Saturday, May 31, 2008

Housing Bubble vs. Tech Bubble Loss of Wealth in Dollar Denominated Terms

How much wealth has actually been destroyed in the current housing decline verse the 2001 tech burst? According to the Case Shiller Indices (the most accurate housing guage available) In 2006, the value of U.S. residential real estate totaled US$ 22.4 trillion. Since this recording the national pricing indices (based on 20 metropolitan areas) has decline 19.87%. This is a loss of asset valuation equal to $4.5 Trillion. To put this loss into perspective, according to the International Monetary Fund the U.S. Gross Domestic Product in 2007 was 13.8 Trillion. So is this decline in value a direct hit to the Net Worth of the United States. Absolutely. If the value of liabilities declined proportionally to asset price then the answer would be no, but they clearly do not. The United States has significantly overstated it's wealth. Sound familiar?

In 2001 the bubble was another significant overstatement of wealth. The Nasdaq Composite Index is a market capitalization weighted index of more than 5000 stocks. Comprising all Nasdaq-listed common stocks, it is the most commonly used index for tracking the Nasdaq. The Dow Jones Wilshire 5000 Total Market Index represents the broadest index for the U.S. equity market, measuring the performance of all U.S. equity securities with readily available price data. No other index comes close to offering its comprehensiveness. For comparison, the NASDAQ listed securities compose 19% of the 5000 Total Market Index. The Market Capitalization of the Dow Jones Wilshire 5000 Full Cap was $16.7 Trillion as of April 30, 2008. Comparatively, the market cap at the end of Q1 in 2000 was approximately $16 trillion (only slightly smaller). However, between 2000 Q1 and Q1 2003 the index lost a stunning 43% of its valuation. In other words, $7.1 Trillion of wealth was lost. This stunning number includes the completeness of the crash. The 2001 bust was a U.S. equity based event and did not impact the real estate market (except for parts of tech specific markets, i.e. silicon valley). I assume this decline was not contagious because interest rates were so low at the time that demand for real property was accelerating.

The current collapse has a very different flavor. While the 2001 decline impacted large tech equity owners the current housing collapse impacts the average American consumer. This decline in wealth as it effects consumer spending is not particularly well known. The self propelling positive feedback cycle has not fully played itself out. There is potentially a 1/2 to $1 Trillion additional loss in the financial sector. Only $350 Billion of losses have been recognized on these balance sheets so far. What about the effect on the broader companies? Sears, Lowes, Home Depot, Microsoft, Alcoa, Catepillar, Merk, Wal-Mart, Disney, etc. The global firms do not seem to have much to fear. But remember, that the United States has the largest Gross Domestic Product in the world. A cyclical retraction of spending could take an enormous bite. U.S. Consumers are responsible for 2/3 to 3/4 of the U.S. GDP (that is approximately $9 to $12 trillion dollars of goods and services). The World's GDP was $54 Trillion in 2007. We're talking about 20%.

There is a strong offsetting effect of the US consumer pullback. Emerging market growth and the weakening U.S. dollar are the most prominent. The taste for leisure, life style, and technology is disseminating out of Western cultures into more agricultural and commodity based economies. A weak dollar makes the United State's taste for leisure, technology, and lifestyle a potentially cheap commodity. U.S. exports are booming. Ironically, emerging market demand, devalued currency, and outrageous commodity prices have created a golden age for the American farmer. Same goes for the steel industry, computer software, etc.

In another ironic twist, the Chinese peg their currency to the U.S. dollar. As the dollar declines because of mounting debt, cheap monetary policy, and a weakening economy, the Chinese are forced to keep the Yuan in step with the U.S. dollar. Allowing the Yuan to rise relative to the dollar would kill Chinese exports (the crux of their economy). The Chinese keep currencies pegged by buying dollar denominated T-bills. Their reserves (a word our culture is completely unfamiliar with) are pushed back into the U.S. financial system. As demand for T-bills is a must for the Chinese, prices are driven up and yields driven down. The United States' symbiotic relationship with the Chinese is largely responsible for the low interest rates obtained in the fixed income markets guessed it....30 year mortgages. Chinese reserves were approximately $1 Trillion last year.

Monday, May 26, 2008

S&P, DJIA, NASDAQ, Russell, Broad Index Declines

The US Stock market is poised for a broad sell off. The rallies we've seen since the mid-March Fed rescue of Bear Stearns are tapped out, and the broader effects of the plummeting US housing market are beginning to impinge on the average American's budget. The US consumer's average debt to income ratios have risen from approximately 90% in the mid 1990's to an impressive 130% at present. Similarly, the mounting trade deficit cannot remain. Financing our consumption with debt from over priced assets has left the consumer between a very hard rock and a very hard place. At the center of this recession is a more complex problem than defaults on subprime mortgages. This is an economically driven correction of financial culture that has lived beyond its means. You cannot consume more than you produce perpetually into the future, particularly when your assets to finance your overspending are rapidly devaluing. Banks are rapidly de-leveraging in a process of selling off assets to improve the asset to equity ratio. Similarly, new risk management criteria including a standardized international banking regulation known as Basel 2 are being embraced by large US broker dealers. These regulations force banks to recognize more complex off balance sheet assets, previously used to fudge capital requirements. To further exacerbate the problem, US consumers are facing rapid commodity price inflations. A number of analyst have tried to identify the causal link including rapid emerging market demand, a flight of capital from dollars to hard goods, and the creation of financial instruments on Wall Street that make commodities an available part of any speculators (or pension fund managers) portfolio. Simply put, there is no room for expansion of consumer spending. Instead, there are very convincing reasons to believe, the average consumer will have to retract, and retract significantly. Consumer spending is approximately 3/4 of the United States Gross Domestic product.

Tuesday, May 6, 2008

Level 3 Assets: Meanings, Markets, and Recent Performance

Level 1
Financial assets and liabilities whose values are based on unadjusted quoted prices for identical assets or liabilities in an active market (examples include active exchange-traded equity securities, listed derivatives, most U.S. Government and agency securities, and certain other sovereign government obligations).

Level 2
Financial assets and liabilities whose values are based on quoted prices in markets that are not active or model inputs that are observable either directly or indirectly for substantially the full term of the asset or liability. Level 2 inputs include the following: a) Quoted prices for similar assets or liabilities in active markets (for example, restricted stock); b) Quoted prices for identical or similar assets or liabilities in non-active markets (examples include corporate and municipal bonds, which trade infrequently); c) Pricing models whose inputs are observable for substantially the full term of the asset or liability (examples include most over-the-counter derivatives, including interest rate and currency swaps); and d) Pricing models whose inputs are derived principally from or corroborated by observable market data through correlation or other means for substantially the full term of the asset or liability (examples include certain residential and commercial mortgage related assets, including loans, securities and derivatives).

Level 3
Financial assets and liabilities whose values are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. These inputs reflect management’s own assumptions about the assumptions a market participant would use in pricing the asset or liability (examples include certain private equity investments, certain residential and commercial mortgage related assets (including loans, securities and derivatives), and long-dated or complex derivatives including certain foreign exchange options and long dated options on gas and power).

Now let's reference rule SFAS 157. According to the Financial Accounting Standards Board:

The changes to current practice resulting from the application of this Statement relate to the definition of fair value, the methods used to measure fair value, and the expanded disclosures about fair value measurements.

Rule SFAS 157 was created as an accounting standard for valuing "hard to value assets" including securitized debt instruments. The rule became effective on November 15, 2007. Banks have been forced to come clean with their true exposure. If an investment bank wants to list an asset it is going to have to be marked to market. The rise in the popularity of level 3 assets amongst America's biggest investment banks has also given rise to the transparency of the market. "Markit" posts daily trading values for Residential Mortgage Backed Securities, Commercial Mortgage Backed Securities, Credit Default Swaps, Leveraged Loan Securities, European and Asian Securitized Credit tranches, and Corporate Default Swaps. The derivatives market and securitized debt market dwarfs the U.S. equity market. But, until recently, its transparency was only well known to institutions, hedge funds, broker dealers, and banks. Real estate has seemed to taken similar shape, as illiquid markets inherently have less transparency. Wall Street's appetite for risk, illiquidity, and easier to arbitrage instruments has undermined itself again (reference Long Term Capital). Derivative instruments have created risk contagion in lieu of efficient markets via risk transfer. This time, the Bankers have lost a big sucker to lay these hard to know instruments off on...the institutional money market investor.

Monday, May 5, 2008

Are the Tupi and Jupiter fields the real thing?

Petrobras claims that by 2009 they will be pumping oil out of the massive Tupi field, discovered off the coast of Brazil discovered last year, ahead of schedule (I must add) Let's review the figures...Petrobas claims that the Tupi oil reserve could produce 5 to 8 Billion barrels of oil. More shockingly, their have also been claims made that adjacent oil fields in the same salt layers contain another 33 Billion barrels of light sweet crude. Those are bold claims. Brazil, seems to have a lot going for it this year. A potential discovery of 41 billion barrels of oil off the coast line, and now investment grade ratings from our jeopardized and overly optimistic credit rating agencies including Fitch. The EWZ, an ETF representing Brazil's major equity indices, rallied 9% on the rating news. Similarly, Petrobras and Brazil has roared on the markets this year (reference Brazil's Sugar Loaf Oil Field and American Oil Dependence). The discovery and investment class rating seems to be thoroughly priced into the market. Even the most sincere skeptics must concede to a correlation between the events. But will these wells produce and when? The most confirming evidence I can find that these reserves are likely the real thing is that Petrobras is multiplying (many times over) its corporate bond issuance (approximately $3.6 Billion this year compared to $800 million on average) . They are betting big on themselves, and tallying up a lot of debt to finance the mobilizations. Are these Brazilian oil men falling for their own narrative fallacies, or are their hard technical indicators that they are going to become extremely rich?