Hussman Weekly Market Comment: Extend and Pretend

Regardless of whether the U.S. banking system would not presently be able to meet its liabilities with its assets, there is another question: assuming that banks are allowed to extend and pretend for a long enough period of time, will they ultimately be able to accumulate enough retained earnings in the years ahead to cover eventual loan losses? In other words, is it possible that everything will be OK if we just look the other way long enough?

From my perspective, it depends on what "OK" means. Simply in terms of long-term solvency - assets being ultimately able to meet liabilities - my impression is that yes, given enough time, retained bank earnings should cover the losses on existing loans. Indeed, it's possible that banks might be able to report fairly healthy "operating earnings" to investors, and then somewhat more quietly write off losses as "extraordinary" charges over a period of years. This type of outcome is beginning to look possible, because investors evidently don't mind repeatedly having their pockets picked as long as "operating earnings" come in above analyst estimates.

Unfortunately, in that sort of world, the economy would likely be hobbled for a long period of time, as Japan has discovered over the past couple of decades. With banks focused primarily on survival and recapitalization, retained earnings would be directed to making the existing liabilities whole, rather than contributing to productive new investment.

In January, the London Economist reported a study by the McKinsey Global Institute, noting "Assigning the odds of further deleveraging is not the same as gauging its likely economic impact. To do that, the study looks to history. It finds 32 examples of sustained deleveraging (at least three consecutive years in which ratios of total debt to GDP fell by at least 10%) in the aftermath of a financial crisis. In some cases the debt burden was reduced by default. In others it was inflated away. But in about half the cases—which the report regards as the most appropriate points of comparison—the deleveraging came through a prolonged period of belt-tightening, where credit grew more slowly than output. The message from these episodes is sobering. Typically deleveraging began about two years after the beginning of the financial crisis and lasted for six to seven years. In almost every case output shrank for the first two or three years of the process. (Countries which defaulted or inflated their debt away saw bigger recessions at first, but had higher output growth than the belt-tighteners by the end.)"

So to the extent that "extend and pretend" is successful in averting insolvency concerns, it will also tend to weigh down lending activity, as resources are allocated toward servicing existing debt burdens on bad assets, rather than toward new lending for productive activity. The most efficient outcome is always for lenders who provide capital to take losses if the loans go bad. That sort of market discipline is the only way to ensure that capital gets allocated properly. This is not the world that we have lived in over the past year, as policy makers have pledged public money to make private bank bondholders whole, regardless of how irresponsibly the banks allocated the money. But it is important to recognize that this policy comes with longer term costs.

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Related previous post: McKinsey Global Institute: Debt and deleveraging: The global credit bubble and its economic consequences

Steve Forbes Interview with Mohnish Pabrai

I love Mohnish's idea that investment management should be set up where men of leisure go about their leisurely tasks and then when the world gets severely fearful, they put aside their leisurely tasks and go to work (6:12 mark in video).

Link to: Steve Forbes Interview with Mohnish Pabrai

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Mohnish's discussion on entrepreneurs reminded me of Malcolm Gladwell's article "The Sure Thing", which is one of my all-time favorite articles. Link to "The Sure Thing": Abstract or on Scribd.

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Ron Peltier on King World News

Ron Peltier is chairman and chief executive officer of HomeServices of America, Inc., a Berkshire Hathaway affiliate and the nation’s second-largest full-service residential real estate brokerage firm. Ron has helped build Home Services of America into a massive conglemeration of 22 companies and eventually this became Berkishire Hathaway’s vehicle to enter the real estate industry. Ron has a bird’s eye view probably better than any other single human being of the real estate market in the United States. In this interview Ron discusses the real estate collapse, price destruction, the current number of people in the US not paying their mortgages, government interference in the market, where he sees the real estate market today, where he sees real estate headed in the future and more.

Winthrop Realty Trust 2009 CEO Letter to Shareholders

Found via My Investing Notebook.

We seem to have a tale of two markets. On the one hand, Moody's recently reported its Commercial Property Price Index has risen for the third straight month. A PriceWaterhouse Coopers survey of institutional investors which gauged investor sentiment indicated an expectation of improved sales volume, improved sales prices and declining capitalization rates. Anecdotally, most major market real estate brokers and investment bankers will confirm witnessing heated auctions for better performing assets that are not dissimilar to those experienced in 2006.

Further supporting this trend is the enormous spread tightening for most senior level commercial mortgage backed securities (CMBS) and performing junior debt. The prices on REIT equity securities as reported by the RMZ Index have risen by 105% since the March 2009 low. All of the foregoing would lead one to conclude that the real estate market has troughed and recovery is imminent, if not already occurring.

On the other hand, REIT earnings, inarguably a relevant measure of ascertaining real estate operating performance, declined during 2009 and are expected to continue to decline in 2010. According to the National Association of Realtors, this deterioration is projected to continue until at least 2011. Moreover, the executive summary of the February 10, 2010, Congressional Oversight's Panel Special Report entitled, "Commercial Real Estate Losses and the Risk to Financial Stability" troublingly states:

"Between 2010 and 2014 about $1.4 trillion in commercial real estate loans will reach the end of their terms. Nearly half are at present "under water"- that is the borrower owes more than the underlying property is currently worth. Commercial property values have fallen more than 40 percent since the beginning of 2007. Increased vacancy rates which now range from 8 percent for multifamily housing to 18 percent for office buildings, and falling rents, which have declined by 40 percent for office space and 33 percent for retail space, have exerted a powerful downward pressure on the value of commercial properties."

Notwithstanding the price tightening of CMBS securities, by February 2010, loans in special servicing increased to $75 billion or 10.7% of the entire CMBS universe with a current loss severity exceeding 44% on defaulted fixed-rate loans. Fitch Ratings now predicts that 20% of all CMBS loans will be in special servicing by 2012. Job growth, the single greatest driver of occupancy rates, continues to remain elusive. These statistics belie any theory that the real estate markets are improving.

Where sentiment/momentum clashes with real time economic data, how should we invest our Company's capital in 2010? While we acknowledge we may miss some of the momentum related opportunity, we believe that capitalization rates will ultimately revert back to historic levels and real estate pricing will trend downward more accurately reflecting its current and near term operating fundamentals. We expect that excessive leverage, reduced liquidity and a reappraisal of value by institutional lenders will create ongoing investment opportunity not presented by the current "pretend and extend" lender policies. Consequently, we intend to continue to invest patiently, with deliberation and dispassionately avoiding market mania.

John Mauldin's Outside the Box: Where Are Rates Headed And Why? - By Barry Habib

So the Fed stopped buying Mortgage Backed Securities, and people are wondering if this will affect mortgage rates. There's been plenty of whistling past the graveyard, guesswork and denial, where so-called experts have been trying to tell us that there will be minimal - if any - change to rates.

That pipe dream is just nonsense.

Let's look at what we can expect for mortgage rates and the overall Bond market in the months ahead. During the past fifteen months, the Fed purchased $1.25 Trillion in MBS, which represented 80% of the mortgage market. Prior to this program, mortgage rates were above 6%. Now that the Fed program has ended, it's reasonable to assume that mortgage rates will rise back towards those levels.

Just How Much Money is $1.25 Trillion?

In today's financial headlines - the word Trillion is often casually thrown around. So much so, that it's easy to lose perspective on how much money this really represents. Picture a stack of $100 bills. It might surprise you to know that it only takes a stack four inches high to be worth $100,000. So $1,000,000 would be a stack of $100 bills 40 inches tall. How about a Billion? Well, you would have to stack $100 bills up to the top of the Empire State Building...twice...in order to reach a Billion. So to picture $1.25 Trillion represented by a stack of $100 bills - that stack would be 850 miles high. If you could turn that stack on its side and were able to drive alongside it, it would take you longer than 14 hours to reach the end. If you laid those $100 bills down side by side, they would travel around the world 50 times. We're talking about a lot of money here.

The Fed's purchasing influence has been significant. And now in the absence of this safety net, Bond prices and mortgage rates will experience greater volatility and a gradual worsening. Adding to this is the fact that the Fed will, albeit gradually, begin to sell some of their mortgage holdings, as they reverse their quantitative easing measures. It doesn't take a rocket scientist to see that this will pressure Bond prices...but read on, because there are additional factors at play, which will influence Bond prices lower and mortgage rates higher.

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The ‘How Much is a Trillion’ topic reminds me of this article:

Exponential Money in a Finite World

Related previous posts:

Arithmetic, Population, & Energy and The Crash Course

Chris Martenson: The Crash Course in 45 Minutes (or less)

Miguel Barbosa’s Interview with Albert Bartlett

Skeletons open window to new species

CRADLE OF HUMANKIND, South Africa – Nine-year-old Matthew Berger dashed after his dog Tau into the high grass one sunny morning, tripped over a log and stumbled onto a major archaeological discovery. Scientists said Thursday that he had found the bones of a new hominid species that lived almost 2 million years ago during the fateful, still mysterious period spanning the emergence of the human family.

"Dad, I found a fossil!" Matthew cried out to his father, Lee Berger, an American paleoanthropologist who had been searching for hominid bones just a hill-and-a-half away for almost two decades. Fossil hunters have profitably scoured the rolling grasslands north of Johannesburg since the 1930s.

Matthew held in his hands the ancient remains of a 4-foot-2 boy. Berger, with the Institute for Human Evolution at the University of the Witwatersrand in Johannesburg, and his fellow researchers have since found much more of the skeleton, including his extraordinarily well-preserved skull, and three other individuals. South Africa's children will compete to name the boy.

In a report being published today in the journal Science, Berger, 44, and a team of scientists said the fossils from the boy and a woman were a surprising and distinctive mixture of primitive and advanced anatomy and thus qualified as a new species of hominid, the ancestors and other close relatives of humans. It was named Australopithecus sediba.

The species sediba, which means fountain or wellspring in the Sotho language, strode upright on long legs, with human-shaped hips and pelvis, but still climbed through trees on apelike arms. It had the small teeth and more modern face of Homo, the genus that includes modern humans, but the relatively primitive feet and "tiny brain" of Australopithecus, Berger said.

Geologists estimated that the individuals lived 1.78 million to 1.95 million years ago, probably closer to the older date, a period when australopithecines and early species of Homo were contemporaries.

Berger's team said the new species probably descended from Australopithecus africanus. At a Wednesday teleconference, he described it as a possible ancestor of Homo erectus, an immediate predecessor to Homo sapiens, or a close "side branch" that did not lead to modern humans.

Many agreed that the skeletons' discovery in the Cradle of Humankind, a World Heritage site where dolomitic limestone caves contain fossils of ancient animals and hominids, was a major advance in the early fossil history of hominids.

Limits to growth: Apollo Asia Fund - the manager's report for 1Q2010

Our concern is over future earnings, given the precarious state of the global economy and doubtful prospects for Asia's exports. Since none of the major problems exposed by the crisis has been addressed, and panic responses have created new ones, major turbulence seems likely to resume. Many of the stocks in our universe are priced on cheery assumptions of business-as-usual: a less complacent view restricts our choices considerably.

Furthermore, the customary assumptions of long-term trend growth for the world, looking out beyond the business cycles to the next 10-30 years, seem increasingly hard to justify given the growing evidence that we are on this timeframe running up against hard limits to availability of resources. It is ironic that we should reach this point just as the pursuit of GDP has become the consensus goal of governments around the world. Continual GDP growth is an absurd goal, bearing little relationship to quality of life, and treating the consumption of assets as a positive. It may now become an impossible goal, not just because of the looming debt traps, but because GDP growth has historically been accompanied by more and more energy usage, and that may no longer be possible. The ability of oil producers to increase output each year is increasingly in question - and the interest of oil-producing countries in nuclear power suggests that many see their own supply falling short of demand within the next 10-20 years. For a long time, limits to growth were far enough away to be beyond the practical horizon of investment calculations, but that is no longer the case.

Asia, at lower levels of per-capita consumption and less constrained by legacy debt, may well be able to outbid the OECD and continue to increase its share of energy and other resources traded. However, leaving aside the impact on export markets, it may not always be just a matter of price, and it cannot be assumed that Asia will always be able to obtain the absolute quantities of resources to sustain the levels of growth to which it has become accustomed. Moreover, those countries which have been subsidised by windfall resource endowments may face shocks when they become net importers.

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Related previous post: Energy for Asia: an overview - By Claire Barnes

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Massive Fraud in the Metals Market?

I don’t really know much about the gold, silver, and other metals markets, but if all of this is true, then it could have a big impact on other areas of the markets. It might be something worth watching. Here are some King World News interviews that describe the details:

Andrew Maguire & Adrian Douglas on KWN – 3/30/2010

Harvey & Lenny Organ & Adrian Douglas on KWN – 4/7/2010

Jim Rickards on KWN - 4/14/2010

Jim Grant discusses Alan Greenspan

Found via The Big Picture.

The Absolute Return Letter - April 2010: When the Facts Change

We are currently in what I like to call echo bubble territory. I assume that most of our readers are familiar with the DNA of an asset bubble (even if Greenspan isn’t). Echo bubbles are children of primary asset bubbles and are usually conceived when monetary authorities respond to the bursting of an asset bubble by dramatically reducing policy rates.

In the current situation, banks have suffered the worst; low policy rates help banks rebuild their damaged balance sheets as they benefit from the steep yield curve. The dilemma now facing policy makers is that the extraordinarily low interest rates we currently enjoy are encouraging another bout of excessive risk taking before bank balance sheets have been restored and the economy is back on its feet again. If monetary authorities were to raise rates now in order to avoid the formation of echo bubbles, it would almost certainly kill the fledgling recovery. The pressure is therefore on them to keep rates low and for that very reason asset bubbles are often followed by echo bubbles.