Quick Takes: UK Real Estate Update, Consumers Stall, Vista Anyone?

UK Real Estate Update
Real Estate issues are not only a prevalent issue in the U.S., home prices in the United Kingdom fell for the fourth straight month in February, dropping 0.5% from January. Mortgage approval rates remain at the lowest level in nine years as recent rate cuts have not been passed along to mortgage consumers; factors that are likely to cause the continued decline of the housing market.

Similar to the U.S., the U.K. housing boom “powered consumer spending over the past decade”; the decline in real estate prices is likely to cause further consumer economic fallout.

U.K. House Prices Fall in Worst Streak Since 2000

Consumer Spending Stalls
The stall in consumer spending is a likely sign that a recession is in the outlook. Consumer spending accounts for over two-thirds of the economy in the U.S.; the second month of a flat reading is not a positive sign.

Consumer spending stalls in January
Data seen raising new concerns about a possible recession
http://www.msnbc.msn.com/id/23406764/

Who wants this Operating System?

Microsoft plans to cut prices of its Windows Vista operating system with the Service Pack 1 release. Vista has not been well received and still accounts for less than 10% of the installed Windows operating systems. Similar to many others, after experiencing Vista on a PC purchased for my family – my first step was to install Windows XP.

Fortunately, Microsoft will continue to sell Windows XP until June 2008, delaying a forced transition to Vista. Despite hyping the figure of 100 million licenses sold of Vista (many of them uninstalled), and pointing to the strong earnings component related to these sales (many charged for and not used on new pre-purchased systems) – analysts need to start questioning the actual relevance of Vista and if Microsoft will take the necessary measures beyond a price reduction to improve actual uptake.

Microsoft cuts Vista prices to urge upgrades

Another Rogue Trader: Where is the risk control?

A trader at MF Global caused $142M in losses on “unauthorized wheat trades”. Once again the market is faced with a situation that leaves the majority of the population wondering if any of these firms have even basic risk control measures in place.

Most decent programmers could implement an algorithm that defines financial limits for each individual trader within a firm in less than two days. Creating a financial control system that can not be bypassed is not rocket science. The only conclusion we can be left with is that the majority of these firms actively support traders in pursuing their greed….until they blow up. At this point they become “rogue traders” and their positions “unauthorized”.

Trader at MF Global Rang Up $142M Loss
Rogue Trader at MF Global Rang Up About $142 Million in Losses on Unauthorized Wheat Trades
http://biz.yahoo.com/ap/080228/mf_global_loss.html?.v=4

‘It discovered Evan Dooley, a trader at the company's Memphis, Tenn., branch, trading wheat contracts in amounts that exceeded how much he was allowed to trade.’

He bought as many as 15,000 wheat futures, the equivalent of about 10 percent of the market for these contracts for any given month. In any type of functioning risk control environment this type of order should set alarm bells ringing very quickly. The concept that MF Global only discovered the trades early Wednesday morning and then ran up the losses as it desperately unwound the positions, should make everyone question if the situation is "a mere aberration in our risk control" or a more systemic institutional problem.

Do Mutual Fund outflows spell the market bottom?

Many times ordinary investors are the last to jump on the bandwagon… this is why Wall Street refers to them as “the herd”. Usually these investors are the last to the door after all the professionals and active investors have already established positions.

Mutual Funds are a good representative vehicle of this unsophisticated investor population. The outflows from U.S. equity Mutual Funds in January appear to demonstrate that these investors panicked and headed for the exit door. Over $432.9 billlion was pulled out of equity funds in January, the worst month of outflows since July 2002. In 2002, this month basically marked the bottom of the market with the S&P at 797.70 on July 23, 2002. These lows were re-tested in October of 2002, before the market took off in 2003.

This leads to the question if this behavior once again acts as a signal of a market bottom… or if this is just the start of a severe redemption cycle leading to “cardiac arrest” for the stock market.
Mutual funds markets face long-term outflows

Just how bad is the situation with local banks?

Well bad enough that the FDIC is adding jobs to prepare for the upcoming crisis. The FDIC is bringing back 25 hired veterans to deal with the situation and hiring additional full time & contract staff. Some are describing the upcoming problem as a calamity that will exceed the scope of the S&L crisis during the late 1980s.

‘Regulators are bracing for well over 100 bank failures in the next 12 to 24 months, with concentrations in Rust Belt states like Michigan and Ohio, and the states that are suffering severe housing-market problems like California, Florida, and Georgia," said Jaret Seiberg, Washington policy analyst for financial-services firm Stanford Group.’

An earlier HingeFire article touched on the subject of shorting local banks. When agencies are gearing up to deal with a developing crisis; this advice appears to be even more pertinent.

An evaluation shows that the bulk of financial weak banks that are publicly-held are located in California. Despite the large population of the state, the ratio of troubled banks within California still stands out as a warning sign for depositors. Other states with significant housing problems such as Florida, Arizona, Ohio and Nevada appear to have much smaller financial exposure in the banking sector relative to the size of their state populations.

The publicly-traded troubled institutions in California with safety ratings of “D” or below include:

• Friendly Hills Bank (FHLB.OB)
• Fresno First Bank (FSNF.OB)
• Folsom Lake Bank (FOLB.OB)
• Fremont General Corporation (FMT)
• Focus Business Bank (FCSB.OB)
• Discovery Bancorp (DVBC.OB)
• Desert Commercial Bank (DCBC.OB)
• Coronado First Bank (CDFB.OB)
• Cornerstone Commercial Bank (CRSB.OB)
• Commerce Bank Folsom (CBFM.OB)
• Bank of Santa Clarita (BSCA.OB)
• Charter Oak Bank (CHOB.OB)
• Bank of Napa (BNNP.OB)
• Atlantic Pacific Bank (APFB.OB)
• Americas United Bank (AUNB.OB)

Florida and Arizona merely have three or less publicly held local banks each with low financial strength ratings. In Florida, the Marco Community Bank (MCBN.OB) and Old Harbor Bank (OHBK.OB) make the list. Likewise in Arizona, the Gold Canyon Bank (GCYO.OB) is an example of an institution with a low financial strength rating.

California stands as an example of the state with an oversized list of publicly traded local banks which have low financial strength rates. This concentration of questionable institutions in a single state, where a large amount of lending has been provided to real estate developers, likely means that a good number of these banks will face liquidity troubles over the coming year as these commercial loans go sour.

Most of these banks are thinly traded on the OTC and putting on a short position may be difficult to implement without excessive slippage in the transaction. The other difficulty is that the majority of these banks have already dropped significantly in price over the past year, in many cases leaving little possible further profit for short-sellers. The most liquid stock, Fremont General (FMT) has already dropped from over $13 to near $2; this bank holding company is already buried in debt downgrades, regulatory troubles, and non-performing sub-prime loans.

Will all of these banks fail – probably not. However in the current economic and credit crimped environment, the risk is leaning in that direction. In California’s Silicon Valley stock option rich environment, executives like to talk about how they “think outside the box”. Looking at the list of financially weak “at risk” institutions in the state, you have to wonder if the entire banking system within California “thinks outside the box”.

California has already been properly depicted as “ground zero” for the subprime crisis. The state was home to dozens of subprime mortgage lenders that imploded; many which appeared to have lax oversight from the state in their greed-driven business. Should there be any expectation that the banks are in any better shape?

At minimum the list above should serve as a warning to depositors that have money at any of these institutions. As outlined in Bank Safety matters more now than ever, paying attention to the financial rating of the institution where you do your standard banking is more important now than any other time in the past years.

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Black-Scholes: Is it simply wrong?

The Black-Scholes pricing model has already been battered by corporations that state the model does not properly reflect the pricing of employee stock options. The gripes of many technology companies include the realities that these employee options are not liquid, have long vesting periods, are lost when an employee leaves the firm, and other factors making the value derived by Black-Scholes absolutely inaccurate. This naturally leads to further imprecision and financial engineering in corporate filings – which does not benefit shareholders.

Now Black-Scholes is under attack from another front – the mainstream financial community. Most traders have ignored the Black-Scholes model for years; finding it next to useless in a fast-paced financial marketplace. However the model is still ingrained in the minds of pension administrators, hedge funds manager, and other institutional executives. There is growing evidence that the model is simply wrong, the most significant problem being that Black-Scholes was never designed for any type of extreme market situation.

Is it time to retract the Nobel Prize awarded to Myron Scholes and Robert Merton for their work in creating the model? Nassim Nicholas Taleb, the author of The Black Swan and Fooled by Randomness appears to believe so. Most of Wall Street is not ready to take this extreme leap however. Many are simply hoping for an updated model that can properly reflect risk.

The current Black-Scholes model views that a multi-sigma event will only occur once every million years, in reality market extremes are much more common. With events that can easily wipe out most risk models occurring regularly within eighteen year periods it is clear that Black-Scholes and other models are broken.

The recent sub-prime crisis should serve as an example to the financial community why proper modeling is needed; rather than greed-driven models focused on putting the largest profits into the pockets of Wall Street firms in the shortest possible time period. While a homeowner who lost their home may not understand the modeling of a credit crisis, Wall Street financial engineers should have an understanding of the obvious risks in their products before billions of dollars are taken as losses.

The panic of October, 1987 should have called the relevance of Black-Scholes into question. A model does not work when investors attempt to sell and nobody will buy. When liquidity is lost, most currently utilized models are worthless. Still the Wall Street community clung to the Black-Scholes model.

Most alarming, if Black-Scholes does not properly model options then trillions of dollars' worth of securities have been priced over the past years without regard to the possibility of multi-sigma events in the markets.

More press is regularly appearing in mainstream financial journals questioning the Black-Scholes model; the detractors will no longer be mute. This trickle is likely to become a roar as Wall Street firms continue to take losses over the coming year which reflects their inability to correctly model risk. At some point, Black-Scholes will be relegated to the financial bit-bucket of the modeling past… only leaving the question if will it occur soon enough to avoid additional pain.

Inside Wall Street’s Black Hole

Quick Takes: Home Prices drop 8.9% in 3 months

The housing bubble has firmly imploded... despite nearly 50% of Americans still believing that their home has not gone down in value. The downward spiral will continue during 2008. This period will be listed as the most catastrophic housing decline in American history, likely exceeding the period of the Great Depression. This has been the first time that the entire nation has experienced a real estate bubble. All speculative bubble events eventually end in a similar painful manner, whether it be with tulips, stocks, precious metals, or homes.

"U.S. home prices lost 8.9 percent in the final quarter of 2007, Standard & Poor's said Tuesday, marking a full year of declining values and the steepest drop in the 20-year history of its housing index."

http://news.yahoo.com/s/ap/20080226/ap_on_bi_ge/home_prices

Two New India ETFs

Two new India-focused ETFs have come to market. The WisdomTree India Earnings Fund (EPI) began trading last Friday with over one million shares in volume the first day. The PowerShares India Portfolio (PIN) is expected to launch tomorrow.

Including about 150 stocks, the WisdomTree India Earnings Index has a dividend yield of 1.24% and a PE ratio of 13.99. The top five companies represented in the ETF are Reliance Industries Ltd. (13.35%), Oil and Natural Gas Corp. Ltd. (6.27%), Infosys Technologies Ltd. (INFY) (5.78%), Bharti Airtel Ltd. (3.93%) and ICICI Bank Ltd. (IBN) (3.32%). Energy is the largest sector in the index at 24.88%.

The 0.88% expense ratio of the Wisdom Tree ETF (EPI) is cheaper than equivalent closed ended funds such the Blackstone India Fund (IFN) with a 1.23% expense ratio or Morgan Stanley’s India Investment Fund (IIF) with a 1.30% fee.

Investors should avoid the iPath MSCI India ETN (INP) whose issuance remains suspended due to problems with India's foreign capital restrictions. The new ETF products have been designed to meet these requirements and avoid the type of trouble experienced with the iPath MSCI India ETN.

A whitepaper from WisdomTree about the EPI Exchange Traded Fund outlines this new product in more detail.

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Bankrupt Cities, Muni failures, and CDS stress

Earlier commentary (see Will State SIV Funds bankrupt local communities?) discussed the stress that rising retirement costs, increasing payroll, and poor investments were placing on local governments. Recent headlines demonstrate this trend including the California city mulls filing for bankruptcy press and similar commentary from communities in Florida. ‘"As of April, we will not have the money to pay employees," Vallejo Councilwoman Stephanie Gomes said in a telephone interview. "It's just projected to get worse and worse.’ This situation is likely to become commonplace in 2008.

Many of these local governments have outstanding municipal bonds. In December the outlook for the muni bond market was discussed (see The Muni Bond dilemma). While a number of financial industry pundits claimed that the muni-bond sector would recover in 2008; the unfortunate reality is that the outlook over the upcoming months is bleak.

The failure in the past two weeks of the muni auction rate market simply underlines the calamity. Morgan Stanley announced the failure to auction the preferred shares for its closed end funds. Many other financial institutions were in a similar position this past week. This will all circle around as higher interest rates for communities as local governments are forced to pay default penalty rates on their muni bonds leading to further financial stress.

Adding to the credit concerns, Bill Gross of Pimco outlined this week that the CDS market is a huge systemic risk. "The conduits that hold CDS contracts are, in effect, non-regulated banks," says Mr Gross. "[There are] no requirements to hold reserves against a significant 'black swan' run that might break them." There is significant risk that counter parties will not be able to pay their obligations if the system breaks down, and the cracks are starting to show. The term “default shock” in now regularly used when discussing this $45 trillion market. ‘Credit default swaps are bigger than the US government bond and housing markets combined.’ Many skeptics view that this non-liquid market is primed for disaster as bond defaults approach historical means with minimum losses of $250 billion expected over the upcoming year.

The credit crisis has clearly spread beyond subprime; the contagion to muni-bonds, commercial CDS, and other sectors is not welcome news for investors. Systemic failure in any of these markets is likely to take down retirement plans and other major institutional holders leaving main street America effectively holding the bag. Investors should take a close look at their fixed rate investments and carefully evaluate their risk of structural failure. Common investments such as fixed rate annuities and other vehicles often hold CDS and other at risk instruments.

Similarly this is a time to cast a wary eye on the Muni Bond market despite the hype from firms that focus on selling these instruments. Investors should avoid pouring new money into muni bond funds or directly purchasing these bonds. Yield-focused investors should be concerned with the structural problems in the auction rate muni market, the failure of insurers, and local government fallout. These problems need to be resolved before the muni sector can be considered safe or viable.