Agora Financial’s Rude Awakening

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Laguna Beach, California

• Markets lose some steam after epic two month rally,
• Three “stress test” facts you might not have considered,
• 90 days to try our best short service, risk free, and plenty more…

Eric Fry, reporting from Laguna Beach, California…

Stock prices fell yesterday. We would not be surprised to see them fall some more – not simply because the stock market has just achieved its biggest two-month advance since the 1930s, but also because the economy remains just as ill as it was on March 9th, when the stock market rally first started.

The only thing about the economy that has changed during the last two months is the way folks TALK about it. Back in early March, when the Dow was making 12-year lows, the news media carried continuous stories of doom and gloom. A second Great Depression was all but certain.

But now that the Blue Chip index has jumped a whopping 2,000 points, most members of the financial press have recanted their faith in doom and gloom. “The economy is recovering,” they say. “The macro-economic data are showing signs of ‘improvement’ and ‘stabilization.’” Judgment Day has come and gone, they believe. Only the land of milk and honey and TARP fund re-payments awaits.

“While the [economic] numbers are still bad, they’re less bad,” beamed one typical professional investor last Friday.

And so what?

Falling more slowly is still falling…and it will never be rising.

So let’s take a dispassionate look at some of the recent economic reports…and then decide whether these data show signs of “improvement” and “stabilization.”

Last Friday, the Labor Department announced that 539,000 workers lost their jobs during the month of April. Jubilant investors cheered the job losses as “less than expected.” But the Labor Department simultaneously revised the job losses for February and March to totals that were 66,000 more than originally reported.

In other words, if you add the revised losses from February and March to the April total, you get 605,000 jobs lost in April, not 539,000. But even if we take the Labor Department’s numbers at face value, we wind up with 1,238,000 lost jobs since the stock market rally began in early March. What other signs of “stabilization” have surfaced since the rally began? Here’s a short list:

• Industrial production fell for the sixth straight month – hitting the lowest level since 1998.

• The ISM Index of business activity dropped for the seventh straight month.

• Factory utilization fell to it lowest level since recording-keeping for this data series began in 1967.

• The S&P/Case-Shiller Index of home prices fell for the 25th straight month.

• An additional 600,000 families lost their homes to foreclosure.

• The number of homeowners who fell 60 days behind on their mortgage payments grew to more than 5 million.

• The number of homeowners who owe more on their mortgages than their houses are worth grew to more than 8 million.

Obviously, investors do not collude with one another to ignore ominous economic data. It just happens. Happy delusions are infectious. We humans sometimes see what we want to see…and fail to see what we don’t want to see.

We’d rather imagine the green shoots of recovery than confront the rot of economic decay. And we’d MUCH rather see soaring share prices than plummeting ones. So what’s the harm in a little delusional optimism?

Well…there’s no harm whatsoever in a little delusional optimism, as long as the delusion persists. But if upcoming economic reports do not continue to inspire rainbows, unicorns, warm fuzzies, group hugs and other feel-good vibes, share prices might retreat for a while. And that would be a bummer

Markets make opinions, as we never tire of reminding the Rude readership. So it’s no surprise that a great big 2,000-point Dow rally has made the very solid opinion that the economy is recovering.

But your editors are not buying it. The market has not made OUR opinion. To the contrary, we think the market has lost its mind. The only reason we haven’t lost ours is because we understand that markets do not reflect underlying economic realities each and every second. Sometimes stock prices overshoot to the downside, sometimes they overshoot to the upside and sometimes they go so far off the reservation that you wonder if they’ll every return.

We think the market has overshot to the upside. It might overshoot some more. But the recession is not over, and 2,000 Dow points won’t make it be over. The credit crisis is not over either. And a bogus “stress test” charade won’t make it be over.

The recently concluded stress test of America’s largest financial institutions is a good idea, conceptually. The FDIC and/or the Fed should have conducted these tests years ago. But the tests contain at least three fatal flaws:

1) Re-building bank common equity up to 4% is woefully inadequate. At 4%, banks would be operating with 25-to-1 leverage – a balance sheet structure that any prudent investor would consider reckless and/or “insane.”

2) The assets on most bank balance sheets remain susceptible to severe impairment. In other words, these assets could still suffer extreme mark-downs. If, in aggregate, these assets were to lose 4% of their value, the nation’s banks would possess tangible common equity of approximately zero.

3) The “stress” to which the bank examiners subjected the balance sheets under their review was not very stressful. Examiners used an “adverse scenario” that featured a 3.3% drop in GDP this year and an 8.9% unemployment rate. Well, guess what, the unemployment rate is already 8.9% and GDP during the first quarter collapsed at an annualized rate of minus 6.3%, compared to the fourth quarter of 2008. So maybe the “adverse scenario” is not nearly adverse enough.

To learn more about the recently concluded stress tests, and where they might lead public opinion and the financial markets, check out the observations of Dan Amoss, the mind behind the Strategic Short Report…

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Commercial Real Estate…The Crisis Begins
By Dan Amoss

What do the Fed’s recently concluded “stress tests” have to do with commercial real estate? Everything. The stress test results convey the illusion that America’s largest banks possess adequate capital. But that’s not true. And since America’s largest banks possess inadequate capital, they will be reducing their exposure to commercial real estate loans. REIT-holders beware!

Forecasting loan losses at banks is an inexact science. In fact, it’s not a science at all. It’s more like a game of chance, like craps or roulette. Even if you know the odds, you still have no idea about the outcome. Forecasting future cash flow from existing loans is also a game of chance. Both of these unknowable forecasts lie at the core of last week’s stress test.

The market’s reaction to the stress test — in the form of soaring bank stocks — tells me that the consensus is treating this stress test as if it has the ability to magically predict yearend 2010 capital levels with pinpoint accuracy.

Most of us do not have magic predictive powers — only the ability to make judgments based on knowledge and experience. In my judgment, the stress test was not stressful enough. For instance, it is not really accounting for borrower behavior in a scenario where they are underwater on their mortgage and under- or unemployed.

For example, the stress test’s estimated losses on second-lien mortgages in particular seem very low. In foreclosure, these are often total losses. With another big wave of Alt-A resets and foreclosures in the pipeline, the performance data on second lien mortgages should worsen. Several state-imposed and bank-imposed foreclosure moratoriums are ending.

The bulk of housing activity right now consists in foreclosure auctions and short sales. How much are second mortgage liens worth under this scenario? Not much.

Most big banks already have low levels of tangible capital relative to towering trillions in risky assets. The cash flow from their existing and new loans must exceed their loan losses in order to simply maintain existing capital levels (let alone increase capital).

Think of this situation as a bathtub. Bank capital is the amount of water in the bathtub, and the faucet pours new water into it (that’s cash flow from existing, paying loans and securities, plus new capital infusions) and the drain sucks it out (these are the loan losses). Pessimists claim that the drain of losses is sucking water out so fast that it will empty the bathtub within a year or two, depending on the bank. They tend to ignore or downplay the new water coming in. Optimists claim that if regulators prevent the water from falling to a very low level during this crisis (regulatory forbearance), in time, the water level will eventually rise back to normal levels. There’s a risk that if the optimists are wrong about the amount of new water coming in, we’ll be stuck with a Japanese-style “zombie bank” situation.

After last week, I think the risk of the zombie bank scenario is much higher. We’ll probably see this manifested in continued tight credit conditions. The banks under the most intense scrutiny will tend to reinvest cash flows into less risky assets like Treasuries and agency mortgage-back securities (another form of government guaranteed debt) — rather than write new commercial or consumer loans.

The big banks certainly will not be underwriting many commercial real estate loans (this is central to my thesis on buying the UltraShort Real Estate ETF (NYSE: SRS). Any commercial real estate lending that’s done will incorporate much lower loan-to-value ratios and higher interest rates. With property prices down 50%, the equity in levered deals done at the peak of the bubble has mostly vanished. REITs are a form of equity in leveraged commercial properties.

As you can see in the term sheet of the latest iteration of TALF lending for CMBS, the Fed is in no position to lower its lending standards (see link here). It is not willing to lend against commercial mortgage collateral that’s below investment grade or was created before July 2008 (“All mortgage loans must have been originated on or after July 1, 2008.”). These terms exclude virtually the entire pool of distressed commercial real estate assets. So even if the Fed lowers its collateral standards further, REIT equity will still not avoid massive dilution or elimination. Underwater commercial property owners (including REITs) are finding it nearly impossible to refinance maturing loans.

Certainly, the Federal Reserve will continue trying to cushion the deleveraging process underway in commercial real estate. The market’s expectation of Fed intervention in this sector has fueled much of the recent rally in REITs. But I think the market has it wrong here. The Fed may be able to slow the destruction of wealth in this sector, but it cannot preserve the equity value of overleveraged REITs, any more than the Fed’s 2007 lending programs could preserve equity value for Citigroup shareholders.

Joel’s Note: Attention serious Rude Awakening traders and investors – DO NOT pass go…DO NOT read a 20-page report about how you can become a millionaire by tomorrow, DO NOT be fooled by the mainstream press that the “worst is behind us.”

Instead – and this is only for serious traders and investors – proceed directly to the sigh-up page here where you can grab a 90-day, risk free subscription to Dan’s Strategic Short Report. That’s right. No muss, no fuss. Just 90 days to try Dan’s service with a full, money back guarantee. Go direct to the sigh-up page here.

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[Rude Endnote: Aside from a rare few exceptions, most major markets in Europe and Asia followed Wall Street’s example overnight. As Eric mentioned above, the Dow slipped 1.8% on the first trading day of the week; the S&P 500 lost 2.15%. After last week’s epic run, a pullback was on the cards from the outset.

Here in Asia, China was the only marketplace that managed to notch up significant gains by the closing bell today. The CSI 300 jumped 2.3%, while Hong Kong’s Hang Seng managed to eek out a modest 0.4% gain. Japan’s Nikkei 225, meanwhile, fell 1.6%. Taiwan’s Taiex, South Korea’s Kospi and the Aussie All Ordinaries all ended the day in the red, down 3.2, 0.9 and 1.25% respectively.

Over in Europe, Germany’s DAX was the only major index in the positive last we checked, up around half a percent. London’s FTSE and France’s CAC 40 were down by as much.

Over in those sweaty commodity pits, traders have their hands full. Nymex crude futures broke through a 6-month ceiling, topping $59 a barrel for the first time since November on dollar weakness and some squiggly lines on the technical charts. Gold was a little quieter, though still managed to add about four bucks to $918 per ounce this morning.

We’ll be back with more of the Rude stuff tomorrow morning.

Until then…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com