Foreclosure on a mass scale is really stupid. Some obvious questions:

Can’t we figure out some way to transition buyers back to being renters that saves the cost of foreclosure to the banks and the pain to the homeowner?

Can’t the cities, state governments and non-profits work with the banks to keep perfectly good furniture out of landfills?

Where is our leadership?

The usual caveats apply. Everyone’s financial situation differs. Consult your own advisor or do your own research. We have been wrong before.

[Formatting problems at the bottom are known issue. Webmaster on the case.]

————————————————————————

The financial sector had taken over our economy. Over 40% of all profits in the US were made by financial firms, a statistic more befitting a small Caribbean tax haven. Financial regulation in this country was inconsistent and ineffective.

Your messengers,

Elizabeth and Jessica

The usual caveats apply. Everyone’s financial situation differs. Consult your own advisor or do your own research. We have been wrong before.

————————————————————————

Shocking VP picks, Russian invasions and now a government takeover of Fannie Mae (FNMA) and Freddie Mac (FHLMC)… the news just won’t stop coming.

Our overall view has not changed. The US will have to suffer through a few unpleasant years before the housing market normalizes, financial institutions can get back to business and our economy can get moving again. It will get worse before it gets better. At the end of the day, the financial sector should be smaller and more efficient which would be a positive thing. People will start saving money and that will be a positive thing.

Asset classes around the world have taken a beating lately. The rumors are that many hedge funds have had to liquidate large positions. While this is ugly for current holdings, most of you hold a lot of cash and we have identified a number of compelling investments.

Items of note from the government takeover of FNMA and FHLMC:

Mortgage rates will probably go down. The government is doing a lot of things to get rates down, many of which will eventually cost us all as taxpayers and mean much higher mortgage rates in the future. But in the meantime… there should be some deals available.

Future tax rates will be even higher than we have been assuming. This bailout will cost a lot. If you can contribute to a Roth IRA, you should seriously consider doing so.

This is not the final restructuring. The current specifics of the FNMA / FHLMC deal have the mortgage giants being responsible for something like 90% of all new mortgages over next year or two and then virtually ceasing issuance after that. The concept is that offering really, really low rates on mortgages over the next 18 months will stabilize the situation enough that the government can just leave. Methinks this is not very realistic. Who on earth will step up to fill the void? Homeowners and banks will be dependent on the US taxpayer for years to come. There are some eerie parallels to the Iraq war…

Debt issued by FNMA and FHLMC is money good. Many of you hold shares in your 401(k)s in the Pimco Total Return fund, which had gone “all in” on a bet that the government would do a bail out. It turned out to be a good bet.

In other news:

Washington Mutual (WaMu) got officially placed on super secret probation by its regulators. This is not a good sign. They are offering desperation-level high rates on CDs. This is not a good sign. We have sent out previous warnings about this bank. You should not have more than the FDIC minimum at WaMu. Your family and friends should not either.

Don’t shoot the messengers-

Elizabeth and Jessica

There are a couple of questions that need to be asked. Will these checks actually do anything on a short term basis? Even if people do go out and spend, is this a desirable outcome? Finally, assuming we are going to spend $150 billion, is this the best we can do?

On a short term basis, giving people money WILL increase spending. How much will it increase spending?

Some families will get their rebate and pay off credit card bills or put the money in the bank. While this may actually the wisest thing to do, it does little for the economy on an immediate basis.

Many people will spend the money. Some will use it to sustain unsustainable lifestyles – those financed by continual dips into their home equity – for another month or two. By summertime, when checks will probably be mailed, home equity loans will be difficult to come by and credit card limits will have been lowered.

There are the poor who have plenty of things they need to buy and can’t. Their checks will be spent the day they arrive – maybe even before (I am sure the same fine financial institutions that specialize in payday loans will lend against rebate payments).

Of the money spent, a portion will enter the US economy and the rest will go abroad. Best Buy keeps some of the cost of a new TV but 75% of it goes to Asia, the land of electronics.

When you balance all these factors and consider who will get what rebate (they are going disproportionately to the well off), you could have $50 billion entering the US economy this summer. That is a lot of money. In a normal downturn, it would be a serious kickstart. What is happening now is far from ordinary.

Headline news right now are focused on the housing bust and financial markets crisis. Construction is plummeting, home sales have plunged and home prices actually fell last year. The financial markets, who got fat off the boom, are now the first to feel the bust.

If we were merely dealing with the aftermath of a housing bubble, it might not be such a big deal. But housing is just one part of the story.

The dramatic rise in home prices and financial market “innovations” have masked over substantial economic problems. A frightening number of American families are spending more money than they earn. This underwater group includes a lot of boomers who should be socking it away for retirement. If families had to publish financial statements like companies do, many would be in the red.

Part of this is a spending problem. The economic statistics for consumption are almost unbelievable. There has been a 10% swing from saving and investment to spending.

We have made it patriotic to go into debt to buy stuff . Our natural competitive streak also applies to keeping up with our neighbors.

Prices have also increased. The cost for health care, energy, education, childcare, food and other essentials has gone through the roof. It is likely that published inflation numbers have dramatically underestimated how much the real cost of living has increased.

Part of the problem is an income problem. We have been transitioning from a manufacturing based economy to a service based economy. This is a trend that started in the 1950s as factories became more efficient and accelerated in the last 10 years with globalization. At this point, the number of workers who make their living in a factory as a percentage of the US work force is almost trivial. Some of this was inevitable and a positive event and some of it is the result of totally laissez-faire industrial policy.

In addition, the balance of power between management and labor has swung far away from the worker. Again, labor flexibility and mobility is a positive but a winner-take-every-little-scrap economy with a diminishing safety net is ultimately not very stable. You need a strong middle class who can save for their future without fear that one medical event will set them back. You need a domestic market that can buy your goods and services without having to take every penny of equity out of their homes. Etc etc.

These are challenging waters to navigate and sensible policy-making has vanished. We appear to be moving away from our problems rather than in the direction of solutions.

I just finished reading Robert Rubin’s memoir of his time as Secretary of the Treasury and the failure in certain key arenas of the policy-making apparatus in the 1990s was apparent, even with an incredibly talented group of people working for the Clinton Administration. I will not even get started about the last eight years.

The point is that throwing some money at the problem does nothing to solve the real problems at hand. It merely postpones the inevitable. The rebates will just about cover the shortfall in American’s need for cash this summer.

There are many things we could do with $150 billion that would start to address some fundamental issues in this country. Health care, basic research, alternative energy, the profound cycle of poverty in the inner cities, encouraging manufacturing innovations.

There is also a strong possibility that this slowdown will look different from ones in the past. Because the manufacturing jobs lost in the last recession never came back, there won’t be the immediate drop off in jobs we have had in previous recessions.

A huge boon in construction and deficit spending took us out of the last recession. This time construction will be part of the problem and the ability of the government to finance aid package after aid package will be limited. Our best guess is a long slowish period. In this case, the best use of tax dollars would be to start making some longer term investments and hold off on a desperate move like rebate checks. Legislators want to avoid the pain, especially in an election year, but we may need an uncomfortable period to make the hard decisions that will get this country back onto solid economic ground.

Some of the adjustment back to a normal level of inventory will simply be price adjustments. These losses will be taken by builders, homeowners and investors. The rest will come from all the houses that will NOT be built over the next few years as the slow but steady natural growth in households finally gets demand back in line with supply. This suggests a serious economic headwind over the next several years.

Five years out, things look much better. The excess inventory should be gone and the baby boomer’s kids start getting married and having kids. Until then though….

We sent the following note to our clients and those we have put on our “Friends of Alexis and Palmer” email list. If you would like to be added to this list, please send a request to info@alexis-palmer.com with your name and affiliation.

We are getting inquiries about E*TRADE, their financial future, and the safety of accounts held at E*TRADE.

General takeaway:

• E*TRADE is definitely over its head but has value as a going concern.
• Even if people try and take a lot of cash out of E*TRADE, it has numerous ways to borrow a lot of money.
• Cash deposits/CDs up to $100,000 are usually FDIC insured and safe. (Use the FDIC calculator to know exactly how much coverage you have)
• Securities in brokerage accounts up to $500,000 are covered by SIPC insurance and are safe.
• Accounts over $500,000 are covered by excess SIPC insurance – we have not done the math to see if it will cover all holdings.
• An easy way to increase the security of large cash deposits is to buy a money market fund or short term bond fund – this then becomes covered under SIPC.

More on E*TRADE
I worked for a brief period for E*TRADE five years ago and I still know people who work there. I became VERY concerned about their mortgage holdings several months ago after they publicly released certain portfolio information about their mortgage holdings. Since that time, the stock price declined over 70%. That said, E*TRADE has a number of strategic options which I think could keep it afloat. I actually published an “article” on SeekingAlpha.com (http://seekingalpha.com/article/54013-e-trade-a-bargain-at-these-levels) about E*TRADE last night that you can read for more background information on their woes.

Please remember that everyone’s financial situation is different and the information provided may not apply to your situation in particular.

(From the Citigroup Business Update Call on November 5, 2007 via Seeking Alpha)

Guy Moszkowski – Merrill Lynch

…Maybe you can comment for us as a follow up on the dependence or lack thereof in any of the vehicles that you have exposure to on guarantees or credit support from the mono line insurers like MBIA or AMBAC that have obviously had some pretty significant credit spread blow outs?

Gary Crittenden [Citibank CFO]

We haven’t quantified what that exposure is. (emphasis ours) They obviously are important counterparties for us in a number of different instruments. I think you raised an important point which is all that I have talked about today are our direct exposures and there’s obviously potentially secondary and tertiary exposures that potentially could exist for the company that are not part of what we have talked about today. This is really the direct exposure that we have. But I would assume virtually everyone else that is a significant financial institution have counterparty exposure to the monoline.(emphasis ours)

You may be going “What the heck? This is gobbelygook to me”. And rightly so.

The business risks that the large money center banks have are REALLY complicated. They are so complicated in fact that Citibank has not gotten around to quantifying them. The justification is that everyone else did it too.

The problem is that just because a risk is difficult to put a number on doesn’t make it insubstantial. A risk may be indirect but until you give it a ballpark number, you have no way of knowing whether it is a second order, third order or first order risk.

The subtext is that if everyone has the same exposure, these are not really risks that you need to deal with because there will have to be a bailout to avoid financial system collapse.

I feel perfectly at ease now with the current situation. How about you?

Note: We are not single stock pickers, we generally do not use single stocks in our client portfolios and we base virtually all comments on a company’s SEC filings, information on Yahoo! Finance, information available on the company’s website and articles in major publications. We do not offer buy or sell recommendations. We are almost always commenting on a company’s business, not their market valuation. Stock prices and company fundamentals sometimes go in tandem, sometimes not. A stock price often already reflects expectations of changes in fundamentals and even those disconnected from fundamentals can stay that way for a long, long time.

Countrywide Financial is HUGE. It has 60,000 employees, about the same number as American Express. It services (i.e. collects the money) for $1.3 trillion worth of mortgages. It makes $500 billion + worth of mortgages each year.

They had a really sweet business model, at least in concept.

Countrywide sold most of the loans it originated, but retained the servicing rights. Servicing a loan entails collecting monthly payments and taking calls from homeowners. The company who services a loan gets a chunk of the interest payments, along with all the fees someone gets hit with (late fees, online payment fees, prepayment fees). The servicer also gets the float on escrow accounts (the money people pay along with their interest payments to cover property taxes and insurance) as well as some float on the interest before it goes to the mortgage owner.

Countrywide did keep some some of the loans it made. Most of the loans they kept were home equity loans and pay option loans made to prime borrowers with significant collateral. These offered higher returns than conventional mortgages yet were still fairly low risk (in theory). Countrywide created a bank to house these loans which were financed by the float from the interest payments and escrow accounts of serviced mortgagees, supplemented with retail deposits and money borrowed on the cheap from FHLB .

There are some clues that they were anticipating some problems. Early this year they converted from being a bank to being a thrift. This got them friendlier regulators and eased capital requirements at the holding company level. They stopped adding assets to the bank. The CEO decided he needed to “diversify” his financial holdings and started dumping stock.

They were not the worst offenders in the mortgage business, despite recent bad press. In the scheme of things, they issued relatively few subprime loans. They do seem to collect a lot of fees, but this nickel and diming (a couple hundred million here and a couple hundred million there) is endemic to the entire financial industry.

Countrywide’s biggest problem was (is) that their balance sheet was a train wreck waiting (starting) to happen.

I had assumed going in that Countrywide was a serious cash cow. I was wrong.

Over the last few years, Countrywide reported profits of about $2.5 billion/ year. It generated virtually zero cash. At first, I shrugged this off. Cashflow tends to be a challenging metric to apply to financial companies.

Then I dived into the numbers.

There is something about the phrase “retain” rights that made me think that Countrywide made money selling on the mortgages and then got the rights thrown in, kind of like the proverbial toaster with the bank account.

Not so. It turns out that the chunk of the interest payment a servicer receives is way more than the cost of providing the service.

The servicing rights along with rights to some residual cashflow from the mortgages, excluding the value of the float and miscellaneous fees as well as the cost of actually servicing the loans, are worth about 1.5-2% of the value of the loan on an upfront basis.

Countrywide includes the value of these rights when they calculate profit. Before expenses, Countrywide was only clearing 1% on the sale of prime loans. This means that they calculated that they got something worth 2% by only paying 1% for it. Countrywide was actually out of pocket $4 billion for the $400 billion of prime loans they originated last year and maybe broke even on cashflow basis on the subprime loans they did and somewhere in between on home equity loans. And this was before spending $4.5 billion on a massively ramped up sales force to actually make the loans.

Countrywide has to borrow a lot of money.

It needs to borrow money to pay for the mortgage servicing rights, which are one part service contract and one part interest only mortgage security, which look kind of like a 5 year bond but one that disappears if people decide to prepay mortgages early (bad) and one that turns into a longer stream of payments if people don’t prepay (good).

It needs to borrow money to make loans, even if that loan will be sold off.

It needs to borrow money to make loans that it wants to hold.

It even needs to borrow money to collateralize the hedges it has to try and lock in the value of its mortgage servicing rights which can dramatically change if interest rates change or if loans are repaid faster than they expected.

Remember, the portfolio is financed via float from the mortgage servicing business, retail and commercial short term deposits, borrowings from FHLB, and other very short financing.

The float disappears if they don’t originate mortgages to replace those that get paid off. The retail deposits are generally “hot money”, seeking the highest yield, the short financing is short. Only the FHLB money is longer term- and I have no idea how long term.

Okay, this is an organization that has some serious balance sheet “challenges”, even in the boomtime of all boomtimes. Its 2006. You are Countrywide management. You know your industry is displaying signs of “froth”. You actually stop adding to your mortgage portfolio. It might be a good time to borrow some money and get a little more capital on your balance sheet, maybe even sell some stock to get equity capital.

You do go ahead and issue some debt – but not for the purpose of bolstering your balance sheet and institutional longevity. You issue it to buyback 60 million shares of stock, and bolster your stock price. It is, of course, a complete coincidence that your CEO decides to dump sell his millions of shares at the same time.

Fast forward to August 2007. The mortgage market finally collapses. You have to sell stock to get the necessary capital to stay alive at less than half the price you bought it for 6 months early. Whoops.

Apparently the class action lawyers are circling, salivating about the CEO’s suspicious stock sales. Note to board members of cyclical companies: think twice before loading up your top executives with equity-based compensation or at least be suspicious about proposed massive stock buybacks.

If I were a shareholder (which I’m not), I would be much more concerned about the basic business model.

The hold some mortgages and finance them part of the business looks shaky – credit writeoffs will likely outweigh any profit from lending money at higher rates than you are borrowing it.

The mortgage origination business is very shaky. Countrywide published some updated financials. Mortgage volume has collapsed and the business they are doing is barely profitable.

They have cut some jobs, but with the need to continue to attract retail deposits and service existing troubled mortgagees, their ability to really downsize is limited.

The only good news is that late fees will definitely be up.

In the meantime, Countrywide will need to continue borrowing money to finance purchases of servicing rights. Who in their right mind wants to lend these guys money?

If they went to the capital markets, they would have to pay very high rates of interest. So instead, they are moving their whole business “inside the bank”. This means they can use retail deposits and CDs to finance their operations. FDIC insured deposits and CDs. At the end of the day, the US taxpayer is effectively taking the risk of a financial institution that definitely failed Balance Sheet 101 earlier this year. Countrywide’s decision to change regulators this year to one reputed to be more lenient now makes a lot more sense…

You live in random Midwestern industrial city. The housing market is terrible. Finally, you find someone who wants to buy your house but they have no money. Zippo. If they could come up with 5%, they could qualify for a loan and buy the house. Hey – why don’t you agree on a price 5% above your asking price, then kick back the 5% to the buyer who can get their loan by using the kickback as a downpayment?

Until Friday, this was totally legal for government guaranteed FHA loans- as long as you used a charity to stand in the middle as the go between. In recent years, up to 50% of ALL FHA loans involved downpayment “assistance.”

The housing and loan bubble was fueled by a lot of sketchy practices, and this one ranks right up there.

As I understand, Downpayment Assistance Programs (DAPs) have existed for a long time. They used to get actual charitable donations and help cash strapped but hardworking people buy houses.

In the late 1990s, a new type of DAP charity came to life. This one was closely linked to the real estate industry and, with the blessing of HUD and municipalities, pursued the seller as the ultimate donor.

The two biggest ones were Nehemiah and Ameridream. Over the last 10 years, Nehemiah has given $900 million in kickbacks, which may have supported $30 billion + worth of home purchases, mostly in low income areas.

Ameridream, founded in 1999, comes close with $400 million and $14 billion of home purchases.

This is big business, albeit one in a 501(3)c wrapper and one with crack lobbyists.

Following the money trail at quasi- charities is always fun. In this case, the loot appears to have been stashed in for-profit marketing affiliates owned by charity officials. A 2006 article tells of some house cleaning that has gone on at several organizations.

While the scandalous parts of this tale are fun, the most outrageous bit is the support these programs are still receiving from cities and elected officials.

Various parts of the Federal government have been concerned about the program from its inception. HUD and FHA don’t like it because the performance of loans with DAP is bad and they know prices are being inflated. The IRS doesn’t like phony charities. The GAO issued a scathing report in 2005.

So why did this program stay in existence for 10 years?

Because cities liked it. It clearly helped move a lot of property and may have even contributed to the boom in certain areas.

It was a quick fix to some long term, seemingly intractable problems.

The problem with short term solutions like artificially supporting the housing market is that they don’t address the underlying problems of decaying cities, the loss of manufacturing jobs and a cycle of poverty. They can even make the problem worse.

Overinflated sales prices are kind of like escalating CEO salaries. Just like the executive talent market, the real estate market is very driven by “comps” – prices that other houses in the area have sold for. And if you keep overinflating overinflated prices, pretty soon you have a bubble.

Nehemiah pioneered the seller-financed DAP in Sacramento, a city which is beginning to face the consequences of a bursting bubble. Many people, even those who can afford their mortgages, are now “upside down” – they owe more to the bank than they can clear on a home sale. Others who want to sell their homes cannot find buyers, even at discounted prices.

What was a virtuous cycle on the way up is now a vicious cycle on the way down.

You would think that officials would have learned their lesson.

Officials throughout the country are begging FHA to change its mind and continue to allow “gifts” from sellers to buyers. Nobody wants the music to end.

But it has.

So why do we bother with single company commentary?

We will sometimes offer commentary on an individual company because understanding the individual players within the economy offers insights into broader trends. Many of our clients have equity based compensation and sometimes we think that what we learn from studying their employer is worth sharing. It also is fun, if you like making financial diagnoses from incomplete financial information like a company’s 10-Q filings. Kinda like House, but a company’s health instead of a real person’s.

Masco employs 56,000 people who make, sell and sometimes install $12 billion worth of building materials each year for new homes and remodels. They make kitchen cabinets (“Kraftmaid”, “Mill’s Pride”), plumbing fixtures (“Delta”), windows and some paints, among other things. Most of their business (80%) is in the US. They mostly sell to the big home improvement centers (20% of all sales are to Home Depot) and to the large home builders.

Masco is a company with a colorful corporate history. It was founded by the current CEO’s father in 1929, just days before the stock market crash. It has manufactured almost everything at one point in time – defense equipment, car parts, furniture, appliances etc etc. It has been a voracious acquirer of companies and is considered to be good at wringing efficiences from manufacturing processes for certain types of products. It has also had to divest a lot of businesses which did not end up working out. It does seem to have more or less figured out what it is good at and what are its competitive advantages. At this point, the business appears to actually be kind of rationalized and streamlined.

Masco appears to be run as a family fiefdom business. The CEO, Richard Manoogian, is 70 years old and has been an executive officer at the company since 1962(!). There have been all sorts of dodgy deals over the year, which have enriched the CEO and other top officers. The executives have an uncanny knack in selling stock at just the right time. There is a special juicy retirement plan just for top officers. Dodgy tax advoidance schemes which have led to writeoffs. Etc. Etc.

This is a classic “value” play, whose major investors include some of the giants of value investing. It’s a money machine but with some clouds hanging over it.

The company’s latest maneuvering may be its most audacious yet (I will not vouch for that not knowing the full details of previous transactions).

Masco’s current business is extremely cyclical, particularly in the case of a housing led recession. And we are about to enter the mother of all housing led recessions. New home construction will likely fall by more than 50% from the stratospheric levels of 2004-2006. Home sales – a major impetus behind remodeling – are falling precipitously. Home equity loans are being cutting off at the knees.

Masco is about to be hit by a tidal wave.

In the last year what has it been doing?

It has increased its dividend (now 4% ), stepped up investments in its plants, and bought back $1 billion worth of stock (for third year in a row).

Not exactly setting cash aside to prepare for a rainy day.

You might think that this wouldn’t matter.

An 80-year old S&P 500 company must have lots of money in the bank by this point, particularly one that has gone through ups and downs before.

No, the company actually has a negative tangible net worth (the one that counts real stuff) and its primary backup bank line is contingent on the company maintaining a certain net worth, not that far from where it is now.

It borrowed a LOT of money this year to be able buy back stock, despite having a really crummy balance sheet and facing an almost certain downturn in its business.

Was it greed? Stock buybacks magically make earnings per share growth without any change in revenue and there were some “interesting” stock option exercises by the CEO. Was it hubris? Is it the tragic end to what was supposed to be the chairman’s last hurrah?

Whatever it was, Masco was not alone. Countrywide issued all sorts of debt to buy back $2 billion worth of stock – stock it reissued to Bank of America in August at half the price it paid for it. It, too, had a lousy balance sheet and could have used the money to get through any challenges as well as have a stash to buy distressed competitors.

Anyway, I’ll keep on an eye on the company. Its stock performance is a good indicator of market expectations for how bad the housing downturn will be.

When sales drop (as they must), it will also be interesting to see how adjustable their cost structure is. There is not a lot of information in their filings about what makes up the cost of goods sold. I don’t know how much is the cost of running 75 plants and 65 warehouses/distribution centers (not that flexible) and how much is cost of buying items made for them in China (very flexible).

One of the things that may be different in this recession is the knock-on impact to manufacturing. Because none of the manufacturing jobs that left the US after the previous recession never came back, there may be fewer to lose here.

For instance, Masco stated that they wanted to move more of their manufacturing of items like faucets to Asia and more of their manufacturing of bulky cabinets to US. When cabinet orders fall, they may turn off the spigot from Asian factories first. They may still have have cashflow “challenges” but it will be the shareholders rather than US workers who take the pain.

On the other hand, Masco may use the slowdown to go ahead and shutter faucet factories here.

We will see.