The complete reversal of last week’s phony breakout together with the poor fundamentals associated with the deteriorating credit climate and impact on the real economy have combined to set up a potentially serious market decline going far beyond what we have seen to date. The housing problem has now extended well beyond the subprime mess into higher quality mortgages, home equity loans, the overall availability of credit and a softening economy. What is so puzzling is the failure by the markets to anticipate what was so clearly evident for all to see if they weren’t so busily denying the facts that were staring them in the face. Even today we noticed on bubble TV an organized attempt to brush the current dip off as just another minor correction in an ever rising market, an effort aided by Treasury Secretary Paulson’s soothing reassurances that everything was OK. But then again, since the Secretary is also Chairman of the so-called Plunge Protection Team, he was just doing his job.
The main problem begins with the housing situation that continues to worsen with no end in sight. New single family house sales dropped another 6.6% in June and are down 21.4% over a year earlier. Median prices were down 1.3% for the month and 2.3% over a year ago. The level of sales is the lowest since June 2000 with the exception of March of this year. Inventories of new houses for sale amount to a bloated 7.8 months supply. June existing home sales were off 3.8% for the month and 14.2% for the year to the lowest level since November 2002. Median year-to-year prices were officially unchanged, but will have to come down to clear out inventories. Statements from home building company executives continue to paint an even bleaker picture of the situation than is shown by the numbers alone.
The immediate shock to the market was sparked by statements made by Angelo Mozilo, chairman and CEO of Countrywide Financial, the nation’s largest home lender. Mozilo said that he expects "increasing challenging" housing and mortgage markets and doesn’t expect a recovery until 2009. He referred to escalating late payments and defaults on subprime loans that are spreading to higher quality segments of the market. The company’s earnings decline reflects higher loan loss provisions and write-downs of securities backed by prime home equity loans. The problem, he stated, was largely related to "piggy-back" loans taken out by people who couldn’t afford a large down payment and took out a second loan to cover all or part of the purchase price. Obviously, with house prices falling lenders may not recover anything if purchasers default and the sale of the house doesn’t exceed the price of the 1st mortgage. Deteriorating quality of home equity loans were also noted by other lenders such as Citigroup, Bank of America and J.P. Morgan Chase.
The problems in the mortgage market have had a severe impact on the credit markets where the high-yield market has basically dried up. Wall Street underwriters have cancelled or postponed billions of dollars of loan deals including among others LBOs for GM’s Allison Division, the Cerberus buyout of Chrysler, an Expedia loan to buy back its shares and a loan for an LBO of U.S. Foodservice. Chad Leat, co-head of Global Credit Markets at Citigroup, referring to the high-yield market, said that "for all intents and purposes the markets are closed right now." Overall, companies are attempting to raise about $200 billion in the next few months, mostly for LBOs. However, the weakening demand for collateralized loan obligations (CLOs) is leading to far higher rates and more restrictive terms. Notably, CLOs have been the main buyers of LBO deals. A large number of the announced deals may still be done, but the underwriters will have to put up a lot of the cash. Already, Goldman Sachs, J.P. Morgan Chase have been forced to finance parts of at least five LBOs over the past few weeks. This is sure to dampen the number of future LBOs—and these have been a huge factor in driving stocks up over the past year.
Contrary to the denials of many economists and strategists, the housing mess is already having an impact on the real economy. This can readily be seen in the slowdown in freight, a key leading indicator. UPS reported that growth in revenue and delivery volumes continue to slow, and that for second straight quarter there was no growth in volume. Burlington Northern Sante Fe reported lower freight volume in the 2nd quarter, particularly in consumer products and construction materials. The railroad’s chief marketing officer said that, based on conversation with retailers, he wasn’t counting on a significant peak shipping season for holiday goods this year. Freight carriers stated that weaker consumer spending has prompted retailers and other customers to delay the start of the peak shipping season. Economic consultant Global Insight is estimating consumer spending growth at an annualized rate of 1.2% in the 2nd quarter vs. 4.2% in the 1st. Auto sales in June were down to 15.6 million units from 16.3 in May. AutoNation, the country’s largest car dealer, puts the blame on housing. The leading indicators for June were down from a year earlier, signaling a weaker economy or recession ahead.
In sum, with the technical situation in the market deteriorating, a housing bottom not in sight, the high-yield credit market in disarray and the economy slowing down, the conditions seem ripe for a major market decline ahead. Although every market downturn in the last four years has turned out to be a temporary dip, we think that it would be imprudent to assume that it will be the same this time around.
