The Ridgewood Group Value Investing Blog

The link below is an article that talks about the state of the housing market and how housing subsidies earlier this year may have been misguided (though well intentioned).  The article also provides a more constructive approach about what factors would be helpful to have a true and sustainable recovery in housing.  Of course one of the issues facing the housing market is that even though rates are low, underwriting standards are more stringent and collateral values have fallen, so a number of people that want to refinance or purchase a home to take advantage of historically low rates are finding that they are not able to do so.

We have enclosed articles (see links below) that highlight some interesting aspects of the current economic climate. They discuss the current extremely low interest rate environment (courtesy of the Fed).  

The common theme on these articles is the unintended consequences arising out of policy decisions made by the Federal Reserve and by Congress.  Through the end of August, the summer has been characterized by renewed fears of a “double dip” recession. As a result, investors have been fearful of investing in businesses in favor of investing in long-term, government bonds.  To a great extent, investors are responding to their fears arising out of their recent traumatic experiences in investing in equities - both over the last few years, as well as, over the long-term (last 10 years).  In prior commentaries, we have noticed that the bond market (particularly on the long-end) may be a bubble that may ultimately create issues down the road.

The articles below suggest that in manipulating rates (in an effort to “goose” economic activity), the Federal Reserve is creating winners and losers.  In the losing column are the millions of retirees and savers who are earning little or nothing on their cash and bank balances while, at the same time, being fearful of equities and high yielding securities.  As a result of this, we’ve noticed that certain dividend paying stocks seem attractive relative to the alternatives.

In the winning column, however, are borrowers.  Corporations are refinancing their obligations at a rapid rate.  For example, On August 12, 2010, Johnson & Johnson raised $1.1 billion in new borrowings.  Half of the notes mature in 10 years and carry a rate of only 2.95% per year.  The other half mature in 30 years and carry a rate of only 4.5%.  Investors who are loaning money to them at these rates may be surprised (especially with respect to the 30 year notes) if, as is likely, inflation rises unexpectedly.

On the other hand, it is an excellent time to refinance a mortgage (if you qualify under today’s somewhat tighter underwriting standards).  At The Ridgewood Group, we eat our own cooking. I just refinanced my own mortgage about 30 days ago and got a 30 year amortizing mortgage at the rate of 4.375% with very low (approx 1%) points. (BTW, compare this rate to what you are quoted by your bank or mortgage broker - for the benefit of our clients, we believe we have found 2 of the lowest cost mortgage lenders in the country and we find that their rates (for borrowers with good credit) seem to be better than most of the other alternatives.  If you are thinking of refinancing and want a referral to these lenders, email or call us back to find out how you might be able to take advantage of their programs.

As a result of the above, my borrowing rate on the new mortgage is only slightly higher than what Johnson & Johnson has to pay!  For the astute among you, you’ll notice that the rate I pay on my 30 year mortgage is actually slightly lower - however this is not an apples to apples comparison - because my mortgage is amortizing and the J&J bond is not, the weighted average life of my mortgage is closer to 20 years than to 30 years, so the imputed rate that I pay is actually higher on an adjusted basis.   Also I had to pay a small amount upfront to buy down the rate slightly, but my payback on the buy down is less than 2 years given the savings in the form of the lower interest rate.

Ken Majmudar, JD, CFA

Links:http://dealbook.blogs.nytimes.com/2010/09/09/falling-rates-aid-debtors-but-hamper-savers/http://online.wsj.com/article/SB10001424052748704103904575337282033232118.html

 There are signs of a bit of renewed activity and optimism - both among investors and the real estate market.  Equity markets are up more than 60%+ around the world and investors (at least psychologically) are breathing easier.  Recently released data shows the volume of new home construction and home resales picked up slightly over the last few months.  However, underneath this data, there are some troubling facts confronting people hoping for a quick return to normalcy and health in housing.    Like any other market, housing is drive by supply and demand.  There are signs of issues related to both.  On the demand side, the market has been “artificially” stimulated by at least two interventions.  The smaller of the two is the home buyer’s credit which was extended into next year, but will eventually end.  By far the larger of the two issues is that the Federal Reserve has “printed” (i.e. created from nothing) over $1 trillion of new money - much of it which has been used to buy mortgage backed securities in the open market thereby driving down the cost of mortgage financing.  While these interventions can continue into next year, the withdrawal of either of these props will immediately hit demand.  Although interest rates are low, qualifying for a loan is much harder than it used to be.  To deal with this issue, Congress has made the FHA assume significant amounts of credit risk - almost certainly, the FHA will eventually go the way of Fannie & Freddie in being unable to meet these guarantee obligations without additional tax payer subsidy.    On the supply side, new home construction is now well below the long-term sustainable/replacement level, so the excess inventory of homes built during the boom will eventually be absorbed though it will take 2 to 3 years.  The far the bigger worry, however, is that in markets around the country, a large percentage of home owners are “underwater” and through the mechanism of forclosure and sale, there are still many millions of homes that are in the “shadow” inventory - they will eventually come to market and depress prices further.    Though we are wary of making forecasts, it appears likely that housing markets (and commercial real estate) may eventually experience another leg down after a brief (and Federally manipulated) hiatus. 

   The article(s) below talk about this important issue and some of its implications.  The first article (One in Four Borrowers Is Underwater) discussed how large the problem for negative equity is among homeowners, including recent purchasers who thought they were getting a bargin.  The second article (Fear of a Double Dip in Housing) talks about the recent stats coming out of the housing market and some potential implications.     Ken Majmudar, JD, CFA  

Unemployment is a major issue for our economy. Unemployment figures are already higher than the highest levels assumed in the very public “stress tests” of the major banks that occured in early 2009. The consensus expectation is now that unemployment will top 10% before it can even begin to improve. This decline in employment is a major headwind that will eventually need to be overcome before the overall economy can decisively improve and move back to a growth stance.
 
The article/opinion piece below (by Mort Zuckerman - billionaire real estate investor and publisher of US News & World Report) provides a good qualitative and quantitative review of various aspects of the unemployment problem and why the author feels that rising unemployment means that the economy is worst than people realize and will continue to be worse than many expect. Of course, in the near term, markets move on expectations and can rise or fall relatively quickly. However, the fundamental headwinds associated with consumers battered by bleaker job prospects has investment implications that will affect the timing and sustainability of any recovery in economy activity and investment values.
 
While we don’t necessarily agree that this issue means that a 2nd stimulus is necessary, we do agree that the consensus may be underestimating the long-lasting impact of these challenges. The economic adjustments necessary may last years not months as some hope.
 
Please feel free to forward these commentaries to your friends and colleagues who may have an interest in the material below. As always, we welcome your questions, comments and referrals.
 
Ken Majmudar, CFA

Article:
http://online.wsj.com/article/SB124753066246235811.html

Among the many issues facing the economy in the short to intermediate term, the precarious budgetary positions of state and local municipalities does not get as much attention in the headlines as a number of other issues.

Given the issues that California is currently experiencing with its budget (in the near term, the state is having to resorting to issuing IOUs to its vendors and recently Fitch downgraded California’s ratings), investors are becoming more aware of both the precarious position of many state and local governments hit by a combination of declining revenues and mushrooming costs (including pension and benefit costs)

The article below does a good job of highlighting some of these issues and raises the interesting and very real possibility of a rise in municipal bond defaults.  Many retail investors (shaken by the stock market) who have been fleeing to the safety of fixed income and municipals may not be fully aware of the risks involved in these investments as the state and local governments issuing these obligations undergo significant stresses.  

Moreover - as highlighted by the article below - a variety of companies (mostly insurance companies) will be significantly affected by potential looming problems and/or defaults in municipal markets.  Will the Feds have to ride to the rescue?  Read on below . . .  

Please feel free to forward these commentaries to your friends and colleagues who may have an interest in the material below.  As always, we welcome your questions, comments and referrals.

Dear friends and clients,

We’ve been cautious about real estate (especially residential real estate) for a few years now.  As a firm that focuses on value investing (quality when it is cheap or cheaper) we tend to have a contrarian orientation.  To paraphrase Buffett, when everyone is greedy, we often feel fearful.  Over the last few years, real estate prices have risen disproportionately in comparison to levels that could have been justified by the underlying fundamental drivers like demographics and income.  The divergence has been fueled by access to larger sums of leverage from an increasing number of undisciplined lenders.  Predictably increasing leverage fueled increasing prices which then also lead to a reflexive (as in George Soros’ theory of reflexivity in markets) shift in the psychology of participants.

In the last few months, the nature of this poor lending has come to light, especially in the subprime space.  However, there is a good chance that there are more shoes to drop (or as Churchill once quipped, “This is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning”).  Millions of americans today probably own more house than they can afford.  While incomes are rising, the unwinding of the leverage fueled bubble in real estate has probably only just begun.  As this purging/unwinding process picks up steam, there will undoubtedly be pain encountered by hundreds of thousands of borrowers and the institutions that lent to them.  Eventually, of course the Fed will respond to this deflationary headwind by easing and when it does, it will provide a bit of breathing room to the financial system.

Of course, the future is uncertain.  Large conservatively financed companies are generally out of favor and may holdup better if the above scenario is even partially right.  Being a value investor focused on purchasing these companies with a long-term view also doesn’t hurt.