Kindling for the Real Estate Inferno
Yippy ti yi yay…the housing crisis is no problem…the trade deficit’s no problem either.
Today’s dreary accounts (a simplified explanation of the U.S. trade deficit):
Spent – $7 billion
Received – $5 billion
Net – misery
Classical economics and common sense tell us this is no recipe for prosperity. But wait…Mr. Michael R. Sesit reports in the International Herald Tribune that there’s more to the story. More below…
“Today that 200-year-old theory is flawed and overly simplistic,” he says. More below…
And don’t worry about the U.S. housing crisis. David Richards, in Barron’s, tells us that compared to the raging elephant of global economic boom, the American housing industry is nothing more than a bothersome gnat.
It is only 6% of the U.S. economy, he says. Of the worldwide economy…it is insignificant.
We reported yesterday that U.S. housing represented more than 10% of the U.S. economy – a $1.5 trillion industry in an $11 trillion industry. The difference in the numbers probably comes from a difference in definition. Are REALTORS part of the housing industry? How about the people who make 2 x 4’s?
Yesterday, we noted that Weyerhaeuser (NYSE:WY) reported an 89% decline in earnings. Today, we follow up with the latest figures from the wall board industry. USG Corp. (NYSE:USG) dominates sheetrock. It is a beautiful business; wall board is too bulky and too low-margin to entice foreign competitors. That’s why Warren Buffett bought a big stake in the company. But when building turns down in the United States, USG’s market disappears. It says net income is down 68%.
Meanwhile, the people who put up houses are going up in flames. It’s the “Bonfire of the Builders,” says BusinessWeek.
And here we pause…and gulp.
By the time BusinessWeek gets onto a story, it is usually too late to profit from it. If BW is announcing the bonfire of the builders, maybe it is time to buy?
On June 19, 2007, the U.S. Census Bureau released the residential construction report for May 2007. It showed that housing starts are down 24.2% year over year…permits are down 21.7% year over year and completions are down 19.3% year over year.
In addition, the Census Bureau report showed that permits are plunging, inventories are rising, and to look for a decline in construction jobs.
Survival Report’s Mike Shedlock noted, “Given that housing permits tend to lead starts (and starts provide jobs), the signs are all in place not just for a continued housing recession, but also for a full-blown severe consumer-led recession. I’m still on recession alert.”
Meanwhile, a cousin reports from Maryland that his business – installing septic systems – has fallen off. “I used to have 50 jobs backed up…now I’m going from one to the next, and happy to have work.”
How big will the problem be? The last crisis in the property market occurred in the early ’90s – both in America and in Britain. In the United States, the Resolution Trust Company was set up to sort out about $300 billion in bad loans. But that was when America had an economy of only about $7 trillion. Today, U.S. GDP is closer to $11 trillion. Back then, consumers had only about half as much debt. And the housing boom of the ’80s was nothing compared to that of the last 10 years. This blow-up is likely to produce a couple trillion dollars worth of casualties…and a long period of rest and rehabilitation for housing values.
“The Great Unwind May Be Here,” says the Wall Street Journal. We did not read the article. We didn’t think we needed to. We’ve been asking the same question already.
When people talk of ‘unwinding’ they are usually referring to the carry trade – speculations involving borrowing in a low-interest currency and placing the money in higher-yielding investments. Typically, the carry trader borrowed yen and bought New Zealand bonds…or maybe U.S. dollar collateralized debt obligations.
So far, the New Zealand bonds are still making their coupon payments as promised, but other things have begun to go wrong. Mortgage backed securities, for example, have proven no more valuable than the flakey mortgages that backed them. And the yen (JPY) has begun to move up. Having borrowed yen to gain leverage, the carry trader is, effectively, short the Japanese currency. If it goes against him, he can lose big. So many speculators are faced with unwinding their positions.
But there is a larger unwind going on. It is what happens at the end of the credit expansion.
Little did they know it, but ordinary Americans were conducting a carry trade of their own. They borrowed from mortgage lenders at 6% or so…and invested the money in houses, which they thought were going up at 10% to 20%. The trade was a good one as long as houses kept rising. When housing stopped rising, they went into ‘negative carry’ and many soon found the burden just too much for many of them to carry at all.
By the way, we reported that the big hump in mortgage resets would occur in October of this year. Not so, says our old friend John Mauldin. Instead of peaking out at $55 billion worth of mortgages subject to upward adjustment in October of this year, John says the total gets bigger…reaching $110 billion worth of mortgages to be reset in March of ’08. Thereafter, the numbers go down.
Not surprisingly, a lot of housing speculators are eager to unwind their positions before the carry gets any more negative. Others wait…and have their burthens reduced, courtesy of the bankruptcy courts and foreclosure proceedings.
The U.S. housing industry may be insignificant to the worldwide economic mega-boom, but it is hardly insignificant to the U.S. economy. As we mentioned yesterday, a substantial decline in housing is like a substantial leak on a big ship. Once she starts taking on water, the whole boat sinks lower. As long as seas remain calm, she can stay afloat for a long time. But as soon as a storm brews up – it’s every man for himself.
Sauve qui peut!
*** And now comes an article in the International Herald Tribune explaining why the trade deficit is no problem. The United States exported $1.4 trillion worth of goods and services in 2004, says Mr. Michael Sesit. It imported $1.7 trillion worth. On its face, this produced a deficit of $300 billion. But many of the products it imported were actually made by U.S.-owned companies. And if you take that into account, he tells us, the picture is much rosier…the result is much less miserable than you might have thought. In fact, instead of having a $300 billion deficit, we had a $1.2 trillion surplus!
Hosanna…and yippy ti yi yay!
So, let’s see…
Ford (NYSE:F) makes a part overseas…using foreign workers…foreign suppliers…foreign factories…foreign currencies…maybe even foreign capital. It then sells the part to Americans, who send their money overseas to pay for it. Not to worry, says Sesit, because it is a subsidiary of an American company making the sale. Of course, almost all the money stays overseas too, where it is used to pay wages to local workers, pay local suppliers, pay taxes to local government, and generally boost up the local economy. Profits, if there are any, are almost certainly re-invested locally too – to hire more workers, pay more suppliers, etc.
Except for the dividends paid to the parent and distributed to shareholders – who may be foreigners themselves – neither the capital, the expertise, the tools, nor the wages paid, end up in the United States. And the dividends might be just one or two percent of sales…in other words, the real amounts measured by the trade deficit are probably 50 to 100 times the amounts represented by dividends that may or may not be paid at all, to people who may or may not be U.S. residents.
Alas, the numbers still tote up in the traditional way:
Expenses – $7 billion.
Revenues – $5 billion.
The United States runs a trade deficit of about $2 billion per day. Result – Misery.
*** The carries are turning negative in a lot of areas.
As much as $64 billion worth of leveraged buyout finance has been withdrawn in the last month. Serious speculators and investors are reluctant to take up more debt; they’ve seen what has been happening to the debt they have. Suddenly, buyers want to know what those fancy financial sausage derivatives are derived from. They want to know what the collateral is really worth…and how debtors are going to be able to make their payments. All up and down the capital structure, they’re asking questions.
“Rates rising on jumbo loans,” says the WSJ. “No Money Down Disappearing as Mortgage Option,” reports the Washington Post.
When the going was good, you could sell a mortgage or an LBO finance deal – no questions asked. The question marks only appear after something goes wrong. And then, suddenly, there can be a lot of them.
And a lot of the questions are posed by lawyers. “Are you telling us that you didn’t know what was in that CDO when you sold it to your customer?” “Do you mean you had no prior warning of any sort that there was any trouble with your hedge fund portfolio when you accepted my client’s check?” “Did you really think you fulfilled the legal requirement of full disclosure by putting the rate adjustment explanation in my client’s mortgage contract in Greek? Did you think my client reads Greek…ancient Greek at that?” “Could you explain to the court exactly how an ‘enhanced leverage credit fund’ works?”
There are a lot more trial lawyers in America than there were during the last major credit contraction. Our guess is that many of them are boning up right now – on bankruptcies, derivatives, workouts… “What’s a ‘CDO tranche’? they will want to know.
The Daily Reckoning
August 7, 2007
P.S. These market ups and downs have economic analysts across the board scratching their heads – and throwing out predictions. Here at the DR, we are much too modest to even pretend we know what lies ahead for the U.S. economy, much less the global one.
Our good buddy, Chris Mayer agrees with us here, telling his Mayer’s Special Situations readers: “I don’t try to make predictions…I just focus on trying to pick up specific situations that will do well – even in the face of market volatility.”
More on Chris’ specific situations, below…
but first, some views from Short Fuse in L.A….
Views from the Fuse:
*** This just in…
The Fed has opted to sit tight and hold the key federal funds interest rate at 5.25% for the ninth straight meeting.
No real surprise there…what everyone was really waiting for was to see what their biggest concern would be – the housing drag on the economy…the volatility in the financial markets…the subprime debacle…
As it turns out, none of the above. They still expect ‘moderate growth’ despite the aforementioned market conditions, and are keeping inflationary risks as their main concern.
“On inflation, the Fed repeated its statement from June that ‘a sustained moderation in inflation pressures has yet to be convincingly demonstrated.’ It said the risk that inflation will fail to moderate was its ‘predominant policy concern.'”
Oy…now the Fed is just recycling old statements. Well, at least it cuts down the time it takes to decipher their ‘Fedspeak.’
*** Bear Stearns (NYSE:BSC) is providing us with the kind of entertainment that we haven’t seen in quite some time…
On Friday, the 5th-largest U.S. investment firm (by market value) kicked Co-President Warren Spector to the curb. Spector was in charge of – you guessed it – the mortgage and fixed income business.
Today comes news from Bloomberg that Bear Stearns has opted to liquidate two bankrupt hedge funds in the Cayman Islands (where they are incorporated) instead of in New York (where most of their assets are).
“The Bear Stearns cases may establish a precedent that would let other failed hedge funds liquidate in the Caymans, where judges have a track record of favoring management,” reports Bloomberg. “The local monetary authority estimates that three out of four hedge funds globally are incorporated in the western Caribbean islands.”
Nice…not shady at all.
As for filing the funds’ for bankruptcy in the Caymans, where the courts are not as transparent as their American counterparts (and let’s face it, the weather’s much nicer), this ‘little stunt’ may buy them some time…but red flags are waving.
The Caymans “ought to be irrelevant,” quips Jay Westbrook, professor at University of Texas Law School in Austin, who helped author Chapter 15 of the U.S. bankruptcy code in 2005. “If a company is basically managed out of New York, then the case should be in New York.”
Of course, there will be a lot of back and forth, back and forth…we think we’ll just sit back and enjoy the show.
And in case you haven’t gotten your fill of the Bear Stearns/debt market fiasco, be sure and check out today’s guest essay, penned by long-time DR contributor, Gary Shilling. Here’s a snippet:
“The global recession that I expect to result from the spreading subprime slime, global de-leveraging and speculative bubble-breaking will benefit stocks by reducing inflation fears and thereby Treasury yields, aided by the usual Fed ease. But as is normal early in the recession, plummeting profits will more than offset those salutary effects to the detriment of stocks. Stocks at home and abroad are suggesting that worldwide problems lie ahead. Meanwhile, the leap in expected stock volatility indicates a newfound appreciation for investment risk, another drag on equities. I suspect that a full-blown bear market is starting, or soon will.”
*** “Amid the clamor over Bear Stearns and tightening credit markets, here’s an interesting note,” writes Addison today in the 5 Min. Forecast.
“At the current pace, speculative money will be pumped into start-ups this year at a rate unheard of since 2001… $7.1 billion financed 977 U.S. start-up deals in the second quarter… the most since Q3 of 2001, when venture capitalists everywhere were throwing money at flailing dotcoms.
“This time around, biotech, alt-energy, and software corporations are pulling in the lion’s share of venture capital.”
For more from Mr. Wiggin, see today’s issue of The 5 Min. Forecast.
*** And what exactly are these ‘special situations’ Chris Mayer was alluding to above?
Well, for one, the unique investment position that the current ethanol craze has put us in. Of course, Chris isn’t suggesting you invest in ethanol…we all know what a fraud that is… What Chris proposes is that we play the profitable side of ethanol: the boom in agriculture.
Now, also spurring agricultural prices is a rising and more prosperous global population – think India and China – which means increasing pressures on grain production.
“It seems a good bet that the boom in agriculture should continue for several years yet,” says Chris. “Either governments back off on their support of biofuels or the price of oil has to come down. Or 2 billion people in China and India have to stop eating. In my view, none of these things seems at all likely in the near term.”
“So it also seems wise that investors should take this into account and look to profit from the agriculture boom’s widening effects.”
More from Chris tomorrow. Enjoy the rest of your day…
The Daily Reckoning