Newsletter Q4 2006
October 15, 2006
Housing,
Mortgage Lending, and the Economy
More consumers are becoming financially
constrained due to higher housing costs. The US Census Bureau recently
released the results of a survey that indicated 35% of US homeowners with a
mortgage had housing costs (mortgage payments, taxes, insurance, and
utilities) that exceeded 30% of household income - the level that the
government says is excessive. This represents an 8% increase in households
from 1999. In California, the number is even higher - 48% of households
spent more than 30% of their income on housing.
In 2007, approximately $1 trillion in
adjustable rate mortgages (ARMs) will reset at higher interest rates.
Although the expected additional interest expense of $24 billion represents
only 0.3% of US consumer spending, the increase is relatively large for
those households that are affected. Goldman Sachs chief economist Jan
Hatzius says the payment shock may be nearly 10% of consumption for the
affected households and “large enough to cause increases in mortgage
delinquencies and foreclosures for households unable to refinance.”
Lon Witter, Partner at Witter & Westlake
Investments, questions the earnings quality of financial institutions with
significant holdings of options ARMs, which allow borrowers to choose how
much to pay. For example, Washington Mutual (WM) had $145.7 billion of home
loans at the end of 2005, $66.8 billion of which were option ARMs. As of
12/31/05, 55% of WM’s option ARMs were in negative amortization. At the end
of 2003, only 1% of their option ARMs were in negative amortization. When
loans are in negative amortization, the principal balance is increasing
because payments by borrowers are less than the interest being accrued by
lenders. Accounting standards allow lenders to include the full amount of
accrued interest on negative amortization loans to be included in reported
earnings, even though some of it has not been collected by the lenders.
The creative financing methods of recent
years have not gone unnoticed by federal regulators. Although they have
been slow to react, the Comptroller of the Currency, Office of Thrift
Supervision, Federal Reserve, and other federal regulators have jointly
issued guidance to all federally chartered lenders, effective October 1,
2006. The guidance has no specific penalties for noncompliance but the
regulators have told lenders that those who fail to follow the guidance will
be asked to take remedial action. The purpose of the guidance is to add
some discipline to the lending process and avoid qualifying people for homes
that they can’t afford. Particular aim is taken at option ARMs. Michael
Calhoun, President of the Center for Responsible Lending, commented: “Just
as the loosening of credit standards made the housing bubble go higher and
last longer, the tightening of standards is going to make it deflate further
and faster.”
Most economists do not expect any
significant impact on the economy from a declining housing market. The Blue
Chip Economic Indicators newsletter surveys 54 economists regarding their
expectations for economic growth in the US economy. In the most recent
survey, forecasters had reduced their estimates for GDP growth to annualized
rates of 2.3% and 2.4% for the third and fourth calendar quarters,
respectively. The consensus estimate for real GDP growth in 2007 is 2.6%.
Nouriel Roubini, Professor
of Economics at New York University, believes that the housing market will have
a more pronounced effect on the US economy than his peers. While real
residential investment fell at an annualized rate of 6.4% in the second quarter,
he is estimating that the contraction will accelerate to an annualized rate of
12-15% in the next several quarters and the effects of the housing sector will
be great enough to tip the US economy into recession in early 2007.
Roubini cites three reasons
for his recession forecast. First, the direct effect of reduced residential
investment on aggregate demand is likely to reduce GDP by 2%. Second, there has
been a strong link between rising housing wealth, home equity withdrawal, and
consumer spending. Residential real estate now represents 48.5% of household
wealth. In 2005, home equity withdrawal (loans based on higher equity values)
amounted to an estimated $800 billion, $300 billion of which was spent on
consumer goods and residential investment. Home equity withdrawals of the same
magnitude are now unlikely, given the absence of housing price appreciation and
higher debt service costs as adjustable rate mortgages reset at higher interest
rates. Third, the employment effects of housing are significant: up to 30% of
employment growth during the last three years was directly or indirectly
attributable to housing.
Roubini concludes “that
this is indeed the biggest housing slump in the last four or five decades: every
housing indicator is in free fall, including now housing prices. By itself,
this slump is enough to trigger a US recession: its effects on real residential
investment, wealth and consumption, and employment will be more severe than the
tech bust that triggered the 2001 recession.”
Additions
Companhia de Saneamento
Basico do Estado de Sao Paolo (SBS) is one of the largest water and sewage
service providers in the world. SBS serves 25.6 million customers throughout
the state of Sao Paulo, Brazil. SBS currently sells for 8.5X estimated 2006
earnings. The company does not have a regular dividend policy but 39.5% of 2005
earnings were paid out to shareholders as dividends.
U.S. Treasury bills were
purchased for many accounts during the quarter. The yield curve has been
inverted - yields are lower for longer maturities. Bond investors do not appear
to be very well compensated for holding longer term bonds and I have shortened
the average maturity of fixed income holdings within portfolios.
Updates
Methanex Corp. (MEOH)
should have windfall profits in the fourth quarter. MEOH has increased prices
by more than 60% since August because two major competitors shutdown plants and
were unable to meet contractual commitments to clients. MEOH estimates that
industry inventory levels are now at 1.5 million tons compared to normal
inventory levels of 3 million tons. A portion of industry production will now
go to rebuilding inventory levels and favorable pricing is expected to continue
into the first quarter of next year.
On October 11, Argentina
announced that it had extended its export duties on oil and natural gas to the
province of Tierra del Fuego, which had previously been exempt. Argentina
currently supplies about 60% of the natural gas for MEOH’s production facilities
in Chile. MEOH’s four suppliers in Argentina are contractually obligated to pay
the increased export duties. MEOH has been negotiating with suppliers and may
pay a portion of the export duties in return for being able to terminate the
contracts earlier and replace Argentine sources with Chilean gas supplies that
are in the process of development. The price of the stock has declined in
recent days as investors have been concerned about the ability of Argentine
suppliers to absorb losses from the higher export duties.
Aluminum Corp. of China
(ACH) has lowered alumina prices three times in two months as competitors in
China have increased production. The lower revenue and profits from alumina
sales will be mitigated to some extent by the Company’s increased downstream
production of aluminum. ACH has expanded aluminum production during the year
through acquisitions. Analysts have lowered 2007 estimates by 35% to $2.05
(adjusted for the 4:1 stock split on October 11). ACH announced an interim
dividend before the stock split of $2.37 per ADR, which should be paid on or
before October 31.
Sinovac Biotech Ltd. (SVA)
announced that the third product of the Company, seasonal influenza vaccine, was
approved for sale by the National Institute for the Control of Pharmaceutical
and Biological Products. Several customers immediately signed purchase orders.
The British medical
journal, The Lancet, also took notice of SVA’s progress in developing an
avian flu (H5N1) vaccine. Iain Stephenson, M.D. wrote about the findings of the
Chinese-British team in the first phase of clinical trials: “These findings
identify a potential dose-sparing approach that could be crucial for a global
supply of pandemic vaccine.”
Sonic Environmental
Solutions Inc. (SEVSF) announced that it will raise C$5 million or more through
a private placement offering. The proceeds will be used to finance equipment
purchases and meet self-insurance contractual provisions. Sonic’s PCB
remediation process continues to garner interest from prospective customers.
One of the Company’s main competitors, the Swan Hills incineration facility in
Alberta, charges twice as much per ton for soil remediation, excluding the cost
of transportation to their facility.
If you have any questions
regarding your accounts, please contact me.
Sincerely,
Robert G. Kahl
CFA, CPA, MBA
Sabino
Investment Management, L.L.C.