March 15, 2010
Ordinary Outcomes of Extraordinary Recklessness
"Not only are new buyers taking out bigger mortgages, but existing owners have increased their mortgages to turn capital gains into cash which they can spend. Housing booms tend to be more dangerous than stock market bubbles, and are often followed by periods of prolonged economic weakness. A study by the IMF found that output losses after house-price busts in rich countries have, on average, been twice as large as those after stock market crashes. The economic damage this time could be worse than in the past because house prices are more likely to fall in nominal, not just real terms. The whole world economy is at risk.
"New, riskier forms of mortgage finance also allow buyers to borrow more. According to the (National Association of Realtors), 42% of all first-time buyers and 25% of all buyers made no down-payment on their home purchase last year. Indeed, homeowners can get 105% loans to cover buying costs. And increasingly, little or no documentation of a borrower's assets, employment and income is required for a loan.
"Interest-only mortgages are all the rage, along with so-called 'negative-amortisation loans' (the buyer pays less than the interest due and the unpaid principal and interest is added on to the loan). After an initial period, payments surge as principal repayment kicks in. In California, over 60% of all new mortgages this year are interest-only or negative-amortisation, up from 8% in 2002. The national figure is one-third. The new loans are essentially a gamble that prices will continue to rise rapidly, allowing the borrower to sell the home at a profit or refinance before any principal has to be repaid."
The Economist (London), June 18, 2005
The first thought that the above quote might provoke is - why would I begin a weekly comment by quoting an economic analysis that is nearly 5 years old? Two reasons. First, it should be evident that the recent credit crisis did not emerge as some unpredictable surprise, but was instead the very ordinary outcome of extraordinary recklessness. Though the mounting problems in 2005 were utterly ignored by the stock market for more than two years after this analysis was published, the fact is that even with the recent rebound, the S&P 500 remains below where it was in mid-2005. Overvaluation and reckless lending do not always translate into near-term market weakness, but they invariably haunt investors in the form of poor long-term returns.
Second, I've chosen a 5-year old analysis of mortgage lending specifically because the Alt-A (no documentation) and Option-ARM (negative amortization) loans discussed by the Economist commonly sported reset dates 5 years into the loan terms. So the observation that "payments surge as principal repayment kicks in" is not an event that was occurring then. Rather, it is an event that has just begun to occur with loans now hitting their resets. And while current ARM interest rates are only about 4.5%, these mortgages now demand a combination of interest plus principal repayment, on a loan balance that is most likely well above the current market value of the home. This is likely to be onerous relative to a previous payment that was less than the interest alone.
Below is a slightly different schedule we've seen. It doesn't show the first round of sub-prime resets that ended in early 2009, and is based on different classifications, but is largely consistent with the overall profile we can anticipate.
I should note parenthetically that as you read reports about the mortgage and credit markets during the next few months, it will be extremely important to pay attention to the time period being discussed. For example, we are seeing articles with very recent datelines that are drawing conclusions based on relatively pleasant data from the fourth quarter of last year, which reflects the end of the reset lull that was completed with the low in September.
To reiterate what the reset curve looks like here, the 2010 peak doesn't really get going until July-Sep (with delinquencies likely to peak about 3 months later, and foreclosures about 3 months after that). A larger peak will occur the second half of 2011. I remain concerned that we could quickly accumulate hundreds of billions of dollars of loan resets in the coming months, and in that case, would expect to see about 40% of those go delinquent based on the sub-prime curve and the delinquency rate on earlier Alt-A loans. Notably, by 2005, the credit score allowed on Alt-A loans fell to about 620, which is consistent with sub-prime. And not surprisingly, the later in the housing bubble the loan was made, the higher the delinquency rate has been right out of the gate.
The earliest data we will observe in terms of Alt-A and Option-ARM loans will be driven by the relatively small initial round of resets that began in November of last year. That implies that any data prior to February is relatively clean of these effects. What we are interested in is the extent to which we observe a spike in 30-day delinquencies in data beginning about the February-March time frame. The size of the delinquency effects is likely to increase through the year, back off in the first half of 2011, and then reach their final peak in late 2011.
Emphatically, we do not need to work through the whole reset cycle in order to accept market risk. But significant damage in the stock market is often taken in the "recognition phase" where troubling reality departs from optimistic expectations. On that front, I am doubly concerned here because on the basis of an ensemble of fundamental measures (normalized earnings, revenues, book values, dividends), the only points between the pre-Depression period and the late-1990's when the market has been so richly valued were November-December 1972 (before a 2-year market loss of about 50%), and August-September 1987. The hostile yield trends I noted last week (The Rubber Hits the Road) only amplify that concern.
The Strategic Growth Fund is fully hedged at present, and would be even on the basis of current valuations and yield pressures alone. We now have our put options in a "staggered strike" configuration, which essentially uses about 1% of assets to raise the strike prices of our protective index puts. This is the most defensive position the Fund has held since the 2007 peak. Importantly, the added risk of this position, relative to that of a "plain vanilla" fully-hedged stance, is only about 1% in option premium. As always, the primary risk when we are fully hedged is the potential for our stocks to behave differently than the indices we use to hedge (this difference has also driven the bulk of the Fund's returns since its inception). Given that we currently observe conditions that have previously been followed by market declines of 10% or more within a period of several weeks, I view a very tight defense as important, but I don't expect that we will maintain this level of defense for a significant length of time. We are not relying on a decline, but we certainly are defending against the potential.
As I've noted before, getting past the window of the next few months will relieve a great deal of the "two data sets" uncertainty that we have faced recently. We are far less concerned about the possibility of marginal new highs in the indices over the near-term than we are about the likelihood of unsatisfactory long-term returns, and the potential for an abrupt "air pocket" based on valuations, overbought conditions, and yield pressures, not to mention the very palpable risk to the "all clear" thesis that investors not only take for granted, but have now priced stocks to depend on.
As of last week, the Market Climate for stocks was characterized by now strenuous overvaluation, strenuous overbought conditions, and hostile yield pressures. Under those conditions, even positive market breadth has not typically been sufficient to produce positive market returns, on average. As usual, however, every Market Climate we define contains both positive and negative returns, so it is important to recognize that our investment stance here is based on the average outcome that has accompanied similar historical conditions, and is not based on a specific forecast of where the market is going in this particular instance. Even in post-war data featuring no major credit strains, the record of outcomes has been decidedly poor when we've observed similar overvalued, overbought and hostile yield conditions, but as always, we deal with average return/risk profiles, not specific forecasts.
Nothing would make life easier here than to get a second wave of credit strains out of the pool of potential outcomes. It is unfortunate and at times uncomfortable that we can't rule this out, because I would much prefer to behave as if we were in a normal postwar recovery. Granted, it wouldn't change our current position any, given the valuations and yield pressures we observe, but it would allow us more flexibility to accept market risk than we've had in recent quarters. Needless to say, I am looking forward to the clarity that the coming months should bring, regardless of the extent to which a second round of credit strains proves to be a concern. For now, we would be defensive on the basis of valuations, overbought conditions, and yield pressures alone, but our vigilance is amplified by the possibility that the data may depart shortly from the comfortable recovery path that investors now assume.
In bonds, the Market Climate last week was characterized by relatively neutral yield levels and unfavorable yield pressures. We continue to carry an average duration of about 4 years in the Strategic Total Return Fund, primarily in straight Treasury notes. I continue to expect that in the event of fresh credit strains, safe haven demand for Treasury securities will tend to outweigh the effects of substantial deficits and new supply over the intermediate term. Longer-term, I expect that we will tend to accumulate commodities and inflation-protected securities on substantial price weakness. Despite near term pressures on the U.S. dollar (which tend to boost commodities), I expect that we'll have enough safe-haven demand and fresh deflation concerns to establish longer-term exposures at better valuations than we see at present.
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