Financial Review

Jitters

Sinclair Noe — April 5, 2017

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DOW – 41 = 20,648
SPX – 7 = 2352
NAS – 34 = 5864
RUT – 16 = 1352
10 Y + .01 = 2.36%
OIL – .21 = 50.82
GOLD – .30 = 1256.40

Stocks started the session strong. The Dow was up triple digits early on the strength of the ADP jobs report, but sellers stepped in following the release of the minutes from the last Federal Reserve policy meeting. The Nasdaq composite slipped 0.6 percent after hitting a new all-time high earlier in the session. The Dow and S&P also posted their biggest one-day reversal since February 2016.

The first two months of 2017 saw strong job gains – 238,000 new jobs in January, followed by 235,000 new jobs in February; part of a 7-year string of steady job growth that has seen the unemployment rate drop to 4.7%.

The feeling is that the economy will not continue with the gains we saw in January and February. Most analysts say the March jobs report, due on Friday, will only show about 175,000 new jobs – good, not great.  We might need to adjust those estimates. Private payroll processor ADP reports their survey shows 263,000 new private sector jobs were added in March.

The ADP report doesn’t always match the Labor Department’s report, but they are usually not too far apart. ADP reports consumer dependent industries including healthcare, leisure and hospitality, and trade had strong growth during the month. The biggest gains by industry in March came from the professional and business services sector, which added 57,000 jobs, followed by leisure and hospitality, and construction.

The Institute for Supply Management’s non-manufacturing purchasing manager’s index slowed to 55.2, lower than the forecast for 57. Readings above 50 indicate that there’s still expansion. It is not necessarily that the services side of the economy has cooled, as it just wasn’t running red-hot.

Meanwhile, Markit Economics reported the slowest growth of the US service sector in six months in March. The firm’s PMI, was 52.8, lower than the expectation for 53.1.

Also today, we saw the minutes of the Federal Reserve’s FOMC meeting in March. Policymakers struggled to come to grips with two big uncertainties facing the U.S. economy — whether it would be safe to let inflation rise faster for a while and how to assess the impact of President Trump’s economic stimulus plans.

There was near-unanimous support for the quarter-point increase in the fed funds rate, the second rate hike in three months. There was less agreement over the issues of inflation and Trump’s economic plans. The minutes also showed that Fed officials had a briefing from staff over the central bank’s massive balance sheet, which was quadrupled during the financial crisis.

The Fed has been keeping the level of the balance sheet steady at $4.5 trillion. But financial markets have been closely watching for any Fed signal on the timing of when the Fed would begin reducing the level of its bond holdings by halting its current practice of replacing any maturing bonds.

The minutes indicated that this change could be announced later this year. Unwinding the balance sheet is significant both because of its sheer size and the impact it could have on markets, as Fed members including Chair Janet Yellen have indicated that the move itself would amount to a rate hike.

The minutes also showed policymakers were concerned about stock market valuations, stating: “Some participants viewed equity prices as quite high relative to standard valuation measures.”

If jobs numbers continue to come in strong, the Fed may have more confidence in raising rates at a faster pace, regardless of market valuations. Currently, the market is pricing in two more rate increases this year, in line with the Fed’s so-called dot plot, which charts officials’ expectations for future rate increases.

The minutes showed that several Fed officials believed that Trump’s stimulus plans would likely not begin until next year. The minutes said that because of the “substantial uncertainties” about the outlines of the program that will eventually emerge from Congress, about half of the Fed officials had not included any assumptions about Trump’s efforts in their economic forecasts.

The possibility of tax reform has been one of the main drivers in the stock market’s massive post-election rally, along with deregulation and infrastructure spending. Today, House Speaker Paul Ryan said that tax reform will take longer to accomplish than repealing and replacing Obamacare would, saying Congress and the White House were initially closer to an agreement on healthcare legislation than on tax policy.

Ryan said: “The House has a (tax reform) plan but the Senate doesn’t quite have one yet. They’re working on one. The White House hasn’t nailed it down.  So even the three entities aren’t on the same page yet on tax reform.”

Yesterday, the Trump administration was testing two tax proposals: a value-added tax and a carbon tax. Those trial balloons were shot down. Neither a VAT or carbon tax would have needed to be floated if the GOP’s other big possible offset – House Speaker Paul Ryan’s border adjustment tax — turned out to be politically feasible.

But with Republican opposition to a BAT threatening to drag tax reform down, something else had to be found. With these three major revenue-raisers now politically unacceptable, the Trump administration and congressional Republicans have very few other options for a revenue-neutral tax reform bill.

There will be other proposals, of course, but don’t expect much that will make the deficit hawks happy.  And that begs the question: If Trump and congressional Republicans want a tax cut but can't agree on ways to pay for it, will they still cut taxes even if it means they will be held responsible for a (much) higher federal deficit? Absolutely.

The two-day summit between Trump and China’s President Xi was still in focus for investors, who are looking for clues on ramifications for trade and the dollar. Xi’s visit to Mar-a-Lago in Florida begins tomorrow. The two men are at odds on several issues. Xi has a highly-scripted style, and the Chinese are accustomed to meetings that are tightly choreographed. And right now, the script is fluid, with North Korea firing off more missiles.

The Korean Peninsula isn’t the only geopolitical hotspot. President Trump said the recent chemical attack in Syria crossed “beyond a red line” and changed his mind about Syrian president Bashar Assad, whom Trump had previously suggested could stay in power. But Trump remained vague when asked whether his calculus on taking military action in Syria had changed. Trump has previously urged against using military action in Syria.

Over the last several years, a European family business has spent more than $40 billion assembling a coffee empire. JAB Holding Company has acquired the American brands Peet’s Coffee, Caribou Coffee and Keurig Green Mountain, all since 2012.

It also combined the European coffee giant D.E. Master Blenders 1753 with the coffee business of Mondelez to create a company now known as Jacobs Douwe Egbert. Then it bought the high-end coffee retailers Stumptown Coffee Roasters and Intelligentsia. Mondelez continues to own 25 percent of Douwe Egbert and has a similar stake in Keurig.

Now JAB is adding a nice little bakery to sell all that coffee. Today, JAB said it would buy the Panera restaurant chain for $7.5 billion, including debt. In 2014, JAB bought the bagel chain Einstein Brothers, which it has been combining with Caribou is some markets. And last year, it paid $1.35 billion for Krispy Kreme, the doughnut chain. At some point, you should imagine Starbucks is getting a little nervous.

For the past few years, the housing market has been unbalanced. Strong demand and tight supply resulted in higher prices. Today, the Mortgage Bankers Association’s weekly purchase loan data showed that the average size of a home loan was the largest in the history of its survey, which goes back to 1990.

Larger mortgage sizes may reflect not just more expensive properties, but also more leveraged ones. The 20% down payment is a relic: the median down payment in 2016 was 10%. For first-time buyers, it was 6%. First-timers and other buyers of less-expensive homes are more leveraged now than they were at the height of the housing bubble a decade ago.

Home loan sizes aren’t the only things that have changed in the years since MBA started its survey. Back at the start of the survey, the median mortgage size was only about 3.3 times the median annual income. It’s now over five times as big – though buyers get bigger homes and lower interest rates.

Mortgage application activity hit a five-week low even as home borrowing costs were little changed from the prior week. The average interest rate on 30-year, fixed-rate conforming mortgages, the most widely held type of U.S. home loan, was 4.34 percent, little changed from 4.33 percent from the prior week.

Arizona lawmakers unanimously approved a bill that would make it tougher for prosecutors to seize property from people suspected of a crime. House Bill 2477 would reform rules dictating when prosecutors can seize the property of those suspected of a crime. Officers can currently seize property based on suspicion alone without the need of a conviction or a charge. Police and prosecutors acquire assets after seized property is forfeited.

The measure comes after recent inquiries into whether officials in Pinal County misused seizure profits and a guilty plea from a former top Pima County official to misusing RICO funds in February. The measure would change Arizona’s civil asset forfeiture laws to require prosecutors to prove property was involved in a crime by “clear and convicting” evidence, a step above the current standard. The bill now goes to the governor.

How to Successfully Rescue Residential Real Estate

There is a growing uneasiness amongst analysts, money managers, and pundits about the nonresponsive residential real estate market. Even the business media are lowering their cheerleading pom-poms to acknowledge the dismal data being reported. Something is amiss.

Sales of previously owned U.S. homes fell in January 7.2% following a December decline of 16.2%. The annualized rate of 5.05 million was at the lower end of estimates ranging from 5.04 to 6 million homes. Also, reported home prices for federal agency sponsored mortgages fell in December 1.6%.

New home sales were reported for January at a 309,000 annual rate. This was below the consensus low of 345,000. This followed a December drop of 7.2% to 342,000 annual home sales.

The Mortgage Bankers Association reported purchase applications dropped 7.3% for the week ending February 19 to the lowest level since 1997.

The S&P Case-Shiller HPI Composite 10 and Composite 20 each fell from 158.49 to 158.19 and 146.28 to 145.90, respectively.

These negative numbers were posted while first-time home buyers tax credits are still in force.

A year ago, last January, I wrote an article prescribing a simple bottoms-up solution to the housing crisis. The Obama administration chose a top-down big bank model, instead. Since the crisis is still with us here is my idea in a nutshell:

The federal government should self-refinance the original mortgages directly with homeowners at 4% fixed for 20 or 30 years, ultimately turning these mortgages into GNMAs.

The new mortgage then would be split in two, for the borrower. The lender would receive the entire mortgage amount due, thereby, eliminating one mortgage from existence. The home owner will now have a first mortgage for the current appraised value of the home. This mortgage becomes completely assumable with the home. The government recovers this portion when the GNMA is sold.

The difference between the original mortgage and currently appraised value, or the second mortgage, is applied to the borrower‘s income tax filing over 20 or 30 years. Each year, regardless of one‘s tax liability or credit, Uncle Sam is due 1/20th or 1/30th of this second mortgage. The borrower has the right to pay off the second at anytime, without penalty. This is the government’s only exposure in this transaction.

Investors and speculators are not eligible for this program. But, if they sell the property back to the family that was foreclosed upon and evicted, they could quote their total cost for the purchase of the property, plus any improvements made at cost, plus a nominal interest rate on their total outlay. Or, investors and speculators could ignore this program and keep these properties that do not have an assumable GNMA mortgage in a new real estate market place which does and is growing day by day.

This program could start with $20 billion. It’s cheap at twice the price. Fannie Mae (FNM) has borrowed $59.9 billion since last April. Fannie Mae will seek an additional $15.3 billion in aid from the Treasury after posting a ninth consecutive quarterly loss of $16.3 billion.

That’s the basic plan. Let’s tease it out some more. Fresh appraisals are needed. Many unemployed workers from the real estate industry could began earning money again as appraisers. Major home builders like Toll Brothers (TOL), DR Horton (DHI), Pulte Homes (PHM), or Lennar Corp. (LEN) could offer a recertification program like the luxury car brands. We have heard stories about homes being stripped and or vandalized before they were abandoned. Let the established homebuilders hire their laid off construction workers to make repairs or even upgrade houses - at the home owners’ expense. It may not be as lucrative as their old business but their old business isn’t coming back anytime soon and it puts people back to work, now.

For the home owner who refinances, he now has several hundred dollars extra each month to pay off other debts like bank credit cards (watch payment delinquencies fall), or make repairs to his home, or buy a new computer for the kids, or resume saving for retirement, or start saving for that vacation that’s been deferred again and again.

Primarily, what this would do is provide what is currently missing from real estate - a spark. Suggesting a real estate purchase in today’s climate is akin to kissing a beautiful stranger who is coughing with a “cold sore” on their lip. I insist, you go first.

Moreover, this plan does not require anyone to invalidate contract law, modify bankruptcy courts protocol, write off principal amounts on loans, antagonize CMO investors, and perform other unnatural acts in finance.

I could pose a half dozen philosophical or moral reasons not to intervene in this manner. As a practical matter, it’s possibly America’s last chance to save the larger middle class for the next generation.

An Alternative to the Trillion Dollar Deficit

Am I the only one who thinks that a trillion dollar deficit, proposed by the President-elect, is financially insane?

True, as we head into the deepest recession since the Great Depression of the 1930's, we may succeed in becoming the Great Depression II. However, before we touch a lit match to a fuse on a trillion dollar budget deficit (not to mention funding for the wars in Iraq and Afghanistan occuring outside the annual budget, which will surely detonate our country in the future), let us try to address the original problem.

We all agree residential real estate began this current economic slide and that residential real estate's recovery is necessary to end this slump. So, let us rethink the solution.

Since a trillion dollars is on the table, why not try the following; The US government enacts a new program to refinance the following mortgages: 1) all sub-prime mortgages that have reset and will reset. 2) Any mortgage that is underwater by more than five percent; 3) mortgages of homes repossessed in the 4th quarter of 2008 and currently unoccupied, if the previous owners are interested in returning.

Once the government has identified these mortgages, borrowers may apply for a new, 30-year, fixed-rate mortgage, issued at one percent over the current 30 year T-bond.

Do not stop reading. Here is how we save residential real estate and America.

All refinanced mortgages are backed by the full faith and credit of the US government. All refinanced mortgages are assumable.

Yes, I said ASSUMABLE.

Catalog the benefits. Currently, a raging debate about mortgage cram-downs by banks is taking place. Both sides have valid points. By refinancing existing mortgages and paying off lenders immediately, investors holding MBSs are "made whole", per the terms of the mortgage, and contract law is preserved.

Is a home more valuable or less valuable with an assumable loan? The current inventory of vacant and unsold homes would quickly reduce while prices stabilized. Ask a real estate agent if a home with a 30-year, fixed rate mortgage, at 4.25%, completely assumable, is marketable.

Banks' capital requirements and their need to raise cash for 2009 is lessened. Banks will also have fewer assets on their books. Retirees living on fixed income investments are starving for yield. T-bills and CDs today only reduce investors' disposable income and subtract purchasing power from the economy.

On a $200,000 mortgage, refinancing a 6%, or 8%, 10% mortgage, down to 4.25% mortgage is like getting a stimulus check, for several hundred dollars, every 30 days. Would a small business owner rather receive a lower tax rate and fewer customers or 10 or 20 homeowners in his neighborhood with additional money in their pockets?

Vacant homes lower property values. Vandalism occurs to individual properties, squatters break in and stay illegally, and crime can increase in the neighborhood.

The government could begin taking applications 30 days after Congress approves such a bill and begin issuing checks within 90 days, for immediate repayment of mortgages to lenders and injecting more disposable income, through lower mortgage payments, throughout the economy. The psychological benefits to the country alone, with such a program, are incalculable.

Mortgages are public records. This program is completely transparent. As the money is spent, its final destination is available for all to see.

Lastly, if the government is going to destroy the dollar by issuing two trillion dollars in obligations this year, why not try this approach first.

It is just as insane as a trillion dollar deficit for years to come.

Macro Trends Spell Doom for Banks and Their Profits

The rise and fall of debt is continuing without abatement. In the U.K., bankers refuse to write new mortgages. U.S. consumers are tapped out. Businesses are finding their cost of borrowing prohibitively expensive to continue certain lines of business, i.e. consumer auto leasing at Chrysler Financial, all the while asset-backed portfolio valuation is tenuous and overvalued, at best.

After 30 years, two generations of consumers and businesses relying on hyper-credit to generate an enviable lifestyle for the middle and working class, trumpeting painless capitalism – all winners, no losers, and endless increasing corporate profits, that bubble has burst.

This perspective should be viewed from two positions, first, historical and secondly, relative to global living standards. The U.S. is the largest economic engine in the world. Household debt has tripled in the last 25 years.

In 2008, the inability to service debt is akin to the credit depression of the 1830's. Europe in the 1820's became mesmerized with transcontinental travel by train and flooded America with credit. The term transcontinental attracted money then the way dot.com attracted funds in the 1990's. A land rush, sponsored by the government, coincided with this period. Between servicing the railroad bonds debt and the leveraged real estate debt, remaining disposable income left little domestic spending for growth. Expansion became contraction. The great depression of the 1930's was more a function of technological advances increasing output, relative to consumption, thereby collapsing demand.

Our savings rate is the lowest in the developed world. It has dropped below 1 percent. Yet, we also buy more things than anyone else using maximum credit. Credit cards, home equity loans, secured and unsecured personal loans, loans against retirement accounts; any loan that continues the buy now, pay later, merry-go-round, until recently, without question and interruption, was marketed and consumed. Ironically, brokerage firms' margin accounts, the villain of the stock market crash of 1929, is our most conservative usage of debt, today.

Currently, home equity, which rose on cheap capital and hid stagnate wages this decade, has reversed while its cost has risen. Homes that were once ATM machines only three years ago are being repossessed in the tens of thousands each month by banks. Equity in an individual's home once was his or her greatest investment. Servicing debt on growing negative equity is becoming harder to do, both financially and philosophically, for underwater consumers. Prosperity from the mirage of supply-side economics has vanished for the masses.

Looking back, in the 1980's, deregulation through supply-side economics redefined risk and value. In the 1990's, heretofore, imprudent levels of credit, a peace dividend from the end of the cold war in the 1990's, and the integration of cheap global labor, provided the west a temporary and significant head start re-imagining comfort and convenience for the working and middle class.

Looking forward, new banking regulations, regardless of the outcome of the November elections, will restrict the future of credit and leverage for commercial and investment banks. The defense industry peace dividend was consumed years ago by the endless war on terror. Wages in developing countries are rising, and so is the cost of limited natural resources. And, the true bill on previous runaway debt created and consumed in a lax atmosphere is past due.

We are heading into a global recession. The IMF projects at least $1 trillion in total write downs. Total U.S. residential single family home real estate value is expected to fall another 5 per cent to 20 per cent; easily another $1 trillion in value. Bankers are considering reducing outstanding credit lines in the next two years by at least $2 trillion dollars.

Yes, banks and their profits are in dire straits.