The Emperors New Clothes

By: Mark McMillan | Mon, Nov 17, 2008
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11/17/2008 10:26:05 AM


We are deferring our expanded analysis on the metals supply chain in favor of the effect of Sovereign Wealth Funds, a perspective of the housing market, and a look under the hood of the Fed Funds rate. We will also cover our regular review of marketplace events, our Market Outlook, and our Conclusions. Look for our Model Portfolio in the McMillan Portfolio, a separate publication.

The week in Review - Events & Fundamentals:

Monday, November 10th:

There were no economic reports of interest released. There won't be any significant economic reports released until late in the week. The focus was on a $586B 2-year stimulus package announced by China. This is equivalent to 18% of their GDP. It will sustain growth in their economy, even as demand for Chinese exports decreases, due to ailing economic conditions in the U.S. and Europe.

The optimism that saw Asian market up more than six percent and European markets up significantly gave way to economic concerns at home as the bullish open of U.S. equities markets gave way to pessimism. AIG received significantly better terms from the U.S. government on its bailout which allowed the stock price to rally some 14% through the day. Bank stock prices opened higher as well, but collapsed through the day as financials dragged the markets lower.

There are worries that GM will have to declare bankruptcy without a government bailout by the end of the year. GM's stock price lost nearly a quarter of its value. Ford's stock price dropped 4% in sympathy. Circuit City filed for bankruptcy which affected the stock price of their landlord, Developers Diversified Realty Corp (DDR). DDR's stock price fell nearly 25% on the day.

DHL announced they would be pulling out of the U.S. domestic only shipping market. Instead they will focus solely on their international shipment business. This boosted Fedex(FDX) and UPS (UPS). McDonalds beat earnings expectations, with same store sales up 5.4%, helped by its Monopoly game promotion.

Tuesday, November 11th:

There were no economic reports of interest released. Financials took the major headlines although earnings short falls and downward revised outlooks contributed to growing pessimism.

Before the market opened, Citigroup (C) announced a plan to keep delinquent mortgage payers in their homes. It affects 500,000 homeowners. Of the four largest banks, Citigroup has the most exposure to delinquent mortgages. American Express (AXP) announced the government had accepted its bid to become a bank. AXP will qualify for $3.8B in aid so that they will not have to raise that amount in the private sector.

At 2:00pm, Fannie Mae (FNM) and Freddie Mac (FRE) and government officials announced a plan to keep delinquent homeowners in their homes. It applies to homeowners who have not yet declared bankruptcy and reduces payments to no more than 38% of total monthly gross income. The move had been signaled earlier in the trading session and the markets and, in particular the financials, moved up in anticipation of the announcement. It was then the classic, "buy the rumor, sell the news" as markets sold off again after the announcement. Still, it was enough to keep the markets from closing at the lows but not enough to keep the financials from closing near their lows.

Bellwether Bank of America (BAC) closed below $19. It's July 15th low was at $18.44, a level we will be watching for a breach of that level to signal a move lower for financials. If bulls are able to maintain that level, we believe this will affect the markets, in general, and bodes well for a rally here.

The list of companies reported lower than expected earnings included KKR Financial (KFN), Las Vegas Sands (LVS), Starbuck (SBUX), and TJX (TJX). Rockwell Automation (ROK) and Tyco (TYC) met earnings expectations but the latter took down guidance. Goldman Sachs took down guidance for Google (GOOG) for 2009 and 2010. Analyst have been taking down earnings expectations for a large swath of companies in reaction to the slowing economic environment.

GM and Ford continue to be battered as investors grow concerned for their survival. President Elect Barack Obama's visit with President Bush to encourage him to bail out the automakers is viewed as partisan, in that unions and their members (which have been staunch supporters of the Democrat party) would benefit disproportionately over the public.

Finally, the price of Alcoa's (AA) stock fell more than seven percent after they announced a cut of 8% of their aluminum production. We have already seen three major iron ore producers cut production 10%. These cut backs are part of a larger cycle in commodities and metals production.

Wednesday, November 12th:

There were no economic reports of interest released.

Only one component of the Dow 30 moved higher on Wednesday. That was GM. Ford also rose on news that representative Barney Frank would seek $25B to bail out the automakers. Frank wants to take the money from TARP and that may be possible.

Treasury Secretary Henry Paulson announced that the Treasury is dropping its plan to buy soggy paper and instead would continue to do what is working, which is to seek preferred shares in companies that had liquidity issues. Those companies may not be confined to financial companies. In a stunning admission, Paulson admitted that by the time the TARP legislation was passed, he knew that the Treasury wasn't going to go through with the auction process for soggy mortgage paper. While we don't disagree that it is probably more effective and certainly faster acting to continue to amplify what is already working, Paulson has lost credibility and severely damaged the public trust.

The Treasury will focus on three priorities for the remaining $410 billion in TARP funds:

The idea behind all of this is to draw in more investment from private parties, rather than only the government.

Meanwhile, Best Buy (BBY) stated that the current environment is the worst they have seen and they took down their guidance well below analyst estimates falling short from 9% - 26% for the full year. Macy's (M) lost less than expected and confirmed in-line guidance for the year but then stated they are concerned they won't meet expected goals for Spring 2009 that they just provided one month ago.

Thursday, November 13th:

There were three economic reports of interest released:

The economic reports didn't affect the market over much as it was primarily moved by the price of oil rising which pulled up energy stocks. Financials led the markets lower and were the biggest drag on equities as they are clearly out of favor with investors.

It is interesting to note that investors/traders are beginning to embrace risk, or at least the short sellers are starting to abandon it. This is measured by the relative performance of small cap stocks versus large cap stocks. Monitoring the Russell-2000, a small cap index, the index has led the markets downward and lagged in the initial bounce on Thursday but then quickly made up for it as it raced upward to close 8% higher on the day. This compares to gains of around 6% for the other major indexes.

The tradable news came as Intel (INTC) and Wal-Mart (WMT) both took down their guidance. This news and the economic reports on jobless claims and the trade balance were all released prior to the open and with the mixed open near the prior close, hadn't seemed to affect trading.

The day was really about a game of chicken. The bears took the market down to try to break support and when the bulls stepped in and refused to yield, they covered their short positions and the market moved rapidly higher.

Friday, November 14th:

There were six economic reports of interest released:

The first four reports were released an hour prior to the open and the latter two were released a half hour into trading. All the economic reports coincided with downward moves of the markets.

Nokia (NOK), a leading handset maker, projected that fourth quarter industry volume would fall, even as they believe they will maintain or grow market share. On top of that, retailers continue to show concern over this season's holiday sales. Kohl's (KSS), Nordstrom (JWN), JC Penney (JCP), and Abercrombie and Fitch (ANF) each guided lower for Q4.

The problem with the downside guidance was the coincident reports for October retail sales were also down more than expected. All of this suggests that GDP will decline even more than the -0.3% contraction already expected.

Sovereign Wealth Funds and their Effect on World Economies

Finding a place to put all the revenues from trade imbalances has been a problem for net exporters. In particular, commodity boom bust cycles wreak havoc on economies that are not able to dampen these cycles. Commodity net exporters found a way to do this, most notably oil exporters. The idea is to place revenues from trade imbalances into diversified investments to even out the effects of boom bust cycles.

The first fund was founded in 1953 by Kuwait as the Kuwait Investment Authority. Since then, other oil exporting nations have placed their excess revenues in sovereign funds, such as Abu Dhabi's Investment Authority (1976), Singapore's Government Investment Corporation (1981), and Norway's Government Pension Fund (1990). Even Russia has set-up a sovereign wealth fund with their excess revenues from their oil exports.

A most prominent fund in the modern era has been the United Arab Emirates. The excess revenues from the high price of oil have created a fund that is often making high profile investments and will likely remain in the spotlight.

By far, the largest and one of the newest sovereign wealth funds is China's sovereign wealth fund which formally began operating with $200B on October 1, 2007. Prior to that, they had invested $3B into the Blackstone Private Equity Group in May. By the time Blackstone went public in June, that investment had lost 19%. It was an inauspicious start, but the need to do something with the $1.33 trillion trade surplus then was insurmountable. Since then, China's surplus has grown and the sovereign fund has some $1.2T in assets.

This fund is, by far, the largest sovereign wealth fund and is different than most funds in that it is not related to the price of oil or other commodities. Rather the fund is from excess revenues derived from Chinese government policy in regards to the valuation of their currency, the Yuan. The government has recently modified their long term stance of pegging the value of the Yuan to the U.S. dollar by letting it adjust in a very modest range to the dollar, but still keeping the Yuan from floating anywhere close to freely against other world currencies. Because of this policy, China continues to accrue excess revenues at an alarming rate.

Prior to the establishment of the fund, China was buying U.S. treasuries, keeping demand for these instruments high, and helping to create the situation where the interest rates on U.S. short term debt approached and even briefly became inverted to the interest paid on long term debt. This is known as an inverted yield curve.

Bank profits have traditionally depended on the spread between rates for borrowing short term money and lending long term money. With the inverted yield curve, this threatened profits of U.S. banks and was, in part, a factor in their heavy, and sometimes leveraged, investments in CDOs and MBSs. These investments required CDS to insure against loss and resulted in heightened counterparty risk. We have witnessed, firsthand, the consequences of these decisions when things began to unravel.

Many Sovereign Wealth Funds (SWFs) have changed their focus from passive investments into strategic investments in high-tech or other companies that can help grow their economies in a more stable way than the export driven approach that created the excess revenues in the first place.

SWFs will be a growing factor in the world economy as they are used to secure assets that ensure continued growth of the economies of countries that use them. When government policy in these countries also restricts free markets to help provide a natural equilibrium, then the natural adjustment made over time doesn't occur and when an adjustment finally occurs, the result is a dramatic and destabilizing move, which causes chaos in global market.

We would argue that this is in process at this time, with the housing market as an example of the folly of prolonging cycles through failed government policies. We also see this in process with the Chinese government policy to peg the value of the Yuan to the U.S. dollar.

We will take a look at the housing market in more detail as we look to a simple fairy tale to illustrate our point.

The Emperor's New Clothes

There is a story by Danish author Hans Christian Anderson called "The Emperor's New Clothes." It was first published in 1837 and was written as a children's story. The emperor unwittingly hires two swindlers to make a new suit of clothes for him and the swindlers tell him that the clothes are made of the finest cloth but are invisible to stupid people and to people who are unfit for their position.

When the emperor "tries on" the clothing, he testifies about the beauty of the clothing and proceeds to tour his empire in them. This of course means that he is not wearing anything but the story has gone out before him and all who see him comment on how marvelous he looks. That is, all except a young boy who asks why the Emperor isn't wearing any clothes.

At this point, it is apparent to all that the Emperor has been swindled. Everyone's fear that they would be found to be stupid or unfit for their position made them go along with the crowd and the farce was propagated. It took simple honesty for the group to recognize that there was indeed a problem.

We believe that there is a similarity between this fairy tale and a more modern fairy tale that might be called, "The Housing Market's Lofty Journey." Of course, the U.S. housing market (and other real estate markets around the world) saw enormous price appreciation since the late 1990s. In fact, the price appreciation was 100% in many areas during the period from 2001 - 2006.

Let's take a look at a chart of 116 years of home price appreciation put together by Robert Shiller.

It is obvious by looking at the chart that from the post WWII era to the late 1990s, the housing market values (adjusted for inflation) were somewhat constant, with notable booms in the late 70s and late 80s. Both of those booms were followed by busts that lasted for years but never saw major corrections. From the late 1990s, housing prices moved outside of the inflation adjusted range of norms that had existed for a hundred years. That ceiling had been about 125% of the arbitrary 100% starting value in the early 1890s.

The housing market began to move up from a 1998 low and by 1999 looked to be repeating the boom cycles of the late 1970s and 1980s. More importantly, the equities markets had been moving up through the 1990s and by the middle of the decade Shiller began warning anyone who would listen that we were in another boom that would be followed by a correction. Shiller even had a lunch meeting briefing government officials of his concerns and one of those attendees was Alan Greenspan. It is rumored that the "irrational exuberance" phrase popularized by Greenspan in his comments about the stock market in the late 1990s was first uttered by Shiller at that lunch meeting.

Alas, Shiller was early in his warnings about equities and the steep growth in the price curve seen in housing in the late 1990s was ignored as the Fed took down interest rates due to the collapse of the stock market that began in 2000. Shiller was continually ignored about his prediction of a collapse in equities and then repeatedly ignored about similar warnings about the housing bubble that followed the collapse of equities markets.

The index ceiling that had constrained home prices for more than one hundred years was surpassed by 2001 and continued to rise at an unimaginable rate due to the Fed's interest rate policy with a Fed Funds rate that sat for years at one percent. Before all was said and done, housing prices had reached 200% of the Shiller Index starting value! Not since WWII had the slope of the trend moved at such a high degree and that was confined to the war years and moved from an undervaluation of 70% to just 110% of the starting value of the index. Never before has there been such a tremendous rise and never from such a high starting point.

For some perspective, Fannie Mae on November 10th released their Q3 results. In that release, Fannie Mae estimates that home prices would fall a total of 19% before hitting bottom. The mortgage giant estimated that home prices have fallen about 9.7% so far. So Fannie Mae estimates we have only seen about half the pain in housing price declines thus far.

So, where does that leave us in terms of our fairy tale? Hans Christian Anderson would have been dismayed by the fact that the Danish housing market was even more overvalued and has come down significantly more than the U.S. housing market. Be that as it may, let's take a look at the U.S. government's reaction to the housing crisis, the financial crisis, and the problems with trading partners that don't embrace free markets.

China's Attire

Since China is the trading partner we have the largest trade deficit with, let's focus on their policies first. China continues to link the value of the Yuan to the value of the U.S. dollar. This pegging of the Yuan to the U.S. Dollar leave Chinese businesses with huge excesses of U.S. dollars and other currencies. They need to convert these dollars to Yuan to pay their local expenses, such as wages, rent, utilities, etc. They then have excess returns that they would like to use as profits to grow their businesses or distribute to owners. The Chinese government won't allow the Yuan to trade freely with the dollar so a grey market exists but is monitored by the government to ensure it is a local only market and the Yuan remains pegged to the U.S. dollar.

To that end, the Chinese government has to step in to exchange the dollars from Chinese exporters. Since the Chinese government is often a partner in these ventures, this is relatively easy for them to monitor. This essentially amounts to a subsidy by the Chinese government and is a barrier to free trade. If China hadn't grown to be so powerful with an economy still growing at 9% annually, perhaps other nations could force it to fall into line. Since there is little that can be done practically without looking either stupid or unfit for their position, world leaders do very little to criticize the Chinese on these policies, even as the global economies are grinding to a halt.

This is the first example of the façade known as "The Emperor's New Clothes." We are awaiting the government official, that isn't concerned about political correctness or fear of being ridiculed, to step up and say, "the emperor has no clothes." Even the Chinese can see that it is failed policy now, but they will try to propagate it further, as the alternative means that their economy will slow and their burgeoning middle class will become discontented with their leadership.

Doesn't the U.S. Government clothing look Wonderful?

Let's first look at the government's reaction to the housing crisis and the financial crisis, as they have been linked due to the widespread ownership of Mortgage Backed Securities (MBS) and Collateralize Debt Obligations (CDOs), and by extension, the risk of collapse of counterparties in Credit Default Swaps (CDS).

The owners of "soggy paper" are caught between a rock and a hard place. When they bought these instruments, the debt had a AAA rating, which implies very high credit-worthiness and therefore, a low percentage of defaults. To backstop that, CDS were used to ensure that if mortgage holders defaulted. Therefore, the holders of these debt instruments should not have been at significant risk, but the system blew up with the collapse of home values. It is the very nature of the holders of these debt instruments, and why they held them that is the cause of the financial crisis, as opposed to being merely a correction of a housing bubble.

The holders of this debt were the large commercial banks, investment banks, hedge funds, and others seeking a return that they couldn't achieve in government or corporate bonds. Once again, we remind readers that SWFs and the Chinese government, in particular, created an environment where the returns on long term bonds had little if any spread over short term debt instruments. In order to achieve greater returns, all of the aforementioned institutions sought the income streams and returns of MBS and CDOs. In fact, in order to generate the returns needed to satisfy investors, they leveraged up on these holdings.

What will fix the soggy paper held by these institutions? Apparently the Treasury department has decided that nothing short of absurd levels of government subsidies will do that. Treasury Secretary Hank Paulson's remarks that he knew that the auction of the soggy paper wasn't the direction they would pursue even as the legislation was passing through Congress. In essence, he suggests he knew that the government auction wouldn't work.

If the government paid a fair price for these assets, the institutions holding those assets would face bankruptcy. If the government paid an inflated price for these assets, then the government would essentially be bailing all institutions out their troubled assets. This would have required more money than initially asked for and would have wasted funds on institutions that are not needed to bring the financial institutions back into positions of stability.

What makes more sense is for the U.S. government to backstop the critical institutions until the assets they hold begin to have sufficient value that they are once again actively traded. This means the government must backstop the primary writers of CDS, such as Fannie Mae, Freddie Mac, and AIG, as well as investment banks, now absorbed or morphed into bank holding companies. That is what the government has been doing and will continue to do until the assets rise to a value where the holders of these assets can begin to reduce their reserves, instead of having to continually increase them.

A Chinese Solution

How much soggy paper do Chinese businesses and their government hold? We don't have the answer to that, but we are certain that Washington insiders are pleased to have the Chinese bail out their own holders, as they are a prime reason that so many institutions were driven to buy up these instruments.

In fact, if the Chinese bought all of these instruments at a price that left primary holders not having to file for bankruptcy and with sufficient capital reserves to continue operating, the crisis would disappear and the Chinese would eventually make a return on these instruments. It would, in fact, cause world economies to be jump started as credit would flow, and there would likely be significant demand for Chinese exports.

Let's not put all of this blame on the Chinese government nor expect them to solve the soggy paper issue. We are sure that they would not accept responsibility for contributing to the crisis, but they could be a part of the solution to it and financially benefit to boot, while getting rid of a lot of excess U.S. dollars.

Swindlers by another name

OK, so the groups lobbying the government to kick start the housing market again aren't swindlers per se, but it fits with our fairy tale.

Finally, let's examine the U.S. housing market decline as the bubble burst, and government policy effects on the length or severity of that decline. Thus far, the National Association of Homebuilders (NAH) and National Association of Realtors (NAR) are lobbying hard to have the government provide incentives to home buyers in order to stimulate home buying. We'll take a look at the incentives being lobbied for and what the government has already put into place, but first, let's take a look at why the housing market eventually collapsed.

The first thing to note is that home prices are based on supply and demand. Unless there is a decline in population from disease such as the plague, or famine, etc., demand for housing tends to grow over time. Of course, local economies will draw new inhabitants when they are growing and residents will depart when local economies slow. Looking back, the population continued to increase at a reasonable rate, suggesting new homes would be needed at a similar rate.

With the advent of the stock market rally in the late 90s, housing prices began to climb as the "wealth effect" caused homeowners to "move up" in the scale and price of their homes. With the collapse of the stock market, the Fed dropped its Fed Funds rate to 1% with the discount rate hovering just over that amount. The Fed held that rate for years.

This caused the interest charged on home loans to drop, as most are tied to either the Discount Rate or to LIBOR (London Inter Bank Offered Rate). More people bought homes for the first time as other owners moved up to bigger nicer homes. The amount of home that you could afford grew, because the monthly payments required for the same size home dropped. This was exacerbated by adjustable rate loans with teaser rates that were often below market for the first year or two of the loan.

On top of that, no down payments were required, so that the difficulty of saving for the down payment was ameliorated and many first time homebuyers found themselves in homes that they didn't have to become financially disciplined to afford. In addition to all of this, many loans were written without proof of income required.

Increasingly, many riskier loans were written to sub-rate borrowers, i.e. borrowers who could not qualify for a regular loan, because they lacked the financial discipline in the past to have built up a high enough credit rating. Many of these loans were advocated and underwritten by Fannie Mae and Freddie Mac with the Government Sponsored Enterprises (GSEs) acting as guarantors of the loans, packaging those loans into MBSs and CDOs that they carried the equivalent of CDS for.

Let's summarize pieces of how we got into this mess in the first place:

  1. Fed institutes loose money policy

  2. Adjustable rate loans allowed homeowners to leverage their ability to get into a home

  3. No down payments were required with loans as much as 110% of the value of a home being made

  4. No proof of income was required on some loans

  5. Sub-rate loans should not carry government subsidies

  6. Loans were packaged and sold with AAA credit-ratings when, in fact, they should not have qualified for such ratings

  7. Ratings agencies were complicit in providing high credit ratings to loan packages containing less credit-worthy mortgages

  8. Loan packages make it very difficult to rewrite loans, and even to determine who holds a specific mortgage. Only mortgages that weren't packaged with other loans are easy to modify

  9. Home loans were sold to borrowers without the lender being responsible for the riskiness of the loan. This encouraged selling mortgages that weren't aligned to credit-worthiness of buyers

  10. Real estate agents encouraged buyers to buy as much house as they could afford, which was much higher than expected, when the lack of down payment, adjustable rate mortgages, and low interest rate environment enabled relatively low payments for hoard of buyers to step-up to relatively expensive homes

  11. There were inadequate standards that allowed lenders to sell loans that borrowers may not have been fully familiar with.

Let's take a look at what the government is doing today to ease the housing crunch and advocate what the government should/should not be doing going forward:

  1. The Fed has dropped back the Fed Funds rate down to the 1% level.

  2. 30-year fixed rate mortgages have dropped to 6.14% last week, down from 6.20% a week earlier and from 6.24% a year earlier. 1-year Adjustable Rate Mortgages (ARMs) came in at 5.33%, down from year-ago levels of 5.50%.

  3. The government has a $7,500 tax credit for first-time home buyers, but it must be repaid over 15 years beginning in 2010.

  4. NAR is lobbying for the repayment requirement for the credit to be dropped and for it to be extended to all home buyers.

  5. NAH is lobbying the government for a 10% home-buyer credit, up to $22,000 depending on the FHA limits in the local area.

  6. There is pressure on President-Elect Barack Obama to aid homeowners in danger of being foreclosed on. Half of 1,000 people polled believe that should be Obama's top priority for his first 100 days in office.

  7. Fannie Mae and Freddie Mac plan to reduce homeowner payments to a maximum of 38% of their monthly income. They may do this by extending the loans to 40 years, deferring some of the principal, or lowering interest rates. Mortgage servicers will be paid $800 to rewrite the loans.

  8. By January 1, 2010 HUD will require lenders to provide a 3-page Good Faith Estimate to prospective borrowers that should help to ensure borrowers understand more about the mortgages they are taking out.

Our Assessment of the Emperor's Clothes

In our opinion, the U.S. housing market isn't wearing any clothes. While a number of the steps are well meaning, we believe that most of them won't address the heart of the matter. Moreover, we are dangerously close to repeating the problems seen in the loose money policy following the collapse of U.S. equities markets that began in 2000.

Prices across most of the U.S. housing market have a long way to fall before they will align with the value of the homes. The value of the homes is what someone is willing to pay for them. If money is cheap, then someone will be willing to pay more than if money is dear. Therefore, with rates particularly low, this should be enough to encourage home buyers to purchase these assets at higher prices than they might otherwise.

If buyers aren't lining up to buy at current prices and if money is available to loan against those purchases, then prices are still too high, end of story. Creating incentives to buy works to bridge a gap between what buyers are willing to pay and the asking price of a home. If the incentives are insufficient to close that gap, then something else is needed to either reduce the asking price or increase the price offered by buyers. Prices will have to drop much further before there will be equilibrium unless cheap money once again fuels buyer prices.


The problem is that speculators own many homes that they are not living in. They need to unload these homes, and home builders need to unload inventory, and banks need to unload foreclosed properties, and people who have become unemployed need to sell their homes, and buyers who moved to a different area need to sell the homes they are no longer living in. All of this needs to happen before the housing market starts to move to a realm of normal supply and demand.

Outfitting the Emperor

Now that we have pointed out that the Emperor is naked, we would like to offer our suggestions on how to address the housing market problem.

First, the financial markets need to be driven to a point where credit is flowing:

  1. Loose money policies will eventually cause excess reserves to be loaned out as banks seek returns.

  2. Lending standards should not be overly loosened but should not be Draconian. Standardized reporting should indicate which banks are adhering to what standards.

  3. Any financial institution that benefited from TARP funds must provide information to show that credit is flowing in terms of:

    1. Level of loans written (with loan standards) prior to the emergence of the Financial Crisis

    2. Level of loans written (with loan standards) during the Financial Crisis pre-TARP

    3. Level of loans written (with loan standards) since funds received from TARP

  4. Institutions found "hoarding" TARP funds should be taken over by the government as they are either unwilling or unable to extend liquidity provided to them.

Second, with credit available, the housing market should be allowed to sort itself out.

  1. If borrowers can't afford to make payments on their homes, they should give the homes back to the mortgage holders. 1.6M homes are estimated to be in foreclosure by the end of 2008. 1.9M homes are expected to be in this same position in 2009. This will be messy but is unavoidable.

  2. If borrowers have a close to sufficient income to be able to make their mortgage payments, the loans should be rewritten to keep the homeowners in their homes and preserve their credit ratings. These will be a very small percentage of homeowners, but it will help.

  3. Packaged loan issues need to be resolved if it forestalls the foreclosure process. A possible way to resolve these is to have the original loan move into foreclosure with a government program listed as the defaulter of the loan when the homeowner would have qualified for a rewritten loan. A new loan should be extended to that homeowner as if it was a rewritten loan. This shields the homeowner from the stigma of foreclosure while extending the benefits of a rewritten loan. These will be a very small percentage of homeowners, but it will help.

  4. All home loans should require minimum percentage down payments or other collateral to be posted for the loan.

  5. Don't put into place special government incentives for down payments that encourage homeowners who haven't saved for a down payment to be able to become homeowners. A program that provides assistance toward some of the down payment as a credit could be acceptable if buyers are still responsible for providing 50% of the down payment plus closing fees. Homeownership is a dream that takes a lot of hard work and discipline. It shouldn't be short-circuited with taxpayers footing the bill.

  6. GSE programs must require the same percentage of down payments as for regular commercial loans. If the GSEs will continue to guarantee loans, at least ensure that program participants also share in the risk of loss from these loans.

  7. GSE programs need to be reviewed in terms of risk transferred from borrowers to taxpayers. An independent audit should provide annual reports as to the sufficiency of reserves in the program based on risk of borrower default. This should always explore systemic risk and provide guidance as to when the reserves would become insufficient.

  8. A lack of GSE programs to adhere to reserve guidelines should cause them to cease making/underwriting loans until reserves are adequate. Mismanagement of GSE programs should not be "bailed out" by the government, as these guarantees should be by the GSEs, not the taxpayers. Inadequate reserves should cause mortgage writers to be unwilling to make the loans the GSEs would like underwritten. In this manner, the true cost of the government programs will become known as government either has to fund these programs at a higher level or less or higher credit-worthy loans will be written.

  9. Alt-A and other loans that don't require documentation should be eliminated. The credit worthiness of the borrower, ability to repay the loan, and collateral for the loan are taken into account when a loan is made. Without a demonstrated ability to repay the loan or collateral posted that is worth significantly more than the loan, the loan should not be made.

Our Assessment of Home Prices

We would expect the housing market to fall much more than the 19% Fannie Mae is currently projecting. In looking at the S&P Case Shiller Index, it is apparent that home prices must fall closer to 40% to reach the high-end of the range they moved in since WWII. Of course, if inflation is high and the housing malaise goes on over enough time, a 19% reduction in home prices would be sufficient, but this is worse than taking more pain in the short term.

We believe that trying to jump-start the housing market would be a mistake. It is ignoring the fact that the Emperor is currently streaking around the countryside. You have to first admit that this problem took a long time to reach the stage where the bubble burst. We are very much in danger of creating another bubble if we leave interest rates too low for very long. The cheap money must be removed as soon as the economy starts to recover. Granted, the interest rates shouldn't be raised too high, too fast, but they must not be allowed to stay this low for very long as it will inevitably lead to higher inflation and more bubbles that will burst and once again cause a financial disaster.

Sometimes there is no quick fix, however much our society has grown accustomed to them. It is time to rally around the emperor as he gets dressed. It may take awhile but he will regain his glory and look perfectly marvelous in real clothing, rather than something imagined. The only question in our minds is, "Is the emperor actually Chinese?"

A Closer Look at the Fed Funds Rate

We have noted with interest that the Fed announced a decrease to the Fed Funds rate that took place on October 29th of this year. That announcement moved the target down from the then 1.5% rate to the current 1.0% rate. This rate decrease happened in conjunction with rate decreases at other central banks globally in the largest global coordinated interest rate decreases yet seen.

What is the Fed Funds rate anyway? The Fed announces a target for the overnight rate it will pay banks to put excess deposits into the Federal Reserve. That rate is actually achieved through an auction process. When the Fed's trading desk is able to match supply and demand through adding or taking away funds, then they are able to balance the rate to be very near the target rate.

Let's take a look at what is actually happening in the Federal System with actual rates achieved versus the target rates publicly proclaimed:

It is obvious that rates do not match up with stated policy. Since it is the Fed's trading desk that adds and removes liquidity from the banking system to ensure that the rates match the target rates, and the actual rates are so different from the target rates, one comes to a startling conclusion. The Fed doesn't want to have the actual rate match the target rate!

Why would the Fed announce a target rate that they aren't targeting? That is almost certainly related to have globally coordinated rate cuts such that confidence is restored in global banking systems. But why wouldn't the Fed maintain the actual rate to the target rate?

The Fed's objective is to ensure that the banking system is so chock full of liquidity that banks will begin to lend among themselves and to businesses and consumers who need credit. Recall that initially, the Fed was backstopping illiquid assets that are related to the housing market bubble bursting. Banks and others holding these assets couldn't sell them to release cash to meet reserve requirements, while at the same time, they had to mark the assets to market. In other words, they needed cash to meet reserve requirements, but they were being dragged under by the falling value of the illiquid assets.

Who needs the treasury to buy illiquid assets when you can just inject so much liquidity that banks can build their reserves while hanging on to these illiquid assets? No wonder Henry Paulson and his gang over at Treasury haven't been interested in buying the illiquid assets from the banks now, since there is so much liquidity sloshing around.

Fed Chairman Ben Bernanke's rationale for this huge increase in liquidity is that if banks have excess reserves, they will loan to each other and to businesses and consumers who need credit. Let's assume that the money supply grows so much that the return on these funds is no longer attractive. For instance, if the return paid to keep these excess reserves in the Fed system is about 0.35% annually, the banks with this excess liquidity will purchase treasuries and the like until they drive the yields on those investments down so much that they again look for other places to achieve a greater return.

Eventually, the banks decide they need to loan to businesses and consumers that pose relatively low risk in order to seek better returns on their excess funds. There is an excellent discussion of this at the link cited below:

Of course, the downside of all this excess money supply is that cheap money eventually leads to inflation. At some point, the Fed will have to contend with getting inflation under control. Until that time, the spigot is open. Belly up to the bar banks and drink your fill.

Market Outlook

Let's take a look at liquidity. Recall the TED Spread is the difference between the 3-month LIBOR rate and the 3-month T-Bill rate. The recent high was on Oct 10th at 4.64%.

The TED Spread finished Friday at 2.10 which is nine basis points higher than a week ago Friday. The TED spread is in the range necessary that banks are beginning to make loans again. It really needs to move down to the 1.40 level or lower for credit markets to have thawed sufficiently that credit will flow through to the businesses and consumers looking for loans. Recall that historically, a measure of credit flowing is when the TED spread ranges from zero to fifty basis points so we have a long ways to get there.

Oil closed the week with near term futures contracts at $57.04 per barrel. That is down four dollars from a week ago at $61.04.

We will take a look at all the daily charts and offer comments on them as a group. First, let's take a look at the DIAmonds (Amex:DIA) next, as they are the ETF that mimics the Dow Jones Industrial Average.

The DIAmonds, as a proxy for the Dow, continue to show the most strength. It is the leadership of the Dow that will move the markets higher or signal a collapse.

Let's take a look at the chart of SPYders (Amex:SPY) since they mimic the S&P-500.

The SPYders chart looks similar to the DIAmonds except support was actually broken intraday and the recent candle bodies actually sit on the lower Bollinger Bands.

Let's take a look at the QQQQs (NASDAQ:QQQQ) next, as they are the ETF that mimics the NASDAQ-100.

The QQQQs shows a similar pattern as seen in the other two charts. The action in the coming week will show whether support will hold or whether price begins to walk down the lower Bollinger Band.

We will use the DIAmonds as the strongest ETF to gauge the direction of the markets. A weakening of the DIAmonds would suggest that the markets will collapse through support.

We continue to believe the bottom was put in five weeks ago, when we predicted it would be. Our bottom call is still intact. The Fibonacci levels where the markets retraced to a week ago are no longer important as that level was broken. Support must hold at these levels or the markets should put in a significant further move downward.


The week was ugly for the bulls. Support was once again tested and the bulls stepped in with significantly heavier volume on Thursday to create an intraday price swing of 10% on the major indexes. Some of this was likely to have been short covering as well. Friday's move lower was an example of the lack of follow-through being seen in the markets along with the incredible volatility.

Like the weather person, the most predictable weather the next day is a repeat of today. For the markets, expect continued volatility with large intraday moves and a lack of trend for the foreseeable future. Trading reversals maps best to the current trading environment. Riding the trend is a recipe for disaster.

Our conclusion last week was that the markets were set-up to make a higher high. That conclusion was proven incorrect as the markets confounded us by moving lower yet again.

This presented an opportunity to pick up call options for the major indexes on the retest of the bottom. Those options can be sold on a rally toward the upper Bollinger Band. We will discuss exit areas for such positions in our next weekly letter. We believe that moves may be somewhat muted due to options expiring in the coming week.

We hope you have enjoyed this weekly article. You may send comments to Please don't be shy in expressing your opinions of what you would like to see covered.



Mark McMillan

Author: Mark McMillan

Mark McMillan
The McMillan Portfolio

Mark McMillan

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