORMAL LENDING / MACRO ENVIRONMENT
$895,000 Co-op Property w/ 2 bids submitted
Bid 1 --> $925,000, solid buyer putting minimum required down and financing the rest
Bid 2 --> $900,000 all cash 2.7% below highest bid
SELLER DECISION --> I would bet that the seller would go with Bid #1 and take the extra $25,000 with little risk the buyer will get a loan and pass the board. When I say solid, I mean that this buyer has the financials required by the board for approval.
TIGHT LENDING / MACRO ENVIRONMENT
$895,000 Co-op Property w/ 2 bids submitted
Bid 1 --> $925,000, solid buyer putting minimum required down and financing the rest
Bid 2 --> $900,000 all cash 2.7% below highest bid
SELLER DECISION --> In today's environment, I'm willing to bet that the all-cash $900,000 offer, even though its $25K less, is extremely appetizing to the seller; assuming of course the seller is aware of what is going on right now in the mortgage markets! It's still over the seller's asking price, who obviously priced low to get a quick sale in first place, and its a lock of a deal both for the loan commitment and the board approval! That is quite a comfort that is certainly worth something.
It's the psychology of the seller that has changed because of the deteriorating credit & mortgage markets. Cash is a very valuable tool for any offer right now, so if you have the means, do use it especially if you want that edge either in negotiating or against competing bids to get the deal done! In my opinion, as long as the mortgage and credit markets are in distress, an all cash offer should be able to win a deal at a 2-3% discount from what otherwise would be an acceptable bid or a competing higher bid!
Rumor has it that last week the Federal Government was considering granting Fannie Mae & Freddie Mac (F&F) ‘explicit guarantees’ of its debt.
Bad idea and the government quickly denied it. But it brings to mind what these groups do and how they affect the markets.
Right now both F&F benefit from an ‘implied guarantee’ meaning that, because the two companies were chartered by the Federal government they’re able to issue debt at a lower rate than comparable corporate debt. Thing is, this ‘implied guarantee’ gives the impression that Congress would bail out F&F in the event of a default, at the taxpayer’s expense. Which is actually not the case.
On the surface the implied guarantee might make sense, given F&F’s contribution to the US housing market and the economy, by enabling wider homeownership and by adding liquidity to the mortgage market through packaging of mortgages into securities. Plus the fact that Fannie was originally chartered as a government agency under FDR in response to the housing issues of that day.
Problem is that today both groups are – surprise! – public listed corporations just like Citi, Merrill and Google, not government agencies like the US Treasury Department or the IRS. This means they should be held accountable to shareholders. And have a board of directors, and all of the other corporate governance-related activities that public companies get to do.
Problem is they hadn’t always been doing this very well. If you’ve been following the business news in recent years, both F&F have been plagued by internal control issues. Fannie’s was so severe that it had to undergo the largest restatement in US history. An investigation revealed accounting fraud initiated by former senior executives and aggressive lobbying on the part of senior executives as to render its regulator, OFEO ineffective, to say the least.
Sure, other companies have done this before but given the impact that FNMA has on the US – no, the world – economy, this is no small lobbying effort. The problem was so severe that the Wall St. Journal called FNMA the “Enron of the Beltway”.
Of course all of this happened before the housing market credit crunch. And FNMA has been cleaning itself up, having hired a new executive team, revamped its board, appointed bright people to its senior management ranks, and Congress has been making a point to hold the company more accountable for its actions.
But all of this has been fairly recent and, I suspect, is still in the process of being ironed out as it takes time to change the culture of any organization; especially one so tremendous as Fannie Mae. So before Congress grants the like of Fannie & Freddie any additional leeway it should make sure they’re up to the task.
Before US taxpayers are really placed at risk.
While many see the machinations on Wall Street as distinctly separate from the day-to-day realities of the real world, the worries or passions that are reflected in securities market moves are based on reality and market participants' concerns and hopes about future trends. Sometimes markets get it wrong and worry far too much about potential future outcomes, or put too much stock in them. Sometimes markets seem prescient and sniff out a new trend before Main Street has any clue it's coming. Rarely, but once in a while, market moves actually drive trends that are normally the impetus for price moves in those markets. We are in one of those strange times, when because of all the leverage in our economy, the tail is wagging the dog. (See my recent piece,The Mother of all Margin Calls)
In recent weeks, the municipal bond market has come under severe pressure due to the capital adequacy problems with monoline insurance companies (see my piece, Tentacles of the Credit Beast) , which insure municipal debt. As many have pointed out, municipal debt has performed very admirably over time, with low default rates. In fact, some municipalities are now wondering, why they ever used the insurance in the first place. However, fear over the efficacy of insurance on products that never really needed insurance, should not cause the kind of huge re-rating of municipal bond risk that it has in the market. According to the Financial Times:
Yields in the US municipal bond market have soared to historically high levels compared with US Treasury bonds, as investors respond to uncertainty over the fate of bond insurers and Wall Street banks withdraw support from the market.
This kind of move does not happen solely because of some arcane issues with bond insurance. Yes, I know that there are many investors who must sell bonds if they don't carry better than a particular credit rating. However, some investment committees can take short-term exigencies into account and override these rules. Additionally, other investors would come in to buy up bonds that those committees that can't flex their guidelines force their portfolio managers to sell, if this were the only issue. Note that smart guys like Bill Gross of Pimco and Wilbur Ross of W.L. Ross have been doing just that, but spreads would never have gotten to record levels if there wasn't some underlying increase in credit risk to these instruments.
So whatup with muni bonds? It's the economy stupid! As I noted in my 8 Predictions for 08, the real estate debacle is hurting state and municipal finances. By my count 16 states were already having budget issues coming into 2008, and I missed New Jersey, which is busy whacking its spending (Sopranos style) and contemplating big job cuts. Collection of real estate taxes and transfer taxes on real estate transactions are down. But revenue is now being further attenuated by falling sales taxes and eventually income taxes. In the meantime, home foreclosures are adding to the need for state-provided services of various kinds. According to Financial Week:
Twenty-one states face budget deficits in fiscal 2009, including 16 that are short at least a combined $30 billion, according to the Center on Budget and Policy Priorities.
These fiscal issues are also impacting cities, abetted by a trickle down impact of a lack of state funds. According to Reuters:
Revenues in one-third of American cities have declined over the past year because of a rise in housing foreclosures, the National League of Cities said in a report released Tuesday. Nearly two-thirds of the more than 200 cities participating in the poll said they have seen foreclosures rise, leading one out of three to cut funding for community programs. The cities are also grappling with growing demands for food banks and counseling, the report said.
Across the northern states, snowstorms have posed budget problems for cities from Milwaukee to Rochester to Wareham, Massachusetts. If these cities can't handle a little extra snow, imagine what's going to happen when the heavy stuff starts coming down. Margins for error in state and municipal finances are thin, because rapidly rising revenue allowed budgets and services to expand even as costs were spiraling upwards. Now that revenues are flagging, healthcare costs, fuel costs , pension costs and construction and maintenance costs are biting hard.
As I noted in my predictions for 2008, "state spending is $1.8 trillion annually and reportedly about 13% of the economy and state spending is going from a big booster of growth to potentially contracting." I think we can safely add municipal spending to the category of areas of the economy likely to disappoint. In some cases the disappointment could be large - for example Vallejo California, which recently narrowly averted bankruptcy. Of course, Vallejo, which has had problems since before subprime was put in the dictionary, and Jefferson County, Alabama (currently caught in a derivatives debacle) were in Warren Buffet parlance, "skinny dipping", before the credit crunch. But of course you only find out who is skinny dipping when the tide goes out and the tide is definitely going out on state and municipal government finances.
Please note that New York State and Gotham City are not immune. The State has an estimated budget deficit of $4.7 billion, but the news on New York City has been pretty good so far. The Independent Budget Office's annual report just came out and in testimony to the City Council, Ronnie Lowenstein had this to say about the outlook this year:
While the local economic downturn and the declines in tax revenue have dimmed the city’s fiscal picture, our short-term budgetary condition may not be as dark as one might expect. One reason is that so far this fiscal year business tax collections have not declined as much as previously projected. In addition, despite Wall Street’s huge losses, bonuses barely declined, bolstering personal income tax withholdings.
She goes on to note that a significant surplus is still expected for this year and that this surplus will help to plug holes in the 2009 budget. A deficit is expected to be forestalled until 2010, and the shortfall in that year is being estimated at a relatively modest $2.1 billion. Please note that these forecasts are based on the assumption of a relatively brief and mild recession. Among other areas where the outlook could go wrong are second order effects. According to the testimony:
There are a number of other potential fault lines for the 2009 budget and January Financial Plan.
For example, the Mayor’s budget plan does not recognize the effects on the city of the
Governor’s proposed budget. Another example is the planned conversion of a merged GHI and
HIP to a for-profit insurer, which could cost the city $200 million or more a year in additional
health insurance premiums for employees. A third example is stock market losses by municipal
pension funds, which may force the city to substantially increase its annual contributions to the
funds in the coming years.
The moral of this story is that major dislocations in financial markets, like muni bonds, don't happen on a whim or just because of mechanical market issues. There is always some truth behind a major move. In this case the truth is that state and municipal finances will have a negative impact on the economy and joblessness, and ultimately will feed back into weaker real estate prices in some places. The second chapter of the liquidity crisis is upon us and we are now going to start seeing the second order effects of it. Hopefully, the Fed's latest moves to give the credit markets an angioplasty will get the money flowing again and ease the severity of these second order effects.
From The Blogosphere
The Tough Choices Ahead
Foreclosure Crisis Has Ripple Effect
New York City eyes deeper budget cuts in shortfall
The 2008 to 2013 MTA Capital Plan: Is There A Way Out?
A: For kicks, I just wanted to check out how the S&P 500 has performed when compared to fed actions over the past 10 years. I wondered if the relationship was clear. It was! Basically, if you SELL when the fed starts to cut rates and you BUY when the fed starts to raise rates, in the short-medium term you probably will do just fine! It's strange how a short term equity investment strategy may be as simple as this!
Lets get right to the 10-year chart:
S&P 500 Chart courtesy of MSN Money
Fed Funds Target Rate courtesy of Moneycafe.com
Its clear that substantial easing or hiking campaigns resulted in a subsequent selloff and rally respectively. Granted, when the fed started hiking in mid-1999 the time to sell was when the fed stopped hiking rates in mid-2000, and not at the next ease. If there is any relationship that is noteworthy here (which would be for periods of time where fed action is aggressive), its that if you buy when the fed starts a hiking campaign, you probably will have missed the majority of the pain that occurred during the slowdown period prior. On the same note, if you sell when the fed starts a new easing campaign (tricky part is realizing when fed action will be aggressive and drawn out), you probably are getting out before the slowdown hits full force! Also, the longer the period of PAUSE after a hiking or easing campaign seems to relate to the length of the current trend in the S&P.
Ok, thats done.
Relating To Todays Fed Announcement: Today's fed move probably means fewer rate cuts down the road. In my opinion, the hidden gem in today's announcement is the targeted nature of the shot that will limit pipeline inflation (geez, there's enough of that as is) by reducing the need to cut fed funds rates as aggressively as previously expected. That means the US dollar may not become as weak as expected and commodities priced in dollars may lose a dose of steroids (rate cuts) that they were betting on. If you want to get real crazy, what if we assume that international markets are lagging the US and they are about to enter a period of financial distress similar to what we have been through for past 4-6 months? Our currency could bounce further if foreign cb's start easing at a time when our fed found a way to limit future rate cuts. Ehh, just a thought with many if's.
Time will tell, as this is a more medium term idea (3-4 quarters) to be watching for; for now, we still have pain to go through waiting for the damaged economic reports to show the carnage left in the wake of the ongoing credit storm.
A: Wow, some big news today and what a timely piece yesterday, "What's A Fed To Do", discussing the ineffectiveness of fed rate cuts and the effectiveness of TAF & repos to heal what currently ails us. The fed pounced on what is working and announced today a new plan to lend up to $200 Billion in treasury securities to unfreeze the credit markets. The key element to the newly created TSLF, or Term Securities Lending Facility, is the 28-day hold period + the further widening of allowable collateral to be used. In addition, the fed has authorized increases in existing programs known as 'swap lines' with foreign central banks. All in all, a very targeted and effective move that is having an immediate effect.
The news from a variety of sources:
The Fed said it will make up to $200 billion in cash available to cash-strapped financial institutions.Bloomberg:
"Pressures in some of these markets have recently increased again," the Fed said in a statement. "We all continue to work together and will take appropriate steps to address those liquidity pressures." The other banks involved are the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, and the Swiss National Bank.
In addition, the Fed has authorized increases in existing programs called "swap lines" with the European Central Bank and the Swiss National Bank.
The Federal Reserve plans to lend up to $200 billion of Treasury securities in exchange for debt including private mortgage-backed securities that have slumped in value as homeowners defaulted on their payments.Here are some reactions I am seeing in the markets:
The Fed set up a new tool, the Term Securities Lending Facility, to lend Treasuries to primary dealers for 28-day periods, through weekly auctions. The Fed also said in a statement in Washington that it's increasing the amount of dollars available to European central banks through swap lines.
a) treasury yields are rising big time
b) equity futures are surging (short-covering will fuel the rally)
c) financials are surging on this targeted fed move
d) fed funds futures lower chances of expected total rate cuts to come
I would also expect this to have a narrowing effect on credit spreads over coming days, and that would be a very welcome macro reversal. Also, to be allowed to use debt including mortgage backed securities as collateral in exchange for the loan, is huge. However, there is something very important to understand here: THIS MOVE WAS TARGETED AT THE CREDIT MARKETS AND MEANT TO EASE THE DISTRESS & ILLIQUIDITY OF THE SECONDARY MORTGAGE MARKETS! It is not a cure all move and it will NOT prevent weakening economic data from coming out over the next few quarters. It will help where help is needed most on wall street, the credit markets. If there was a secondary mortgage market where MBS can be traded again, the process of cleansing the balance sheets of financials could occur at a faster pace so that we can return to a more normal lending environment.
For all those that believe that we must have a functioning credit market and a liquid secondary mortgage market if we are to start the recovery phase, me included, this move was aimed at achieving this. Equity markets were oversold and this probably will result in a sharp bear market rally over the coming days; we will not enter a new bull market until the financials balance sheets are cleaned, and the cleansing process for this is still ongoing.
The bigger picture here is that the fed seems to have found a tool that works, outside of traditional rate cut actions that have negative effects on the US dollar & commodity prices.
PHOTO Source: Denovobanks.com
A: The fed came out on Friday, right before the scheduled release of the employment data, and announced up to $200 Billion in additional loans via the use of term auction facilities (TAF) and repurchase agreements. The interesting thing here is the changes to the repurchase agreements; extension of loans to 28 days + widening of allowed collateral requirements. Steve Waldman at Interfluidity, has an excellent piece (found via Naked Capitalism) that discusses what the fed may be quietly up to! Since 2.25% fed funds rate cuts thus far has done little to help normalize the credit markets, confidence, LIBOR, or liquidity in secondary mortgage markets, whats a fed to do?
First, some key elements of Steve Waldman's piece regarding the fed's announced stimulus actions on Friday:
The Fed announced that it would auction off $100B in loans this month rather than the previously announced $60B via its TAF facility. In the same press release, the FRB announced plans to offer $100B worth of 28 day loans via repurchase agreements against "any of the types of securities — Treasury, agency debt, or agency mortgage-backed securities — that are eligible as collateral in conventional open market operations".
The second announcement puzzled me. There are a couple of differences, then, between this new program and typical repo operations:
1. The loans are of a longer-term than usual. Ordinarily, the Fed lends on terms ranging from overnight to two weeks in its "temporary open market operations". The Fed will now offer substantial funding on a 28 day term.
2. The Fed is effectively broadening its collateral requirements by collapsing what are usually 3 distinct levels of collateral which are lent against at different rates to a single category within which no distinctions are made.
Until the current crisis is long past, I think it unlikely that any large bank will default and stiff the Fed with toxic collateral. Why not? Because for that to happen, the Fed would have to pull the trigger itself, by demanding payment on loans rather than offering to roll them over. Since TAF started last fall, on net, the Fed has not only rolled over its loans to the banking system, but has periodically increased banks' line of credit as well. In an echo of the housing bubble, there's no such thing as a bad loan as long as borrowers can always refinance to cover the last one.
The distinction between debt and equity is much murkier than many people like to believe. Arguably, debt whose timely repayment cannot be enforced should be viewed as equity. (Financial statement analysts perform this sort of reclassification all the time in order to try to tease the true condition of firms out of accounting statements.) If you think, as I do, that the Fed would not force repayment as long as doing so would create hardship for important borrowers, then perhaps these "term loans" are best viewed not as debt, but as very cheap preferred equity.
What we are witnessing is an incremental, partial nationalization of the US banking system. Northern Rock in the UK is peanuts compared to what the New York Fed is up to.
You may object, and I'm sure many of you will, that our little thought experiment is bunk, debt is debt and equity is equity, these are 28-day loans, and that's that. But notionally collateralized "term" loans that won't ever be redeemed unless and until it is convenient for borrowers are an odd sort of liability. Central banks are very familiar with the ruse of disguising equity as liability. Currency itself is formally a liability of the central bank, but in every meaningful sense fiat money is closer to equity.
The entire piece is a great read, but it's interesting to see the collateral requirements widened to include agency debt & agency MBS. It seems we will be seeing more of these types of moves for the next few quarters as commodity inflation pressures the aggressiveness of future rate cuts. That doesn't mean we have no room left for rate cuts, but lets be honest here: RATE CUTS THUS FAR HAVE HAD NO EFFECT ON CONFIDENCE OR EASING DISTRESS TO THE SECONDARY MORTGAGE MARKETS AND RATES! The bankrate.com chart to the right shows you how lending rates have risen as the fed cuts FFR.
So whats needed? You may not want to know what Paul Miller over at Friedman, Billings, Ramsey estimated ---> $1,000,000,000,000. According to Marketwatch.com:
Why are interest rates on 30-year fixed-rate mortgages rising even as the Federal Reserve slashes interest rates and yields on Treasury bonds fall? The answer is that the mortgage market is short of roughly $1 trillion in capital, according to Paul Miller, an analyst at Friedman, Billings, Ramsey.Since every rate cut is in essence a wasted bullet in a limited capacity gun, the fed knows it needs to pick & choose its next shots wisely. Personally, I think another rate cut will come soon and there is now a Goldman Sachs rumor floating around the markets that one may come today. I doubt that rumor as it is consistent behavior when stocks have had an ugly downturn and are now seeking a quick short-covering rally. The next scheduled fed meeting is May 18th, and I think the move will come then.
The modern mortgage market works with lots of leverage, or borrowed money. Investors, including hedge funds and mortgage real estate investment trusts, buy mortgage securities, but finance a lot of their purchases with this leverage. FBR's Miller estimates that $11 trillion of outstanding U.S. mortgage debt is supported with roughly $587 billion of equity. That's a leverage ratio of 19 to one. This has sparked a de-leveraging cycle in which some highly leveraged mortgage investors have to sell assets to meet margin calls. Forced selling pushes prices lower, sparking more margin calls, which in turn produces more selling and even lower prices.
The credit markets (auction rate markets, secondary mortgage markets, corporate credit spreads, CMBX's, CDX's, ABX's, etc.) continue to LEAD the stock markets and the world for that matter; these are the markets to watch for signs of confidence and right now the credit markets are not reacting to rate cuts. So, any future rate cuts we get will be targeted as 'setting a floor' and easing the downturn that we are clearly in right now at the expense of commodity inflation. The actions that seem more effective right now are the TAF & repos. Your thoughts?
At the Urban Digs "bar night" two weeks ago, a few people asked me how my house in Bed Stuy turned out. Thanks for asking!
If you'd like to catch up on how / why I decided to invest my money in a two family house in Brooklyn instead of a one bedroom condo in Manhattan, please check out a few of my earlier posts:
A Broker's Search - Where To Buy
A Broker's Search Has Ended - Sort of
My Townhouse in Bed Stuy
Townhouse Renovation Tips
I am really happy to report that although it wasn't easy, my purchase on MacDonough Street in Bedford Stuyvesant, Brooklyn, turned out really well! Of course, none of my projections worked out as the "best case scenario" but none of them were "worse" than the "worst case scenario," either. I did my research & my numbers turned out to be almost "spot on."
I had hoped to have the construction finished by early December, but it was finished in mid December (NYC DOB permit issues set the work back by almost 2 weeks). I rented out the 3rd floor apartment for a Dec 15th move in, but had some trouble renting out the "owner's duplex" in the middle of the holiday season (which I was afraid would happen). The 2nd apt was rented out for a January 15th lease start.
I thought I would get about $1500 for the 1.5 bedroom and about $2550 for the owner's duplex, and my projections were very close. I offered a small credit for my tenants to postmark their rent by the 25th of the month before the rent is due. So far, my tenants have all sent in their rent early. I asked my tenants to sign leases that expire in the summer so that I don't have to worry about renting an apt out in the middle of the holiday season again. Summer rents are higher also, so my cash flow should continue to increase over time.
All in, I am covering the mortgage, taxes, homeowners insurance, heat & hot water expenses with the rent roll and I am slightly cash flow positive. Rates have actually come down since I purchased, so I will be working on a re-fi soon. As soon as I have paid off the $75K home equity line of credit on the house, I will be making more cash flow.
The project took time and money, though. I had hoped to spend $110K on the construction, but budgeted $130K "just in case." After 2 new kitchens, one new bath, two upgraded baths, painting, floors, new windows, upgraded electrical, two structural changes, a new closet, etc... When everything was said and done, I spent $135K. Part of that was my fault, though - I decided to add a washer dryer in the basement. In addition to adding the water line, there were additional expenses to convert the 110 power to 220 in order to support today's washer-dryers.
Of course, the heat stopped working in half of the house about 2 weeks after my tenants moved in. I tried to find someone through the grapevine to fix the problem because I prefer using vendors who are referred to me. Despite recommendations from other homeowners and brokers, it took me 2 weeks to find someone reliable to diagnose & fix the problem. The job was too small for my contractor's HVAC guys. One vendor that was recommended to me didn't do forced air gas heat. One vendor only did oil heat. One vendor kept saying he would go over and check it out and then never made it to the house, or arrived at the wrong time & the tenants weren't home. I offered to reimburse my tenants for space heaters. Finally, I Googled "boiler repair & Brooklyn" and just started calling numbers off of the internet. $1100 and half of a day later, the problem was fixed.
Buying a townhouse, renovating it, and getting it to cash flow is certainly not a "get rich quick" scheme, at least not in NYC. But if you are undertaking this kind of project as a 10 year (or in my case, longer) plan, I am confident that it will be more than worth your while.
Of course buying a one bedroom condo in a new development would have been a lot easier! But (so far!) my townhouse in Bed Stuy has been a hell of a lot more interesting. As a complete real estate addict (some would say "nerd"), I have to admit that it has been really fun.
My next adventure? I'm currently studying up on foreclosures:)
The answer to this might seem obvious these days. But with banks and the economy feeling the heat of the subprime mortgage mess, of course Congress and the Fed are weighing in. The real question, however, isn't regulation in of itself but what KIND.
Few anticipated that the value of mortgage loans, traditionally a mainstay of banking, would take a nosedive. As Fed Vice Chairman Donald Kohn told the Senate Banking Committee this week, "I don't know that we fully appreciated all these risks out there. I'm not sure anybody did."
Tuesday's Wall St. Journal included an article on the possible effects of Basel II (B2), proposed international standards for risk capital that - in theory - should help prevent the kind of massive write-downs by banks.
First, a little primer on risk capital: It's the amount of capital that regulators require banks to hold against their total assets. Typically it's based on a % of assets, which are categorized in terms of risk. So the riskier the asset, the more capital a bank has to hold aside in a reserve fund.
Why B2? One reason is set international standards for capital. Because each country has different accounting standards and capital markets, what might be considered 'equity capital' in Germany may not hold the same in the US. Keeping everyone on the same playing field would enable US banks to compete better globally.
Another reason is to allow the banks to assess risk levels specific to the type of asset, taking into account their own risk assessments and the opinions of credit rating agencies (i.e. Moody's, S&P), rather than adhere to regulatory guidelines that are more standard. After all, who would know better than the banks as it's their own business? Furthermore, B2 requires a safety net of capital for assets held off balance sheet. Theoretically B2 would enable banks to assess their capital reserves in a way that better reflects the underlying risk if their assets.
Some European banks have recently implemented B2 compliance; US banks have a couple of years to phase it in. The concern is that under B2 banks might underestimate how much of a capital cushion they'll need to absorb future losses. Another issue is the reliance on the opinions of credit rating agencies. Oh, and there’s the point that B2 doesn’t require as much monitoring of liquidity as US regulators would like.
Even under current US regulatory capital standards, banks are having trouble. This has Congress and regulators concerned that B2 standards would only exacerbate the situation, calling for further tinkering before banks implement the new program.
So here's what happened: banks valued their mortgage holdings as safer investments, only to find out the market didn't agree. Oops.
Ironically, hedge funds, that were previously thought of as a possible cause of the next big market bust, are lightly regulated in this regard. Of course many of them are feeling the same heat, so it calls into question the overall effectiveness of our current bank regulatory environment. Perhaps Congress and the SEC will pick up on this.
There was a great article in Thursday's Wall Street Journal about the fragile state of the markets called "Magnifying the Credit Fallout." It explains for the non-Wall Street audience how the $400 billion or so in mortgage losses could be causing such large reverberations, despite the fact that similar sums of money are often lost in equity markets on a daily basis, with no ill effects. The notable difference, the author highlights, is that these losses are taking place at banks and banks are levered about 10:1 - a leverage ratio that is much higher even than hedge funds. I have commented here before about banks' roles in money creation and destruction in a piece called Making Money out of Thin Air. The Wall Street Journal article points out that the losses at banks are resulting in a $4 trillion contraction in their lending capacity due to this high leverage - an impactful number to be sure. Importantly, this contraction is cascading down to other levered borrowers like mortgage REITs (At 12/07 Thornburg had assets of 18x their equity, while Carlyle was levered 36:1), hedge funds (many are down below 2:1 leverage, but some go as high as 7x and higher and several have begun to implode in the last couple of days), leasing companies (Financial Federal who reported earnings the other day has assets of 5x equity, but they fund themselves with long-term debt - obviously smart guys), etc, etc. But perhaps most importantly, the consumer is heavily levered in their real estate holdings. If you put just 10% down on your house, you're 10:1 levered on that investment. While people oftentimes have abundant additional assets too, my bet is this is a pretty good approximation of many such borrowers' overall "household leverage." FYI, the average homeowner has a historically low equity of 47.9% in their homes, which is nonetheless a much less levered position than that of many homebuyers of recent years.
Lately we have been hearing more and more about margin calls - Thornburg Mortgage REIT and a few hedge funds have felt the pain of dealing with a margin call when you are highly levered. For newbies, when an institution or an individual pledges a marketable security as collateral for a loan to buy another marketable security, the bank monitors the value of this collateral constantly. If the value of the collateral declines, the bank may ask for more collateral to be posted by the borrower....the infamous margin call. This will often cause the institution who borrowed money to have to raise new equity capital or sell positions to pay back the bank or boost collateral by some other means. This often happens at inopportune times and the institution often exacerbates its own situation by being forced to sell securities into a declining market.
A version of this scenario is currently happening to banks and I think it's instructive to think of the current situation in financial markets as the "Mother of all Margin Calls." Due to the transition in banking from making whole loans that a bank owns to maturity, to an environment where banks instead assemble packages of loans and sell off the pieces as securities, banking for most large banks has transitioned to an investment banking and trading business. As a result, they are falling increasingly under the purview of "fair-value accounting," which applies to marketable securities. See The Economist's article Mark it and weep for a primer on this subject. The result of the marking to market of mortgage backed securities, and recently muni bonds, collateralized loan obligations and CMBSs has resulted in banks' capital bases being hit hard by write-downs. It has exposed the problem that these most highly levered of all institutions' capital bases are actually much more exposed to market volatility than is comfortable for the financial system. So why the margin call analogy? In this case the margin lender to the banks is the Federal Reserve. The collateral level that the Federal Reserve requires the bank to maintain is called the regulatory capital requirement. So you can think of the stock offerings and sovereign fund investments the banks have been indulging in lately to boost their capital levels as reactions to the potential threat of getting a margin call from Uncle Ben Bernanke.
It is no wonder that banks are nervous about lending. They need to harbor their scarce and volatile capital, in case of future losses or just securities price declines. It's no wonder they are nervous about lending to each other - read about this phenomenon in the Economist' s When the rivers run dry.
So when will banks feel better about their positions and the security of their capital bases? They keep saying they have enough capital, but then they raise more. (I don't need to tell you they would never admit to being worried about their capital levels as that would be like yelling fire in a crowded theatre.) We all now know that their models for defaults on various securities have stunk so far. Since we are sliding into a recession, with tons of consumers levered 10:1, they are probably useless altogether. But eventually we will get through this and banks will feel better because:
1) They raise so much capital that the margin call issue becomes moot.
2) Real estate and other riskier debt securities have a huge rally.
3) The delinquency trend starts to visibly improve.
Let's think about each of these scenarios. The huge capital raise is a possibility, but let's face it, they have raised a lot and at least one sovereign fund is sounding like they aren't ready to pony up more money to save Citibank. I think a lot of the investors who bought the recent offerings by Citibank and Merrill actually bought into the "margin call" scenario and figured they could make a quick killing by helping relieve an acute but short-term liquidity squeeze situation. They probably aren't betting on a quick fix of this nature anymore. With regard to scenario #2, higher-risk debt securities could have a big rally if investors believed that they were very cheap even in a historically high default level scenario. Indeed, both Pimco and Wilbur Ross appear to feel this way about municipal bonds and their buying has helped support the market recently. However, my guess is that most of the buyers of this ilk are long-term investors, who can and need to be able to absorb short-term pain and by definition, use little or no leverage. This means they have to use much more capital to offset any selling by any entity receiving a "margin call." They can cushion the fall, but they probably can't stop it, or they already would have. With regard to the last scenario. The end to the delinquency trend seems nowhere in sight. Freddie Mac had this to say about the housing market and defaults on its recent earnings conference call:
The large decline in house prices in the fourth quarter has led us to increase the expected decline in our median house prices pass to approximately 15% peak to trough causing us to increase our expectations for expected default cost. While the relationship between house prices and defaults is clear, the forecast for expected defaults is not precise. This is particularly true in this environment as the rate of decline nationally is without recent precedent and the lack of correlation between unemployment and declining house prices is also unusual.Of the total 15% decline in home price nationwide that Freddie expects, they have only seen 5 percentage points of it so far. That said, they feel that they have written down their portfolio enough, so that they will actually see a large amount of reversals of write-downs as the market improves. Let's hope they are right as Fannie and Freddie are the most levered of all financial institutions at 40:1....Woof!
Not much to be positive about regarding this liquidity crunch, it will take time and absorption of the many losses to come before conditions are likely to improve. The wheels of de-leveraging are in motion and they will likely have to travel many miles through this great unwinding before we see a return of normal liquidity to the markets and the economy. You can be sure regulators are thinking about these things and will be doing their part to move the unwinding along, by clamping down on the use of leverage anywhere they can. Same as it ever was.
From the Blogosphere
Carlyle Capital receives default notice after failing to meet payment demands.
Citigroup to shrink mortgage portfolio
Hedge funds stem exits as credit lines tighten
Long-Term Capital's Meriwether hedge fund loses 9% this year
KKR and Carlyle Funds in Deep trouble
Peloton lays blame on Wall Street lending crackdown for hedge fund liquidation
A: If you are watching CNBC or reading up on some headlines on Bloomberg, you probably can sense the fear level that is gripping the secondary mortgage markets! The problems have been bubbling under the surface for weeks and it seems that it can no longer be contained. The seizing up of these markets is causing companies like Thornburg & Carlyle to miss margin calls and receive default letters. The ugliness is a combination of fear, illiquidity, risk aversion, de-leveraging, and risk repricing; so expect sharp movements both up & down as the correction process continues. The unfortunate side effect is higher lending rates.
Have you seen the spreads between gov't backed conforming paper & 10 year treasuries! Even the safest paper is seeing risk aversion as a result of the credit turmoil. According to Bloomberg's article, "Agency Mortgage-Bond Spreads Rise; Markets 'Utterly Unhinged'":
The difference in yields, or spread, on the Bloomberg index for Fannie Mae's current-coupon, 30-year fixed-rate mortgage bonds and 10-year government notes widened about 7 basis points, to 223 basis points, the highest since 1986 and 89 basis points higher than Jan. 15. The spread helps determine the interest rate homeowners pay on new prime mortgages of $417,000 or less. The markets have become "utterly unhinged," William O'Donnell, a UBS AG government bond strategist in Stamford, Connecticut, wrote in a note to clients today. A lack of liquidity has "led to stunning air-pockets in price levels."I discussed the effect on lending rates this two weeks ago in my post, "Inflation + Credit Crunch Means Higher Mortgage Rates":
Investors are realizing that banks have little room to make new investments amid rising losses and a flood of unwanted assets, said Scott Simon, head of mortgage-backed bonds at Pacific Investment Management Co. The world's top banks have reported more than $181 billion in asset writedowns and losses, been stuck with $160 billion of leveraged buyout loans, and bailed out $159 billion of structured investment vehicles.
"Everything is telling you the financial system is broken," Simon, whose Newport Beach, California-based unit of Allianz SE manages the world's largest bond fund, said in a telephone interview today. "Everybody's in de-levering mode." Agency mortgage securities outstanding, which are guaranteed by government-chartered Fannie Mae and Freddie Mac or federal agency Ginnie Mae, total almost $4.5 trillion, about the same size as the U.S. Treasury market.
"...this credit storm is now a full blown category 5 hurricane on so many levels and is hitting land at numerous points; analogy --> credit crisis is spreading! Put both these FACTS together and you will understand why lending rates are rising."To the right is a 1-Month chart (courtesy of Bankrate.com) showing you 30YR Fixed Jumbo NY, 5/1 ARM NY, & FNMA 30YR MTG Yield. While the green & blue lines (the 30YR & 5/1 ARM respectively) seem to only slightly trend higher, take a look at the left axis and you will see that these yields have risen about 40 basis points & 50 basis points respectively over the past 4 weeks! Then look at what FNMA yields have done! These are the side effects of a secondary mortgage market in distress where risk aversion & fear are starting to effect even the safest paper out there.
All this is occurring as the latest round of housing data comes in and confirms what the credit markets have been deeply concerned about:
a) Home Foreclosures Hit Record High
b) Pending Home Sales Remain at Second-Worst Number on Record
c) Homeowner Equity is at Lowest Since 1945
As usual, the folks at the NAR put their car salesman spin on these disturbing numbers further eroding any credibility they have left. De-leveraging is a bitch and right now that bitch is taking over the cleansing process; it's quite a dirty job. As the credit markets continue to LEAD the stock markets, I am now starting to get more interested in the severity of the slowdown in future economic data reports that will reflect the turmoil that we have experienced over the past 4-6 months.
In prior pieces I have been both an outspoken supporter of Long Island City (LIC) in the intermediate and long-term, and also a skeptic with regard to the significant supply of condo product coming to market in the near term. See my piece Spotlight Long Island City for a background. Today I want to revisit Long Island City, with the help of some input from a couple of local brokers and sources who are better informed and closer to the market than I am.
The press and blogosphere have been rampant with rumors of condos gone rental. According to an article in the Real Deal, "Developers become landlords, not by choice" one unfinished project, 512 Lofts at 5-12 51st Avenue, has gone partially rental. My pal Michael Stoler wrote recently in the NY Sun that:
One senior development director told me, Sales have dried up in Long Island City even for products in the best locations. Since October, we have only sold five units."
Other scuttlebutt suggested that even some of the most successful projects in LIC might be seeing some slowdown. According to Curbed, Toll Bros. 5SL had a one week sale on a particular unit, with a 3.4% price cut, followed by price reductions on 15 of 22 active listings. This was supposedly followed by prices being raised back up to prior levels as demonstrated by data from Street Easy. I have heard the Powerhouse mentioned as one property which appeared to have backed off from some higher than average prices, albeit for larger than normal apartments.
When I spoke with Eric Benaim of Nest Seekers, the only guy from a New York City real estate brokerage to open an LIC office, he offered a sunnier outlook and some explanation for the "gone rental" rumors. Eric has been a broker for 6 1/2 years, he's a Queens native, lives in LIC and has been dedicated to the market for the last 2 years. He opened up the LIC office for Nest Seekers a year ago on Vernon Boulevard. According to Eric, "People are taking a little more time to buy, but prices just won't go down." Condominiums like 44-27 Purvis street are having strong interest, with 20 - 30 people showing up to open houses on Sundays. The confusion over condo projects going rental may be being caused by rental availability in certain condo developments. For example, Eric reckons that 10% of the buyers at Arris Lofts, where he lives, were investors. These investors have since rented out their units....the developer has not gone rental. While the 20 or so units out of 237 units and 17 artist lofts that have rented may have generated some chatter, the magnitude of rentals is pretty small, and in part may also be indicative of the long waits owners had for the property to be built. According to Eric, at least one couple who were early buyers had twins while they were waiting for their unit to be delivered and put it up for rental, while they look for more appropriate space.
Darleen Krimetz of CITYVIEW Real Estate was the former VP of Sales and Marketing for the well known CITYLIGHTS building. She is still considered the expert on this property and is a top producer of resales there. Darleen also handles resales elsewhere in LIC and often shows new product to her clients for comparison. According to Darleen: "The market is still strong; with more product available, people are taking longer to make decisions. Resales have been turning over in 30 to 60 days vs. a typical 30 - 90 days, so they're back to normal, but the market is hanging in there. New developments have adjusted some prices which were getting high."
While it is apparent that sales velocity has slowed some in LIC, recent reports from the blogosphere suggest that new developments are still selling reasonably well. Curbed recently reported that Ten 63 Jackson Ave. has sold out 30 of its 37 units. Studios sold for around $375,000, 1BRs for $465,000 and 2BRs for $610,000, with an average sell-out price of $759 per square foot. According to LIQ City, One Hunters Point and Hunters View - both developed by Simone Development of Westchester - which started selling last October, have sold a combined 40% of their units. Curbed also recently opined that Crescent Club was in price increase mode on a couple of dozen units, which soon went to contract.
Still, rumors are circulating that the narrow windows seen being installed at 11-15 50th Avenue imply a "direct to rental" situation. The logic goes that condos have big windows, particularly when NYC views are an amenity, because owners pay the heating bills. Apartments are equipped with smaller windows, to keep this cost lower for landlords. The development had reportedly filed a Co-operative Policy Statement 1 (CPS1) with the state Attorney General's office, according to LIQ City, which allows general advertising of a development, without specific price information. An offering plan has supposedly not yet been accepted, further feeding the speculation.
Either way, the arrival of new tenants or new owners to LIC is seen as an overall net positive. One of the complaints about the area, from some but not all quarters, is that it's under-retailed. I pointed out the magnitude of this situation in my prior piece. According to Dan Minor, at the Long Island City Business Improvement District (LICBID):
It is very understandable that retail may be cautious until more tenants arrive in Long Island City and it's a bit of a chicken and egg situationAccording to Eric Benain, demand for retail space is on fire and rents have rapidly escalated to the $55 - $70 per square foot range.
That said, the much-awaited and somewhat delayed arrivals of Duane Reade and The Amish Market to the Queens West waterfront complex (The Amish Market opening is said to be postponed until at least May) is seen as a big boost to the livability factor for potential new residents. Rumors continue to circulate that Starbucks will be "arriving" in LIC with a store in the Eastcoast building and potentially one on Vernon/Jackson Avenues. Other recent additions to the nabe, according to LIQ City include Ethereal (a women's clothing boutique), City Vet (pet care), BANY (Japanese fusion restaurant) and Ihawan (Asian Grill & Sushi Bar).
Bottom line: The things I like about LIC - one stop from Manhattan, neighborhood feel and great views- appear to continue to attract people to the area, which still holds lots of long-term appreciation potential. The necessary amenities are coming into focus, which I see as a big positive to the area moving out of the pioneering phase. My backbone still says there will be deals coming in this market as development continues apace while the economy cools. Savvy buyers should be keeping their eyes on the Pepsi sign and the buildings springing up beyond.
A: So we have had our fair share of failed auctions, margin calls, financial write-downs, fiscal & monetary stimulus, gov't sponsored targeted programs, and private sector bailout injections. It's exhausting. But the one thing we have not had yet, thankfully, is a rapidly deteriorating jobs market; but the radar is up. Of course its logical to expect it given the environment we have been in for over 8 months now, but the reports are always lagging and usually revised at a later time. To me, Friday's jobs report is going to be a big market mover IF the number beats or misses expectations by any significant amount. It's all on jobs now.
Jobs reports could be the final nail in the coffin for recession talk. If the unemployment rate unexpectedly jumps to 5.2% or higher, current expectations call for a 5% rate of unemployment, you are going to hear the media go nuts with 'recession is here' articles & the markets react fairly negatively; the combination of these two forces will hit consumer confidence in a way that just doesn't bode well for future economic reports. The messed up thing about following leading indicators is that we will see worsening economic data for a period of time AFTER the leading indicators normalize.
Here is a chart of unemployment rate since 1998, courtesy of the BLS. After the dot com bust, corporations cut back on spending and jobs ultimately bringing the unemployment rate to a high of 6.3% in June of 2003. That was about 3 years AFTER the top of the dot com bubble (back in early 2000), as the jobs reports lagged the stock markets and rapidly deteriorated from mid 2001 to mid 2003. Looking at the how the housing market, credit markets, and financial institutions have been performing over the past 8 months or so it is hard to argue that employment will be pressured. Unfortunately, this blogger expects some sharp upward pressure on the unemployment rate in the months ahead.
Lets play a bit and compare stocks to the unemployment rate since 1998, and see if we can see the relationship. The chart below compares the DOW vs UNEMPLOYMENT RATE over the past 10 years:
When I view this, I see a few things:
a) when unemployment really started accelerating in mid 2001, stocks corrected sharply.
b) in early 2003, stocks bottomed before unemployment topped out in mid 2003. For the record, the fed aggressively lowered the FFR to a low of 1% in June of 2003; about when unemployment topped out! Stocks started rallying 2 YEARS AFTER THE FED STARTED CUTTING RATES AND 6 MONTHS BEFORE THE LAST RATE CUT!When the fed started hiking interest rates (JUNE 2004 --> June 2006), stocks rallied about 20% during that period.
c) Unemployment has been slowly ticking higher since the low in early 2007; since unemployment is lagging, eyes MUST be on jobs now and probably for the next 3-4 quarters to see the reaction to the distress we have experienced thus far
On Friday we will get the unemployment rate and expectations are for 5%; the last report was 4.9%. What I don't know is which unemployment report (this one, or a report yet to come) will confirm what the fed is telling us when they say, "unemployment is expected to rise". The reason this is so important is the secondary effect it has on the consumer and on corporate strategy; as unemployment rises, confidence falls and the consumer gets more conservative while corporations cutback investments and look to cut costs contributing to the cycle.
ADD-ON (10:53AM): Forgot Non-Farm Payrolls on Friday too. Market expects growth of 25,000.
A: Look, there are things going on out there that some people feel the need to discuss, some people just don't want to discuss, some people HATE hearing, and some people refuse to believe! Wishing and hoping is not going to solve this situation! Denial works for some people, but not for me. While I eagerly await for the light at the end of the tunnel to show it's first ray, it's good to see the equity markets wake up to what is going on and adjust expectations downward. If the damage lies before the light, then bring on the damage so we can get to the light! And lets continue to discuss these issues head on, which means keeping that head out of the sand!
Hey, guess who joined the club today? Mr. Bernanke!! In a speech to a banking group this morning, the fed chief seemed to acknowledge that the role of biased optimism needs to change to a role of crisis management. According to Yahoo Finance's article, "Fed Chief: Mortgage Crisis To Continue":
Federal Reserve Chairman Ben Bernanke called Tuesday for additional action to prevent more distressed homeowners from falling into foreclosure. "This situation calls for a vigorous response," Bernanke said in a speech to a banking group meeting in Orlando, Fla.So, over the past few weeks the fed is now telling us that the coming quarters are going to bring us:
Even with some relief efforts under way by industry and government, foreclosures and late payments on home mortgages are likely to rise "for a while longer," Bernanke warned.
a) rising inflation pressures
b) weakening economy
c) rising unemployment
d) rising foreclosures
e) rising late payments on home mortgages
Man, what took him so long to publicly acknowledge all this? Bloggers have been discussing these concerns for 6-8 months already. If there is a sliver lining that I can think of, is that it seems we are going through the painful process that in my opinion we MUST go through to get out of this mess. It's one thing to watch all the data, indicators, fundamentals, etc.. and discussing the likely path; but it's another thing to experience the carnage. I think we are in the 4th or 5th inning of the painful deflationary process that we must go through. Eventually, all the stimulus we had thus far will put a floor on the down cycle. The problem is that the root cause of the problem (housing) is illiquid, takes time to reverse course, and was inflated through the use of leverage that was securitized by wall street. What I mean is, this will take time because of the self-fulfilling relationships of the individual problems we face...
HOUSING/CREDIT DEFLATION LEADS TO DEFAULTS/FORECLOSURES which leads to BROKEN CREDIT MARKETS which leads to MASSIVE WRITE DOWNS OF MBS which leads to CAPITAL RESTRICTIONS which leads to RISING LENDING COSTS + TIGHTER LENDING STANDARDS which leads to SLOWER GROWTH which leads JOB LOSSES which leads to FALLING STOCK PRICES which leads to NEGATIVE WEALTH EFFECT which leads to GO BACK TO BEGINNING!
The cycle feeds on itself. Remember this discussion back in late October of last year, "To Mr. Bernanke: BE STRONG", where I was concerned about commodity inflation & instead said to bring on the recession:
Gone are the days where bad bets are penalized by the tradable markets, because if they were it would cause financial distress to our economic system that maintains afloat from interventions from government and private institutions. That is why free market capitalism is NOT AT WORK HERE!Its not that I want the economy to weaken or stocks to go down, I don't, but I don't have much of a say into that now do I? It is going to happen anyway. Its the only way to cleanse the situation we created. Inflating us out of this mess has serious medium term ramifications, and should be a topic of conversation because it could affect all of us.
If it was, the markets would have to work themselves out and stocks of banks, lenders, and others who hold these assets would have corrected significantly more; and that is obviously not happening. We have become a society that fears recessions rather than understand them for what they are; healthy and normal disruptions in economic growth necessary to ensure longer term sustainable growth. We need to shake out the bad bets and weak players, let the markets fix themselves, and move on with the lesson learned.
The markets are working, even if that means the marketplace itself is not working. The markets are currently self-correcting in the following ways:
a) seizing up of secondary mortgage markets - the very market where banks offload mortgage backed securities is dead. This is causing lending standards to be tightened, available capital to be restricted, lending rates to rise, risk to be re-priced, and losses to be booked on the bad holdings. Weak corporations will die and likely be taken over or declare bankruptcy. This is a self-correcting process as the industry adjusts to the way it used to be. You can't be a heroin addict for 5 years and expect to go through no withdrawal when you quit! Well, the credit markets are in withdrawal right now. Let the detox continue as we provide some minor painkillers (monetary & fiscal stimulus) to make the cleansing process a bit more manageable; and beware giving too strong of painkillers that will re-ignite the addiction.
b) housing deflation - the turnaround in housing is removing speculative players from the market who helped power the unsustainable boom. In addition, as housing prices fall banks are re-thinking to whom they will lend their capital to and at what rate. In short, the bullshit days of giving anybody a loan because housing goes up are gone! As housing deflation continues & lenders actions help correct the credit markets & clean the books, fundamentals should start to reverse course. These two forces, housing deflation/weak fundamentals & credit markets, are inter-related. It is likely that credit markets will normalize when housing fundamentals start to improve.
There will be great opportunities as a result of this cleansing cycle; so keep your eyes open. In the meantime, lets get more clarity on the depth of the crisis and watch for housing fundamentals to turn before we can start discussing the brighter times that lie ahead. We are not out of the woods yet by any means. Here are some of today's creditville headlines:
Bernanke Plan; Citigroup/Goldman Earnings Estimates Cut (via Bloomberg)
U.S. stocks fell, led by financial shares, after Federal Reserve Chairman Ben S. Bernanke urged banks to write down more mortgage debt and analysts cut earnings forecasts for Citigroup Inc. and Goldman Sachs Group Inc.Ambac Decides Against Splitting (FT.com)
Citigroup fell $1.39 to $21.70. Merrill Lynch & Co.'s Guy Moszkowski said he expects $18 billion of credit writedowns related to the company's holdings of subprime mortgages, collateralized debt obligations, leveraged loans, bad consumer debt, real-estate lending and other investments.
Ambac, the troubled bond insurer, has decided against splitting in two as it completes a $2bn-$3bn recapitalisation, insiders said.
Under a recent proposal, Ambac, the second biggest bond insurer, or monoline, would have split its operations into a triple-A-rated municipal bond insurance business and a structured finance business with potentially lower ratings. A lower rating on the structured part of its business could have forced banks to reduce the value of guarantees on collateralised debt obligations and on derivative trades.
A: In a sign of the times, jumbo mortgage lender Thornburg Mortgage is getting whacked as I write this because of deterioration in the value of their mortgage backed securities holdings. The losses are resulting in margin calls at the worst possible time. There is no market right now for these risky assets, except from vulture investors who will scoop up holdings at a high discount. But that is not the story here. Take one look inside Thornburg's Industry Expert Spotlight, as publicly displayed in the news section of their website, and you can see why we just can't trust what is told to us.
The news. According to Yahoo Finance's article "Thornburg May Be Forced Out Of Business":
Jumbo mortgage lender Thornburg Mortgage Inc. said Monday it may be forced out of business as it faces an additional $270 million in margin calls on top of the more than $300 million it was being forced to repay, or provide more collateral for, last week.LOOK AT WHAT I BOLDED! The margin calls are 'strictly a result of the continued deterioration of prices of mortgage-backed securities precipitated by difficult market conditions'. Now take a look at what their website states about their business model in mid 2007: Origination Strategies: Above The Fray; Thornburg Mortgage takes the high road on risk in its origination niche serving high-end borrowers.
Thornburg said it has not met the majority of the most recent calls, but is working to repay them by selling assets or through the raising of additional debt or capital. If Thornburg is unable to meet the current calls, it said the result could materially affect its ability to continue to operate.
Margin calls force borrowers to repay loans or put up more collateral to secure them. Thornburg said the margin calls are "strictly a result of the continued deterioration of prices of mortgage-backed securities precipitated by difficult market conditions." The calls are not reflective of the actual performance of the securities, the company added.
Note that Larry Goldstone is Thornburg's President & CEO, as stated in this publication. WTF! If this is the case, then why the hell would they be forced into margin calls because "of the continued deterioration of prices of mortgage-backed securities precipitated by difficult market conditions"...? Didn't Goldstone state in that publication that..."...company isn't driven by what he calls 'gain on sale' model, referring to the business of providing mortgages and selling them to investors" and then state right after this that..."The Thornburg model is a throwback to the old-school way that mortgage lending occurred"?
If they are not driven by the so-called 'gain on sale' model of packaging up mortgages and reselling them to investors, why would they have to meet margin calls due to the continued deterioration of prices of mortgage backed securities? But if that doesn't light a flame under your a$$, here are some more tidbits from this publication:
* "We are risk managers before anything else, and there's a discipline required to being an effective risk manager" says Goldstone
* "In my own personal opinion, what happened in the subprime sector is history repeating itself," Goldstone says, referring to past real estate boom-bust cycles. "It's no surprise to me, I've been anticipating it".
A sign of the times. We STILL do not know who holds what, what IT is worth, and HOW much further the secondary mortgage market will deteriorate bringing up more margin calls like this one at Thornburg. The shame of this whole thing is that investors may have bought into TMA stock because they thought their model was safer, and their risk managers had the discipline to avoid this type of situation. After all, this is what was told to them!
Thornburg's stock price is currently trading down 54%!
I am working with a few $800K - $1.05M buyers these days. None of them has the time to do any work on an apartment, so they want something new. None of them wanted to go through the scrutiny of a co-op board, or they didn't quite have the 20% down plus 18 - 24 months of assets in reserves to purchase in a co-op, so they needed something with no board approval. Adding to the challenge was that they all wanted to be below 34th street, which is, in general, more expensive than Midtown East and West and the Upper East and West Sides.
I joke about the Million Dollar "Mansion," because when you buy an apartment over $1M in NYC, you pay a "Mansion Tax" of 1% of the purchase price of the apartment. In a new development, the sponsor's transfer taxes somehow also "count," so usually you have to buy something under about $980K in order to avoid the Mansion Tax. Most New Yorkers find the tax to be ridiculous, because a million dollars does not buy a mansion in Manhattan.
So what does $1M buy you in a new development or condo conversion below 34th street these days?
It buys a one bedroom apartment. An approximately 750 - 1000 sq ft apartment. To make you more depressed, in buildings like the new "W" Hotel & Residence in the Financial District, a million dollars buys you 500 sq ft, but we're going to try to avoid the insanity in this post & focus on some semblance of normality. (If you can call it that!)
There really is a difference between a condo conversion & a new development built from the ground up. A lot of people say that you are paying a premium for buying in a new building and that it isn't worth the money, but in reality, you get what you pay for. Here are the buildings we looked at and my and my buyer's overall impressions.
The Charleston (225 E 34th St) is 90% sold (occupancy is immediate upon closing) and only has two apartments remaining for under $1M for sale by the sponsor. Both are about $1,000/sq ft, which is a fabulous value for a new, from the ground up development with a fitness center, roof deck, zen garden, and private storage that comes with each apartment. Apt 2K ($875K for 836 sq ft) is on the ground floor and has 131 sq ft of outdoor space, but not a substantial amount of light. It faces the "zen garden," so at least it is quiet. My buyers loved that there was a washer dryer in the unit, the bathroom wasn't cramped, and they much prefer open kitchens with a large breakfast bar to galley kitchens. They also loved the central air/heat, garbage disposal, 9'4 ceilings, and floor to ceiling windows. You rarely get these little luxuries in a rental building that is being converted to a condo. The second apartment (5B) we looked at was on a higher floor, also facing north, with a balcony and was less than $1000/sq ft (1005 sq ft with a 67 sq ft balcony for $960K). Sometimes when you buy at the very end of sales in a new development, you can get a relatively good deal. The developer just wants to sell out the building. He/she wants to stop paying the salespeople to be there, can stop spending the big marketing bucks, and can move out of the apartment that the sales office is in. I would say that at this time, the building is a really good value. The downside of the building is the location on 34th street next to one of the midtown tunnel exits. The apartments themselves are quiet, however.
Twenty 9th is being built on 29th street between Park and Madison, across from the site of the new Gansevoort Hotel. The sales office is not yet in the building but they have a model apartment so you can see what the finishes will be like. They had a few studios and quite a few one bedrooms on the market, but since they're over 50% sold, there wasn't that much left under $1M. Every one bedroom on the higher floors will be over $1M. A south facing one bedroom on the 5th floor came in at $950K and a north facing unit on the 10th floor (less light, less of a view on the low floor apartments on the north side), was $920K. The apartments also have washer dryers, an oven and an additional microwave/convection oven, an open kitchen with breakfast bar, & floor to ceiling windows. My buyers thought that the finishes were more luxurious and the building would be more high end than the Charleston, so 788 sq ft for $950K was reasonable (common charges of $611 and with the 421A tax abatement, taxes of $47). Above the 5th floor in some units, there is a window in the bath, and above the 10th floor in some units, there is a small, corner window, so you have a double exposure. The building will have a roof deck with BBQ and wet bar, fitness center, parking and resident's lounge. Occupancy is expected on the lower floors in mid-June to mid July and on the higher floors closer to the fall of 2008.
133 W 22nd Street had one apartment left at $1.005M and by the time my buyers got back to it, it had a contract out. There aren't many new construction buildings below 34th street and above the financial district with a pool. And the ones that are out there don't have anything under $1M. The pool at 133 W 22nd is a 25 footer, so it's not quite the lap pool you can find at the (farther north) Laurel, Sheffield57, or One Carnegie Hill, but at least it's a pool. Closings are anticipated in January 2009.
I thought it would make sense to bring my buyers by 205 Third Avenue because they really love the location. The building is on 18th street so is really close to Union Square as well as Irving Place & Gramercy Park. 205 3rd is a co-op building but the sponsor of the building is selling off the apartments he owns and is gut renovating them with finishes you would find in a new condominium. The apartments are a good value for the location. You can buy an 868 sq ft Junior - 4 (one bedroom with a dining area) with a terrace for $950K. Your total monthly charges including electricity are $1,150/month. But once a buyer gets used to seeing buildings with a washer/dryer in the apartment and a huge, gorgeous, brand new fitness center, roof deck, and resident's lounge, it is hard to move into an older building with 8'4 ceilings, laundry and a small gym in the basement, and an older lobby & hallways. I still think these apartments are a great value for someone who might not quite have the liquid assets in reserves to pass a strict co-op board but wants to live in the Village/Gramercy area. There is no board approval and you only have to put 10% down. Although you pay the sponsor's transfer taxes of approximately 1.8% of the sales price, you are still paying about 3% less in closing costs than you would be paying if you bought an apartment in a new condo building. Of course, when you resell the apartment, your buyer will need co-op board approval, and you have sublet restrictions that you wouldn't have in a condo.
I checked the A Building & The Oculus just in case, but they only had one or two small studios or ground floor apartments available. I have stopped taking buyers to The Gramercy (which was once my favorite downtown new development for entry level buyers), since the word got out that a McDonalds and a CVS are going into the commercial space in the building. Ugh. And we scoped out a resale one bedroom at Crossing 23rd, which is only about 2 years old, but the apartment had kind of an awkward layout. It was overpriced in comparison to what we had seen, even taking into account the 2% savings in closing costs you get when buying a resale condo.
One couple also wanted to see how much farther their money would go in the Financial District. Light and a view were important to them, though, so we skipped District, The South Star, and 45 John, and a few others that only had apartments in their budget on low floors where there would be another building or an interior courtyard less than 25 feet away. Since the buildings are so close together in the heart of the financial district, you usually don't have much light or a view unless you are on a really high floor. My buyers fell in love with the Setai (40 Broad), but the only available one bedroom was out of their price range at ~ $1.1M. There was one apartment left at The Exchange (25 Broad) but it faced a courtyard and didn't get much light.
We had a few apartments to choose from at 88 Greenwich on higher floors with open views and a peek here or there of the river. One apt (just over $1M) had 16 foot ceilings! My customers liked the iPod docking stations, wine rack & step stools built into the kitchens, personal trainer available for most of the day in the fitness center, the library, the resident's lounge, the roof deck, and the continental breakfast in the morning. They really wanted a washer dryer in the apartment and if they could have had a larger bathroom, they might have been sold. It was a great combination of price per sq ft, amenities, light, views, and finishes, and there are so many different layouts, the building doesn't feel "cookie-cutter" even though it is huge.
99 John, recently converted from a rental building, had two stunning and unique apartments for right around $1M. One of them had a slightly triangular shape, high ceilings (over 11 ft), an open view, fantastic light and SEVEN windows. When you walked in, the first thing out of your mouth was, "WOW!" I doubt that the apartment is even still available - the price per sq ft was fabulous. My customers had the same issues at 99 John as they did at 88 Greenwich, though - the bathrooms in a conversion are usually smaller than in a ground up development, and there was no washer dryer in the apartment.
At 99 John, even in the hallways that have been redone, I couldn't shake the feeling that I was still in a rental building. It's a little hard to explain, but the entryways to the apartments don't have a luxury condo feel. There are narrow planked wood floors instead of wide planked floors & shower rods instead of glass partitions. The resident's lounge had about 8 different design elements going on, so it just seemed a bit over the top for the size of the space. Still, it's tough to beat 970 sq ft for $955K in a gut renovated condo with light and a view!
Next up: Battery Park City
We stopped at 225 Rector Place. Since it isn't a pre-war building, the ceiling heights are lower, windows are smaller, baths are smaller, no washer dryers in the apartment (laundry on the floor). They loved that the building will have a POOL, though. And a few of the apartments in their price range had river views & fantastic light. Since BPC is on a landlease, the real estate taxes (called PILOT - "Payment in Lieu of Taxes") are higher than in the tax-abated buildings in the Financial District. For example, 99 John Street still has 6 years left on their tax abatement, so taxes are $120/month for a one bedroom, versus $650/month at 225 Rector. The taxes at 99 John will increase every 2 years, however. Also, when there is a pool involved, your common charges are higher. You might have $750/month common charges at 225 Rector and $500/month common charges at 88 Greenwich St. for a comparably sized apartment. Of course, it isn't just the pool, if a building has 600 apartments, your common charges are probably going to be lower than in a building with 300 units. The more apartments there are in a building, the more people to split the costs between.
The last stop on our trip was Visionaire, a LEED certified "green" building in Battery Park City. There were three lines of apartments that would have worked for my customers, and they were impressed with the quality of the workmanship in the building. No detail has been spared. And it is always nice to feel that you are helping the environment. 5% of the building's power will run on solar power and electric bills are expected to be 40 - 65% lower because of the way the building was designed. My customers were excited that the amenities included a pool, but felt kind of far from the subway, stores, restaurants, etc. The saleswoman at The Visionaire was unbelievably friendly and knowledgeable about the building.
So what did my buyers choose? I will let you know when the ink dries on the contracts! Until then, I'm keeping it a secret:)
A: Sorry for the off-topic discussion here as I got some motivation to talk about this topic from a client I chatted with earlier in the day. In this case, one of my clients was bullish on equities since the fed started cutting rates because of the old mantra 'Don't Fight The Fed'! "That old saying can hurt you if you follow it too soon...", I tried to explain. I brought up my feelings about rate cuts (as I discussed last year as well) and what that tells us, and also the effect it has on our currency and commodities that are priced in the resulting weakening dollars. I told her to compare a chart of stocks vs gold over the past 5 or 6 months, a few weeks after the fed first started to cut the fed funds rate. While this is not your normal situation, it still shows you the basic conclusion! When the fed cuts and they say the bias shifted towards growth concerns, chances are you should wait to not fight them!
The fed's first rate cut was on September 18th, from 5.25% to 4.75%. Since then, we have had 4 additional rate cuts totaling an easing of 1.75%, or 175 basis points. We currently stand at a FFR of 3%, and it certainly appears to be going lower. During this time, I have had numerous discussions and arguments about why this is not good for stocks.
First off, let me say this: If you are going to follow the mantra of 'Don't Fight The Fed', be VERY cautious with the timing of any investment decisions when the fed is EASING! Why?
When the fed cuts the funds rate, it is doing so because there are perceived risks with economic growth that require stimulus. Stocks generally trade on near term profit expectations and confidence; lets say 6 months out. The accepted valuation models for whether the stock of a corporation is cheap (lack of confidence and low expectations) or expensive (plenty of confidence and high expectations), is the P/E ratio! Now, if the fed is cutting rates because there are risks to economic growth, and stocks trade on confidence and profit expectations, then chances are you will see pressure in stock markets as the fed eases. The more the fed eases, the higher the perceived risks to economic growth by our monetary policy setting body. In this cycle, hindsight shows that the fed was a bit late but aggressive so far with rate cuts. Stocks are now seeing pressure to profits and are re-adjusting equity prices to be more in line with lowered profit expectations.A side-effect of aggressive fed easing is inflation; especially in commodities. Every time the fed cuts rates and/or economic data comes in weak, our currency goes down. Commodities that are priced in US dollars, in turn, get more expensive. With the case of gold, a few other dynamics are contributing to the metals latest attractiveness; gold is widely viewed as a safe haven & inflation hedge play. This was perfect for the environment that was in place when the fed first started cutting rates in mid September; fed easing + uncertainty about economic risks + fed fueled inflation.
The uncertainty element comes from a combination of so many forces at once; housing deflation, de-leveraging, seizing up of secondary trading markets, major credit-related losses, commodity inflation, and a weakening US economy. Its a perfect storm. But if you do not believe me, just look at the charts and you will see the re-allocation of money a few weeks after the fed started their rate cuts:
GOLD ---> up $234/oz or about 31%
*DJIA ---> down 1,517 pts or about 11%
*does not include Friday's fall of 2.5%
These are the moves that happened a few weeks AFTER the fed started cutting rates. So be very cautious how you put your hard earned money to work in any environment when the fed is known to be aggressively easing because the economy is expected slow; which we knew in this latest easing campaign. 'Don't Fight The Fed' nah! Perhaps it should be, 'Don't Fight The Fed YET' instead!
When the fed tells us that they are no longer biased towards 'risks to economic growth', it will be a sign that inflation is now the focus and rates are likely to head higher in the near term; a good time to start observing the mantra of 'don't fight the fed' as the full effects of the easing cycle work through the system. That is when the US dollar will probably bottom and some speculative commodity trades will take their profits off the table.
PS: Something to keep in mind. Another way our currency will rebound is if our fed EXITS a rate easing campaign and STARTS a rate hiking campaign at the same time foreign central banks deal with the lagging slowdown that is a result of largely the same issues we are facing and our economic slowdown. It's widely accepted that the US economy leads the world economies; so our central bank will generally be AHEAD of other central banks. If Europe is to see a lagging slowdown, their ECB will likely cut rates and focus on growth concerns; and that could occur as our fed is nearing the END of our rate easing cycle! The combination of expectations of US rate hikes at the same time foreign central banks are easing, should certainly cause a rebound in the greenback and a slowdown in commodities that are priced in dollars!