Tuesday, July 03, 2007

The Nuclear Cocktail

Bear Sterns is assuming that the housing crisis is going to go away. If it does, Brear Bear Sterns gets better. Well, that is a pretty tall order for this fairy tale.

Right now, we are in a housing equilibrium moment. No one is waiting in line to buy. Housing is not appreciating (why take the risk). At the same time, nobody wants to sell for a loss.

Add on to that, most people paid too much for their present home, by about 50%- to 100%. The banks can help you refinance, but the amount you signed for on the note is not going to change. The mortgage mechanics may be different, fixed instead of adjustable, but no one is reducing your loan amount. It’s kind of like some sort of cruel Simon Legree movie, titled "Slave to the Bank, for Life."

Bear Sterns announced their problem in mid June. If these hedge funds all use the same boiler plate investors agreements, then anybody that wanted to bail out of the fund had to notify the fund by June 1, to get a check three months later. We know that didn’t happen. So the next redemption date would be September 1. But if you were a relative of the boss, they might back date . . . . . . . . . . . . .Hmmmmm.

There were 34,000 foreclosures in San Diego County as of June 1. If we project out this to September 1, we could have about 70,000 (that’s a double in 3 months). The abstraction of these home loans to bonds, and then further up into Tranches, and then derivatives, the multiplier effect in the past, worked wonders. Now the least little hic-up, at the lowest level, could turn into a mushroom cloud at the top.

Of course, if you want something that could really go nuclear, the words “Credit Card Bubble,” come to mind. I wonder what Bear Sterns has in their wallet?

As a note of curiosity, the vehicle of investment in the late 1920’s was the “Holding Company.” It was leveraged differently but similar in its purpose to the Hedge Funds of today. The only one still around, from the 1929 debacle, is Goldman Sachs. By 1933, their investors had lost close to 90% in that mess.

8 comments:

Anonymous said...

Are you saying that: if everybody's home value is reset to a "reasonable" value, and we're all on the mortgage hook for the purchased value, then millions of people are suddenly in debt for $100K+ that will never be recovered?

Don't forget that the late 1920's also saw a real estate crash, especially in Florida. One haunting reminder is the picture from the crash showing real estate developments in Florida where neighborhood developments were stopped cold turkey. Paved streets, blocked-out lots, nice street lamps, but no houses.

Within the past 6 months, this has happened here in North Texas where a local forest was slashed down, streets paved, nice brick entrances built, but not a single home constructed. The lots have been overtaken by weeds and it looks like a 100 acre ghosttown.

Question: If bonds are doomed, the stock market is doomed, and real estate is doomed, what do I move my 401K into? Gold?

Jim in San Marcos said...

Hi Anon

Bonds stocks and real estate are not really doomed, just the owners of them. Now isn't the time to be buying. You want to be in cash and VERY short term Treasury's and have about 10% in gold and silver. My IRA at my bank is also FDIC insured. Max FDIC insurance level at a bank for an IRA is 250K.

Stocks are overpriced because the dividend (if there is one) doesn't support the price. The same with real estate, rental rates don't support real estate as an investment. Selling a house in this market is a lost cause.

Once reality returns to our markets, that will be the time to invest in Stocks and Real Estate.

Bonds are a different story. If interest rates were to double, a 100,000 dollar 30 year treasury bond (issued before the jump) would be discounted to $50,000. If the interest rates returned to normal in a few months, you would have doubled your money.

Most people are completely "invested." So if the markets fall apart, they won't be able to take advantage of the sales and bargains.

I remember seeing those pictures from the late 1920's. Coral Gables comes to mind with William Jenning Bryan, another interesting story of the times.

Anonymous said...

Jim,

If I followed a single sub-prime loan all the way through the process to the instrument that produces income, or losses, for me as a Bear Stearns customer, how much leverage would I find at work?

That's the only part I'm having trouble grasping, how much leverage are we talking about at the end of the process?

Thanks,
Jim M

Jim in San Marcos said...

Hi Anon 6:12

I would suggest the leverage ranges from about 15 to 1 on up to 60 to 1.

Check back tomorrow. I will have another missive on hedge funds for release.

Anonymous said...

Wow!

Thank you.

By the way, I really enjoy your blog.

Jim M

Troubled Loner said...

Hi Jim,

You say that an area one might want to be in is very short term Treasuries. Just curious, how short, and why?

Thanks, I enjoy your blog!

Jim in San Marcos said...

Hi Troubled Loner

A bond or treasury bill each have two distinct features; an interest rate and a maturity date. Let's take a an example; a $10,000 bond bought today at 5% interest due in 2017. If interest rates jumped to 10% and you wanted to sell it next week your bond would only pay half the interest the newly issued 10 year bonds would be paying. So to sell it you would have to discount the face about from $10,000 to $5,000. The new buyer would hold the bond for 10 years and receive the face amount but during that time he would only receive 5% interest on the bond.

By picking very short maturity Treasury bills, like the 90 day ones, even if the interest rate jumps to 20%, the most time you have to wait for the T-Bill to mature is 90 days, so there is no real need to discount your Bill to raise cash. Plus you can stagger your T-Bill investments over a three month investment window. That way you would have a T-Bill maturing every 30 days.

Right now, the interest rate on 3 month T-Bills is the same rate you would get on a 30 Government Bond. Historically, you got a couple of percentage points more for the 30 year, so why go long (30 year) if they both pay the same? The real factor to look at is liquidity, the 90 T-Bill has it, the 30 year bond doesn't.

Insurance companies that deal in annuities with a locked in term for life would purchase these 30 year bonds. It eliminates risk in their portfolio.

An easy way to remember it, as interest rates rise bond values decrease and vice versa. It seems kind of backward

Jim in San Marcos said...

TL

I forgot the most important part. If interest rates increased and you were to buy a $10,000 10 year bond at 15% and interest rates drop to 5%, you in effect have the interest on a current $30,000 bond.

So if interest rates were to jump to 15% you would want to buy as much time as you could (the 30 year bond). Then as interest rates dropped, your bond would increase in value.

Remember the interest payments are going to remain the same 15%. So a realistic sale price of the bond would be around $25,000 even if the rates dropped to 5%.

If you step back and think for a moment, there should be no reason to sell the bond. You would have locked in an "annuity" that pays 15%.