Things We Are Glad We Said but Wish We Had Listened To

California's Housing Market: How Much ‘Froth’ Is Out There?

A conference held in October 2005 sponsored by the Milken Institute.

"Angelo Mozilo of Countrywide Financial Corporation predicts that the market will slow and even decrease by a couple percentage points “so that incomes can catch up with the price of homes.” His concern reflects the historic low affordability level that prices many potential buyers out of the market unless they resort to creative financing, which is inherently riskier."

"With new-loan originations now being comprised of 60 percent adjustable-rate mortgages and 40 percent fixed-rate mortgages, Mozilo concedes that his company “may be selling products to individuals who can’t manage risk.”

Things We Wish We Never Said

California's Housing Market: How Much ‘Froth’ Is Out There?

A conference held in October 2005 sponsored by the Milken Institute.

"Although the market is cooling off, the demand for housing is real, and we will continue to see modest single-digit gains below 6 percent, he said."

-Emile Haddad, President, Western Region, Lennar Corporation

Remember the Good Old Days?

Do you remember the good old days when every bank investor only wanted to own banks that had deposits in Florida? That's where the growth was, and everything else was looked down upon with scorn. Things are a little different now judging by the latest crop of Bank earnings that have come out. The latest taste of too much growth comes from BankAtlantic Bancorp, Inc. (BBX) which reported earnings on October 25.

"Non-performing loans increased from $21.8 million at June 30, 2007 to $165.4 million at September 30, 2007 resulting primarily from the placement of eleven commercial real estate loans totaling $148.7 million on non-accrual status. As a result, the ratio of non-performing loans to total loans increased from 0.47% at June 30, 2007 to 3.53% at September 30, 2007 and the ratio of non-performing assets to total loans plus other assets increased from 0.94% at June 30, 2007 to 3.74% at September 30, 2007.

"The Bank's loss experience for the quarter ended September 30, 2007 was a net charge-off of $11.3 million compared to a net recovery of $0.2 million for the quarter ended September 30, 2006. Included in the $11.3 million net charge-off was $8.8 million related to the write-down of one 'builder land bank loan' and consumer net charge-offs of $1.6 million, representing primarily home equity lines of credit. ('Builder land bank loans' are characterized as loans made to borrowers with agreements to sell the underlying collateral to national and local home builders pursuant to option contracts.)"

The market has beaten the stock price down to $4 a share as of today, or a market capitalization of $238 million. BBX owns around 2.3 million shares of Stifel Financial Corp (SF) which is valued at approximately $136 million. BBX also has warrants to purchase more SF at $36 a share. If you have a strong stomach and buy this one you are practically getting the bank operations for nothing.

Beware, however, that its capital ratios may deteriorate further. At 6/30/07 the relevant capital ratios were:

Core capital (leverage) ratio 7.48%
Tier 1 risk-based capital ratio 10.62%
Total risk-based capital ratio 12.34%

An institution is considered well capitalized if its ratios exceed the following percentages:

Leverage Ratio > = 5%
Tier 1 Risk-Based > = 6%
Total Risk-Based > = 10%

The stock is now trading at only half of its book value, if you can believe the book value, as compared to 1.6 times back during the good old days.

Symetra Financial IPO - White Mountains Insurance

The long awaited initial public offering of Symetra Financial Corp. has finally arrived. An S-1 filed by the company this morning has put a price range of $18-20 per share on the 39.5 million shares being offered in the IPO. Symetra was created in 2004 by an investment group led by Berkshire Hathaway and White Mountains Insurance. Both entities own 26,887,872 shares of Symetra. WTM will be selling from 9,870,306 to 11,350,852 shares.

If we assume a pricing of $19 per share then WTM will receive from $187 to $215 million in the IPO. Its remaining stake in Symetra Financial, which will trade under the symbol SYA, will be worth $295 to $323 million.

Book value per diluted share for Symetra as of 9/30/2007 is $15.10, so the IPO is being priced at 1.25 times book value assuming a final price of $19 per share. In my blog post from June I used 1.5 times book value so the value comes in a little less than I thought.

This was still a good deal for White Mountains Insurance as the investment group purchased these assets from Safeco at less than book value in 2004, and they have also withdrawn capital since the original purchase. Here is the lead paragraph from the WTM press release in 2004:

"HAMILTON, Bermuda, Mar 15, 2004 /PRNewswire-FirstCall via COMTEX/ -- White Mountains Insurance Group, Ltd. (NYSE: WTM) announced today that it and Berkshire Hathaway Inc. are leading an investor group that will acquire the life and investments business of Safeco Corporation for $1.35 billion, subject to adjustment based on June 30, 2004 adjusted statutory book value.

Safeco Life and Investments, with headquarters in Redmond, Washington, focuses mainly on group insurance, individual life insurance, structured settlements, retirement services and mutual funds. As of December 31, 2003, the business had approximately $22.5 billion of total assets and $2.57 billion in GAAP book value ($1.74 billion excluding FAS 115). President Randy Talbot and his management team will continue to run the business following the acquisition."

The S-1 is here at the Edgar web site.

Bring Me the Head of Stan O'Neal

There was a movie made in the 1970's called "Bring me the Head of Alfredo Garcia." You can read about it here at the IMDB database. The movie starred Warren Oates as a bounty hunter, but maybe when they do the remake, they should be hunting the head of Stan O'Neal. Here are excerpts from his grilling by the analyst community courtesy of Seeking Alpha.

"If I can ask Stan, do you feel comfortable that there is not another shoe to drop and a lot more writedowns on the ABS CDOs?"

"We have tried to capture everything that we can capture at this point, in the market. The expectation for progression of these securities as of the date that we took the markdowns. I cannot tell you what the market trajectory might be from here, but as of the date that we took these markdowns, and even looking at it as we sit here today and observing the general environment, we are comfortable that we have marked these positions conservatively."

"How did you wind up with such a large concentration in the first place? I mean the number of employees is such a small fraction of the overall firm, and it results in results like this? I guess I am asking about risk management, and what went wrong and what happened in the last three weeks to wind up with $3 billion of additional charges?"

"The $3 billion in additional charges is taking a look at the methodology and going through the marking models, again, and coming to a conclusion that is still within the same range that we had before, but it was more appropriate to be at a more conservative end of the range than we had previously indicated. That is where the $3 billion comes from. Why do we have such a large position in the first place? We made a mistake. There were some errors of judgment made in the businesses themselves, and there were some errors of judgment made within the risk management function, and that is the primary reason why those exposures exist."

"On the $8 billion in losses, can you give us a feel for how much of that is realized versus unrealized?"

"I think we already said that we are not breaking that down."

"Can you give us some more comfort with your understanding of your current risk loss exposures? I'm having a little trouble with how you can feel that you understand your risk exposure, when September 28 marks deteriorated an extra 75% on you after the quarter closed?"

"It is because we have had some time to do a lot more work and we have reviewed the methodology, we have reviewed the pricing standards, we have reviewed the inputs and we have come to the conclusion that again, within the same range it is appropriate to mark it much more towards the more conservative end of the range."

All is Forgiven in Love and War and Energy

Energy is back again as investors seem to have a short memory and despite weakness in North America, they are banking on international growth to bail out the Sector. Sounds a little familiar doesn't it? Here are the rest of the highlights from the Schlumberger call that caused the 10% one day drop. The stock has now recovered half of the loss. Transcript courtesy of Seeking Alpha

Once management comments ended, they were hit with a blizzard of questions on the outlook going forward:

The bane of all cyclical industries - too much capacity coming on line.

"I think pricing deterioration is still single-digit compared to last year. I think it will accelerate slightly in Q-4; and where the bottom is, I really don’t know, because what we have is a situation very different from 2001, in that the bottom is going to be created by additional capacity and not by a drop in the rig count."

And exactly how much extra capacity?

"So what is going to change the pricing profile is the additional capacity. And, you know, we, I’m not quite sure where we stand in the additional that was coming on. But, you know, when we looked at it a few months ago, it was certainly an increment in the high double, in the high teens, if not more."

On the margin effect:

"The biggest effect on margins in the Q-3 in North America was the lack of operating days in the Gulf of Mexico, due to precautionary evacuations, not from land. There was a deteriorating on land but it was not the major part of it. And, in terms of the pricing of services, other than pressure pumping, we have not so far seen the noticeable effect."

This next excerpt might have really panicked the street as Schlumberger almost seemed to be backpedalling on its growth forecast that it headlines at the beginning of every conference presentation.

"What I’m saying is that we won’t get a high teen growth rate in North America in 2008. Everywhere else, we probably will not be that far from it; but in North America we’re not going to get it. Now, what happens through the end of the decade, I, you know, I can’t speculate yet on North America specifically. The rest of the world, I’m perfectly confident."

And then they refused to confirm where the bottom is in North America:

"Overall, do you think that the North American EBIT in ’08 is going to be above, below or in line with the ’07 contribution?"

"Well, I don’t think I’m ready to answer that yet Geoff; but obviously, you know, if there is a big pricing impact on land, then it will have an effect."

"So a decline is a possibility?"

"It’s not excluded, no."

Private Homebuilder to File Bankruptcy

Another one bites the dust.

"Neumann Homes, one of Chicago's largest homebuilders, announced on Monday that it intends to file for bankruptcy.

The company said in a press release at 5 p.m. that it had been "unable to procure adequate funding" to operate its business. Marketing director Jean Neumann said that despite other published reports, the bankruptcy had not been filed, though "it will be done shortly."

The company, ranked among the top 10 in Chicago, also builds in Wisconsin and Colorado. Company CEO Kenneth P. Neumann said in the statement that "significant downturn in the Detroit, Chicago and Denver housing markets resulted in this situation. ... Even after the significant help we have received from our lenders this year, the company can no longer weather this storm."


Neumann Homes Bankruptcy

Is the Energy Cycle Over?

I know its heresy to even suggest that a hot sector has seen the peak and I will no doubt be greeted by a chorus of cat calls and boos from the rafters, but is it possible that the Energy Cycle is rolling over? The market was down big on Friday, but the Energy stocks really got hit hard, spooked by an earnings report by Schlumberger. The market bounced back on Monday but Energy did not share in that rebound.

So what spooked the market so badly? Here are some excerpts from the call courtesy of Seeking Alpha:

First up were management comments on the North American market:

"North America pre-tax margin declined 427 basis points sequentially, to 26.9%, due to weather-related disruption in the Gulf of Mexico, the continued erosion of pressure pumping stimulation pricing on land in the US, and a reduction of exploration activity in the Alaska, partly compensated by re-bound in Canada after the second quarter Spring break-up. In North America, activity increased in Canada, but this was off-set by weaker pricing for pressure pumping on land in the US, and by a sharp revenue drop in the Gulf of Mexico, due to the departure of several rigs to overseas locations, and a loss of approximately 15 operating days, due to weather."

This wouldn't have caused a 10% decline in the stock. The market knew that pressure pumping pricing was weak and the down time from the Gulf was also common knowledge.

And then the first bombshell hits:

"In the immediate future, while there will be some recovery from the low activity levels in the Gulf of Mexico, natural gas activity in both Canada and the US is likely to stabilize, as production remains relatively strong and gas storage approaches winter at comfortable levels."

"As a result, pressure pumping pricing deterioration will continue. This situation, however, does not change our view that North American natural gas supply will require sustained activity to combat production decline, and advanced technology, to increase production rates from poorer-quality reservoirs."

I will post again tomorrow on the rest of the Schlumberger call. It will be interesting to see if the Energy Sector will catch a bid from the Apple earnings blowout from last night.

A Typical Energy Cycle

The Energy Sector is inherently cyclical and a typical cycle moves in this fashion (beginning at the top):

1. Companies are flush with cash due to great pricing, and/or high commodity prices. Earnings and price momentum is also superb, and everyone is happy. Most companies can't decide what to do with the excess cash - dividends, stock buybacks?

2. Customers begin letting rig contracts roll over as high day rates and service costs cause exploration to be less economical. Smart money starts to exit positions, while the economy weakens a little bit and demand for the commodity drops due to high prices.

3. Rig utilization and day rate declines start to show up in official reports as capital budgets of customers are cut back due to a further drop in commodity price, possibly due to an unexpected dip in demand. Smaller Exploration and Production companies cut back almost immediately as cash flow decreases. The larger independents swear that they will "drill through the downturn." Integrated oil companies adopt a wait and see attitude due to more diversified cash flows, secure balance sheets, and a more disciplined capital program. Stock prices begin to flatten and even decline in some cases.

4. Sell side begins marketing push to prop up stock prices in the sector during conference season, claiming that "valuations are compelling."

5. Stock prices weaken materially as the sell side begins to cut earnings estimates and commodity price assumptions.

6. Extra supply of oil or natural gas hits the market due to the high level of drilling activity in the preceding 12-24 months. Commodity price weakens further, leading to another round of estimate cuts. Stock prices “fall off the cliff.”

7. Sell side throws the towel in on the sector.

8. Utilization and day rates plunge as contracts rollover and are renewed at lower rates or not at all. Industry starts “cold stacking” rigs. Majors begin cutting capex budgets.

9. Commodity prices bottom and industry bumps along the bottom for six to twelve months as malaise sets in over industry. Drilling falls to an all time low. Late cycle companies (international and construction) see earnings peak.

10. Commodity prices begin to strengthen as demand recovers and little supply is added due to a lack of drilling.

11. Rigs begin to be put back to work again as cash flow improves. Day rates and utilization inches up.

12. Debate erupts as sell side breaks into two opposing camps: (1) Time to invest or (2) Is it too early?

13. Cycle is in full upswing as more rigs are put back to work which leads to increasing day rates for drillers and pricing power by service companies. Commodity prices strengthen further.

14. Majors begin to announce increases in capex budgets.

15. Companies start to beat earnings estimates, and momentum money gets into the stocks.

16. “Boom” mentality takes over in the industry. First articles are circulated claiming “we are running out of oil and/or natural gas.” Alternative energy companies begin to get a lot of press and attention.

17. Federal government announces “Energy Policy.”

18. Go to number 1.

So the two questions I have are - Where are we now in the cycle? And is it different this time?

Contrarian Thought of the Day - October 20, 2007

I have been in a particularly contrarian mood lately so I am going to publicly disagree with whatever conventional wisdom I happen to read about. I hate hearing and reading the same point of view all day with everyone saying the same thing over and over. Don't take this personally if you are on the other side of these issues.


The Structured Investment Vehicle (SIV) Bailout Plan

This is a good thing. Psychology and confidence is everything in the financial world. Do you have any idea how much actual cash a bank keeps on hand to back your checking account? How about nothing up to a maximum of 10%. No public money is being used in this bailout so what's it to you. "We bought the sandwiches, and that's it," a Treasury official was quoted in the Wall Street Journal. The real question is will it work? Or is this the 21st century equivalent of Richard Whitney's walking onto the floor of the New York Stock Exchange in October 1929 and announcing that he was buying stocks.

Don't Get All Giddy Now

Please don't get overexcited about Google. Remember the market isn't always right. It once told you that Nortel was worth a couple hundred billion also.



And then look what happened:



(Charts courtesy of Big Charts.com)

Crash of 1987

The popular media is full of reminiscing about the crash of 1987, replete with touching stories about what people were doing at that particular time. This is our generations version of where were you when Kennedy was shot. So here is my story.

I was working for Olde Discount at the time. Olde was the 1980's version of the pre Internet, low cost discount broker where they charged $40 a trade, a level that would be laughable now of course. They had just opened a new office on Long Island, and I was the only broker in the office, fresh from Series 7 school. It was a frightful day watching just about every stock ticker go down, while contemplating that maybe I had chosen the wrong career.

The second part of the reminiscing stories ask whatever pundit happens to be on TV the question - Could it happen again? The usual answer is no, because of "liquidity," and the regulation/circuit breakers that have been put in place since then. I will take the contrarian opinion, because, after all that is the point of this blog.

Yes, it could happen again. Liquidity is a specious argument. Liquidity can evaporate in an instance, as we saw over the Summer. Liquidity is there until its gone. There is nothing magical about it. It's like saying that humans can breathe because the earth has an atmosphere that contains a Nitrogen/Oxygen mix. Well, duh.

The second argument is also flimsy, as circuit breakers, while closing the market for various amounts of time, can actually accentuate the panic as sell orders queue up with nowhere to go. Also, more volume trades off the exchange now than in 1987 so the "market" will really not close at all.

I would say that it is not very likely that it will happen again.

Enough is Enough

I've had it with all this talk about emerging markets and how great they are and how nothing can go wrong. Everyday these markets make new highs. Everyday some other talking head is on TV regurgitating some Groupthink on the Emerging markets.

I lived through a previous era where pundits said the same thing about a different market. When I first started working on Wall Street, the Japanese and its markets were like gods. Nothing could go wrong. They were like Supermen destined to take over the world economy. They made marquis purchases of our domestic assets - Rockefeller Center and Pebble Beach, etc. The Japanese Stock Market hit a new high everyday.

I was working in Fixed Income at the time at Chemical Bank in New York City, selling short term money market products. All you needed was a Letter of Credit from a Japanese Bank and it was like gold to a customer. We had another unit at the bank that sold only two funds to retail customers - the GT Global Asia Pacific and the GT Global Japan Fund. Want to guess how those funds did once the boom ended in the late 80's?

Oh I know, it's different this time. I forgot.

Hunting Bargains

Some of the best bargains during the trough of the real estate cycle may come in the condo market in Miami, where the word overbuilding acquired a new meaning. It's too early so don't get lured in by these auctions yet, but here's a web site to keep track of the foreclosure sales going on in that city:


Miami Dade County Clerk

Are We There Yet for Homebuilders? - Part VI

Since I mentioned the California unemployment rate as it relates to Housing in my last post, I figured I would post it here. The chart is from Economagic, a great resource for economic data.




As you can see the unemployment rate has started to tick up, but it is nothing compared to the last downturn.

Are We There Yet for Homebuilders? - Part V

One fact that argues for investing now in Homebuilders is the strength of the general economy currently as compared to economic conditions back in 1989 to 1991. The chart below from Economagic shows the decline in non farm payrolls during the last great Housing crisis. The revision this morning to non farm payrolls for August from a previously reported loss of jobs to a gain, is more evidence of general economic strength. I seem to remember back in the early 1990's California had an unemployment rate around 9%.



Just think how bad things would be for Housing if another 2 million Americans lost their jobs.

Homeownership Rate

One of the symbols of the recent Housing Boom was the increase in the Homeownership rate to above trend levels. Some debated the cause of this increase. A recent study by Matthew Chambers, Carlos Garriga, and Don E. Schlagenhauf entitled "Accounting for Changes in the Homeownership Rate," published as a working paper in September 2007 by the Federal Reserve Bank of Atlanta, concluded that the main reason for this increase was the growth of exotic mortgage products, and not demographic reasons.

A copy of the study is here.

"We find that the long-run importance of the introduction of new mortgage products for the aggregate homeownership rate ranges from 56 percent to 70 percent. Demographic factors account for between 16 percent and 31 percent of the change."


What does all this mean? If this study holds up under peer review, it would argue for a more prolonged housing downturn for two reasons - this demand will not be coming back anytime soon, and houses purchased by this group will swell inventories.

Are We There Yet for Homebuilders? - Part IV

Another issue to grapple with when buying the Homebuilders is the number of new home sales relative to previous peaks. As you can see in the chart below, if you declare a bottom for housing at the current level, one of the assumptions that you are incorporating into your analysis is that you are comfortable with the fact that the number of new home sales will trough above the peak of the last cycle.

New Home Sales Monthly (January 1963 - August 2007)




This is an important decision because during the last three cycles, new home sales never went above a 900,000 annual rate. During this cycle, they went much higher and peaked at an annual rate of 1.389 million in July 2005. If this extra demand was real demand, due to higher population growth or a more affluent population buying second homes, then this is fine. If it is speculator demand, then we are in big trouble.

So it remains to be proven whether the trough of this cycle should be above or near the peak of the last three when referencing new home sales. Months supply of new homes solves this problem in some ways since it transforms the data into time. If that is the case then we may not be at the trough yet as months of inventory peaked at much higher levels at the troughs of previous down cycles. (9.4 in January 1991, and 11.6 in January 1980.)

Housing Conference

I just got an e-mail on an interesting conference coming up in December. I am hoping that it will be webcast. It is the 2007 National Housing Forum to be held at the National Press Club on December 3. Here is the agenda.

OTS National Housing Forum

Facebook equals Broadcast.com equals Geocities?

It was reported a few days ago that Microsoft is considering buying a minority stake in Facebook, the social networking site. The investment implies a value for Facebook of $10 billion. So what can $10 billion buy you these days?

Facebook, according to the Wall Street Journal, will have revenues of $150 million, and profit of $30 million in 2007. That gives us a multiple of 67 times sales and 333 times earnings. This assumes that the $30 million are actual “earnings” and not “adjusted” or “non-cash” earnings.

Growth you say. “Don’t forget about growth,” you scream at the top of your lungs. “I worship the god of growth.” Let’s do a discounted cash flow model and see what those earnings have to grow at, that when discounted to the present, justifies a valuation of $10 billion.

If we use the following assumptions

Growth Rates

Years 1-5 40%
Years 6-10 25%
Years 11-15 15%

Terminal Growth Rate of 2%
Discount rate of 7%

We get a present value of cash flows of $10.1 billion. Zuckerberg….take the money and run.

Lennar Stock Last Cycle

One problem with Wall Street is a lack of institutional memory. It seems that no one even remembers the last big downturn in housing that occurred in the late 1980's and early 1990's. I am posting a series of charts of different Homebuilders from that era. The first up is Lennar.

Two things are clear from this chart. First, this is not the first time that Homebuilders have gone down 75%, and second if you time this right on the upside, these stocks will be the buy of a lifetime.

It's hard to see in the chart but the stock looks like it bottomed out in October 1990 at around $0.55. This is down from the peak of about $2.05 in early 1987. Also, you will notice in the chart that there was a false rally after the crash of 1987. If you bought Lennar after the crash in October 1987 at $0.78 you saw your investment almost double in two years, before the stock fell to its true trough in October 1990. It would be interesting to see when the book value of Lennar stabilized in this downturn. Unfortunately, the SEC web site only goes back on line to 1994.