Friday, August 31, 2007

The Dow(n) Homes Index

Fact: A house is no longer a home; it has become a financial asset with windows.

Through the ceaseless efforts of financial engineers houses have been transformed into assets - financial assets. In this blog I have written numerous times how a simple mortgage spawned a series of related financial instruments, from simple CMOs all the way to synthetic CDOs, CDO cubed, or even CPDOs. One single mortgage could insinuate itself into literally dozens of such financial constructs, particularly through the widespread use of CDSs. What's more, homeowners frequently used their house as security for home equity loans, which are nothing more than speculative home margin loans. In other words, we have turned the previously conservative housing market into a volatile financial market. Thus the title of this post, a la Dow Jones.

PIMCO's Bill Gross is now frightened of the possibility that house prices will decline by as much as 10%, if the government doesn't step in to bail out homeowners (and bondholders, of course).

But now that we have turned housing into finance, complete with securities, derivatives, leveraged plays and rampant speculation, is there a realistic way to stop the Dow(n) Homes Index from heading...down? In my opinion, no. The process of assetizing, financializing and margining houses is so far advanced that the decline will only stop when housing once again reflects its fundamental value, i.e. when homes are valued as secure places to live and raise families for a long time, as opposed to volatile trading and collateral "sardines". This means that a buyer has to have something like 20% down and obtain long-term predictable financing that requires a reasonable portion of his/her disposable income.

Houses ARE assets; but they are long-term, non-fungible physical assets belonging to one or two individuals that need them to fulfill their most basic human need of shelter. They cannot realistically be used as collateral backing super-complicated, volatile market instruments that go up and down with "the market". Square pegs don't fit inside round holes, no matter how fine you slice and dice them - they are always square.

Meanwhile, despite all the hubbub about the Discount window, accepting ABCP as collateral, providing $25 billion loan exceptions for banks with brokerage subs, etc., it has all had zero effect on the ABS market. As one can see from the ABX and CDX charts below, CDS spreads (i.e. measures of credit risk) are still very high. Given the stockmarket's furious bounce up (another supposed measure of risk) we are currently getting curiously mixed signals. (Arbi, anyone?).
ABX HE BBB- 2007-1

CDX Investment Grade

Can anyone provide an explanation why stocks are signaling "all clear" while CDSs keep yelling "duck and cover"? Is it perhaps because the Dow Jones is followed by 300 million Americans who are suddenly clutching their pocketbooks closer to their chests, while CDS's are followed and traded by only a few thousand professionals?

And something else... I have started following weekly jobless claims as a gauge of what is happening to the "real" economy. The latest figure was announced a couple of days ago and it was significantly higher than expectations (334.000 vs. 320.000) but no one spoke about it. Notice how the latest data from BLS show 5 weeks in a row with higher claims.

Weekly Jobless Claims (from BLS)


  1. When your Dow home index will stop falling ? of course when prices will reach a reasonable value. but and when trading will come back on ABS. Wait for the chacals, distressed debt managers to arrive soon, negociate cruelly the prices! The US consumer is like Argentina. Cry ! because his debt will be renegociate at a lower price...

  2. I don't think stocks are signalling "all clear." They are signalling massive amounts of leverage, manipulation and speculation, mostly driven by hedge funds and institutional trading desks.

    Higher cost of borrowed capital, combined with weaker earnings prospects, should drive down the values of riskier equities. Their cost of capital (mainly debt) is a direct input into the mechanism for estimating equity values on a "discounted cash flow basis." The more it cost smaller, riskier companies to borrow, the less their future earnings are worth.

    Yet, you have the barometer of U.S. small caps, Russell 2000, still trading for 38 P/E on a TTM basis. On a discounted cashflow basis, Russell 2000 would be worth about 50% its current level.

    And there is an almost direct inverse relationship between Russell 2000 and yen. This relationship is stronger than with, say, the S&P 500. Just watch it...scary.

    It indicates that heavy leverage is still being flung about madly in search of a little more bounce in the riskiest stocks.

    Stocks almost always are leading indicators. But this time, due to hedge funds and madness perhaps, lagging.

  3. "sardines"....?

    You wouldn't happen to be refering to the infamous carload of rotten sardines that were for selling and not for eating, are you...?

    Remember, this is the Labor Day Holiday, no one could possibly think that the boys out in the Hamptons would have to spend an anxiety filled weekend....

    I was warned that if I even thought of selling one S&P today that I would be arrested. I had big planss for today but had to cancell them on that note....

    Oh well, there's always Tuesday...

    Great post as usual.

    Have a great weekend,


  4. Re: S&P arrests

    They put the fear of God into you, eh?

    Wait until tomorrow's post. Fire and Brimstone awaits us all!!


  5. Hi hellasious,

    Nice post as always.

    Most of it applies to the situation here in France and, of course, even more so, UK and Spain.

    Another clear thing is that these late mortgages were not financed by the US but by invisible and careless foreign investors... Allowing the country to consume well above its means for a long period of time.

    This MBS has acted as economic EPO for quite a long time.

    How will the current western super-effective US, UK, Spanish economies perform without these performance-enhancers.

    These countries display absolutely massive external deficits. I now have the feeling that the oiled MBS mechanics just paid the SUV and BMW , beneteau and others bills.

    I have a bad feeling.

  6. Programmed trading by CPDOs are almost guaranteed to make the CDS market irrational. They double down when prices are high and sell when prices are low.

    I'm not sure how much of the current CDX spreads are concerns over the economy and corporate cash flows and how much is concerns over the meaning of "investment grade".

    I'd really like to see how much variance there is in the spreads between the various constituents of the CDX index. Increasing spreads and decreasing variance would show concerns about a weakening economy since a recession would hit all equally. Increasing spreads and increasing variance would suggest fear or distrust of the ratings of some of the companies in the index. Spreads on financials may be high, but spreads for industrials may be "in-line".

    P.S. The Fed made a mistake when it removed home prices from the CPI in '83 and swapped it for Owner's Equivalent Rent.

  7. How will the current western super-effective US, UK, Spanish economies perform without these performance-enhancers.

    Who's more to blame? The drug abuser or the dealer?

    Most of Western Europe has adopted economic policies that favor exports over consumption. A perfect example of this is Europe's gaming of the WTO rules on VAT and direct taxes.

    Look at Asia. Asian currency manipulation has been a direct subsidy to producers at the cost of their own middle classes' consumption for over 30 years.

    The results is a huge surplus of production capacity around the globe. To sustain this excess production capacity the producers have extended credit to consumers around the globe. This has allowed consumers to bring forward future consumption.

    But maybe, just maybe, consumers have hit the wall. Incomes no longer allow consumers to borrow against future consumption. What happens when all those goods can no longer find a home? Where does the dealer go now?

  8. Re: They put the fear of God into you, eh?

    Yeah..... Kinda... But they didn't say anything about gold.... ;-)

    I think that Putin is getting ready to put the squeeze on the dollar big time. He's grinding his axe and he knows that he's holding the best hand at the table.... He's looking to F--k the Chi and Dubya. I know that he wants his pound of FLESH, no more no less.... I believe that he'll be the first out the door and when he goes, he'll go like a Water Buffalo, if you know what I mean.

    Good luck, but I don't think you need luck...


  9. Dear Econolicious

    I rather be always lucky than sometimes smart, hehe.

  10. "I rather be always lucky than sometimes smart, hehe."

    You don't have to be smart to be lucky, however, you do have to be awake. You're bound to be luckier if you're diligent, that's all.

    The more that I practice playing this game, the better I get at it. It's like the archer that hits the bullseye all the time. You kinda create your own luck....

    It seems to me that you've been doing a pretty good job of it. Practice, practice, practice.


  11. The Fed is working with the broker dealers to punish the shorts. The last thing they want is for market participants to earn short-term profits by short selling. IMO, this is a sign of extreme desperation. There is just too much at stake when you think about all the retirement money in the market, what this would do to the wealth effect and corporate profits, what it means for retail trading profits. They will fight this until at some point selling pressure will become so overwhelming that the longs will capitulate. Until then expect aggressive short squeezes. The cut in the discount rate the morning of options expiration is a perfect example of this.

  12. I think that Putin is getting ready to put the squeeze on the dollar big time. He's grinding his axe and he knows that he's holding the best hand at the table

    Fun, a murder-suicide...

    Russia has its own consumer debt problems, its economy is mostly dependent on the price of energy, it has a looming demographic crisis, and its only been 9 years since its economy collapsed and it's best and brightest fled the country.

    I have no doubt that Putin would love to shove one up America's backside but it can't do that until the world has de-coupled from the US consumer.

  13. kicker,

    you said: 'the results is a huge surplus of production capacity around the globe.'

    how true! and that surplus of production capacity is, in other terms, the manifestation of capital's overproduction of itself, i.e. an overproduction crisis need not be seen as so many do, as an overproduction of final products showing up as excess retail inventory but, and more importantly, what you mentioned.

    so what's the significance? well, primarily a falling rate of real economy economic profit as consequence of overaccumulation of production capital (overinvestment). ok this is not strictly financial but the financial is not strictly financial and, even with the massive credit creation 'machinery', ultimately depends on real economy conditions and profitability.

    most seem to think, really believe, that equity markets are forwards looking. that may have been the case once upon a time but, with the progressively greater substitution of credit for investment capital, wages and profits, was very much not the case in the late 1990s. rate and mass of economic profit turned down in 3Q97 but earnings and share prices rose for more than another two years before trying to return to value.

    over the last few years we have developed a serious case of fictitious profits, the so-called 'profit boom', even as fundamentals have not done well at all. the price/value gap more than re-opened -- as before, it will begin closing and i expect it to fully 'correct' this time around.

  14. Juan,

    You're spot on....

    Over investment in manufacturing, then retail, then consumer finance.

    Now that consumer finance has hit the wall, what's left?

  15. Hi Kicker,

    Most of Western Europe has
    adopted economic policies that favor exports over consumption. A perfect example of this is Europe's gaming of the WTO rules on VAT and direct taxes.

    It is difficult to be fair on these issues.

    Overall the European zone is just breaking even. I do not think the VAT should be challenged. And not only because it started as a gallic trick.

    It is technically a smart and business-neutral taxation scheme. I accept that it may marginally favor exports. But it would just be impossible for European states to balance their budgets without it.

    Here in Europe people did love America economic and financial pattern as it was able to provide the necessary kick just after year 2000.

    We now tend to condemn the US as an over-endebted nation. I accept that this is unfair especially in view of the exports of the Eurozone to the US.

    Let us hope this very serious financial crisis will be resolved in the peaceful way with significant reshuffling of the monetary cards.

    In the current situation we alas need quite a dose of hope.

  16. I protest that you are using "BBB-" tranche of ABX. It's not important. All the money are in AAA and AA.