Tuesday, April 29, 2008

Are We There Yet?

The bottom in the housing crisis is nowhere in sight, according to data released today. Take your pick, the stats are all bad:

* Foreclosure filings: up 112% in the first quarter compared to 2007.

* Home prices: down 12.7% in one year (Case-Shiller index).

* Vacant homes: up 5.7 % in 2007.

* Owner-occupied homes: stuck at 68%--and headed lower.

The vacancy rate is the one that really gets me. It is a capsule summary of the colossal, almost obscene misallocation of capital (aside from war spending) that took place in the U.S. over the past decade.

Let's look at the vacancy numbers more closely. In 2007 the number of vacant homes increased by one million to a record 18.6 million. If we take out seasonal homes, we are left with 13.9 million vacant homes that are suitable for year-round occupancy. Of those, 4.1 million are for rent (over 10% of the total rental stock). Another 7.5 million are off the market for one reason or another; they may be second homes, homes in foreclosure, or homes in undesirable locations. Bottom line: there are 2.3 million vacant homes awaiting buyers, an overhang that is nearly double the usual.

How did it happen? The Federal Reserve helped with its loose monetary policy, encouraging risk-taking among lenders and borrowers alike. Artificial demand was created as homes (particularly at the high end) morphed into something else: fungible assets that investors could swap in and out of. In other words, these homes were not built for occupancy. Wall Street fueled the boom by securitizing home loans and hence increasing the velocity of all that easy money.

Many (most?) of these home loans were structured to serve quick flippers, not long-term occupants. These so-called "exploding ARMs" (adjustable rate mortgages) came with low introductory interest rates good only for two or three years before resetting much higher--no problem if you can get out before the reset. Oh, wait, you mean you actually want to live in that house? Then you had better be ready for higher monthly payments. Hybrid ARMs worth $362 billion will reset in 2008 and will devour a lot of those IRS rebates going out in the mail starting this week. Unless these loans can be reworked, many will fail.

Vacant homes lose value in many ways. Not only do they have to be repriced (downward) according to the law of supply and demand, but they are beset upon by squatters and vandals. The physical deterioration, in the words of a Boston attorney, is "like Katrina without the water." And it will get worse before it gets better.

Monday, April 21, 2008

These Lips Are Not For Reading

"Read my lips,"
said Republican presidential nominee George H. W. Bush 20 years ago, "no new taxes." The man got himself elected largely on that pledge, then was dismissed by the electorate four years later after, you guessed it, raising taxes. It was an infamous, though hardly unprecedented, example of saying one thing and doing another. Happens all the time in American politics.

And also in American finance. Two weeks ago Merrill Lynch's Chief Executive Officer, John Thain, reassured investors in Tokyo that his company had no plans to raise further capital, that the $12 billion already obtained from sovereign wealth funds would suffice. At that moment Merrill's Chief Financial Officer, Nelson Chai, squirmed in his seat. Chai knew the numbers, which have no lips and thus do not lie. "I wish he didn’t say that," Chai said later of Thain's remark.

Chai's caution was understandable in light of last Thursday's earnings update (see my April 18 post). Despite the reported losses and writedowns, Thain insisted that the firm is "well-capitalized" and that "we do not have any plans to raise any additional common equity, and Nelson actually agrees with that"--at which point Chai squirmed again. During the Q & A segment of the conference call, a Citigroup analyst pressed Thain on the possible need for additional capital. No problem, said Thain, who pointed out that the $12 billion already raised exceeded losses in 2007 by $4 billion. "That capital, that excess capital, was intended to reassure the market that we didn't have to come back into the equity markets and it'd give us the capital base to go forward into 2008. And that continues to be the case."

Given Thain's hope for restored profitability in 2008, Merrill's stock was up on Thursday and Friday. It retreated this morning, however, after the company's announcement of a preferred-stock offering at 8 5/8%. Oops, so much for Thain's reassurances. One wonders if his loose lips in recent days might provoke more shareholder suits. Meanwhile, bean-counter Chai continues to fret over Merrill's balance sheet and the $44 billion of debt maturities coming due in 2008. "We obviously continue to roll commercial paper and repo [repurchase agreements]," said Chai during the conference call.

How long can the juggling continue? Merrill is lunch, in my opinion.

[update, April 24:]
Merrill Lynch announced today that it will continue to pay out a quarterly dividend of 35 cents a share to holders of common stock. No matter that it is rolling over short-term debt at 6% and offering preferred stock at almost 9%. The dividend, which makes no sense from a business standpoint, is obviously meant to buy investor confidence.

[update, May 6:]
Minyanville's Bennet Sedacca has an updated scorecard on the need for new capital and the prices being paid by troubled Wall Street firms:

They just keep coming and coming and coming.
Legg Mason, Fannie Mae, Freddie Mac, Fifth Third, Citigroup. I'm hearing JPMorgan too.
Insurance companies are gobbling up this paper, but at some point they'll say 'no mas'.
What seemed 'cheap' at 7% is now getting done at 9%.
They're on their way to 12%. Or until companies just can't justify paying those yields and start cutting dividends and selling common stock.
As they should.

Friday, April 18, 2008

It Ain't Over

Has it really been three weeks since I last made fun of Merrill Lynch? Well, I am back to fix that. Merrill reported first-quarter earnings yesterday, and it was another disaster. The third-largest investment bank lost almost two billion dollars, compared to a profit of over two billion in the year-ago quarter. It was the firm's third straight quarterly loss. Another $6.8 billion was written off for troubled assets (CLOs and mortgage-backed securities for those of you keeping score), raising the nine-month total to over $30 billion. Money heaven is running out of room to keep all that wealth.

Still, Merrill's CEO said that he was "optimistic" about the remainder of 2008. His remarks harmonized with those heard earlier this week from the CEOs of JPMorgan Chase, Lehman Brothers, and Goldman Sachs, all of whom sang the same tune: the worst of the credit crisis is behind us. This was music to the ears of Wall Street investors, who bid up stocks all week.

Don't be fooled. Nobody's dancing at Merrill, where 4,000 employees will be laid off. Today Citigroup (Q1 loss of $5 billion and write-downs totaling $12 billion) compounded the damage by announcing lay-offs of as many as 6,000. Add another 5,000 at Goldman and 7,000 at Bear Stearns, and pretty soon you're talking about some serious unemployment--over 30,000 up and down Wall Street.

The cheerleading by overpaid executives is a pathetic attempt to buoy investors' confidence and somehow to disrupt the negative feedback loop that threatens to take the financial sector down. The fact is that all these firms hold impaired assets for which there is no market. These collateralized debt/loan obligations--little more than cleverly formulated perfumes to mask the stench of worthless loans--amount to "your basic, garden-variety nuclear waste, which isn't trading," points out Minyanville's Bennet Sedacca. "So how you can you say the crisis is over when the market is frozen? To me, it will be over only when all of this garbage trades, defaults and clears the market. Not until."

So much for the banks on Wall Street. How about the ones on Main Street? On Wednesday Wachovia announced a quarterly loss and slashed its dividend. Particularly ominous were remarks during the conference call by Wachovia's Chief Risk Officer, Don Truslo, who noted that even their most creditworthy customers are abandoning upside-down mortgages. "When a borrower crosses the 100% loan to value," said Truslo, "their propensity to just default and stop building their mortgage rises dramatically and, I mean, really accelerates up." The bank's risk models did not see that one coming, so capital is being hoarded to boost reserves. That means less for business investment, which spells S-L-O-W-D-O-W-N.

At least Wachovia has a Chief Risk Officer. Merrill finally hired one of its own, but only after the sh-sugar hit the fan. And if Merrill wants me to stop picking on them, all they have to do is give Mainers our $20 million back.

Wednesday, April 16, 2008

Quick Hits: Slots, Minimum Wage

Not on my watch,
said Governor John Baldacci yesterday as he vetoed legislation to allow slot machines on Indian Island, the Penobscot reservation near Old Town. Baldacci insists that gambling is too important an issue for mere legislators to decide. In his view, a new gambling venue should be created only through a ballot initiative passed in a statewide election, such as the 2003 referendum that allowed the Hollywood Slots racino in Bangor. The message to Native Americans: get your own referendum. Any exception to the referendum process, in the Governor's words, "sends Maine down a perilous path, fraught with risk of unfair, arbitrary treatment among future gaming proposals."

His logic escapes me. The slippery slope was created when Maine first introduced a lottery in 1974. That was when Maine voters decided that gambling was OK. All regulation since then has been "unfair" and "arbitrary." I may be running against her, but I agree with Representative Sheryl Briggs of Mexico when she sees discrimination against the Penobscots. "What gives us the right to tell them no?" she asks.

The "path" that we are on right now leads us to annual referenda on specific gambling proposals. Last year it was a casino in Washington County; this year it's one in Oxford County. Let's stop cluttering our ballots ad eternam and settle the question once and for all. Either gambling is allowed anywhere in Maine, subject to local approval, or it is allowed nowhere in Maine, in which case we dispense with the Maine State Lottery. It is a matter of fairness and consistency.

Raising the minimum wage gets votes, but is it the right thing to do? The State Legislature on Friday gave initial approval to a plan to raise Maine's minimum wage from $7 an hour to $7.50. Setting a minimum wage is a form of price control (in this case the price of labor), and government has never been good at price controls. Artificial prices interfere with free-market pricing and are ultimately self-defeating. Wages propped up by fiat eventually lead to fewer jobs.

According to U.S. Census data, over 98% of employees whose wages would be increased by this proposal live with working parents or relatives, live alone, or have a working spouse. Less than 2% are sole earners in families with children, and each of these sole earners has access to supplemental income through the federal and state earned income tax credit (EITC). Economists generally agree that the EITC is a better way to target resources at poor families than boosting the minimum wage.

Politicians jumping on the minimum-wage bandwagon will argue that rising wages are needed to counteract inflation in the costs of food, energy, and housing. But will they lower the minimum wage when deflation sets in (as I believe will happen in the coming depression)? Not likely. Ultimately, the ones best able to determine the fair price of labor are employers and employees freely negotiating between themselves.

Monday, April 14, 2008

Pigging Out Is All Too Human

Be careful what you wish for,
the saying goes, because you just might get it. So what is so bad about wishing for food? Can't survive without it, right? Throughout human history survival meant successfully finding food--and packing it in when you finally found it. Days of gluttony would get you through weeks or months of scarcity. You became adept at identifying and favoring energy-dense foods. At the end of the day, you burned enough calories hunting and foraging that you never worried about crushing your bathroom scale.

But that was then. Or maybe now, just not here. In 21st-century America a huge caloric imbalance has come to exist, with more energy consumed than expended. And the imbalance is killing us. Two-thirds of American adults are at least 20% over their ideal body weight, an ominous statistic since obesity is a risk factor for diabetes, heart disease, and stroke. What's worse, their kids are being groomed to follow along. "This generation of children," says Yale Psychologist Kelly Brownell, "may be the first in American history to live shorter lives than their parents."

Blaming folks for a lack of willpower, according to Brownell, misses the point. He argues that we are genetically programmed to prefer dense diets. Our bodies still think scarcity even though we live in an age of abundance. Add to that an economic system that strives for surplus and capitalizes on consumption, and you have a recipe for excess. Brownell suggests that we address the problem of overeating the same way we do tobacco consumption: regulate product advertising (especially to children), raise student awareness in public schools, and tax empty calories.

Some may think that a public-policy approach may be too heavy-handed. But if we are looking for ways to share or socialize the costs of healthcare, then we also must make a collective commitment to manage risk. Let me say it another way. If you want society to pay your medical bills, then you have to do your part by adopting a healthy lifestyle. Of course you are free to choose prehistoric pig-outs. Just don't ask the rest of us to pay for the consequences. "Eat less and exercise more," says Arthur Frank, medical director of the George Washington University Weight Management Program. "You cannot violate the laws of thermodynamics."

For more on Kelly Brownells' work, check out:
The Belly of the Beast

Friday, April 11, 2008

Making Money the Old-Fashioned Way (Not)

Remember the old Smith Barney commercial?
"We make money the old-fashioned way," a dignified John Houseman solemnly asserted to the camera, "we earn it." He enunciated with such gravitas (we UHR-RN it!) as to signify peerless professionalism and unstinting performance--earnings into eternity. You just knew that it was safe investing with him.

He may just as well have been speaking for General Electric, a veritable icon of American ingenuity and industrial engineering. But the U.S. economy has evolved during the years since the Houseman ad. This morning we got a reminder that GE, like so many American companies, has been juicing earnings by straying from its roots. It doesn't just make stuff anymore; it also plays with its excess cash, hoping to boost the bottom line with vigorish. It has become a financial company in drag.

GE's first-quarter earnings came up light. Net income fell by 5.8% compared to a year ago even though revenue grew by 7.8%. How can that happen, you ask? Answer: only through a markdown in paper assets--or, in the words of Chairman and CEO Jeff Immelt, "higher mark-to-market losses and impairments" in the financial-services side of the business. In truth, GE's global infrastructure business peformed admirably, with revenue up 23% and operating income up 17%. But when your betting operation turns south, you suffer.

GE's stock is getting hammered today, off over 10%, largely because of its tepid guidance for coming quarters. But it is not just GE investors who should be concerned here. If a triple-A credit like GE is struggling, then imagine what will happen to other companies who made money by financial legerdemain and not by earning it. Profits will vanish, as will the corporate tax payments they generate. State governments used to receiving their piece of the action will continue to see revenue shortfalls. Taxpayers will have either to ante up or to lose programs.

Meanwhile the Wall Street firms who specialize in financial alchemy are still at it. The Wall Street Journal reports this morning that Lehman Brothers has repackaged $2.8 billion in unsold debt--stuff that no one wants--into a collateralized loan obligation called "Freedom." The new debt securities issued by Freedom have been given investment-grade ratings by Moody's and S&P, qualifying them to be offered to the Federal Reserve as collateral in exchange for U.S. Treasuries through the Fed's new Primary Dealer Credit Facility. That's the way to do it, as Mark Knopfler sings in Money For Nothing.

Wednesday, April 9, 2008

Governor Proposes Increased Funding for Bridges

One bridge in seven in Maine is structurally deficient,
according to data gathered by the Federal Highway Administration in 2007. This compares to a nationwide average of one in eight. To address the problem, Governor John Baldacci yesterday submitted a bill to the Legislature that would raise an additional $40 million a year through increases in fees for motor vehicle registrations, titles, and vanity plates. The new revenues would boost spending on bridges to over $100 million annually.

Car registrations would jump 40% from $25 to $35. Reviewing registration fees in other states, one cannot easily determine whether the new fee in Maine would be above or below average. Some states charge a flat fee, while others have sliding scales based on vehicle weight, age, horsepower, or sticker price. Comparisons are apples-to-asparagus, at best. While a fee proportional to vehicle weight makes sense--after all, heavier loads have greater impacts--such a fee is better collected at the pump, where fuel usage captures both weight and miles driven.

35 bucks seems cheap to me. Last fall Delaware doubled its fee from $20 to $40. California Governor Arnold Terminator wants to go from $41 to $52, Wisconsin DOT from $55 to $80. Colorado Governor Bill Ritter has floated the idea of a one-hundred-dollar increase. Triple-digit registration fees, I predict, will be commonplace within five years.

And for good reason. As long as we pour hundreds of billions of dollars into securing and rebuilding Iraq and trillions of dollars into treating and managing lifestyle diseases, we will not have enough left to restore our transportation infrastructure without new user fees. Massachusetts Governor Deval Patrick wants to borrow to build now and figure out the revenue sources later. This morning he is unveiling a $3.8 billion bond proposal to repair more than 400 bridges over the next eight years.

Governor Patrick points out that aside from the issue of public safety, the initiative will create jobs during an anticipated economic downturn. We should be doing the same in Maine: putting people to work in order to pave the way to future prosperity.

Tuesday, April 8, 2008

Chalk Up Number 3

This Jayhawk fan is smilin'. Last night the University of Kansas men's basketball team erased a nine-point deficit with two minutes remaining in regulation, forcing overtime and eventually pulling away from Memphis to claim its third NCAA title ever.

I joined the Jayhawk fan flock as a grad student in 1971-72. Even then Kansas was a storied franchise, with such celebrated alums as Clyde Lovellette, Wilt Chamberlain, and Jo-Jo White and a coaching succession going back to the game's creator, James Naismith. They were coming off a Final Four appearance in 1971, and the highlight of my season in Lawrence was a 50-point blitz by All-American Bud Stallworth against arch-rival Mizzou
in the season finale. There was no three-point arc then. Bud was throwing up heat checks from all over the court, and making them. I have been bleeding K.U. blue ever since.

Title Number Two came twenty years ago when Danny Manning carried a dark-horse Kansas team to an upset over favored Oklahoma in the championship game. The first half of that game was played with as much energy as you will ever see in a basketball game, with each team scoring fifty. This year's team brought similar intensity to the Final Four, nearly running a very good North Carolina team out of the gym in the first fifteen minutes of their semifinal. They did it with hyper-alert help defense and breakneck transition. That same ferocity eventually wore down Memphis in the final. The Tigers had no legs at the end and could not hit their shots.

"That's a T-E-A-M, if I've ever seen one," writes the Boston Globe's venerable hoops guru Bob Ryan. Indeed, teamwork has been a trademark at Kansas since forever. This year's edition can be viewed as the Clydesdales of the tournament, pulled together by pedigree, practice, and purpose, perfectly harnessed. Such is the esprit de corps at Kansas that very few players leave early--Paul Pierce, Drew Gooden, and Julian Wright (who would have been a junior on this year's team) are the only ones that come to mind. The Jayhawks seldom want for senior leadership.

So what happens now? First of all, expect a lot of newborns named Mario in the Sunflower State soon after New Year's Day 2009. As for the basketball program, rumors are flying that Coach Bill Self will move on to his alma mater, Oklahoma State, and that Brandon Rush and Darrell Arthur will follow Wright into the pros. We'll see. Sad it would be if rock-solid Allen Fieldhouse were to be retrofitted with a revolving door.

Friday, April 4, 2008

Privatizing Gains, Socializing Losses

Will homebuilders get a mulligan?
That's golf-speak for a do-over. When a golfer hits a truly horrendous shot, his buddies (once they get done laughing) might graciously ignore his shot, pretend it never happened. He gets to hit again from the same spot without a penalty--a mulligan.

The U.S. Senate wants to grant a similar reprieve to two industries that conspired to create a bubble in housing. Builders and lenders made fat profits for several years by putting up houses faster than Americans could occupy them. It got to the point where houses were bought not for mere shelter, but for the prospect of resale at a higher price. Why bother moving in when (a) you already had a decent home and (b) you were just going to flip the property anyway? Easy money created by the Federal Reserve led to an artificial demand and, eventually, an over-supply of unaffordable homes.

It was a train wreck in slow motion. We all knew the pace of building was unsustainable, but the lenders kept lending and the builders kept building. The activity served no useful social purpose, but dished up immediate profits. Company executives got mega-salaries and stock options. Investors saw rising share prices, and Uncle Sam collected rising corporate tax payments. Short term, steroids are awesome.

Now come the consequences. Homebuilders and mortgage lenders are reeling from a falloff in demand and the failure of borrowers to keep up with their payments. For these companies, the bad news that they are now losing money outweighs the good news that, hey, at least they don't have to pay income taxes anymore. But wait, Congress has a solution in the Foreclosure Prevention Act of 2008: how about if we refund to these companies the taxes that they paid when times were good!

That's right, we will expand the so-called "tax loss carryover," an accounting tool by which companies are allowed to deduct net operating losses retroactively against earlier profits. Ordinarily companies can reach back two years to erase earlier profits (hence, earlier tax liabilities), but the Senate bill hashed out on Wednesday would double that to four years. Lobbyists had failed to get the new provision included in the economic stimulus bill passed two months ago. But lobbyists are nothing if not persistent. Only once before, in the wake of 9/11, has Congress extended the carryover timeframe.

This is yet another case of taxpayers bailing out risk-takers, this time to the tune of $6 billion. In the words of Minyanville's Fil Zucchi, "if ever there was an action that should undermine investors' confidence in the U.S. market system and reinforce the view that the government exists to grease the palms of those who pay their way into influencing the government, this is it."

Wednesday, April 2, 2008

What's In Your (Candidate's) Wallet?

"Clean" money has its own agenda.
If my candidacy accomplishes nothing else, it may at least disabuse you of the notion that public funding of political campaigns somehow purifies the process. No matter where it comes from, money is money. By itself it is neither "clean" nor "dirty." It is a means toward an end, a means by which people motivate and influence each other. More money means more influence.

The State of Maine spends about $6 million each election cycle in public financing of campaigns for the Legislature. Of the 305 House candidates who have registered thus far in 2008, 258 are seeking public financing (about 85%). The intent of the Maine Clean Elections Act is to level the playing field by limiting campaign expenditures and equalizing contributions, thereby empowering ordinary folks who might not otherwise have the resources to run.

If every candidate were required to run "clean," then the field would indeed be level. But such a requirement would be an unlawful abridgment of a candidate's First Amendment rights. So privately financed campaigns are still part of the political landscape, and any spending limits pertaining to these are strictly voluntary. It is still possible for a candidate to outspend his opponent and for "outside" money to impact a race.

But even a "clean" system can be gamed, and Maine's Democrats have shown that they are quite good at it. Of the 154 Democrats seeking House seats, 146 want house money (95%), compared to 75% of Republicans, 70% of Green-Independents, and 67% of Unenrolled candidates. If you are a Democrat thinking about running, you will be directed by party leaders to the public trough.

Let's look at our local House District as an example. LD 93 serves the towns of Mexico, Dixfield, Peru, Canton, and Carthage. The seat became vacant last August, prompting a special election. Democrats and Republicans had one month to hold their caucuses and nominate their respective candidates for the November election. The Democrats picked a first-timer named Sheryl Briggs and within 48 hours had her seed money of $500 taken care of: $100 from Speaker of the House Glenn Cummings (of Portland), $100 from Rumford Rep. John Patrick, $50 from House Majority Whip Sean Faircloth (of Bangor), $50 from County Sheriff Wayne Gallant (Rumford), $40 from Roy Gedat (Norway), and the other $160 from contributors residing in the district.

Think of it. Two-thirds of Sheryl's seed money came from outside the district. To whom does she owe her loyalty? How about to career politicians with future plans. Cummings is posturing for a gubernatorial run, Faircloth would like to be the next Attorney General, and Patrick is running for County Commissioner. These guys are players. When they tell Sheryl to jump, she will ask "how high," not "what for?"

Counting her seed money, Sheryl spent almost $8,000 on a ten-week campaign. She was authorized by the Ethics Commission to spend $7,495.18 of public funds; of that, she spent $7,493.99 and returned $1.19 to the MCEA kitty. This year she will do it all over again. I expect to spend much less, and none of it will be taxpayers' money.

Tuesday, April 1, 2008

Tug of War Over Lehman's Stock

Some see a white flag, others a red cape. Late yesterday afternoon Lehman Brothers announced a stock offering to raise up to $4 billion. This is usually considered a sign of trouble for a seasoned company such as Lehman, which has repeatedly denied over the past several months the need for fresh capital. While yesterday's move was not telegraphed by management, it was anticipated by speculators.

Check out the chart above, which tracks Lehman's stock price over the past year. See that downward spike about two weeks ago? Option traders were frothing at the company's prospects, halving and then doubling the share price in a 48-hour period. Newbies tempted to swim with the sharks got a serious case of whiplash.

Strangely, Lehman reiterated its mantra of "no problem" even as it announced its offering.
Chief Financial Officer Erin Callan insisted that the capital was not needed to offset the impacts of write-downs or losses. Rather, the deal was meant to end questions about the bank's balance sheet--to restore investor confidence, as it were. "We have not changed our view on our real need for capital, but we have changed our view from a perception perspective," Callan told Reuters. In effect, the firm is double-daring speculators to press their bets.

Lehman is issuing convertible preferred stock that will pay quarterly dividends at a rate of 7.25% per annum, a cost of capital more favorable than that obtained by either Citigroup (11%) or Merrill Lynch (9%) in earlier deals. Holders will have the option of swapping the preferred for common stock at an initial conversion price of just under $50 a share. Should Lehman's stock recover sufficiently to trigger conversions, shareholder equity will be diluted by as much as 20%. For that reason, the common stock should be selling lower today. However, LEH is opening up 10% as I post this, indicating that short-sellers may be covering.

Lehman may be safe for now, but see how times have changed. Six months ago Lehman was offering to buy back stock at $65 a share. Clearly management has revised its idea of what the company is really worth. For preferred shareholders, the risk is minimal. They get paid to wait and are first in line if the company is forced to liquidate. And the short-sellers will be back. Says one: "How can we have confidence in a firm that just diluted shareholders who have been just obliterated in the last year?"