Tuesday, December 7, 2010

Morning Note...

Futures ~1% higher this morning as Obama & the Democrats compromise on tax cuts and agree to extend the Bush-era cuts two more years to 2012.  Additionally, in M&A news in the natural gas sector, AGL Resources will acquire Nicor for $2.4 billion.  In other corporate news, Citigroup is ~3% higher pre-market as the government announced it sold its remaining $10.5 billion overhang in the company.  Asia was mostly higher overnight and Europe is ~2% higher as the tax cuts were announced at roughly 7pm EST last night.  Also, in Europe, EU finance ministers are due to officially vote for Ireland’s rescue package and they ruled out immediate aid for Portugal or Spain and refused to increase the current $750 million debt crisis fund.  Oil +130bps.  Gold +1%.  USD -60bps.  EUR/USD 1.34. 

Regarding the tax cut extension – which includes a few other sweeteners, by the way – MF Global had this summary:

Tax Deal Framework

What Happened:  The White House Office of Public Engagement held a conference call to discuss the tentative framework on the tax deal between the White House and Congress.

What This Means:  The “kitchen sink tax bill” now has structure and is nearing the finish line.  We stress that this is a framework and that nothing is set in stone.  We expect the bill to be sent to Obama’s desk by next Friday, December 17th.

We believe this framework represents the floor to the tax negotiations.  There is still plenty of room for more “sweetners” and many details remain for the negotiators (clean tech, ethanol, etc.). 

The one year Doc Fix is moving independently of this bill.  The $19.2 billion deal, expected to be brought to the Senate floor in the next 48 hours through a unanimous consent resolution, would be paid for by recovering a greater share of excessive subsidies expected to be paid to low-income people to buy health coverage beginning in 2014. The measure also contains a number of other Medicare provisions that would expire at the end of the year.

The Framework:

            2 year extension for all Bush Tax Cuts in 2001/3 bill (including cap gains and dividends);

13 months Unemployment Insurance Extension;

13 months 2% payroll tax holiday on employee side (i.e., reduce FICA from 7.65% to 4.65% up to FICA wage base cap of about $105K);

1 year for “traditional” extenders (Research and Development);

Other extenders TBD (including BABs and other provisions from ARRA, SBJA, HIRE, Energy, etc.);

2 years for individual-level refundables (EITC, CTC, AOTC);

2 year AMT patch;

2 years Lincoln-Kyl Estate Tax ($5/$10M exemption and 35% rate).

From a technical perspective, btw, breaking up through 1230-1235, the S&P appears set for a near-term pop to 1300 (the next level of resistance):
BofAMLCO trader commentary this morning:

Good Morning – The President has made his first move of many to the middle.  Bottom line he wants to keep his job, and will do everything to keep it.   His fold to the GOP on taxes is just the beginning of his campaign for 2012.  Markets reacting well to the news, making new year highs on its way to 1250.    Treasury out of Citi, it will trade an incredible number of shares today.   Ireland’s parliament to hold budget vote late this morning, it must be approved in order to receive aid.  Consumer Credit is out at 3 p.m. est.  I would like to see all the financials lead this tape higher.   Crude above 90.00, no one seems to care.   Inflation is real.  Keep buying the market there is no supply. 

TLB beats by 2c.  VE upgrade at JPHQ.  HWAY higher on earnings.  FSYS lowers guidance.  BofAMLCO ups SFD, TEL, WTW.  GSCO ups STP, TSL.  HSBC ups GFI.  MSCO ups RHT.  BofAMLCO cuts MWV, TIN.  BCAP cuts NRGY.  MSCO cuts FIRE.  WEFA cuts NBR. 

S&P 500 PreMarket 8:30am (last/% change prior close/volume): 
Today’s Trivia:  Name the world’s largest cocoa exporter.
Yesterday’s Question:  In pre-Bible days in ancient Rome, when a man testified in court, what did he swear on?

Yesterday's Answer:  When a man testified in court in ancient Rome, he swore on his testicles. 

Best Quotes:  Hedgeye…


"Everyone has a plan 'till they get punched in the mouth."
- Mike Tyson

There have been a lot of interesting Mike Tyson quotes over the years, some fit for print, others less so, but this one seems apropos for the times. The Fed tells us they have a plan, and they're implementing it. So far, the markets seem to like it. Let's see how their plan fares once they get punched in the mouth.

This summer we introduced our bearish thesis on housing with our 100-page report entitled: "How Low Will Housing Go in 2H10 and 2011". In that report we laid out our three separate home price models: our supply model, our demand model, and our combination supply & demand model. The output of those models forecast home price declines ranging from high single digits to 20%+ over the next 12-18 months. How have we fared so far? As the chart at the end of this note shows, the four major home price series that we track (Case-Shiller 20 City, Corelogic, FHFA, and Existing Home Sales Median Home Price) are all heading south. After peaking in the April/May timeframe on the strength of the tax credit, three out of four home price series are now solidly in negative year-over-year territory. The lone holdout, Case-Shiller, is a 3-month rolling average, which is why it lags the other series in reflecting the degree of slowdown. The next few months of Case-Shiller data will show a comparable negative trend.

For reference, the Corelogic series is the series now used by the Federal Reserve. How has the Fed's preferred series fared? According to Corelogic, home prices have rolled from being up +4.3% YoY in May 2010 to being down -2.8% YoY in September 2010, a negative -7.1% swing in four months. Looking month-over-month, the Corelogic series was down -1.8% sequentially in September (the most recent data available), which translates to the fastest rate of decline since February 2009.

The supply and demand imbalances were at the root of our housing call this past summer and nothing has changed on that front. The market is more dislocated today than it was when we made the call in the summer. At the time we made our call in June there were 3.99 million homes on the market for sale and existing home sales were running at a rate of 5.37 million, which equated to 8.9 months of supply. Today, there are 3.86 million home on the market for sale (October), while existing home sales are running at a rate of 4.43 million, which equates to 10.5 months of supply. Existing home inventory peaked at 12.5 months of supply in July. Based on our conclusion that home prices take one year to fully respond to supply and demand imbalances, we would expect to see July 2011 be the low watermark for year-over-year price trends in housing. The more important takeaway, however, is that between now and July 2011 the trends should continue to get worse. While it is possible that the market's "bad news is good news" mentality will persist and ongoing weakening in home prices will simply translate into greater and greater expectations for further quantitative easing, we continue to think that bad news is simply bad.

Another point to consider is the impact QE2 is having on the housing market. While recent demand statistics have been modestly upbeat (i.e. October pending home sales up 10.4% month-over-month), the reality is that mortgage rates have backed up sharply in November. The Bankrate 30-year conforming mortgage index has ballooned from 4.20% a month ago to 4.70% yesterday. For reference, a 50 bp backup in 30-year rates has a 5% negative effect on affordability.

It's also worth pointing out that no amount of stimulus or quantitative easing seems to increase banks' willingness to underwrite residential mortgage loans. In the most recent Senior Loan Officer Survey released November 8, the net percentage of lenders tightening access to prime mortgage credit rose to +9.3% from -5.5% quarter over quarter meaning that the average American is now finding it more difficult to get a mortgage than they were over the summer. The trend was similar for access to nontraditional mortgage credit: +9.5% of respondents reported tightening standards, up from +4.5% last quarter. This isn't helped by the fact that banks are currently engaged in trench warfare with Fannie & Freddie as well as the entire private-label MBS universe over mortgage putbacks. Further, there are 8.5 million borrowers who have either been foreclosed or are currently non-performing on their loan. This is a large slice of the overall homeownership pie that has been semi-permanently eliminated from the buyer pool (7 years for most lenders to look past a mortgage default). All of this has cast a pall over banks' willingness to underwrite new mortgages.

Many investors forget just how slippery the slope of negative home prices can be. Falling prices don't happen in a vacuum: they have two insidious offshoots. First, they generate a tangible negative wealth effect. For reference, for all the excitement resulting from the upward move in equities recently, consider that as a rough rule of thumb, every 100 points of upside in the S&P is roughly equivalent to a 5-6% rise in home prices based on there being total direct equity wealth of $10.8 trillion and total residential housing wealth of $17.1 trillion. That said, the wealth associated with housing is much more broadly felt as 65% of American families are homeowners, a far higher proportion than those with material equity wealth. Second, negative home price trends increase pools of underwater borrowers. We have shown that there are presently 11.3 million borrowers (20% of all borrowers) who are underwater. 4.9 million of whom are underwater by more than 25%. A 20% decline in home prices from here would increase those who are underwater to 21.9 million (46% of all borrowers) and those underwater by 25% or more would rise to 9.4 million (20% of all borrowers). Laurie Goodman, a Senior Managing Director with Amherst Securities, one of the leading providers of mortgage data analytics, has shown that loans with LTVs greater than 120% are currently defaulting at an annualized rate of 19.1%, while those with LTVs between 100-120% are defaulting at an annualized rate of 11.3%. Those are scary statistics when one considers that there could be 22 million borrowers in a negative equity position with a 20% drop in home prices from here.

The real question is, what will a 20% drop in home prices feel like for the markets and for the consumer? Our guess is that it will feel a lot like getting punched in the face by Mike Tyson.

Josh Steiner
Managing Director