Dynex recovered quickly from stock offering but remains down from early 2011 levels

Soon after my post, I received an interesting message from David Kowal of Kowal Communications on behalf of Vertical Capital Markets Group of Irvine, California. Vertical Capital Markets Group was founded in 2004 to underwrite, monitor, and service home loans that it purchases. Last December, Vertical launched the Vertical Capital Income Fund (VCIF) to provide retail investors the opportunity to diversify their portfolios with investments in home mortgages. VCIF is a continuously offered, diversified, closed-end management investment, also known as an "Interval fund." Vertical buys high quality loans at a steep discount and, when necessary, works with homeowners to restructure their loan as part of their mission to keep people in their homes. From a company press release, Vertical states the following as part of its unique value proposition:

"…The company's wide network of contacts within the banking industry allows the firm to uncover mortgage loan opportunities that other buyers might not find. As loan servicer, Vertical also has access to information not readily available to most institutional investors."

Intrigued, I asked Kowal some follow-up questions which eventually led to an interview with Vertical's chairman, Gus Altuzarra. Mr. Altuzarra is a 30-year veteran of the mortgage industry. I enjoyed talking with him and learned a lot more about the way Vertical operates, its investing philosophies, and the dynamics of the current housing market. I provide below an edited transcript from the interview. I encourage you to do your own additional research before deciding to invest in the fund.

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Vertical Capital Markets Group sold mortgages until 2007 when the prices of loan sales dropped too much to account for the risk of the loans. For example, Vertical could make 2-3 points on a $1 million loan in the secondary market (or $20,000-30,000). The average person does not take this deal and, moreover, Vertical had to guarantee the loan. Vertical changed its model in December, 2007 and decided to raise money to make loans and keep them. The company raised money from "friends and family." In total, Vertical has raised $27 million for its Vertical U.S. Recovery Fund I and $5 million for its Vertical U.S. Recovery Fund II.

When the market dropped starting in 2007, raising money became extremely difficult. The lack of sufficient capital held the company back. The 2010-2011 change in the definition of an "accredited investor" diminished the pool of investors further. A retail fund allows Vertical to continue growing and purchasing more discounted loans.

Vertical is able to get loans at a steep discount because the collateral (the home) has dropped in value. Across the country, homes have depreciated about 40%. Anyone planning to deliver loans into the secondary market before this big decline found themselves holding a large basket of loans that they never intended to keep. Most loan-to-value metrics became negative, forcing these players to sell. Given the low liquidity in the market, these companies also could not sell these loans all at once.

These companies cannot hire a firm to manage their portfolio of loans because their capital is (unexpectedly) tied up. The drop in property value makes the loans impaired. The companies will realize heavy losses if such loans go into foreclosure. Some of these companies bought too early in the cycle and used too much leverage. The specific motivation for a company to sell distressed loans depends on the capital position.

This situation represents Vertical's window of opportunity. Vertical buys loans at a price where it can achieve positive equity. Buying loans at 60 cents on the dollar with a 6% coupon generates about a 10% return. The fund is over-collateralized, so foreclosure risk is manageable. Vertical looks for loans with people who have a reason to stay in the house whether for emotional reasons (like amount of time living in the home) or for financial reasons (like a large down payment) or other reasons. For those who require help, they generally face issues of affordability or the loss of hope in ever paying off the house. Vertical will lower payments through a reduction in principal and lower interest rates. This is a non-taxable event for owner-occupied homes. Vertical has made such financing accommodations for about 30% of its loan portfolio.

Investors in the Vertical Capital Income Fund receive an income stream and capital appreciation. Dividends are paid monthly and automatically re-invested. Shares are priced daily but investors can only tender their shares once a quarter. Vertical can only redeem 20% of its shares per year (5% per quarter); this can increase to 25% if the capital is available. Investors get a pro rata redemption if the limits are hit. Investors can purchase shares any day. Investors own shares in the fund and do not own the mortgages directly.

The current funds have averaged returns of 10.7%. With fees, the average returns are 7 1/2 to 8%. The Funds that include modified loans started with much higher returns. Removing leverage from the equation, Vertical's funds likely provide similar returns to a mortgage real estate investment trust (REIT) like Dynex Capital.

The Vertical Capital Income Fund reached $2 million in funds on January 1st and can now purchase its first loan portfolio. Diversification standards for mutual funds extend the time it takes to acquire loans.

Dynex Capital is a very different financial instrument for investing in mortgages from Vertical Capital Income Fund. DX invests in mortgage-backed securities (MBSs). An MBS provides a rating and maybe some insurance. On the other hand, Vertical intimately knows the assets underlying its investments. Vertical reviews the physical house and analyzes the individual borrowers. Vertical reviews maximum loan-to-value, property types, and payment patterns.

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If you want to learn more about the Vertical Income Fund I highly recommend you take the time to review Vertical's website and the detailed information about the fund. Over the coming weeks, I intend to do my own additional review, and I anticipate investing in the fund as another alternative for investing in the recovery of the housing market.

Be careful out there!

Disclosure: I am long [[DX]].

A friend and I have actively discussed how best to position ourselves for the near-term, bearish risks in the market. As my favorite technical indicator, T2108 – the percentage of stocks trading above their 40-day moving average (DMA), hit oversold territory, he asked my opinion about adding to his SSO put spread. Puts on SSO have formed the core of my own bearish bets, but given the oversold technical conditions, it did not make sense to me to buy fresh puts unless they are used for downside protection and not to make money.

My astute friend quickly challenged me on the notion of buying puts for protection versus for profit. After all, we trade to make money, right? I provide below the explanation that makes sense to me:

SUMMARY

Puts purchased for protection are out-of-the money with as short a duration as needed to cover the perceived risks. Minimization of cost is important given these costs eat into the eventual profits one expects to make on the underlying shares. If the feared risks never materialize, the overall position makes money from the underlying shares while the puts go to zero. Thus, the best outcome is a bullish one.

Puts purchased for profit have strikes that are closer to the current stock price. Costs are finely tuned to the perceived profit potential (risk/reward) and leverage applied to the trade. All risk is packaged within the puts given there is no underlying to protect. If the feared risks never materialize, the overall position loses money (likely everything). Thus, the best outcome is a bearish one.

I find it easiest to define “puts for protection”:
Identify the specific risk factors that cause concern and buy just enough puts for just the amount of time the risks appear greatest. Puts should expire shortly after the feared event. Buying for a longer period of time does not make sense because of the extra time and risk premium this will cost. Since the position will include the underlying shares, a trader or investor assumes that the eventual (or longer-term) prospects are bullish. Otherwise, immediately sell the underlying position.

The puts are out-of-the-money because it is only the out-sized and unexpectedly negative reaction that could cause enough loss to force the trader or investor to deviate from the overall plan. In other words, the puts are positioned such that the overall risk in the underlying is capped at a “manageable” level, and the puts are selected to minimize overall cost.

If the perceived risk is at the macro-level, like a new bear market, then clearly the time horizons on the puts have to extend further. The trader or investor will also have to create a strategy for rolling the protection periodically since the timing of such a large event will always have a wide band of uncertainty.

I find defining “puts for profit” to be a lot more squishy:
The clearest component of this strategy is the lack of underlying shares (hedging strategies are a big exception). Moreover, the trader or investor requires the perceived risks to materialize to avoid losing money.

For example, what happens if a trader expects the market to sell-off in the next three months? The trader can choose to sit out the market to wait for the risks to play out over this time, or the trader can transform this risk into an opportunity by buying puts now. To make money, the trader needs to cover the uncertainty of time and depth. The chosen puts must expire a little later than the duration of the perceived risk. The chosen puts should also not be out-of-the-money so that profits can accrue even if the correction is not as deep as expected (nothing worse than being directionally correct with nothing to show for it). If the correction gets steeper, the trader can always lock in profits on the original puts, and apply those profits to puts with lower strikes (and start riding on the “house’s money.”)

The further the expiration goes in time, the more likely a put spread becomes the trader’s best choice. While it tightly caps overall profits, it also greatly reduces the cost of time premium which can destroy the profit potential of a trade if the puts are far out in time. The trader achieves good risk/reward by selecting a strike price for the short side of the spread around the downside target generated by the perceived risk.

For example, if on expiration day, the underlying hits the strike price of the short side of the put spread, the trader realizes the full potential profit of the spread. This scenario is the best case. The short side of the spread goes to zero, and the end result is the same as having bought just the long side of the put – with much less risk. A trader can also choose to cover the short side if the market moves strongly against the position on the way to the downside; this strategy increases the profit potential with a small extra cost.

To learn more details about trading options, I strongly recommend perusing Schaeffer’s Research. Bernie Schaeffer founded this site and is the author of the most well-read book on options: The Option Advisor: Wealth-Building Techniques Using Equity & Index Options (A Marketplace Book). One of my favorite books on options strategy is Options as a Strategic Investment. It is the most comprehensive book I have read on the subject of options trading.

Be careful out there!

Full disclosure: Long SSO puts

On June 15, Bank of England Governor Mervyn King spoke at the Lord Mayor’s Banquet for Bankers and Merchants of the City of London at the Mansion House. The speech covered very familiar themes for King and the Bank of England.

King first acknowledged the squeeze on the economy in the United Kingdom:

“The challenge facing monetary policy is obvious – the combination of high consumer price inflation and weak economic growth. Both of these might seem surprising given the large amount of spare capacity in the economy. But the rise in world energy and other commodity prices, and the need to reduce both the external and budget deficits, are squeezing real living standards, pushing up on consumer price inflation and slowing domestic consumption.”

This challenge provides plenty of reason for bearishness on the pound. However, it is King’s explanations for maintaining loose monetary policy, comforted by the theme of rebalancing the UK economy, that seal the deal for me.

Over the years, King has consistently hammered on the theme of rebalancing in the UK’s economy: a transition away from domestic consumption and toward exports and the business investment required to support this shift. In Wednesday’s speech, King indicated that the rebalancing underway will continue for several more years. This process has necessitated the devaluation of the currency. King cleverly attributes the devaluation to market forces while indicating the Monetary Policy Committee (MPC) chose not to counter-act the pressures on the currency:

“A necessary precondition for that rebalancing was a fall in the real exchange rate. Markets anticipated that need. The nominal effective sterling exchange rate fell by around 25% between the start of the crisis in 2007 and the beginning of 2009, since when it has been broadly stable…

…We could have raised Bank Rate significantly so that inflation today would be closer to the target. But that would not have prevented the squeeze on living standards arising from higher oil and commodity prices and the measures necessary to reduce our twin deficits. And it would have meant a weaker recovery, or even further falls in output…”

In other words, the MPC decided to focus on the implications of a weak economy over the implications of high inflation, judging the former to be the greater threat. In doing so, King has frequently noted that today’s high inflation is temporary, thus rationalizing on-going accomodative monetary policy and low interest rates in the face of high inflation. The primary blame for high inflation has shifted from hikes in taxes (the Value Added Tax or VAT) to commodity and energy prices, both presumably out of the control of monetary policy. Internally, conditions do not exist for sustaining “domestically generated” inflation:

“So far, subdued rates of increase in average earnings, as well as remarkably – some might say disturbingly – low growth rates of broad money have provided strong signals that inflation will fall back in due course. Banks are still contracting balance sheets and reducing leverage. Spreads between Bank Rate and the interest rates charged to many borrowers remain at unprecedentedly high levels, if indeed borrowers are able to access credit at all.”

King really caught my attention when he provided two key conditions that would actually compel rate hikes:

• A pickup in domestically generated inflation
• A contraction in the spreads between Bank Rate and the interest rates charged to many borrowers

Given the dour outlook for the economy and an on-going reblancing in the economy, I continue to assume that rate hikes in the UK are somewhere off in a very distant future. There are many parallels in approach between the Bank of England and the Federal Reserve with very compatible world views. King has proven quite adapt in conjuring reasons for maintaining loose monetary policy, and I continue to see strong evidence that he is reluctant to tighten for fear it could upset the rebalancing he eagerly anticipates. Indeed, King notes that there is no way to tell when the MPC may hike rates:

“Uncertainty inevitably surrounds both the speed of the rebalancing and the impact of today’s consumer price inflation on tomorrow’s domestically generated inflation. So it is simply impossible to know now at what point monetary tightening will begin.”

I am sure this reality frequently disappoints currency traders who keep pushing out target dates for the Bank of England’s first rate hike. In the meantime, there is every reason to bet against the pound when the opportunity arises. The biggest challenge is figuring out which currency to use in a bearish bet on the pound, not to mention when to make such bets. No real “safety currency” exists any more. The usual suspects have real issues:

• The U.S. dollar is on the verge of resuming the downtrend it was on prior to the financial crisis. Just read between the lines anytime Federal Reserve Chairman Ben Bernanke talks about the dollar.
• The Japanese have the support from the international community to weaken its currency, the yen. The renewal of strength in the yen is certainly unwelcome. The Japanese are also looking down the barrel of serious long-term issues given the aging population and tremendous debt burden (see in particular “Kyle Bass Reiterates the Case for A Sovereign Debt Default in Japan“)
• The Swiss franc has maintained the most consistent strength over the past two years (much to my surprise!) after the Swiss National Bank failed miserably to prevent the currency from appreciating against the euro. Sooner than later, the Swiss economy should buckle and compel market forces to reverse the currency’s powerful hold on traders.

If the eurozone ever resolves its sovereign debt problems, the euro might be the best play against the pound. Instead, shorting the euro versus the pound is actually the better trade given the euro’s sharp appreciation against the pound since 2008. (The volatility is also lower than the other options mentioned above).

I remain a huge fan of the Australian dollar, so this has become my favorite tool for shorting the pound. The “Aussie” cannot be considered a true safety currency because of the economy’s heavy dependence on commodities. Nonetheless, as long as I remain bullish on commodities over the long-term, I will stick by the Aussie. The pound is at historical lows against the Aussie with no end in sight:

The UK's rebalancing has tipped the scales strongly in favor of the Australian dollar

Be careful out there!

Full disclosure: short GBP/CHF, short EUR/GBP, long AUD/JPY, long AUD/USD, long USD/JPY, long FXA

(T2108 measures the percentage of stocks trading above their respective 40-day moving averages [DMAs]. To learn more about it, see my T2108 Resource Page.)

T2108 Status: 42% and Neutral.
General Trading Call: Hold. Identify some shorts to cover.

Commentary
Given that today was the stock market’s worst performance since August of last year, I should expect to get caught well off guard. Yet, this provides little consolation for extrapolating yesterday’s strong follow-through rally to an imminent return to overbought territory. Such are the perils of trying to read the tea leaves. The good news is that I noted the time was not to buy but to sell and prepare to short. My quote from yesterday is ringing VERY true today: “I am expecting fireworks for the summer from beginning to end.” We have started with MAJOR fireworks. (Also see my analysis of summer trading where I observe that the summer tends to end positively but produces very large losses when it ends negatively).

T2108 cratered back to 42% as the S&P 500 plunged 2.3%. The S&P 500 dropped right back toward the May lows, putting it right back into the thick of the former short-term downtrend. If the S&P 500 closes below the May lows, we should expect continued selling closer to oversold levels on T2108. So, I am reviving my downside target of the lower part of the 30-40% range for this cycle and aborting my previous assessment that we had re-entered an upward phase to over-bought territory.

S&P 500 plunges back into a bearish pattern

The dollar index did not soar as I would have expected. Instead, it was the Swiss franc that soared, recording all-time highs against the U.S. dollar, euro, and the pound. The Japanese yen was also strong, and the currency has regained its losses from yesterday’s downgrade warning from Fitch. It almost seems that on up days, we look to dollar weakness and down days we look to franc and yen strength. I am still developing and refining my understanding of who leads whom, but I think we can expect a lot more volatility in the stock market aided by jittery gyrations in foreign exchange.

Daily T2108 vs the S&P 500

Black line: T2108 (measured on the right); Red line: S&P 500 (for comparative purposes)

Related links:
The T2108 Resource Page
Expanded daily chart of T2108 versus the S&P 500
Expanded weekly chart of T2108

Be careful out there!

Full disclosure: long SSO puts, net long short Swiss franc, net long Japanese yen, net long U.S. dollar, net short British pound, net short the euro