The Half-Empty Glass: Whitney Tilson

Tilson traces the history of the housing bubble leading to the sub-prime crisis, and those interested in his concise and informative summary should consult his presentation.  The following slide clearly shows the rise in housing prices over the last 30 years:

Tilson’s thesis rests on the relatively small correction that has taken place in housing prices.   Year-over-year decreases in housing prices have yet to reach 10% and, without a historical precedent for defaults and foreclosures at this level, Tilson takes a conservative view of the way things will unfold.  Tilson cites some ominous statistics:

• Foreclosures rose 57% and repossessions 90% in January, year-over-year.
• 8.8 million homeowners have mortgages exceeding the value of their homes, and 30% of sub-prime mortgages are underwater.
• Nearly 3 million homeowners are behind in their mortgages, with an additional 1 million risking “imminent foreclosure.”
• In the last two years, home inventories have surged from a 4 month supply to an 11 month supply

Approximately $440 billion in mortgages are scheduled to reset this year.  Despite interest rate cuts by the Fed, mortgage lending rates have not decreased.  Combined with the declining value of homes, it is highly unlikely that these mortgage holders will be able to refinance. 

The most problematic loans are those with two-year teaser rates.  These became exceptionally popular starting in early 2005, and we are now starting to see the effects of their resets.  It takes approximately 15 months from a missed payment until a foreclosure through a sale or auction of a property.  Thus, the defaults we are seeing now relate to lending activity in early 2005, when lending practices were just beginning to deteriorate.

Lending practices deteriorated rapidly through 2005 and 2006, and delinquencies and defaults in the bulk of these problematic loans will surface over the next two years.

Tilson’s data shows over $800 billion of loans made between 2005 and 2007 with little or no precedent, as well as another $56 billion in second mortgages with similar characteristics.  The best quality two-year teaser loans made in 2005 are defaulting at annualized rates of 35%-46%.   The worst quality of these two-year teaser loans are defaulting at 48% annually before the reset kicks in, and at 7%-8% per month immediately thereafter.

Tilson cites a Citigroup estimate of $300 billion in residential mortgage loss write-offs, of which nearly two-thirds is sub-prime related.  He says this is “likely to prove [to be] very low.” 

Lastly, Tilson notes that $3.2 trillion in asset-backed and non-agency securities were collateralized with an underlying assumption that housing prices would continue to rise, allowing borrowers to refinance when necessary.

Our Analysis

We have a hard time swallowing Bove’s argument.  While we’d like to believe the combination of monetary policy, regulation, and fiscal support will allow us to overcome this crisis quickly, we find Bove’s analysis unconvincing.

We disagree with Bove’s fundamental assumption, that home prices are not due for an extended period of decline.  Bove believes home prices cannot decline in an environment where commodity prices are increasing.  We do not accept this line of reasoning.  The recent surge in commodity prices is due to a fall in the price of the dollar and investors seeking hedges against inflation and economic distress.  Housing prices will be dictated by supply and demand, and the overwhelming evidence is that excess supply will depress the real estate market for the foreseeable future.  Bove’s experience in the Florida market may be correct for some limited waterfront properties.  But it is not true for the vast majority of the housing market, especially those homes financed with sub-prime mortgages.  We do not believe foreign buyers are going to step in to buy these homes, at least until they are confident the housing market begins to rebound.

We are skeptical of Bove’s estimate of $500 billion that will ultimately be written off by financial institutions.  Tilson’s figures, which show over $800 billion in outstanding loans with unprecedented credit criteria, is a more reasonable figure (although this does not include leveraged loans, commercial real estate loans, and other forms of credit which may be impacted by an economic slowdown).  Moreover, Bove’s calibration of $500 billion as 1% of the total US debt has little significance.  A more meaningful yardstick would be the size of the US budget, now approximately $2.8 trillion.  In this context, a price tag of $500 billion (which we believe is a very conservative estimate) is very significant.

Bove’s analysis represents a best case and highly unlikely scenario.  A worst case - and hopefully equally unlikely – scenario combines a precipitous fall in real estate prices and the dollar, leading to a decline in equity prices.  This would force the unwinding of leveraged positions held by hedge funds, fueling further declines in the equity markets which could not be stemmed by Federal Reserve actions.

The sub-prime crisis is not over and, as Tilson says, the worst is yet to come.

We note that Bove’s employer, Punk, Ziegel, is an underwriter and advisor to the financial services industry.  His firm stands to gain from a recovery in the financial services sector.  We also note that Tilson’s firm, T2 Partners, has short positions in both Ambac and MBIA, and (at least on these two positions) stands to gain from further mortgage defaults.

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