When Leverage Attacks

The real estate market is certainly heating up in the San Francisco, my new city, despite the broader Case Shiller Home Index still hovering near cyclical lows.

How soon we forget.

I will admit, real estate does sound like close to a sure thing with mortgage rates at record lows, potential inflation on the horizon, negative real rates in savings accounts (i.e. zero opportunity cost), and prices as much as 50% or more off. And it may be, but not necessarily when leverage is introduced.

But, first, let's take a look at housing without leverage.

Case Shiller Index (without Leverage)

As last week's post The Power of Momentum outlined, the broad Case Shiller Composite-10 index was stagnant from 1987 to 1997, rocketed between 1997 and 2006, and has tumbled since. However, over this entire period we have seen a healthy increase in the price (a bit more than the rate of inflation... assuming growth using the composite-10 index, a house worth $100,000 in 1987 is now worth a bit less than $250,000)

Case Shiller Index w/ Introduction of Leverage

As James Montier of GMO has pointed out:

Real risk is the risk of permanent loss of capital.

Investments made with borrowed money reduces the range that the investment can move without causing a permanent impairment of capital.

Using the same Case Shiller Composite-10 index data as in the above chart, we introduce leverage using the following rules:

• 5x leverage (i.e. a 20% down payment... pretty standard, though not so much during the bubble)
• If prices rise, sell your investment property each year and with the equity gains, buy a more expensive property at 5x leverage

Simplifying Assumptions:

• Mortgage payments = rental receipts
• No taxes / transaction fees

Using the same $100,000 house as an example (this time with 20% down), we get the following:

Returns were actually okay from 1987 to 1997, but were dwarfed by the boom seen from 1997 to 2006 as property values, debt to go along with it, and equity SOARED, taking the original $20,000 investment to $3.7 million.

BUT, it all came crashing down. As property values declined, the new outsized level of debt remained, which resulted in all that hard earned equity flipping negative (in the above example) by early 2008. 5x leverage means that when the value of the property turned down just 20%, the entire equity stake was gone.

Takeaways....

• Real estate investment is not riskless, especially when leverage is introduced
• Down payments of 20% do not prevent bubbles (as the chart above shows, asset appreciation allows an investor to put gains back in the market)

A case can be made (specifically within real estate) that negative equity does not equal permanent impairment. As long as payments continue to be made, an investor is still alive. While this is true, it does completely reduce liquidity (i.e. you can't sell without making the loss permanent) and it require an investor to make mortgage payments that are higher than the current market clearing price for similar properties.

Source: S&P

End of Recession / No End of Private Sector Deleveraging

From NBER:

The Business Cycle Dating Committee of the National Bureau of Economic Research determined that a trough in business activity occurred in the U.S. economy in June 2009. The trough marks the end of the recession that began in December 2007 and the beginning of an expansion. The recession lasted 18 months, which makes it the longest of any recession since World War II.

In determining that a trough occurred in June 2009, the committee did not conclude that economic conditions since that month have been favorable or that the economy has returned to operating at normal capacity. Rather, the committee determined only that the recession ended and a recovery began in that month.

And how were we able to get this non-recovery, recovery? The federal government (from exhibit D.3 of the recent Federal Reserve flow of funds report):

End of recession or not, any sector not labeled government or corporate continues to delever (and local government and corporations are dwarfed by the federal government), which to me says any domestic led recovery from here will be limited.

Source: Federal Reserve

Greed is Global

Per Infectious Greed:

Europeans banks have long been gaming their regulators, having far less than the actual capital reserves that they needed given their balance sheets. AIG filled the hole, selling credit defaults swaps to European banks via which they could tell regulators that they were adequately covered -- at triple-A, no less -- while carrying less cash than required.

How large scale was this "gaming"? According to AIG, about $379 Billion of their $527 Billion default swap portfolio:

"represents derivatives written for financial institutions, principally in Europe, for the purpose of providing them with regulatory capital relief rather than risk mitigation."

According to analysis done by CEPS, banks were levered as much as 60x. The biggest culprits? UBS, ING, Barclays, and Deutsche bank.

Remember these names and let the write-downs continue...