Friday, March 07, 2008

About that Recession....

The employment report today provides a splash of cold water on those, like me, who believe that the economy will avoid recession. This is the second consecutive month of job losses and we have never experienced that without a recession. The losses were small - 85,000 jobs total over two months - but it is two consecutive declines. Of course, in the last recession we were shedding jobs at the rate of 200,000 per month at the bottom, so if this is going to be worse - and many say it will - we've got a long way to go.

The Fed announced new additions to the liquidity pool this morning. The TAF auctions will be raised to $50 billion - there are two scheduled for March - and they'll make another $100 billion available through weekly repurchase agreements. The repurchase agreements are arguably more important right now as they will accept mortgage backed paper for the repos. The implosion of the mortgage market this week obviously got the Fed's attention.

Stocks had another tough day as no one apparently wants to be long over the weekend. Who knows what hedge fund or bank will announce bad news before the opening bell Monday? It does seem that sellers are starting to get exhausted though. The market action seems lethargic; there's been no panic selling climax, just a steady drip of sell orders.

I'm not sure where this ends. This week is the first time since this started last July that I really felt worried. The selling in the muni market last week and the AAA mortgage market this week is really worrisome. These securities are not sub prime - Fannie Mae and Freddie Mac are AAA - and if investors are unwilling to hold these, then Houston we have a problem. The banks that lend to hedge funds and mortgage REITs through repos are demanding more collateral which leads to selling which leads to demands for more collateral. If this continues we have to consider the possibility of Fannie Mae and Freddie Mac going under. If that happens we will finally find out if the US government will really guarantee this agency paper. Given a choice between economic collapse and adding to the national debt, I think we can all rest assured that politicians will be falling all over themselves to spend our tax dollars bailing out FNM and FRE.

Making money as an investor requires that one be optimitic when everyone else is pessimistic. You have to be a buyer when everyone else is a seller and vice versa. It is hard to do when it seems that there is no end to the bad economic news but I guarantee you that the bad news will end. And when it does, those who have been able to preserve capital will be the winners. We have performed much better than the stock market because of our exposure to commodities and bonds, so I expect to be in that group, but to paraphrase Thomas Paine, "These are the times that try investor's patience".

It is always tough to see past the valley when the economy is not clicking on all cylinders, but every recession in history has been followed by an expansion. During times like this, I spend my time picking through the debris of the previous boom to see if any bargains exist. Obviously, that has led me into the real estate related securities and this week I spent considerable time working on the mortgage reits. My interest was spurred by the Carlyle Capital and Thornburg blow ups. Both of these entities had relatively good mortgages in their portfolios; that wasn't the problem. The problem was leverage. Carlyle was leveraged 32 to 1 and Thornburg was about 15 to 1. As the value of their mortgages fell their banks demanded more collateral and in both cases, it appears they have been unable to come up with the money.

These failures drove down the price of all mortgage backed securities, including agency paper. Obviously, the market is anticipating that the two portfolios will be liquidated and the lower prices put pressure on all the mortgage reits. Mortgage reits with more reasonable levels of leverage saw their stock prices get hammered over the last two days. Are there opportunities here? I suspect there are and what I learned this week about these companies was very enlightening.

First of all, there is no guarantee that the portfolios will be liquidated. When E trade got in trouble last year, Citadel came along and bought the portfolio. And Citadel has been buying up smaller mortgage companies (they bought Res Mae and Sowood) so they would be a natural buyer of Thornburg. There have also been rumors that JPM and Citadel forced this issue with Thornburg so they could buy the assets on the cheap. I really don't buy that but it will be interesting to see if Citadel emerges as a white knight. The point is that those selling in anticipation of these portfolios being liquidated may be disappointed.

Second, most of the mortgage reits operate with a lot less leverage than these two. Analy, MFA and Anworth all have leverage ratios between 8 and 10 times. That is much easier to deal with and I wouldn't expect these companies to go Thornburg's way. But with all the Black Swans around these days, it can't be ruled out.

There is a reason that smart outfits like Citadel are getting in the mortgage business. With good credit and permanent financing, the mortgage business is very profitable. Using reasonable leverage, returns on equity in the mid teens and even in the twenties is pretty easy to obtain. And the balance sheets of these mortgage reits are not as bad as they appear. The accounting rules used to adjust the balance sheets of these companies has produced some weird results. I am not done with my analysis yet, but I expect to see some major changes in the balance sheets of these companies when this crisis finally passes. I'll be posting on these balance sheet issues when I finish and fully understand the implications.

Here's a timely example of what I mean by balance sheet issues. Crystal River (CRZ) (I bought CRZ today for my personal portfolio) reported earnings today and the results were eye opening. CRZ stock is down from 29.48 last May to 10 now so they've had some problems. But does the stock price really reflect the reality of the situation? CRZ reported a loss of $10.10/share for the quarter and that sounds awful but the reality is somewhat different. Net Investment Income was $.80/share and operating income was $0.72/share. Everything else that contributes to the GAAP loss are balance sheet items that don't affect cash flow. Evidence of that is that CRZ declared a dividend today of $0.68/share. Of course, we don't know what will happen in the future; the dividend could be cut, but at least for now, this looks like a relatively healthy company with a balance sheet that is being whipsawed by the accounting rules.

I'm not nearly done with trying to figure out all the accounting rules that are affecting these companies but it appears there may be some major bargains. This is what every investor should be doing while we wait for the recovery. Every panic produces opportunity; you just have to find it.

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