More fantastic commentary out of hedge fund firm Hayman Advisors. You may recall Hayman as one of the few to recognize the oncoming crisis. The difference between Hayman and other "Doomsayers" is their ability to implement strategies to profit (nothing against Nouriel Roubini and others but I have far more respect to those who put their skin in the game and actually have risk riding on their calls). Without further delay, happy reading:
Hayman Advisors 10-09
Monday, October 5, 2009
Wednesday, September 2, 2009
Prepare for the next leg in the Ice Age journey into deflation
Deep deflation thoughts from SocGen's Albert Edwards:
"While there can be no doubt that survey evidence is pointing to a more robust second half, equity markets should be far more nervous than they currently are. We heartily concur with GMO’s Jeremy Grantham who remarked recently that after 20 years of more or less permanent overvaluation of US equities, we saw just five months of under-pricing through the March trough. Do bursting global equity valuation bubbles really end like this? Of course they don’t.
One of the lessons from Japan was that, in a post-bubble world, equities were subject to far more violent swings. We expect to see an exact replica event play out in the west. The Great Moderation - where the 1980’s debt super-cycle filled in troughs of recessions - will now give way to far more violent swings in the economic cycle more usually seen in the pre-war years and the 19th century. Meanwhile, as we saw in Japan, each economic downswing will sink us deeper and deeper into the deflationary mire."
"While there can be no doubt that survey evidence is pointing to a more robust second half, equity markets should be far more nervous than they currently are. We heartily concur with GMO’s Jeremy Grantham who remarked recently that after 20 years of more or less permanent overvaluation of US equities, we saw just five months of under-pricing through the March trough. Do bursting global equity valuation bubbles really end like this? Of course they don’t.
One of the lessons from Japan was that, in a post-bubble world, equities were subject to far more violent swings. We expect to see an exact replica event play out in the west. The Great Moderation - where the 1980’s debt super-cycle filled in troughs of recessions - will now give way to far more violent swings in the economic cycle more usually seen in the pre-war years and the 19th century. Meanwhile, as we saw in Japan, each economic downswing will sink us deeper and deeper into the deflationary mire."
Thursday, August 27, 2009
Eclectica August Letter
Here is the August letter from Eclectica, the hedge fund managed by Hugh Hendry. For those of you unfamiliar with Hugh, he stands firmly in the "deflation" camp. He appears from time to time on CNBC Europe. He brings up many though provoking topics that often aren't discussed or even contemplated, especially in the age of Quantitative Easing. This is a must read for any contrarian investors and I would make the argument is necessary for all investors. As we have all seen over the past 2 years, no scenario should be considered impossible anymore.
Eclectica 08-09
Eclectica 08-09
Monday, April 27, 2009
Tuesday, March 24, 2009
Ron Paul Speaks The Truth...Again
To quote the Wizard of Oz:
Pay no attention to the man behind the curtain.
Wednesday, March 11, 2009
1/2 Trillion Loss? Just Another Day at the Office
Seeing stories like this make me incredibly upset. Not just the sticker shock of the size of the loss, but also the amount of money made by those who ran the entire global financial system into the 7th level of hell.
ABC News is reporting that a London office of AIG might have lost up to $500 billion dollars:
So who was the genius who deserved to be so well compensated? A man by the name of Joseph Cassano.
In the article, ABC News claims they have a tape of Cassano speaking to investors. This is a quote that will live in infamy for many, many years to come:
Brilliant. And now we, the taxpayers, are subsidizing his $1 million a month salary for "consulting services" (I'm sure its work that adds loads of value to AIG). This is one of the more infuriating things I have heard or seen so far during this collapse. Forget Madoff, forget Jerome Kerviel, forget Brian Hunter, forget Nick Leeson...if you roll up every "Rogue Trader" into one, they don't even come close to this man.
ABC News is reporting that a London office of AIG might have lost up to $500 billion dollars:
Ground zero for AIG's spectacular implosion, which has soaked up more federal bailout money than any other entity, appears to have been a small London branch office that may have lost nearly half a trillion dollars in bad deals.
The disastrous deals were built up in a decade and, when the crisis hit, the man who ran the unit for the last eight years retired after making $280 million for himself and leaving with a $1 million-a-month consulting contract.
So who was the genius who deserved to be so well compensated? A man by the name of Joseph Cassano.
In the article, ABC News claims they have a tape of Cassano speaking to investors. This is a quote that will live in infamy for many, many years to come:
It is hard for us with, and without being flippant, to even see a scenario within any kind of realm of reason that would see us losing $1 in any of those transactions.
Brilliant. And now we, the taxpayers, are subsidizing his $1 million a month salary for "consulting services" (I'm sure its work that adds loads of value to AIG). This is one of the more infuriating things I have heard or seen so far during this collapse. Forget Madoff, forget Jerome Kerviel, forget Brian Hunter, forget Nick Leeson...if you roll up every "Rogue Trader" into one, they don't even come close to this man.
Monday, March 9, 2009
Hayman Advisors Letter
This is a very good letter from Hayman Advisors. Hayman is a firm managed by Kyle Bass. They made huge gains in 2007 using similar trades to Paulson in the mortgage market. What I took away as important highlights:
*In the past, I have stated my belief that there is not enough money in the world to soak up the tens of trillions of dollars of deleveraging that must occur over the next few years. This could not be truer than it is today. While I do not have a solution (and maybe it does not exist) to the problems facing us today, what I do know is that attempting to re‐lever a massively over‐leveraged system is clearly NOT the answer.
*If the U.S. were a public company, not even Ken Lewis would consider purchasing us (at a premium no doubt).
*The silver lining in our research is that the U.S. is one of the least levered countries in the world! Just saying that puts a bit of fear into me, but it is true. The U.S. is less levered and less exposed to radical economic deterioration than Western Europe. It is also far less dependent than East Asia on worldwide trade that is a byproduct of the net aggregate demand that previously emanated from the U.S. and other parts of the developed world. East Asia is quickly catching up to Central and Eastern Europe as the most afflicted region of the global economy.
*To be clear, we believe that the U.S. (and in fact, the world) is in an ongoing debt deflationary spiral that will likely continue for some time (possibly years). The rampant printing of currencies around the globe is not, in our opinion, likely to be immediately “inflationary” (in the common understanding of the term) as leverage comes out of the private sector and asset values continue to decline. The greater concern is the potential inflationary time bomb that grows as governments continue to borrow, print and “stimulate.” What happens to inflation when the velocity of money goes from zero to 100?
*Given all of the above, we are very confident in two predictions: 1. The U.S. is in relatively better shape than the rest of the world, and the dollar will be a safer currency than virtually any other (and yes, that includes the Yen). 2. Uncertainty and fear are rampant. Confidence in governmental and central bank leadership (are the two really that separate?) is plummeting worldwide. As a result, we believe people will look to “old-fashioned” stores of value – those which represented money long before green pieces of paper backed by a promise existed. Indeed, investors have already begun moving into precious metals. We expect this will continue.
*Once you have a deep understanding of how the U.S. and world banking systems work, it gives you a sense of how bad things really are and may become. So far, the Federal Reserve and the Treasury's “best and brightest” have decided that the best way to get through this is to add more leverage to an over-levered economy. The TALF program is attempting to re‐start the securitization market. Wait a minute! Did we not just get here through the disintermediation of risk? Shouldn't institutions that are actually making loans be required to keep some or all of those loans on their balance sheets? It looks like we are trying to head right back to where we just came from. The problem is that they have already taken all of the “suckers'” money in the securitization marketplace. Re‐levering will not work, in my opinion. We need to let the weak fail and the strong survive. Bernanke needs to take some cues from Von Mises and the Austrians.
*For your wealth, you must think about the enormity of this problem around the world, and what the likely governmental responses will be. I believe they only have two paths to walk down eventually. One is to print money in an attempt to paper over their losses (pardon the pun). This path can only lead to massive debasement of the fiat currency in our wallets and bank accounts, which is akin to them stealing it from savers. The second path is to move all of the “bad” private assets to the government or public balance sheets and then default on their sovereign debt. The world needs a “do‐over” and this would be the cleanest way to rebuilding the world's financial system. As much as I would like to think there is another path to salvation that does not include enormous pain, there is just no other way when you look at all of the numbers.
Hayman Capital
*In the past, I have stated my belief that there is not enough money in the world to soak up the tens of trillions of dollars of deleveraging that must occur over the next few years. This could not be truer than it is today. While I do not have a solution (and maybe it does not exist) to the problems facing us today, what I do know is that attempting to re‐lever a massively over‐leveraged system is clearly NOT the answer.
*If the U.S. were a public company, not even Ken Lewis would consider purchasing us (at a premium no doubt).
*The silver lining in our research is that the U.S. is one of the least levered countries in the world! Just saying that puts a bit of fear into me, but it is true. The U.S. is less levered and less exposed to radical economic deterioration than Western Europe. It is also far less dependent than East Asia on worldwide trade that is a byproduct of the net aggregate demand that previously emanated from the U.S. and other parts of the developed world. East Asia is quickly catching up to Central and Eastern Europe as the most afflicted region of the global economy.
*To be clear, we believe that the U.S. (and in fact, the world) is in an ongoing debt deflationary spiral that will likely continue for some time (possibly years). The rampant printing of currencies around the globe is not, in our opinion, likely to be immediately “inflationary” (in the common understanding of the term) as leverage comes out of the private sector and asset values continue to decline. The greater concern is the potential inflationary time bomb that grows as governments continue to borrow, print and “stimulate.” What happens to inflation when the velocity of money goes from zero to 100?
*Given all of the above, we are very confident in two predictions: 1. The U.S. is in relatively better shape than the rest of the world, and the dollar will be a safer currency than virtually any other (and yes, that includes the Yen). 2. Uncertainty and fear are rampant. Confidence in governmental and central bank leadership (are the two really that separate?) is plummeting worldwide. As a result, we believe people will look to “old-fashioned” stores of value – those which represented money long before green pieces of paper backed by a promise existed. Indeed, investors have already begun moving into precious metals. We expect this will continue.
*Once you have a deep understanding of how the U.S. and world banking systems work, it gives you a sense of how bad things really are and may become. So far, the Federal Reserve and the Treasury's “best and brightest” have decided that the best way to get through this is to add more leverage to an over-levered economy. The TALF program is attempting to re‐start the securitization market. Wait a minute! Did we not just get here through the disintermediation of risk? Shouldn't institutions that are actually making loans be required to keep some or all of those loans on their balance sheets? It looks like we are trying to head right back to where we just came from. The problem is that they have already taken all of the “suckers'” money in the securitization marketplace. Re‐levering will not work, in my opinion. We need to let the weak fail and the strong survive. Bernanke needs to take some cues from Von Mises and the Austrians.
*For your wealth, you must think about the enormity of this problem around the world, and what the likely governmental responses will be. I believe they only have two paths to walk down eventually. One is to print money in an attempt to paper over their losses (pardon the pun). This path can only lead to massive debasement of the fiat currency in our wallets and bank accounts, which is akin to them stealing it from savers. The second path is to move all of the “bad” private assets to the government or public balance sheets and then default on their sovereign debt. The world needs a “do‐over” and this would be the cleanest way to rebuilding the world's financial system. As much as I would like to think there is another path to salvation that does not include enormous pain, there is just no other way when you look at all of the numbers.
Hayman Capital
Friday, March 6, 2009
The Doom Bunker
Absolutely brilliant Colbert from Thursday night. Here is Part I:
Now, prepare to enter the Doom Bunker!!!!!!!!
Now, prepare to enter the Doom Bunker!!!!!!!!
Wednesday, March 4, 2009
Europe on the Ropes
If the following letter from Niels Jensen, head of UK-based Absolute Return Partners, doesn't scare the shit out of you...I suggest you get your head checked. Eastern Europe represnets a potentially massive systemic risk and I don't see how anyone thinks stocks can sustain any rally. Yes we are oversold, yes there is significant cash sitting on the sidelines, yes every government worldwide is throwing everything they can think of at this crisis. Despite all of this, I am staying out. Enjoy!
Europe On the Ropes
The Absolute Return Letter March 2009
"Many of today's policy proposals start from the view that "greed" and "incompetence" and "poor risk assessment" are the ultimate source of what went wrong. In fact, they were not the true cause at all. Moreover, even if they had been, it is fatuous to think that we will now create a post-crash generation of bankers and traders who are not greedy, much less a new generation of quants who will be able to assess and manage risks much better than "the idiots" who have brought us to the current abyss. Greed cannot be exorcised. Nor can the inherent inability of any quants to determine the "true" probability distributions of all-important events whose true probabilities of occurrence can never be assessed in the first place."
Woody Brock, SED Profile, December 2008
Policy mistakes 'en masse'
The last few weeks have had a profound effect on my view of politicians (as if it wasn't already dented). All this talk about capping salaries for senior bank executives is quite frankly ridiculous. It is Neanderthal politics performed by populist leaders. That Gordon Brown has fallen for it is hardly surprising but I am disappointed to see that Barack Obama couldn't resist the temptation. The mob wants blood and our leaders are delivering in spades. The stark reality is that we are all guilty of the mess we are now in. For a while we were allowed to live out our dreams and who was there to stop us? Policy mistakes – very grave mistakes – permitted the situation to spin out of control. From the U.S. Federal Reserve Bank under the stewardship of Alan Greenspan being far too generous on interest rates to the British Chancellor of the Exchequer -who now happens to be our Prime Minister - advocating 'Regulation Light'.
Policing must improve
If you really want to prevent a banking crisis of this magnitude from ever happening again, the focus should be on the way banks operate and not on how much they pay their staff. And, within that context, any discussion must start and end with how much leverage should be permitted. The French have actually caught onto that, but their narrow-mindedness has driven them to focus on hedge funds' use of leverage which is only a tiny part of the problem. It is the gung ho strategy of banks which brought us down and which must be better policed. And guess what; if banks were better policed - and leverage restricted - then profits, even at the best of times, would be much smaller and there would be no need to regulate bankers' compensation packages.
It is pathetic to watch our prime minister attacking the bonus arrangements of our banks when the UK Treasury, on his watch, spent £27 million pounds on bonuses last year as reward for delivering a public spending deficit of 4.5% of GDP at the peak of the economic cycle. Even my old mother understands that governments must deliver budget surpluses in good times, allowing them more flexibility to stimulate when the economy hits the wall. What Gordon Brown has done to UK public finances in recent years is nothing short of criminal.
So, with that in mind, let's take a closer look at the European banking industry. The following is not pretty reading. I have rarely, if ever, felt this apprehensive about the outlook. So, if the crisis has made you depressed already, don't read any further. What is about to come, will make your heart sink.
More leverage in Europe
Let's begin our journey by pointing out a regulatory 'anomaly' which has allowed European banks to take on much more leverage than their American colleagues and which now makes them far more vulnerable. In Europe, unlike in the US, it is only risk-weighted assets which matter to the regulators, not the total leverage ratio. European banks can therefore apply a lot more leverage than their US counterparties, provided they load their balance sheets with higher rated assets, and that is precisely what they have been doing.
That is fine as long as you buy what it says on the tin. But AAA is not always AAA as we have learned over the past 18 months. Asset securitisations such as CLOs proved very popular amongst European banks, partly because they offered very attractive returns and partly because Standard & Poors and Moodys were kind enough to rate many of them AAA despite the questionable quality of the underlying assets.
Now, as long as the economy chugs along, everything is dandy and the AAA-rated assets turn out to be precisely that. But we are not in dandy territory. Many asset securitisation programmes are in horse manure to their necks, so don't be at all surprised if European banks have to swallow further losses once the full effect of the recession is felt across Europe. The two largest sources of asset securitisation programmes are corporate loans and credit cards. Senior secured loans are still marked at or close to par on many balance sheets despite the fact they trade around 70 in the markets. The credit card cycle is only beginning to turn now with significant losses expected later this year and in 2010-11.
Not much of a cushion left
Citibank has calculated that it would only take a cumulative increase in bad debts of 3.8% in 2009-10 to take the core equity tier 1 ratio of the European banking industry down to the bare minimum of 4.5%1. By comparison, bad debts rose by a cumulative 7% in Japan in 1997-98. One can only conclude that European banks are very poorly equipped to withstand a severe recession. Seeing the writing on the wall, they are left with no option but to shrink their balance sheets. Despite talking the talk, banks will use every trick at their disposal to reduce the loan book. No prize for guessing what that will do to economic activity.
The wheels are coming off
But that is not the whole story. It is not even the most worrying part of the story. For the true horror to emerge, we need to turn to Eastern Europe for a minute or two. Nowhere has the credit boom been more pronounced than in Eastern Europe. And nowhere is the pain felt more now that credit has all but dried up. One measure of the credit fuelled bonanza is the deterioration of the current account across the region. Credit Suisse has calculated that in four short years, from 2004 to 2008, Eastern Europe's current account went from +6% to -6% of GDP2. That is a frightening development and is likely to cause all sorts of problems over the next few years.
Meanwhile Western European banks, eager to milk the opportunities in the East after the iron curtain came down, have acquired many of the region's banks (see chart 1). Now, with many Eastern European countries in free fall, ownership could prove disastrous for an already weakened banking industry in the West.
The problem is widespread
To make matters worse, the problems in the East are beginning to look systemic. Credit Suisse has produced an interesting scorecard where they rank a number of countries around the world on factors usually taken into consideration when assessing the credit quality of sovereign debt (see chart 2). At the top of the tree (i.e. the worst credit score) you find Iceland – hardly surprising considering their current predicament. More importantly though, of the next 14 countries on the list, 8 are Eastern European – not what you want to hear if you are an already undercapitalised European bank with huge exposure to Eastern Europe.
Swedish banks are already reeling from their exposure to the Baltic countries. Austrian banks are in even worse shape, having been the most acquisitive of any European banks. Some Italian banks could be dragged under by their Eastern European exposure and even the conservative banking sector in Switzerland doesn't look like it can escape the mayhem.
Worst of all, the problems in the East are just about to unfold at a point in time where the European banking industry is bleeding heavily from massive losses already incurred in other areas. With no access to private funding, banks find it virtually impossible to re-build their capital base with anything but tax payers' money.
US banks are better off
US banks are in less of a pickle. Unlike the subprime debacle which hit both the US and the European banks hard, US banks have little exposure to Eastern Europe. To prove my point, according to the IMF, European banks have 75% as much exposure to US toxic debt as American banks, but 90% of all cross border loans to Eastern Europe originate from Western European banks. And, to add insult to injury, European banks have been much slower than US banks in terms of recognising their losses. Write-offs now total about $750 billion in the US and only about $325 billion in Europe.
The great mortgage show
The problems in Eastern Europe begin and end with their large external debts. In recent years, ordinary people all over the region have converted their traditional mortgages to EUR- or CHF-denominated mortgages. Some have even switched to JPY mortgages. Who can possibly resist 3% mortgages? Didn't anyone inform them of the risk? As currencies across the region have fallen out of bed in recent months, these mortgages have suddenly become 30-50% more expensive. No wonder the local economy is suddenly tanking.
Credit Suisse has calculated that net foreign liabilities (as a % of GDP) have risen from 47% to 65% in recent months as a direct result of the loss of local currency values (see chart 3 – and don't ask me why Credit Suisse has included South Africa in Eastern Europe!).
Chart 4: Eastern European vs. Asian Crisis
Source: Wall Street Journal
Back in 1997-98 Asia went through a similar currency crisis. However, as you can see from chart 4, Asian current account deficits were much smaller than Eastern European deficits are now. So were debt levels. Despite that, the Asian crisis did enormous damage to the local economy. Eventually Asia came good, primarily because the devalued currencies allowed the Asian countries to export more. Eastern Europe does not share this luxury. With over 90% of the world's GDP in recession, who are they going to export to anytime soon?
Austria is in greatest trouble
According to the latest estimates from BIS, Eastern European countries currently borrow $1,656 billion from abroad, three times more than in 2005 and mostly denominated in foreign currencies (ouch!). 90% of that can be traced to Western European banks. About $350 billion must be repaid or rolled over this year. Not an easy task in these markets. Austrian banks alone have lent about $300 billion to the region, equivalent to 68% of its GDP according to the Financial Times. A default rate of 10% on its Eastern European loans is considered enough to wipe out the entire Austrian banking system. EBRD has gone on record stating that defaults in Eastern Europe could end up as high as 20%3.
An extra $250bn to the IMF
Hungary, Latvia and Ukraine have already received emergency loans from the IMF and both Serbia and Romania are reportedly considering asking for help. Meanwhile the IMF's coffers are draining quickly and it has asked leading industrial nations for new funding. At their summit a week ago, EU leaders coughed up an extra $250 billion but nobody said where the money is going to come from. Even if they find the money, it is likely to prove hopelessly inadequate. Our leaders must grow up. Measuring everything in billions is so yesterday. Trillions are the new billions, like it or not.
Conspiracy or...?
On the 11th February the Daily Telegraph's Brussels correspondent Bruno Waterfield wrote an article under the header: "European banks may need £16.3 trillion bail out, EC document warns." In the article, the reporter revealed that he has seen a secret document produced by the EU Commission which briefed the union's finance ministers on the true extent of the banking crisis. Less than 24 hours later, the article's header was changed to "European bank bail-out could push EU into crisis" and two paragraphs had mysteriously disappeared. Here they are:
"European Commission officials have estimated that "impaired assets" may amount to 44pc of EU bank balance sheets. The Commission estimates that so-called financial instruments in the 'trading book' total £12.3 trillion (13.7 trillion euros), equivalent to about 33pc of EU bank balance sheets.
In addition, so-called 'available for sale instruments' worth £4trillion (4.5 trillion euros), or 11pc of balance sheets, are also added by the Commission to arrive at the headline figure of £16.3 trillion."
Do yourself a favour - read those two paragraphs again. Newspaper editors do not change content light-heartedly. Did the Telegraph editor receive a call from Downing Street? Or Brussels? Did he have second thoughts about the avalanche that he could possibly instigate? I don't know and I probably never will. But one thing is certain. If the EU Commission's estimate of £16.3 trillion of impaired assets is correct, then the crisis is far worse than any of us could ever imagine. Not only would we have to get used to the prospects of a systemic meltdown of our banking system, but entire nations may go down as well.
Public debt to rise and rise
Even if actual losses prove to be much, much smaller (and I sincerely hope so), the banking sector cannot, in the current environment at least, raise sufficient capital to stay afloat, so more, possibly a lot more, tax payers' money will have to be put forward. This can only mean one thing. Public debt will rise and rise. The official estimate for the UK for next year is already approaching 10% of GDP, an estimate which will almost certainly rise further. We probably have to get used to running 10-15% deficits for a few years, a fact which seriously undermines the notion of government bonds being next to risk-free.
BCA Research has calculated the effect on public debt in a number of countries, as a result of further bank losses being underwritten by tax payers. Obviously, those countries with the largest banking industries (as a % of GDP) will be hit the hardest (see charts 5a and 5b).
For that very reason, and as pointed out in last month's Absolute Return Letter, there is a real risk that investors will demand much higher risk premiums on government debt. Only a few days ago, Ireland issued 3-year bonds at almost 250 basis points over corresponding Bunds. As more and more debt is transferred to sovereign balance sheets, we will likely see the spreads between good and bad paper rise further but we will also witness increasingly desperate measures being applied by the men in power. If they could prohibit short-selling of banks on the stock exchange (which didn't work), why wouldn't they consider prohibiting short-selling of government bonds? Not that it would necessarily work any better, but desperate people do desperate things.
Can Germany rescue us?
Most investors remain convinced that Germany will come to the rescue - in my opinion not as simple a solution as widely perceived given the enormity of the crisis. One possible solution which has been mentioned frequently in recent weeks is for all the eurozone nations to get together and start issuing joint bonds. This would undoubtedly help the weaker nations, but the idea was shot down by the German Finance Minister only a few days ago when he said that closer economic harmony across the eurozone would be needed before Germany would be prepared to entertain such an idea.
The most obvious trick left in the book, therefore, is to inflate us out of this mess. With the enormous amounts of public debt being created at the moment, years of deflation a la Japan would be catastrophic. You will never get a central banker to admit to it, but a healthy dose of inflation is probably our best prospect of surviving this crisis.
Given this outlook, do you really want to be long euros?
Niels C. Jensen
Europe On the Ropes
The Absolute Return Letter March 2009
"Many of today's policy proposals start from the view that "greed" and "incompetence" and "poor risk assessment" are the ultimate source of what went wrong. In fact, they were not the true cause at all. Moreover, even if they had been, it is fatuous to think that we will now create a post-crash generation of bankers and traders who are not greedy, much less a new generation of quants who will be able to assess and manage risks much better than "the idiots" who have brought us to the current abyss. Greed cannot be exorcised. Nor can the inherent inability of any quants to determine the "true" probability distributions of all-important events whose true probabilities of occurrence can never be assessed in the first place."
Woody Brock, SED Profile, December 2008
Policy mistakes 'en masse'
The last few weeks have had a profound effect on my view of politicians (as if it wasn't already dented). All this talk about capping salaries for senior bank executives is quite frankly ridiculous. It is Neanderthal politics performed by populist leaders. That Gordon Brown has fallen for it is hardly surprising but I am disappointed to see that Barack Obama couldn't resist the temptation. The mob wants blood and our leaders are delivering in spades. The stark reality is that we are all guilty of the mess we are now in. For a while we were allowed to live out our dreams and who was there to stop us? Policy mistakes – very grave mistakes – permitted the situation to spin out of control. From the U.S. Federal Reserve Bank under the stewardship of Alan Greenspan being far too generous on interest rates to the British Chancellor of the Exchequer -who now happens to be our Prime Minister - advocating 'Regulation Light'.
Policing must improve
If you really want to prevent a banking crisis of this magnitude from ever happening again, the focus should be on the way banks operate and not on how much they pay their staff. And, within that context, any discussion must start and end with how much leverage should be permitted. The French have actually caught onto that, but their narrow-mindedness has driven them to focus on hedge funds' use of leverage which is only a tiny part of the problem. It is the gung ho strategy of banks which brought us down and which must be better policed. And guess what; if banks were better policed - and leverage restricted - then profits, even at the best of times, would be much smaller and there would be no need to regulate bankers' compensation packages.
It is pathetic to watch our prime minister attacking the bonus arrangements of our banks when the UK Treasury, on his watch, spent £27 million pounds on bonuses last year as reward for delivering a public spending deficit of 4.5% of GDP at the peak of the economic cycle. Even my old mother understands that governments must deliver budget surpluses in good times, allowing them more flexibility to stimulate when the economy hits the wall. What Gordon Brown has done to UK public finances in recent years is nothing short of criminal.
So, with that in mind, let's take a closer look at the European banking industry. The following is not pretty reading. I have rarely, if ever, felt this apprehensive about the outlook. So, if the crisis has made you depressed already, don't read any further. What is about to come, will make your heart sink.
More leverage in Europe
Let's begin our journey by pointing out a regulatory 'anomaly' which has allowed European banks to take on much more leverage than their American colleagues and which now makes them far more vulnerable. In Europe, unlike in the US, it is only risk-weighted assets which matter to the regulators, not the total leverage ratio. European banks can therefore apply a lot more leverage than their US counterparties, provided they load their balance sheets with higher rated assets, and that is precisely what they have been doing.
That is fine as long as you buy what it says on the tin. But AAA is not always AAA as we have learned over the past 18 months. Asset securitisations such as CLOs proved very popular amongst European banks, partly because they offered very attractive returns and partly because Standard & Poors and Moodys were kind enough to rate many of them AAA despite the questionable quality of the underlying assets.
Now, as long as the economy chugs along, everything is dandy and the AAA-rated assets turn out to be precisely that. But we are not in dandy territory. Many asset securitisation programmes are in horse manure to their necks, so don't be at all surprised if European banks have to swallow further losses once the full effect of the recession is felt across Europe. The two largest sources of asset securitisation programmes are corporate loans and credit cards. Senior secured loans are still marked at or close to par on many balance sheets despite the fact they trade around 70 in the markets. The credit card cycle is only beginning to turn now with significant losses expected later this year and in 2010-11.
Not much of a cushion left
Citibank has calculated that it would only take a cumulative increase in bad debts of 3.8% in 2009-10 to take the core equity tier 1 ratio of the European banking industry down to the bare minimum of 4.5%1. By comparison, bad debts rose by a cumulative 7% in Japan in 1997-98. One can only conclude that European banks are very poorly equipped to withstand a severe recession. Seeing the writing on the wall, they are left with no option but to shrink their balance sheets. Despite talking the talk, banks will use every trick at their disposal to reduce the loan book. No prize for guessing what that will do to economic activity.
The wheels are coming off
But that is not the whole story. It is not even the most worrying part of the story. For the true horror to emerge, we need to turn to Eastern Europe for a minute or two. Nowhere has the credit boom been more pronounced than in Eastern Europe. And nowhere is the pain felt more now that credit has all but dried up. One measure of the credit fuelled bonanza is the deterioration of the current account across the region. Credit Suisse has calculated that in four short years, from 2004 to 2008, Eastern Europe's current account went from +6% to -6% of GDP2. That is a frightening development and is likely to cause all sorts of problems over the next few years.
Meanwhile Western European banks, eager to milk the opportunities in the East after the iron curtain came down, have acquired many of the region's banks (see chart 1). Now, with many Eastern European countries in free fall, ownership could prove disastrous for an already weakened banking industry in the West.
The problem is widespread
To make matters worse, the problems in the East are beginning to look systemic. Credit Suisse has produced an interesting scorecard where they rank a number of countries around the world on factors usually taken into consideration when assessing the credit quality of sovereign debt (see chart 2). At the top of the tree (i.e. the worst credit score) you find Iceland – hardly surprising considering their current predicament. More importantly though, of the next 14 countries on the list, 8 are Eastern European – not what you want to hear if you are an already undercapitalised European bank with huge exposure to Eastern Europe.
Swedish banks are already reeling from their exposure to the Baltic countries. Austrian banks are in even worse shape, having been the most acquisitive of any European banks. Some Italian banks could be dragged under by their Eastern European exposure and even the conservative banking sector in Switzerland doesn't look like it can escape the mayhem.
Worst of all, the problems in the East are just about to unfold at a point in time where the European banking industry is bleeding heavily from massive losses already incurred in other areas. With no access to private funding, banks find it virtually impossible to re-build their capital base with anything but tax payers' money.
US banks are better off
US banks are in less of a pickle. Unlike the subprime debacle which hit both the US and the European banks hard, US banks have little exposure to Eastern Europe. To prove my point, according to the IMF, European banks have 75% as much exposure to US toxic debt as American banks, but 90% of all cross border loans to Eastern Europe originate from Western European banks. And, to add insult to injury, European banks have been much slower than US banks in terms of recognising their losses. Write-offs now total about $750 billion in the US and only about $325 billion in Europe.
The great mortgage show
The problems in Eastern Europe begin and end with their large external debts. In recent years, ordinary people all over the region have converted their traditional mortgages to EUR- or CHF-denominated mortgages. Some have even switched to JPY mortgages. Who can possibly resist 3% mortgages? Didn't anyone inform them of the risk? As currencies across the region have fallen out of bed in recent months, these mortgages have suddenly become 30-50% more expensive. No wonder the local economy is suddenly tanking.
Credit Suisse has calculated that net foreign liabilities (as a % of GDP) have risen from 47% to 65% in recent months as a direct result of the loss of local currency values (see chart 3 – and don't ask me why Credit Suisse has included South Africa in Eastern Europe!).
Chart 4: Eastern European vs. Asian Crisis
Source: Wall Street Journal
Back in 1997-98 Asia went through a similar currency crisis. However, as you can see from chart 4, Asian current account deficits were much smaller than Eastern European deficits are now. So were debt levels. Despite that, the Asian crisis did enormous damage to the local economy. Eventually Asia came good, primarily because the devalued currencies allowed the Asian countries to export more. Eastern Europe does not share this luxury. With over 90% of the world's GDP in recession, who are they going to export to anytime soon?
Austria is in greatest trouble
According to the latest estimates from BIS, Eastern European countries currently borrow $1,656 billion from abroad, three times more than in 2005 and mostly denominated in foreign currencies (ouch!). 90% of that can be traced to Western European banks. About $350 billion must be repaid or rolled over this year. Not an easy task in these markets. Austrian banks alone have lent about $300 billion to the region, equivalent to 68% of its GDP according to the Financial Times. A default rate of 10% on its Eastern European loans is considered enough to wipe out the entire Austrian banking system. EBRD has gone on record stating that defaults in Eastern Europe could end up as high as 20%3.
An extra $250bn to the IMF
Hungary, Latvia and Ukraine have already received emergency loans from the IMF and both Serbia and Romania are reportedly considering asking for help. Meanwhile the IMF's coffers are draining quickly and it has asked leading industrial nations for new funding. At their summit a week ago, EU leaders coughed up an extra $250 billion but nobody said where the money is going to come from. Even if they find the money, it is likely to prove hopelessly inadequate. Our leaders must grow up. Measuring everything in billions is so yesterday. Trillions are the new billions, like it or not.
Conspiracy or...?
On the 11th February the Daily Telegraph's Brussels correspondent Bruno Waterfield wrote an article under the header: "European banks may need £16.3 trillion bail out, EC document warns." In the article, the reporter revealed that he has seen a secret document produced by the EU Commission which briefed the union's finance ministers on the true extent of the banking crisis. Less than 24 hours later, the article's header was changed to "European bank bail-out could push EU into crisis" and two paragraphs had mysteriously disappeared. Here they are:
"European Commission officials have estimated that "impaired assets" may amount to 44pc of EU bank balance sheets. The Commission estimates that so-called financial instruments in the 'trading book' total £12.3 trillion (13.7 trillion euros), equivalent to about 33pc of EU bank balance sheets.
In addition, so-called 'available for sale instruments' worth £4trillion (4.5 trillion euros), or 11pc of balance sheets, are also added by the Commission to arrive at the headline figure of £16.3 trillion."
Do yourself a favour - read those two paragraphs again. Newspaper editors do not change content light-heartedly. Did the Telegraph editor receive a call from Downing Street? Or Brussels? Did he have second thoughts about the avalanche that he could possibly instigate? I don't know and I probably never will. But one thing is certain. If the EU Commission's estimate of £16.3 trillion of impaired assets is correct, then the crisis is far worse than any of us could ever imagine. Not only would we have to get used to the prospects of a systemic meltdown of our banking system, but entire nations may go down as well.
Public debt to rise and rise
Even if actual losses prove to be much, much smaller (and I sincerely hope so), the banking sector cannot, in the current environment at least, raise sufficient capital to stay afloat, so more, possibly a lot more, tax payers' money will have to be put forward. This can only mean one thing. Public debt will rise and rise. The official estimate for the UK for next year is already approaching 10% of GDP, an estimate which will almost certainly rise further. We probably have to get used to running 10-15% deficits for a few years, a fact which seriously undermines the notion of government bonds being next to risk-free.
BCA Research has calculated the effect on public debt in a number of countries, as a result of further bank losses being underwritten by tax payers. Obviously, those countries with the largest banking industries (as a % of GDP) will be hit the hardest (see charts 5a and 5b).
For that very reason, and as pointed out in last month's Absolute Return Letter, there is a real risk that investors will demand much higher risk premiums on government debt. Only a few days ago, Ireland issued 3-year bonds at almost 250 basis points over corresponding Bunds. As more and more debt is transferred to sovereign balance sheets, we will likely see the spreads between good and bad paper rise further but we will also witness increasingly desperate measures being applied by the men in power. If they could prohibit short-selling of banks on the stock exchange (which didn't work), why wouldn't they consider prohibiting short-selling of government bonds? Not that it would necessarily work any better, but desperate people do desperate things.
Can Germany rescue us?
Most investors remain convinced that Germany will come to the rescue - in my opinion not as simple a solution as widely perceived given the enormity of the crisis. One possible solution which has been mentioned frequently in recent weeks is for all the eurozone nations to get together and start issuing joint bonds. This would undoubtedly help the weaker nations, but the idea was shot down by the German Finance Minister only a few days ago when he said that closer economic harmony across the eurozone would be needed before Germany would be prepared to entertain such an idea.
The most obvious trick left in the book, therefore, is to inflate us out of this mess. With the enormous amounts of public debt being created at the moment, years of deflation a la Japan would be catastrophic. You will never get a central banker to admit to it, but a healthy dose of inflation is probably our best prospect of surviving this crisis.
Given this outlook, do you really want to be long euros?
Niels C. Jensen
Monday, March 2, 2009
Quote of the day
The top five U.K. banks have $10 trillion of assets and their GDP is only $2.13 trillion. The whole country could fall into the ocean. The top five U.S. banks represent only about 60 percent of GDP by comparison.
Friday, February 27, 2009
Milton Friedman
With all the government intervention, calls for the end of the free-market capitalist system, and total misunderstanding of the circumstances that led the global economy to where it is today, I think the following clip is warranted:
I have always been a devoted student of Milton Friedman. I often wonder what he would say today if we were lucky enough to have him alive. I do know, however, that at the very least he is spinning in his grave.
I have always been a devoted student of Milton Friedman. I often wonder what he would say today if we were lucky enough to have him alive. I do know, however, that at the very least he is spinning in his grave.
Friday, January 23, 2009
Fractional Reserve Banking, Revisit
I had posted this video towards the end of last year but it has since been removed (I wonder why?). Let's see how long it takes before this one is removed:
This is only Part I, the others are very interesting as well.
This is only Part I, the others are very interesting as well.
Thursday, January 8, 2009
Denial Still Prevelant, Wait for Capitulation
I feel that most people are still drinking the housing kool-aid, specifically those in the high-end. I live and work in New York. People are still 100% in denial. It will take a while for people to reach capitulation but once they do, I want to be there to see their faces. Take a look at this report Goldman Sachs issued yesterday. Scary:
The Valuation of the New York Apartment Market
We use the recently introduced S&P/Case-Schiller index for condominium prices to assess the valuation of the New York apartment market. Although housing market valuation typically has little predictive value for the near term, it is useful for anticipating longer-term moves, especially when prices are far away from equilibrium.
Indeed, New York apartment prices are very high relative to observable fundamentals. Using three alternative yardsticks – price/rent, price/income, and affordability – we find that prices would need to decline by 35%-44% to return to valuation levels seen in the 1995-1999 period, before the start of the recent boom.
The uncertainty is substantial. On the one hand, the picture would worsen further if per-capita incomes in Manhattan returned from their current level of 3 times the national norm toward the pre-1990s average of 2 times the national norm. On the other hand, it would brighten somewhat if jumbo mortgage rates converged toward conforming rates, perhaps because of a broadening of the Fed’s support measures. In addition, societal and demographic changes could also help, though these types of arguments are difficult to quantify and are often heard just prior to a real estate market downturn.
Following a decade-long boom, activity in the New York City apartment market is now slowing sharply. The sales reports for the fourth quarter of 2008 released on Monday by two of the largest New York real estate brokers—the Corcoran Group and Prudential Douglas Elliman—suggest that sales dropped by 25%-30% from the fourth quarter of 2007 (see “Striking Declines Seen in Manhattan Real Estate Market,” New York Times, January 6, 2009, page A20). Although the prices of closed sales were little changed from a year earlier, one analyst estimated that the prices of apartments that were under contract but had not yet closed fell by 20% from August to December. Moreover, it is well known that prices lag sales activity in the housing market, so most observers agree that both contract and closing prices are likely to decline in the near term.
Information on sales and price momentum is very helpful for predicting near-term moves in the real estate market. But in order to gauge the longer-term outlook, it is better to look at fundamental valuation indicators, such as the level of prices relative to rents or incomes, either directly or adjusted by mortgage interest rates. These types of variables don’t have much predictive power over the near term, but they start to become much more powerful at horizons longer than 1-2 years.
Until recently, a fundamental analysis of the New York apartment market was hampered by the lack of high-quality price data. The various brokerage firms publish mean and median prices for both co-ops and condos on a quarterly basis, but these are difficult to interpret due to significant changes over time in the size and quality of apartments being sold. In addition, research firm Radar Logic, Inc., publishes a “price per square foot” series for the New York condo market. However, there is only a year’s worth of history, and changes in the average quality of homes sold can still distort the data even though the Radar Logic approach does control for variations in size.
But the data situation has improved dramatically with the recent broadening of the S&P/Case-Shiller (CS) repeat sales home price index to cover five of the nation’s largest condominium markets, including New York. These indexes stretch back to 1995—not as far as we would like but much better than what is available currently—and they adjust for changes in both size and quality of the condos by using only matched price observations involving successive transactions in the same condominium for estimating the overall change in prices.
Admittedly, a repeat sales index does not perfectly adjust for quality changes. In theory, the bias could work in either direction. On the one hand, wear and tear will reduce the value of a given condominium over time if the owner does not look after the property well. On the other hand, upgrades such as new flooring or a nicer kitchen may raise the value. While the CS index seeks to eliminate the influence of these factors by downweighting price change observations that are far out of line with local comparables, this is unlikely to eliminate all sources of bias. Still, we believe that a repeat sales index is far superior to the available alternatives for the purpose of measures changes in underlying real estate prices.
In analyzing the data, it is useful to look first at the raw numbers for New York condo prices. As shown in the table below, nominal prices tripled from 1995 to 2006, went essentially sideways in 2007, and have declined by about 3% in 2008. The stability since 2005 is somewhat at odds with reports from the New York real estate brokers that still show meaningful gains in mean and median prices over this period. However, we suspect that the apparent contrast is resolved by a shift in transactions toward larger and higher-quality apartments over this period, which would increase the mean and median price figures but leave the CS index unaffected.
Index
(Jan 2000=100)
Oct-95
75.3
Oct-96
75.4
Oct-97
80.6
Oct-98
89.2
Oct-99
97.5
Oct-00
111.3
Oct-01
126.7
Oct-02
144.3
Oct-03
161.2
Oct-04
188.8
Oct-05
222.6
Oct-06
227.4
Oct-07
226.7
Oct-08
221.1
Source: Standard and Poor’s.
But are the price gains sustainable? To assess this, we focus on three primary valuation measures:
1. Price/rent ratio. We divide the CS index by the Bureau of Labor Statistics’ index of owners’ equivalent rent for the New York metropolitan area, and index the resulting ratio to 100 for the average of the 1995-1999 period. We choose this base period because it mostly precedes the recent boom but covers a period when the quality of life in Manhattan had already improved significantly from the 1980s and early 1990s. Hence, a return to the average 1995-1999 valuation level might seem like a fairly neutral assumption.
2. Price/income ratio. We divide the CS index by the Bureau of Economic Analysis’ measure of personal income per capita, and again index the resulting ratio to 100 for 1995-1999. Although the condo price index covers the entire New York metro area, we use an income series for the County of New York (i.e., Manhattan) rather than the entire metro area. The New York condo market is quite concentrated in Manhattan; this concentration is particularly pronounced in the CS index because it is weighted by value rather than units and therefore typically assigns a much greater weight to condo sales on Fifth Avenue than in Queens. (Note that New York County income is only available through 2006; we somewhat optimistically assume that it has grown at the average national rate since then.)
3. Affordability. Using a standard mortgage calculator and assuming both a jumbo mortgage and a 30-year maturity, we calculate (an index of) the share of Manhattan per-capita income spent on condo mortgage payments at the current level of the CS index and the current level of jumbo mortgage rates. We again index the resulting ratio to 100 for 1995-1999.
The table below shows what all three of our indicators say about the current valuation level, as of October 2008. We focus on the percentage decline in nominal condo prices that would be required to bring our three valuation measures back to the 1995-1999 average, assuming no changes in other inputs such as rents, incomes, and mortgage rates.
Price/Rent
Price/Income
Affordability
Required Decline*
-44%
-37%
-35%
* In order to return to 1995-1999 valuation levels.
Source: Our calculations. See text for additional explanations.
Our indicators suggest that New York condo prices would need to fall by between 35% and 44% to return to a neutral valuation level, depending on the valuation measure we choose. Under the (admittedly unrealistic) assumption that prices decline by the same percentage in each market segment, this type of drop would imply that a 1-bedroom condo whose price currently averages roughly $800,000 million would decline to $480,000; a 2-bedroom condo would decline from $1.7 million to $1 million; and a 3-bedroom condo would decline from $3 million to $1.8 million. (All these figures are approximate and are loosely based on the brokerage firms’ fourth-quarter reports.)
Since economies typically grow over time, one would normally hesitate to predict that “mean reversion” in a price/income or price/rent ratio should occur entirely via a decline in prices rather than an increase in incomes or rents. In our case, however, the assumption of flat nominal incomes and rents does not seem excessively pessimistic. In fact, it is quite possible that nominal Manhattan incomes will decline for a while. Such a nominal decline would be extremely unusual at the national level but did occur in Manhattan following the 2001 recession, which was much less severe than the downturn we are currently seeing.
In fact, it is instructive to consider the potential implications of a return of relative Manhattan incomes toward the national norm prevailing before the Wall Street boom of the past two decades, either because of pay cuts in the financial industry or because of a possible out-migration of affluent individuals. From 1969 to 1986, Manhattan per-capita income averaged 2 times the national average, with no clear trend. Over the next two decades, however, it grew to 3 times the national average. If incomes fell back to the pre-1986 level of 2 times the national average—and if national per capita income remained unchanged—prices would need to fall as much as 58% to return to the 1995-1999 price/income ratio. (The 58% drop is calculated as the 37% drop shown in the table assuming constant income, plus the 33% drop in per capita incomes, minus a term for negative compounding.)
So is there any hope for the New York apartment market? Apart from a dramatic turnaround in the city’s economic fortunes, the most plausible story is a drop in jumbo mortgage rates. So far, jumbo rates have not benefited much from the recent decline in mortgage rates, but this could change if the Fed (presumably in conjunction with the Treasury) decided in the course of 2009 to broaden its support from the conforming market to the private-label mortgage market. To make an extreme assumption, if the jumbo mortgage rate fell from the current 7% to 5%, this would reduce the “required” price decline from 35% to 19%. Of course, this assumes that affordability is the only measure that matters for home prices and there is no role for the “raw” price/rent or price/income ratio, and that Manhattan incomes stay at 3 times the national average.
In addition, it could be that societal and demographic changes will keep New York apartment valuations above the levels that prevailed in earlier periods. For example, one might argue that the memory of high crime rates was still fresh enough in 1995-1999 to make this period an excessively pessimistic benchmark. If crime stays low during the current economic downturn, perhaps Manhattan real estate will retain its higher valuation in coming years. Alternatively, one might argue that the aging of the baby boomers will continue to support the New York market as “empty nesters” want to live closer to the city’s attractions. These types of arguments are difficult to quantify and are often heard just prior to the start of a real estate downturn, but they do underscore that our analysis of the observable data on prices, rents, incomes, and interest rates only provides a very partial view of the New York apartment market.
The Valuation of the New York Apartment Market
We use the recently introduced S&P/Case-Schiller index for condominium prices to assess the valuation of the New York apartment market. Although housing market valuation typically has little predictive value for the near term, it is useful for anticipating longer-term moves, especially when prices are far away from equilibrium.
Indeed, New York apartment prices are very high relative to observable fundamentals. Using three alternative yardsticks – price/rent, price/income, and affordability – we find that prices would need to decline by 35%-44% to return to valuation levels seen in the 1995-1999 period, before the start of the recent boom.
The uncertainty is substantial. On the one hand, the picture would worsen further if per-capita incomes in Manhattan returned from their current level of 3 times the national norm toward the pre-1990s average of 2 times the national norm. On the other hand, it would brighten somewhat if jumbo mortgage rates converged toward conforming rates, perhaps because of a broadening of the Fed’s support measures. In addition, societal and demographic changes could also help, though these types of arguments are difficult to quantify and are often heard just prior to a real estate market downturn.
Following a decade-long boom, activity in the New York City apartment market is now slowing sharply. The sales reports for the fourth quarter of 2008 released on Monday by two of the largest New York real estate brokers—the Corcoran Group and Prudential Douglas Elliman—suggest that sales dropped by 25%-30% from the fourth quarter of 2007 (see “Striking Declines Seen in Manhattan Real Estate Market,” New York Times, January 6, 2009, page A20). Although the prices of closed sales were little changed from a year earlier, one analyst estimated that the prices of apartments that were under contract but had not yet closed fell by 20% from August to December. Moreover, it is well known that prices lag sales activity in the housing market, so most observers agree that both contract and closing prices are likely to decline in the near term.
Information on sales and price momentum is very helpful for predicting near-term moves in the real estate market. But in order to gauge the longer-term outlook, it is better to look at fundamental valuation indicators, such as the level of prices relative to rents or incomes, either directly or adjusted by mortgage interest rates. These types of variables don’t have much predictive power over the near term, but they start to become much more powerful at horizons longer than 1-2 years.
Until recently, a fundamental analysis of the New York apartment market was hampered by the lack of high-quality price data. The various brokerage firms publish mean and median prices for both co-ops and condos on a quarterly basis, but these are difficult to interpret due to significant changes over time in the size and quality of apartments being sold. In addition, research firm Radar Logic, Inc., publishes a “price per square foot” series for the New York condo market. However, there is only a year’s worth of history, and changes in the average quality of homes sold can still distort the data even though the Radar Logic approach does control for variations in size.
But the data situation has improved dramatically with the recent broadening of the S&P/Case-Shiller (CS) repeat sales home price index to cover five of the nation’s largest condominium markets, including New York. These indexes stretch back to 1995—not as far as we would like but much better than what is available currently—and they adjust for changes in both size and quality of the condos by using only matched price observations involving successive transactions in the same condominium for estimating the overall change in prices.
Admittedly, a repeat sales index does not perfectly adjust for quality changes. In theory, the bias could work in either direction. On the one hand, wear and tear will reduce the value of a given condominium over time if the owner does not look after the property well. On the other hand, upgrades such as new flooring or a nicer kitchen may raise the value. While the CS index seeks to eliminate the influence of these factors by downweighting price change observations that are far out of line with local comparables, this is unlikely to eliminate all sources of bias. Still, we believe that a repeat sales index is far superior to the available alternatives for the purpose of measures changes in underlying real estate prices.
In analyzing the data, it is useful to look first at the raw numbers for New York condo prices. As shown in the table below, nominal prices tripled from 1995 to 2006, went essentially sideways in 2007, and have declined by about 3% in 2008. The stability since 2005 is somewhat at odds with reports from the New York real estate brokers that still show meaningful gains in mean and median prices over this period. However, we suspect that the apparent contrast is resolved by a shift in transactions toward larger and higher-quality apartments over this period, which would increase the mean and median price figures but leave the CS index unaffected.
Index
(Jan 2000=100)
Oct-95
75.3
Oct-96
75.4
Oct-97
80.6
Oct-98
89.2
Oct-99
97.5
Oct-00
111.3
Oct-01
126.7
Oct-02
144.3
Oct-03
161.2
Oct-04
188.8
Oct-05
222.6
Oct-06
227.4
Oct-07
226.7
Oct-08
221.1
Source: Standard and Poor’s.
But are the price gains sustainable? To assess this, we focus on three primary valuation measures:
1. Price/rent ratio. We divide the CS index by the Bureau of Labor Statistics’ index of owners’ equivalent rent for the New York metropolitan area, and index the resulting ratio to 100 for the average of the 1995-1999 period. We choose this base period because it mostly precedes the recent boom but covers a period when the quality of life in Manhattan had already improved significantly from the 1980s and early 1990s. Hence, a return to the average 1995-1999 valuation level might seem like a fairly neutral assumption.
2. Price/income ratio. We divide the CS index by the Bureau of Economic Analysis’ measure of personal income per capita, and again index the resulting ratio to 100 for 1995-1999. Although the condo price index covers the entire New York metro area, we use an income series for the County of New York (i.e., Manhattan) rather than the entire metro area. The New York condo market is quite concentrated in Manhattan; this concentration is particularly pronounced in the CS index because it is weighted by value rather than units and therefore typically assigns a much greater weight to condo sales on Fifth Avenue than in Queens. (Note that New York County income is only available through 2006; we somewhat optimistically assume that it has grown at the average national rate since then.)
3. Affordability. Using a standard mortgage calculator and assuming both a jumbo mortgage and a 30-year maturity, we calculate (an index of) the share of Manhattan per-capita income spent on condo mortgage payments at the current level of the CS index and the current level of jumbo mortgage rates. We again index the resulting ratio to 100 for 1995-1999.
The table below shows what all three of our indicators say about the current valuation level, as of October 2008. We focus on the percentage decline in nominal condo prices that would be required to bring our three valuation measures back to the 1995-1999 average, assuming no changes in other inputs such as rents, incomes, and mortgage rates.
Price/Rent
Price/Income
Affordability
Required Decline*
-44%
-37%
-35%
* In order to return to 1995-1999 valuation levels.
Source: Our calculations. See text for additional explanations.
Our indicators suggest that New York condo prices would need to fall by between 35% and 44% to return to a neutral valuation level, depending on the valuation measure we choose. Under the (admittedly unrealistic) assumption that prices decline by the same percentage in each market segment, this type of drop would imply that a 1-bedroom condo whose price currently averages roughly $800,000 million would decline to $480,000; a 2-bedroom condo would decline from $1.7 million to $1 million; and a 3-bedroom condo would decline from $3 million to $1.8 million. (All these figures are approximate and are loosely based on the brokerage firms’ fourth-quarter reports.)
Since economies typically grow over time, one would normally hesitate to predict that “mean reversion” in a price/income or price/rent ratio should occur entirely via a decline in prices rather than an increase in incomes or rents. In our case, however, the assumption of flat nominal incomes and rents does not seem excessively pessimistic. In fact, it is quite possible that nominal Manhattan incomes will decline for a while. Such a nominal decline would be extremely unusual at the national level but did occur in Manhattan following the 2001 recession, which was much less severe than the downturn we are currently seeing.
In fact, it is instructive to consider the potential implications of a return of relative Manhattan incomes toward the national norm prevailing before the Wall Street boom of the past two decades, either because of pay cuts in the financial industry or because of a possible out-migration of affluent individuals. From 1969 to 1986, Manhattan per-capita income averaged 2 times the national average, with no clear trend. Over the next two decades, however, it grew to 3 times the national average. If incomes fell back to the pre-1986 level of 2 times the national average—and if national per capita income remained unchanged—prices would need to fall as much as 58% to return to the 1995-1999 price/income ratio. (The 58% drop is calculated as the 37% drop shown in the table assuming constant income, plus the 33% drop in per capita incomes, minus a term for negative compounding.)
So is there any hope for the New York apartment market? Apart from a dramatic turnaround in the city’s economic fortunes, the most plausible story is a drop in jumbo mortgage rates. So far, jumbo rates have not benefited much from the recent decline in mortgage rates, but this could change if the Fed (presumably in conjunction with the Treasury) decided in the course of 2009 to broaden its support from the conforming market to the private-label mortgage market. To make an extreme assumption, if the jumbo mortgage rate fell from the current 7% to 5%, this would reduce the “required” price decline from 35% to 19%. Of course, this assumes that affordability is the only measure that matters for home prices and there is no role for the “raw” price/rent or price/income ratio, and that Manhattan incomes stay at 3 times the national average.
In addition, it could be that societal and demographic changes will keep New York apartment valuations above the levels that prevailed in earlier periods. For example, one might argue that the memory of high crime rates was still fresh enough in 1995-1999 to make this period an excessively pessimistic benchmark. If crime stays low during the current economic downturn, perhaps Manhattan real estate will retain its higher valuation in coming years. Alternatively, one might argue that the aging of the baby boomers will continue to support the New York market as “empty nesters” want to live closer to the city’s attractions. These types of arguments are difficult to quantify and are often heard just prior to the start of a real estate downturn, but they do underscore that our analysis of the observable data on prices, rents, incomes, and interest rates only provides a very partial view of the New York apartment market.
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