Chuck Ponzi June 30th, 2008

I recently had a reader pose a question to me via email and I’d like to take some time from our normal programming to see what is on his mind

Our friend, let’s call him Boomer for short, had this to ask of me:

Moved my family to La Costa area (renting) and own a house in AZ which I owe $159k at 6.5% (it adjusted and will again in 8 months) The home was at peak worth $750k now $550k I had it rented last yr for $2200 and just signed a 3 yr lease w/ new tennant for $2,400 . I have $600k in cash..Should I pay this house off?? or should I just refi it and hold on to my cash to buy here in S cal in a yr or two?

First off, I have a couple of thoughts:

1. Whoever Boomer is, he’s in a pretty good position, relatively speaking

2. Without knowing his age, I’d say Boomer is likely Early Xer or Late Boomer.

3. The most important point of all (where he wants or needs to live) is missing from the question. Don’t feel bad, many people forget this little factoid. We’ll assume that he wants to stay in SoCal.

I’ll deal with some important points:

1. What is that house in Arizona really worth long-term?

2. What should Boomer do with the cash?

3. What kind of financing makes the most sense?

What is that house in AZ really worth?

This is the question that wasn’t really asked, but needs to be answered, what is the house in Arizona worth, so we can understand what to do with the money.

Well, Arizona is a big place. It has a varied geography with beautiful vistas, scorching deserts, and some bone chilling mountains. You may not like what I have to say, but I’ll say it anyway. Your perception of the world and finances is the boiled frog syndrome. Not that I blame you. You’ve been raised in a world of ever decreasing interest rates and increasing asset values. The world has been kind to you.

You see, the success of many of the past 30 years (primarily the boomer cohort) is a demographic abnormality. Asset values have increased simply because of the organic demand of the Baby Boomer generation and ever increasing ability to finance that demand. In addition to this, an extremely relaxed monetary policy has increased the value of assets consistently since inflation was trounced back in the late 70s.

Unfortunately for many, that time is over.

In the short run, houses are worth what someone else is willing to pay for it, but in the long run, they are subject to the value of the next best alternative, or substitute pricing. The best substitute for owning a house is renting one. In some cases (such as short-term living), renting is almost always the clear alternative.

There are many formulas for determining the value, but one of the simplest mechanisms is the GRM (Gross Rental Multiplier). Basically, this number is used to multiply the monthly rent to arrive at a fair estimate of rental value. However, this is only a rule of thumb and is not to be taken as gospel; lower interest rates (like I expect we will see for the forseeable future) will increase the GRM, while substitutes (buildable land, locus to employment centers) will decrease it. In certain premium places like Orange County, the upper stretch might be 220 or so, while in places like Las Vegas or Arizona, a more reasonable 120 to 160 is more in line with reality. If we err on the side of optimism (150 GRM), this places the current value based on long-term fundamentals at about $360,000, leaving Boomer with a $190,000 premium over its fair value. If I were evaluating a stock, I’d say SELL! SELL! SELL! Doubly more so if Boomer had lived in the house for more than 2 of the last 5 years since he can walk away with pretty much all of the money tax free. It doesn’t matter what the market is selling at, if there is really that much of a disparity, sell that house and get your money! (of course, it doesn’t help that it was just rented, but there are always ways to let a renter go, if the price is right). At a 229 GRM, his house is badly overpriced. When it was $750K, I haven’t a clue how someone could justify that, since it would have been a GRM of 340. Holy smokes!

The future good in some ways, but bleak in other. The Southwest is largely overbuilt in nearly every city with a real dearth of extensive employment opportunities (unless WalMart is your target), and if energy prices remain elevated (not a given in my mind), the ability to pay will deteriorate along with the economy. Boomer may end up with late (or no) payments from his rental. Rentals are generally difficult to manage from a long distance and I would only advise it if you were planning on returning back to the home at some date. However, that would be hard after living in LaCosta for a few years.

In addition, a house can be valued at the cost of money to purchase it. This is a bit more detailed, but an easy rule of thumb is to take the rental equivalent, figure in future increases in rent, and discount the cash flows based on current borrowing rates. It accomplishes about the same thing as GRM, but removes the variability of borrowing rates (especially if it is held as a long-term investment). Using the inverse calculation, you could figure what the “money rent” on the current place would be given a few variables such as the “current value” and current interest rates. Given a current value of $550,000, the money rent valuation using 7% says that Boomer should be collecting about $3,700 in rent on that money. This leaves out taxes, repairs, rental expenses, vacancy, and many other options, so it is by far the most optimistic. By this reckoning, the house would have an imputed value of $357K, pretty darn close to our above $360K value. Sounds like time to sell this puppy no matter how you look at it.

As another way of thinking of it, as interest rates go down, this increases the ability to pay, but that can only increase so much since the risk of buying on low interest rates and being unable to sell into a similar situation will weigh heavily on others’ minds and prices will need to adjust to handle this uncertainty. Since demand for housing is waning as the boomer generation ages in place or downsizes (or simply dies), it is unlikely that houses will be able to continue their rich valuation long into the future without a substantial demographic to replace them with the ability to purchase.

Any way you look at it, the house is currently valued at more than it is “worth”. I can show houses in Orange County that currently have better GRMs than what this house is showing, and Orange County is one of the most overpriced locales in the US.

Tomorrow, I’ll deal with the question of what Boomer should do with his cash. Any thoughts before then?

• Bubble , Boomers , Denial , Deflation , Investing
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Chuck Ponzi June 19th, 2008

I always said we didn’t have a bubble until we had some perp walks.  These are from today thanks to Bloomberg:

Ralph Cioffi

Matthew Tannin:

The NYT has a great piece on the indictments of former Bear Stearns Fund managers.

In an April 22 e-mail from Mr. Tannin — which the indictment said was sent not from Mr. Tannin’s account at Bear Stearns, but from his personal account to the personal e-mail account of Mr. Cioffi’s wife — Mr. Tannin wrote:

the subprime market looks pretty damn ugly… If we believe the [CDOs report is] ANYWHERE CLOSE to accurate I think we should close the funds now. The reason for this is that if [the CDO report] is correct then the entire supbrime market is toast… If AAA bonds are systematically downgraded then there is simply now way for us to make money — ever.

Three days later, Mr. Cioffi and Mr. Tannin hosted a conference call for investors in the funds. This time, his tone was very different.

Lying openly like that to garner more money needs to be treated pretty harshly.  Maybe some in the securitization business can get some religion.  If not, they can always find Jesus in the clink.

• Bubble , Speculation , SubPrime
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Chuck Ponzi May 13th, 2008

This is a travesty.

No mortgage bailout! None at all! Not to striving homeowners, not to the insanely-paid CEOs. Risk has penalties too.

Here’s our typical homeowners:

Here’s the problem with CEOs:

• Bubble , Psychology , Speculation , Housing Crash
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Chuck Ponzi March 11th, 2008

Despite all that you hear and see in the headlines about rising oil and gold prices, we are about to experience the worst deflation in the history of the United States, or at least the 2nd worst after the Great Depression.

I have to write this entry because of the amount of absolute rubbish that I see printed throughout the media and repeated ad nauseum in the blogosphere regarding the money supply and how the recent fed actions are inflationary.

Even with the dramatic action today in the stock market (the last time we saw a 400 point day in the dow was mid 2002, near the depth of the last bear market), the general trend is that the market is quickly siphoning off the dollars put out via the central bank the past 8 years.

Noone now doubts that Greenspan made 2 fatal mistakes that caused the largest bubble in history. First, he brought interest rates too low and held them too long, and secondly and more importantly oversaw the most complete and utter breakdown of lending standards in history. Put together, it pumped too much debt into the system.

This debt became non-servicable from income during a time when debt should have been waning, not peaking since the largest demographic baby boomer bulge is passing into its retirement age. The sad state of affairs of most baby boomers is only a testament to the incredibly poor management of their finances until this point. Several decades of declining interest rates and ever-increasing credit has created a new age of debt serfdom where most can only hope to ever service the debt and hope it never gets called, the serf ever sickens, or misfortune visits a single household.

Put succinctly, increasing the money supply is inflation, deflation is decreasing the money supply. The accomplished blogger Mike Shedlock has made this case quite well, and the facts speak for themselves.

In the deluded minds of those pumping housing, they are hoping that actions by the FED will rescue housing. It won’t. Housing was in a bubble that was reinforced by the increase in money supply, and as long as the money supply is contracting and remaining contracted, we not see a return to the insane days of lending we have seen the past 7 years. This is deflation. Assets going down in value. Housing, stocks… even commodities should be declining. Which brings us to the next bubble… commodities. It was only a matter of time; and frankly I haven’t a clue as to how long it will last. But it’s not ready to pop yet. We are just now getting the first whiff of a bubble; and there will be plenty of time for commodities apologists to scoff it off and disprove recent price action, but let’s not forget the fundamentals… commodities are priced between the cost of production plus normal profits and the cost of alternatives. Gold, corn, rice, sugar, even oil has alternatives, and let’s be honest… we have departed from these fundamentals. It costs approximately $400 to produce an ounce of gold. It costs approximately $4 to produce an ounce of silver. We have all gone mad in the search for the next place to put our dollars. We are living in an inflated world where stocks and housing are no longer considered safe havens after the last 2 bubbles have popped, yet commodities are just warming up.

But, let’s not forget that even with the bubble forming in commodities, it does not yet have a complicit Federal Reserve bank… borrowing for precious metals is much more difficult than leveraging equity in a house or margining stocks; and there are few takers to lend the money in that kind of speculation.

I predict this next commodities bubble will be much shorter than the last 2 and more violent to the participants.

Disagree below.

• Bubble , Inflation , Deflation
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Chuck Ponzi August 9th, 2007

This was the headline of some financial reasearch issued by Joseph Hargett of Schaeffer Research on March 27th, 2007.

I’ll let you decide how prudent that advice was by viewing the top homebuilders’ stocks from that date until today measured against the S&P 500.

I’m predicting that even with all of the price declines, I believe there’s still a lot more.

Here is what Joseph had to say:

It seems you can’t talk about the housing sector these days without mentioning the “S” word. Subprime, yes I said it, has even wormed its way into the vernacular of many Fed watchers and Fed members - not to mention the warning shots fired from the sidelines by former Federal Reserve chief Alan Greenspan every other week or so. This morning, the Fed sounded yet another gloom and doom note for the housing sector, as Sandra Braunstein, the director of the Fed’s division of consumer and community affairs, stated that borrowers could see “more difficulty” in the next one to two years. In particular, those borrowers with recently originated adjustable-rate mortgages are likely to experience more delinquencies and foreclosures, Braunstein said.

and

Admittedly, the situation is not very flattering for the U.S. housing market. However, I think that the hype over the popping of the so called “housing bubble” is being overplayed just a bit too much. Just take this quote from a March 18 New York Times article titled “On the Homefront”: “In many quarters, Greenspan was essentially accused of cheating the country out of the depression we deserved: instead of allowing the swooning Nasdaq to bring down the United States economy and punish us for our sins, he had rolled the tech bubble into a housing bubble and allowed the party to go on.”

Blaming Greenspan seems convenient at this point, especially with Bernanke’s Fed in a holding pattern. And comparing the “Dot-com” bust to the current situation in housing seems rather irresponsible. After all, betting on virtual real estate seems a far cry from betting on housing prices and “real” real estate. I mean, can you really compare the long defunct Pets.com and WebVan to Lennar ( LEN: sentiment, chart, options) and Hovnanian (HOV: sentiment, chart, options) ?

I have sat on this article for 5 months to see if my research was right on where they were headed… in an effort to dispel any myths. He was dead wrong, and worse than that, revealed poor research on the underlying fundamentals of the housing problem. It is and still is an affordability crisis. The decline in sales will not abate until that affordability standard is reachieved. At current course and speed, that won’t be for another 2 years at the minimum.

I believe that we will still see some of these builders declare bankruptcy (ch 11) before this bust is through.

• Bubble , Mean Reversion , Inventory , Housing Costs , Contrary Indicators , Housing Crash
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Chuck Ponzi May 11th, 2007

Remember the good ‘ol days when Subprime was “contained” and we were all just lauging at all of those people with bad credit who were going to lose their homes while we with good credit were sipping Mint Juleps and smoking cigars? Those were the days, right?

How fast a month passes. Impac just created a massive earnings crater.

Impac Mortgage is an Alt-A lender.

If you’re not sure what that means… it’s basically people with good credit, but can’t qualify for traditional loans due to “unreported income” (aka wink, wink, nod, nod)

While the reality could conceivably not be as bad as it now seems, their book losses this quarter were $112M. Which, by most peoples’ standards, is a lot of money (except rich people who own homes in SoCal) However, much of that loss is a book write-downs. The big question is, does it get better from here on out for them, or worse? Does the future hold more, or less write downs?

It is important to remember that in the heyday (just months ago), bubble bloggers everywhere stated that loan loss reserves were incredibly low. Making up for the difference is going to be painful for current shareholders.

• Bubble , Credit Bubble
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Chuck Ponzi April 20th, 2007

Now that Option One has been on the selling block for some time, it seemed like H&R Block would never be able to get out of its subprime mess. The subprime smearout has had far-reaching implications for the local economy. I think we’re all interested in how Option One’s new overlords will treat the underlings. It seems that Cerberus Capital Management has purchased Option One $300 million less than tangible net assets. Yahoo reports:

H&R Block Inc. will sell its troubled Option One Mortgage Corp. subsidiary to an affiliate of Cerberus Capital Management LP, the finance management company said Friday, in a continued shakeout of the subprime lending market.

OOMB Acquisition Corp., a newly formed company, will pay $300 million less than the value of Option One’s tangible net assets, which were valued at $1.27 billion on Jan. 31.

H&R Block will also receive an “earnout” representing half of Option One’s loan origination sales for 18 months after the deal closes, which is expected in the company’s second quarter, ending Oct. 31. The earnout is capped at $300 million.

That seems like a very expensive price for one of the worst underwriters of Neg-am products. Someone at Cerberus must think that the subprime mess is nearly blown over. I don’t think so, and I think there are significant liabilities that go along with the entire business model.

With Bear Stearn’s announcement yesterday effectively capping Neg-Am products at 110% of original value, that may prompt others to follow suit (hat-tip to Calculated Risk). I believe the cap at OO is 120%. Can someone clarify if that is wrong? **Updated**

Any way you look at it, Alt-A is beginning to show cracks. Yahoo tells us more:

Don’t expect a quick recovery from the subprime mortgage debacle.

That’s the view of well-known value investor Robert Rodriguez. A rare switch-hitter in the fund industry, he runs both a stock and bond fund: FPA New Income, a $1.8 billion fixed-income fund (one of Money’s 70 recommended funds) and $2.2 billion FPA Capital, a small value fund (currently closed to new investors), which both have solid long-term records.

Rodriguez is a contrarian who buys issues that are out of favor on Wall Street, and he keeps a sharp eye on risk. When he cannot find compelling bargain, or when he sees economic problems mounting, he lets cash build up in his portfolios. Recently, cash made up a hefty 40 percent of assets in both FPA Capital (FPPTX and FPA New Income (FPNIX.

“We see significant risks, so I’m in preservation mode,” said Rodriguez.

Topping Rodriguez’s list of worries is the collapse of the subprime mortgage market, where he first saw problems emerging two years ago. “Starting in 2004, it’s has been one of the worst mortgage underwriting cycles that I’ve seen in my career,” says Rodriguez. “Lending standards deteriorated as more and more groups got access to credit even though they didn’t qualify.”

Right now, the economic consensus is that the subprime fallout will cause only a temporary economic downturn. It’s a view that Rodriguez does not share.

“It’s still early in the cycle to know how things will turn out. But I think the notion that we won’t have a major economic readjustment is really optimistic.”

I think we all envy optimists, but optimism can be fatal if you ignore the risks and warning signs. We hope that Option One’s new owner can bring their company into some semblance of an organized entity. Good luck to them.

• Bubble , Credit Bubble , Lending Standards
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Chuck Ponzi April 2nd, 2007

Not as if everyone didn’t expect this, but New Century has filed for Chapter 11 Bankruptcy protection.

As always, I am interested in the impact on the local economy… as it is central to my forecast for Orange County’s housing debacle.

Subprime mortgage lender New Century Financial Corp. filed Monday for Chapter 11 bankruptcy protection, and said it would fire 3,200 workers, or 54 percent of its work force, to better position the company for a possible sale.

And, cutting off the arm to escape:

New Century said it has agreed to sell its loan servicing business to Carrington Capital Management LLC and its affiliate for about $139 million, subject to the approval of the bankruptcy court.

There’s not much left of this company to reorganize. Might as well make it a Chapter 7 and be done with it. I guess all we need now is to sell the new office chairs and give up the commercial office space in Irvine…

I recently heard some rumblings of how commercial RE was going to save our sorry butts in OC… not here, not now.

************************Update 04-02-2007 5:45PM**************************************

Just found out that Matthew Padilla has the inside scoop on Layoffs for New Century:

500 from Today.

I suppose many more to come.

Best quote:

Jack Kyser, chief economist with the Los Angeles County Economic Development Corp., which also covers Orange County, said buyers are interested in parts of New Century, but no one is likely interested in the brand or company as a whole.

“What do people think of when you say New Century?,” Kyser said. “There’s no value in the company name anymore.”

You can say that again. New Century has turned into a certain liability for other companies similarly named.

• Bubble , Credit Bubble , Lending Standards , SubPrime
• Comments(2)

Chuck Ponzi March 27th, 2007

There is quite a bit of contention of just how many foreclosures will be a part of the housing/credit bubble unwinding.

Here’s a breakdown of the differing theories:

1.1 Million

Americans borrowed $2.2 trillion from 2004 through 2006 in the form of adjustable loans, which start with low monthly payments that reset to higher rates. As those loans reset, 1.11 million people will lose their homes, according the study by First American CoreLogic, a firm that tracks mortgage risk for the financial services industry.

The figure is significantly less than a widely published number from the Center for Responsible Lending.

1.5 Million

As many as 1.5 million more Americans may lose their homes, another 100,000 people in housing-related industries could be fired, and an estimated 100 additional subprime mortgage companies that lend money to people with bad or limited credit may go under, according to realtors, economists, analysts and a Federal Reserve governor. Financial stocks also could extend their declines over mortgage default worries.

2.2 Million

A new Center for Responsible Lending (CRL) study reveals that 2.2 million American households are likely to lose their homes and as much as $164 billion due to foreclosures in the subprime mortgage market.

The CRL study is the first comprehensive, nationwide review of millions of subprime mortgages originated from 1998 through the third quarter of 2006.

CRL’s research suggests that risky lending practices have triggered the worst foreclosure crisis in the modern mortgage market, projecting that one out of five (19.4%) subprime loans issued during 2005-2006 will fail.

5 Million

But Ackelsberg listed that as one of the myths about subprime borrowing.

Actually only 11 percent of subprimes are made to first time buyers, he says. The majority are homeowners convinced to refinance into inappropriate loans.

The second myth is that subprimes are good credit repair products. The pitch here is that by paying a subprime for a while, borrowers will increase their credit scores and soon transfer into a prime loan. Ackelsberg says there is scant evidence that this happens very often.

According to him, the entire subprime meltdown should come as no surprise to anyone. Subprime mortgage lending was the modern equivalent of a gold rush with home equity the gold. Furthermore, even though foreclosure stats are spiking, they represent subprime loans that have mostly not yet reset.

He guesses that as many as five million foreclosures may occur over the next several years, basically saying, if you think it’s bad now, wait until all those ARMs reset.

How many will there really be? While it’s easy to say that it’s probably somewhere in the middle, that middle area is awfully large between 1.1M and 5M.

• Bubble , Credit Bubble , Inventory
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Chuck Ponzi March 21st, 2007

After today’s rousing repeat, of doing nothing, the FED is having one of its final days in the sun.

Change is afoot that has the potential to drown out any discussions of rate cuts in the future.  I’m talking about China’s currency reserves.

China will stop stockpiling its massive foreign exchange reserves, China’s central bank governor Zhou Xiaochuan said in an interview published Tuesday.

“Many people say that foreign exchange reserves in China are [already] large enough,” Zhou told the Emerging Markets magazine, whose latest issue was released at a meeting of the Inter-American Development Bank in Guatemala.

“We do not intend to go further and accumulate reserves,” Zhou said, adding the government will “cut a small piece of reserves” for a new agency to be set up for the management of its massive foreign reserves, which have swollen because of the trade surplus.

He did not say how much money would be passed to the agency.

China’s premier, Wen Jiabao, said last week that plans to form a new agency to invest part of the country’s swollen foreign exchange reserves, the world’s biggest at more than $1 trillion, would not have an adverse impact on the U.S. dollar.

Right,  I guess it all depends on what you consider “adverse impact”.  With the USD just recently testing the 80 mark and accumulation stopping, we may have a hard time selling too many treasuries the the remaining buyers.

Time to monetize that debt, baby!

• Bubble , Credit Bubble
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