When I was a young trader, there were two calls you wanted to avoid: one was from the risk department, which usually was more of a suggestion, than an order--“we’d like to see you trim that position a bit”. The other call was a direct request: “please deposit additional funds in your account or we will sell some of your positions so that your margin account complies with the rules.” I have never received a margin call in my life, but I have to imagine it does not feel too good.
We are discussing margin, the ability to trade your account using borrowed money, or leverage, because yesterday investors who may never have opened a margin account in their lives were affected by it. News emerged that two large investors, Carlyle Capital and Thornburg Mortgage had missed recent margin calls. The news triggered a chain reaction, as investors considered that other similar firms could be facing the same problem, which would mean a forced liquidation of already-depleted positions to meet margin obligations.
The numbers were ugly: the Dow plunged 214.60 points, or 1.8%, to end at 12,040.39; the S&P 500 fell 2.2%, or 29.36 points, to close at 1304.34, the lowest close for the broad market measure since Sept. 22, 2006--the S&P 500 is down 11% this year and is 17% below its record close last October; and the Nasdaq tumbled 2.3%, or 52.31 points, at 2220.50, down 16% for the year and is 22% below its October high–and officially in a bear market. What is occurring for some companies is similar to what may be happening to your neighbor who overreached on his real estate exposure when interest rates were low. The process is called “deleveraging” and it means that folks need to shake off one heck of a hangover!
When credit was easy, the punch bowl was full of delicious loans. Some used that cheap money to buy condos in Florida, while others, like hedge funds, used it to enhance their returns. As the punch bowl was drained, the aggressive real estate maven could not find a buyer in sight, while the hedgie had to deal with declining asset prices and margin departments who are not interested to wait and see whether markets correct back in the favor of the funds. Forced sales are now occurring on a daily basis.
I have seen the deleveraging process before and it is not pretty, but it is a necessary component to recovery—kind of like sleeping off that hangover. Hopefully you are in a well-diversified portfolio that can withstand the swirling winds. And if you are like me, you never partook in the party in the first place, which means that you did not get drunk last night, but you sure feel pretty good today.
Saturday, March 8, 2008
Thursday, March 6, 2008
Stag-Baby
Yesterday, the Fed released its beige book, a summary of economic activity prepared for use at the central bank's Federal Open Market Committee meeting set for March 18. The report suggested that the US economy is slowing in growth amid upward price pressures. The Beige Book only confirmed what many are worried about: STAGFLATION.
Stagflation is so emblematic of the seventies that I feel like we should don some groovy “Whip Inflation Now” pins on our cowl-neck sweaters as we discuss it. Stagflation has become the newest worry to plague the investment landscape, so its time to parse the word and understand whether we need to really become alarmed about the prospects of stagflation today.
“Stagflation” describes the condition of slow economic growth (usually highlighted by relatively high unemployment) - a time of stagnation - accompanied by a rise in prices, or inflation. You may think, “Well, we have the slow growth part and the rising price part, so we must be staring down a pretty nasty barrel.” Before getting too crazy about the situation, it is important to note that today’s “stagflation” while serious, is far different than the 1970’s variety.
One way to evaluate where we are today vs. in the seventies is to analyze the “misery index” -- only in economics could there be such a number! The misery index is the sum of the unemployment rate and year-over-year inflation, weighted by the GDP. The index hit a record of 22% in 1980, while this past January, the index weighed in at 9.2%, below the recent high of 9.8% in September, 2005. Clearly we are not near the historically nasty levels and of course, the seventies stagflation was exacerbated by the imposition and subsequent lifting of wage and price controls.
On the “flation” side of the equation, today there clearly is an upward shift in the real price of commodities, causing big pressure on inflation and downward pressure on growth. But this could be a temporary situation. As the economy cools, it takes time for the unemployment rate to rise and commodity prices to ease. As Greg Ip noted in the Wall Street Journal on Monday, although there is great fear surrounding the prospect of recession combined with inflation, “history suggests the two almost never happen at the same time. And that explains why the U.S. Federal Reserve, for now, has chosen to focus on the first threat rather than the second.”
To some extent, the Fed is betting that the current spike in prices is temporary. Last week, Ben Bernanke said that “inflation could be lower than we anticipate if slower-than-expected global growth moderates the pressure on the prices of energy and other commodities or if rates of domestic resource utilization fall more than we currently expect.” In order for the current inflation to become a larger problem, the idea of rising prices must become part of consumer and business expectations and thus far, those expectations have not increased too much. One final word: according to the WSJ, “inflation did fall after the recessions of 1969-70, 1973-75 and 1980.” Perhaps you need not find those platform shoes, Nehru jackets or bell bottom pants!
Stagflation is so emblematic of the seventies that I feel like we should don some groovy “Whip Inflation Now” pins on our cowl-neck sweaters as we discuss it. Stagflation has become the newest worry to plague the investment landscape, so its time to parse the word and understand whether we need to really become alarmed about the prospects of stagflation today.
“Stagflation” describes the condition of slow economic growth (usually highlighted by relatively high unemployment) - a time of stagnation - accompanied by a rise in prices, or inflation. You may think, “Well, we have the slow growth part and the rising price part, so we must be staring down a pretty nasty barrel.” Before getting too crazy about the situation, it is important to note that today’s “stagflation” while serious, is far different than the 1970’s variety.
One way to evaluate where we are today vs. in the seventies is to analyze the “misery index” -- only in economics could there be such a number! The misery index is the sum of the unemployment rate and year-over-year inflation, weighted by the GDP. The index hit a record of 22% in 1980, while this past January, the index weighed in at 9.2%, below the recent high of 9.8% in September, 2005. Clearly we are not near the historically nasty levels and of course, the seventies stagflation was exacerbated by the imposition and subsequent lifting of wage and price controls.
On the “flation” side of the equation, today there clearly is an upward shift in the real price of commodities, causing big pressure on inflation and downward pressure on growth. But this could be a temporary situation. As the economy cools, it takes time for the unemployment rate to rise and commodity prices to ease. As Greg Ip noted in the Wall Street Journal on Monday, although there is great fear surrounding the prospect of recession combined with inflation, “history suggests the two almost never happen at the same time. And that explains why the U.S. Federal Reserve, for now, has chosen to focus on the first threat rather than the second.”
To some extent, the Fed is betting that the current spike in prices is temporary. Last week, Ben Bernanke said that “inflation could be lower than we anticipate if slower-than-expected global growth moderates the pressure on the prices of energy and other commodities or if rates of domestic resource utilization fall more than we currently expect.” In order for the current inflation to become a larger problem, the idea of rising prices must become part of consumer and business expectations and thus far, those expectations have not increased too much. One final word: according to the WSJ, “inflation did fall after the recessions of 1969-70, 1973-75 and 1980.” Perhaps you need not find those platform shoes, Nehru jackets or bell bottom pants!
Wednesday, March 5, 2008
Borrower SOS
In 1976, the average first-time homebuyer down payment was 18%. According to the National Association of Realtors, from mid-2005 to 2006, the median down payment was TWO PERCENT, with almost half of first-time buyers putting down nothing at all. In essence, that is the crux of our problem today: buyers and lenders alike got caught up in the housing euphoria and became lazy.
Yesterday, the Senate Banking Committee wanted answers: Did banks know how much risk they were taking? Did they know how much capital would be needed if things went downhill in a hurry? Did they prepare for the possibility that the esoteric mortgage-backed products that were created might not be easily convertible into cash when things got ugly? The answer to these questions is that of course banks understood risk in the abstract, but the reality is that few can fully project what will occur when the risk comes home (sorry for the pun!) to roost.
But that’s the past and now this country faces some difficult choices about the future: with an estimated 15 million homeowners owing more on their mortgages than their homes are worth, lawmakers contend that we may not be able to afford to wait for the ugly process to play itself out without intervention. Is this fair to the folks who patiently waited to accumulate a 20% down payment before jumping into the real estate market? Not really, but the housing problems of a few have the potential to drag all of us down, so its time to come up with a game plan. To some extent, the Senate hearings are supposed to help with the process.
I get a sinking feeling in my stomach when I consider a government bailout, but Sen. Chris Dodd, chairman of the Banking Committee, seems intent on creating a federally financed rescue effort for the nation’s housing woes. It is unclear what form the effort would take, but Mr. Dodd claims that the voluntary industry plan backed by the White House isn't going to do the job. “Hope Now (the industry plan) does not have the resources or capacity to deal with the sheer size of the problem that has millions of Americans in financial dire straits.”
Treasury secretary Paulson has resisted a major bail-out, noting that “our efforts are best focused on helping homeowners who want to stay in their homes.” Meanwhile, Fed Chairman Ben Bernanke, speaking at the Independent Community Bankers of America conference yesterday said the current turmoil in the housing market "calls for a vigorous response…Efforts by both government and private-sector entities to reduce unnecessary foreclosures are helping, but more can, and should, be done." Like it or not, I think we are headed towards more government meddling. After all, I can’t help but get the feeling that the guys who created Sarbanes-Oxley after the tech bubble burst are not going to sit idly and wait for a market-based solution.
Yesterday, the Senate Banking Committee wanted answers: Did banks know how much risk they were taking? Did they know how much capital would be needed if things went downhill in a hurry? Did they prepare for the possibility that the esoteric mortgage-backed products that were created might not be easily convertible into cash when things got ugly? The answer to these questions is that of course banks understood risk in the abstract, but the reality is that few can fully project what will occur when the risk comes home (sorry for the pun!) to roost.
But that’s the past and now this country faces some difficult choices about the future: with an estimated 15 million homeowners owing more on their mortgages than their homes are worth, lawmakers contend that we may not be able to afford to wait for the ugly process to play itself out without intervention. Is this fair to the folks who patiently waited to accumulate a 20% down payment before jumping into the real estate market? Not really, but the housing problems of a few have the potential to drag all of us down, so its time to come up with a game plan. To some extent, the Senate hearings are supposed to help with the process.
I get a sinking feeling in my stomach when I consider a government bailout, but Sen. Chris Dodd, chairman of the Banking Committee, seems intent on creating a federally financed rescue effort for the nation’s housing woes. It is unclear what form the effort would take, but Mr. Dodd claims that the voluntary industry plan backed by the White House isn't going to do the job. “Hope Now (the industry plan) does not have the resources or capacity to deal with the sheer size of the problem that has millions of Americans in financial dire straits.”
Treasury secretary Paulson has resisted a major bail-out, noting that “our efforts are best focused on helping homeowners who want to stay in their homes.” Meanwhile, Fed Chairman Ben Bernanke, speaking at the Independent Community Bankers of America conference yesterday said the current turmoil in the housing market "calls for a vigorous response…Efforts by both government and private-sector entities to reduce unnecessary foreclosures are helping, but more can, and should, be done." Like it or not, I think we are headed towards more government meddling. After all, I can’t help but get the feeling that the guys who created Sarbanes-Oxley after the tech bubble burst are not going to sit idly and wait for a market-based solution.
Tuesday, March 4, 2008
Bubble Task Force
“How a Bubble Stayed Under the Radar” was the headline in the New York Times business section this past Sunday (3/2/08). The esteemed Yale professor of economics and finance Robert J. Shiller said “One great puzzle about the recent housing bubble is why even most experts didn’t recognize the bubble as it was forming.” After reading this, I shouted, “YOU HAVE GOT TO BE KIDDING ME!!!”
Dr. Shiller described why many smart people (including former Fed Chairman Alan Greenspan) get caught up in bubbles because seeing “only the prospect of outsized investment returns, they will pursue those returns with disregard for the risks.” This behavior has much to do with the fact that people are human beings, “subject to emotional reactions,” and are often led astray by information that they believe to be “expert”. That’s all well and good, but why do people who are confronted with a contra-argument throw their lot in with the bubble?
I pose this question after reviewing my past articles about mortgages and housing. On February 24, 2004 (“In the Merry ole Land of Oz”), I compared Alan Greenspan to the Wizard of Oz and warned that the Wizard’s advice of using an adjustable rate loan, could lead to “real problems of credit card defaults, foreclosures, repossessions and a litany of unfulfilled financial goals.” That was in 2004 when the bubble was just starting to form and so I did not take it personally that many scoffed at my point.
By 2006 as the froth had morphed into mania, I tried to sound the alarm bell. On January 20, 2006 (Homeowners’ Revenge), I wrote: “There is nothing like a bull market to make an industry of excess…like every other mania, a correction is never too far off. Tulips, stocks and now it’s time for the homebuilding and construction market to come back from the stratosphere…There have been many signs that the housing market is cooling off.” On March 1, 2006 (Is it here yet?): “For some time, experts, analysts and plain old regular folks have been expecting the end of the housing boom…it looks like we are indeed seeing the end of the awesome streak for home sales in the US…the writing appears to be on the wall: the housing market is undergoing a gradual shift away from the manic pace of the past five years.” How much clearer could I be when I said the following on May 25, 2006 (Cinderella at the Housing Ball)? “Like any speculative bubble, the housing bubble will end—the way it will end is unclear right now. Unfortunately, for those who viewed real estate as a way to make quick money (perhaps to replace losses experienced from their stock portfolios!), it may end badly.”
I go back in history not to point out that I was right, because I wasn’t exactly right—I was a bit early in my call about the housing bubble. But here is some news from your friendly correspondent on the Bubble Task Force: the action that we are currently seeing in commodities has many of the signs of a bubble…we may not be there yet, but I sure do recognize many of the tell-tale signs.
Dr. Shiller described why many smart people (including former Fed Chairman Alan Greenspan) get caught up in bubbles because seeing “only the prospect of outsized investment returns, they will pursue those returns with disregard for the risks.” This behavior has much to do with the fact that people are human beings, “subject to emotional reactions,” and are often led astray by information that they believe to be “expert”. That’s all well and good, but why do people who are confronted with a contra-argument throw their lot in with the bubble?
I pose this question after reviewing my past articles about mortgages and housing. On February 24, 2004 (“In the Merry ole Land of Oz”), I compared Alan Greenspan to the Wizard of Oz and warned that the Wizard’s advice of using an adjustable rate loan, could lead to “real problems of credit card defaults, foreclosures, repossessions and a litany of unfulfilled financial goals.” That was in 2004 when the bubble was just starting to form and so I did not take it personally that many scoffed at my point.
By 2006 as the froth had morphed into mania, I tried to sound the alarm bell. On January 20, 2006 (Homeowners’ Revenge), I wrote: “There is nothing like a bull market to make an industry of excess…like every other mania, a correction is never too far off. Tulips, stocks and now it’s time for the homebuilding and construction market to come back from the stratosphere…There have been many signs that the housing market is cooling off.” On March 1, 2006 (Is it here yet?): “For some time, experts, analysts and plain old regular folks have been expecting the end of the housing boom…it looks like we are indeed seeing the end of the awesome streak for home sales in the US…the writing appears to be on the wall: the housing market is undergoing a gradual shift away from the manic pace of the past five years.” How much clearer could I be when I said the following on May 25, 2006 (Cinderella at the Housing Ball)? “Like any speculative bubble, the housing bubble will end—the way it will end is unclear right now. Unfortunately, for those who viewed real estate as a way to make quick money (perhaps to replace losses experienced from their stock portfolios!), it may end badly.”
I go back in history not to point out that I was right, because I wasn’t exactly right—I was a bit early in my call about the housing bubble. But here is some news from your friendly correspondent on the Bubble Task Force: the action that we are currently seeing in commodities has many of the signs of a bubble…we may not be there yet, but I sure do recognize many of the tell-tale signs.
Monday, March 3, 2008
“That Party is Over”
Here is a most unpleasant fact: February was the fourth consecutive losing month for US stocks. After trying to rally in the beginning of the week, investors could not get out from underneath the deluge of bad news, whether it was disappointing results from financial giant AIG, tech bellwether Dell or flat out fear over exploding commodity prices. Many threw in the collective towel on Friday, hoping that a weekend would soothe their frayed nerves.
Perhaps you thought that you would dive into the financial news with words of wisdom from billionaire investor Warren Buffett, who released the much-anticipated annual letter to Berkshire-Hathaway shareholders late Friday. Mr. Buffett is not only known for his investment acumen, but his wonderful cheeky investor letters. You have to love a guy who comes right through the front door and says “that party is over” for the insurance business. (Berkshire posted an 18% drop in fourth-quarter net income on lower investment gains and a drop in insurance underwriting fees.)
If these are trying times even for the most sophisticated investors like Mr. Buffett, how are the rest of us mere mortals expected to weather the storms? When I find myself confused about a situation, I return to the basics about financial markets. The most important thing is that it is nearly impossible to determine the true inflection point of a market or economic move. That means that you should probably stop trying to figure out the top or the bottom and be content with simply making the most informed allocation decisions based on the information that you have.
The next thing that I always do is to constantly test my thesis. If you are feeling wildly optimistic or down-in-the-dumps pessimistic, find someone who can articulate the exact opposite opinion that you hold and listen to him/her! Markets are not static, they evolve and there are people who may see the landscape differently than the way you have surveyed it. Be willing to weigh the contra-argument to yours and allow yourself to say, “what if he is right and I am wrong? How would my portfolio perform if his thesis plays out?” You may actually find yourself reducing/increasing risk based on this process.
Of course, don’t go out and blow up your portfolio just because someone says, “the world is falling apart!” because you know that there is another smart person who can argue that “everything is coming up roses.” You should constantly question your assumptions. It sure would have been great if more homeowners were able to ask, “Wait a second…what if the value of my house were to fall, not rise? Would I still want this fat mortgage?” That simple moment of introspection may have been able to prevent disaster. Just ask Mr. Buffett, who noted that the housing recession has turned into a full-fledged crisis where “a huge amount of financial folly is being exposed…You only learn who has been swimming naked when the tide goes out - and what we are witnessing…is an ugly sight.” Yes, it is ugly and indeed Mr. Buffett is correct, that party is over. Of course experience tells us that there will surely be another out-of-control bash around the corner…commodities anyone?
Perhaps you thought that you would dive into the financial news with words of wisdom from billionaire investor Warren Buffett, who released the much-anticipated annual letter to Berkshire-Hathaway shareholders late Friday. Mr. Buffett is not only known for his investment acumen, but his wonderful cheeky investor letters. You have to love a guy who comes right through the front door and says “that party is over” for the insurance business. (Berkshire posted an 18% drop in fourth-quarter net income on lower investment gains and a drop in insurance underwriting fees.)
If these are trying times even for the most sophisticated investors like Mr. Buffett, how are the rest of us mere mortals expected to weather the storms? When I find myself confused about a situation, I return to the basics about financial markets. The most important thing is that it is nearly impossible to determine the true inflection point of a market or economic move. That means that you should probably stop trying to figure out the top or the bottom and be content with simply making the most informed allocation decisions based on the information that you have.
The next thing that I always do is to constantly test my thesis. If you are feeling wildly optimistic or down-in-the-dumps pessimistic, find someone who can articulate the exact opposite opinion that you hold and listen to him/her! Markets are not static, they evolve and there are people who may see the landscape differently than the way you have surveyed it. Be willing to weigh the contra-argument to yours and allow yourself to say, “what if he is right and I am wrong? How would my portfolio perform if his thesis plays out?” You may actually find yourself reducing/increasing risk based on this process.
Of course, don’t go out and blow up your portfolio just because someone says, “the world is falling apart!” because you know that there is another smart person who can argue that “everything is coming up roses.” You should constantly question your assumptions. It sure would have been great if more homeowners were able to ask, “Wait a second…what if the value of my house were to fall, not rise? Would I still want this fat mortgage?” That simple moment of introspection may have been able to prevent disaster. Just ask Mr. Buffett, who noted that the housing recession has turned into a full-fledged crisis where “a huge amount of financial folly is being exposed…You only learn who has been swimming naked when the tide goes out - and what we are witnessing…is an ugly sight.” Yes, it is ugly and indeed Mr. Buffett is correct, that party is over. Of course experience tells us that there will surely be another out-of-control bash around the corner…commodities anyone?
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