A New Twist For Housing

by: The Other Street

Yes, Wall Street is bipolar. The emerging conventional wisdom is that Operation Twist is good for no one, and that Dr. Bernanke belongs to the Cuckoos’ Nest, along with his European comrades. We should have had a non-sterilized QE3 instead. This comes from the same people who said QE2 was an abomination, not to mention QE1. On second thought, they even go further. Europe should TARP – coming from the same people who pilloried Dr. Ben and Henry Paulson. They even suggest Europe should leverage…the EFSF, of all Ponzis!

I am trying to stay away of the funny stuff. In early August, when we were hovering around S&P 1300, I called for 1190, a level that has proven to be pivotal, and my conclusion was “We are going to grovel for QE3.” I have not changed my mind since.

I then wrote about Europe’s dysfunctions. In a nutshell, I concluded that Germany will take care of its own, the ECB of the others, while Greece graciously defaults. Europe has to monetize, not sterilize, and recapitalize. As this is shaping up, if the Financial Times report on Thursday of 16 banks in bad need of recapitalization is accurate, there are more questions coming up. One is “where will the money come from?”

Here is a simple answer: Nationalization. Boohoo, a bad word in “progressive” economies. Only Chavez, the Chinese and the Russians could do that, right? Wrong. I thought I had an original thought here. The idea came to mind as I recalled President Mitterand's massive nationalization program in 1981 – 36 banks and several leading industrial complexes. Sacrebleu. Well, he was another social-communist, so it couldn’t happen this time.

It did. In 2009, Germany passed a nationalization law and took a 25% stake in Commerzbank after it agreed to purchase Dresdner. It then nationalized Hypo Real Estate, after having provided $109 billion in government guarantees. Before that, in 2008, it had taken over IKB Deutsche Industriebank. In the UK, Northern Rock was nationalized in 2008. The point is, been there, done that. Ultima Ratio in German, Last Resort in English. Even Joseph Stiglitz, Nouriel Roubini and Nassim Taleb agree. So the roadmap is getting more obvious by the day, as the markets are twisting the Politicians' arms. If Merkel thinks she can overrule the markets, she may need more vacation. Europe will monetize and nationalize, and Greece will default. In the US, Twist will evolve too. Curiously, at the end of the day, while this may improve the dollar, it should not induce a major dislocation. With everybody in the same boat – including Japan by the way – which currency to sell and which currency to buy?

Now, what does this all have to with Housing? The reason why Twist is decried is because by flattening the yield curve further, it reduces the incentive for banks to borrow short and lend long. This usually is the prelude to a Fed engineered economic slowdown, when the yield curve becomes inverted and causes similar results. Well, two things here. First, borrowing short to lend long is not necessarily a good idea, depending on what comes next, i.e. inflation or not. Second, banks are not lending anyway. That is, they are keeping the money provided by QE1 and QE2 at the Fed, as Excess Reserves, $1.6 trillion last I looked. With a reserve requirement of 10% (RR), this should theoretically translate into an increase in Money Supply of $16 Trillion, where the multiplier is
m = 1/RR
Allowing for currency drain (the desire by the public to hold currency outside the system) and for banks’ desire to hold more than 10% in reserves (desired banks reserve), the formula becomes:
m = (1 + currency drain)/(currency drain + desired bank reserves)
Assume currency drain at 25%, and desired reserves at 25%, this would still provide for m = 2.5, i.e. $4 Trillion. No wonder the Fed is upset and “we” say QE did not work.
OK, so what do we do now? According to all US banks, they have no net exposure to Europe. I question the word “net,” which somehow implies they bought CDS and other derivatives to cover their positions. Until I know whether the sellers of CDS can come through with their obligations, I must suspect the notion of zero exposure. That being said, let’s assume it is true. Why then do they keep so much excess reserves? Remember, on August 7, 2008, to pick a date before the storm – see my book – these excess reserves amounted to a paltry $11 billion, the norm at the time. One or two things, either they lie, or they lie. There is only one way to find out: the Fed is pushing the banks’ logic. If the they don’t want to lend, the Fed will take their margins away.
At the same time, the Fed is forcibly reminding us about its dual mandate, meaning job creation. Got it?. The only sector that can move the needle at this point is Housing. Exports, forget it - to whom? Europe, gotta be kidding. South America, check Brazil. China, wobbly. Consumption? Not until Household Net Worth improves, and it just took a bit of a whacking. Federal, State and Local Government? It’s the deficit, stupid. Remains Housing. Guess what, with mortgage rates at 4%, this is a nice spread for banks. That’s the Twist. The Fed is not engineering a slowdown, it is stimulating a pick-up. Let’s see if Arm Twisting works. Here is a long-term chart to put the current numbers of 400,000 single family and 200,000 multi-family starts in perspective:

(Click charts to expand)


The net of it all is this, as far as yours truly is concerned. Now that Pandora's box has been opened, Europeans - Athens and Rome in particular - know they have no alternative but to deal with the Evils if they want to find Hope. Translation: the financial system will be saved. It will look different when all is said and done, much like in the US, with plenty of headlines and cacophony in the meantime, but there will be no financial liquidity crisis. Since this fear accounts for the stock market's depressed valuation, I continue to expect a regression to the mean, call it an Earnings Yield of 5%, for a P/E of 20, the average in post WW II non-inflationary periods. Based on a revised $80 estimate for the S&P through mid-2012, this equates into 1600. Because of the cacophony and the 2012 elections, I don't expect this level before 2014. And because of the damage that has been done to the market, technically, I will take it one step at a time. My first objective, like most who think the downside risk is limited, is my favorite pivot point of 1194. But we have work to do to get back there, with resistances at 1150 and 1170. The key challenge now becomes Q3 E as in Q3 Earnings. While they are likely to be weak, as usual it will be the reaction to the news rather than the news itself that counts. Given the current drubbing, I would not be surprised by positive reactions. So I continue to maintain my intermediate target of S&P 1270 before 1010. We are at 1140 as of September 23, 11:30 EST. That's 11% either way, and I'll take White Swan.



Disclosure: I am long TOL, URI, WCC.