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Housing
woes spread to Fannie Mae & Freddie Mac
In July, credit woes extended to the strongest
participants in housing finance - Fannie Mae & Freddie Mac. Fannie
Mae (originally Federal National Mortgage Association) was established as
a "government sponsored entities" (GSE's) in 1938 to help
Depression era homeowners to obtain mortgages. In 1968, Fannie Mae
was partially privatized-shareholder owned, but retained an implicit
government guarantee of its obligations and thus can obtain capital at
exceptionally low cost. Freddie Mac was established along similar
lines in 1970. The two firms own mortgage assets of over $5
trillion, which is about the same amount as the entire US government
debt.
Since the credit crisis began last August, FNM and FRE took an
increasingly central role in mortgage lending as sub-prime lenders
stopped lending or went bankrupt. The range of mortgages acceptable
to the GSE's was expanded earlier this spring. Unfortunately, the
rescuers were dragged into the quick sand. Defaults on higher
quality mortgages are running at twice the rate of 2007. Even a 1%
default rate on the $5 trillion portfolio is $50 billion versus combined
equity capital of $80 billion at the two companies.
Similar to the Bear Stearns crisis in mid-March, investors bet
aggressively against both companies in mid-July by shorting the stock and
buying out of the money puts. For a couple of days, it looked like
both companies would be forced into receivership (and indeed, bankruptcy
does not remain out of the question.) Federal Reserve and Treasury
officials announced credit extensions to both companies which keeps them
solvent for the time being. Even so, stock prices remain 85% below
last August levels.
Housing - how much more pain?
The May Case-Shiller Housing index showed that the national average of
house prices fell 15.8% year over year and is now 18.4% below the July
2006 peak. Forecasts for further declines range from 5% to
20%. However the month by month rate of decline is easing from a
maximum loss of 2.63% in February to the most recent decline of 0.86% for
the month of May. Residential construction activity is down 26.4%
compared to June 2007, and overall construction is down 5.9%. Sales
of existing homes fell 15.5% over the last year, but the available
inventory appears to have leveled off even as new permits and new
construction ticked up recently. As we have commented often, we're
less shocked by the decline in housing prices over the last two years
than the steady surge in prices over the previous 14 years.
Case-Shiller Home Price Index(1993-2008)
Month by month rate of increase (decrease) in US housing
prices
Energy
costs, inflation and the dollar
For 6 months, we've focused on the relationship between the cost of
energy, the decline of the dollar, and the potential for a rapid rise in
inflation. As the Federal Reserve cut short term rates from 5.25%
in August 2007 to 2.0% in April 2008, the dollar fell 12%. So while
oil climbed 121% from $67 to $148 barrel, it rose only 85% in Euro
terms. While demand is falling in the US, it remains flat to rising
in the rest of the world. The falling dollar not only increases the
costs of imported oil but also the cost of every other imported good,
which stokes inflation.
The Fed is expected to leave rates alone on August 5th, but the
forecasters are starting to think about a 0.25% INCREASE at the
September, October or December meetings. The dollar therefore is
rising from the generational lows set earlier this spring (higher
interest rates relative to the Euro and other trading partners makes the
dollar more attractive to traders.)
Judging by the dramatic slump in the US of purchases of gas guzzling
trucks and automobiles, demand for oil will continue to fall in the
US. With the dollar rising, even hurricanes in the Gulf of Mexico
and Iranian saber rattling seem unable to support the high cost of oil,
which slid 18% to $121/barrel over the last 4 weeks. Over the last
year, higher energy costs have been the driver of high inflation
readings. Oil at or below $120/barrel would reverse that trend.
A tale of two economies
Three major US industries - housing, automobiles and airlines - are
on the ropes right now. Small homebuilders are going bankrupt,
airlines fly in and out of bankruptcy, and we expect General Motors to
enter bankruptcy within 5 years. Despite that bad news, US GDP
accelerated to 1.9% in the first estimate for Q2 2008, gaining from 0.9%
in the final estimate for Q1 2008, and a decline of 0.2% in Q4
2007. Growth in the US is forecast in a range of 0.8%-1.5% for the
next year, while unemployment may peak at 5.8% versus the current
5.7%. These are not great numbers, but not a recession either.
Technology and healthcare companies grew earnings 25.0% and 18.7%
respectively. Financials obviously delivered another disastrous
quarter, down 28.1%, but the rate of write-downs is diminishing; earnings
in that sector will benefit from favorable comparisons later this
year. Overall, earnings will grow about 8% in Q2 2008 and 9% in Q3
2008. Bottom line: US stocks remain at the cheapest levels since
the last major recession in 1989-1991.
Strategy
Stocks looked pretty grim in mid July, hitting new lows for the
year. Yet, as we noted in our July 15th commentary, "We're not
selling ANY stocks right now." By the end of the month,
overall averages were on both sides of unchanged. However, energy
stocks, which we're underweight, slid 13.9% on the quarter, while
financials and healthcare stocks, which we're overweight, gained 7.2% and
5.1% respectively. Every S&P 500 sector is now negative on the
year, and financials are negative for the last 5 years. So few,
very few, investors are willing to step up and buy stocks right
now. The recent decline in oil is very supportive, however.
We continue to rebalance accounts and move cash into stocks.
Yours sincerely,
The Heron Capital Management client letter is published
immediately following month end and when market conditions require
comment. The views expressed in this letter represent HCMI opinion and
strategy as of the date published and can change at any time upon receipt
of new information. Data quoted in this letter are from sources deemed
reliable, but no guarantee of such data is implied.
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