Effor.com

It was all over the headlines yesterday - existing home sales rose 5.5% (seasonally adjusted) from August.  The median price dropped too - down 9% to about $191K.  Good news right?  It IS good news except for one minor detail absolutely no one reported.  Here it is straight from the press release that everyone’s story is from:

http://www.realtor.org/press_room/news_releases/2008/ehs_rise_on_affordability
“Compared to a fairly small share of foreclosures or short sales a year ago, distressed sales are currently 35 to 40 percent of transactions.”

Oops - it seems that foreclosures are counted as sales, and foreclosures and short sales are about 35% of all sales right now.

A short sale is where the bank agrees to the sale and take less money than you owe on the mortgage as payment in full.  For example, if you owed $100K on your house but you could only sell it for $80K, the bank would take it.  Why would they do this?  Because getting 80% of the money it better than getting none and having to go to the expense of foreclosure.  Then the bank is stuck with it and they’ll still need to reduce the price to sell it.

So a short sale cuts out the foreclosure process - but it’s the same result:  The bank didn’t get paid back in full, so they need to writedown that loan and take the loss.  Then the CDS’s (Credit Default Swaps) that were written on that loan need to be written down and taken as losses, and the “Traunches” (pieces of mortgages packaged together for resale to investors) need to be written down, then the “Super Traunches” (bundled groups of Traunches) need to be written down, etc.

Look at the example in this Wikipedia article: http://en.wikipedia.org/wiki/Tranche
(From what I’ve read, this example is a simple simple one, but it illustratates how one debt is packaged and repackaged.)

CDS’s, Traunches, Super Traunches and dozens of other alphabet soup abbreviations are all forms of derivatives, and this is why just a few percent increase in foreclosures (or short sales) can cause hundreds of billions (we’re at about $1 trillion now) in writedowns and losses.  And that’s why we’re nowhere near seeing the end of huge losses, and that’s a big reason the stock market is tanking.

To give you an idea of the size of the writedowns (losses) that need to happen, it’s estimated that the derivative market totals about $500 trillion.  The total GDP of the entire world is about $55 trillion.  These debt instruments have been repackaged and resold and repackaged and resold so many times that they total about 10 times the entire world ecomony.  That’s why Buffett (Warren, not Jimmy) called them WMD’s.  And unlike the ones in Iraq, these actually exist,and they will go off.

gk

Wow, here’s an interesting tidbit that you should keep in mind when you hear something about home sales increasing.   According to an article published in the San Francisco Chronicle today, 4 out of every 10 home sales in the state were foreclosures.

Among the California homes sold in June, 41.9 percent were foreclosure resales, compared with 6.6 percent a year earlier, DataQuick said. The Realtors group noted that sales of homes priced under $500,000 represented 67 percent of all sales, up from 40 percent.

So if you read that home sales jump (as this article also states) keep in mind how many of those sales are foreclosures.   It evidently counts as a sale when a bank repo’s your house, and then again when the bank sells it at auction or via a traditional sale using a realtor.

In other words, the number of sales may increase, but is it really increasing if almost half of the sales are fire sales because the owner couldn’t make their payments?  I know that technically these sales do count, but it’s something to keep in mind as these types of numbers turn up more frequently in the next year or two.

BTW - I tried to find the percentage of home sales nation-wide that were foreclosure sales, but I haven’t found that number yet.  I’ll add to this post later if I find it.

gk

It was quite a day today in the financial media.  I’ve read stories tonight about why it’s great for everyone that the Fed bailed out Bear Stearns, I’ve read stories about why it’s bad that the taxpayers are bailing out Bear Stearns, and I’ve read stories where I don’t think the author had a clue what he was talking about.

But one of the best of the bunch has to be an article at Minyanville.com about why the housing market is nowhere near a bottom yet.  On page 2 of the article John Mauldin has a good synopsis of the current situation.  He states:

• 8.8 million homeowners will have mortgage balances equal to or greater than the value of their homes by the end of March.
• 30% of subprime loans written in 2005 and 2006 are already underwater.
• Nearly 3 million homeowners were behind on their mortgages at the end of 2007, with 1 million at risk of imminent foreclosure.
• As of the end of last year, 5.82% (!) of all mortgages were delinquent, the highest level in 23 years.
• 0.83% were in the process of foreclosure, also an all-time high.
• When you look at just subprime mortgages, you find that 20% are delinquent (the number is rising rapidly), and almost 6% were in foreclosure.
• Finally, the average American’s percentage of equity has fallen below 50% for the first time since 1945.

That pretty much sums up the current state of the market, but he goes on to explain why it’s going to get worse.  I’ve said much of this before, but he says it better:

Mortgage lending standards became progressively worse starting in 2000, but really went off a cliff beginning in early 2005. The worst loans are those with two-year teaser rates. As the subsequent pages show, they are defaulting at unprecedented rates, especially once the interest rates reset. Such loans made in Q1 2005 started to default in high numbers in Q1 2007, which not surprisingly was the beginning of the current crisis.”

 It’s an excellent article and I encourage you to check it out if you like knowing what’s probably going to happen over the next few years.

gk

Here’s another case of someone buying more house than they could afford and now they’re whining.  According to the story “She has had to take extreme measures to pay for her interest-only mortgage of $2,500 a month.”

Let’s take a second and do the math on this.  Which is something Patricia Guerrero should have done before she bought the house.

According to the article, she made $70,000 per year - great money!  I’m assuming that was her gross pay, so let’s deduct 8% for SSI and Medicare taxes, another 15% for Federal taxes, and 9.3% (!) for California income tax according to BankRate.com.

$70,000 x 8% = $5,600 in SSI and Medicare taxes.  $70,000 x 15% = 10,500 in Federal income tax, and (assuming CA allows you to deduct Federal taxes) her CA taxable income was $53,900 x 9.3% state tax = $5,012.

Add it all up, and she had about $49,000 per year in take home pay - assuming she wasn’t putting anything into a 401K or company stock, health insurance, etc.  In other words, that’s about the most she could take home under any circumstances.

$49,000 per year is $4,083 per month.  I don’t know about you, that’s pretty good money where I come from!  But anyway, the standard rule of thumb is that your house payment should be no more than 25% of your gross pay, or no more than 33% of your take home pay.  A $2500/month house payment is way above that - it’s 43% of her gross and a whopping 61% of her take home pay!

When you factor in utility bills, a car payment or two, insurance, property taxes, etc, she couldn’t afford that house when she had a job!  Although the article doesn’t mention other bills, she almost had to be ringing up credit card debt each month just to stay afloat - kinda like banks borrowing from the Fed to stay afloat, but that’s a different topic….

To top it off, she has an interest only loan, so she wasn’t making any progress in paying down her mortgage.   But I guess we’re supposed to feel sorry for her, because now she’s broke.  To be honest, she was broke before - she was simply refusing to recognize what was staring her in the face.

Sorry, I have no pity for Patricia.  She spent more than she made for too long, and now she has to face the music.  She wasn’t a home owner, she was a squatter, and that home will be auctioned off when it goes into foreclosure.  Why should we (taxpayers) pay to bail her out of her self-made mess?

gk

From the 400 point rally today in the stock market, you’d think that the bulls are running rampant in Pamplona.  And you may be right, however….

Stocks are still down over 10% for the year.  The highly leveraged banks and Wall Street firms are still highly leveraged.  Massive amounts of mortgage backed securities - and their higher default rates coming this year and next - are looming.  When a CDO takes a 10% loss because the home owners can’t make the payments, that translates to a 300% loss on a 30 to 1 leveraged portfolio such as Bear Stearns and Lehman Brothers.  (Citigroup is also highly leveraged.)  The $2/share Fed ”take it or leave it” financed JPM buyout of Bear Stearns still needs to be approved by shareholders.  Hmmm…. How would you vote if you owned BSC?

As I’ve written before, this unwinding of the leverage in the financial markets will take quite awhile.  The longer the Fed props up failing companies, the longer it will take to hit bottom.   JP Morgan is getting a deal only because the Fed is guaranteeing $30 billion of BSC’s “assets.”  They’re not really worth $30 billion, but the Fed took that much risk away from JP Morgan.   That’s $30 billion that US taxpayers will end up spending to finance this bailout - because the underlying securities are “riskier assets.”

 A couple of weeks ago, I thought we were headed for a repeat of the Carter years and stagflation, but it’s beginning to look more and more like we’re repeating Japan’s mistakes of the 1990’s.  Low interest rates, keeping bad debt on the books (instead of recognizing the loss and getting it over with) propping up banks with fake assets on their books, etc. 

Japan still hasn’t fully recovered from the 1990’s.  I sincerely hope that we don’t continue making the same mistakes, but today’s 3/4% drop in both the discount and Fed funds rates isn’t helping.  That only serves to drive up long term inflation, and that (rather than deflation that I’m reading about) is my long term worry.

As regular readers know, I don’t try to predict short term market swings, I simply try to stay on the right side of the market during long term trends.  I don’t know if today’s action signals a turnaround or not; my gut says no - because of the reasons listed above - but my gut doesn’t make the market move.

Regardless, I don’t see any fundamental change in the long term trends of the dollar going down, commodities (especially gold, silver, corn, and oil) going up, and the broad market (especially financials) going lower.

My feeling is that the majority on the street think that the worst news is behind us; that most people are looking for a reason to buy.  They’ve discounted all the bad news and they’re ready for another bull market.  I don’t think they’ll get it just yet.

Too many firms have too much debt.  Too many firms are leveraged enough so that a small change in the base assets (mortgages in most cases) results in a huge change to their balance sheets.  One little piece of unexpected bad news will be enough to cause a dramatic sell off.  I’m talking about a sell off big enough to trigger a halt to trading. 

I think the coming upswing in the foreclosure rate (because of all the ARM’s taken out in 2005 through 2007) hasn’t been fully factored in to the stock prices of the companies that are using these mortgages as collateral on their loans. 

When people realize how little capital is propping up these companies, share prices will drop.  The dollar will drop, and commodities will rise.  Again, I have no clue what the market will be at in a week or a month.  I don’t know if commodities will be higher a month from now or not.  But I’m betting that 10 years from now, you’ll be glad you bought gold at $1000/oz, silver at $20/oz, oil at $105/barrel, etc. 

If we really are following the deflationary path Japan took in the 90’s, the Dow may well be at 7000 10 years from now.  As it stands, buy and hold investors are down from where they were 8 years ago….  How much longer do we need to prolong the agony? Take the losses now, write off the sub prime and alt-a loans, get it over with!

Of course that’s just my opinion, I could be wrong.  :-) 

gk