The Potemkin Market

As our friend David Kotok noted, the Treasury’s action moves us one step closer to the day when the government will formally nationalize Fannie and Freddie and add their debt to the nation’s already swollen balance sheet.  But the difference between the so-called “implied” guarantee and a formal guarantee at this point is a matter of form over substance – nobody believes that the U.S. government will ever walk away from these obligations.  For all intents and purposes, these companies were nationalized long ago and the financial crisis just confirmed what everybody already believed.  Accordingly, the latest move, designed to minimize press coverage and market disruption, fooled absolutely nobody but showed the limitations of our leaders.  The U.S national debt is not $11 trillion, but $16.5 trillion and rising once Fannie and Freddie are counted.

Mr. Kotok also makes the very important point that this move adds to the necessity for the Federal Reserve to maintain low interest rates for a prolonged period of time.  In 2009, the Federal Reserve bought more than $1.1 trillion of Fannie’s and Freddie’s home-loan bonds and more than $124 billion of their corporate debt in an effort to lower their funding costs.  This helped push mortgage rates to a record low of 4.71 percent in December 2009.  Throughout 2009, rates on a typical fixed-rate 30-year mortgage averaged 5.04 percent, down from 6.05 percent in 2008, according to weekly surveys from Freddie Mac.  Mortgage rates need to stay as low as possible for the housing market to have any chance of recovery.  Rates on Fannie and Freddie paper will play an important role in determining where mortgage rates settle out in 2010.  The Federal Reserve will be sure to do everything in its power to keep mortgage rates low, which means that zero interest rates are here to stay for the foreseeable future.

But the rot runs even deeper at Fannie and Freddie.  The government had to do even more to keep the two GSEs afloat.   In order to keep Fannie and Freddie solvent, the Treasury had to purchase $191 billion of their mortgage bonds and $112 billion of their preferred stock.  Why did the Treasury have to do this?  Because the companies lost a combined $188.4 billion over the last nine quarters!  That is even greater more money than AIG lost during this period.  This is the performance for which their CEOs – who are working for the government - are being paid millions of dollars!!!!!?????

The Treasury Department’s management of the GSEs continues the disastrous Congressional creation and management of these entities.  Trying to slip through the extension of aid on Christmas Eve was also amateurish at best.  There was absolutely no chance that savvy market watchers would fail to factor the lifting of limits on aid to the two housing agencies into their investment and trading calculations.  Moreover, the Treasury Department must be seen to be engaging in more of the same wrongheaded economic policies that caused the financial crisis in the first place, and delaying the necessary adjustments that need to occur in order to purge the economy of the excesses that are preventing it from regaining a productive growth path.  To quote Marc Faber:  “the ‘crisis’ is unlikely to compel economists at the Fed and the Treasury ‘to reach for a new paradigm.’  With fiscal and monetary measures they will attempt to prevent consumer prices from declining, which would actually be favorable for the economy as consumers’ purchasing power would increase…But in the process of combating consumer price declines, these economists and bureaucrats will create massive bubbles in one or another sector of the global economy, which will lead to renewed economic and financial instability sometime in the future.”³  Actually, rather than creating a new housing bubble moves like the Treasury’s are preventing the previous bubble from being effectively unwound.

Between the end of 2002 and the end of 2006, total U.S. outstanding debt increased from $31.84 trillion to $45.32 trillion, an increase of 42.3 percent.  By 2006, total U.S. indebtedness equated to 350 percent of GDP.⁴  This rise in indebtedness coincided with a period of extremely low interest rates and brought the country to the cusp of the financial crisis.  Moreover, a significant portion of this indebtedness was concentrated in the financial sector.  Between the end of 2002 and the end of 2007, financial sector debt increased from $10.1 trillion to $16 trillion, reaching an unprecedented 117 percent of U.S. GDP.⁵  We all know what happened then (we were treated to a front row seat to Hyman Minsky’s “financial-instability hypothesis”), and what the authorities did to combat the near collapse of the system – they increased debt further to replace the trillions of debt that was wiped out.  Virtually everybody considered this traditional Keynesian approach to the crisis to be the correct one because the alternative – a complete systemic collapse – was considered unthinkable.  But treating a debt crisis with more debt can only delay the ultimate day of reckoning, which is one reason why assets such as gold are rising while paper assets such as the U.S. dollar and other fiat currencies are falling.  The hope is that delaying the end of days will give policymakers time to design a different and far less painful endgame.  In order to do that, however, they are going to have to start heeding the lessons of the past.  And there is little indication that they will be able to that.  But this is the beginning of a new year, so one can always hope.  But while one hopes, one should also be preparing for the worst.

Bernanke the clueless

We will definitely need to prepare for the worst as long as our leaders continue to deny the obvious.   In a speech on January 3, Federal Reserve Chairman Ben Bernanke argued that low interest rates did not cause the housing bubble.  Instead, he argued that monetary policy after 2001 “appears to have been reasonably appropriate, at least in relation to” the so-called Taylor Rule.  The Taylor Rule is named after Stanford University economist and former Treasury undersecretary John Taylor, who created a shorthand formula that outlined how a central bank should set rates if inflation or growth veers from targets.  This is another example of why economic policy should not be left in the hands of professors who have little real-world experience.  For Mr. Bernanke to continue to argue at this point in time, when the evidence is staring him in the face, that low rates did not cause the housing bubble is truly alarming.  It frankly should be sufficient to disqualify him from serving another term as Chairman of our central bank because it suggests that he has no understanding of how the real economy works (a flaw he shares with his predecessor, Alan Greenspan).  But his comments also make it clear that as long as Mr. Bernanke is in charge, the Federal Reserve will keep rates low for a very, very long time because he doesn’t believe that low rates cause bubbles.

The Pricing of Risk

The pricing of risk remains the gravamen of financial markets.  Some risks are properly priced for the short term, others for the long term, while other risks are improperly priced.  The best way to approach the markets in 2010 is to consider whether markets are pricing different types of risks properly. 

Political Stability:  Political instability is being severely underpriced by the financial markets.  There is little indication that the financial markets are expecting any type of political instability in 2010, either domestically or abroad.  Perhaps it is more accurate to say that markets are so focused on the fact that the economy appears to be recovering from its near-death experience in 2008 and early 2009 that it is ignoring political threats.  Unfortunately, however, those threats have not disappeared. 

Domestically, President Obama and the Democratic Party are facing significant resistance to their economic and foreign policies.  The healthcare bill that is being forced down the throats of both Congress and the American people has taken on a life of its own in the minds of its creators but appears to be profoundly flawed.  The goal of insuring more Americans is a worthy one, but there are better ways to accomplish it than this bill, which is highly unpopular and was constructed in an unseemly manner that highlighted the worst aspects of our political system.  The failed Christmas-day bombing revealed the contrast between the current administration’s soft approach to foreign affairs and the hard line taken by the Bush administration and may have initiated the inevitable reconsideration of our former president’s reputation in that area (his economic reputation is unsalvageable).  The unity of the Democratic Party is beginning to show serious signs of erosion, and the 2010 elections could spell the end of the liberal ascendancy. 

Abroad, instability is brewing in a number of familiar places.  Pakistan, Afghanistan, Yemen and Iran are four places that threaten global stability.  The Taliban and Al Qaeda are growing bolder in their attacks both within these countries and around the world.  Iran is moving forward with its nuclear plans despite the distractions of growing domestic unrest and remains a potential flash point.  It will require extraordinary leadership from the Obama Administration in foreign affairs to steer events in positive directions.   In the area of foreign affairs, the President continues to believe that he can use “soft power” to battle stateless Jihadists whose battle plan consists of blowing up soft civilian targets. With the exception of Afghanistan, President Obama has failed to exert American power in a manner that promotes either American interests or the prospects of peace.  He should change course immediately by reversing his decision to close the prison camp at Guantanamo Bay.  It takes a wise leader to understand that the types of enemies we are facing today understand strength, not weakness.

HCM cannot recall a time at which this country cried out more loudly for national leadership, and when that cry was greeted with more resounding silence.  President Obama is spending his authority and political capital in too many directions; the result is that he is becoming diminished in stature and power.  This has allowed Congress to step into the vacuum created by an over-committed president, and the legislation being written in Congress is wreaking havoc with the future of America.  The President should use his upcoming State of the Union Address to take back the agenda from Congress and reassert his leadership.  Failure to do so will could seriously hamper the rest of his term and make a second term an uncertain proposition.

Volatility:  Stock market volatility is also being underpriced.  The Chicago Board Options Exchange Volatility Index, popularly known as the VIX index, measures the implied volatility of S&P 500 index options and is currently trading at extremely low levels, implying that the market is expecting relatively smooth sailing in the months ahead. 

Graph 1 below shows the recovery in the VIX index since the dog days of the 2008 financial crisis:

Graph 1

One of the easier trades that can be made in today’s market is one that bets on volatility rising.  Even though HCM expects the stock market to rise for the foreseeable future, this is one relatively inexpensive way of hedging that view.

Credit:  Another area in which risk is being priced extremely cheaply is corporate bond spreads.  Credit default swap spreads on the Markit CDX North America Investment Grade Index, which measures the creditworthiness of 125 investment grade companies in the U.S. and Canada, have tightened inexorably over the course of 2009 and at the end of December stood just above a paltry 80 basis points.  This is shown in Graph 2 below.

Graph 2

It is not particularly surprising that these spreads have tightened so dramatically in view of the fact that default risk has receded significantly over the course of the year.  The government has made it abundantly clear that it will do everything in its power to reflate the economy, which includes maintaining interest rates at zero and providing liquidity in virtually every form known to man.  Moreover, investment grade companies have learned the lessons of the credit crisis and have aggressively moved to extend their debt maturities and improve their balance sheets.  Therefore, the default risk on investment grade companies is negligible (barring fraud a la WorldCom or Enron). 

The spread on less-than-investment grade bonds rated B is currently about 650 basis points, which is close to its long-term average. See Graph 3 below.  In the current environment, which will be characterized by high levels of new bond issuance and low defaults (under 5 percent), spreads could easily tighten another 100 basis points over the next six months and as much as 150 basis points through the course of 2010.

Graph 3

HCM views this spread tightening as a long-term trap.  The pattern in credit markets over the past three decades is for spreads to tighten over a period of years until they snap; when they snap, virtually all of the previous gains earned from spread tightening are lost.  Accordingly, it is necessary for investors to be extremely nimble in trading and timing the market; buying and holding has served to be a very poor strategy.  This boom and bust pattern has been driven by poor monetary and fiscal policy, which is continuing as we speak.  While HCM has every expectation that spreads on investment grade and less-than-investment grade debt will continue to tighten for much if not all of 2010, investors should avoid illiquid names (this is primarily an issue in the junk bond market, not in investment grade bonds).  Spread tightening in a zero interest rate environment will lead to a situation, particularly in high yield bonds that are quasi-equity securities, where bonds are severely underpriced for the risks that they pose.  This is exactly the situation in which markets found themselves in early 2007 before they collapsed in the credit crisis.

Mexico

Mexican Navy Petty Officer Melquisedet Angulo fought dying for his country.  He was killed in a Special Forces operation that killed Arturo Beltran Leyva, a high-profile Mexican drug lord.  Mr. Angulo was hailed as a hero and buried with a military honor guard in Mexico City on Monday, December 21. Later that evening, around midnight, a dozen hit men carrying assault rifles burst into the home in eastern Mexico occupied by Mr. Angulo’s family.  They murdered his defenseless mother, aunt, sister and brother.  Previously, family members were thought to be off limits in the drug wars that are tearing apart America’s southern neighbor.  But the public take-down of Leyva was perhaps the most direct challenge to the hegemony of the drug cartels over Mexican society in recent memory, and the public funeral of Mr. Angulo was a further affront to the cartels’ belief that they are beyond the reach of the law.  Wiping out Mr. Angulo’s family lent a bloody exclamation mark on their refusal to live under the laws of civilized society. 

The drug cartels have deeply corrupted the Mexican government and law enforcement, and it will be very difficult for Mexico to solve this problem alone.  While the last thing the U.S. needs is further foreign entanglements, Mexico remains a vital border state whose stability is of vital national importance to this country.  Violence has already poured over the border, and the drug trade had caused countless damage to our country.⁶ The U.S. should treat this issue as a matter of national security and lend its power and military to its neighbor before the Mexican state crumbles into anarchy.  Congress is not oblivious to the problem, having agreed to contribute $1.3 billion of aid to Mexico to fight the cartels.  The problem will only worsen as the Mexican state suffers further economic weakness with the slow but steady draining of its sole national resource – oil.  As noted in last month’s report, Mexico remains a source of economic instability for the U.S., and U.S. investors should pay close attention to what is happening there.  The attack on Mr. Angulo’s family is a tragic and historically significant event in Mexico’s decline. 

The investment markets are currently undervaluing Mexico risk.  As of December 28, 2009, Mexico’s five year benchmark bond, the 5.875s of 2014, were trading at a spread of only 130 basis points over U.S. Treasuries.  Mexico’s sovereign credit default swap spreads were trading only slightly wider at 140-145 basis points.⁷  These spreads are far too tight in view of Mexico’s deteriorating oil industry and the threat posed to civil order by the drug cartels.  HCM believes that these spreads are likely to widen significantly in the year ahead and should be shorted.

General Growth Properties, Inc. (GGP)

Hedge fund manager Bill Ackman has been engaged in a public debate about the value of bankrupt mall REIT operator GGP with another money manager, Hovde Capital Advisors LLC.  Mr. Ackman, who is a member of GGP’s Board of Directors, believes that GGP’s common stock is undervalued at its current trading price of $11-12 per share, while Hovde argues that the stock is overvalued and could even be worthless.  Mr. Ackman’s Pershing Square Capital Management, L.P. has reportedly already earned hundreds of millions of dollars of profits on its positions in GGP’s debt and equity securities, but Mr. Ackman believes there is more to be had from the bankrupt mall operator. 

HCM did a little digging into GGP’s numbers and into the analysis on which both Pershing Square and Hovde based their investment recommendations.  We came to the conclusion that GGP’s stock is fairly valued at about $12.50 per share.  This is based on using a NOI (net operating income) figure for 2010 of $2.29 billion, which is about $200 million lower than the $2.478 billion figure Pershing Square uses in its latest public presentation (dated December 22, 2009, “A Detailed Response to Hovde’s Short Thesis on General Growth Properties,” p. 26) and about $550 million more than the $1.734 billion figure Hovde used in its December 15, 2009 presentation that briefly drove the stock lower.  We believe Hovde’s NOI figure is understated because it includes $538 million of non-recurring impairment charges related to GGP’s bankruptcy filing.  On the other hand, we believe Pershing Square’s NOI number is too generous because it does not properly reduce recurring cash flow for the costs involved in luring new tenants to the properties.  We believe Pershing Square’s analysis of the company’s fundamentals is superior to Hovde’s, but we are more sympathetic to Hovde’s negative long-term view of the retailing and mall businesses and the consumer outlook.  We also note that REITs have traded historically at a 7.6 percent capitalization rate, and applying that rate to $2.29 billion of 2010 NOI at GGP gets us to a $12.50 stock price.  Pershing Square argues that the cap rate should be below 7 percent (implying a much higher valuation on the company) based on where the market is currently valuing Simon Properties (at a cap rate of about 6.6 percent), which it believes is the most appropriate comparable for GGP.  HCM would argue that Simon deserves a lower cap rate (higher valuation) than GGP because its properties are higher in quality by a number of important measures. 

We would also concede that a strong stock market, especially one driven by a belief in economic recovery, could lead GGP stock higher over the first half of 2010.  One thing is certain – Pershing Square and Hovde will continue to battle it out, and GGP will be a stock to watch in 2010.

Michael E. Lewitt

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