Tuesday, September 11, 2007

Mortgage Mayhem 
Longtime readers are aware that I've been watching the increasing constriction of liquidity in the credit markets for some time. In March of this year, I wrote "Is this the beginning of the end of the bull market in bonds?"

Also in March, I posted "This is a terrible time to buy a house."

In December of last year, I wrote:

I have been quietly making a few rebalancing moves on the edges of my very meager portfolio; With the dollar back down near all-time lows against the Euro, I sold off some holdings in foreign stock funds (mostly European) and brought them back into US equities - effectively buying cheap US assets with (hopefully) overpriced Euros. Foreign stocks have had a beautiful run, relative to US equities, and I took a little money off the table.

Further, the expansion seems to be getting a little long in the tooth. I'm not bearish, but I think the economy will not continue to expand at the pace it has. I have moved some money from the Vanguard Total Stock Market index into a large-cap growth and income fund -- effectively selling a modest number of small- and mid-caps, which are more sensitive to slowing economies, as well as selling a few no-dividend large-cap growth stocks.

The bet I'm effectively making is that if the economy slows, dividends will play a comparatively greater role in future returns - as compared to earnings growth - than they had previously.

I'm also building a small margin of safety, as I see potential short-term losses in equities as greater than my expectations for economic growth this year.

P/E's seem fairly reasonable to me, still. Not cheap, but not psycho crazy, either.

Fair weather ahead, with a few scattered squalls.

Unloaded some REIT ballast, with foreclosures peaking up in key markets.

Trimming sails slightly.

In December, I did not foresee the Dow's movement to 14k, but I didn't think that level was sustainable at the time, and pulled some money off the table then, and began looking for other options.

In March, a commenter, Red A, asked for a suggested strategy going forward. I apologize I did not have time to post a coherent response then. I'm not sure if I could have fully articulated my own views at that time, but my ideas are coming into clearer focus now. Here are my thoughts:

1.) While I have always been an adherent of the idea that markets are very efficient, and have therefore invested almost exclusively in low cost index mutual funds (I use Vanguard, but the Spartan funds offered by Fidelity, and the comparable offerings by T.Rowe Price, TIAA-CREF, and even USAA are excellent choices as well), I am now officially moderating my somewhat militant Bogleheaded views. Why? See paragraph 2.

2.) It seems clear to me that there are substantial inefficiencies in certain areas of the market Markets are fearful, and there is terrific uncertainty in the credit markets. There are substantial swathes of assets being unloaded at absolutely fire-sale prices. Why? See paragraph 3.

3.) Mortgage companies have to raise cash to operate. Which means they have to borrow heavily from more diversified institutions and sell off mortgages on reasonable terms to Fannie and Freddie. Servicing these loans can be a profitable business, but many companies have no appetite for the additional outlays in labor and facilities it would take to diversify into this area. They're regretting it now, because a healthy servicing arm is a handy diversifier against a pure mortgage, sell, and mortgage some more business model, because the stream of revenue you can get from good mortgages you keep on the books can offset the reduction in book value on the mortgages themselves - a reduction in book value which affects the market price of good debt as well as bad. Which brings us to:

4.) As the book price of existing pools of mortgages fall, these mortgage companies are having raise cash quickly to make margin calls against their debts secured by these assets. As a result of the time pressure, they are being forced to sell these pools to other buyers prematurely, and at pricing very advantageous to buyers with some cash to invest.

5.) Consider the contrast in the positions between the mortgage originators and the aftermarket buyers active today: While the mortgage originators were enthusiastically recruiting Americas Most Clueless to beef up their sales force and rack up sales volume, they created a perverse system that compensated idiot, unprofessional mortgage brokers for sheer volume by paying them for the deal, without regard for the provision for the safe return of capital to the bondholder.

The result: A dramatic increase in the "liar" coefficient of "liar loans," which of necessity increased with the price of real estate assets, and a general and well-deserved loss of faith in the integrity of the credit underwriting process. The first line of defense simply did not execute their risk management responsibilities, because they were not at all compensated for so doing.

This was idiotic, and I think shareholders in mortgage outfits ought to be lynching their CEOs and credit officers and directors for this foolishness.

The contrast: shrewd investors who acted responsibly in the last few years have been rewarded with an opportunity to purchase these mortgage pools from desperate sellers - the mortgage-pure companies struggling to avoid default and bankruptcy. These secondary buyers have the opportunity to do so after having made the appropriate discount for credit-worthiness and margin of safety.

Enter the Dragon.

No one is shrewder in this market than Warren Buffett, the chairman and brain of Berkshire Hathaway. Absent a mega catastrophe which would put a severe crimp on Berkshire's insurance obligations, the incoming premiums from General Re, GEICO, and several other insurance companies generate a mountain of cash, which Warren has been allowing to accumulate - to the tune of nearly $1,000 per B share, which are now trading just under $4,000.

In order to generate book value for his investors, Warren needs to put that money to work somewhere, and fast -- IF he can do so to advantage.

Character Counts

Buffett is a master bridge player, and has a well-deserved reputation for being able to keep a secret. Everyone in the market knows that Berkshire has billions in cash looking for a home. I believe this is Buffett's market. Because of his ability to make quick decisions and keep them under wraps until his next report, Buffett is getting the pick of the litter. His phone in Omaha has, no doubt been ringing with opportunities in the aftermarket. I have no special insight into exactly how the man is doing business, but I am confident he is now putting his cash surplus to work buying up assets that few others would even have access to.

Moreover, there are mounting opportunities in the publicly traded sectors for Buffett to pick up shares of common stock in financial companies now trading at 20% to 30% discounts off their book value, trading at 6 to 10 times earnings, and in many cases, generating healthy dividends. Buffett, the former chair of Salomon and longtime investor in American Express and Wells Fargo, understands the financial market very well.

My own finger-in-the-air assessment: Financial stocks are now priced as if half of their assets are subprime. But many of these companies, Countrywide and Washington Mutual among them, have less than 10% of their assets in subprimes. The wildcard is in the adjustables.

In these markets, I would look for a healthy diversification across the country, without overexposure to the frothy markets in Florida, California and Arizona.

Meanwhile: Homebuilder stocks have taken a pummelling - and there is nothing at all wrong with them. Pulte, Lennar, and Centex are all fantastic companies. Pulte has a reputation for terrific quality. Lennar and Pulte both have fabulous brand names.

But Pulte is currently trading at a 40% discount to book value. Book value, for a homebuilder!!! It's worth 1.2 times book value, and traded there in the late 1990's. (I'm discounting the even higher valuations it received vis. book value during the housing boom of the 2000s).

Lennar, another homebuilder, is trading at 30% below book value. I think it's easily worth 1.2-1.3 times that. Meanwhile, it's paying a 2.5% dividend to wait.

Centex is also trading at 30% below book. But in the late 90s it traded at over 4 times book value, and stayed at 2x book value throughout the 2000s.

These are compelling values, and you won't get a substantial piece of them for indexing.

Again, Warren Buffett has already acquired homebuilders - and happily so. He did learn a painful lesson with Oakwood a few years back, after having bought up junk bonds from them. Buffett has admitted he had underestimated the scumminess of the loan underwriting process in the prefab home world. I doubt he will be inclined to make the same mistake again.

Buffett has already recently acquired shares of Bank of America in a recent large common stock transaction. B of A is diversified, and its exposure to bad mortgages is offset by a powerful retail banking operation, an amazing brand name, and the ability to attract deposits to counteract defaults - a capability many pure mortgage plays lack.

I like book value as a measure for evaluating financial companies, but I think the book value of mortgages as carried on annual reports in December of this year are substantially overstated. So I would mentally make a downward adjustment of such assets by, oh, I don't know - 40% for subprimes and maybe 20% for everyone else, and make my own calculations based on that.

I would also not put a lot of weight on earnings over the last few years for these companies.

For me, personally, I don't want dividends outside of my IRA. For one thing, they generate income tax liability. For another thing, I don't have the economies of scale to reinvest my dividends efficiently.

I also don't have the time or expertise to really pull apart the financials of banks, mortgage companies, or homebuilders to determine the relative worth of each.

But Buffett is more than capable of dealing with both.

I have therefore abandoned my all-index, all-the-time strategy of investing - it tends to work against you in bear markets, anyway, because asset cap weightings overexpose you to inflated assets - and have placed a significant amount of my miniscule, pathetic net worth in my first single-stock transaction:

I am long Berkshire Hathaway.

I have taken additional funds available for investment and entrusted them to a disciple of Buffett's, Wally Weitz, manager of Weitz Value, who has a very similar approach.

I interviewed Mr. Weitz several times over the years in my capacity as a dumbass, clueless financial reporter, and was impressed by his clarity of thought and his facility in explaining his analysis of the earning power of underlying corporations. Again, he is quite comfortable in financials and homebuilders as well, and I think he will be finding a number of opportunities in the weeks ahead. Indeed, I think he already has, and will be busily going to work with any funds he has incoming.

I think it will take a couple of years for this strategy to bear fruit to the upside. But I am comfortable with the wait, and have a tremendous amount of respect and admiration for Buffett and Weitz alike.

If the bull market continues in stocks, I will lag for a while. I don't think I will lag forever. If stocks enter a bear market, I will lose less with Weitz than in a broader index (unless Countrywide goes bankrupt - but I trust Weitz, who holds the stock, with assessing those odds reasonably). I should do better with Berkshire.

I am not long Countrywide, except via Weitz Value.

It's tempting. It trades at 5x official earnings (I mentally adjust that to more like 8 to 9 times "real world" earnings, and trades at 20 to 30 percent off book value. It is less than 10% into subprimes. It is about 40% into adjustables, but those adjustables are spread across the United States, and not concentrated in California (in contrast to someone like Wells, which is a western franchise, and even Washington Mutual, which is overexposed to California, which surprised me to learn.)

Countrywide also recently executed a large buyback of shares around the 40 dollar mark last year. Shares are now trading at around 18.

It's very tempting - with a nice dividend in the meantime to pay me for waiting for a recovery.

But I look at their CEO, and he is selling shares as fast as his options vest. He doesn't seem to be retaining any of them personally, and therefore I distrust him as an owner-manager.

It also seems clear to me that Countrywide is depending on the goodwill of others in order to raise liquidity. It has a substantial retail base, as well, and has a nice operation in mortgage servicing which diversifies its exposure. But apparently, it's insufficient in the short term. I cannot assess its exposure to put backs from loan pools previously sold to Frannie and Freddie, as defaults from adjustables deepen if the economy weakens and interest rates rise. If the situation worsens, and Countrywide is faced with substantial forced repurchases of its previous loan sales, I think there is a real chance I'd place it at about 20% if any such thing is knowable - that Countrywide will go under.

In other words, Countrywide is cheap for a reason.

Countrywide has a wonderful appeal for speculators. But because of the uncertainty of the safe return of capital, I don't see it as a good choice for the small investor right now. I think they will rely on Buffett and other aftermarket purchasers to raise cash, and will be among the desperate sellers. They already are.

But Countrywide is as much a speculation as it is a reasoned investment at this stage. I have carefully considered it, and passed for now.

Let me know if you think I'm stupid.

Splash, out



For some reason it won't accept my blogger id anymore.

I am trying to find a way to diversify my portfolio to include a bit of real estate - specifically good farm land. I don't want 'a farm', but rather little bits of a whole bunch of farm land, spread out across the country and across crops, and leased out to farmers. Like a mutual fund or REIT for farm land. They have them in Europe but I haven't found any in the US.
No critique, just a data point.

With no knowledge I did something sort of similar when I wised up and got the heck out of USPA&IRA in '05--bought some BRKb, put IRA into a S&P index, and loading $$ into TSP's L fund. I don't have the bandwidth to be able to do much more. I figure we're in for a bear *some*time between now and when I retire, and it would be nice to anticipate it. However, if I could do *that* then I would be much smarter than I actually am.

I do have to find me a decent fee-only CFP, though...
You know, I don't have any brilliant ideas about a farmland REIT play. I'd be interested to see the portfolio that demands that as a diversifier, though. It's an interesting idea.

A lot of states have bans on the non-resident ownership of farmland, it seems. I notice, in my quick google search, that one company is specializing in acquiring vineyards, but that seems insufficiently diverse to be meaningful.

I looked at the major agricultural stocks - ADM, General Mills, etc., and they don't seem to be huge landowners themselves (though I didn't look at balance sheets. I could be wrong.)

It seems that these REITS, if they existed, would be very much tied to the price of the commodities they produced. So you might consider a small position in these commodities as a proxie.

The downside is that commodity options eventually expire worthless if prices don't move your way, and they're not free to begin with. It's hard to take a direct position in them, as well, since crops are perishable.

Why do you feel you need an asset this narrowly defined?
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