Friday, March 27, 2009

The Real Estate Bottom

The real estate market seems to be in a calm state right now. There were strong numbers this month showing an increase in both new homes sold and existing homes sold. With these numbers announced the chorus has once again entered in that we have reached the bottom in the real estate market.

Most of the subprime toxic loans issued in the earlier part of this decade have reset and exploded. We are currently in a period where the monthly resets have fallen dramatically. Does that mean they are finished? Take a look at this graph below:



As you can see we are currently located in the eye of the storm. The next wave to hit us is going to be larger, and its going to be far more devastating. It will take place from the end of this year throughout the end of 2011. The new storm will take a different look, however, in that the bulk of the loans will be option arm loans adjusting.

As I've discussed previously, these are the loans that allowed borrowers to decide on a range of options in making their payments every month:

1. Principle and Interest
2. Interest Only
3. Less than full interest

The last option adds to the total principle amount owed every month putting homeowners deeper and deeper in debt. Not surprisingly, most borrowers continue to choose to pay this option.

During this second wave of home mortgage resets we will also be faced with a new enemy: the commercial real estate loans. They will start to reset about the same time later this year and will continue on through 2012. It is estimated that this is another $1.2 trillion problem approaching the banking system. My estimate is much higher, due to the fact that commercial real estate is tied directly to the office and retail market which is directly tied to the strength of the economy.

As businesses close their doors in both office and retail buildings this will increase the vacancy. Commercial loans are given on the income buildings produce, which is much different than residential loans. Without new leases these buildings are going to be impossible to refinance.

Coming down the tracks is the continuing failure of credit card, auto, and student loan securities. The Fed's new TALF program is designed to purchase all these forms of assets.

Richard Duncan, author of The Dollar Crisis and former employee of the IMF and World Bank, recently said that he believes it will ultimately take $15 to $20 trillion printed from the Fed in order to keep the bubble economy afloat. He estimates based on the new ocean of defaults approaching that it will be in the manner of around $6 trillion per year over the next three years.

As seen in the graph above, we currently rest in the eye of the storm. Buckle up, because the bail out headlines you've read so far are the tip of the ice burg.

Monday, March 23, 2009

A Solution Announced?

Every bank plan that has been presented all the way back to the original TARP program has had one major underlying problem that our leaders have not been able to find a solution for. Here is the problem:

Imagine you are a bank called J.P. Morgan. Your balance sheet is fairly simple. You have ten large bundles of mortgage securities (CDO's) that you paid $10 trillion for back in 2006. So here is your portfolio breakdown:

CDO 1: $1 trillion
CDO 2: $1 trillion
CDO 3: $1 trillion
CDO 4: $1 trillion
CDO 5: $1 trillion
CDO 6: $1 trillion
CDO 7: $1 trillion
CDO 8: $1 trillion
CDO 9: $1 trillion
CDO 10: $1 trillion

Total company worth: $10 trillion

Today these bundles of mortgage securities have lost value because home owners are not paying their mortgages. In order to try and remove some of these assets J.P. Morgan goes out into the open market and tries to sell them. The problem is that new investors are afraid to purchase these securities because they cannot put a value on the CDO based on the large number of mortgages in each bundle.

So the government has repeatedly come in to try and figure out a way that they could purchase the assets to put a price in the open market and get real buyers (private capital) buying as well. The problem is that the government obviously has no idea what they are worth, and if they underpay to try and protect the taxpayers there are huge consequences.

For example, lets say that the government approached J.P. Morgan and told them they would like to buy their CDO 1 for $600 billion. This is a huge discount from the original price purchased and if home prices ever find a bottom the government may be able to one day sell that CDO for a price higher than $600 billion and make a profit.

But here is where the problem comes in:

Because J.P. Morgan sold their first CDO for $600 billion, that means that the other nine CDO's are now worth $600 billion and they have to write down each one to represent that when they report earnings. That means they would have to write down a $400 billion loss for all nine remaining CDO's for a total loss of $3.6 trillion.

Most banks do not have even close to the cash reserves to cover that kind of loss. This means they are now insolvent and would have to declare bankruptcy.

Other banks around the world are now insuring investors against the failure of J.P. Morgan. For example, lets say that Bank of America purchased $200 billion of J.P. Morgan debt(bonds) back in 2006. They then asked Citigroup to insure that debt to protect them in case of a J.P. Morgan failure. So if J.P. Morgan fails, then Citigroup has to come up with $200 billion in capital to pay out to Bank of America.

Citigroup does not have this money and thus they would have to declare bankruptcy as well. Another bank that is insuring Citigroup is facing the same issue and they would have to declare bankruptcy.

This is the concept of systemic risk. One large failure would trigger the payment of insurance (called a credit default swap), taking down every institution.

This brings us to the new plan that is going to be announced today. The government is announcing a plan that involves backing private investors who would like to purchase these mortgage securities. If the assets rise in value, the private capital gets to keep the profits. If the assets fall in value, the government will pay for the losses.

It is a pretty fantastic opportunity for new investors that have the ability to purchase. Of course, they take the risk that the government could change the rules of the game. That assurance will be the most important component of getting private capital to participate.

However, even if they do participate, it does not solve the underlying problem that I was describing before. Who will cover the losses when the banks need to write down the rest of their assets to market prices?

My personal guess is that this is already in place as well. It will involve the Fed covering the difference with those crispy, freshly, printed dollars. The cost to do so will dwarf the size of the money printed so far.