Thursday, August 30, 2007

Why People Could Walk Away from their Homes even when Employed

I suddenly had a brilliant idea. Bulls on housing say that as long as people have jobs, they will keep paying their mortgages. But suppose the price of my own falls by, say 10%. Then, it might be better for me to walk away from the mortgage on that home, and buy the same home at 10% lesser price. My decision will depend on how much equity I have built into my previous home, as there will be penalties associated with walking away from my old mortgage. Plus, because of my now suspect credit history, my new mortgage might be at a higher interest rate. But, at a certain level of decline in the price of my old home, that could be a worthwhile tradeoff. So the rate of home price decline could be a more important variable than the rate of employment.

There is an entire category of people in the US who have very little equity in their homes today - they took option ARMs in the last 2 years. Why shouldn't they let their house go into foreclosure - whether they are prime or subprime, and whether are employed or not - when the ARMs reset in the next year or so?

In 1988 in Japan, people used to take 3-generation mortgages to pay off the loan on their house. Thereafter, real estate prices collapsed by 50% (or 30% or 80%, need to check on this). Why didn't people just walk away from their loans? Maybe they did. And banks became insolvent because of the NPAs. But because of the guarantee of the Japanese government, there were no failed banks. That is what maybe commentrators mean that Japanese just prolonged their agony by supporting their banks.

The Federal Reserve Policy - from here

That the Fed will cut on Sep 18 is a certainity - Fed doesn't like surprising markets. The question is - will Fed cut down all the way to 4.50 by the end of the year?

The Fed wants to balance growth and inflation. Growth is equivalent to reduction in unemployment.

Right now, the trouble in the real economy is in the housing market. Still, unemployment rate has remained low at 4.6%. At its August meeting, the Fed cut its outlook for growth for 2H by 25bps, without changing its inflation outlook, because of lower productivity gains (I predicted this correctly What this implies is that if Fed cuts too much and ends up stimulating the economy, growth could be above trend and lead to unemployment rate remaining where it is (or decline). This could worsen inflation over time. Recall that after Sep 1998, Fed cut by 75 bps, and that was enough to start the tech bubble.

Has what happened last month increased the chances of higher unemployment going forward? That is the only reason Fed should cut substantially. I don't know the answer to that. Unless Fed is convinced that unemployment rate is headed to 5%, they shouldn't cut substantially.

What is happening in US is interesting. Is it possible that strong exports to a strong world economy offset weak domestic growth in US? Then you might continue to have strong employment.

Another issue is this - the current problem is in the asset backed commercial paper market, where investors don't trust assets underlying some of the conduits. Even if Fed cuts rates, these mortgage backed assets are not regaining investors confidence anytime soon, because of the suspect credibility of their ratings. It is very likely that more rating downgrades by S&P, Moodys are on the way - $120bn of subprime ARMs are being reset this qtr and next. So some other AAA CDOs are going to 0. Investors are already looking at the scenario and refusing to rollover the CP backing these securities. So the Fed could cut rates by 25 bps, and CP market could continue facing issues.

Monday, August 27, 2007

Am I wrong?

Am I wrong in being too bearish on the market? That markets have gone up in the last week after Fed cut its discount rate was expected. But is this crazy?

Markets are not stupid. Last year too in late July, markets started moving up after Ben Bernanke's testimony to the Congress, when the Israel-Palestine war was still on and oil was going crazy, and people were worried that Fed would raise interest rates again. Is it that even this year, a bottom has been set amidst the chaos, and markets are going up from here.

Why should one be bullish?

a) Fed will cut rates on Sep 18.
b) Global growth remains strong. This will be enough to offset any weakness in US housing.
c) US I-banks are well capitalized and they will be able to withstand the loan losses on the financing deals with PE players. All this deal financing issue is a temporary hiccup, and PE mergermania is soon going to be replaced by corporate mergermania and stock takeovers.

The most important question is - what will the Fed do? Will it cut or not? Lets consider the two scenarios:

Fed cuts: Considering that the 3 month T-bill is still yielding 4.5%, much below 5.25%, one can argue that credit conditions are still distressed, even though equity markets have moved up in the last week. So Fed should cut. (By Sep 18, this argument might not hold water. But lets assume Fed cuts). Markets rally on Sep 18.

However, BOJ also holds its next monetary policy meeting on Sep 18 and Sep 19. If markets stabilize by Sep 18 (and rally on Sep 18 because Fed cuts), BOJ will in all likelihood raise rates on Sep 19, after having decided not to raise it last week due to worsening global conditions.

The dollar-yen carry trade will get whipsawed on both sides. If Fed cuts and BOJ raises rates, the interest differential between USD and Yen has narrowed by 50bps - a very significant amount. The risk to unwinding dollar-yen carry trades is indeed high then.

Fed doesnt cut: Considering that Fed futures are pricing in a 100% probability of a rate cut, markets will surely dive if Fed doesn't cut.

Considering Fed doesn't like to surprise markets, I think a Fed cut is certain, simply because Fed futures are pricing in 100%. It will not help Fed's credibility if they say we are not cutting, markets seize up again, and they end up again lowering the discount rate or the Fed funds rate.
But one can also argue Fed won't cut. Things have only improved since they cut the discount rate. So then why should they cut the Fed funds rate? It is very tricky this time.

But whatever they do, I think there is a high likelihood that markets get whipsawed on Sep 18 and Sep 19.

Over the next 1 year, I think the US housing market will take its toll. This is US housing - the biggest category of US aggregate wealth. It will have lost 10% of its value by next year. Why will this deflation not spread to other asset classes? With a lot of mortgage bankers in bankruptcy now, the fight for market share has gone down => crazy mortgages are gone. Plus rates just went up in August - the impact of which is going to come after a few months. I dont think a 25 or 50 bps cut by the Fed will save housing from here. The Fed needs to cut steeply if it has to save housing. But that will risk inflation and declining dollar.

Maybe I am wrong and it will all turn out to be fine. After all, the people at Fed have spent their lives with this stuff, while I have been reading this only in the last 3 years. Lets see how this evolves.

Monday, August 20, 2007

From Excess Liquidity to Credit Crunch.. Gone in 2 weeks

The last week I was on vacation in France and Switzerland. I found a nice castle to get married in France next year, of which I have forgotten the name. I will post the link as soon as I remember.

A lot of drama happened in the markets when I was away, especially last week. Please read WSJ to get more details. And the Fed cut its bank lending rate by 50bps on Friday, because of which all the markets are up today.

A lot of pain of recent days has been on the quant funds. Some of them seem to have become even for the year (esp. AQR, Renaissance) after the jump in the last 2 days. They have all been delevering for sure. But overall in the long run, quant funds will make money, unless they are so overleveraged that they go under when markets make 5 std deviation moves against them. Goldman will make money on the $2billion it put in its quant fund for sure.

I think the next issues would be these -

(a) Are all the hedge funds and money market fund blowups over? It is the money market fund blowups (which were holding AAA rated sub-prime paper) that has shaken investors, who are now questioning the very credibility of AAA rating. And if investors ask higher returns to hold the AAA paper, it implies credit spreads have widened. All this credit crunch is more of a ratings credibility issue than anything else.

(b) What happens to the $300 bn+ LBO financing coming up in the next few months? In some cases, offers will be revised down, like with Home Depot supply chain sale. In others, PE and I-banks will take a hit.

(c) What are the quarterly results for I-banks? Note that some of them operate on Aug-end quarter, and almost half of the quarter would have virtually no I-banking/debt market activity. The big question would be - how did the prop trading desks of the banks do? This is where the Mogans and Goldmans of the world have been minting money over the years. Were their traders smart to make money even this time?

(d) And the most important of all - will the Fed really cut rates on or before Sep 18. And how much will it cut? The Fed has not cut rates on Friday - it has lowered the rates at which banks can borrow directly from it (which is now 50bps higher than its fed funds rates, in normal times nobody borrows from the Fed as it is considered a sign of weak credit). So homeowners are still squeezed in US - their rates are determined by the Fed Funds rates.

(e) If the Fed has to cut a lot to stabilize the markets, dollar would depreciate sharply because capital will flow out of a low interest bearing currency. Or it could appreciate if investors seek safety of US treasuries. Or it can remain stable because both these effects offset. And how does this impact other currencies (Yen, Euro) - I have no idea. This could turn into a currency crises, or it may not. Note that Australian Dollar and NZ currency had their biggest declines last week as investors unwound carry trades.

I still think that there will be a lot of volatility in the markets, and a better time to invest would come probably next month. As somebody said, people have lost more money catching the first 5% move than they made in next 95% move. I will wait and not invest in the first 5%.

Friday, August 10, 2007

Going into unchartered territories

The ECB and Fed injected liquidity into the markets today. ECB allowed european banks to borrow close to 100 billion euros. Reason was that liquidity pressures developed in the call money market, and call rates moved up significantly higher - above the European fund rate. This is almost like a run on a bank. This happened because BNP Paribas lost money in 3 of its money market funds today due to AAA rated subprime blowup. Is my money in Vanguard money market accounts safe??

With this, I think we enter unchartered territories. Risk spreads are not going back to last months levels in a lifetime. I don't know where markets are headed in the next 2 months. But they won't be where anyone expects them to be. This is going to be the best learning experience that I have so far had. Will the Fed cut? How deep will the turmoil be? Will it impact economic growth?

Tuesday, August 07, 2007

Fed Meeting

It was exactly a year ago that Fed stopped raising rates. And perhaps this meeting is as crucial as that one for the outlook of markets over next few months. For, at both times, markets were pretty rocky just prior to the meeting.

Some people expect the Fed to change its language to signal risks of inflation and growth are now evenly balanced, vs inflation being a primary worry of the Fed till last meeting. After all, housing has been much worse than expected.

Question is: what level of growth is the Fed comfortable with? Recent revisions to historical data suggest productivity growth in last 3 years was slower than earlier reported. If productivity growth is lower, then the economy's growth potential is also lower. So while 2H growth outlook has come down following housing decline, this might now fit with the new reduced growth potential of economy.So the risks could still be towards inflation. But a few data points on productivity don't make a trend.

I am sure Fed will not move to neutral simply because of recent market volatility. While troubling, it is hardly a systemic threat. True some lenders and funds have blown up, but it is not the job of Fed to prevent every small $500 million blowup. True credit markets are seized up, but this is not LTCM with 6 sigma credit spreads. Credit spreads right now are more in line with historical averages. They are wider compared to where they should be because of low bankruptcy rate today.But they are not in unchartered territory.

A true test of whether risks are really dispersed enough globally would be to not intervene in the market and see how it plays out. One should also recall that Fed tightened in summer of 2000 when internet bubble burst, and didn't intervene till fall 2000. I vaguely recall Greenspan saying somewhere that we should let hypothetical bubbles build and if real, clean up the bubble after it has burst, rather than preventing a hypothetical bubble forming in the first place, as it might not be a bubble. If Fed signals it will be cutting rates, it would have let a bubble build and prevented it from a hypothetical bursting.For all the hue and cry of the last 2 weeks, Dow is off just 5% off its peak.

Friday, August 03, 2007

Why India Should Raise Capital Gains Taxes?

I think I found the perfect answer to two problems facing India.

a) Widening disparity between rich and poor
b) Currency appreciation because of huge capital inflows

Simple. The government should increase long-term capital gains taxes from the stupidly low 0%. Which country in the world has these kind of taxes? Manmohan Singh complaints that CEOs are making 5 crore in salary. They have made much more through stock appreciation. True stock markets will take a hit, and true that capital will flow out suddenly. But I think a 10%-15% capital gains tax is justifiable and can be justified to investors. It is better than the capital controls that RBI hinted to in its credit policy and which would really hurt investor sentiment towards India.

If Democrats seize power in next year's Presidential elections, expect a tax hike in US too. I also figured out the debate over taxes that PE pays. Currently they pay capital gains taxes (15%) on the gains they make by buying and selling companies. Some people are now arguing that since it is the job of PE guys to buy and sell companies, the gains should be considered as income and taxed at income tax rate (35%), rather than capital gains tax rate. I am in the camp of higher tax rates to lower income disparities. I think government is a better circulator of wealth than PE guys through their charities (the argument being made by PE guys as to why they shouldn't be taxed highly). The assumption, of course, that I am making here is that a equal society is better than an unequal one.

Thursday, August 02, 2007

August Blues

So finally, we have entered the period of volatility that I had been expecting since March. Considering that S&P is up 3% for the year while I have made 2.5% in my bank account (in dollars), cash hasn't been that bad.

But still, the major markets of the world are only 5% off their peaks. That's a very minor correction, considering that we have been up 30% since last july, from the day of Bernanke's testimony in congress in 2006, and the end of Israeli-Palestine conflict.

Yesterday, the Dow rallied by about 250 points in the last 20 min of trading, after having been down as much as 100 points. Clearly, this kind of volatility is unsettling.

The Fed meets next week. If they as much mention that they are aware of the turmoil in the credit markets, markets will rally in anticipation of a rate cut. What would be best is markets keep oscillating around current levels for next week, Fed again says that inflation is still a concern, and markets correct after that.

Then after 15 Aug, we enter hurricane season. I wouldn't be surprised if oil jumps to 85 this time. At least one hurricane always goes by Gulf of Mexico. If that were to happen, markets will shake, on concerns of declining consumer spending.

And finally, BOJ meets on 22 Aug. After the defeat of the ruling party in recent elections, I am not sure how they are thinking and whether they will raise rates. But if they do, that would be the really big headwind facing the markets.

I am convinced markets will end up 10% for the year. I am also convinced that a better entry point will occur in mid september.