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April 13, 2007

When Leading Fund Mgr Talks, Do People Listen: "Biggest housing price decline since the Great Depression"
by Econotech

Apr 13 (Econotech FHPN)--"The one thing they [investors] shouldn't go anywhere near is a CDO or residential mortgage-backed securities rated triple-A by Moody's and S&P because these securities are going to get downgraded by the hundreds of billions because they are secured by sub-prime and Alt-A mortgages where there's going to be massive defaults ... most of them appear to have been sold to hedge funds and foreigners and pension funds. Interviewer: Who owns them? Heebner: No one wants to talk about it ... They [hedge funds] buy a pool of mortgages that yield 8%, and they borrow against the yen and pay 3% [a yen carry trade], and they lever it ten to one, and so you have a lucrative profit. The hedge fund that you're running, the manager gets 20% of the gain. So even if you go a year before you go broke in the hedge fund, you get rich until the thing gets shut down. So there's a huge incentive to gamble recklessly here in the hedge fund business ... They [largest investment banks] created, they invented this machine. They're the ones that came up with the idea of securitization. They know the products are toxic. I don't think they're going to suffer losses. They simply passed them on to everybody else ... The only impact [on the i-banks] this will have when it shuts down is that the profits flow from it will get less ... So, they know the product is toxic; they're not going to get caught. Interviewer: And basically you think they've disposed of all the risk. They created it, they made their fees, and they got rid of the risk. Heebner: That's right." Kenneth Heebner, manager, CGM Realty Fund, Bloomberg video, Apr 12, my transcription

"They [investment banks] know the [mortgage securities] product is toxic; they're not going to get caught," Kenneth Heebner, Co-Founder, Capital Growth Management Heebner, a very experienced mutual fund manager, is one of the tiny handful of the absolute best out of many thousands. According to the Bloomberg video, his CGM Realty Fund had a 5-year CAGR of 30%. CGM as a whole manages more than $6 billion, so this is real money, not economists' forecasts.

I.e., when Heebner talks, serious financial people listen. He's not a permabear. In fact, despite his views on the residential real estate market I quote below, he said he currently doesn't think this will lead to a U.S. recession.

"Heebner, manager of the top-performing real-estate fund over the past decade ... co-founded Capital Growth Management in 1990 ... known for making concentrated investments in a few industries. He sold homebuilders after owning them from 2001 to 2005, record years for home sales. He bet against technology and telephone stocks in 2000, correctly timing their collapse." Bloomberg , Apr 12

Here's the link to the full Heebner Bloomberg video, a short ad appears first.

On April 4 I posted an article titled "When Citibank Chief Exec Talks, Do People Listen: 'A market correction is coming, this time for real'" link.

Likewise, Heebner also has very important comments on real estate prices, which follow in the next section.

I chose to lead with the above quote because I wanted to focus first on the issue of the hyper-speculative nature of global capital markets, who wins, who loses, a major theme of my web site link. That issue is also taken up below with respect to private equity.

Heebner says that the creators of the "toxic" mortgage products, the largest investment banks, i.e. the Goldmans and Lehmans of the world, will not be the losers. They almost never are.

"would estimate that housing prices in '07 will decline at least 20% in a lot of markets from where they are today ," Kenneth Heebner, Co-Founder, Capital Growth Management

"I think it's not only sub-prime, I think the Alt-A mortgages are going to default on a huge scale also ... As we get a large amount of these two and half trillion of mortgages going into default ... You're going to see foreclosed houses dumped onto an already weak market where homebuilders are struggling to sell their spec houses. And so the price declines that have started will continue and maybe even accelerate in some of the hotter markets. I would estimate that housing prices in '07 will decline at least 20% in a lot of markets from where they are today ... What you're going to see is the biggest housing price decline since the Great Depression ... The consequence of this is going to be a big decline in housing prices ... ... housing prices in the inflated markets, that's California, Arizona, Nevada, Florida, and parts of the northeast, they have to decline a lot before it's attractive to buy rather than rent ... They're [mortgage losses] going to dwarf those [Resolution Trust - S & L crisis of the early 190s] losses ... It could easily approach a trillion dollars. That dwarfs anything that has happened. Enron was a hundred billion dollar loss, this is going to be far greater than that." Kenneth Heebner, manager, CGM Realty Fund, Bloomberg video, Apr 12, my transcription

"a new Bloomberg/Los Angeles Times poll ... Most Americans remain sanguine about home prices, the poll showed, with more than half expecting homes in their neighborhood to hold their value over the next six months. Twice as many respondents said home prices will increase as those who predicted a decline. A majority said slowing home sales nationwide will hurt the economy." Bloomberg, Apr 11

"The overarching question is why public companies can't do the same things [as private equity] to create the most value," Michael Mauboussin, Legg Mason strategist

In addition to mortgage-backed securities, CDO's, etc, that Heebner discusses above, private equity and m&a continue to be key issues in the global financial markets, with m&a reaching $1 trillion in the first quarter, a record on pace to top last year's nearly $4 trillion.

Here is a recent comment on private equity from Michael Mauboussin, the highly regarded strategist for Legg Mason:

"The overarching question is why public companies can't do the same things [as private equity] to create the most value. That hasn't been satisfactorily answered by many executives. If there are ways to create value, why aren't they doing those as public companies? Why do they need to be private? Those are concerns that should weigh on public shareholders ... That's the right word: incentive. Two things in particular make these transactions attractive to an executive. First, often the ownership stake or equity stake of the executives can rise quite a bit. They're more leveraged to the success of the operation, so they stand to do better financially. Second, there may be corporate actions, asset sales, downsizing or other capital allocation decisions that managers may feel are truly in the best interests of the value creation for the company, but there's a perception that making those moves as a public company would be unpopular. That's a perception, not a reality, but perception is important. So when you go to an executive and say the prospects are for you to have more skin in the game and do very well financially if this works out, and to have more latitude to make tough decisions, that's the one-two combination that draws executives." Legg Mason strategist Michael Mauboussin, printed interview, MarketWatch, Apr 4

Mauboussin's points seem somewhat similar, though more polite, than those I made in my Dec 19 article, "World Needs Better 'Face of American Capitalism' than Private Equity, Goldman Sachs" link. In short, private equity is a leading symptom of massive under-investment in real innovation and productive capital:

"my main criticism of private equity and the rest of the global hyper-speculators, such as hedge funds and investment banks like Goldman Sachs (mainly a very large hedge and private equity fund), is the economically unproductive ways in which they "earn" their extraordinarily high returns on leveraged legal looting (ROLLL) ... If all this shareholder value enhancing was supposedly done by CEOs already, then after two decades of it, what could possibly be the role of private equity in now supposedly greatly providing even more of the same? However, if public companies haven't enhanced shareholder value by such draconian actions and now need to be wholesale taken over by private equity, then the whole system of "free capital markets" and corporate governance that the ex-Goldman Sachs U.S. officials mentioned above are trying to persuade China and the rest of the world to adopt was perpetrated for the benefit of the very few who have become unfathomably rich. Even if the day of reckoning of the current immense wave of private equity deals were continued to be postponed another year or two, this unproductive use of capital already has greatly distorted global capital market flows, corporate incentives, and thus corporate allocation of scarce and critical resources, especially all-important human talent."

"Income inequality grew significantly in 2005, with the top 1 percent of Americans ... receiving their largest share of national income since 1928, analysis of newly released tax data shows ... The new data also shows that the top 300,000 Americans collectively enjoyed almost as much income as the bottom 150 million Americans." NYT, Mar 29

I doubt this enormous concentration of income and wealth in the top 1/10th of 1 percent can be adequately explained by educational levels without significantly accounting for the effects of unprecedented unproductive global hyperspeculation.

Of course, love him or hate him, Jim Cramer can be counted on to be brutally frank and honest, more so than any other recognized name on Wall Street. Here's his recent take on private equity:

"They [private equity firm Cerebus Capital Management] have to break the union. The key strategy behind everything they're doing is to crush the unions. That has to happen ... the Goodyear model is the model for Cerebus ... Cerebus is a very smart company. The lynchpin of the strategy, I believe, is to break the union ... I'm pro-union, I'm against manipulation." Jim Cramer, "Wall Street Confidential" video, Mar 29, my transcription, on Cerebus' strategy in the U.S. auto sector.

This is a very old story, several decades old, that's almost finished, union busting came into vogue at least as early as one of Pres Reagan's first acts as president in the air traffic controllers strike.

Very Brief Update on Global Financial Markets

In my Apr 4 article link, I noted: "each [global major index] etf has rebounded from the decline that started at the end of Feb and is now nearing or at its previous high. Should they take out those highs, especially EEM [emerging markets], perhaps in another manic run along with rising commodities like last April, this might then trigger another sharp decline, like last May-June."

For now, that scenario seems to playing out, especially in the continued enormous speculation in China's equity markets, now up more than 50% this year, and any commodity that feeds into China's economy. I also noted the recent loss in relative strength in India's equity market as a possible cause for concern, and that also continues.

Finally, I noted that updated data plugged into a leading economic indicator developed by a Fed researcher, while not yet signaling recession, was well on the way to doing so. Since 1962, on six of the seven occasions when it has reached the March level, it then went on to correctly forecast a recession.

I would like to note two things regarding this. First, as I've discussed elsewhere (e.g. the section "Why I Like Charts and Leading Indicators" in my Sep 26 article, "Global Markets Hope 'Mid-Cycle' 'Soft Landing,'" link) while I greatly prefer leading economic indicators to economic model forecasts, since the latter usually miss the turns, I much prefer charts to both, trying as best I can to stay aligned with their main trends, as I've mentioned several times before.

Second, I have a great deal of respect for the work of perhaps the leading provider of leading economic indicators, Economic Cycle Research Institute (link). While ECRI stopped posting its Weekly Leading Index (WLI) freely on its site a couple of years ago, it does post media comments, such as follows:

"We're hitting bottom on the economic growth and we should expect more positive surprises as the year progresses," said Lakshman Achuthan, managing director at the Economic Cycle Research Institute ... Achuthan says it's normal to have "a lot of confusion" during this time. "We don't have any recession here, I think those fears are largely being laid to rest by a lot of the data coming out," he said. "But we're still having of [sic] what seems to be a cyclical bottoming in the growth rate in the economy, and when you're at a turning point like that, you're going to get mixed data." CNBC, Apr 9

Just look at how confused Wall Street is as it flip-flops almost daily, indicated by futures contracts, on its what is the Fed going to do guessing game. My advice for a "big picture" is to follow leading indicators (e.g. Conference Board and OECD provide others), but most especially key longer-term market charts as closely as you can.

In trying to ascertain these key trends, we must never underestimate the very real possibility of financial "volatility shocks" mentioned here by the IMF, which markets and forecasters always underestimate (in part due to human psychological nature, part to huge vested interests), but which can do great damage to capital preservation:

"Against the backdrop of continued global growth, none of the individually identified risks by themselves threaten financial stability. However, with volatility across asset classes close to historic lows and spreads on a variety of credit instruments tight, investors may not have adequately factored in the possibility that a "volatility shock" may be amplified given the increased linkages across products and markets. Institutions may well be acting in accordance with their own incentives, but collectively their behavior may cause a buildup of investment positions in certain markets, possibly resulting in a disorderly correction when conditions change. For instance, the rapid growth of some innovative instruments, the rise in leverage in parts of the financial system, and the growth of carry trades suggest that market participants are expecting a continuation of the low volatility environment and that a sustained rise in volatility could perturb a wide range of markets" "Summary" section, "Global Financial Stability" semi-annual report, April 2007, IMF

What Private Equity, I-Banks and Hedge Funds Taketh Away, Can Philanthropy Give Back?

"Wealthy philanthropists have the potential to do more than the Group of Eight leading nations to lift Africa out of poverty, according to Jeff Sachs, special adviser to the United Nations secretary-general ... "There are 950 billionaires whose wealth is estimated at $3.5 trillion [$3,500bn]. An annual 5 per cent 'foundation' payout would be $175bn per year - that would do it. Then we don't need the G8 but 950 people on the Forbes list," said Mr Sachs. "Maybe private philanthropists will champion solutions to individual problems rather than the G8," he said. He was speaking as the OECD reported last week that aid from rich countries to Africa remained static last year even though G8 leaders promised in 2005 to spend $50bn more each year to 2010 on aid, with half the rise going to sub-Saharan Africa. The so-called Gleneagles commitments were championed by Tony Blair, the prime minister, and Gordon Brown, the chancellor." Lead article, FT, Apr 9

I have enormous respect for the almost super-human efforts of Sachs in this area, along with incredible philanthropy such as that of the Gates' and Buffet. That said, my take on this in my April 4 article, "When Citibank Chief Exec Talks," link:

"Rajan [ex IMF economic counselor] does make a key point that I have tried to make far less well several times on my web site, i.e. low interest rates are not mainly the result of a so-called "savings glut," a la Bernanke, but rather also due to under-investment (I would argue massively so) in real productive assets, in my formulation to meet the needs of most of the world's population, resulting in what Rajan calls a "financing glut," what I consistently label global hyperspeculation. And, btw, the unprecedented amount of philanthropy directed at these needs by Gates, Buffett, etc, which is incredibly worthwhile and extremely admirable, is not enough, what I would argue is that what the philanthropists consider to be a "market failure" itself ultimately must be directly addressed as such and changed."

Once Again, Whither China?

Since Goldman Sachs and other i-banks, private equity, hedge funds, etc, have long ago captured the global capital markets in the "developed" world, that battle is mainly being fought in "emerging" markets, most particularly China:

"Carlyle Group's bid to buy part of Chongqing City Commercial Bank will be rejected as China stiffens opposition to buyout firms, especially in the $5.6 trillion banking industry, three people familiar with the matter said ...The regulator is also mulling plans to make it harder for private equity companies to purchase stakes in banks. It is the latest setback in China for Washington-based Carlyle, which was forced last month to scale back a planned takeover of Xugong Group Construction Machinery Co. The Chinese government is concerned that buyout firms seek short-term profits and don't improve companies they buy enough, the people said." Bloomberg, April 4.

As I put it in my Dec 19 "World Needs Better "Face of American Capitalism" link:

"China is in the midst of a multi-year effort to try to reform its financial system. The U.S., led by ex-Goldman chief Treasury Secretary Paulson, is strongly trying to influence it in the direction of the American-Anglo "free market" model, rather than perhaps the more traditional Asian one of state dominated banking systems that produced remarkable results in the industrial rise first of Japan then later S. Korea, both under authoritarian regimes. China going from the huge problems of its own state-dominated banking system to the Wall St-City of London hyper-speculative "free capital markets" model would be somewhat like jumping from the frying pan into the fire, but that limited choice is the way the issue is always framed."

And in my "Whither China?" section of my Oct 27 article "Global Strategic Bargain" link:

"Thus, with very limited domestic and international opposition, that basically leaves China and Russia left standing in the way of total global domination by the hyper-speculators, two states which the U.S. government can not currently strongly influence, to the obvious chagrin and anger of those pushing U.S. hegemony in the current hyper-speculative version of globalization (there is a good version), hence the trotting out of Paulson's and Rice's current "soft cop" approach to China. The U.S. is not really interested in "free trade," it no longer has much that countries like China seem to want to buy, except Boeings and soybeans, since as noted above U.S. industry has long since been hollowed out, as opposed to Japan's and the EU's, which are more slowly getting there, to their great dismay. Rather, what the U.S. mainly wants from China, and everywhere else, is unlimited capital mobility for its mega- global financial institutions, so it can ROLLL (again, return on leveraged legal looting) over them as they have the rest of the world. Both China and Russia seem aware of this, and their elites are playing a fascinating game with the global hyper speculators ... One of the most important areas to focus on is control of the financial sector. Huge Western financial institutions have made significant investments on very favorable terms in China's four main banks, but China is clearly reticent to give up too much control of its key financial institutions and its nascent capital markets, as with Citigroup's efforts to take a stake in Guangdong Development Bank ... As it did with its industrial state-owned enterprises, China is using the club of foreign competition to do much of the politically unattractive dirty work, so to speak, to shake up its four large banks and the financial sector. In the long term, the Goldman's will ultimately need China far more than China needs the Goldman's. China is at the center of East Asian production networks that generate real savings/capital, which the U.S. currently does not. It is critical that China continue to channel its capital where it is needed, into China's internal development, not into very low-yielding U.S. securities, it holds $1 trillion in foreign exchange reserves, that are just being printed up in massive amounts to control and confiscate real wealth."

Econotech

Visit Econotechs Blog at http://econotech.blogspot.com/.

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