The coming mortgage crisis

If you read the papers and watch the news, you may believe that we are in and have been in a subprime mortgage crisis for the last year or so. That is true. Many pundits are also saying that the subprime crisis is nearing its end. That is also true, to a point. Subprime mortgage troubles will not inflict that much more damage on the broader economy. However, prime and Alt-A mortgages with toxic features will cause troubles that will make the current troubles look like a walk in the park. Furthermore, broad-based declines in housing prices will start to wreak havoc on housing markets across the country.

The Cataclysmic Shift

The problem with the housing market bulls is that they are thinking within the framework of past housing downturns. The current downturn is unlike any other since the Great Depression. No other downturn has started with houses so overpriced relative to rents. Few downturns started with such reasonable interest rates. No other downturn saw double digit house price declines across the country. This downturn is different, and it is going to lead homeowners (or homedebtors, as the Irvine Housing Blog calls those who have little equity) to change their behavior in ways that only the pessimists such as myself anticipate.

The problem with most predictions is that they are linear extrapolations of the past into the future. Have global temperatures been rising? They will continue to rise at the same rate. Has crime been increasing? It will continue to increase at a similar rate. The problem is that significant change often comes suddenly. That is why no one who knows anything is worried about the gradual increases in the Earth’s temperature that will occur if global warming continues. What really scares people is the possibility (however remote) that the changes could accelerate or could cause something unexpected to happen (such as the jet stream moving or the ocean currents changing). A thorough review of the history of global temperatures reveals that such cataclysmic change is not unusual.

In the case of housing, the cataclysm will come within the next couple years. It will be fueled by two factors: option ARM mortgage recasts and house price declines. (Slate has a worthwhile take on what will happen, but its analysis is less detailed than mine.)

Why House Prices will Continue to Decline

House prices are elevated relative to rents and relative to incomes, especially in the hottest markets, such as California, Nevada, Florida, and Arizona. However, price increases in middle America have been no less astonishing. One example with which I am all too familiar is the house I just sold in the Saint Louis suburb of Maplewood. Zillow has a decent graph of the house’s value, although it is not completely correct. If you look at the county assessor’s website (and search by the address) you can see that the house sold for $100k back in 1997 and then for $188k in 2004. I just sold it for $165k. Over this period of time few renovations of note were done on the property and the neighborhood did not improve significantly. The employment situation in the area has not changed. So from 1997 to 2004 the house appreciated by 88%, while between 1990 and 1997, during great economic times, the house appreciated by only 25%. In relation to both rents and area incomes, the house is still probably 20% overvalued.

Housing Starts

Moving from the anecdotal to the statistical, we can see that this is not an isolated situation. The chart above shows housing starts and permits for the last 30 years. Over this period the population has increased at a fairly steady rate. Since 2003 there have been too many houses built. This will lead inevitably to falling prices.

Orange County Price to Income

If you look at the ratio of income to house prices in the above graph (from Piggington’s Econo-Almanac), you will see that house prices are way higher than they should be relative to incomes (while this graph is for one area of California, prices are elevated relative to incomes across most of the country). While creative financing can lead to a bubble in prices, there is no way for house prices to remain unaffordable indefinitely.

Price to Rent ratio

Another thing to consider is that house prices remain tethered to rental prices over the long term. If renting is cheaper than buying, people will choose to rent rather than buy and house prices will fall. House prices have never been so much higher than rental prices than they are now. Above is a chart of the ratio of the OFHEO house price index to the CPI-Owner’s equivalent rent.

Foreclosures

Another factor weighing on prices is the increase in foreclosures. Banks that own foreclosed houses are motivated sellers and they will cut the prices so that they can sell their inventory. Increasing foreclosures will increase supply and decrease prices of transactions. Why pay $200k for a house when your neighbor but his out of foreclosure for $140k? Foreclosures are actually understated because banks often don’t have the manpower necessary to foreclose and sell delinquent properties.

The foreclosure problem will soon get much worse. Considering that it often takes over half a year (and can take much longer) between when a homedebtor falls behind on a mortgage and when the house is repossessed, the current wave of foreclosures began before house prices had fallen significantly. With prices now down 20% in many areas and 30% or more in some areas, the rate of foreclosures will increase drastically over the next year. Those that need to sell and who have little equity will be unable to sell for more than they owe. Short sales are difficult, so foreclosure will be the last resort for many who need to move.

Even though asking prices for houses have fallen dramatically already, they have not fallen nearly enough: witness the low volume of house sales relative to prior years. In the graph below we can see that the spring selling season in San Diego has been a bust, as it has elsewhere (image from the Bubble Markets Inventory Tracker blog).

sd-house-sales.jpg

Option ARM Recasts

Besides falling house prices, another factor in the coming mortgage crisis is the coming recasts of millions of option ARM mortgages. Most of you will be familiar with the problem of interest rate resets on ARMs (adjustable rate mortgages). This problem is well-known. Almost all ARMs have fixed rates for the first couple years and then the rates reset to market rates. Considering the current low interest rate environment, this problem is likely overblown.

imfresets.jpg

The greater problem, however, is recasts. Option ARMs allow for the choice of the size of the payment. Homedebtors can choose to pay an amortizing payment (such that their mortgage balance is reduced), an interest-only payment, or a negative-amortizing payment, where their mortgage balance increases. Recent data from Countrywide indicates that 71% of borrowers with option ARMs are only making the minimum, negative-amortizing payment. Option ARMs have provisions such that when the mortgage balance exceeds the original mortgage by 10% to 15%, the loan converts into a fully self-amortizing loan. Considering that many of these loans were made over the last few years (beginning in 2005), we should start to see a number of recasts. When a mortgage recasts, the payment size can easily double or triple. Those who could afford their payments before will no longer be able to do so.

Option ARMs are highly prevalent, especially in the most bubbly markets. See the following map and click on it for a larger version (courtesy of the Irvine Housing Blog):

map_of_misery.jpg

The Coming Crisis

The coming crisis will be caused by option ARM recasts, falling prices, and banks’ increasing reluctance to lend. The crisis will manifest itself in people simply walking away from houses where their mortgage is worth more than the house. Considering how many people have used home equity loans to remove equity, how many have had negative amortization in their loans, and considering how small down payments became over the last few years, very few homeowners will be left with equity in their houses. Economy.com currently estimates that 9 million households have negative equity. That figure could easily double or triple as house prices fall by another 20% to 30%.

The assumption on the part of mortgage lenders, regulators, and housing market optimists is that as long as people can afford to pay their mortgages, they will. But homedebtors faced with 20% to 30% negative equity will be much better off going through foreclosure than they will paying off their debts. Helping them is the fact that in a number of states, purchase money mortgages are non-recourse debt, meaning that banks cannot sue to recover the money they lose. The sheer number of foreclosures will mean that banks will not have the manpower to go after domedebtors even when they want to do so.

The rising tide of foreclosures caused by people walking away from houses in which they have negative equity will act as part of a positive-feedback loop to increase the rate of price declines. The housing market is not getting better anytime soon and it will soon get much, much worse.

Timothy Sykes is full of bullship

[Edit 8/18/2009 – Since writing this article I have changed from Tim Sykes’ biggest critic to his biggest fan. Please see this article on my new trading blog about how my opinion  of Tim Sykes changed.]

Timothy Sykes, the boy wonder who turned $12,000 into $1.65 million while still a teenager, has abandoned his hedge fund Cilantro to re-create his day-trading achievement in full view of the internet on his new blog. Sykes is best described as young, brash, egotistical, and annoying. Of course, an impartial observer would describe me in much the same way. Timmay and I also share the preference for shorting stocks over buying them. But rather than being two peas in a pod, we are polar opposites: Tim is the quintessential short-term trader and I am the archetypal buy-and-hold value investor.

I am not like some people who say that day trading is a crock and that it never works. It can work for some people some of the time. The problem with Tim Sykes is that he encourages others to follow in his footsteps by buying his $297 DVD trading seminar. There are several problems with buying a trading system such as Tim’s:

  1. Even assuming that some strategy works, if enough people follow that strategy it will cease to work. This is exactly what happened to Richard Dennis, the noted commodities trader, who famously lost tens of millions of dollars in 1988 after his trend-following strategy stopped working. Sykes of course likes trading microcap stocks with relatively thin markets. This means that his system is especially prone to break when too many people start using it.
  2. Trading takes a lot of time; this is particularly true for Timmay’s day trading and momentum trading. Most people have jobs, and very few people have enough in savings and enough trading talent to make a lot of money trading. So for most people, time learning to trade would be better spent nurturing their career or working a second job.
  3. Trading any system takes incredible self-restraint and guts. Very few people have the self-control to be able to stick to a system even when it is not making money. This is even harder if a trader buys a system (say, from Tim Sykes), because it is harder to become truly convinced in the system if that trader did not invent it himself or herself.

Traders and investors should steer clear of Sykes’ DVD and his trading system. Those few who could be good traders would likely do better developing their own system rather than following Tim’s. Of course, I find Tim amusing, so I encourage you to read his blog for its amusement value.

Disclosure: I had no connection to any person mentioned at the time I first posted this. Since I first published this post I have bought many of Sykes’ products, successfully used his trading system, and am now an affiliate of his (earning a commission on anyone who buys his DVDs using a link from my site).

Stifel, Nicolaus, and a Broker’s Theft of Client Money

Stifel, Nicolaus & Company [[sf]] has a reputation as a straight-shooting company. The regional brokerage, based in St. Louis, avoided accusations of biased stock research that ensnared many other brokerages at the time of the tech-stock bust. The company has not previously seen any of its Missouri brokers charged with securities violations by the state Securities Division. But all is not well with the company. In fact, Stifel, Nicolaus has recently shown that it has little concern for its brokerage clients, beyond its desire to extract as much money as possible from them. One of the company’s brokers, Girard Augustus Munsch Jr., was recently sanctioned and fined by the Missouri Securities Division for excessive trading in client accounts. How excessive?

One client, an 81-year old with a net worth below $250,000 and a liquid net worth under $100,000 (according to brokerage documents), paid $63,861 in commissions over three years on a total of 262 stock trades. In his deposition, the broker (Munsch) stated that for many of the trades, he was the only one to benefit. In other words, the trades were executed solely to garner trade commissions.

Another client, 72-years old when the client began with Munsch, had 122 stock trades over three years in her account, generating $32,389 in commissions for Stifel, Nicolaus. According to brokerage documents, this client had liquid assets of under $100,000. When interviewed by securities regulators, the client stated that she wanted to keep her money in mutual funds and to avoid high risk stocks. Girard Munsch acknowledged that he was was aware that he was the only beneficiary of many of his client’s trades, and that did not bother him.

Stifel’s Culpability

There are of course bad apples in every bunch. But Stifel, Nicolaus showed willful negligence and a casual disregard for the financial well-being of its clients in how it managed Munsch. Back in 2000 Munsch was put under heightened supervision due to customer complaints of unauthorized trading. Due to client complaints of unsuitable investments, Munsch was again put on heightened supervision in March of 2003 and 2004. Munsch’s supervisor, while requiring a phone log to make sure that he was acting appropriately, never checked that log or instructed Munsch in completing the log. Evidently it takes more than repeated mistreatment of clients to get a broker fired from Stifel.

The Punishment

The punishment meted out by the Missouri Securities division is of course insufficient. Munsch should be barred from working as a broker. Instead, he has to be closely supervised and pays a meager fine of $105,700. For a successful broker, such a sum is far less than one year’s salary.

Stifel, Nicolaus, despite failing completely to supervise Munsch and to fire him after earlier violations of the law, gets off without a fine. A fine of $10 million would have been appropriate. However, the broker did one thing right : when I checked with Stifel, Nicolaus, I was told that Munsch had “retired”.

Disclosure: I have no position in any company mentioned.

When analysts get paid to provide positive opinions

People will respond to rewards. This is one of the most consistent findings in psychology. Whether the reward is pecuniary, emotional, or philosophical, people will (within reason) do whatever it takes to get rewarded. So if my business partner asks me to do something that is unimportant, I am likely to do it, distracting me from things I consider more important, because it matters to me what he thinks of me. If I am paid by someone to do something, I will make sure I act in such a way as to continue to get paid.

Acting in such a way as to continue to get paid is a problem when a person or company is being paid to give an unbiased opinion about a company. This is why Fitch, Moody’s, and S&P all have given absurdly high ratings to CDOs and other structured bonds: they were paid handsomely by the banks who put those bonds together. Those types of structured finance provided much of the profit growth of the ratings agencies over the last few years.

This same conflict of interest is often present in the micro-cap world. For example, I have previously criticized Beacon Equity Research for being paid by many microcap companies to cover them. Its reports are unfailingly bullish. The problem is that many investors do not take the trouble to investigate the company and they consider the reports meritorious. If an investor had invested in many of the companies covered by Beacon Equity Research, he or she would have lost lots of money. However, if the investor had instead read my blog and taken my advice (on stocks covered by both Beacon and myself), they would have avoided many losses.

For example, on February 6th, Beacon issued a positive report on Continental Fuels (OTC BB: CFUL), when it was trading at $0.28 per share. The analyst’s target price was $0.53. My most recent opinion on Continental Fuel’s valuation came last December 28th, when I said that the stock, then at $0.40 per share “continues to trade at 40x my fair value estimate of $0.01 per share.” The stock has since fallen to $0.03 per share.

Lighting Science Group (OTC BB: LSCG) makes another great example. Jeff Bishop of Beacon Equity Research published a positive article on the company on SeekingAlpha on February 8th. The stock closed that day at $9.80 per share. On February 22nd, I posted a negative article on the company on this blog. The stock price has since fallen from $9.90 per share to $2.85 per share.

Investors should always be careful to examine how analysts are compensated for their services. They would do well not to pay attention to any analyst paid by the company they are covering. In the end, each investor is responsible for his or her own investment performance. Those who are incapable or unwilling to put forth the necessary effort to understand the companies they buy deserve what they get.

Disclosure: I have no position in any company mentioned. I was short LSCG when I last wrote about it, as I disclosed at the time. I have a disclosure policy.

Playing hot potato with the shares of an overvalued microcap

If you are not from Germany then the only time you have probably heard the term “Landesbank” is in relation to the subprime mortgage problem. WestLB and IKB required rescue from their owners after speculating and losing billions of dollars in subprime mortgage securities. Their peer NordLB (or for the German-speaking, Norddeutsche Landesbank Girozentrale) evidently decided to emulate WestLB’s and IKB’s idiocy by purchasing for a client 24% of perennially-overvalued microcap Remote MDX (OTC BB: RMDX). Now, normally this would not be a problem: if the client loses money the bank still gets its fees. However, the bank’s unnamed client refused to take the shares and those shares are now sitting on the bank’s books. NordLB recently filed a form 13D to announce this. Here is an excerpt:

Since November 2007, NORD/LB has been acquiring RemoteMDx Common Stock at the instruction of a client and with the intention to pass the shares on to the client. However, the client now refuses to accept the RemoteMDx Common Stock and to settle the orders. In the course of a review conducted with regard to these business activities, one of NORD/LB’s brokers mistook the trades for settled with the client and entered them into the books accordingly. Because the settlement process with NORD/LB’s client is still disputed, NORD/LB, as a matter of precaution, on February 25, 2008, assigned the shareholding to its own assets and is therefore making this disclosure on Schedule 13D. However, NORD/LB disclaims beneficial ownership of the shares of RemoteMDx Common Stock included in this Schedule 13D subject to resolution of this dispute.

The shares were purchased near the stock’s all-time highs. Whoever ends up with the shares will have a mark-to-market loss of $81 million, or 70%. No matter what happens, this situation makes NordLB look incredibly bad.

Note 3/16/08, 7pm: since I first published this I  was made aware that Carol Remond of DJ Newswires published an article about this Friday. She identified the client as Vatas GMBH, a previous 13D owner of RMDX stock. The hedge fund had also left Nord/LB with stock in several other microcaps.

For more information:

Remote MDX (RMDX.OB): A ‘Bit’ Overvalued (August 2007 – GoodeValue.com)
Remote MDX Redux (August 2007 – GoodeValue.com)

Citron Research Comments on Remote MDX (December 2007 – CitronResearch.com)

Disclosure: I have no position in RMDX.

Book Review: Essentials of Corporate Fraud

I have many great things to say about Tracy Coenen, who is a blogger, author, and above all, a forensic accountant. I love her blog and I find her to be witty and intelligent. As a short seller I am also something of a fraud connoisseur, so I appreciate what she does. I eagerly anticipated her first book, Essentials of Corporate Fraud. She was kind enough to let me review before it was published, for which I thank her.

Here is the synopsis of the book from the publisher:

The book guides executives, managers, attorneys, and auditors through the basics of corporate fraud. In order to effectively fight fraud, it is important to understand who commits fraud, why they do it, how they do it, and how it affects the company as a whole.

Essentials of Corporate Fraud is more than a primer on fraud detection and prevention. It is a real-world look at how fraud occurs from an expert who has investigated hundreds of internal frauds, including embezzlement, financial statement fraud, investment fraud, bribery, and corruption. Tracy’s broad experience ranging from law enforcement to traditional auditing and finally to forensic accounting and fraud investigations brings a unique perspective to this publication.

To describe my overall impression of the book I find that I must resort to analogies. The book is like Michael Jordan scoring 18 points or like me only making a 20% return on a stock I have sold short. It is good, and a worthy read, but it is not great. I had expected better. However, I did find the book to be a worthy primer on fraud. There are of course a couple reasons that the book did not live up to my expectations, neither really Tracy’s fault: the book appears to be geared towards management types and it is an introductory book.

While being president of a small company, I am decidedly not a management-type; in fact, I would say that my IQ is about 2 standard deviations higher than the IQ of most managers (or at least people who read management books). The other problem is that this book is an introductory book. To someone who deals with messing up financial statements on a weekly basis (as bookkeeper of my company) and analyzing them on a daily basis (as a short seller), I am already familiar with many ways to defraud.

Despite not being wowed by the book, I found it to be a solid introduction to fraud. It was easily readable, not repetitive (unlike most books geared towards management), and it got me thinking. This book made me reconsider certain ways that my small company operated. Since reading it I have made changes to reduce the risk of fraud. For a book such as this, the best compliment is to say that it was useful, and this book was a useful read for me.

While this book would be useful to many, it is decidedly not useful (nor does it pretend to be) to investors who only care about financial statement fraud. If you are a CPA, manager, or business owner who is not an experienced fraud fighter, this seems to be a good place to start, so you should buy the book.

Whether or not you buy the book I definitely suggest reading Tracy Coenen’s Fraud Files Blog.

Interim Performance Review

Your humble blogger is not averse to eating crow. So it is time to admit that I have been wrong so far about Frederick’s of Hollywood [[foh]] (Movie Star Inc prior to a recent reverse merger). It is difficult to invest without knowing all the information, and I appear to have been over-optimistic about the growth of the company. Especially with competitors like Limited Brands [[ltd]] (owner of Victoria’s Secret) selling quite cheaply, Frederick’s does not look like a worthwhile stock to buy. Frederick’s stock has recently fallen from $3.60 to $2.80 (its 52-week low after adjusting for a recent 2-for-1 reverse split).

On the other hand, my bearish advice continues to be very good: since scolding Patrick Byrne and Overstock.com [[ostk]] in a Dueling Fools article (for The Motley Fool), the stock has declined from $15.76 to $8.90.

In other news, despite Exmocare (OTC BB: EXMA, formerly 1-900 JACKPOT) being a horridly overvalued useless piece of trash with no sales and no significant book value and no chance of ever being worth one-tenth of its market cap, its stock has gone up since I pledged the profits from my short position in the stock to charity. The 1st Annual GoodeValue.com Short-a-Thon was a failure and raised $0 for charity.

Disclosure: I have no position in any stock mentioned. I trained in the dark arts of Jedi under the Sith Lord himself. My disclosure policy wants you to read it.

A worthless company that shall soon reward its foolish investors

Many things can be said about MaxLife Fund Corp (OTC BB: MXFD). Certainly, it could be called overvalued: the company, trading at a recent $18.89 per share and a market cap of $572.2 million (it has 30.3 million shares outstanding as of January 14), has a book value of $560,000 and revenues for the most recent quarter of $330,000. The company could be called a great speculation: since August 6, 2007 its share price has increased from $1 to $18.89. Since January its shares have doubled.

One thing that is certain about MaxLife Fund Corp is that it will not reward long-term investors. Even if the company does execute on its highly optimistic plan put forth in a recent press release (which I believe to be unlikely), its revenues and earnings will not justify its current market cap. One day its stockholders will realize this and the share price will crash down below $1.

Another ill omen for investors: Itamar (Eddy) Cohen is a 46% owner of the company. Stocks promoted by Cohen have not faired well: two of his recently promoted stocks have fallen 97% from their peaks.

For more information:

Forbes Informer article
10Q filing with SEC

Disclosure: I am short MXFD. I have a disclosure policy.

The fall of a pumped penny stock

I have previously written about Continental Fuels (OTC BB: CFUL) a number of times. I called it the most overvalued penny stock I had ever seen when it was trading around $2.50 per share (although there are now some good competitors for that honor). When its stock price had fallen to $0.70 per share, I said it remained 100-times overvalued. With a current stock price of $0.05 per share, I can finally say that the stock’s inevitable fall is mostly over (although it would still be a poor investment).

The moral of this story is do not invest in over-hyped stocks. Do not invest in stocks mentioned in spam emails, junk faxes, or junk mail. Do not invest in any individual stock unless you have read and understood its financial statements. For those who are not savvy investors, don’t worry: just invest in broad-market index funds and you will do better than most investors and mutual funds.

Disclosure: I have no position in CFUL.