Monday, July 28, 2008

Bill Gross IO for August 2008 - inflation/deflation conundrum and home prices

Bill Gross' new IO for August as always is a joy to read and again he hits the nail on the head. This time he tackles the risk for asset price deflation which in his opinion rests entirely with home prices. "Let's blame it on the barn, or if you must, home prices." Falling home prices put some 25 million homes, purchased in 2004 and beyond, at risk for negative equity which could eventually lead to a cumulative loss of 1 trillion dollars on the balance sheets of financial institutions according to Gross. If not matched by raising capital that loss necessitates a sale of assets and a general reduction of lending. There you have it "deflation", but to be sure we are not there yet. Capital raising so far has been very succesfull and the world is still awash in cash. Not all financial institutions have entirely lost its earnings prowess or so it seems. Last weeks gains in stock indeces was in part due to better than expected earnings for the second quarter from some of the major financial institutions in the U.S. C&I loans and consumer loans at US financial institutions are still growing according to data from the Federal Reserve Bank of St.Louis. All this for the moment argues against a major asset price deflation threat but if home prices continue to slide this possibility might become the next nightmarish reality and this time for the real economy.

Bill Gross' Mooooooo:
An asset deflation in turn becomes a debt deflation, as subprimes, alt-As, and finally prime mortgages surrender to the seemingly inevitable tide. PIMCO estimates a total of 5 trillion dollars of mortgage loans are in risky asset categories and that nearly 1 trillion dollars of cumulative losses will finally mark the gravestone of this housing bubble. The problem with writing off 1 trillion dollars from the finance industry’s cumulative balance sheet is that if not matched by capital raising, it necessitates a sale of assets, a reduction in lending or both that in turn begins to affect economic growth, creating what Mohamed El-Erian fears as a “negative feedback loop.”

Financial asset prices, as well as those for homes, are really the discounted present value of what investors believe those assets will be worth far into the future. When the discount rate – in this case a 30-year mortgage – rises faster than the expectations for home prices themselves – then the price of a home falls. 7% + “all in” yields for current home financing, in contrast to prior periods of monetary easing, are lowering, not raising the discounted present value of an existing home. Blow them up? Well, yes, I suppose if we could. But absent that, lowering the cost of mortgage credit via the omnibus housing/GSE bill now placed before the Congress and the President is the best way to begin the long journey back to normalcy.

To return the housing, cow milking, asset price deflating metaphor to its broader context, the increasing price of credit is a common denominator worldwide in the delevering process which it drives, or in turn, is driven by. If the cost of credit – the discount rate for present value – would go down, then asset prices would be better supported. Stocks wouldn’t sink so fast, commercial real estate wouldn’t wobble so, ..But the cost of credit is going up, not down, in contrast to prior cycles, because astute investors recognize the myriad of global imbalances that threaten future stability. In addition to home prices, $130 a barrel oil and their resultant distortion of global wealth and financial flows head that list. For now, investors should remain in high quality assets – until – until, well…until the prospect for home prices points skyward or until the cows come home, whichever one’s first.

source: Mooooooo!
Investment Outlook, Bill Gross | August 2008

read also: Consumer loans and C&I loans at commercial banks are still growing
Wednesday, July 16, 2008

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