Now What?

Okay. We got our subsidy check. We got our housing bailout. Now what?

George Bush signed the housing rescue plan into law yesterday. It provides an explicit government guarantee for Fannie and Freddie debt and provides assistance for homeowners in financial trouble and first-time homebuyers.

Apart from keeping the Agencies in business, what does this package do? It’s not like the Federal Government had a bunch of cash sitting around to put to use. Indeed, the Federal Debt ceiling was raised 800 billion dollars to $10.6 trillion just to accommodate the plan.

We should know by now that you can’t borrow your way to prosperity. Oh sure, many a start-up business was capitalized with credit cards and a second mortgage. But the US economy isn’t running out of a garage. Unless we do something to provide incentives to invest and grow, the adjustments will just continue.

I don’t think we’re headed for a recession. But we won’t solve anything by throwing tomorrow’s dollars at today’s problems.


Douglas R. Tengdin, CFA
Chief Investment Officer
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All Real Estate is Local

So where is the sub-prime crisis, anyways?

Whenever I pick up the paper I read stories about people turning in the keys because they couldn’t pay the bank. But I don’t see a bunch of vacant homes when I look around.

I know that you can’t judge an economy anecdotally, but it seems like the national residential vacancy rate of 10% is a little overstated. Probably if I worked in Nevada or Phoenix it would be different, but horror stories of suburban blight and 1 in 4 homes empty seem more like scary tales we tell around the campfire than clear-headed assessments of the real estate market.

The latest Case-Schiller data show that prices rose the last couple months in 8 of the 20 major cities that the index follows. The basket cases—Southern California, Nevada, Arizona, Florida, and Detroit–are still falling, but their pace of decline has slowed. In places like Portland, Denver, Atlanta, and Boston, prices are rising.

I know the pundits say that there’s a tsunami of foreclosed properties just waiting to hit the market. But when I look at the local numbers, the horizon looks clear.


Douglas R. Tengdin, CFA
Chief Investment Officer
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Winglets

Remember George Bush’s magic wand? A few years ago he said that if he could wave a magic wand and lower oil prices, he would. I cringed at the time, thinking about the magic of prices, and what they communicate to everyone in an economy. If we mess with that language by distorting the price signals, we miss out on all sorts of important effects.

One example is winglets. You know, those little upturned jobs at the wing-ends of newer airliners. It turns out that this design saves the plane about 2% of its fuel cost each trip. And they have the added plus of smoothing out the ride.

But they cost about a million bucks to put on each plane. With jet fuel prices higher, the payback period for re-fitting the older airframes is a lot shorter now. And winglets are sprouting up everywhere.

This is just one example of the magic of prices. In a free market prices communicate incentives. If someone waves a wand and distorts this, we’ll all have a lot bumpier ride.


Douglas R. Tengdin, CFA
Chief Investment Officer
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Socialism is Impossible

So we seem to have settled on a Fannie bailout. Yuck.

While I don’t see any alternative to a government rescue, I’m deeply disturbed by the bailout of the large mortgage agencies. By providing an emergency line of credit, American taxpayers are subsidizing the risk-taking that went on as more and more people bought more and more homes.

But easy credit and rising home prices didn’t turn out to be an unmitigated good thing. When an average income can’t afford to buy the average home the only way to keep prices rising is to get “creative” with the financing. And that meant loaning money to people who couldn’t afford it.

Now the chickens have come home to roost and the government’s stepping in. What’s the right interest rate for a mortgage? Ask your legislator. In a market economy, people with competing interests settle mutually agreeable prices. When risks are socialized, the government sets the prices. If rates are set too low, the Feds will be saddled with a lot of below-market debt.

After 70 years of price-setting nonsense the planned economies of Europe collapsed under their own weight. Let’s hope that it doesn’t take a similar failure in mortgage finance to cure us of the same error.


Douglas R. Tengdin, CFA
Chief Investment Officer
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Readiness is All

Many commentators are frustrated because their predictions of a recession early this year aren’t coming to pass. Not to mind, they insist. The upcoming downturn, while delayed, is not to be denied.

The number one culprit in the search for their error’s source has been the government’s economic stimulus checks. But the total cost of the program was $100 billion in a $15 trillion economy—less than 1%. And the sub-prime crisis has show us again that we can’t borrow our way to prosperity. So what’s the real source of our economic strength?

Exports have been on a tear. Agriculture, capital and construction equipment, technology, and services have been strong sources of domestic growth. Add to this the weak dollar, and we’ve seen foreigners buying US goods and services in droves.

This isn’t going to change over the summer. US companies have been marketing overseas for years, and now their efforts are bearing some fruit. A stabilizing housing and energy market should allow economy to continue to muddle along, with the improvement in trade serving as the engine.


Douglas R. Tengdin, CFA
Chief Investment Officer
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Ground Zero

Ground Zero of the economic slowdown has been the housing crisis. And ground zero of the housing crisis has been Detroit.

Actually, Detroit has been in a housing slump since the middle of 2005, when oil prices began to boom and domestic car sales began to slow. Clearly, Detroit got sucked into focusing on big, profitable trucks. More than 10 years after Toyota introduced the Prius in Japan, there is still no American hybrid.

So what can Detroit do now? In the ‘80s and ‘90s styling did the job. But this time it will take more than a makeover. Engineering needs to come into play.

A big paper asked what consumers want in a car. The answer? Milage. A minivan with 25 mpg. A sedan with 40 mpg. We may act like we want a GPS and other toys, but really, mileage is gonna sell cars.

Can Detroit deliver? Advance stories are that they may be late to the party, but several new models could deliver SUVs and sedans with what we need. Only the companies need to do it sooner rather than later.


Douglas R. Tengdin, CFA
Chief Investment Officer
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The Constancy of Crisis

Are we living in a continual state of crisis?

Ever since Adam and Eve walked out of that Garden, it seem like we’ve been living in an age of transition. Whether it’s higher energy prices, collapsing housing prices, a global savings glut, or new accounting standards, every time you turn around there’s some sort of crisis both here and just around the corner.

Is it just the media? Does the need to papers turn our news into alarmism? I tend not to think so. Keynes notes that we’re forced to act even when our information and expectations are imperfect. Emotional people acting on imperfect knowledge will make mistakes, some of them zingers. And as the world grows larger and flatter at the same time, more and more mistakes affect more and more of us.

Does that mean we’re doomed to suffer the slings and arrows of outrageous fortune? Sort of. But we can plan ahead and be sure our institutions have enough capital to outlast the next storm and enough humility to return capital to investors when it’s not needed.


Douglas R. Tengdin, CFA
Chief Investment Officer
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Shining the Apple

So the shine is off the Apple. Or is it?

Apple announced that earnings were up 30% from a year ago. Sales were up 40%. And they made more than most observers expected. So why did the shares trade down?

Some say it was the downbeat guidance that they posted for next quarter. After all, the economy is slowing and people may not want to drop $200 on new toys. Others say it’s Apple’s price. At 32 times earnings, you could say that the stock is priced for perfection. And some say that the stock has just come too far too fast. Over the past five years the stock has gone up 16 times. Trees don’t grow straight to heaven.

Whatever the reason, Apple’s action today shows that sometimes bad things happen to good companies. Great products and a commanding market share just aren’t always enough to overcome ennui and skepticism.

I’m not saying that Apple’s a bad company or a bad investment. But with the market asking “What will you do for me tomorrow” a thoughtful review may be in order.


Douglas R. Tengdin, CFA
Chief Investment Officer
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What Went Wrong?

So what happened?

Fannie Mae and Freddie Mac were supposed to do well by doing good. Since increasing homeownership facilitates hard work, community, and respect for property, why not charter a private company to facilitate financing? Use an implicit government guarantee to lower financing rates. Harness the profit motive to meet a social objective.

But the more I look at it, the more Fannie and Freddie resemble the old British East India Company. They have an effective monopoly on the US mortgage market, and this has emboldened them to take on more risk with their capital through leverage, loan size, and guarantees.

Over its 250 year history the East India Company overreached and had to be taken over. Fannie and Freddie’s tenuous position has led many to question whether they can survive, or whether the taxpayers will have to bail them out.

It’s hard to do well. It’s hard to do good. When someone suggests combining the two, it’s a smart idea to reach for your wallet.


Douglas R. Tengdin, CFA
Chief Investment Officer
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Courage

The world has a funny way of not ending.

Just when the gloom couldn’t seem much darker, here comes the cavalry. This time it took the form of Wells Fargo, which not only met earnings expectations and raised guidance, but actually had the audacity to raise the dividend. Don’t they know we’re in a banking crisis? They’re supposed to be asking investors for more capital, not giving it back!

Other banks have followed suit. JP Morgan earned 60% more than expected. PNC Bank’s earnings were up 10% from a year ago. As a result of all this good news, bank stocks have risen about 25% in the past couple days. While this doesn’t erase this year’s decline, it does lift the cloud a little.

Warren Buffet says to be brave when others are afraid and to be afraid when others are brave. Judging from the way the market’s been behaving, this may be a good time for bank investors to show some grit.


Douglas R. Tengdin, CFA
Chief Investment Officer
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