Strategic Default

     I believe there is a new wave of property defaults coming to add even more pressure on the banks.  This is probably the last new wave of defaults before the market finds a bottom.  This next wave is being led by the property taxes in a way that you might never have considered.

     In Florida where I live, the counties are required to send out annual notices of proposed property taxes in July so that you can challenge them prior to your November payment (if paid by mortgage deduction, up to April for other payers).  This happens in most states but the month differs.  These tax notifications are finally starting to reflect true market value of properties after years of declines.

     I have a family member that is upside down on their house because of past indiscretions where they used equity lines and refinancing to extract cash out of their property as it increased in value during the real estate bubble.  They took a house they bought for around $50K 20 years ago and increased the mortgage to over $160K today.  If they sold their house today they would be lucky to get $45K to $50K.  They no longer have any equity lines of credit and refinancing is clearly not an option when you owe almost 4 times the value of the asset.  They were content on making their mortgage payment during most of the bust but now they are having second thoughts.  Why now?

     The reason they are thinking of either short selling their property or stopping payments and waiting over a year for a foreclosure is what came in a little white envelope.  The envelope was from their county tax collector advising them the good news that their property tax is going to decrease again this year because the price has now declined to $44K. In fact with all their exemptions they will be paying little or no property tax.  So what is so bad about that?

     They are happy about not having to pay much property tax.  What is making them upset is the reality of the hopeless situation they are in.  They are in their mid-40’s with very little to show for it.  They owe more on a house than it is worth by almost a factor of 4.   They realize that might take 20 years or longer for them just too breakeven.  With an already a poor credit history they would be fools to not default.  They are in an almost impossible situation.  Default is the answer.  Their wake-up call came via the US post they got from their local government telling them the good news.   I doubt they will be the only ones.

A bonus by defaulting

     I have a friend that has a positive default situation.  He got in over his head with some large commercial deals that drove him to seek bankruptcy.  He also owned a personal residence with almost $450K worth of mortgages ($300K 1^st and $150K second).  For over 2 years he did not make a single payment on all of his properties, including his home.  When the creditors got close to foreclosing he filed for bankruptcy on advice from his lawyers.  The bankruptcy proceedings took almost 1 year to get to a final result.  The one big thing holding him up from exiting bankruptcy was that his home mortgage holder, Thornburg, also went through bankruptcy and a lot of their original documents are scattered around different document storage locations and no one is quite sure where his original note is.  Since this was delaying the bankruptcy the judge allowed him to stay in his home until the note holder can find his note.  The judge also cancelled his second mortgage in the proceedings. 

     The creditors for Thornburg have not been sure what to do.  That is until last week.  Recognizing they do not have a note, they decided they needed to get him on a note.  They offered multiple different solutions until they finally came up with the following.

     They offered to writedown the value of the mortgage to $200K from $300K (house is now worth around $189K), give him a new mortgage with a 40 year amortization, 4.125% interest rate, no PMI, ballooning in 24 years, no money down, with no prepay penalties.  This is for a guy that just exited bankruptcy less than 6 months ago.  This is a smoking hot deal.  He thought he might need to rent a place once they found his note.  He was thinking of spending $1,500 for rent.  With the new arrangement his mortgage payment went from approximately $2,600 per month (1^st, 2^nd, taxes and Insurance) to $1,200 per month now- cheaper than renting.  He would be a fool to turn this down.  The only thing he is giving up is possibility that they may never find the original note and he would have gotten the property free and clear eventually.  This is a real possibility but realistically, probably extremely remote (1 in 1,000,000 at least).

Marginal Mortgage Payments taking the economy into recession

     Today in lots of locations around the country where the housing market has busted there are large percentages of the population that are living in their current properties for free.    They are in various stages of foreclosure and are awaiting the final judgement day when they are eventually evicted from their “home”.  These consumers are using the money they would normally have used on a mortgage payment to pay down credit cards, save, but most is going to purchase everyday items.   Imagine if you were given a 40% raise, what you would do with it.  For these people not having to pay a mortgage or rent is like having at least a 40% pay raise.  I believe that this freed up source of funds is what helped support the meager growth in the economy we have seen over the last couple of years.

     Eventually they will be foreclosed on and kicked out of their homes.     These people will then have to find other accommodations to live in thus giving them at least a 20% pay cut (assuming they try and rent a lower priced location).   This will give them less to spend on everything.  This will drain money out of our already weakened economy.  And it is coming.

Conclusion

     Situations like these and demographics (more on this in a later post) will likely cause the US to go in and out of recession for the next decade.  We are on our way to following the Japanese and having multiple lost decades.  This is what a depression is.  It will not end until the debt that has accumulated is paid off, dismissed, or defaulted on.  If we choose to deal with our situation like Germany did in the 1990’s and 2000’s we could possibly be free sometime around 2020.  If we keep adding debt and not address the situation like Japan has, 20 years from now we will still be asking “when will this end?”.

Buy Recommendation on Ford

     Ford looks like a solid buy and long-term hold at $9.75 and below.  Unlike the other two large domestic automakers, Ford was able to stay out of bankruptcy AND fix their balance sheet and product offering since 2008.  That is not the whole story.

     They have changed for the better.  They have a longer term focus and are the only automaker playing their own game.  They are not copying anybody.  They are poised to surpass GM in the next decade to become the 2nd largest automotive group behind Toyota.  

     The Key to Ford is Alan Mulally.  Alan came over from Boeing where he was instrumental in helping turnaround that company in the early 2000’s.  Unlike most of the CEO’s today, Alan truly looks out 3 to 5 years down the road to engineer a company for long-term benefit of the shareholders and employees.  Couple this with the Ford families’ long-term ownership and you have the makings of a true buy and hold stock, rare these days.

     The Ford family used to get a large share of their income generated via the large dividends that Ford paid out.  Ford has not paid a dividend since 2006 when they halted payouts at $.05 per share per quarter (they regularly paid $.10 a quarter for years before).  They halted their dividends because Ford had gotten into trouble financially and it was becoming apparent that when the housing bubble popped, so did demand for trucks and cars.  In my opinion you will see Ford start paying a dividend when they get their financial rating to an investment grade AND get their debt on Ford Motor (excluding Ford Motor Credit) down below $5B (possibly $0) from $14B today.  They are reducing their automotive debt by $2.6B per quarter.  The timeline for dividend would be probably the end of 2012.  The dividend may be delayed by a recession in the US.

     Ford has taken the last few years to clean up their balance sheet, right size their production with facilities and employee reductions, and revamped their lineup of vehicles.  These changes are resulting in lower incentives given to buyers of Ford products, translating into higher profits.  Their revenues are consistently growing year-over-year for the last 3 years.  Their earnings per share have grown from a       -$6.41 per share in 2008 to a projected $2.02 this fiscal year.

     Today Ford is rated junk at BB- (S&P).  They have gone from total long-term liabilities of $280B in 2006 down to $162B as of the end of June 2011.  Total long-term liabilities are a mixture of debt, taxes, and pension obligations.  Their total debt is $98.6B down from $172B over the same period.  Most of their debt is in their financial arm (think car loans, unlike some of the other automakers that ran into trouble with home loans).  They are growing their net cash by $3B per quarter.  I feel that they are overdue an investment grade rating possible a low A grading.

Projection

      I am projecting that Ford will obtain an A/BBB+ financial ranking within the next 18 months (positive for their bonds) and their shares will to increase to $27 per share by October 1, 2014.    

Full Disclosure

      I do not own any Ford securities as of Sept 15^th, 2011.  I plan on adding Ford shares to my portfolio starting at prices below $9.75- which I think we will touch this fall if the markets continue their slide.  If the shares do not get to this level by the end of October I will probably add some at a higher price point.  I plan on slowly building the position up to approximately 20% of my portfolio.

The Grandma’s going to have to eat dog food act

     Obama released his so called “American Job’s Act” to little fan fair last week.  The proposed act promises $447 billion in tax cuts and government spending in an effort to jump start the ailing US economy.  The act looks to extend the temporary tax holiday, rolled out in 2009, that reduced payroll tax deductions on employee paychecks.  This new act purposes to lower taxes by $1,500 annually for the average family and provide incentive for businesses to hire additional people. 

      The lower taxes are via lowering the social security tax that employees must pay via payroll deduction.  An employee used to be taxed 6.2% of their salary (up to a maximum salary of $106,800) and an employer was also taxed 6.2% of the employee’s salary, all supposedly going towards social security.  With the change in 2010 that percentage dropped to a 4.2% tax for employees but remained at 6.2% tax for the employer.  The new change that Obama is proposing has both the employee and employer’s contributions decreasing to 3.2%, thus by Washington math freeing up to $1,500 for employees and employers.  

      But where is that money going to come from?  The last I checked the US government has a $1.3 trillion budget deficit forecasted for 2011 (per the CBO).  The social security “trust fund” for the first time in 2010 spent more money in benefits and payments then it received in taxes.   This was not supposed to happen until 2016.  This premature deficit was caused by only reducing the original amount the employees were taxed by 2%.   Now this new act is tripling the original reduction (2% goes to 4%- 1% additional for employees and 3% for employers) we are almost assure of seeing larger deficits. Hmmm, how is this going to work? I will tell you how. 

     The only way to fix social security in the future is to either increase the amount we tax our citizens and businesses, raise the retirement age, change the amount that retirees receive, or a combination of all three.  No other way will work.  Time and demographics are against us.   We are borrowing from the future just to make the present seem better.   So in other words, Obama wants Grandma to be forced to eat dog food in the future or grandpa to work into his 80’s just to support his sorry ass in order to be elected again!    Grandma was once on the Atkins diet, in the future she will be on the Alpo diet.    Grandpa used to shop at Walmart now he will be greeting people at Walmart.  All this just so we can reelect arguably the worst president this republic has ever had in power. 

     I know one job cut where we can save trillions…..fire the president and while you’re at it, have those 535 worthless souls start preparing their resumes as well.  Now that is an American Job Act I could get behind.  

Full disclosure

I am an independent voter that thinks both political parties need to stop playing government like little kids and do their damn job and reduce the government deficit to $0.  But alas it seems this is just a pipe dream because every time someone goes to Washington they learn “new math” that never seems to add up right.  It must be something they learn from those wonderful public schools in the district.

Why Can’t an EU Member go Bankrupt?

I have repeatedly heard in the press that if a European Union (EU) member defaults on their debt they will be kicked out of the EU. But is this correct?

The EU’s economic framework is based off the Maastricht Treaty. In the Maastricht Treaty there are four main economic policies a EU member must follow to stay a member of the EU.

1. Exchange Rate Policy – The members must maintain a strict exchange rate in the market for 2 years prior to joining the EU.
2. Inflation Rate – The members must try to have no more than 1.5% higher inflation rate over the bottom three lowest inflation countries in the EU.
3. Long-term Interest Rates – Nominal Interest rates must not be more than 2% higher than the lowest three EU members inflation rates
4. Government Finance

• Annual Government Debt cannot exceed 3% of the GDP of their country
• Government Debt Ratios to GDP cannot exceed 60% of the member states’ GDP

Items 3 and 4 on the list imply issues with regards to bankruptcy by the nature.

• If you debt ration does not exceed 60% of GDP chances are you will not be filing for bankruptcy because your sovereign house is probably in order.

• If you do not run an annual budget deficit larger than 3% of your GDP you are probably not a candidate for bankruptcy

• If you are close to bankruptcy your nominal interest rates are most likely going to exceed the 2% above the three lowest inflation member states.

Nothing in the treaty specifically says a member cannot file for sovereign bankruptcy. If you look across the EU there are many EU members that do not meet items 3 and 4 today and have no way of meeting them in the future without filing bankruptcy. I would argue that once a member state exits bankruptcy they will be more apt to meet all the requirements. Imagine when Illinois and California have to file bankruptcy in the coming years. Will the US kick these states out of the US and not let them use dollar bills? NO! The only thing a sovereign bankruptcy does is it allows a country or state to reorganize their obligations to others to a more manageable number.

The way I see it, there are many economic benefits to the Euro in the form of trade and movement of individuals. If you combine this with the same currency covering over 500 million people, thus gaining critical mass, and you have a viable reason to remain a member. Because Greece, Ireland, Portugal, and Italy will eventually need to file for bankruptcy it does not mean they should have to leave the EU or stop using Euro’s. I say let them file today and in two years most of those locations will be in growth mode.

Full Disclosure

I do not own the Euro or any bonds in any of the countries or states mentioned.

When the Domino’s fall

What happens when Bank of America (BoA) fails?  In my opinion BoA is a severely wounded giant with odds approaching 33% chance of the US government, in some shape of form will need to bail them out for the second time in three years.  I will not go into any argument about why BoA has a good shot of failing.  So much of that story has been covered.  Martin Weiss did an excellent job detailing the issues that BoA faces.  For more view http://www.moneyandmarkets.com/america%E2%80%99s-largest-candidate-for-bankruptcy-46993

The question I am raising tonight is who else might blow up or become weakened/crippled if and when BoA fails?  I think most of that story is determined by the derivative market.

Using the latest Office of the Comptroller of the Currency (OCC) derivative report I will try estimate who is likely to be hit the hardest if BoA cannot pay their derivative bets.

According to the OCC the derivative market in the US has a notional value of approximately $244 trillion.  That is “T” as in trillion dollars, not billions of dollars.  BoA (as a holding company) is a very large player in this market, in fact it is the 2^nd largest player with a notional value of $72.7T in derivative contracts outstanding ($52.5T for their commercial bank operations).    The top 5 banks that trade derivatives in the US represent 96% of all notional amounts and 83% of industry net current credit exposure (OCC Q3 2011 report).

Who the banks trade with and their exposure to each other or any one party for derivative contracts is not disclosed.  The reason they obfuscate that exposure is simple; it is so that you cannot see their true exposure.    The banks use Value at Risk (VAR) to try and measure the statistical odds that they will lose a set amount on any given trading day.  JP Morgan and Goldman Sachs use 95% confidence ratio and Bank of America and Citi use 99%.  A 95% ratio states that on any given 5 of 100 trading days (99% is 1 in 100 trading days) they can expect to lose more than their VAR amount.  This is a false assumption and does not really take into account extremely volatile trading days.  Example is the day AIG was bailed out in 2008 or when Bear Stearns failed.  At best it is a cute statistical representation guessing risk in normal or up markets, volatile bear markets where a key player could fail the VAR measurement will probably be way off.  Given the large sums of money involved in derivatives there is a good chance that if one of the top 5 players fails it will take out a large portion of the market.  

The banks will all claim this is another black swan event that should only happen once every billion or so years.  History shows the financial markets have these events every 10 years or so.  So who is right?  I vote history and not some stupid model in a spreadsheet.  The derivative market is a time bomb ticking.

How a large player failure might work through the system

Suppose that BoA gets so weak that the US Government decides to step in and break up the bank to help protect depositors.  Who will be affected by this change?

BoA depositors will be made whole on their FDIC insured accounts up to the maximum allowed by law.  Large depositors and money market holders will be in line waiting with the bond holders hoping to be made whole either by a government program or by money received from selling the remaining assets of the bank.

BoA Shareholders (regular and preferred) will likely be wiped out with just a token amount refunded to them sometime in the future (many months or possibly years)

BoA Bond holders will probably take a large haircut in the value of their bonds.  The amount is debatable but it could be anywhere from 40% to 100% depending on what an acquiring firm pays for the pieces they purchase.  When Bear Stearns was forced taken over by JP Morgan they made the bond holders whole with the help of the US Government.  I am not 100% convinced the US Government will step in again and do the same thing.

BoA derivatives bets made by the company will need to be worked out.  Contracts where BoA has a positive value will be attempted to be collected.  “Attempted” is the key word because the counter party that owes the money to BoA might also be owed money from BoA on other derivative trades, and may seek to have it netted out to minimize what they need to pay or to get paid in general.  The administrator that is brought in to run BoA during the transition from failed bank to whatever their new form will seek to minimize paying out on these contracts just so that they can control the cash outflow and potentially maximize the amount of cash large depositors and bond holders receive.  If BoA actually files bankruptcy or FDIC takes them over they can tie up any payments on the trades for a long time.  The counter party to BoA might have won the battle but ultimately lose the war because they might not get paid or if they are paid, they might not be paid in full and it might be years before they get any cash.  For large investors this is where the main risks lie.  BoA is a large counter party risk.

Given that BoA represent approximately 21.5% of the entire market their failure might also severally impair other derivative traders.  This is the theory why Bear Stearns was bailed out.  Some people contend that if JP Morgan did not take over Bear Stearns and the US Government did not bailout AIG, Goldman Sachs and Citigroup would have been mortally wounded and might have started a chain reaction of failure in more derivative players.  Remember the top 5 traders of Derivatives control 96% of the derivative market and all received government money in 2008 to help them through the financial crisis (though it was rumored that the US Government forced JP Morgan to take the cash).

This is 2011 and not 2008.  A lot of the banks have truly cleaned up their balance sheets (i.e. Wells Fargo).    So who is at risk if BoA should happen to fail?

To be fair to the top 5 derivative traders, they have all increased their cash and most have lowered their overall debt levels from 2008.  The two that I feel are most at risk is Goldman Sachs and JP Morgan. 

Goldman Sachs clearly punches way above their weight class.  With the lowest amount of equity of the top 5 traders they take some of the biggest risks as measured with Notional Value to Equity or Notional Value to Risk-Based Capital.  They are the fastest grower of derivatives.  They have grown faster than any other derivative trader in notional value.  Their balance sheet is getting worse as they add more and more leverage.
Most of the same can be said about JP Morgan.

If BoA falls over and we assume that 21.5% of the trades that either Goldman Sachs or JP Morgan have placed were with BoA as a counter party, and looking only at the one that are in favor of Goldman or JP – measured by Gross Positive Fair Value- , they would easily overwhelm their equity if they had to recognize the loss as uncollectable.  

The domino of Goldman Sachs falling over would not have that big of an impact outside of Wall Street.  If BoA happened to bring down JP Morgan we would see the financial markets freeze up on Wall Street and every day markets freeze up on Main Street.  As bad as that may sound we would eventually get over this and our markets would be much stronger without the dangers of derivatives hanging over them.

Full Disclosure

As of September 7, 2011 I do not own any positions in any companies mentioned.  I do use some of these companies for banking and my mortgage. 

Netflix- One price point away from a failed business model

Netflix is one price point away from a failed business model.  The price point I am referring to has nothing to do with the recently announced price increase by Netflix.  I am referring to the competition i.e. the cable companies.

All the cable companies need to do to destroy Netflix is start offering unlimited pay per view movies and TV shows for a flat monthly fee slightly lower than Netflix.  They could even wait to show the newest releases 7 days before allowing the unlimited package group from seeing them, thus minimizing the impact on the pay per view new movie stream to the operators.

The benefits to the cable operators and users

 

• Less IP traffic associated today with their customers’ use of Netflix over the cable operator’s internet network.  They would probably need to spend less capital to enhance their networks since a bulk of the usage today over the internet is video.

• Increased revenue for cable operators because the change would offer them a new revenue stream.  I for one would buy it as a type of TV/Movie insurance from charges my kids run up for pay per view now.  Some months I spend $0 on pay per view but other months it can be as high as $20 even though we have Netflix.  If I did not have to worry about individual charges for movies I would pay say $10 flat.  It would be cheap insurance to protect me from large pay per view bills.

• No need to wait 28 days for new releases like you do for Netflix.  Obviously the movie studios would want to get a slice of the pay per view revenue.    The delay could be negotiated.  The movie studios like cable operators better than Netflix because they could at least get paid for each time a movie is viewed compared to Netflix use of DVD’s (downloads by Netflix would probably be treated the same).

• No need for additional equipment or accounts.  Consumers would not need to buy other devices like DVD players, XBoxes, or TV’s equipped with Netflix to get the same service.  The reason Netflix does this in the first place is because they see the hole in their business model and they are trying to plug it by having Netflix on all devices known to man.   They are in an absolute panic hoping the cable companies do not catch on.

• Cable companies control the customer.  Like the battle between AOL dial up and broadband.  AOL lost out once customers switched operators when the cost of broadband came down in the early 2000’s. People watch movies not Netflix.  It is the content not the company bringing it to them.  The cable operators will win out because Netflix becomes irrelevant.  Why do you need them if you could have the same thing from your cable operator?  Plus there is no second bill to pay.

Forecast

Within 18 months of 3 of the top 5 cable operators and Verizon offering this price point, Netflix will sustain negative growth and a rapidly declining share price.  Netflix, as of September 1^st, 2011, trades at $233.27 down from almost $305 as a 52 week high.  Start your short when the cable operators start offering a flat rated product through mass advertisements.  Within 18 months the stock will lose 95% of its value.  I predict the stock will trade between $5 to $10 per share once they are finally taken over by private equity or a company like Newscorp.  Do not do this short until you see the cable operators make a change.  That is the trigger for the 18 month decline to irrelevance.

Full Disclosure

I am a Netflix customer.  As of September 1, 2011 I do not own any shares (long or short) in Netflix.