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Posts from the ‘Macro’ Category

Feb 26

Week 34: Its a bull market (for the moment)

Portfolio Performance:

Portfolio Composition:

Trades:

Europe to the sidelines (for the moment)

Eric Reguly had a worthwhile article in the Globe and Mail this weekend.  He outlined the reasons why Greece and Europe are still as badly off as they were a couple of months ago.   Apart from the markets perception, nothing has changed.

The basic problems in Greece, and in the rest of the periphery, he says, remain.

The country’s economy and its social fabric are unravelling at an alarming pace and the second bailout, combined with a sovereign bond haircut, will do next to nothing to stop the horror show.

So why is the market rallying when these problems have not gone away?

I think that there are a lot of similarities between the markets reaction to Europe today and the reaction of the market in 2007 and 2008.  During the housing crisis, what drove the market down was not so much the fear of falling housing values, as it was the fear that falling housing values would cause banking problems.

At times, when it appeared that the housing problems were going to create only housing problems, the market rallied.  When the spillover to the banking system was evident, the market fell.

There are different types of bear markets.  There are bear markets that are economic and those that are financial.  When an economic bear market hits, some sectors get hit hard, some get hit, and there are always some that actually don’t do too badly at all; the idea being that there is always a bull market some where.

When a financial bear market hits, everything goes down.  Because in this case what drives the bear market is a lack of liquidity to buy stock.  So all stocks fall.  To be sure, this eventually hits the economy and causes a financial bear market, which happened in late 2008-2009 and compounded the problem.  But there is a fundamental difference here in that during an economically driven bear market, though it may be more difficult a stock picker can still pick stocks.  In a financial bear market you can’t pick anything and you just have to get the heck out.

How this relates to today is seen in how the market does not seem to care whether Greece goes into a severe recession.   This is because Greece is an insignificant spec in the world economy.  The market only cares if the problems in Greece spill over into the banking sector and cause banks to fail, not lend, seize up, and other worrying verbs, thus precipitating another financial bear market.

I wrote a long piece on the LTRO a month ago.  As it turns out this has been the most popular blog post that I have ever written.  This is somewhat unfortunate because this isn’t intended to be a blog about Europe, I am not an expert on macro economics or on banking, and the post is only tangentially related to the purpose of this blog; the stocks I own.  At any rate, in the post I argued that the LTRO may have a short term psychological impact, but over the long run it wasn’t going to do much for the Greek, Portugese, Italian and Spanish economies because none of the problems those economies are having have been dealt with.

I still think this will be the case.  Reguly highlighted the reasons why (referring specifically to Greece) in his article:

Labour costs remain too high. The economy is sinfully undiversified and laden with low-value industries, like stuffing tourists onto cruise ships. Corruption is rife. The tax-collection systems are primitive. The professional protection rackets – from truck drivers to doctors – remain intact. The country lacks a working land registry. The bureaucratic red tape leaves entrepreneurs and land owners in despair.

This is all really bad stuff.   And its stuff that applies in large part to Italy, to Spain, and to Portugal.   However, what is forgotten, and what I think I neglected  in my post about the LTRO, was that while all this is true, it was also true a year ago, two years ago, long before Greece came to be a headline and before it began to cause markets to collapse.

The LTRO has accomplished an extremely important objective and that is that is has (temporarily) removed the mechanism for a banking collapse.  The banks in Europe were on the precipice because they were overlevered (see my analysis of Deutsche Bank which remains levered at an insane 60:1) and they faced problems funding that leverage.  Now, with the help of the LTRO, the banks are still overlevered but can get all the funding they want from the ECB.

Juggling Dynamite

I was listening to the Canadian money program Money Talks yesterday.  The had Danielle Park, who writes the blog Juggling Dynamite, on as a guest.  You can listen to the interview here by selecting the 10:00 am segment for February 25th.  Parks basic argument is that this rally is a sham.  Its built on liquidity, will die by liquidity, and there is no evidence that the economies of the world are getting better.

The main theme is the incoming recession… its already underway in Europe, Japan and the UK, what has been going the last several months is all about liquidity injections again, but the reality is it doesn’t fix things, we don’t have any solutions, debt has to be written off…

She argues that individual investors have to be very careful right now.  They have to be careful about chasing the market up here, careful about jumping into dividend stocks to try to get a bit extra yield, and to be extra careful about fixed income because the yield you are getting there are miniscule.  She has some very good comments about how dangerous the current environment is to the individual and moreover, how criminal it is that central bankers continue to punish savers and try to force risk averse individuals into risky assets.

Now, if you look at what I have done over the last few weeks, I have moved from almost 50% cash to basically no cash.  So I must be completely at odds with her assessment right?

Wrong.

I think she’s dead on.

This is a false rally.  This is a liquidity driven rally.  This remains “the banks in Europe are not going to implode tomorrow so they must be worth more today” rally, which is not a positive pronouncement about anything other than that the end of the world is postponed.

CNBC had Lakshman Achuthan on this week to talk about his recession call from a few months ago.  Last week I talked about how one of the indicators I follow, the ECRI’s WLI, was perking up, and that this perhaps portended to a strengthening US economy.

Maybe I have been too quick to look for confirmation.  The counterpoint is that it is indeed simply a liquidity driven event.  Achuthan also argues, much like Park, that it is.  Central bankers are printing money and that money has to go somewhere.  Real economic activity is weak and so the money goes into speculative investments instead.  Achuthan said that given the amount of money being pumped into the system, he is surprised that the WLI has not risen more than it has.

Here’s the entire clip:

But what can you do?

So rally is on weak legs.  Nevertheless, its a rally. If you recognize it as a liquidity driven rally then really, what you want to invest in (temporarily) is liquidity driven stocks.  If you look at the stocks I am buying lately, they are exactly that. I am doing the right thing, even if perhaps I have not fully understood the reasons.

I like to call the junior gold explorers, companies like Geologix, Golden Minerals, Canaco, little liquidity eaters.  The stock price of these sorts of companies have much more to do with the availability of liquidity then they do with the price of gold.  That is plain to see by looking at a chart of any stock in the sector.  Every stock suffered through 2011 even as the price of gold rallied hard.  Every stock soared beginning in 2012 once the LTRO was announced and it became clear that liquidity would be in abundance again.

But these are trades.  I do not expect to be holding any of these stocks 2 years from now.  Absent some sort of paradigm shift like a move to the gold standard, these are stocks to hold for the run up and then cut loose when it looks like they are turning the taps off again.

But in the mean time, in the words of Jesse Livermore, from whom I stole my blog title and my avatar:

“But I can tell you that after the market began to go my way, I felt for the first time in my life that I had allies- the strongest and truest in the world: underlying conditions”

The underlying condition right now is one of liquidity.  It is not the intent of this blog to philosophize (too much) on the eventual consequences of such liquidity.  There are plenty of folks, like the wonderful Ms. Park, who are already describing those consequences eloquently.  The intent here is to try to evaluate those conditions clearly, and to describe how I am acting to capitalize on those conditions.

For the moment anyways, that means that I own stocks.

Of course next week could be a different story.

Feb 19

1 Comment

Shadow Inventory and how an improving US Economy begets an Improving Housing Market begets and Improving US economy begets….

FT Alphaville did a nice piece on Friday talking about shadow inventory in the United States. To sum it up:

Two things about this graph.

  1. Visible housing inventory is approaching a low not seen in 30 years.
  2. You can’t take a shadow inventory number at face value.  You have to understand how it was estimated.

First a little bit about shadow inventory

I want to talk for a second about shadow inventory. I wrote this explanation about shadow inventory in Letter 23:

Laurie Goodman (who I first learned of from ftAlphaville fame) pegged shadow inventory at 11M (which is an amazing 20% of housing mortgages outstanding).  Mark Fleming pegs it at 2M.  Both analyts are using the same data…How is this possible?  Its all in the assumptions.  Shadow inventory is really just houses that are expected to go into default at some point.  There is nothing particularly nefarious about the concept, even though the name suggests it is some sort of inevitable flood of housing supply.  It may be, but it may not.  It depends on what happens.  Laurie, to come up with her 11M number, assumes a fairly large number of prime mortgage defaults, including some that are currently with LTV (loan to value) of less than 100%.   Laurie also looks at 60 day past due as her “bucket” from which to extrapolate current nonperforming loans.  Mark on the other hand, uses 90 day past due, and does not include currently performing prime mortgage defaults.

I did a bit of investigation and the number used in the above graph is the CoreLogic number, which is the lowball Mark Fleming estimate from the above quote.  According to CalculatedRisk that number is comprised as follows:

Of the 1.6 million properties currently in the shadow inventory, 770,000 units are seriously delinquent (2.5-months’ supply), 430,000 are in some stage of foreclosure (1.4-months’ supply) and 370,000 are already in REO (1.2-months’ supply).

The thing about the shadow inventory is that if what you see is what you get, then we are almost through the worst of it.  Looking at the above categories that comprise the shadow inventory estimate, they total about 1.6M homes.  If there was a little bit of confidence in the housing market, and you began to see sales returning to pre-crisis and pre-boom levels, you would run through those homes quite quickly.

As well, it must be kept in mind that the month-of-supply number is assuming a continuation of a level of sales that is a historically low level.  Rising sales would help eliminate shadow inventory and real inventory much more quickly than the monthsof-supply number might suggest.

The most basic point here is that shadow inventory is not an inevitable houses-on-the-market number like visible inventory is.  Shadow inventory is a “houses that are likely to go on the market” number where the definition of “likely” is a function of whether those home owners have jobs, how low interest rates are, whether the refinancing market is liquid enough to let home owners with high interest rate mortgages refinance to low interest rate mortgages, and probably most ambiguously, what homeowner think about the future prospects of the housing market.

Laurie Goodman and her firm Amherst Securities have some of the most pessimistic numbers on shadow inventory.  She does an excellent job describing the methodology they use at her firm on this conference call.  Amherst ends up with the following estimate of shadow inventory:

This is a huge number.  Much bigger than the 1.6M number that CoreLogic is using.  If Goodman is right then we are years and years away from a housing recovery.

But lets go through this.  Amherst uses 60 days past due to define nonperforming loans.  Reperforming loans are loans that were in default before but aren’t now.  MTM LTV means mark to market loan to value, so a 120 MTM LTV is basically saying that the loan is worth 120% what the house is worth.

I would say that you can make vastly different assumptions about how many loans in each of these categories will default depending on whether you assume the housing market is improving or not.

Somewhat paradoxically the true amount of shadow inventory is going to be determined by the perception of just how much overhang exists in the housing market.  To put that more bluntly, would you walk away from your house right now if you saw the housing market turning up?

You would be a lot less inclined to I think.

And all of this brings us to the US economy

I have two graphs here to prove my point.

When I started dumping stocks and raisigng cash in the late summer and earlier fall it was partially because of my uncertainty about Europe.  But it was also partly because of my concern that the US economy was slowing down again. The big reason for my concern was that the ECRI leading index was falling again.  I am reluctant to be too invested in stocks when this indicator is dropping.   Once it starts to drop, I’m not all that sure that anyone knows when its going to stop.  It could stop and turn around relatively quickly, suggesting a soft patch in  the economy, or it could fall precipitously, indicating a sustained move back into recession.

The move down ended at the end of the last year, and the last few weeks the uptrend has shown itself to be persistant.  Such persistance must be noted.

The second graph is simply jobless claims.  Jobless claims are the single best indicator of the health of the economy.  You simply can’t deny that claims are heading down, and that the trend down is accelerating.

Growth in an economy builds on itself.  Growth begets growth.  Taking it back to the housing market, I think that these early signs of true growth in jobs could begin to snowball into a housing market.  Jobs beget stabilizing housing prices which begets greater housing activity, which begets rising prices, which begets falling inventories (and non-materializing shadow inventories), which begets the need to build new homes which begets more jobs. And so on.

Economies as large as the US economy do not turn on a dime.  But when they turn a lot of the viscious cycles that had amplified the downturn become virtuous cycles that amplify the move up.   I am of the mind that we may be in the process of making such a turn right now.

Jan 26

1 Comment

What is the LTRO going to do for Europe? And how does it affect my stocks?

I think that the essence of this bullish rally can be summarized by this one chart

Investors have taken to the opinion that the long term financing operations (LTRO) provided by the ECB back in December has removed the risk of collapse in Europe from the table, maybe even for a couple years. It’s all clear to buy stocks.

Investors are of the mind that the LTRO has removed the risk of collapse in Europe from the table, maybe even for a couple years.

As described by Citigroup:

The ECB’s LTROs have succeeded in breaking the negative spiral of rising risk aversion, poor asset performance and forced selling. Money is cheap, and every day, confidence is building little by little, prompting buying. The resulting asset performance in turn raises confidence further. The lack of street inventory implies small shifts in demand have a much bigger impact on spreads than in the past.

I underestimated the effect of the LTRO. I might have recognized that having a liquidity backstop for the banks would be a big confidence builder for the market.  Unfortunately I didn’t.  Whether this confidence can be sustained, well that is a question I hope to look at here.

Things came very close to going sideways

We were on the edge of the cliff at the end of November and early December. No where can these be seen more clearly then by the yields of short term bills of the periphery. While I have put up the chart for the 10 year Italian bond a number of times, I have not focused on the short term bills.  Below is the rather shocking collapse and then restabilization of the 6 month bill in Italy.

The LTRO coincided with a tremendous drop in short term yields.  A lessor, but still significant, drop came in longer term yields.  Equities rose as yields fell and the crisis abated.

Is it sustainable?

Citi doesn’t think so.  In the same note Citi says that the rally is likely mostly based on fumes. The reason?  While QE1 and QE2 stimulated lending (and speculation), the LTRO is not expected to stimulate anything other than bank liquidity.

To put it simply, almost all the big banks in Europe are going through a process of deleveraging.  The LTRO simply helps them through this process without putting undue stress on one another, like the stress at the end of November last year.

FT had a good piece on just what the ECB’s intent is for the LTRO. In it they argue that the ECB did not create the LTRO funding to flood the EU with Euros or to stimulate government debt buying by banks. They did it to “stop a heart attack of bank deleveraging in the eurozone.”  When the LTRO is understood this way, it can be seen that it is more akin to the Fed’s response to the commercial paper crisis in 2008 than it is any QE.

This is an important point.

Providing liquidity directly to banks for operational use, as the Fed did in 2008, has historically not been much of a prop to equity markets beyond an initial, confidence induced, blip. The Fed did all sorts of operations in the fourth quarter of 2008. It wasn’t until it embarked on a true QE in 2009 that the market actually responded favourably for an extended period.

It makes you wonder what the half life is of the LTRO effect.

What are the mechanisms of transmission?

The problem is that the LTRO is a liquidity mechanism and the problem in Europe is not a liquidity problem. As Mauldin pointed out in that piece I referenced last week, europe has a solvency problem brought on by countries that simply aren’t competitive and banks and sovereigns that are overleveraged. QE begins to solve the solvency problem because newly printed money pays off old, otherwise unpayable debt.  But is the LTRO intended, or should it be expected, to do that?   I don’t think so.  Its just a long term repo, or in other words, long term borrowing for the banks with very little restrictions on the collateral they have to put up in order to get the money.

I think that to speculate on the real effect of the LTRO on equities over the medium run, you have to think about the mechanism by which QE causes the market to rise.

So certainly there is a change in market psyche.  QE lifts the spirits of the market.  The LTRO did that too.  I would attribute the rise in stocks over the last few weeks mostly to this effect.

In our current case, there is probably also an element of pessimism that was no longer warranted.  The bank stock in Europe, in particular, had been priced to fail.  Failure was no longer imminent, so a rally had to be expected to reprice a degree of solvency back into the stock prices.

Those two elements are probably the biggest effects in the short term.  At some point though, they are going to wear off, and the market is going to start asking, so what is this LTRO actually doing?   Its this longer term impact where the picture gets fuzzy because I don’t think the LTRO has the same long term effect as QE.

The two main long term (with long term meaning months) effects of a QE program is  that the excess money sloshing around from the QE lowers the cost of funding, entice businesses and consumers to borrow, and it provides banks with the liquidity and capital to make more loans.

The problem is, I don’t see that happening here.  Banks in Europe are in deleveraging land.  Just as would be expected, the evidence is that the banks are taking the money and turning right around to inject it back into short term bills (see that chart of Italian bill rates above).  They want liquidity that can be easily accessed in case their wholesale funding dries up.  They don’t want to make a 3 year loan to Acme Manufacturers, taking on the associated risk.  They already have too much risk on their balance sheet.

This is great for the bill market; rates fall, and it certainly removes the most stressed condition from Q4, but if the money not finding its way into the economy, what good is it going to be for growth?

The Eurozone still isn’t growing much

Back to the Citi note one last time:

Despite a mild winter the European economic data isn’t really improving. Our economists have just lowered their Euro zone growth forecast for 2012 from -1.2% to -1.5%. Spain’s Budget Minister Montoro has just warned the country may miss its 4.4% budget deficit target for 2012. The earnings season has been decidedly mixed, with about 60% of US S&P 500 companies beating to date – much lower than in past quarters.

Access to liquidity just lets banks keep on keeping on for a few more months. Like the Fed operations in 2008, the liquidity injections led to short term spikes but no lasting impact on the market. I am willing to speculate that the LTRO response with follow suit.

Capital Ratios an other impediments

Another FT article, this time referring to Richard Koo of Nomura, speculated similarly.  Koo is talking specifically about the impact of the 9% capital ratio, but as he alludes to, there are a number of factors producing the same basic effect on banks: new capital is used to assist in de-leveraging, not growing:

What is preventing the funds supplied by the ECB from flowing into the real economy and improving economic conditions? Although there are a number of answers, the biggest obstacle from a policy perspective is the European Banking Authority’s tough new capital rules.

The EBA has demanded that European banks raise core Tier 1 capital to 9% of risk-weighted assets by June 2012. None of the policies unveiled in response to the crisis has been so counterproductive…This 9% rule effectively prescribes the size of European banks’ balance sheets. This means banks will not be able to increase lending no matter how much liquidity the ECB supplies, effectively rendering any monetary accommodation by the ECB powerless to stimulate the economy. The EBA’s 9% rule may help in preventing the next crisis, but it will do nothing to resolve the current one—in fact, it will make it much worse.

Yields in Portugal aren’t falling

On a related note, one of the most interesting developments over the past month is that the Portugese 10 year yield has NOT fallen.

Investors aren’t being totally fooled by the LTRO.

In the next few months we should start to get a better picture about the impact of the austerity measures on the economies of Greece, Portugal, Italy and Spain.  I would speculate the numbers will be grim, and a lot of the wind provided by the LTRO will be knocked from the sails.

Bringing it all back home (to the portfolio moves)

As you know, I continue to hold a couple shorts of European banks.    I also added more gold stocks yesterday (specifically ABX and more OGC)  after the Fed news so these banks shorts could be seen as a bit of a hedge on my rather large gold stock position.

The other day I was contemplating some of my positions which had begun to move against me.  A lot of that has cleared in my head over the last few days.  The Fed announcement brought back my conviction in gold stocks.  And after taking a long and hard look at Europe, I have decided that I am likely on the right side of this bet, and while I would be wary of adding too much to that bet as the market moves against me, its not time to cut it just because of a few tough weeks.

The biggest thing that I think I have to remain wary of is that the ECB holds the trump card here.  A true QE style of bailout in the neighbourhood of E2B to E5B would truly push the problem so far out that it would be someone else’s worry.   Today’s announcement by the Fed to keep rates low for much longer than most anticipated could be seen as a step towards that.  At the end of the day, realizing that the LTRO is not the QE that everyone seems to be interpreting it as leaves an open question: is the QE still to come?

Jan 22

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Week 29: Conviction and Humility, Investigating PHH, Don’t forget about Atna, Buying Midway

Portfolio Performance

Portfolio Composition:

On Conviction and Humility

I find that investing in stocks is a constant antithesis/synthesis (to use a couple of terms from philosphy) between conviction and humility.  Never is this more evident than when things aren’t going your way.

While the market has been up the last couple of weeks, and my portfolio has been up somewhat as well, it is not doing as well as I would like, not as good as the market even, and that makes me want to reevaluate.

Part of me wants to just get out and start all over again.  Right now there are things of  which I am wrong.   Wrong about some of the gold stocks I own (while Atna continues to do well, Aurizon is not doing well, Lydian is not doing well, and a couple of my more recent purchases, Esperenza and Canaco, have stalled out).  Wrong about some of the oils I own (I probably should have sold out of Reliable Energy at 30 cents)  that aren’t doing much of anything.  Certainly wrong about my big bad bailout bank short bet, which went quite far south last week.

The other part of me, pushing just as strongly, wants to stay the course and, more exactly, to ignore what the market might be telling me because the market is wrong and I am right and in time I will be vindicated.

It goes without saying that this last attraction is a dangerous one.  Surely we all have listened to the expert that held his conviction against all evidence to the point where his credibility was lost forever.

The truth between these two extremes lies, of course, somewhere in the middle.  The difficulty is figuring out exactly where that is.

The basic long term investment theses on which I am currently holding stocks (and shorts) are as follows:

  1. Europe is on an inevitable course to dissolution, with a collapse in Japan not far behind
  2. Gold is the only asset that is no one’s liability and it will gain respect as a store of value as these events unfold
  3. The US, while troubled, is muddling through, and the US housing market has likely had, as Kyle Bass has put it, the pig go through the python
  4. Oil is harder to find and harder to get out of the ground then most people appreciate, and its price will prove sticky to the upside
  5. The hz-multifrac is a revolutionary technology and so you want to own oil companies that can take advantage of that technology

I think its helpful to review these basic points on occasion, particularly when things are not going my way.  If I can still stand by these tenants then the rest is just a matter of evaluating if the individual stocks themselves are decent businesses (or perhaps more importantly good stories) in their own right.

And, having thought about it over the weeked, I wouldn’t stand away from any of the above.

Two weeks of a market moving up with many of my stocks doing nothing can seem like an eternity.  Sitting with as much cash as I currently have (though I have reduced that cash level somewhat, mostly in response to specific opportunities and a recogntion that the deterioration of Europe no longer seems imminent) while the market rises, can be tough to bare.  But I can’t just abandon what makes sense because of a few tough weeks.  If the facts change, certainly I have to change with them.  No doubt about that.  But when the main fact that has changed is that the market is not going down any more, I think it is wise to respect that fact (no sense doubling down and some sense in lightening up with what doesn’t work) but not so wise to change course entirely.  Better to move as a big ship might, slowly inching it way towards a new course, ever on the lookout for signs on the horizon that might make the destination more clear.

Wading into the Mortgage Market

On Tuesday this week a 13-G was issued that Hayman Investments (the hedge fund run by Kyle Bass) had purchased over 7% (4,448,751 shares) of PHH Corp.  I got a google alert  on the news almost immediately.  It still wasn’t soon enough.  The stock was up 10% within minutes and closed up 12% on the day.

I sat down on Tuesday night with the intent of understanding what Bass what was up to.

I don’t think this is just Bass buying a cheap company (which they are) and hoping for the best.  I think there is more to this story, as I will explain below.  But first, lets talk a bit about where I think we are in the housing cycle.

First of all, I am no blind optimist here.  I don’t think for a second that housing is about to make a robust 180 with rising prices and robust new builds.  That’s not happening for a long time yet.

But that does not mean that all housing company’s should be left in the trash bin.  No I think that those that rely more on volume then price may find themselves doing better this year, and may be ripe for a move.

Why?  Because I think prices have fallen enough in many markets.   Most of the damage in terms of declines appears to have been done.  There was a great graph provided by Core Logic a couple weeks ago that showed prices both including and excluding foreclosures.

Illuminating!  If you ignore foreclosures, prices nationwide are on the verge of going positive.  If you look at the regional data, prices are actually up in many locales.  And while some areas are still bogged down in foreclosures, many have worked through the worst of it.  Those are going to be the areas where we start to see a turn.

So it makes sense to look for companies that stand to gain from these first signs of stabilization.

And with that, onto PHH…

PHH is in the business of mortgage origination. They are in the business of mortgage servicing rights.  Tthey are also in the business of commercial vehicle fleet management but I don’t think that’s the story here so I’m not going to dwell on that.  Lets talk for a minute about the two former businesses.

Mortgage Origination

Mortgage origination basically consists of finding a person that needs a loan to buy a home, showing that person a list of mortgage options of how they could finance that loan, qualifying the borrower for loan guarantees such as those from the GSE’s, and then processing the loan through (doing all the paperwork) and passing it through to the eventual lender institution (usually to Fannie, Freddie or a bank that will either keep it on their books or sell it to another investor).  PHH takes a cut in the process, or an origination fee, that is typically between 1/2% and 1%.  In the third quarter the company said that their “pricing margin also expanded by more than 47 basis points as compared to the second quarter.”

Mortgage Servicing

Mortgage servicing happens after the loan is made. The servicer is responsible for calculating how much the borrower owes and collecting that amount.  If a loan is not being paid then the servicer takes on additional responsibilities such negotiating a workout upon default, looking after the foreclosed property and such.

PHH refers to these businesses as a natural hedge of each other.  Why?  Because they are inversely correlated with respect to interest rates.

Let’s say interest rates fall.  What happens?  People with mortgages at higher rates refinance those mortgages.  That’s great for the origination business.  They are writing up refi’s and taking in the fees.

Not so great for the servicing business. Those refi’s mean that the mortgages that PHH has the rights to service no longer exist.  Now ideally PHH originates the refi and thus takes on the servicing rights for that refi so the old mortgage servicing right (MSR) is replaced with a new one.  But there’s no guarantee of that.

Rates go up and the opposite situation occurs.  Origination suffers, no one is refinancing at the higher rates, but that also means the MSR’s are not being lost either.

As it is, PHH has proven to be pretty good at holding on to more MSR’s then it loses.  Forthe 9 months ending in the 3rd quarter the company had a replenishment rate on MSR’s of 167%.

Ok, back to Bass.  There are a number of things happening in the mortgage business right now from which PHH stands to benefit.  Let’s go through them one by one starting with Harp II.

HARP II

Harp stands for the Home Affordability Refinance Program.  Harp II is the name that has been coined for the new version of HARP.  It supersedes the original Harp.  Harp I was a total failure.

The HARP program has helped far fewer borrowers than its proponents estimated — roughly 894,000 borrowers since Aug. 31, 2011. — and many less than the estimated 11 million U.S. homeowners who owe more than their homes are worth.

Why was it a total failure?  A few reasons:

1. Put back risk: Basically when a bank participated in the original program they were worried that they would get stuck with the original mortgage.  I think what happens here is that to rewrite the original loan to new terms, the loan is going to be scrutinized.  The banks and other underwriters know that the quality of many of those original documents are sketchy at best and they would rather not have to pull out the skeletons.

2. LTV Limits: This is probablythe biggest problem.  The original HARP program dealt with current loans with LTV’s of 80-105.  That was expanded to 125 in 2009, but that still wasn’t enough.  I was surprised by that until I read this:

This should have a big impact in certain parts of Nevada, Arizona, and Florida where many borrowers owe more than 125% of the value of their homes. In Nevada, for example, two thirds of all loans backed by Fannie Mae are underwater, and half of all loans are above the 125% loan-to-value cut-off.

3. Appraisal costs: the borrower had to have an appraisal done to qualify for the original program.  That appraisal could cost $400.  Borrowers were reluctant to take this cost on when there was no guarantee they would be accepted by the program

HARP II aims to correct these mistakes.  The LTV limit is gone.  Appraisals are no longer required.  And banks are protected against the put backs.Says Brian Ye, analyst at J.P Morgan Chase & Co:

“We are of the opinion that there are enough changes to the program that bank servicers could really change their behavior, and this could be one of the first times that the administration has under-promised and over-delivered,”

The two tiers of HARP II

There is one particular element of the new program that helps out PHH is that servicers get a head start over third party originators.   I confess I don’t know just what of impact this is going to have, but it is interesting and potentially significant, so I think its worth mentioning.  Servicers like PHH have been writing borrowers up for the program since the beginning of the year.   A third party originator cannot submit any documents to Fannie or Freddie until March.   This was done to entice the banks into the program, but the corrollary is that a company like PHH can capture business up front without the competition.

There is more interesting information on the new HARP program here.

What’s it going to mean?

This is, of course, the big question. The program is aimed to attract two million borrowers by the end of 2013.  This would be a little more than twice what the original program attracted.

However if the program works, and if JP Morgan turns out to be right and the administration “under-promised”, there is certainly a lot of room for upside.  According to CoreLogic:

10.9 million, or 22.5 percent, of all residential properties with a mortgage were in negative equity at the end of the second quarter of 2011.  Eight million borrowers with negative equity, or nearly 75 percent of all underwater borrowers, have above market rates. The disparity is even greater for those with severe negative equity. More than 40 percent of borrowers with 125 percent or higher loan-to-value (LTV) ratios have mortgages with rates at 6 percent or above, compared to only 17 percent for borrowers with positive equity.

Apart from the obvious fact that these numbers show just how staggeringly bad housing has become, if you prefer to see the glass half full those numbers also suggest that there are a lot of borrowers out that could benefit from a program like this.

I was listening to this week’s Lykken on Lending and they were talking about Harp II.  Lykken said that listeners (brokers and third party originators) needed to gear up for the “mother of all refinancing booms”.  In another segment a couple of weeks earlier Lykken and his guests spoke quite excitedly about the impact of no LTV limits. The one guest talked about how common it is to have to turn away borrowers because they are too far under on their home.  HARP II should help with that.

BOA and correspondent lending – another tailwind

So first of all, what is a correspondent lender?

Consider a broker who develops significant business volume, has earned the confidence of wholesale lenders who will authorize him to approve their loans, and has accumulated some capital. He can now obtain a credit line from a bank that can be drawn against to fund loans, repaying the loans when they are sold to wholesale lenders. Under the law, the broker has morphed into a “lender” – the type called a “correspondent lender”.

This has been a business the big banks have taken a large piece of.   Until now.  In August BoA reported that they were exiting correspondent lending.

This isn’t small potatoes.  It accounted for”47 percent of Bank of America’s mortgage originations, or $27.4 billion, in the first quarter of 2011, the Wall Street Journal said citing Inside Mortgage Finance.”

There are rumors others are leaving the business.  Its a low margin, highly competitive business but it could become less so with some of the big players moving on.

In comparison, for PHH total mortgage closing volumes for 2011 so far were $36.3 billion of which approximately 70% were retail and 30% were wholesale/correspondent.  Here is what management said on the Q3 conference call:

Yes I’m going let – yes the answer to the question is yes, we think there are better opportunities but once again we’re really pretty opportunistic in that channel. So we pay close attention to margins in that channel. As you know it’s probably the most cost competitive channel, it is the most cost competitive channel that we operate in and we’ve seen some really strange behavior in that market in terms of where margins are being priced. Some of our competitors are in the market, when they are in the market they’re very aggressive in terms of their pricing and then they back off and they’re out of market and that’s why we stay really opportunistic in that market. Luke, do you want to add anything?

The company made a total of $95M off of mortgage production, meaning off of fees for new originations of that $36.3B of loans they processed.  The company doesn’t break down the margins between the retail and the wholesale/correspondent.    Total revenue from the segment was $264M, which suggests that the fees on average are around 0.7% of total loan value.

Tailwind 3: Signing up new partners

The last tailwind for PHH is that they are having success signing up some big partners for their origination business.  From the Q3 CC:

We also made significant progress in growing our nationwide sourcing footprint over the past two quarters signing five new private label accounts. The new relationships include Barclays which we mentioned on last quarter’s call and today we’re pleased to announce that we’ve added Ameriprise and Morgan Stanley Private Bank along with two other financial institutions all as new PLS partners.

They also lost one significant client in Charles Schwab but over all the company expects to gain significant production:

We expect the five new PLS accounts in the aggregate based on their 2011 production and taking into account ramp up time and anticipated launch schedules to produce about 7 billion in closing volume in 2012, about double what we predicted for Schwab.

Twisting in the (tail)Wind

The Donald Coxe conference call this week was very good, and it produced one particularly enlightening graph.

Long term rates, both treasury and mortgage, are at all time lows.  When the Fed embarked on operation twist, it was with the intent of bringing down the long end of the curve, and by doing so, propping up and ideally pushing ahead, the housing market.

I would say this was a success.

When you add to the fact of HARP II that interest rates are at all time lows and really, given the decline in house prices in many markets, are basically creating the conditions where you would be crazy not to buy a house, you just have to think that this is going to help origination activity in 2012.  I think the point that is sometimes forgotten is that the downard spiral of housing is really caused by the foreclosure mess.  Its the lynchpin.  If you could create the conditions to stem that flow, I think the situation would right itself a lot faster than is appreciated.

When core earnings matter

A lot of the time when a company is reporting some sort of non-GAAP earnings, its in order to hide something.  A good example of this is Salesforce.com.  They report non-GAAP earnings that exclude certain costs (particularly stock options) that they would rather ignore.

PHH reports a core earnings number every quarter but for a very good reason.  Core earnings is a far better representation of the company’s profitability than is the GAAP number.

The problem with the GAAP number is that it is obscured by changes in the mark to market value of the MSR portfolio. PHH has to write up and down their mortgage servicing rights with changes in interest rates and to a lessor degree credit quality.  When rates go down they have to write down the value of the rights and when rates go up they have to write up the rights.

The fluctuations on the income statement caused by these mark to market moves are huge.  Up to $400M in some quarters.  If you look at quarterly GAAP earnings over the past couple years they look like a scatter chart.

The reality of the MSR’s is that as long as the company is replenishing the existing pool with more rights from new originations then its losing to payoffs of its existing pool, its all good.  As I already noted, PHH is doing that.

The core earnings number takes out that effect. And if you look at that core earnings number you see a pretty cheap looking company.

All that, and discount to book…

The last point I would like to make about PHH is the discount relative to book value.   You can get the shares at a pretty substantial discount, even after the post-Bass run up:

What’s even more interesting is that this discount exists even after the valuation of the MSR portfolio has been clobbered by falling interest rates.  It is not impossible to imagine a scenario where the MSR’s add book worth $500M plus, or another $10 per share.

So what does Bass see?

To sum it up, with PHH you are getting a cheap company that has earned decent money of late and that should benefit from the tailwinds of HARP II, weary competitors and a rebounding housing market.

The negative with PHH is the debt they have coming due, and whether they will have the cash to pay it off.  That debt is an issue I believe is worthy of a post in itself, and I will try to get around to that next week.

Europe is still a problem

…it just doesn’t seem like it right now.

I have a few other things I was hoping to talk about this week but I’m running out of time and this letter is getting quite long already.  But I do want to talk a bit about some of the reading I have done on Europe the past week.

It seems what with the stock market rising every day that Europe is old news now.  Yet I think that to ignore the risk of Europe right now, to go all in, is still at best a gamble.  It may turn out, you could do it and cash out big in 6 months.  But to say you knew it would turn out that way would be kidding yourself.  We could just as easily wake up tomorrow in crisis mode again as in the happy-happy-risk mode that we’ve been in the last couple weeks.

Europe  hasn’t gone away.

The S&P downgrade of a number of European countries been widely reported already so I’m not going to dwell on it, but I do want to point out that the language used.  In particular:

We also believe that the agreement is predicated on only a partial recognition of the source of the crisis: that the current financial turmoil stems primarily from fiscal profligacy at the periphery of the eurozone. In our view, however, the financial problems facing the eurozone are as much a consequence of rising external imbalances and divergences in competitiveness between the EMU’s core and the so-called “periphery”.

This strikes at the basic point that I have made in past posts.  Austerity measures are not going to fix the problem with Europe because the problem is not a one time spending binge that just has to be paid off.  The problem is much deeper, relates to inherent inequities in the productive abilities of the economies, and is quite possibly not solvable without a break up.

As John Maudlin said in his piece “End of Europe”:

For most of the past two years, European leaders have tried to deal with the problems as though they were short-term liquidity problems: “If we just find the money to buy some more Greek bonds, then Greece can figure out how to solve its problems and then pay us back. Given enough time, the problem can get solved.”

They have now arrived at the understanding that it this not a short-term problem. Rather, it’s a solvency problem of the various governments, which of course creates a solvency problem for their banks. They are now addressing the problem of solvency and providing capital until such time as certain countries can get their budgets under control and the bond market sees fit to provide the capital they need.

But they are completely ignoring the third and largest problem, and that is massive trade imbalances. Germany exports products to the peripheral European countries, which run trade deficits. As I have shown in several letters, a country cannot reduce private-sector leverage, reduce public-sector leverage and deficits (balance its budget), and run a trade deficit all at the same time. That is simple, unavoidable math, based on 400 years of accounting understanding. Ultimately, there must be a trade surplus if leverage and debt are to be reduced.

There is a great model that Maudlin creates in the post that summarizes the situation of Greece, Portugal et al to a tee.  I would recommend reading the piece in its entirety.  One last point from the piece:

Prior to the euro, the imbalances would be handled by currency exchange rates. The value of the drachma would go down relative to the value of the deutschmark. Things would balance over time. Now, all of the eurozone countries are effectively on a gold standard, with the euro standing in for gold this time. Britain, the US, and Japan print their own currencies. Their currencies can rise or fall over long periods of time, based on national accounts and the desires of foreigners to buy goods or invest in their countries.

He is retreading the old Jane Jacobs idea that I brought up a couple weeks ago:

What Europe has embarked on with the Euro is the exact opposite of what is needed.  Currency regimes need to evolve to produce better feedback, not worse.  The Euro currency feedback mechanism is skewed by the strength of the German economy (actually more exactly the economy of its one or two prime export replacing cities, Berlin and Frankfurt).  Peripheral countries like Italy, Greece, Spain and Portugal are doomed to receive faulty feedback rather than the natural “export subsidy” that would occur if those countries had (lower value) currencies of their own.

To think that all is well is to mistake the calm eye of the storm for the end of it.

Meanwhile, I’ll end my Europe talk with this: There seems to be a growing recognition that Greece needs to exit the Euro.  The chief executive of Germany’s natural gas firm Linde’s chief executive Wolfgang Reitzle was quoted as saying the following in Reuters:

“In the medium term Greece needs to exit. And the writedowns on Greek debt will not be between 50 to 70 percent, but in the end will be written down by 100 percent,” Reitzle said.

Asking Germans to pay more than 50 percent taxes to help fund other euro zone countries will erode the will of the German electorate to support rescue measures, Reitzle said.

Although this scenario is not desirable, he felt that German industry would survive working in a new currency.

Atna’s jump in reserves (and share price)

I haven’t spent as much time as I should writing about Atna.  I tend to ignore the stocks that I am right about.  This is perhaps not the best way to self-promote, but since I’m not really in that ballgame anyways, who cares.  I learn more from my mistakes.

But don’t take that for disinterest.  I watch Atna like a hawk every day. As I pointed out a month ago, I think that if Pinson works out the stock is worth somewhere between $3 and $6.  I know that there is some skepticism around Pinson, that there may be rock stability issues, but I’m of the mind that the current stock price is more than pricing in that risk.

It feels to me like a stock being accumulated before a break-out.  Perhaps we got a taste of things to come this week when the stock popped over $1 and up to as high as $1.05.

On the news front, Atna released an updated resource at Briggs on Thursday.

There is not too much to get too excited about, though it is nice to see that they managed to move about 50,000oz to measured and indicated, basically replacing production.  Overall they showed a slight increase of about 14,000 oz all in.  At the current production rate (45,000 oz), Briggs is good for another 10 years. That alone is probably good for the current share price.

Buying Midway Energy (Again)

The other move I made this week was to reinitiate a position in Midway Energy.  I decided to pull the trigger here because the other Swan Hill players showed signs of moving up towards the end of the week.

I already own positions in Second Wave and Arcan (though the Second Wave position didn’t get taken in the practice account due to an unfortunate glitch in the order fill).  I did not own Midway and it had not moved higher and it seems a reasonable presumption that it will follow suit eventually.

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