Just what is leverage anyway?

I was responding to some comments to a post I made to www.seekingalpha.com a few minutes ago, when I said something that I think needs to be explained further.  I mentioned “leverage” and since that’s been in the news (especially regarding financial stocks) quite a lot over the past few months, I decided to expound on it a bit.

In the comment I referenced above, I said “Let’s say you have $1 million equity in your house, and you take it out in a HELOC. You take that $1 million and put 10% down on 10 other $1 million properties – and you depend on the renters to make your payments.“

That’s leverage.  I just took $1 million in assets (my home equity) and used it to gain control on $10 million in assets.  I used the words “gain control” rather than saying “to buy” because I don’t actually own them – the bank I borrowed the other $9 million from actually owns those properties.

It’s an important distinction, because what happens to my $10 million in assets if just one renter falls behind on their payments?  Suddenly I can’t make my mortgage payments.  It’s only 10% less income, but it causes me to suddenly have to sell the whole $10 million in leveraged assets – because I can’t make the payments.

That’s what happened to Bear Stearns.  They had some assets which they leveraged (borrowed against) in order to buy (with other peoples money) other assets.  When one small part of the initial asset didn’t make their payment, the whole house of cards fell.

In my example, I used a leverage ratio of 10 to 1.  Bear Stearns was leveraged over 30 to 1.  I’ve sen some arguments from pundits (including Ben Stein) where they say the markets have over reacted; that a 10 percent jump in the rate of defaults doesn’t warrant a 20 or 30 percent drop in the stock price of financial companies. 

They’re wrong.  And they’re wrong for the reason above.  When you’re that highly leveraged; when you have 20 (or more) dollars of debt for every dollar of assets; you are hosed when just one percent of the underlying assets doesn’t pay up.

Suddenly you can’t make your payments on all the debt you’ve borrowed.  And since you really didn’t make much of a down payment anyway, you have no equity in the investment.  If you had some equity, you’d have a little breathing room.

But you don’t.  You need every dollar that you’ve counted on to make those payments – because you’ve leveraged your equity. 

And what happens when the value of thoseleveraged assets turns out to be too high?  You’re fucked.  Not only are you highly leveraged, but the base value of thoseassets has dropped, so now you are more leveraged than you were just a monthago.  And so you’re even more vulnerable when there’s a small rise in loan defaults and bankruptcies.

It’s a wild, wild world right now.  I can’t think of a single bank or REIT that I’d touch with a 10 foot pole.  Go ahead and Google the news results for the 3rd quarter of last year.  Check out all the stories that claimed that the 4th quarter was the “kitchen sink” quarter.  Be sure to read how damn near everyone thought that the banks and investment houses have finally fessed up and come clean.

Now watch the headlines during the week ahead.  Let’s se how many additional write-downs there are.  A lot of people have written me saying that I’m overestimating the impact of the sub prime stuff.  Many have told me that all of those losses for the upcoming rate adjustments (for the Option ARM’s and ARM’s written in 2005 through 2007) have been accounted for, and that there’s no where to go but up.

They may be right, but I don’t think so.  I don’t think people truly understand the impact of leverage.  I don’t think they truly understand that just a 3 or 4 percent drop in the base asset (mortgages) can cause a company to disappear.  

I’m not putting my money back into the market until I’m sure that risk has been priced in.  Given the (in my view) extremely optimistic earnings forecasts for 2008 and 2009, that risk is being ignored right now.  I may be wrong (I often am!) but I think I’ll be getting 2 or 3 percent in my money market funds while the optimists are losing 10 to 20 percent (or more) trying to bottom fish the market.

Any questions?

gk

 

The running of the bulls

From the 400 point rally today in the stock market, you’d think that the bulls are running rampant in Pamplona.  And you may be right, however….

Stocks are still down over 10% for the year.  The highly leveraged banks and Wall Street firms are still highly leveraged.  Massive amounts of mortgage backed securities – and their higher default rates coming this year and next – are looming.  When a CDO takes a 10% loss because the home owners can’t make the payments, that translates to a 300% loss on a 30 to 1 leveraged portfolio such as Bear Stearns and Lehman Brothers.  (Citigroup is also highly leveraged.)  The $2/share Fed “take it or leave it” financed JPM buyout of Bear Stearns still needs to be approved by shareholders.  Hmmm…. How would you vote if you owned BSC?

As I’ve written before, this unwinding of the leverage in the financial markets will take quite awhile.  The longer the Fed props up failing companies, the longer it will take to hit bottom.   JP Morgan is getting a deal only because the Fed is guaranteeing $30 billion of BSC’s “assets.”  They’re not really worth $30 billion, but the Fed took that much risk away from JP Morgan.   That’s $30 billion that US taxpayers will end up spending to finance this bailout – because the underlying securities are “riskier assets.”

 A couple of weeks ago, I thought we were headed for a repeat of the Carter years and stagflation, but it’s beginning to look more and more like we’re repeating Japan’s mistakes of the 1990’s.  Low interest rates, keeping bad debt on the books (instead of recognizing the loss and getting it over with) propping up banks with fake assets on their books, etc. 

Japan still hasn’t fully recovered from the 1990’s.  I sincerely hope that we don’t continue making the same mistakes, but today’s 3/4% drop in both the discount and Fed funds rates isn’t helping.  That only serves to drive up long term inflation, and that (rather than deflation that I’m reading about) is my long term worry.

As regular readers know, I don’t try to predict short term market swings, I simply try to stay on the right side of the market during long term trends.  I don’t know if today’s action signals a turnaround or not; my gut says no – because of the reasons listed above – but my gut doesn’t make the market move.

Regardless, I don’t see any fundamental change in the long term trends of the dollar going down, commodities (especially gold, silver, corn, and oil) going up, and the broad market (especially financials) going lower.

My feeling is that the majority on the street think that the worst news is behind us; that most people are looking for a reason to buy.  They’ve discounted all the bad news and they’re ready for another bull market.  I don’t think they’ll get it just yet.

Too many firms have too much debt.  Too many firms are leveraged enough so that a small change in the base assets (mortgages in most cases) results in a huge change to their balance sheets.  One little piece of unexpected bad news will be enough to cause a dramatic sell off.  I’m talking about a sell off big enough to trigger a halt to trading. 

I think the coming upswing in the foreclosure rate (because of all the ARM’s taken out in 2005 through 2007) hasn’t been fully factored in to the stock prices of the companies that are using these mortgages as collateral on their loans. 

When people realize how little capital is propping up these companies, share prices will drop.  The dollar will drop, and commodities will rise.  Again, I have no clue what the market will be at in a week or a month.  I don’t know if commodities will be higher a month from now or not.  But I’m betting that 10 years from now, you’ll be glad you bought gold at $1000/oz, silver at $20/oz, oil at $105/barrel, etc. 

If we really are following the deflationary path Japan took in the 90’s, the Dow may well be at 7000 10 years from now.  As it stands, buy and hold investors are down from where they were 8 years ago….  How much longer do we need to prolong the agony? Take the losses now, write off the sub prime and alt-a loans, get it over with!

Of course that’s just my opinion, I could be wrong.  🙂 

gk

The bad 2%

I said most of this last week, but Paul Farrell probably says it better in this articleposted on MarketWatch tonight. 

I also talked about Warren Buffett a bit last week when he posted his annual letter to shareholders, but Mr. Farrell quotes both Buffett and PIMCO bond guru Bill Gross when he says “Buffett and Gross warn: $516 trillion bubble is a disaster waiting to happen“.

There are a lot of people saying that this is all overblown, that the Fed will handle it, that all we need is trust, etc.  But the more I learn about what’s going on, the more I’m convinced we’re in for a big crash.  Bigger than 2000, worse than Carter’s bungling in the late 70’s, worse than Johnson’s Great Society that wasted trillions of dollars.

Please read the article.  Earlier tonight I said that we’d be facing huge losses if just 10% of the mortgages defaulted.  According to this, I was way too optimistic.  Farrell says “There’s nothing intrinsically scary about derivatives, except when the bad 2% blow up.” Unfortunately, that “bad 2%” did blow up a few months afterwards, even as Bernanke and Paulson were assuring America that the subprime mess was “contained.”

Bottom line: Little things leverage a heck of a big wallop. It only takes a little spark from a “bad 2% deal” to ignite this $516 trillion weapon of mass destruction. Think of this entire unregulated derivatives market like an unsecured, unpredictable nuclear bomb in a Pakistan stockpile. It’s only a matter of time. “

AP is reporting that  “The Mortgage Bankers Association said Thursday the proportion of all mortgages that slipped into foreclosure set a record, 0.83 percent, from October through December. The previous high, 0.78 percent, came in the July-through-September period.”

We’re almost at 1%.  Watch what the foreclosure rate goes to over the next few months as all the ARM’s given out in 2005 start to reset.   Buffett’s view that “…derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”  will probably be proven right. 

gk

Jingle Mail

I’ve seen this a couple of times over the past few days, but here’s CNN’s version of a story about “homeowners” simply walking away from their homes.  I say “homeowners” because most of these people put little or no money down, they took out teaser rate ARM’s, interest only – or even negative amortization loans – so they’ve never had any equity to speak of anyway.  They didn’t “own” their homes, they were renting them.

A couple of quotes from CNN’s story – here’s the headline:
Homeowners: Can’t pay? Just walk away
More and more borrowers are watching their house values sink while the cost of their loans skyrockets. What to do? Skip out on the mortgage all together.

Yeah, that’s a good plan.  Just “buy” a nice house which you can’t afford, then stay there for a year or two until your rate adjusts and you can no longer pay for it.  Then mail the keys to the bank (hence the term jingle mail) and walk away.   Next thing you know they’ll be wanting a bailout from the Fed’s…

Another quote: The Los Angeles-based writer bought two properties in Hancock Park, west of downtown, using no-down, interest-only mortgages in 2006. He paid just over $1 million for both.

Often they chose hybrid adjustable rate mortgages (ARMs) that came with low initial payments. After a few years, interest rates on these loans reset higher. But buyers thought they could count on the increased value of their homes to refinance into affordable, fixed-rate loans.

Question – If you couldn’t afford a fixed rate loan on a house 2 or 3 years ago when rates were at a 40 year low, why the hell did you think you’d be able to afford to refinance before the interest only or ARM reset?  Were you counting on a huge raise that never came through?  Or did you just get more house than you could afford on a 15 year fixed rate loan?  If so, you’re too stupid to be a homeowner anyway.

Go ahead and blame it on predatory lending practices, blame it on your real estate agent, blame the economy, blame the house pricing slump, blame your neighbor – just be sure you don’t take responsibility for your own decisions, because that would mean you’re an adult.  And if you did any of the things above, you’re not an adult. 

You’re also not a victim, you’re the cause of the current mess.  You’re the one walking away (or defaulting) on a mortgage that you promised to pay.  You’re the one who is causing banks to lose money because you lied about your income on your application.  And when those banks write down a loss on your loan and their stock price drops, you’re probably bitching the loudest because now it’s hitting your 401k and Roth accounts – although maybe I’m giving you too much credit – anyone who did the above loans is probably not bright enough to plan for their own retirement – you’re counting on Social Security. 

I normally don’t call people names, but if you fall into the category of the people above – you are stupid.

gk