End of a Mania

(September 2007, Canadian MoneySaver)

by Wynn Quon

Whenever a bubble bursts, one inevitably hears the curious opinion that no-one saw it coming. The collapse of the U.S. real estate bubble is no exception to this rule. As subprime mortgage borrowers lose their homes (over 573,000 foreclosures so far in the U.S in the first six months of this year) and mortgage companies go bankrupt, it is certain that many a banker, a homeowner or a hedge fund manager will stoutly claim that no-one could have predicted how badly things would turn out. But as in all bubbles, the warning signs were in plain sight.

Let’s go back a few years. From 2003 to 2006, the U.S. mortgage industry came up with the following innovations: (this list courtesy of Steven Pearlstein at the Washington Post)

- The "option ARM" loan, in which the borrower can pay less than the agreed-upon interest and principal payment, the shortfall being added to the outstanding balance of the loan.

- The "piggyback loan," in which a combination of a first and second mortgage allows the borrower to buy a house without a down payment.

- The "teaser loan," which gives the borrower an artificially low initial interest rate, which is then ratcheted up to a considerably higher rate after two years.

- The "stretch loan," in which the borrower has to commit more than 50 percent of gross income to make the monthly payments.

- The "liar loan," in which the borrower is asked merely to state his annual income, without presenting any documentation.

- And last but not least the “Ninja” loan for those with No Income, No Job and no assets.

Innovation is generally a good thing except in finance where a new twist inevitably turns into a hangman’s noose. But hey, everyone knows that real-estate prices will grow at 20% per year forever. So why be the one left out? If your income is only $35,000, why should you be prevented from taking out a $300,000 mortgage? (see Fig. 1) Does this pitch sound familiar? It’s the same “borrow and buy” tune that lured dot-com investors to a less than happy fate: Except that the real-estate bubble makes the dot-com mania look like a small-town flea auction. Across America the blinded masses of the middle class made their starting bets at $300,000 and $400,000, something that few dared to contemplate during the glory years of the Internet boom.

The trillion-dollar noose has tightened in short order around the necks of both borrower and lender. Wall Street syndicates had repackaged dubious home mortgages and resold them to hedge funds, pension funds and private investors all around the world. And now as homeowners default on their loans we’re seeing massive asset writedowns. American Home Mortgage, the tenth largest mortgage lender in the U.S. filed for bankruptcy in August, laying off six thousand people. A dozen hedge funds have already blown up obliterating billions in paper wealth with more casualties to come. Because these mortgage securities are not regulated or tracked, I expect that even some money market funds (which have typically been viewed as conservative investments) may be affected. We tagged Countrywide Financial in last October’s column (when things were quiet) as a company living on borrowed time. What a difference a few months make. This mortgage company has gone from relative obscurity to international notoriety – the poster child for lending lunacy.

The question everyone’s asking is whether the turmoil will lead to recession. Optimists point to robust GNP growth in the U.S. and the historically low level of unemployment. What they’re missing is that it is not only mortgage debt that is out of control. As of June 2007, consumer credit stood at US$2.5 trillion, an all time high. On the New York Stock Exchange, margin debt, the amount of money investors have borrowed to buy stock stands at US$378 billion. (Amazingly this is 35% higher than in March 2000 just before the dot-com crash). The huge amounts of debt in the system means we’re not going to get off easy. The mortgage crisis will likely trigger a sharp drop in the housing market. As house values plunge, borrowers will try to raise money by selling their stocks and slashing their spending. The fall in stock prices will set off a slew of margin calls, causing yet more forced selling of stocks. The vicious circle will trigger a significant economic downturn. If we were not so debt-ridden the crisis could be taken in stride but this time the dominos are standing too close together.

As far as the stock market is concerned, I expect financial stocks to be hard hit. The uncertainty surrounding mortgage securities puts every financial institution under suspicion. Interbank loans are now much more difficult to secure and the drying up of liquidity is forcing mortgage companies in the U.S. to close their doors. But this is just a prelude. Practically all stock sectors will be affected with one exception: If the credit crunch gets a lot worse, expect gold stocks to outperform as investors rush to tangible assets. This sector may be the only one to shine as stock prices drop anywhere from 30-70%.

Hopefully, MoneySaver readers have been taking time to reduce their own debt levels and exposure over the past few years. The North American investor has not seen or experienced a severe recession in over twenty years and it behooves everyone to ensure that prudence remains front and center in their finances. The disassembling of overextended debtors and the resulting repricing of assets can proceed at a terrifying pace.

Portfolio Update – The Great Sell-Off

We’re going to do something unprecedented with our long-running Tech Portfolio but before talking about that, let’s see what’s happened since our last update in June 2006.

We had bought Bausch & Lomb in May 2006 (see CMS June 2006) when it ran into some temporary quality control trouble last year. But we weren’t the only ones who had an eye on the company. This May, the company was bought out by Warburg Pincus for US$65, netting a 47% gain for us.

In the same month we put Telik, a biotech company on the Loser List, citing its huge US$1 billion market capitalization which was based on an unproven pharmaceutical. The verdict was not long in coming. In December of last year the FDA announced that Telik’s cancer drug was ineffective. It later emerged that instead of helping patients, it hastened their deaths. The stock price tanked 70% in a single day. Thus the prescription for investment success: never pay full price for a half-baked idea.

Cisco has been one of the few tech stalwarts that have announced solid results recently. It has moved solidly up to US$31.

So now that we’re caught up, I’d like to make a special comment. Our technology portfolio has been running for almost ten years now. We went through the biggest technology boom in history, and we held a ringside seat on the most amazing wave of innovation of any century. We also went through the subsequent bust-up that saw good tech stocks fall to a fraction of their real values. Throughout we’ve managed to reap profits and while we haven’t been able to avoid losses, the former have thankfully outweighed the latter.

But now I believe that we’re approaching a watershed moment in stock market and economic history. I think we’re at a point where the unfortunate financial excesses of the last decade have come to a head. As a result, financial assets and especially non-dividend paying stocks are going to face tremendous headwinds. Looking at our portfolio today and also the broader tech sector I do not see many technology stocks outperforming a good old-fashioned GIC in the next few years. We’re going to sell off all our tech holdings. The upside of a potential recovery from the financial crisis doesn’t compare to the downside of what will be coming. I believe there will be substantial bargains in the years ahead (and we will be making those choices when the time comes) though this may be scant consolation in a ruined financial landscape.

All prices market close Aug 10, 2007 in US$ unless indicated

The Long List

TXN Texas Instruments....bought at $16.68 Nov-97. Current: $33.09. Gain: 98.38%

ADI Analog Devices.........bought at $11.65 Oct97/Sep98. Current: $37.72 Gain: 223.78%

NT Nortel Networks .......bought at $40.00 Oct97/Jun02/Oct02. Current: $18.90 Loss -52.75%

CSCO Cisco Systems .....bought at $14.88 Sep-01 Current: $31.39 Gain: 110.95%

GLW Corning Inc ...........bought at $4.56 Sep01/Jun02/Oct02 Current: $23.45. Gain: 414.25%

SYMC Symantec Corp. ..bought at $16.90 Dec-01. Current: $17.87. Gain: 5.74%

PALM Palm Inc.............. bought at $6.90 Oct-02. Current: $14.74 Gain:113.621%

Bausch & Lomb.............. bought at $43.97 May-06 Current: $65.00 Gain: 47.83%

e-mail: Wynn Quon, Chief Technology Analyst at Legado Associates, wynn_quon@hotmail.com