Reasonably Thinking

A decline in housing remains one of my strongest investment ideas.  Let’s walk through the thought process…

Congress is subsidizing housing demand via its first-time homebuyer tax credit.  This pulls forward future demand.  When the program ends, demand starts to dwindle (and will fall to an even lower amount than what normally would have occured).  If Congress extends this subsidy, which happened last fall, even more demand will be pulled forward, and the fall will be even greater.  This ongoing game of taxing people to subsidize home ownership has consequences as demand cannot be artificially inflated forever.  Housing demand will decline.

A simple rule of economics:  when demand declines, prices fall.

 The second part of the equation is the onslaught of delinquencies and foreclosures coming onto the market.  Reasonably thinking, with an enormous amount of houses soon to be available for sale, constructing even more houses is not a good business to be in.

Another simple rule of economics:  when supply increases, prices fall.

The trade:  bought 2 ITB July put options at strike $17.50, for $4.50 each.  The breakeven is about $13, and the stock closed at $13.25 today.  (I made a very similar trade last month).

I had an old short straddle on Merck (MRK) that I bought to cover today.  These were converted options (I originally sold the short straddle on Schering-Plough which subsequently became MRK options).  As such my broker’s software didn’t properly recognize them (crazy in this day in age).  The result was that I had to phone in every trade that I wanted to make.  So, I decided to rid the position (although I still retain the underlying 57 MRK shares).

Simultaneously, I had an order in to purchase more put options on ITB.  The theory was long MRK and short ITB.  However, the ITB trade never went through.  Hopefully I can increase my ITB put exposure in the near future.

The 2/8 Forbes cover story is well written and quite compelling.  Here is the link along with some of my notes.

http://www.forbes.com/global/2010/0208/investing-credit-auditing-leverage-global-debt-bomb.html

[Bass] If 2008 was the year of the subprime meltdown, 2010, he thinks, will be the year entire nations start going broke.
…Reinhart has found that a 90% ratio of government debt to GDP is a tipping point in economic growth… The U.S. government-debt-to-GDP ratio is 84%…
The CDS market is priced to imply a 3.1% chance of default over five years on Treasury debt.
To buy insurance against a default in Greece over the next five years costs 3.4% a year.
[Bass] His biggest potential score is in Japan. Government debt has soared to 190% of GDP from 50% in the mid-1990s, hitting an estimated $10 trillion in 2009… …Kanno in Tokyo says that Japanese bonds are in a bubble that could pop in the next three to five years, as savings rates drop.

I purchased 12 put contracts on Freddie Mac (FRE), with a strike price of $1 and expiration of July, for $0.16 each.

The thesis was brought to my attention by John Hussman in his November 16 weekly column where he quotes Freddie Mac’s quarterly report:

“In June 2009, the Financial Accounting Standards Board issued an amendment to the accounting standards for transfers of financial assets (SFAS 166) and an amendment to the accounting standards on consolidation of variable interest entities (SFAS 167). Both amendments are effective and will be applied prospectively by the company on January 1, 2010 … Under these accounting standards, the company will record the underlying mortgage loans in these single-family PC trusts and some of its Structured Transactions on its balance sheet. These mortgage loans have an outstanding unpaid principal balance of approximately $1.8 trillion as of September 30, 2009… While Freddie Mac continues to evaluate the impacts of adoption, the company expects that the adoption could have a significant negative impact on its net worth.”

Fundamentally, I still believe that this economy has problems ahead.  Moreover, even if the economy was in decent shape, the market is still overvalued.  With a probable second round of foreclosures upcoming, the FASB amendment could be a nice catalyst for a larger trend, at least for FRE.  As for the execution, I’m well willing to risk $200 on this.

I know who it is before I even answer the phone.  At 9:40AM, the market has just opened, and I already know that at least one of my short positions has been covered…

“Hello?”

“Hi… this is [broker] calling to inform you that there was an SEC mandated forced buy of 1 share of CYN from you account…”

Seriously!  Seriously?  1 share?  You’re going to pawn me off one share so that my position is now 49 shares?  Who will want me to buy 49 shares from them?  Yuck.

So my 1 share was bought at $49.85.  I decided to cover the entire position later in the day at $49.55.  Seeing my thesis erode, I would liked to have covered in the high $40s, perhaps a dollar or so lower.  In review, the FDIC-Imperial deal to CYN was clearly a blow to my short position; the deal was instantly accretive to City National’s book value.  Further, I now recognize that I may not have had the right stock for the play–I wanted to profit from a fall in California banks, thinking all would suffer (which still might happen).  However, even though CYN is in a losing region, it is probably the best of a bad lot.  Whether or not this thesis eventually plays out is no longer worth my coin.  At this point, I take the loss and move on.

From a portfolio perspective, I wanted to keep a similar amount of negative exposure to replace the covering of CYN.  So, I purchased two put options on SSO (the double levered S&P500 ETF).  These were the June $44 contracts, at $8.00 each.

Even in a loss, I still keep score:

An interesting graph from Hussman Econometrics:

“…the ability of companies to increase book value over time has been a critical determinant of long-term earnings growth…”

“…Investors now rely on the renewed attainment of bubble valuations in order to achieve acceptable returns…”

http://www.hussmanfunds.com/