Tuesday, July 31, 2007

Inventory Update

Good morning,
In preamble for the release of July real estate board statistics, to be released later this week, I am updating the Lower Mainland real estate inventory situation. Total inventory in the Lower Mainland has surprisingly dropped during July.
Fraser Valley Real Estate Board inventory has risen steadily during most of July. This area includes North Delta, White Rock, Surrey, Langley, Abbotsford and Mission.
Greater Vancouver has seen a drawdown of inventory because of very brisk sales volumes. I don't know who can afford to buy at these prices but, whoever they are, they are buying.
The good old Chipman area. Still trending 20% higher than last year for total inventory.
Any predictions for the stats release? I predict yet higher prices in all categories for the GV and a mix of price changes in the FV. I have thought all along that when the correction comes to our real estate market that it will begin in the Fraser Valley and other outlying areas. We may be in the beginning of that divergence.

Monday, July 30, 2007

Canadian Real Estate Prices

House prices across the country hit another national record in June as the average cost rose to $315,332, the Canadian Real Estate Association said Monday. Between June of this year and the same month in 2006, average home prices rose by 11.2 per cent, the biggest 12-month increase since August 2006, CREA said.

The group also said average prices broke records in Alberta, Saskatchewan, Ontario, New Brunswick, Nova Scotia, and Newfoundland and Labrador. British Columbia continued to have the highest average house price at $446,893 in June, though that was down from $454,962 in May. The biggest 12-month jump in average June prices was seen in Saskatchewan, where prices rose 34.9 per cent from June 2006 to $180,934. Alberta has the next-largest increase among the provinces, with a 12-month jump of 24.7 per cent to $364,072.

On July 10, the Bank of Canada boosted its key overnight interest rate by one-quarter of a percentage point to 4.50 per cent. The increase was the first hike by the bank since May 2006, and economists expect the bank will boost rates again in September. "Higher interest rates and additional housing price increases will gradually impact affordability and housing demand over the second half of the year," said CREA economist Gregory Klump.

Sunday, July 29, 2007


The Tulip-Bulb Craze

When: 1634-1637

Where: Holland

The amount the market declined from peak to bottom: This number is difficult to calculate, but, we can tell you that at the peak of the market, a person could trade a single tulip for an entire estate, and, at the bottom, one tulip was the price of a common onion.

Synopsis: In 1593 tulips were brought from Turkey and introduced to the Dutch. The novelty of the new flower made it widely sought after and therefore fairly pricey. After a time, the tulips contracted a non-fatal virus known as mosaic, which didn’t kill the tulip population but altered them causing "flames" of color to appear upon the petals. The color patterns came in a wide variety, increasing the rarity of an already unique flower. Thus, tulips, which were already selling at a premium, began to rise in price according to how their virus alterations were valued, or desired. Everyone began to deal in bulbs, essentially speculating on the tulip market, which
was believed to have no limits.

The true bulb buyers (the garden centers of the past) began to fill up inventories for the growing season, depleting the supply further and increasing scarcity and demand. Soon, prices were rising so fast and high that people were trading their land, life savings, and anything else they could liquidate to get more tulip bulbs.

Many Dutch persisted in believing they would sell their horde to hapless and unenlightened foreigners, thereby reaping enormous profits. Somehow, the originally overpriced tulips enjoyed a twenty-fold increase in value--in one month! Needless to say, the prices were not an accurate reflection of the value of a tulip bulb. As it happens in many speculative bubbles, some prudent people decided to sell and crystallize their profits. A domino effect of progressively lower and lower prices took place as everyone tried to sell while not many were buying. The price began to dive, causing people to panic and sell regardless of losses.

Dealers refused to honor contracts and people began to realize they traded their homes for a piece of greenery; panic and pandemonium were prevalent throughout the land. The government attempted to step in and halt the crash by offering to honor contracts at 10% of the face value, but then the market plunged even lower, making such restitution impossible. No one emerged unscathed from the crash. Even the people who had locked-in their profit by getting out early suffered under the following depression.

The effects of the tulip craze left the Dutch very hesitant about speculative investments for quite some time. Investors now can know that it is better to stop and smell the flowers than to stake your future upon one.

Check out other crashes at http://www.investopedia.com/features/crashes/

What Have We Learned?
As hindsight is always 20/20, we should take the time to highlight what we can learn
from these past tragedies. First off, we should point out that most market volatility is all our fault. In reality, people create most of the risk in the market place by inflating stock prices beyond the value of the underlying company. When stocks are flying through the stratosphere like rockets, it is usually a sign of a bubble. That’s not to say that stocks cannot legitimately enjoy a huge leap in value, but this leap should be justified by the prospects of the underlying companies, not just by a mass of investors following each other. The unreasonable belief in the possibility of getting rich quick is the primary reason people get burned by market crashes.

Remember that if you put your money into investments that have a high potential for returns,
you must also be willing to bear a high chance of losing it all. Another observation we should make is that regardless of our measures to correct the problems, the time between crashes has decreased. We had centuries between fiascos, then decades, then years. We cannot say whether this foretells anything dire for the future, but the best thing you can do is keep yourself educated, informed, and well-practiced in doing research.

Friday, July 27, 2007

Friday Humour and Misc. . .

There is clearly more to life than finances and I find humour a great way to escape from the day to day. I don't know if you have a similar sense of humour to me but its my blog and I get to do what I want with it!

Some things I found funny this week:
http://thereisnohousingbubble.blogspot.com/ which reminded me of http://vancouvercondo.info/2006/07/you-can-get-rich-in-real-estate.html

This was kind of funny:

This was serious:

This was pointless:

Thursday, July 26, 2007

Markets are Down, Down, Down!

Mohican is doing a quiet little cheer this Thursday as markets around the world, overvalued by many measures for a while now, are coming back down to more prudent valuations this week. I don't take pleasure in losing money or my client's money but I have had money on the sidelines now for many clients and the satisfaction of protecting them from this market correction is fantastic. It will also provide us with some great buying opportunities once the dust settles.

The TSX is down over 6% on the week so far as the resource and financials heavy S&P TSX Composite Index is feeling the selling pressure. The US markets and overseas markets are declining even more. Emerging markets and especially Latin American markets are being hit the hardest. The Brazil and Mexico stock indices were down over 5% today alone.

All in all, the Canadian market is fairing better than other world markets although it never reached the same lofty valuations as many others - especially those emerging markets. In contrast, with the TSX Composite down nearly 6% on the week the Canadian Value Index is down less than 5% indicating that, even over short term corrections, value is the safest place to be.

Tuesday, July 24, 2007

CMHC Starts and Completions for June 2007

CMHC just released the June statistics on starts and completions for Vancouver.

All I can say is "build them houses" and "build those condos" to all the developers out there. Give us the biggest supply overhang in history so we have lots of choice and you have to compete for the few actual homebuyers there are out here.

I'm not including those speculators as an "actual" homebuyer and I am hearing more and more stories of developments finishing but nobody is moving in. These developments are sold out but up to 50% of the buyers were speculators and are hoping to now flip their presale townhouse or condo - you can see their asking / wishing prices on the MLS. Ironically, these speculators are now competing with the developer in many cases to sell the units in the complexes they are in.

Mohican says - bring on the supply. Use the comments to tell us about your anecdotes of speculators gone wild.

Sunday, July 22, 2007

US Housing Market

Bill Moyers discusses the "housing market meltdown", the ongoing subprime mortgage and hedge fund crisis, and the "housing bubble" and "homebuying mania" with the New York Times' Pulitzer-prize winning business reporter Gretchen Morgenson.

Part 1.

Part 2.

Thursday, July 19, 2007

Approach to Market Risks

From Pacific Capital Associates.

It is often noted that in the long-run, stocks are the best asset to own. It has also been noted that “in the long-run we are all dead.” So the question becomes how long an investor must wait for that attractive long-term performance to be realized. If one is not careful, it could be a long time.

For an understanding of why this is, consider the following table which shows that at least one serious stock market correction has occurred in every 10 year period since the 1920s:
Source: Investech Research

Consider also that many investors ride down the bulk of these vicious declines only to sell near the lows because they can’t stand the idea of losing any more. Next, many investors miss the ensuing rally and then feel that their hands are tied because they have missed the rally and it’s too late to buy back in. This pattern has been repeated time and again and explains how many studies have shown that the typical investor greatly underperforms the average market returns over time.

It is easy to understand this typical investor behavior, but we must know that it will not achieve satisfactory and timely results. Investing genius Warren Buffet famously wrote, “ be fearful when others are greedy and to be greedy only when others are fearful." This is easier said than done. When it seems like everyone else is throwing caution to the wind and driving prices ever higher, it is frustrating not to be fully invested. Such an approach requires patience and discipline. One must be willing to give up potential gains by reducing market exposure during times when the markets are rising. Similarly, it requires the fortitude to invest when markets are going down and others believe that there is little hope. We believe that an investment approach based upon such discipline has a greater chance of minimizing the downside and maximizing the upside of our investments over time.

When risky market conditions prevail, it’s more important than ever to pay attention to major economic trends, to be diligent about seeking investments with strong long-term fundamentals, and above all to stay cautious. It seems like common sense to state that the top of the market is the worst time to be fully invested, but that topping moment is the point at which the most people have bought in and are most optimistic and least concerned with risk. Of course it is also the point at which the next moves are down. Interestingly, as the top nears, there are always analysts explaining why such price increases are justified, but we find that their reasons have a lot more to do with hype and wishful thinking as to why “it is different this time” than they do with the fundamentals.

At this point we will continue to look for investment opportunities in specific areas of the US market as well as areas outside the US market. After experiencing very favorable returns over the last 4 years, at this point, if the market continues to make gains, we will have to be content with a comparatively smaller return. However, we suspect that any market gains beyond this point will most likely be given back during the next downside correction. As long-term investors, that’s not the kind of gain we’re interested in.

When the next downturn is upon us, we will stay focused on this additional bit of wisdom from Warren Buffett: "Fear is the foe of the faddist, but the friend of the fundamentalist." In other words, market corrections and environments of fear and risk-aversion are devastating to trend-chasing speculators, but to long-term fundamental investors they need not be so harmful. The best approach is to minimize exposure to such downturns, to endure them, and to be ready to capitalize on them as they pave the way for better risk-adjusted opportunities ahead.

During times such as these, our strategy is to be disciplined and to focus on the time-tested measures of value, risk, and reward. The “father of value investing” Benjamin Graham famously wrote, "In the short run, the market is a voting machine but in the long run, it is a weighing machine." This is to say that on a shorter term basis, the popular stocks or sectors can rule the day, but over a longer term, it is the stocks that are supported by sound fundamentals that provide the best results. We agree

Tuesday, July 17, 2007

Inflation - Different Schools of Thought

Inflation, as most people generally interpret it, is "a persistent rise in the general price level, as measured against a standard level of purchasing power." This is currently the way that inflation is measured in North America and subsequent attempts on controlling it are based on these measurements. In Canada, when referring to inflation, we reference CPI, or Consumer Price Inflation. The Bank of Canada attempts to keep CPI in a range of between 2% and 3% through controlling the overnight lending rate or "prime rate" and this policy meets with some success.

"Mainstream economists' views of the causes of inflation can be broadly divided into two camps: the "monetarists" who believe that monetary effects dominate all others in setting the rate of inflation, and the "Keynesians" who believe that the interaction of money, interest and output dominate over other effects. Keynesians also tend to add a capital goods (or asset) price inflation to the standard measure of consumption goods inflation. Other theories, such as those of the Austrian school of economics, believe that inflation is caused by an increase in the supply of money by central banking authorities."

The thought I wanted to put forward today is this: What if the current Keynesian view and approach is faulty? What if inflation is more accurately termed as the Austrian school view it as an increase in the supply of money by central banking authorities? If this is true, what would we observe?

To illustrate I've put together a chart comparing recent Consumer Price Inflation with the Bank of Canada M3 total Money Supply. The question I have is: Where does the money go once it is created? Consumer goods? Homes? Cars? Stocks? Equipment?

Sunday, July 15, 2007

Why does micro-credit work?

If you have never heard of micro-credit and its current impact around the world I suggest you watch the video. Let us know what you think and if you think it works - get involved. Mohican supports http://www.opportunityinternational.ca/ and so does Bill Gates. Here is a letter from Bill and Melinda Gates.

Every day, more than 1,000 children die because they didn’t get a 15-cent measles vaccine. Almost 3 billion people around the world live on less than $2 per day. Here in the United States, only one-third of the students who start the ninth grade will graduate from high school with the skills they need to succeed in college and work. A disproportionate number of those who fall behind will be African American and Hispanic.

Our foundation and our partners are trying to solve these problems because we believe that all lives have equal value, no matter where they are being lived—in rich countries with high-quality health care or poor countries with almost none; in well-off suburbs with shiny new high schools or in disadvantaged communities where most kids drop out.

We also believe that from those to whom much is given, much is expected. We benefited from great schools, great health care, and a vibrant economic system. That is why we feel a tremendous responsibility to give back to society.

Starting from these core values, our foundation is guided by some key principles.

First, we concentrate on a few areas of giving so we can learn about the best approaches and have the greatest possible impact. We choose these issues by asking: which problems affect the most people, and which have been neglected in the past?

Our Global Health Program focuses on diseases and health conditions that cause the most illness and death and receive the least attention and resources—diseases such as tuberculosis and malaria that barely exist in rich countries but still kill millions in the developing world. And AIDS, which infects 5 million new people every year, the vast majority of them in poor countries.

We also believe in the power of science and technology to improve people’s lives. In recent years, the world has made tremendous advances in fields ranging from biology to information technology, and yet not everybody is benefiting from these innovations. Our goal is to help apply science and technology to the problems of the neediest people.

As an example, our Global Development Program works with an organization called Opportunity International on a relatively simple technology that is helping women in Malawi save their children from destitution. In Malawi, life expectancy is about 37 years. When a man dies, his parents and siblings often seize his possessions and his money, leaving his wife and children with nothing.

Opportunity International helps by distributing “smart cards.” These cards are similar to our ATM cards, and they let women keep money in super-secure savings accounts that are protected by a thumbprint scanner. Only the cardholder herself can access the account, using her unique thumbprint. Smart cards have become so popular in Malawi that they’re now regularly given as gifts at wedding showers.

Finally, our foundation is deeply committed to the importance of partnerships. All of the issues we’re tackling will require the talents and resources of many people and many different organizations.

To effect lasting change, we must collaborate with governments, business, and other nonprofit organizations. Our work with high schools in the United States, for instance, involves dozens of partners, from grass-roots community organizations all the way up to national policymakers. Changing high schools will require the efforts of parents, teachers, school administrators, school districts, a range of organizations devoted to school reform, and government leaders at every level. We need this kind of coordinated approach to make sure we prepare every child for college, work, and citizenship.

These are just some of the ways we think about the work we do. We are optimistic about the future. We were deeply gratified by the gift Warren Buffett gave our foundation in June 2006, which will allow us to roughly double our grantmaking starting in 2009. Warren’s incredible gift inspires us and makes us even more aware of the opportunity and deep responsibility we have to make a lasting impact for people in need.

Some of the problems we work on already have solutions, and our focus needs to be on getting those solutions into the hands of the people who need them most. Other problems have never been given the attention they deserve, and we believe focused efforts can lead to amazing advances. The challenges we face are great, but so is the opportunity to improve people’s lives.

Bill Gates
Melinda French Gates

Friday, July 13, 2007

On crystal balls and market falls

I dug up this old post from the VHB archives from last January.

VHB Post from Saturday, January 14, 2006

The suggestions that the current situation is just a temporary slowdown could very well turn out to be correct. The market certainly did experience only a temporary slowdown in 2004, for example, before resuming high growth. Also, many of the typical indicators of a slowing market (skyrocketing inventory, for example) are just not happening right now. Maybe growth will soon take off again. However, before we take too much reassurance from the experts, let us take a look at the past. I have selected a series of quotes from our 'blasts from the past' series. As you read each quote, it is striking to see how easily it would fit right into a newspaper article in January 2006.It's not easy to predict the future.

The point of this post is not to make fun of some predictions that turned out to be wrong. Instead, I simply want to emphasize that we should not turn our brains off simply because some person quoted in the media reassures us that everything is A-OK.Here are 10 quotations. After each in italics you'll find the source, timing, and a link for the quote. Enjoy:

1. "Price stability, rather than decline, would be expected for most of the housing stock . . . since underlying home ownership demand remains strong due to continued high immigration." (Frank Clayton, January 18th 1981 in the Sun. link The market crashed by about 50% over the following year. )

2. Renaud said he thinks that the trend to prices for houses has been broken by a temporary lull and that by [next year] or so prices will be equal to or greater than peak prices. (Claude Renaud, VP of Mortgage Insurance Canada on April 14, 1982. link The market took 26 quarters (over 6 years) to regain its peak in real terms.)

3. "To those who are waiting for Vancouver house prices to collapse, I can only advise them not to hold their breath . . . Unless there is a major recession or significant depopulation, house prices are unlikely to drop significantly." (Jerry Jackman, VP Royal Lepage, November 18, 1988 in the Vancouver Sun. link In 1989, prices started to drop - with an eventual 30% or so drop. Real prices did not attain these heights again for 58 quarters, or around 15 years.)

4. "We are definitely in a transition market in areas such as the West Side, Vancouver East, and Burnaby . . . it is too early to tell if the market will stall." (Jerry Jackman, April 20th 1989 in the Province. link Prices did not recover in real terms until 15 years later.)

5. "It is unlikely that prices will decline significantly." (JJ again, July 18th 1989 in the Sun. link)

6. "The whole world wants Vancouver because everybody is moving here now and everything points up, up, up." (Realtor David Goodman, December, 1989 in the Sun. link The market did not reach these heights again for 15 years.)

7. " . . .no one is panicking over the west side housing market and he insists that it has simply 'normalized'." (Jerry Jackman, January 27th 1990 quoted in the Sun. link West-side prices fell by 40% in the next 2 years.)

8. "I can't see prices reversing themselves there [in the west side] because it is still a very desirable place to live." (Same as above.)

9. "The market is entering a more 'normal' phase." (REBGV president Brian Calder, Feb 2, 1990 in the Sun. link If normal means that it takes 15 years to recover, then 'normal' it was.)

10. "A BC Central Credit Union newsletter released Tuesday said BC's housing market is currently experiencing a contractionary phase but the worst of that phase should be over by late summer or early fall." (BC Credit Union economist Richard Allen quoted in the Sun, July 5th 1995. link The decline in the late 90s was slow, but it took 28 quarters to bottom out and 33 quarters to recover to the previous peak. Some 'phase', eh?)

posted by Van Housing Blogger at 9:55 PM

Wednesday, July 11, 2007

CFA Society of Chicago Speech – June 28, 2007

This post is long but it is well worth the read. I basically agree with everything Mr. Rodriguez is saying here. He is no quack and he his flagship mutual fund's performance has far outstripped the market's returns since founding it in 1984. He has his fund at 40% cash right now.

Absence of Fear, by Robert L. Rodriguez, CFA

I’m CEO of First Pacific Advisors, an $11-billion investment management company located in Los Angeles. I’ve been in the investment business for 36 years and I’ve managed FPA Capital and FPA New Income funds for 23 years. I’ve deployed a classic absolute value equity investment style along with a contrarian investment philosophy. This methodology also applies to my fixed income management process as well. FPA Capital Fund has a very respectable performance track record for 23 years, with an average portfolio turnover ratio of less than 20%. FPA New Income is a high-quality intermediate investment-grade bond fund that can and does invest in high-yield securities. The fund has not had a down year in 30 years and has had positive total returns in every bond bear market.

My talk today, Absence of Fear, is a follow up and expansion of the Special Commentary section that appeared in my March 31, 2007 shareholder reports. It will focus on the concept of RISK since there appears to be little concern about risk in the financial markets currently. My goal is not to scare or sensationalize, but to get investors to consider various risks and ask the basic question, “Am I being sufficiently compensated for these apparent risks?”
I will raise issues involving several markets including: housing, fixed income, private equity, hedge funds and equities. I will also raise another issue that my associates and I do not believe is being adequately considered by investors or the public, in general. Finally, I will update you as to what my current strategy is for both my equity and fixed income funds and where we may be finding value. I will then be available for questions, should there be any.

We are concerned that, after many years of an excessively easy monetary Fed policy, a bubble of massive proportions has been created in the housing market. Many experts believe that the housing cycle is at or nearing a trough or at least is at a stable level. We are not of this opinion. We do not believe you inflate prices and demand over at least a decade and then this over stimulation is corrected in barely 18 months. We are of the opinion that this bubble has infected many areas of the financial economy. I will detail more of this in the fixed income portion of my speech.

There have been several studies as to how inflated housing prices had become prior to the present correction. According to the work done by Gary Shilling’s firm, home prices would have to correct between 22% and 28% to return to the equivalent of the median asking rent or to the trend line of the CPI. Prior to 1996, both of these measures approximated the rate of increase in home prices. According to Robert Shiller of Yale University, his real quality-adjusted existing house price index would have to correct nearly 45% to bring it back into alignment. My initial reaction to this estimate was one of disbelief and that it appears excessive; however, home prices would appear to have a considerable way to fall, given the high level of total homes available for sale. With nearly 4.5 million homes for sale in 2007, this compares to an average of approximately 2.5 million homes since 1990 or an excess of approximately 2 million homes. Since 1965, the median dollar volume of single-family homes sales as a percentage of nominal GDP has averaged 8.4% versus 16.3% at the 2005 peak, according to Northern Trust Global Economic Research.

This housing price bubble has infected the fixed income market. As loan underwriting standards deteriorated, more potential home buyers were then able to qualify for a loan. We are seeing the initial effects of this erosion in underwriting standards by the collapse in the prices of sub-prime mortgage securities and the firms that originated them. The sub-prime mess has been detailed quite extensively but not another area—Alt-A. Alternative-A refers to a class of borrowers that cannot qualify for a conventional mortgage. Typically, they are owners of businesses that do not take out income in the form of W-2. They also have limited documentation; however, they have credit scores that are at or near prime credit scores.

Two years ago, we noticed a problem developing in our bond portfolios involving Alt-A securities. Despite having average FICO scores of 718 on the underlying loans, these securities experienced rapidly escalating delinquencies and defaults after just nine months. We sold them since we did not want to wait around to find out the reason why this was happening. Our worst fears were recently confirmed in a study by First American Financial entitled, “First American Real Estate Solutions Report, Alt-A Credit—The Other Shoe Drops?” This report shows the following changes in underwriting standards between 1998 and 2006, with the major changes occurring in the last two or three years:

  • ARM % of originations rose from 0.7% to 69.5%
  • Negative Amortization rose from 0% to 42.2%
  • Interest Only rose from 0.1% to 35.6%
  • Silent Seconds rose from 0.1% to 38.7%
  • Low Documentation rose from 57% to 79.8%
  • FICO scores were essentially unchanged at an average of 706.
What is interesting is that the origination volumes for the last two years, when the most egregious deterioration in underwriting standards occurred, total more than the previous seven years of originations combined. Of further interest, Dale Westoff, senior managing director of Bear Stearns, Inc., estimates that 25.8% of sub-prime and 41.2% of Alt-A originations were in California; the combination of these total 33.7% of the total sub-prime/Alt-A universe. For 2006, sub-prime/Alt-A represented approximately 40% of total mortgage originations. I reference this Alt-A underwriting data because I believe it reflects the wider trend of underwriting deterioration throughout the entire mortgage universe. Because of a laxness in credit underwriting standards, along with an accommodative Fed, the housing price bubble was magnified and, thus, it has spread into the asset-backed securitizations market.

Securitization Contamination
We have witnessed an explosion in the size and types of securitizations, with mortgage securitizations leading the way. We were on the March 22 call with Fitch regarding the sub-prime securitization market’s difficulties. In their talk, they were highly confident regarding their models and their ratings. My associate asked several questions. “What are the key drivers of your rating model?” They responded, FICO scores and home price appreciation (HPA) of low single digit (LSD) or mid single digit (MSD), as HPA has been for the past 50 years. My associate then asked, “What if HPA was flat for an extended period of time?” They responded that their model would start to break down. He then asked, “What if HPA were to decline 1% to 2% for an extended period of time?” They responded that their models would break down completely. He then asked, “With 2% depreciation, how far up the rating’s scale would it harm?” They responded that it might go as high as the AA or AAA tranches.

Adding to this appraisal, in a recent study by Joshua Rosner, managing director of investment research firm Graham Fisher & Co., and Joseph R. Mason, associate finance professor at Drexel University, “Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions,” they say, “the senior levels of these structures are probably not as safe and secure as the rating companies have said, as an investor would assume, or as regulators are counting on.” In an interview, Mr. Rosner commented that whether the top-rated classes of these securities are downgraded, “depends on home price appreciation. It is a strong possibility that there could be downgrades.”

The asset quality problems in sub-prime and Alt-A have the potential to affect other areas, such as the collateralized debt obligation (CDO) market, in ways that many of the holders of those securities have little idea of how exposed they might be to unexpected changes in the security’s credit rating. It is estimated that U.S. banks have invested as much as 10% of their assets in CDOs, and the Office of the Comptroller of the Currency (OCC) requires that all of those CDOs be investment grade, says Kathryn Dick, deputy comptroller for credit and market risk. She says, “We rely on the rating agencies to provide a rating.”
As Kevin Fry, chairman of the Invested Asset Working Group of the U.S. National Association of Insurance Commissioners says, “As regulators, we just have to trust that rating agencies are going to monitor CDOs and find the subprime.” This statement really enhances my comfort level.

Investors have been gobbling up CDOs, sub-prime, Alt-A securitizations because they can earn considerably higher yields than if they deployed the capital into similarly rated corporate debt. The key element of this strategy is the rating assigned to the particular security. Various financial institutions have bought into this thinking. IN OTHER WORDS, A CORPORATE BOND RATING IS EQUAL TO A SECURITIZATION RATING OR A CDO RATING.

Encouraging this strategy are the international bank capital rules, established by the Bank of International Settlements, that do not differentiate between types of debt rated securities (corporate versus securitized) other than to require a 0.6% capital allocation for a AAA security and higher capital requirements as the credit rating declines, so that a BBB requires a 4.8% weighting. According to Darrell Duffie, professor of finance at the Stanford Graduate School of Business, “you can’t compare these CDO ratings with corporate bond ratings. These ratings mean something else—entirely.” While so many investors and regulators are relying on these ratings, the rating agencies take the position, as exemplified by S&P, “Any user of the information contained herein should not rely on any credit rating or other opinion contained herein in making any investment decision.” As Joseph Mason, finance professor at Drexel University says, “The ratings giveth and the disclaimer takes it away.”

A recent example of the flawed nature of this market came to my attention when my associate, Julian Mann, showed me a very garden variety LIBOR sub-prime floating rate security. A major pricing service valued this bond at par, while on March 19, 2007, one of the major rating agencies rated this bond A3. To affirm the accuracy of this bond’s pricing, we went to two brokerage firms that traffic in this type of security and requested what their bid might be, if we owned this security. One responded with a $7 bid. In other words, a 7% of par bid, a difference of 93% to the pricing service. The other firm declined to bid, but they did indicate that, if they were to, their bid would have probably been around this level. Julian has found several other similar examples, so this one does not represent the proverbial “needle in the haystack.”

We believe that many of these models are flawed and give a spurious representation of accuracy. Given the deterioration in underwriting standards, models predicated on prior experience have little value when compared to the data of the last two or three years. In essence, one is assuming a normal distribution curve of data for modeling purposes, while in reality you have data that comes from a highly skewed distribution. We are beginning to see the negative effects of flawed modeling by the growing number of downgrades in the sub-prime sector. This trend is also starting to develop in the Alt-A sector as well. We believe these trends will continue to unfold over the next two or three years and should lead to a retrenchment in the securitization/origination industry. If our assessment is reasonably correct, mortgage credit availability will likely contract and, therefore, exacerbate the housing contraction and its effects upon the general economy. We disagree with the opinion expressed by our esteemed Federal Reserve Chairman Bernanke, when he said in his speech of May 17, 2007 at Chicago’s 43rd annual conference on Bank Structures and Competition, “We believe the effect of the troubles in the sub-prime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the sub-prime market to the rest of the economy or to the financial system.” We will see if this optimistic assessment proves to be the correct one.

We are of the opinion that the distancing of the borrower from the lender has contributed to the development of lax underwriting standards. Each participant, in the securitization/origination process, takes their ounce of payment, but no one truly worries about the underlying credit quality since the loan will be sold. Furthermore, most participants are compensated on volume and not quality of loan originated. In our opinion, “a rolling loan gathers no loss.” Possibly, with so many sub-prime originators failing because of loan put-backs to them, some degree of underwriting discipline will return to the market; however, with so many types of loan originators operating outside of the regulatory system with minimal capital, it is far better to originate a loan, capture the fee, and then get out of Dodge, should the business go bad. One can always return another day.

Finally, the securitization market and the multiplicity of products that have been created have never been truly tested in a major credit contraction like that of 1990-94. This is because most of today’s securitization products did not exist back then. Another risk is how have they been used in various types of leveraged investment strategies? Have the creators of these products structured their operations to be able to handle a contracting market? It remains to be seen how this all works together. One may gain some insight to the potential risk by reviewing the collapse of the manufactured-housing securitization market. After seven years, it is still a fraction of its former size with all the former major originators gone.

Another example of risk knowing no boundaries, on June 1, the Government of Pakistan issued a $750 million 6.875% of 6/1/2017 dollar denominated bond priced at par and rated B1/B+ at barely 200 basis points above the ten-year Treasury bond yield. The following week in the Los Angeles Times, the headline read, “Musharraf’s grip falters in Pakistan.” The second headline, “Dismay over U.S. support of general.” I guess the market believes the extra 200 basis points of yield spread is sufficient compensation for risk. I think not.

This weakening in credit quality trend also applies to the corporate bond market. High-yield bond spreads are at record lows, with the CCC component of the Merrill Lynch high-yield index at 18%, more than double the proportion ten years ago.
High-yield spreads have declined from nearly 1100 basis points over the Treasury yield in 2002, to barely 240 basis points recently. We believe this narrowing of credit spread is being driven by the near-record low default rates. For this trend to continue, a near “perfect” credit environment must continue. We see virtually no margin of safety for this sector. This narrow credit spread environment is the key driver that is propelling Private Equity and their bids for companies. As Dan Fuss, manager of the top-performing $10.7 billion Loomis Sayles Bond Fund, recently said, “I haven’t felt this nervous about a market ever.”

The Private Equity (PE) industry is flourishing. PE has seen its capital raising rise more than ten-fold between 1990 and 2000, only to witness a temporary pullback in 2002, and then more than double between 2000 and 2006. PE is no different than any other hot investment trend, in that its peak capital raising and capital deployment occurred in 2000, the stock market peak, only to see this process collapse in 2002, the stock market trough. Capital deployment fell from $270 billion in 2000 to $49 billion in 2002, per the Leuthold Group. I call this process “buy higher” and then “don’t buy lower.” Now we’ve seen PE fundraising rise to new all-time highs and along with that, acquisitions as well. Leuthold estimates that in 2006 $469 billion in cash acquisitions were announced and/or completed. While this was occurring, valuations have skyrocketed, according to JP Morgan’s data.
Between 2001 and 2006, the average EV/EBITDA multiple paid rose 41%, from 6.1x to 8.6x. Leverage increased 54%, with the Average Total Debt/EBITDA multiple rising from 4.6x to 7.1x.

We are of the opinion that PE is pushing the boundaries of prudence and that this trend is elevating valuations in the equity market. It would not surprise us that there will be many other Chrysler situations in three to five years. By that I mean, Daimler-Benz A.G. paid approximately $36 billion for the Chrysler Corporation in 1998, only to sell 80.1% of its ownership for $7.4 billion in 2006. Given that this is other people’s money, why worry.

Since 2000 hedge funds have more than doubled in number, while their assets have tripled. They too are using elevated levels of leverage, as are PE firms and investors in highly leveraged fixed income securities. These funds are heavy users of derivatives. The Global derivatives market grew nearly 40% in 2006--the fastest pace in the last nine years--to $415 trillion, per the Bank of International Settlements. The amount of contracts based on bonds more than doubled to $29 trillion. The actual money at risk through credit derivatives increased 93% to $470 billion, while that amount for the entire derivatives market was $9.7 trillion.
The International Monetary Fund, in its April 2006 Global Financial Stability Report, estimated that credit-oriented hedge fund assets grew to more than $300 billion in 2005, a six-fold increase in five years. When levered at 5-6x, this represents $1.5 to $1.8 trillion deployed into the credit markets. Fitch, in their June 5, 2007 special report, “Hedge Funds: The Credit Market’s New Paradigm,” says that despite the upward trend in maximum allowable leverage, “notably, no prime broker reported raising margin requirements in response to historically tight credit spreads and growing concerns about the general level of risk-complacency in the credit markets.” The report provides a forced unwind example where an initial 5% price decline in the value of a hedge fund’s assets could lead to a forced sale of as much as 25% of its assets, assuming leverage of 4.0x (20% margin). They conclude that liquidity risk is among the more important issues facing credit investors. In an era of constrained returns and narrow yield spreads, increased leverage is the solution since volatility is low; therefore, a higher level of leverage may be utilized. We question this logic.

Enhanced risk taking is widespread here as well. Equity mutual funds are now at or near their all-time record low cash percentage holding of 3.6%. According to the Leuthold Group’s data, investors are directing their cash flows to among the riskiest areas of the equity universe—foreign focus equity funds. $80 billion has flowed into these funds through May compared to $11.8 billion for large-cap domestic equity funds and a net outflow of $4.2 billion for small-cap equity funds. This is the second year in a row that the foreign sector has overwhelmed the flows into domestic equity funds. We are of the opinion that investors are chasing the enhanced returns in the foreign sector but do not realize the extent of the risks they may be taking. We see little value in the domestic equity market since we view valuations as being elevated because, in our opinion, consensus profit expectations are assuming unsustainably high operating margins. There appears to be minimal valuation differentiation across most market cap sectors. For example, my value screen just hit a new low in terms of the number of qualifiers. Prior to the recent equity market decline, only 33 companies, with market caps between $150 million and $3 billion, were identified out of nearly 10,000 in the Compustat universe. The previous low was 46 this past February, and before that, it was 47 for both January 2004 and March 1998. When the market cap upper limit was expanded to $150 billion, only ten additional companies qualified. In times past, I would generally get 250 to 400 companies in just the smaller market cap range alone.

The other risk we see is energy. We have been big bulls on energy and energy prices since 1999. We include ourselves in the Hubert’s peak crowd, until proven wrong. For the last several years, the general consensus has underestimated the long-term price of oil. We discussed this topic at length in our September 2006 Capital Fund shareholder letter. We are now witnessing a potential collapse in Mexican oil production in the Cantarell field. It now looks like the peak for Mexican oil production was 2004. In our discussions with some drilling rig companies, they have confirmed that the Mexican government is either “very concerned” or in a “panic.” With approximately 40% of the Mexican government’s budget funded by tax receipts from the state oil company Pemex, they should be very concerned.

A recent study by ExxonMobil went back and took all the oil fields discovered and what their initial estimates of proven reserves were and then added all the subsequent oil production that has taken place since the time of discovery. When this was done, the peak in oil discovery was in the early 1960s. After 40 years of the most advanced technology applications, no new major fields have been discovered to reverse the declining trend of discovery. As such, the odds are increasing that many of our older, more prolific fields are at or near their peak production levels. If this assessment proves to be correct, the era of cheap oil prices is over because conventional oil production is in the process of peaking. Should this idea, peaking conventional oil production, become a consensus opinion, what might be the implication of it for the financial markets or the economy? We do not believe this risk has been factored into the valuations for either stocks or bonds.

FPA Capital Fund has over 40% allocated to cash (short-term investment securities) and our largest sector investment is in energy. Preservation of capital is paramount to us in this risky investment environment. We are at a record low number of holdings, with our largest new addition, Rosetta Resources, acquired nearly two years ago. We have added selectively to some of our existing positions, when their prices declined sufficiently to warrant additional ownership. Our most aggressive addition of this type was in July of last year, when we increased our Avnet holding by 40%. Since then, it has risen nearly 150%. We find very little that currently interests us. Given the virtual non-existence of names on the new low list, along with the sparse number of names that qualify from our value screens, I am presently thinking about renaming my fund the Tylenol Fund. I have a saying, “you never know the value of liquidity until you need it and don’t have it.” When others are having headaches and need Tylenol, in other words, liquidity, we will provide it to them but at a very, very high price.

FPA New Income has a 1.4-year duration with nearly 16% in cash. The Fund’s duration has been kept extremely short since the beginning of 2003. On June 11, 2003 we wrote a piece that is on our website entitled, “Buyer’s Strike.” We have been of the opinion that, with longer-term Treasury bond yields in the 3% to 4% range, there is little, if any, value in the bond market. We have focused our investing in the two-year sector and less. During the fourth quarter of 2002, our high-yield exposure hit our limit of 25%. Today, that exposure is at a record low of just barely over 1%. We see little, if any, value in this sector as well. It would not surprise me to see high-yield credit market yield spreads equal or exceed the peak levels of 2002 again, given the excesses that appear to be occurring in the financing of private equity acquisitions. Our high-quality asset allocation has never been higher, with 90% in AAA and above, and 8.5% deployed in AA. We hold no exotic securitization securities. We have been moving up the credit quality pyramid for the past two years. The bond market’s recent decline has just started to provide some level of investment value in the three- to five-year sector of the Treasury curve. We are carefully monitoring this.

We see most investment sectors as providing little in the way of a margin of safety. The potential risks that we see do not appear to be well considered in the valuations within these sectors. Investors/ speculators, in all sectors of the investment universe, appear to be willing to engage in highly risky strategies or investments. There is a sense of virtually unlimited liquidity in the financial markets presently. We believe this liquidity safety net can be withdrawn without any notice. In many cases, the abundance of liquidity is a function of creative debt leveraging. Like all leverage, it feels wonderful on the upside, but watch out how it can come back to bite you on the downside.

Because of this widespread leveraging, we are quite willing to position our portfolios in a highly defensive posture. This has included changing client guidelines and index benchmarks. For example, the separate account portfolio cash limitations have been increased from typically 10% to about 40%. We are willing to bet our firm and our reputation to be right. This may lead to investor defections, but that is the price one has to be willing to pay to be right. If we are wrong, our clients will earn positive investment returns, just not as positive as our competition. Should we be correct, we will have protected their principal so that we may be able to redeploy it at more attractive valuation levels. Our primary investment strategy is one of principal preservation. We are not opposed to taking risk; we just want to be more than fairly compensated for doing it. We love chaos, conflict and controversy since these create price volatility, investor fear and investment opportunity. As Warren Buffett wrote on page 8 of Berkshire Hathaway’s 2006 annual report, “Be fearful when others are greedy, and be greedy when others are fearful.” We are patiently waiting for that period when we can be very, very greedy.

Tuesday, July 10, 2007

Bear Cave - Feel Free to Growl

Good morning,

There are lots of little things going on that are not worthy of their own post so here is a place we can discuss them all.

1. Interest rates went up today. As was widely expected, the Bank of Canada raised the short term rate to 4.5%. They also said that "some modest further increase in the overnight rate may be required to bring inflation back to the target over the medium term.”
2. There is a new blog on the block where we can find daily updates to the local real estate inventory situation - http://vannumbers.wordpress.com/. Welcome REsteven.
3. Canadian Housing Starts are still hot, hot, hot. In the words of Beata Caranci at TD Economics, "Canadians can sleep well under their roofs tonight with the belief that the housing experience on this side of the border looks to be day-and-night versus its U.S. counterpart."

Saturday, July 07, 2007

Kim Shannon - Home in the range

Bull markets are rarer than you think
by Mark brown http://www.advisor.ca/images/other/aer/aer_0207_homeintherange.pdf

Markets have been range bound for the past seven years and, if history is correct, they will stay that way for at least another eight years, according to Kim Shannon, value manager and founder of Sionna Investments. “Typically after a major mania condition, the market capitulates, consolidates and goes sideways for a minimum of 15 years and once as long as 30 years,” she told an audience attending an event to promote Shannon’s move to become a partner with Brandes Investment Partners & Co. “Markets are more often range bound,” she says.

When bull runs do occur, they’re generally short and over before most people have a chance to enjoy it. In fact, markets have been range-bound for 100 of the past 134 years. The telltale sign that markets are moving sideways is the average price-to-earnings ratio. According to Shannon, P/E ratios creep up during a bull run before the market levels off. In subsequent years, that ratio is slowly eroded away in one of two ways: The price comes down or the earnings catch up to the price. The last sideways market began in the middle of 1965 when the P/E ratio was pulled down into single digits. Over the next 18 years investors returns flat-lined with an average return of 0.6%. Dividend yields were the main income generator over that period with an average yield of about 4.5%. The two combined produced an average return of 5% per annum. The single digit P/E ratios set the conditions for the next bull run, which took off in 1982.

Currently, the average P/E ratio in Canada rests at about 15. “People don’t want to think that our market could go single digits,” Shannon says, but to her that likely means we are not done with the recovery and capitulation stage. Generally, the commodities index falls during a bull market and rises during a sideways market. This obviously bodes well for Canada, she says. The data available seems to support that assertion. Shannon notes Canada has outperformed most markets during these range bound periods. While she thinks this will continue, she warns investors not to become compliant. “Keep in mind, through these sideways markets you can have individual fabulous rallying years, but you get much more frequent bear markets,” she says. And while it’s possible to set new record highs on the market, they almost never sustain them. This is one of the reasons why Shannon doesn’t like to make year-to-year predictions for the market. It also says something about how this successful long-term value manager invests.

The key theory for value managers is reversion to the mean, she says, that is, a stock companies trade will do nothing more or nothing less that what it has tended to do before. By looking at how the stock has performed relative to the market in the past, Shannon can make a prediction on how it’s going to behave in the future. “In simple terms,” she says, “what we do is search the investable universe looking for dollars that happen to be trading at $0.70 or less and, if the risk factors are acceptable, patiently waiting for them to go back to a dollar.” In a recent interview she talks about her reluctance to make broad market predictions. “What happens in a year is more noise than anything else,” she said. Overall, when it comes to the market Shannon has always been something of a pessimist when it comes to setting predictions for the market. “My clients know that I tend to wear bear coloured glasses all the time,” she said. “When I make predications and forecasts, if they add a dose of optimism, they’ll probably get it about right.”

Friday, July 06, 2007

Royal LePage Numbers for East Vancouver

Mohican has been kind enough to add me as a contributor. I've taken on the task of keeping VHB's famous condo graph up to date. In addition to this, I've taken what VHB has done for Van West and done the same for Van East.

Here's VHB's condo chart but for East Van Standard Condos:

In the last Quarter Reported, Van East Condos reached a new high of 299,000. Unfortunately, the data for Van East is not as comprehensive as that for Van West. I've used VHB's method of assigning values of the average of present data on either side of the missing data point. Data is missing from 1995Q3 to 1997Q2, then the data is missing every second quarter for a year and a half.
Here we see Royal LePage Prices for East Vancouver bungalows and condos for the time period 1982Q2 to 2007Q1. All prices are stated in 2007Q1 dollars. Detached Bungalows reached a high of $542,000 in the last quarter reported.

In order to see if the theory of price compression is showing up in East Van prices closing in on Van West prices, the idea being that priced out Van West home buyers are slumming it in East Van, I've plotted East Van prices as a percentage of Van West prices. The results were not what I expected.

The relationship between condos was fairly stable. However Van West homes pull further and further away from East Van homes starting in the first half of 2003. Whether this implies Van East homes are now under priced or Van West homes are just that much more into bubble price territory...well that's yet to be seen.
Update: Here's Royal Lepage Numbers for Condos/Bungalows for the West Side and East Side.

Wednesday, July 04, 2007

Fraser Valley REB Statistics

(Surrey, BC) – Halfway through 2007, the Fraser Valley housing market remains strong with 2,053 sales processed on the Multiple Listing Service® (MLS®) in June, a decrease of only three per cent compared to last year’s 2,126 sales, the second highest June on record.

“Summer is traditionally a slower time for real estate sales, but what REALTORS® are seeing currently is on par with some of the strongest real estate cycles in Fraser Valley’s history,” says Jim McCaughan, President of the Fraser Valley Real Estate Board.
The number of new listings at 3,082 is five per cent higher in June compared to the 2,938 new listings added to the MLS® in June of last year. The total number of active listings in June remained buoyant with 8,182, a 39 per cent increase over the 5,893 active listings the same month last year.

“We did see a two per cent dip in the number of active listings from May to June of this year, which makes sense when you look at the strong sales,” says McCaughan. “Buyers want the increase in choice. At the same time, sellers are moving to catch prices while they remain strong.”

Prices increased across all residential property types during the month of June compared to the same month last year. Single family detached homes in the Fraser Valley averaged $529,678, an increase of 11.5 per cent compared to last year’s average price of $475,075.
Townhouses averaged $321,614 in June, a 10.9 per cent increase compared to the average price last year of $290,016 and the average price of apartments last month was $219,935 compared to $189,226 in June of 2006, an increase of 16.2 per cent.

Tuesday, July 03, 2007

Meaty Reading - Bank of Canada Paper on Housing

I recently read an interesting working paper published by the Bank of Canada on the correlation between the US and Canadian housing markets. Here is the summary (emphasis added):

The brief synopsis (no surpises here):
  • Real estate is cyclical (it goes up and goes down)
  • Real estate prices across North America are highly correlated
  • Real estate prices are more volatile in Canada (this is a little surprising)

"Housing cycles in the U.S. and Canada are quite similar overall, but Canadian housing market cycles are more volatile than those in the U.S. Most notably, Canadian housing market contractions are somewhat shorter and sharper than those in U.S. cities. An average expansion lasts from five to six years in both countries and is characterized by an average increase in real prices of about 32%, although the median expansion is larger in Canadian cities (26% versus 18% growth) in our sample. In both countries, real house prices decline by 10% to 11% during an average contraction. This price decline however, occurs more rapidly in Canada since the average contraction lasts only 3.5 years in Canadian cities compared to 4.4 years in the U.S. cities.

Real house price growth rates in the two countries are quite strongly correlated at the national level and among the largest cities in both countries. Canadian cities are in the same housing cycle phase as that of the U.S. 70% of the time. Future work could examine the possibility that there is a common housing cycle in Canada and the U.S. or in broad North American regions. This would be of interest since our findings suggest a clear link between the housing markets of the two countries, yet housing is a non-tradable product.

Real policy rates and the growth of income per capita appear to have strong effects on the transition probabilities of housing market expansions and contractions. After controlling for these fundamental variables and decade-specific time effects, we still find considerable positive duration dependence in expansions, but little evidence of duration dependence in contractions. These findings suggest that fundamental factors do a fairly good job of explaining the transition of housing markets out of contractions phases.

Therefore, to the extent that policy-makers influence real income growth and real interest rates, they are likely to have a substantial effect on the duration of housing market contractions. However, the existence of significant positive duration dependence in expansion phases probably means that there are other factors such as speculation, overbuilding and surplus inventories that drive the transition of housing markets out of expansion and into contraction.

Furthermore, the duration dependence result in expansion cycles could also prove to be a useful tool for policy makers simply because it may help predict housing market turning points. So, while rising incomes and lower interest rates almost certainly played a role in the continuation of the long housing expansion that most cities in the U.S. and Canada recently experienced, these factors alone cannot fully explain its extraordinary duration."

Another interesting piece of research I read recently is by John Burns Consulting.

Yet another interesting piece of research by Robert Shiller. He examines historical house price booms and their turning points.

Have a look and let us know what you think.

Monday, July 02, 2007

CMHC Starts and Completions

In real estate, like all other industries, it's all about supply and demand. Demand for products can be created through marketing or because of a need (food, clothing, shelter). What makes someone spend their resources on an item is a basic question of whether its available and if the price is suitable for their situation. Obviously, we live in a real world with limited resources and we must make individual choices about the items we need (food) and the items we want (concert tickets). We tend to base those choices on the perceived benefit that an item will give us and the cost of that item - is it reasonable given the benefit I expect to receive.

On the supply side, a manufacturer of an item will typically make as many items as he can get away with selling at a profitable price. As prices rise, assuming his costs are the same, his motivation is to manufacter even more items to sell them at even higher profits. If he perceives demand to be strong and that there are willing buyers at ever higher prices, then he will continue manufacturing the item in ever increasing quantities and prices. This usually results in all current demand being used up and then the manufacturer must focus on creating demand for his product through creative marketing and by affecting the conditions in which his item can be used. Sometimes this results in a paradigm shift in social perception or some totally new use for a product never imagined before (think computers before and after the advent of the internet). Sometimes it ends badly for the manufacturer as he creates too many items than can possibly be sold with any level of demand and he is motivated to either sit on a large quantity of items or sell them at whatever price he can get.

Throughout history, there have been many situations where manufacturers make too many items, perceiving demand to be higher than is actually is, and there ends up being a glut on the market. This glut is fantastic for potential buyers, many of whom were priced out of the market for the item as prices rose faster than they could save for the item. The glut is horrible for those who bought the item at a much higher price. They are often left bitter and resentful of the new buyers buying the item at a much lower price.

So, the question for today is, will there be a housing supply glut in the Vancouver area in the next couple years? If I were a housing manufacturer in Vancouver, I would be eager to sell as many of my items as possible at today's prices given the profit involved. Why not manufacture more if the demand seems to be there?