The US housing market played a fundamental role in the meltdown of the US and latterly the global economy in late 2008/early 2009, with the aftermath of high unemployment and massive government debt problems being sorely felt now. Whitney Tilson, managing partner of T2 Partners and Tilson Mutual Funds and editor-in-chief of Value Investor Insight recently gave Cayman’s investment professionals some food for thought, with his outlook for the US housing market and the economy for 2010 and beyond. Business Editor Lindsey Turnbull reports.
Cayman’s CFA Society members as well as the Cayman Chapter of AIMA gathered last month for a luncheon at The Marriot Resort at which guest speaker Whitney Tilson gave a presentation highlighting that while he believes the worst of the recession is over in the US, there would still be what he termed “headwinds” that could threaten to derail recovery at least in part.
“The US debt problem is now running at around US$70 trillion,” Tilson said, “and the US housing market debt accounts for about US$12 trillion, so it plays an enormous part in the overall debt problem.”
The good news, according to Tilson, was that the US government managed to avert an all-out meltdown of the economy with its huge injections of cash into the markets, however he said the most likely outcome of this recession would be more of a “muddling through” by the US economy, rather than a V shaped recovery as some would hope.
Background to the housing crisis
In 2003 there was a surge in the number of mortgages written in the US, Tilson said. Mortgages that had totalled around US$2 trillion suddenly leapt to around US$11 trillion with two thirds of all homes under a mortgage. As has been well documented, mortgages were recklessly written and then sold to institutional investors repackaged as RMBSs (residential mortgage-backed securities) and given triple A ratings by the ratings agencies that were paid big bucks to do so. Investors had no interest as to whether the home-owner could pay back their debt.
“A Doomsday machine was subsequently created.” Tilson said. As the housing bubble burst, so too did the home owners’ ability to pay their mortgage, particularly those who had been lent their mortgage at sub-prime rates because of poor credit histories.
“Around a half of all subprime loans defaulted,” Tilson confirmed.
At the same time that subprime loans were being churned out at a phenomenal rate, adjustable rate mortgages were also being written at a fast pace, with worrying consequences.
“Mortgage owners with ARMs were given the option to only pay interest up front and sometimes then not all of the interest required. The remaining interest would be added on to the balance of the outstanding loan. This was fine while house prices continued to increase; however, the minute the prices started to fall, homeowners found themselves in negative equity and in the same situation as the subprime debt owners,” Tilson explained.
Although Tilson thought the US had ploughed on through the subprime and ARM crisis (“the subprime train wreck is largely behind us” he said), a worrying trend that lagged these two types of mortgages was about to rear its ugly head within the US economy.
Alt A (Alternative A-paper) mortgages were also written during the boom years to those with a better credit rating than the subprime buyers.
“These loans were otherwise known as “liars’ loans” because prospective borrowers would rather pay an extra half a per cent to the lender rather than provide all the necessary documentation required to undertake the mortgage,” Tilson said.
Typically these loans were written with initial teaser rates that were lower than average to entice would-be borrowers. The rates would then be adjusted after a period of two or three years to reflect a higher interest rate.
“Such loans lag behind the subprime loans in terms of default because they are only now about to be readjusted,” Tilson confirmed. “If interest rates go up, which is predicted by the end of the year, we could see considerable default in these loans and they may well follow the same trajectory as the subprime loans. 20 per cent of Alt A loans are now in default and these figures are rising.”
The good news
Tilson pointed out three reasons why he believes the US would not see a repeat of the crisis brought about by the collapse of the subprime loans.
“The most likely Alt A loans to default were already in default prior to any reset so I don’t believe that the reset will cause any sudden surge in defaults,” he explained.
Secondly, interest rates were currently very low and would stay so for the foreseeable future. Thirdly the subprime crisis came about because the debts were repackaged and sold off to institutional investors as tradable instruments. These instruments were priced mark-to-market however those carrying the Alt A loans would be able to keep them on their books at par. The net effect of any losses would take many months to trickle through, Tilson believed.
“Market crashes do not come about by big losses; they come about by sudden losses that blow holes in the balance sheet without any way of making a profit to cover those unexpected losses,” Tilson added.
More good news?
Tilson spoke about US President Barack Obama’s ambitious loan modification plan to rescue the housing market, with the underlying conviction that restructuring distressed mortgages will keep struggling borrowers in their homes and help insert a floor beneath plummeting property values.
“There is currently tremendous pressure from the government to modify home loans,” he explained. “We may just be buying time to a certain extent [of which Tilson estimates there are about one million such mortgages] and simply staving off the inevitable calamity.”
A new normal
At the beginning of this century home owners who defaulted on just one mortgage payment were still very likely (85 per cent) to get back on track. Those who missed two payments were still more than likely (66 per cent) to get back to repaying while those who missed three payments were possibly likely (33 per cent) to begin repaying.
“If someone lost their job and was unable to repay for a month or two they’d be back in employment relatively quickly,” Tilson said.
Not so in 2010. One payment missed nowadays means that only 28 per cent would get back on track while out of those missing three mortgage payments only one per cent would restart payments.
“14 per cent of the 56 million mortgages currently in existence are currently in some kind of default,” Tilson warned. “That means that there are seven million bad mortgages in the States and there is still a huge inventory overhang.”
Unemployment: the figures
Although unemployment levels were at 10.2 per cent [at the time of writing] Tilson said that this figure was more likely to be around 17.3 per cent, taking into consideration those who lost their jobs and had given up looking (unemployment figures only include individuals who have looked for a job four times in one month).
“We need to create around 125,000 to 150,000 new jobs every month just to offset immigration and growth rates,” he said. The Wall Street Journal predicted it could take us until 2016 to get back to where we were pre-crisis,” he said.
Tilson said there is cause to believe in a cautious stabilisation of the housing market but that there was still room to fall.
“We are currently positioned in the valley of low resets, which helps to keep the rate of foreclosures at a steady pace. In the future this could well increase,” he said. “Banks are under enormous pressure not to foreclose on homes and thus the supply of homes has been artificially constricted, albeit possibly temporarily.”
Tilson also worried about the increase in house sales during the summer of 2009, which he attributed more to the cyclical nature of home buying (i.e. typically people purchase more property during the summer months than the winter).
“If you look at the summer data you would assume that the housing market was on an upturn, and that house prices were at their bottom,” he explained. “But the usual ups and downs of home buying need to be taken into consideration.”
Tilson also worried about the apparent lack of foresight by institutional investors ready to lend almost as freely as they did prior to the crisis.
“Small businesses still find it difficult to borrow from banks, which would rather sit on their capital earning a nice spread with treasuries; however, large institutional investors are happy to lend money without seemingly any lessons learned from the past,” he stated.
Where to invest?
All in all it is a time to be cautious, warned Tilson. His own investments centred on solid blue chip companies that might not make mega big profits in the short term but which would provide for steady growth amid the booms and busts of the stock market.
“We believe in not getting seduced by rallies and a get-rich-quick mentality. We don’t believe in running with the herd,” he said.
In particular his funds look to Berkshire Hathaway, a huge conglomerate owning a diverse range of businesses including insurance and reinsurance, with Warren Buffet at the helm as its Chairman and CEO.
“We own Berkshire Hathaway stock because we believe it is relatively cheap and about to be included in the S&P 500. We are very excited about this as investors.”