Alan Moore Commentary 11-1-2011

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   The first important economic thing is that we did not go into a recession in the third quarter like I thought; GDP grew at 2.5% which indicates a continuation of a sideways economy. Second, Europe has a plan, which has temporarily relieved the threat of a bank panic there and here. But, these two headlines need a further look.

     First, I see the five largest banks in the United States hold gross derivatives in excess of fifty Trillion dollars each (that is Trillion, not billion); altogether $335T(WSJ 10-3-11). They usually report only their net derivative holdings------ for example, last summer JP Morgan said it was exposed by $35 billion in net derivatives invested in European, African and Middle East paper. That could mean they are long $200B in Greek, Irish and Spanish sovereign bonds, and have sold much of that paper short at Deutsche Bank to hedge the long position. The problem with that strategy is that maybe Deutsche Bank can’t pay-off if a meltdown occurs in Europe: that is the “counter party risk” these derivative trading banks are taking with their capital and consumer deposits; leveraging 20 to 1 on a net basis, but maybe 500 to 1 using their gross exposure to those products. After all, Deutsche Bank is the biggest bank in Europe and it only has 3% in tangible equity capital leveraged against a gross amount of derivatives that it owns (equity capital is much different than the widely bantered Tier 1 capital).  Having more confidence in equity capital, I don’t think the big five’s “net exposure” strategy will contain the damage done by a sovereign default………… PIIG debt may be the least of Deutsche’s problems compared to its counter party exposure to our banks. As the satirist Tom Lehrer once said: “I’m so pessimistic I don’t even buy green bananas.”  

    Alas, the latest EU bailout plan is still non-funded. It is primarily an insurance program underwritten by France and Germany: to get the picture, imagine two guys treading water in the middle of the ocean with no boat in sight. The better swimmer manages to take off his belt and tosses one end to the other because he is sinking----------- A noble gesture, but how long can it work?  Nevertheless, the EU has put together a fast deal to save the banks and PIIG bonds that must ultimately be guaranteed by Germany to have credence-------- which will require more Euros than the German people will stand for if insurance claims arise. They look upon the Greeks as drunks and lazy, dancing fools like Zorba; they view the Italians as incompetent cowards---- an opinion originating from the Second World War. I can remember the old German joke about Italian army tanks: “they attack in only one gear, reverse”. In a conflict, no one wants Italy as an ally and eventually the Germans will “raise Cain” and say nein, nein, nein, when one-too-many bailouts are put to a vote in the Bundestag; then Merkel will let go of the belt and the rest will buckle under. But, that may not happen until late in 2012. Until then, no cash will be thrown into the deal: it just rearranges the paper trail leading back to distressed borrowers, who will become more distressed as they try and implement austerity.

     In the mean time, this is my take on how it goes: the EU agreed last week that holders of Greek debt should take a 50% haircut to align with market reality (nothing was said on how to handle Irish, Portuguese, Spanish and Italian bonds); this will force the banks to sell equity to raise capital to compensate for the write-downs, or else ask for a EURO-Fund bailout which will come in the form of a book entry, not cash. Joe Ackermann, the head of Deutsche Bank, has already widdled-down his PIIG bond holdings from 12 billion Euros this summer, to 4 billion, and he can afford to take the hit on his small 1 billion Euro Greek holdings. Although, he will never go along with buying more PIIG bonds in the market to provide a deficit bridge to solvency that may never occur ------the EU obligation to continue buying PIIG bonds to fund future deficits is the reason the plan will fail---the private sector will balk. It doesn’t make any sense to an old-school banker like Ackermann to give away the bank for political expediency; the Italian tank joke is not amusing to him and neither is “Zorba The Greek”.  Ackermann will continue to shuck PIIG debt, as attempts to achieve austerity budgets cause riots and violence in the streets. The European crisis is not over and the can is in the air: Merkel kicked it, but Ackermann will determine where it hits ground………… and Merkel will ask, “say it isn’t so Joe?”

    Rick Perry and others have been calling the social security system a Ponzi scheme lately, but it really isn’t. When the SS act was passed in 1935 it was never setup to be funded by income from investments: it was a current cash flow program redirecting a payroll tax on the working class to the disabled and retired. That is still the deal except that the benefits have been increased to the extent there won’t be enough workers to completely fund them anymore in five years or so, and because there are 30% more >65-year-olds today, than in the 1930s. In 2010, Social Security collected $781B in FICA taxes and paid out $721B, so it is still cash flow positive. In 1920, Charles Ponzi promised clients a 50% profit within 45 days, supposedly investing in discounted postal coupons in other countries and redeeming them at face value in the United States as a form of arbitrage. It was all a lie. However, the only lie today is that Social Security can continue as is without cutting benefits and raising payroll taxes; and Congress can’t tell the truth and get re-elected. With his gift for gab, Ponzi could have easily been elected a Senator and lied with impunity, in campaign ads and speeches.  Often stammering, Rick Perry is no Charles Ponzi------ he doesn’t have the gift, but he does have good posture and the temerity to follow the teachings of the great Russian mathematician Nicolai Lobachevsky with the advent of his new, flat tax proposal. When asked to tell the secret of his success in mathematics Lobachevsky said: “plagiarize and be sure to call it research”; He once gave a lecture on infinity that was said to have gone on forever: So goes Perry’s infinite tirade on Social Security.      

    Something new is happening in the housing market: listed inventory has fallen 20% nationwide because homes priced over the median are being taken off the market because they aren’t selling, and banks stopped foreclosing last spring due to the robo-signing lawsuits; therefore, there aren’t as many low-priced houses on the market now------- the ones that are really selling. Buyers aren’t blinking though; they are not buying the higher priced homes------------- and listings are off 48% in Miami for example. However, given the huge shadow inventory, once the banks get their paperwork in order, buyers sense that an avalanche of foreclosures will be coming on the market again. For that reason, I think the buyers hugging the sideline will win the standoff and home prices won’t go up in the next two years for sure; maybe not in a decade. Other things holding back the housing market are the credit requirements necessary to qualify for a loan and the low appraisals: the banks went from no-doc loans five years ago to over-doc loans now. I have never seen it so tough to get a mortgage----------a 4% interest rate or 7%; what’s the difference if you can’t qualify? Of course the National Association of Realtors (NAR) will banter the 20% fall in listings as another turn in the real estate market, but the only turn will be a fall in commissions as realtors run out of inventory that sells. Ironically, we need more foreclosures to stimulate new jobs, created by new owners fixing up dilapidated properties and applying for mortgages. Not only has the robo-signed-paperwork hindered the process, but the government’s loan modification program has turned into a Mexican standoff between the banks and homeowners. In financial circles, the Mexican Standoff is typically used to connote a situation where one side (the homeowner) wants something, like a concession of some sort, and is offering nothing of value to the other side, so the other side sees no value in agreeing to any changes (in the mortgage) and refuses to negotiate in good faith. These are hard times for underwater homeowners and banks and the only way out of the pickle is to liquidate their common problem---------just get rid of the house.
    Hard times are best faced head on, then moving as fast as you can past them. Investors take note: the rental market will only get stronger.  With that in mind: I have another contract on a short-sale in Orlando, waiting for the bank to sign off on it which usually takes 3 months. I intend to steadily buy properties over the next year, following the housing market down to a bottom; I’m betting that someday the NAR may be right. In my opinion, investing in the stock market at its current price level seems riskier than rental property. If the economy recovers, they both will do well; if not, rental returns are currently double dividend yields and I like the cushion.
    Just in case you don’t remember, I only recently became bullish on residential real estate; this is what I wrote in my 7-1-2007 commentary, and it all came true:
“”As the housing market continues to deteriorate, loan write-offs will cause lenders to tighten credit, which will further depress prices, although this is a slow process. There will be no big selling month like we had with the stock market crash in 1987, there will be no sudden up-turn in the market sparked by a surge in new home sales or building permits; it will be a steady slide back to home prices that reflect the long-term, average ratio of income to mortgage debt. For example, the median home in south Florida is $340,000 and the median family income is $57,000.  Assuming 10% down, 1980s, credit policy dictated that a bank not lend that family more than 3 times annual income, meaning the median family should be able to borrow $171,000 and buy a $190,000 house,” (my prediction of where the median is headed).

As of October, the median home price in Palm Beach County is $180,300. In hindsight, I was too optimistic back in 2007.