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Housing Gets a Helping Hand

(February 5, 2009)

Dear Subscribers and Readers,

In today's CNN poll regarding executive pay at financial institutions that received TARP funds, nearly 95% of those polled stated that executives should either have their pay capped, or not get paid at all.  Starting with the peak of the technology bubble in 2000, and progressing with the Enron scandal, the outsized payouts of hedge fund and private equity fund managers (the 75% decline in Blackstone and 90% decline in Fortress from their peak stock price is a joke), and ending with the financial system bringing the global economy to its knees, the populist backlash against capitalism and the financial sector has now reached a crescendo.  Of course, the Austrians would say that this current crisis (similar to the 1929 crash and the subsequent global depression) all began with government intervention, starting with Alan Greenspan's “easy” monetary policy during 2002 to 2003.  Perhaps.  What it isn't taken into account is that the US, under a strict gold standard and prior to the establishment of the Federal Reserve in 1913, also experienced severe booms and busts.  In fact, if it weren't for the interventions of John Pierpont Morgan during the Panic of 1893 and the Panic of 1907, the subsequent busts following those panics would've been much more severe.

Regarding the payouts and bonuses in many parts of the financial sector in recent years, I am personally appalled by it.  These issues have already been discussed in numerous articles and blogs, but the number one issue was the severe misalignment of risks and rewards, both on the upside and downside.  After all, under a capitalist system, only capitalists should be entitled to great rewards.  If one isn't taking much risk with his own capital (this is a horrible way to live your life, until of course, you make it to the other end), then why should one be rewarded with hundreds of thousands, if not millions of dollars?  People who speculated with other people's money, mortgage brokers pushing option ARMS on unsuspecting subprime borrowers, and Wall Street executives paying themselves tens of millions of dollars were great examples.  Main Street is not only getting tired of Wall Street and Fortune 1000 executives, but is about to have a riot (with so much of Main Street now unemployed, this is particularly understandable).

In response to the popular sentiment of the masses, the Obama administration has fired the first shot in the salvo – declaring that senior bank executives who seek “exceptional assistance” deals with the Treasury (such as those brokered with Citigroup and Bank of America) with have their total compensation capped at $500,000.  Fortunately for many still working in the financial sector, this is merely a political ploy to soothe populist sentiment, as this restriction isn't applied retroactively, and most probably won't apply to any banks seeking financial assistance as long as any deals are done under a systemic guarantee with other banks (such as the first round of the TARP recapitalizations).

For now, this is more of a calculated political move to enable “social harmony” (borrowing a term from the Chinese government) in the US.  But this much is clear: The hedge fund “2&20” fee structure, along with the outsized executive pay packages in recent years, is definitely on its way out.  Going forward, I expect more laws and guidelines to discourage high executive pay packages or to outright limit executive pay.  This is where the political winds are shifting – there is nothing Wall Street, you, or I could do about it.

In the meantime, my neighbors, myself, and everyone with a 401(k) (or 403(b)) account are still watching for signs of a turn in both the financial markets and the US economy.  Aside from the numerous leading indicators that we track (such as money supply, Fed policy, corporate yield spreads, and even technical overbought/oversold indicators such as the ARMS Index, the McClellan Summation Index, and so forth), one thing that we haven't discussed recently is housing prices.  Until the housing price decline is arrested (housing prices just need to decline more slowly), it would still be difficult for the market to stabilize.  That said, we actually received a little bit of good news last week, as the National Association of Realtors announced that total housing inventory declined by 11.7% to just 3.68 million homes (on par with 2006 inventory levels) – which is equivalent to a 9.3-month supply based on current (depressed) monthly sales.  Assuming a “normalized” existing homes sales number (such as 5.5 million a year, which is equivalent to existing homes sales during the 2001 to 2002 period), an inventory of 3.68 million homes is equivalent to only an 8.0-month supply.  With so much “pent-up demand” resulting from so many potential homeowners sitting on the sidelines, my sense is that existing and new home sales could quickly spike up as soon as the housing market starts to see some signs of stabilization.

In the meantime, the cash-constrained homebuilders are contributing to the cause.  The following chart, which shows the number of US building permits over the last 50 years, indicates that new homes are going to have much less impact on housing inventory going forward:

US Building Permits - Seasonally Adjusted (January 1960 to December 2008) - Seasonally-adjusted housing permits sank to a record low of  547,000 units in December 2008!

Since not all housing permit filings would result in new housing starts, my sense is that housing starts would decline below 500,000 sometime in the next few months.  This would be beneficial to housing inventory and should provide some stability to housing prices.

More importantly, the Fed remains committed to keeping conforming rates low by purchasing up to $500 billion of agency MBS and $100 billion of agency debt.  In addition, Senate Republicans have proposed adding a $15,000 tax credit provision to the stimulus bill for credit-worthy borrowers to purchase either an existing or a new home.  Combined with the latest decline in housing prices, this should boost housing affordability going forward.  A final “tailwind” is demographics.  The "Y-gens" are now just coming of age and are starting to form households and buy starter homes.  Most estimates put this at an additional 150,000 households on an annual basis over the next decade at the very least, if not over the next 15 years.  For comparison purposes - during the last housing bust in the early 1990s - household formation fell off the cliff as the baby boomers literally stopped buying in 1989.  Unlike the last housing bust, subscribers should note that demographics is much more favorable this time around – with a potential swing of 300,000 households every year to the buying side relative to the early 1990s.  Of course, all of this rests on the assumption that the Fed will continue to ease policy, and that banks will make more loans over the next few months.  That said, assuming the credit markets open up in the next few months, we could see some signs of housing price stabilization by this summer.

In the meantime, the deleveraging process still rules the day.  This has been evident in both the financial markets and the “real” economy.  As shown in the following monthly chart, the amount of margin debt outstanding declined by another $17.1 billion during December.  For the three months ending December 2008, margin debt outstanding declined by a whopping $135.6 billion:

Wilshire 5000 Vs. Margin Debt Outstanding(January 1997 to December 2008) - 1) * Ratio = Margin debt divided by Wilshire 5000 divided by 10 2) Total margin debt decreased $17.1 billion during December to $210.2 billion, from $227.3 billion at the end of November 2008. Margin debt outstanding has decreased by a whooping $135.6 billion in the three months ending December. This immense rate of margin debt liquidation is unprecedented. Even during the 2000 to 2002 bear market, margin debt outstanding never declined so quickly. From its peak in July 2007, the amount of margin debt outstanding has now declined by 50%, and is now at its lowest level since October 2004.

As mentioned in the above chart, total margin debt outstanding was $210.2 billion at the end of December 2008, and is now at its lowest level since October 2004.  Moreover, since its peak in July 2007, margin debt outstanding declined by an unprecedented 50%.  Such a rate of liquidation is unprecedented – not only during the 2000 to 2002 bear market, but the 1973 to 1974 liquidation as well.  With the decline in stocks in January, there is no doubt that margin debt outstanding at the end of January is even lower, although we would not know for sure until January margin debt numbers are released later this month.  While the liquidation in margin debt is getting “long in the tooth,” I don't anticipate any reversal until the stock market settles into a lower volatility level.  More thoughts to come this weekend!

Signing off,

Henry To, CFA

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