Interesting Times

(A client of mine asked me the following question, which caused me to do some thinking. I’ve included my response below. Let me know what you think. – John P Bremner)

So, which of these do you think will see a return of confidence first?

The equities markets

The credit markets

The general economy/business

Residential property

Commercial property

An interesting question, Craig. I think we all want to know which area will recover first and which will begin a sustained rise.

Actually, I think all these markets are declining together with the collapse of the housing bubble, and none will recover significantly until the residential market hits bottom. The ongoing decline of housing prices nationwide will continue to cause banks and financial institutions to fail as the assets on their books evaporate like the mortgages that underlie them.

Yes, the government is taking actions to try to stop the credit crunch, but it is important to keep in mind that it’s not just a problem of liquidity, (which the Paulson plan and the Fed are attempting to address), it’s a problem of solvency (which is not adequately addressed).

As housing prices go down, the value of the banks’ mortgage assets decline. When the assets fall below the bank’s liabilities, the banks become insolvent, and, in normal times, would be seized by the FDIC and liquidated or sold. But since the too big to fail banks are on the verge of insolvency, the Fed’s elbowing aside the FDIC and planning to inject billions to save the big banks.

It seems that the Paulson plan will try to buy up the bad mortgage assets from the banks at prices at or above the market value carried on the bank’s books, although this is still up in the air. Buying the mortgages at market value would increase the bank’s asset base by a relatively small amount since the bad mortgages are already on the bank’s books at market value. (And since it doesn’t really increase the bank’s equity capital, it’s not going to cause the bank to roll out the “we make loans” banner). But as housing prices continue to decline, the bank’s assets continue to go down as well. While the bank’s assets are declining in value, the Treasury has to work out the mechanics of the purchase plan.

The bottom line is that the Paulson/Bush/McCain plan is based on the notion that the housing market has stopped going down, or will do so shortly. I believe that is wrong. If housing prices continue on their downward path, in addition to buying $700B of mortgage assets, the Treasury and the Fed will have to inject capital (as preferred stock) into the banking system – effectively taking over most of the banks – to avoid a collapse.

Because it’s a nationwide housing decline, it has become a nationwide banking problem. We’ve seen the tip of the iceberg so far, with the “too large to fail” banks being bailed out or forced into a merger (WAMU, Wachovia, Lehman, Bear, Merrill, etc.). Now the banking and credit problems will be moving into the smaller, but still large, banks. These bank failures, in turn, will cause more liquidity problems, which will deepen the recession and the general economic weakness. The bank failures will limit business financing, construction, and commercial real estate financing, as well as consumer credit – credit cards, autos, appliances and furniture, etc.

The housing market is declining because housing prices are still, even after all the losses, significantly higher than homebuyers can afford. This has created a fundamental supply/demand imbalance, which has been aggravated dramatically by the mortgage financing fiascos of 2003-2007 – sub-prime lending, Alt-A loans, option arm loans, 100% NINA (no income no asset ) loans – and the “irrational exuberance” of homebuyers who were encouraged by the homebuilders, realtors, and the mortgage industry to buy homes that they couldn’t possibly afford, because “home prices never go down” .

The perfect storm of overpricing, overfinancing, and overextending created the boom, and has now created the bust - a negative spiral of home prices that will only stop when all three elements have been changed. That is, 1) median home prices have to come down to levels that are affordable for median income homebuyers, 2) more conservative home financing becomes the norm (keep in mind that the FHA is still, today, making loans for 97% of the purchase price, and up until two weeks ago they were still allowing 100% financing with the DAP program), and 3) homebuyers become more realistic about what they can afford.

In most boom and bust cycles, there is a pendulum-like tendency to go too far in each direction. So, just as housing prices and financing and exuberance went too far in one direction on the upside, they’re likely to shoot past the mark on the downside as well. Although prices have come down substantially – about 20%, roughly speaking – the educated guess is that there is another 10%-20% to be knocked down during 2009. As a result, I don’t see the housing market bottoming out until the fourth quarter of 2009 or first quarter of 2010.

But will the housing market then begin to go back up again? Consider that millions of homebuyers will have lost their credit ratings and savings and home equity during 2006-2009. They won’t be coming back anytime soon. Millions of other potential homebuyers will have lost their jobs during the recession, and will have to rebuild their finances before they can look at a house. Consider also that home purchase financing will be much more difficult than it was from 2002-2008. Now it’ll be 700 FICO, 20% Down, Tax Returns and Verification of Income.

And finally, consider that there will still be a very large overhang of foreclosed homes as well as sellers who have held back on the way down. I believe the supply/demand equation will still favor the buyer for a substantial period of time, and even when the market works through the overhang, we will not see the increases in home prices people became accustomed to over the past ten years.

So with that overview, let’s take a look at the different markets you asked about:

1) The Equity Market. As I write this, the Dow Jones is at about 9,300, down about 34% from the high of the year, and down 20% from the high point in the last 30 days. It’s the sixth straight down day. Every day that the market has gone down, the elves on CNBC have touted it as the beginning of a bottom! There is a tremendous upward bias in the stock market, and people will continue to look for that elusive bottom.

Sometimes the stock market is a leading indicator, and sometimes a trailing one. In this case, I think the stock market is chasing the economy, not forecasting it. And, like the pendulum effect I mentioned above, it is likely to overshoot it’s mark on the downside as well, when people finally realize that the housing price “correction” (as Mr. Paulson calls it) is continuing apace.

I expect the stock market to continue down, with bear rallies along the way, to about 8,000 before it stabilizes, and then to plateau for a substantial period of time. Remember that the stock market went nowhere for several years during the Depression, that the stock market also went nowhere for several years during the late 60’s through the 70’s, and that the Japanese economy went nowhere for most of the 90’s. Although admittedly just a guess, I wouldn’t be surprised to see the stock market remain relatively flat through 2015.

2) The Credit Markets. The credit markets have dried up because the banks don’t want to make loans. I suspect that there is more than one reason for this, but the consensus seems to be that “toxic” mortgage bonds and credit swaps have made everyone nervous, too nervous to lend each other money or credit.

The Fed is trying to lubricate the credit market by becoming the lender of last resort for the large banks, and is taking any old junk that the banks have on their books as collateral. This is consistent with the Paulson plan of buying up the toxic bonds. I would think that the Fed and the Treasury can continue to lube the system and keep at least the large banks in business, but I doubt they’ll want, or be able, to save the many, many large (but not large enough) banks who also have toxic bonds.

However this whole house of cards seems to me to be based on an underlying belief that these “toxic” mortgage bonds have more value than the banks are pricing them at on their books (because of that mean old killjoy “mark to market” accounting requirement.) That, in turn, depends on the housing market halting its downward path. Since the housing market is still heading down for at least another year, I think the credit markets will seize up again, and this time the Fed and the Treasury will have to step forward and inject massive amounts of capital, probably in the form of preferred stock, to make these entities viable. If it can.

Although Bernanke has been quoted as saying that the Fed could always “drop money from helicopters” to cure financial problems, I don’t believe even the gov can/would/should buy up all the banks and take over the banking system, but I do believe they’re going to rescue the big boys. The smaller banks are on their own.

Anyway, this washout of the banking system is going to take a while. I would think the Paulson plan would get its chips on the table in about six months, and then about six months later need to start injecting capital into the purchase of bank stock. So we’re looking at about 12-15 months of turmoil. After that, the banks will be owned, in large part, by the federal government. It won’t be business as usual, but at least it’ll be come kind of business. For political and ideological reasons, we’ll be determined to restore them to private ownership, but I expect that phase to take a couple of years.

So that’s my scenario for the credit markets – another year of crisis, followed by the government taking over the bulk of the banking system. I doubt that this is a growth curve.

3) The General Economy. See (1) and (2). We’re going to have a very serious recession over the next two years, followed by a slow recovery.

4) Residential Property (aka the Housing Market). Sell now. Sell tomorrow. Housing prices are going down and staying down for a substantial period of time. 10-20% more decline in the next two years, followed by a stagnant housing market for five years, followed by 2-4% growth.

5) Commercial Property. Commercial Investment Property – Offices, Shopping Centers, Industrial, Apartments, Retail, etc. – will not be immune to the recession and the financing crisis, but should be stronger than the stock market, credit market, and housing market. Triple Net (NNN) leased properties should be even more attractive as the stock market declines (although vetting the tenant will become more important).

The recession will cause businesses to cut back, increasing vacancy rates in offices, shopping centers, and retail. The recession will cause higher unemployment, which will increase vacancy rates in Apartments. Of course these increased vacancies will create opportunities for savvy buyers, who can take advantage of lower prices and higher cap rates.

Commercial real estate, for the most part, did not share the excesses of the housing market in pricing, financing, or over-promoting, although there were clearly a number of excessively optimistic financings based on fanciful income projections. Still, the principal lenders for commercial real estate tend to be local banks, which were effectively priced out of the residential market.

These commercial banks, as a group, tend to be more conservative lenders, and tend not to have access to the Wall Street securitization process, and hence are still making loans (unlike some of their big Wall Street city cousins – like WAMU, Lehman, Indymac, for example). The loan requirements may be stiffer – 60-65% LTV, 1.25 Debt Coverage – but business is still going on.

I believe that over the next two to three years, while the residential market, the credit market, the general economy and the stock market are in pain, the commercial market will offer some terrific opportunities for investors, especially when compared to the losses associated with other markets.