bubble

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The QE2 leaving Southhampton

The QE2 leaving Southampton

Today the Federal Reserve launched the highly anticipated QE2, announcing that it will buy $600 million of Treasuries in 2011 ($75 million per month). It will also continue to reinvest payments on its securities holdings which could bring the total capital injection closer to $1 trillion dollars.

I’m still waiting to see any evidence of  “Change You Can Believe In” and for the $8.5 trillion bailout to kick in and create jobs. But since Bernanke seems that it hasn’t been working too well, we’re going to do exactly the same thing that got us in to this mess – keep interest rates low and turn on the liquidity spigots!

One point of interest is these policies seem to benefit banks the most. Here’s an excerpt from an article on Yahoo! News:

Meanwhile, market watchers noted the Fed’s plan is to focus its QE2 purchasing power on the middle of the Treasury curve, i.e. securities from 2.5 years to 10 years. As a result, prices of shorter-term bonds rose while the price of the 30-year bond tumbled, sending its yield sharply higher.

So the real result of the Fed’s action today is a steepening of the yield curve, which most benefits (wait for it)…the banks. The ability to borrow from the Fed at effectively zero and then reinvest in “risk-free” Treasury securities at a higher yield is a huge reason why bank profits rebounded so quickly from the depths of the 2008-09 crisis.

Despite loads of evidence to the contrary (and very little lending) the Fed is effectively doubling down on its bet that boosting the banks’ balance sheets is the best way to revive the economy.

I can’t believe that this is the best policy to revive the economy. However, it definitely makes sense to align yourself with the Federal Reserve’s determined course of action. Seems like there are 2 things you should do:

  1. If you’re currently unemployed, find a job at a bank. Most banks are hiring like crazy. Bank of America has thousands of job postings (I’m not making this up)
  2. If you’re looking to invest, look for companies that benefit by borrowing at zero interest and reinvesting in risk-free Treasury or Treasury-like products.

There are several companies that fall in this category. Not only do they benefit from the current scenario, but they also pay high dividends and enjoy REIT status (meaning there’s no double taxation of profits) without actually investing directly in real estate.

Any guesses? I’ll talk about them in my next post.

Since I’ve been a homowner, landlord and tenant in my neighborhood for the past 6 years, I follow the real estate market pretty closely. I recently noticed that there was a condo on Realtor.com listed at $264,900.  Since I bought my 2nd condo in 2003 for $270,000, I was curious to find out more info on it.

[Picture of a foreclosed condo for sale in San Diego]

I emailed my friend who’s an agent and she sent me the list details. Apparently its bank-owned. The previous owners bought in 2001 for $170,000 and refinanced it last year for $260,000. The mortgage company has it listed at $265k to break-even on it.

These condos were sold at a peak price of $375,000. I sold both of mine on either sides of the peak at around $350,000 each. A sale price of $265,000 represents a 30% drop from the peak. I’d be amazed if it sold at the asking price.

If I was in a hurry to buy property, I’d be tempted to make a low-ball offer. When I bought my condo in 2001 and again in 2003, there was usually only 1 for sale at a time and usually several buyers. Right now, its the opposite, several for sale and not a single buyer!

Even though the pricing looks good, I expect things to get considerably worse.

Since 2005, I’ve been saying that San Diego home prices are way overpriced and are due for a 40-45% correction. The homes are so far out-of-whack thats it’s 30-50% cheaper to rent than it is to buy. Of course, the National Association of Realtors (the cheerleaders of the real estate world) will always tell you its always a good time to buy, but anyone who can use a calculator might think otherwise.

Already in most parts of San Diego, home prices are down 20-30%, unsold inventory has sky-rocketed, and real estate is no longer the main topic of cocktail parties.

Someone recently asked me if I though it was a good time to buy in San Diego. Houses in a Cardiff/Solan Beach/Encinitas/Pt. Loma that were $800-900k during the peak were now in the $600-700K range. When would we see the bottom?

I obviously thought it made sense to wait until the prices overshoot fair-value and become undervalued. Real estate has a tendency to keep moving in a trend for a very long period of time. Once its started to go down, it’ll just keep on heading in that direction. The Federal Reserve may try to give the bust a ‘soft landing’ but that won’t have much of an effect. It’ll probably just increase the duration of the downturn, similar to what happened in Japan after their real estate market crashed and was depressed for 15 years.

BusinessWeek finally has an interesting article about the Housing Meltdown: Why home prices could drop 25% more on average before the market finally hits bottom..

Even Mike “Mish” Shedlock thinks that home prices will reach more reasonable levels in 2009. Nice to finally see some corroborative data from an economists point of view.

How many of you think the bottom is in 2008?

I’m currently on a short trip to India. For the past 2-3 years, India’s economy has been booming. There is construction everywhere and they’re building new malls and apartment complexes like crazy.

Even though I’ve been living in the US for the past decade, before that I spent 12 years in India. There’s been so much development in my city that I can barely recognize some of the areas. The people have definitely become a lot more prosperous and their standard of living is on the rise too. Up until 10 years ago, there was 1 new car model introduced every 5-10 years. This year, there are 30 new car models slated to be released!

Along with the booming economy and growth in jobs and salaries, there’s also jump in asset prices. Real estate has become insanely expensive, having jumped 10 fold since 2000. The stock market has also increased substantially. The Bombay Stock Exchange Sensitive Index which is a weighted index of 30 stocks has doubled since February 2006. This rapid escalation has created an investing frenzy among average people in India and I think the market may be getting somewhat speculative.

Unlike the US, where non-accredited investors cannot invest in a stock’s Initial Public Offering (and other high-risk investments), in India anyone can invest in an IPO. Right now Anil Ambani, son of legendary industrialist Dhirubhai Ambani and the 6th richest man on earth, is raising $3 Billion via IPO for Reliance Power.

Based on his track record and networth of $45 Bilion, which comes mainly from his 35-50% holdings in his 4 public companies Reliance Communications, Reliance Capital, Reliance Natural Resources and Reliance Energy, that doesn’t really sound like a lot. However, the financial report of Reliance Power for the year ending on March 31st 2007 shows it had revenues of ~$562,000 and net revenue before taxes of ~$135,000. After taxes and carry forward losses, its net income was only $3,900!!!

In order to give it a market cap of over $3 Billion, the market is assuming there will be a tremendous amount of growth in the next few years. Considering that the money is ear-marked for buying the land and building energy plants, thats some serious growth that investors are banking on. I’m no accountant and I haven’t even fully read Benjamin Graham’s The Intelligent Investor, but that seems like a pretty lofty valuation.

You’d think that a company with few assets and little revenue would have a tough time raising the money. However, on the very first day is was over-subscribed by 10 times. The period of allotment for the IPO is about 3-4 days and its presumed that it will eventually be over-subscribed by 100 times!

Somehow, this reminds me of the excitement and speculation surrounding Enron in 1999! While Reliance Power probably wont go bankrupt due to fraudulent accounting, I really think the market is getting a little frothy. This doesn’t mean the stock won’t make initial investors money. It might. And the Indian stock market might go up 50% this year too. In fact, it might go up 20% a year for the next 10 years.

But paying such a high valuation for a stock with no earnings and no assets isn’t really investing, it’s mostly speculation. Speculation isn’t always bad. But you should know the difference and set you expectations (and allocation of risk capital) accordingly. Once of the best books about investment manias is Extraordinary Popular Delusions and the Madness of Crowds which was written over a 100 years ago.

Reliance Power’s valuation puts it in the same league as First Solar (FSLR). FSLR had revenues of $350 million and a net profit of $30 million last year. Yet, based on the hype surrounding solar stocks, its market cap went as high as $23 Billion. On Monday, its market cap was $18 Billion and I shorted it. Since then it’s dropped ~17%. Lets see how they both turn out.

Well I lost money trying to short WCI Communities (WCI) and Countrywide (CFC) by being too early. However, I was right on the money and both stocks are less than 50% from where I tried to short them.

Apparently, even the Miami condo market is down 50% from the peak too. Check out this interesting video.

I’ve heard that water-front lots in Florida that used to sell for $80,000 are now going for only $18,000! When the market turns, land gets marked down significantly more than houses. Thats why the builders are taking significant write-downs on their land inventory and are getting rid of a lot of it, or not exercising their options to purchase land at inflated peak prices.

At some point, Miami condos are going to be selling for much less than the price to build them (replacement value). That’ll be a good time to buy them. What do you think? Would you buy a condo/house if it was 50% off?

A lot of people are wondering where to invest in order to catch the next real estate boom. I don’t have a ready answer for that, but Forbes magazine was nice enough to tell us where the riskiest markets are.

1. Miami, Fla.

Due in part to escalating insurance costs, Miami produced a price-to-earnings ratio that was sixth highest. Despite a loan-to-value rating around national averages, a high vacancy rate of 3.5%, and a 43% share of adjustable rate mortgages was enough to propel Miami to the top of the list of riskiest housing markets.

2. Orlando, Fla.

Its moderate price-to-earnings ratio didn’t do enough to set off an astronomical vacancy rate (over 5%) and scores in the bottom third for 90%-plus loan-to-value mortgages and share of adjustable-rate mortgages. Strong local economic indicators like job growth and immigration significantly mitigate the risk, but the city is in a vulnerable position.

3. Sacramento, Calif.

A high vacancy rate of 3.3%, which ranked 10th worst, the seventh highest price-to-earnings ratio despite consecutive quarters of falling prices, and a share of adjustable-rate mortgages in excess of 50% made Sacramento the riskiest investment in California. A very low number of loan-to-value ratios above 90% means the market can bear the stress of continued price drops should the local economy take time to absorb the slump.

4. San Francisco, Cailf.

More than 70% of the market’s residential loans over the last year were adjustable-rate mortgages, which puts San Francisco in a very vulnerable position should interest rates rise. A middle-of-the-pack vacancy rate of 2.4% is well above healthy, which means that any future price dips for the highest price-to-earnings ratio market could hurt.

5. San Diego, Calif.

San Diego has the lowest share of mortgages with loan-to-value ratios above 90%, which bodes well for any future price decreases, suggesting the city can stand some short term strain. Its problems are a 2.8% vacancy rate, the nation’s third-highest price-to-earnings ratio despite prices not yet reaching a trough, and above-90% loan-to-value and adjustable-rate mortgage shares–among the top three in the nation.

6. Phoenix, Ariz.

There isn’t one poison-pill measurement for Phoenix. A high 3.1% vacancy rate hurts, but so does the 10th-worst price-to-earnings ratio, despite significant downward price pressures over the last year. Adjustable-rate mortgages rank eighth-highest of cities measured and loan-to-value ratios above 90% are in the middle of the pack. The question is whether Phoenix’s labor force and local economy, which is highly tied to the building industry, can sustain a prolonged slump.

7. Kansas City, Mo.

Things look dicey for Kansas City. Vacancy is above 4%, and the share of mortgages with loan-to-value ratios above 90% is the worst of the cities measured. The housing market is strained and ill-equipped to handle any future price declines. At least, with its low price-to-earnings ratio, mortgage costs are little compared with what one could earn renting the property.

8. Cincinnati, Ohio

The share of adjustable-rate mortgages and those with loan-to-value ratios above 90% usually have an inverse relationship. Not in Cincinnati. The city has the 5th-highest share of 90%-plus loan-to-value mortgages and, at 30%, an above-average share of adjustable-rate mortgages. This exposes the market to both price-decrease problems as well as interest-rate hikes.

9. Chicago, Ill.

Chicago is a traditionally stable market, but is currently under pressure. Its 2.3% vacancy rate isn’t unmanageable, nor is its price-to-earnings ratio, which is the 12th highest nationally. Chicago’s problem is a very high share of adjustable-rate mortgages (45%) and a middle-of-the-road share of mortgages with loan-to-value ratios above 90%. Having a high share of one is sustainable if there’s a low share of the other, but in a scenario like this, both lenders and borrowers have elevated risk.

10. Denver, Colo.

Vacancy is high, at 3.7% – it’s the list’s fifth worst, which means that the city has a ways to go before it experiences price recovery. Adjustable-rate mortgages comprise 40% of Denver’s mortgages, which exposes a market that’s already struggling to problems if interest rates should increase.

I’m not sure if I’d invest in any of these cities, but just in case there are any concerns, they’ve also included the Most Overpriced Cities. The top three cities are

1. San Diego
2. Miami
3. Sacramento

which incidentally are also amongst the least affordable, along with Los Angeles and San Francisco.

I definitely wouldn’t be buying in any of these 5 markets, whether for investment or as a personal residence.

In other interesting news today, Beazer Homes (BZH) is rumored to be facing bankrupcy.

American Home Mortgage (AHM) was up today, jumping from $1.25 to ~$4.60. It closed the day with news that it would close down tomorrow and the stock dropped in After-Hours trading back to a $0.72.

CFC and WCI, both of which I lost money on shorting too early were down and are likely to head lower in the long term. In the short term they’ll probably bounce, just like IYR. I had sold naked calls on IYR, which I closed out on Tuesday for a decent profit. Since then IYR has bounced up again. I look for another entry point and buy SRS instead this time.