Real Estate – Goode Trades

Are your deposits insured? How to avoid losing money in the coming bank Armageddon

I am not one to use the term Armageddon lightly. But when major banks like National City (NCC) and Washington Mutual (WM) are trading under 30% of book and Wachovia (WB) is trading at under 50% of book value, what othe term is appropriate? The market is pricing in a fair probability of a number of very large banks being bought out at firesale prices (like just happened to PFB) or being taken over by the FDIC and then being dismantled.

That being said, while the coming two years will be a very bad time to own bank stocks or bonds or to have uninsured deposits at banks (over the $100,000 FDIC limit), the economy will not completely collapse (though we should have a decent recession) and the world will move on.

The main thing to do is make sure that you and any friends and relatives never have more than $100,000 at any bank. If you wish to keep more, you may want to visit the FDIC website to see if your type of account is protected for more money (some are). You can search for your bank here and find out if it is insured by the FDIC and you can view financial information on your bank, even if it is private. For example, try searcing for “Home State Bank NA” in zip code 60014* (see random note at bottom of post). Then click on “Last Financial Information”, and on the next page click on “generate report”. This brings you to the bank’s balance sheet. If you click on the link towards the bottom for “past due and nonaccrual assets”, you will be taken to the good stuff. You can see that past-due loans have more than doubled over the last year. Unsurprisingly, much of the increase ($2.5m) was from “construction and land development loans”. It also pays to note that this big increase in past-due loans was solely in the 30 to 89 days late category. A more agressive bank might still be accruing interest on those loans. However, this is a conservative community bank and as you can see towards the bottom of the page, all loans that are more than 30 days late are non-accrual. (An interesting discussion of regulatory vs. tax requirements for deciding which loans are non-accruing can be found here.)

If you go back to the main balance sheet page and click on “net loans and leases” you can find the breakdown of loans. This is a good place to find out how risky your bank’s loan portfolio is. Unfortunately for Home State Bank, 20% of their loans are construction and land development loans. This bank is based in the far northwest exurbs of Chicago, so I think it likely that the bank will take a huge hit here. If you click on “1-4 family residential” you can see the breakdown of these loans. Luckily, most of these are first mortgages. Overall, Home State Bank looks okay. What about your bank?

If you have accounts as a credit union, visit NCUA to see details on insurance of your deposits. You can find your credit union and then request that a financial report be emailed to you. As an example I uploaded the report on my credit union. You can download the Excel Spreadsheet here. When analyzing credit unions, be aware that they will generally have more real estate exposure than similar commercial banks. Important things to examine are delinquent loans as a percent of assets (sheet 2, line 21 in the spreadsheet), asset mix including the amount of REO (sheet 4). If you are afraid of a bank run sparked by articles similar to this, take a look at the amount of uninsured deposits (sheet 5, lines 46-50). Delinquent loan info is always interesting (sheet7). For most of the data in the spreadsheet, an average of peer group credit unions is provided as well, making comparison easy. Overall, I think West Community looks quite safe.

What should you do if your bank doesn’t look safe (such as National City, where I have multiple accounts)? First thing that you should do is make sure your deposits are insured. Then make sure that you have enough cash in safer banks so that you can last awhile if you temporarily lose access to your money. Up until now the FDIC has been very good at getting depositors quick access to their insured deposits at a failed bank, but if things get really bad and big banks go down the FDIC could become backed up and take weeks or months to grant depositors access to their money. It pays to be prepared for such a scenario, even if it is unlikely.

*This bank, by the way, provided me with my first mortgage. Easiest mortgage I ever got — my father and I ran into Steve Slack, the bank president, while dining at the local country club, and I mentioned that I was buying a house in St. Louie. Slack gave me his card and told me to give him a call when I get close to finding a house. There are benefits to relationship banking–my extended family has banked there for three generations and uses the bank for a family company.

Disclosure: I am short several regional and local banks.

The Coming Mortgage Crisis Part III: Low Interest Rates Do Not Make Housing More Affordable

Many people have argued that the current high house price to income ratio is not reason for house prices to decline, considering that interest rates are very low now. These people argue that what is important is not the actual price of the house, but the mortgage payment required to carry the house (for an example see user jcrash’s comments on my previous aritcles on the coming mortgage crisis at SeekingAlpha).

To some extent, these arguments are correct. Most home buyers use mortgages, and the difference in monthly payments between a 5.5% and a 8% mortgage is staggering. However, there are two important reasons why low interest rates do not mean that houses are affordable now: household debt is at an all-time high and mortgage rates will certainly go higher.

Total Debt Matters

Housing affordability is not independent of the affordability of other consumer goods. What matters for the affordability of housing and all consumer goods is the money available to pay for those goods (ie, money not spent on necessities). Total household debt is at an all-time high. The savings rate is close to zero. The most instructive number to look at is the household financial obligation ratio, or the ratio of income to household debt servicing and house or apartment-related expenses. To quote the Federal Reserve definition, “Debt payments consist of the estimated required payments on outstanding mortgage and consumer debt. The financial obligations ratio (FOR) adds automobile lease payments, rental payments on tenant-occupied property, homeowners’ insurance, and property tax payments to the debt service ratio.”

Keep in mind that these ratios do not include other non-discretionary expenses such as food and gasoline, the price of both of which has been increasing at staggering rates, which means that consumers have less ability to service their debt than even the following graph shows (click for a full-sized image). The data are available from the Federal Reserve. The key number to look at is the FOR Homeowner Total (light blue). Over the last decade this has increased from about 15% of income to about 19% of income.

These are the costs on debt and home-related expenses that current homeowners pay. Because these are broad averages (many homeowners do not have mortgages after paying them off, reducing these ratios), it is important to look at the change over time. The ratio is currently about 4 percentage points higher than anytime prior to 2000. While this may not seem like much, consider that house prices are set on the margin and that approximately 40% of homeowners do not have mortgages. The marginal home buyer has much larger debt payments of all kinds than ever before, reducing his ability to buy. This alone indicates that home prices need to fall. However, the picture gets even bleaker when we look at mortgage rates.

Inflation Matters

Those that argue that house prices are affordable would agree that lower interest rates make houses more affordable, ceteris parabus. This is true not just for houses but for all capital assets. As interest rates increase, asset prices decrease. As interest rates fall, asset prices rise. If a buyer finances a high-priced asset with cheap financing and does not sell when financing becomes expensive, that buyer will do fine. However, a buyer who cannot hold indefinitely must pay attention to asset prices. Even when payments are equal, it is better to buy a cheap asset with expensive financing than to buy an expensive asset with cheap financing. The reason is simple: interest rates change. Interest rates are more likely to fall when they are high than when they are low. If they do fall, the seller who had bought when interest rates were high will have a capital gain as the price of the asset increases. However, the seller who buys when interest rates are low will take a capital loss if he sells after rates rise.

Inflation in the US is at a 4% annual rate as of March, and investors expect inflation to continue or get worse, as evidenced by the low yields on TIPS (Treasury Inflation Protected Securities). With 15- and 30-year fixed rate prime mortgages near their lowest rates since before the 1960s/1970s inflation epidemic, there is little place for mortgage rates to go but up. Even if housing were fairly affordable now (which the FOR ratios above show that it is not), higher interest rates will ensure that it becomes less affordable and that house prices need to continue to drop.

See Also

Option ARMageddon take on this issue

The Coming Mortgage Crisis: Part 1
The Coming Mortgage Crisis: Part 2

Disclosure: I have significant real estate holdings and I plan on selling short one or more regional banks.

The Coming Mortgage Crisis: Part II

Things are different this time. That is what I argued in my previous post on the coming mortgage crisis. Exploding option ARMs will lead to record foreclosures, which will cause house prices to further decline, which will cause many households to have negative equity. Rather than pay mortgages that are larger than house values, people will simply walk away.

One additional factor that will cause great harm to the housing market is that many stated income loans fraudulently overstated income ( I almost committed mortgage fraud myself). Bond insurers and buyers of RMBS and CDOs will force these back onto the balance sheets of investment banks and mortgage originators, leading to a further decrease in lending and an increase in lending standards. This will increase the cost of buying a house and put further downward pressure on house prices. The Market Ticker blog has a good discussion of this problem and the harm it will cause to banks.

Following are a couple more graphs to support my case that the bubble is nowhere near finished deflating. The first is the average house price to income ratio across the US, courtesy of PIMCO.

The second is a beautiful graph of home prices in every city in the Case/Shiller home price index. This comes courtesy of The Mess that Greenspan Made blog.

You can see from this graph that home prices have a long way to go before they return to pre-bubble levels. Cleveland and Detroit are back to the 2000 price levels, but the fundamental deterioration in those cities means that prices should fall further. Detroit and Cleveland have had declining populations for a number of years, and that trend continues. It is predicted that Detroit will continue to lose population and have only 705,000 residents in 2035, down from 890,000 in 2005.

Disclosure: I own real estate in St. Louis and Chicago. I have a short position in a land development company. I have a full disclosure policy.

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.

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.

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.

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.

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).

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.

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):

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.

The Subprime Primer

A slidshow on Google Docs. Enjoy.

Disclosure: I did not create the comic and I do not know who did.

Financial Armageddon 2008: Part II

Well, it looks like my thoughts on a big financial catastrophe this year were not simply the inane ravings of a lunatic. Nouriel Roubini thinks very similarly to me. While neither he nor I am sure that this will happen, it is a distinct possibility, and it is worth preparing for it.

A game of risk or a risky game?

The traditional thinking in the world of finance is that to increase returns you need to increase risk. This view is quite logical. Let’s consider an investor who wants a minimum of risk. She can buy certain blue-chip stocks such as Wal-Mart, Home Depot [[hd]] , and GE [[ge]]. The stocks offer low risk because they are all giant companies with dominant market positions; I think it is a fair bet that all three companies will still be around in one form or another 50 or 100 years from now. For such low risk our investor will get a relatively low return because these companies are so huge and have less ability to grow than they had in the past. Now, with such great blues chip stocks available why would our investor choose to buy shares in a company such as DayStar technology [[DSTI]] or Cheniere Energy [[LNG]]? Neither of these companies currently makes a profit nor has any significant revenue. In owning such companies an investor has significantly more risk of losing her capital. Therefore, no rational investor would buy the stock of such companies without being assured that those investments offer the potential of very great reward.

This thinking underlies the Capital Asset Pricing Model (CAPM). Now, for the most part this works quite well. However, there are some problems with the capital asset pricing model. One huge problem is that in this model risk is defined as the stock’s volatility. Volatility is of course a measure of how much a stock’s price changes each day, week, and year. For those of us who are long-term investors, however, volatility is an inadequate measure of risk. What matters more for us is the stability of the future earnings of a company.

For financial analysts and portfolio managers, volatility is most commonly measured by something they call beta. Simply put, beta is a measure of the correlation of the stock’s price to the broader stock market as a whole. Therefore, an index fund would have a beta of 1.0. Let’s say we have a stock that has a beta of 2.0; this means that in general, when the market goes up 10% the stock will go up 20%, conversely, when the market goes down 10% the stock will go down 20%.

Since we’re already talking about beta and financial analysts, I might as well mention alpha. Alpha is a measure of a portfolio’s performance. An alpha of zero indicates that a portfolio matched the market’s return. An alpha of one would indicate that a portfolio outperformed the market by 1% annually.

The goal of a professional portfolio manager, at least according to the capital asset pricing model, is to construct a portfolio with the desired amount of alpha in order to maximize returns without exceeding a certain level of risk (beta). According to the model, it is impossible to consistently beat the market because the market is efficient. This aspect of the model is known as the efficient market hypothesis and I obviously believe it to be wrong. I will deal with why this is wrong in a later article. For now let’s return to risk.

One finding that has been problematic both for the efficient market hypothesis and for beta is the finding that low P/B stocks outperform high P/B stocks. According to the CAPM, this could not happen without low P/B stocks being more risky than high P/B stocks. However, low P/B stocks do not have higher betas than high P/B stocks. The creator of the efficient market hypothesis himself, Eugene Fama, realized then that beta do not adequately measure risk. He and his collaborator Eric French argued that low P/B stocks are more risky than high P/B stocks. I disagree with this but the important point is that as of their paper in 1992 (unfortunately not available free online), beta was officially dead or at least dying.

So how can we measure risk? There are no easy ways to do so. We must rely on sound fundamental analysis. Risk obviously decreases the more products the company makes and the more customers to which it sells. Thus, GE and Berkshire Hathaway are less risky than almost all other companies because their revenue streams are so diverse. Conversely, ExpressJet [[xjt]] and the other regional airlines are very risky because they all have only one or two customers. Similarly, small defense contractors are risky if they sell only a few major products and to only one major customer: the United States government.

Another risk factor is debt. Companies with more debt are much less likely to be able to survive a recession or industry downturn because they would be unable to meet their debt obligations if their revenues drop more than slightly. For this reason, companies such as Fortune Brands [[fo]], Blockbuster [[bbi]], and Ford [[f]] have elevated risk due to high debt loads.

Another risk factor is obviously competition. Companies and highly competitive industries have greater risk than companies with monopolies or that for other reasons do not have much competition. There are many ways that a company can avoid too much competition, including patents, trade secrets, operating in a niche market, and effective branding. Ceteris paribus, a dollar of earnings that is at lower risk from competition is worth more than a dollar of earnings that comes from a highly competitive industry.

This is not to say that companies in highly competitive industries cannot be great investments. Those companies that are wildly successful in competitive industries usually have some key advantage that gives them an edge in that is not easily copied. This advantage is not always easy to identify. For example, Southwest Airlines [[luv]] had the important advantage over legacy carriers of not having an established business prior to airline deregulation. This meant that Southwest was not burdened with the same costs that hindered the larger airlines. In addition, Southwest’s fares were simple and did not penalize travelers for arbitrary reasons such as not staying over a weekend. Another good example of a successful company in a competitive industry is Wal-Mart [[wmt]]. What did Wal-Mart offer that Kmart [[shld]] and other discounters could not? One thing it offered was everyday low prices. By avoiding sales Wal-Mart gained both the reputation as the low-price leader and it gained more consistent profitability. Wal-Mart has also been known for some time for the effectiveness of its distribution system. In an industry with low profit margins and high inventory requirements, any improvement in logistics drops straight to the bottom line.

The last important risk factor is the elasticity of demand for a company’s products. The business cycle is a fact of life; any company that suffers less during recessions, whether because it sells products that are always in demand or because it sells to people who are not greatly affected by recessions, has lower risk than the average company. Big industrial companies such as auto manufacturers and aircraft manufacturers are usually very cyclical. Cyclicality of earnings is not in and of itself a black mark against a business. However, combined with high debt and stiff competition, a cyclical company in an industry downturn can be a very risky bet. See, for example, General Motors [[gm]] or Northwest Airlines [[nwa]].

While it is not possible to exactly quantify risk, it can still be approximated. Any decision to invest in a company should come only after carefully weighing the possibility for reward against the risk that company presents. In certain circumstances, adequate calculation of risk and reward cannot be made, such as with development stage companies with no revenues. In such cases, the conservative investor would do well to watch from the sidelines unless she is an expert in the field and is sure that she is not paying too much.

On a related note, I urge you to read Richard Russell’s article on the perfect business, which discusses the ideal business from the standpoint of a small-business owner. The points Russell brings up are also important to large publicly traded companies.

Disclosure: I have no position in any stock mentioned above. I have a full disclosure policy.

Bill Ackman’s most recent letter

See it here (PDF). He goes through his model of how the bond insurers will lose money.

Disclosure: I have no connection to Ackman and I have no positions in the bond insurers, although I am long BRK-B, which has recently started a competing bond insurer.

My (Optimistic) Prediction for 2008: It Will “Suck”

In response to a reader comment on my prediction of financial Armageddon for 2008, I have another, more optimistic prediction. As I said before, I am not a fan of predictions per se. It is, however, useful to outline possibilities. This possibility is more likely than financial Armageddon. As you can surmise from my title, I do not believe the economy will be all roses and sunshine this year.

What everyone seems to ignore is that recession is necessary from time to time. Mal-investment must be corrected. Profligate spenders must be chastened. The economy has invested too much capital into housing and it needs to reinvest that capital into other sectors. Unfortunately, that will cause pain. But to try like the Fed to avoid the pain will only delay it and worsen it. That is exactly what happened in 2001 as the Fed cut rates drastically to avoid pain from the stock market crash. The easy money went into housing and caused the current problems.

February: Lenders and counterparties give up on ACA Capital Holdings, the smallest and weakest monoline bond insurer. It declares bankruptcy. The bailout of the other bond insurers succeeds, barely. Ambac [[abk]], and MBIA [[mbi]] survive in run-off mode. New competitors such as Berkshire Hathaway’s [[brka]] subsidiary take over 100% of the municipal-bond insurance market. Harry Macklowe loses much of his real estate empire when he fails to refinance his short term debt. Rents decrease in Manhattan for the first time in years.

March: The stock market continues to stagnate.

April: Towards the end of the month, the homebuilders report more huge writedowns. Several see their stocks drop another 80%. One or two small public builders declare bankruptcy. The largest all survive. On a personal note, the author of this blog sells his house, which he had owned for almost four years, for a 20% loss.

May: Losses to banks from the failure of ACA alone top $20 billion. Bank stocks continue going down, but losses look like they won’t increase further. House prices in St. Louis are down 25% from their peak. In parts of California, house prices are down over 30%.

June: No bank runs, surprisingly.

July: Numerous small companies declare bankruptcy. The default rate on junk bonds approaches an annualized 7% for the year.
August: By this time house prices have fallen over 40% in California from their peak prices. The worst seems over, although house prices will stagnate for the next four years at least.

September: Mortgage insurers Radian [[rdn]] and PMI Group [[pmi]] are bailed out by banks and vulture investors, and none of the mortgage insurers declare bankruptcy. The carnage in the financial sector appears to be over.

October: Google’s profit increases 80%. Citigroup continues to flounder after losing several more top executives.

November: Barack Obama or John McCain wins the election. His (and Congress’) plans to help the economy do nothing for the economy while wasting taxpayers’ money.

December: The unemployment rate hits 5% in the US and the country enters a recession.

Disclosure: I am long BRK-A. I think Barack Obama is naive at best (and a corrupt scoundrel at worst; see his land dealings in Chicago) and John McCain is a fool who has no regard for free speech (as shown by McCain-Feingold).

My Prediction for 2008: Financial Armageddon

I’m not much for predictions (because they are usually bad), but I thought I’d give it a try. Here is how financial Armageddon could come to pass this year. I do not think it will happen, but it is possible.

February: Lenders and counterparties give up on ACA Capital Holdings, the smallest and weakest monoline bond insurer. It declares bankruptcy. The bailout of the other bond insurers fails. Ambac [[abk]], already in run-off mode, is downgraded to junk. MBIA [[mbi]] survives a bit longer. Harry Macklowe loses much of his real estate empire when he fails to refinance his short term debt. Rents decrease in Manhattan for the first time in years.

March: Ambac becomes insolvent. MBIA is downgraded to junk.

April: MBIA declares bankruptcy. Towards the end of the month, the homebuilders report more huge writedowns. Several banks surprise everyone by calling loans on a teetering Standard Pacific Homebuilders [[spf]]. It declares bankruptcy. Several smaller, private, homebuilders are likewise pushed into bankruptcy by their lenders.

May: Losses to banks from the failure of ACA alone top $20 billion. Analysts estimate that the major banks will have to write down $250 billion as a result of the failure of the other bond insurers. Citigroup’s [[c]] stock is now down over 50% in the last 6 months alone. The Bank of America [[bac]] acquistion of Countrywide Financial [[cfc]] falls through and Countrywide declares bankruptcy. On a personal note, the author of this blog finally sells his house, which he had owned for almost four years, for a 25% loss. House prices in St. Louis are down 30% from their peak. In parts of California, house prices are down over 50%.

June: Several regional banks based in California are paralyzed by bank runs. They declare bankruptcy. The FDIC estimates that the bailout of their depositors will cost $30 billion.

July: Forgotten by almost everyone, pushed to collapse by banks’ unwillingness to refinance its debt, Chrysler declares bankruptcy. Several small companies join it there.

August: By this time house prices have fallen over 60% in California from their peak prices. It is now impossible to obtain a mortgage with a FICO score below 600, a smaller than 20% down payment, or an income at least four times the mortgage payment (including insurance and taxes).

September: A large insurer reveals write downs due to mortgage-backed security losses equal to its book value. Its stock drops 90% in one day, leading the S&P 500 down 8%. Mortgage insurer Radian [[rdn]] declares bankruptcy. It is joined in bankruptcy by competitor PMI Group [[pmi]].

October: Google’s profit increases 70%. Citigroup’s book value is now down 50% over the last two years.

November: Hillary Clinton wins the US election even though 80% of the population hates her. She decides to play the role of Franklin Roosevelt and her policies look to drive the US into a depression.

December: The unemployment rate hits 6% in the US and the country continues a recession that started back in the spring.

Disclosure: I have no position in any stock mentioned above. I hate Hillary Clinton. I am actually not pessimistic enough to believe that much of the above will occur.