GDP, M&A, EBITDA, P/E, NASDAQ, Econo-thread Part 11

[DanS]

"If you don't expect a bull for the moment, I'd be wise to put your money into something that at least guarantees you a positive return for the next year or two, wouldn't you think so?"

I have no idea whether there will be a bull market any time soon, so no, I don't think wisdom has anything to do with it--or at least wisdom would only dictate the fact that you can't time a market. I'm just doing a simple comparison in returns over a long-term time horizon.

"And besides, you're forgetting that inflation doesn't only affect treasury returns, but also profit growth, so that 7-8% might be a couple of % lower."

I don't follow you. All of my numbers are nominal.

[Colonâ„¢]

Originally posted by DanS
I have no idea whether there will be a bull market any time soon, so no, I don't think wisdom has anything to do with it--or at least wisdom would only dictate the fact that you can't time a market. I'm just doing a simple comparison in returns over a long-term time horizon.

I reacted on this sentence of yours: "No, no basis for a bull. But considering what is available otherwise...", which seems to imply to me that you don't see any alternatives at short term.

But if you were thinking about the LT from the start, timing does matter if the market still has 1/3 to go on the downside.
And remember that 7-8% is just an average that consisted of a huge bull market that made up for decades of stagnation or loss.

I don't follow you. All of my numbers are nominal.

You were comparing current 10-year treasuries rates with the historical average of stock return but you're forgetting that the treasury rate is this low because they're expecting very low inflation the next decade (about 1.5%) while the stock return average was formed in decades of inflation much higher than that. Hence my idea that stock returns will be much lower as well if the inflation forecast is correct, because the inflation rate impacts earnings growth. (obviously)

So, if you're using the 7-8% average, you're assuming that inflation will be higher than they forecast, which makes me wonder why you wouldn't buy inflation protected treasuries.

[Sten Sture]

Originally posted by Colon

... put your money into something that at least guarantees you a positive return for the next year or two, wouldn't you think so?

And if you expect inflation to pick up, why not purchase inflation protected treasuries?

Ah, inflation indexed treasuries and something with a positive return...

by the by, in the States the inflation indexed treasuries have a very long payout tail and therefore duration, so they tend to move coincident with other treasuries, not inverse. If the yield curve backs up because of rising inflation, inflation indexed bonds will get crushed. Seems ass backward odd, but that is the way they work.

What does guarantee a positive real return over the next year? Nothing I know of!


Roland - (all was well and dry in Mozartland until they left)

I owe you two responses, I see.

Why would the Treasury rally reverse when mortgage refinancing slows? The traded mortgage market in the states is huge. Fixed rate mortgages outstanding at monthend were over $2.7 trillion. Comparably traded US Treasuries totaled less than $1.7 trillion, US Agency debt was $960 billion, and investment grade corporates were just over $2 trillion. At monthend February, the duration of the outstanding mortgages was 2.90, at monthend September it was 0.91.

As mortgages shorten their duration from expected prepayments, portfolio managers at Banks, Agencies, and Investment houses have to buy longer durated assets to offset the duration reduction until the new long duration mortgages come to market. So you get purchases of long treasury notes and bonds. This process is generally a sixty to ninety day type of window. So as new mortgages are packaged and issued, Banks, Agencies, and Investment houses roll over their prepayments into the new longer duration loans and sell long treasuries to keep from having their durations extend too far.

This process doesn't have much to do with the Fed, or the mortgage agencies for that matter. It is just a function of the mathmatics of a securtized mortgage instrument that can be refinanced at a low fixed cost at the borrowers discretion.


The US mortgage industry is something of a capitalism phenomenon. For years, people did their banking with small local lending institutions. At that time, almost all residential mortgage loans were for 30yrs at a fixed rate of interest; the banks hated it when a client wanted to refinance, and charged large fees to dissuade clients from pursuing that option. When banking laws were liberalized here in the states to allow for larger geographical distribution systems, a lot of banks found out that they had very geographically concentrated loan portfolios. The first pooled mortgage securities were issued at a time when the manufacturing sensitive regions were having an awful time, so the banks there quickly realized that they could diversify their loan exposure by securitizing their mortgages.

Eventually most banks realized that selling off local loans and buying back a generic diversified substitute was a great risk management tool. Since those banks no longer owned the specific loan they had made on Mr & Mrs Smith's house, they stopped making it difficult for the Smiths to refinance. Then they started trying to get the Jones' who banked across the street to refinance with them. The way they did that was by offering a variety of loan structures like 15 year fixed rate loans, 5 year balloon payment loans, adjustable rate loans, etc.

Now the average homebuyer can finance the purchase of a house or refinance their existing loan with hundreds of competing firms offering tens of different structures. Since the primary structural change in loans has been a move down to the shorter end of the yield curve, the average home loan would carry a lower rate of interest today than it used to, even if rates had stayed exactly the same. This lower "discount rate," if you will, has provided a natural tailwind to housing valuations that will only cease when financing innovations cease, or become counter productive.

One could argue that a certain percentage of financing options available today are counter productive, though if they are not pervaisively used, their effects may be marginalized. In any case, the average loan today is not yet a 125% of market value Interest Only Adjustable Rate Floater at a 4% teaser for a year and then reset to Tbills +675bp with a quarterly reset, uncapped and a 5 year final.



Was that post long enough???

[Roland]

Longposting bastard.

"This process doesn't have much to do with the Fed, or the mortgage agencies for that matter. It is just a function of the mathmatics of a securtized mortgage instrument that can be refinanced at a low fixed cost at the borrowers discretion."

I thought you were talking about some fundamental turnaround. If I understand correctly you say there will be a shortterm correction ?

Btw, I don't think we've seen the last refinancing round in this game....

[Roland]

"At that time, almost all residential mortgage loans were for 30yrs at a fixed rate of interest"

Aha... odd.

"Since the primary structural change in loans has been a move down to the shorter end of the yield curve, the average home loan would carry a lower rate of interest today than it used to, even if rates had stayed exactly the same."

Well there's a reason why the yield curve usually is not inverted. Where did that reason go in the securitization game ?

"In any case, the average loan today is not yet a 125% of market value Interest Only Adjustable Rate Floater at a 4% teaser for a year and then reset to Tbills +675bp with a quarterly reset, uncapped and a 5 year final."

Sounds funny. Anyway, as you seem to think innovative products are important, I can describe my mortgage deal:

120k € loan. At first 185 k loan at 3.5 %, 65k of which is put on a tax-favoured building-saving account at 1.5 % interest, for 3 years (bridge financing).

Then the actual loan is given fixed at 4.25 % for 10 years, effective ~4.5 % due to a couple of fees.

For the remaining duration of 15 years the rate will be fixed at the beginning at the average 3 month euribor of the last 12 months, rounded on 25 bp, + 150 bp. But capped between 4-6 % in any case. As the nominal rate should hover around 4 %, the bastards have calculated that they'll usually get towards the 6 % top.

Prepayment is possible up to 36 (or 72 ? not sure now) monthly rates, above that you need the consent of the lender.

I've been digging through half a dozen offers with different structures. So why is our real estate market not booming ?

[Saras]

--"Anyway, as you seem to think innovative products are important, I can describe my mortgage deal:

120k € loan. At first 185 k loan at 3.5 %, 65k of which is put on a tax-favoured building-saving account at 1.5 % interest, for 3 years (bridge financing).

Then the actual loan is given fixed at 4.25 % for 10 years, effective ~4.5 % due to a couple of fees.

For the remaining duration of 15 years the rate will be fixed at the beginning at the average 3 month euribor of the last 12 months, rounded on 25 bp, + 150 bp. But capped between 4-6 % in any case. As the nominal rate should hover around 4 %, the bastards have calculated that they'll usually get towards the 6 % top. "

BAUSPARKASSE IS EVIL !

Our parliament is trying to push through something like that. Bah!

[Roland]

"BAUSPARKASSE IS EVIL !"



Faaaar better than the Yankee GSEs and excessive tax subsidies.

[Saras]

--"Faaaar better than the Yankee GSEs and excessive tax subsidies."

Seriously, though, there should be no tax advantages. Like here, now.

[Roland]

Absolutely. But the tax advantage of the whole thing is quite limited. Unfortunately.

I missed the real pork fest, and that's the so called "Wohnbauförderung". I'm above the income threshold.

[Saras]

Geez, those german Uberwords

[Colonâ„¢]

Could someone tell me (for educational purposes) what the such called "surrender value" British life insurers apply is?

[Sten Sture]

If it is anything like the American version, some life insurance policies can be cancelled and the original purchasor can get their premiums repaid at some sort of anemic accrued interest.

Insurerers must include in their financial reporting a figure representing the impact that cancellations and payouts would have on their financial condition. Payouts would reduce future liabilities for death benefits, at the cost of reducing invested assets liquidated to make the payout.

That should be close.



Euribor still sounds weird to me. Can you guys get it changed to something else??

Hej Roland, I like your loan structure! It would fit right in over here.


More US Mortgage securitization info that you really didn't want to know. The GSE only repackage Conforming loans. The maximum loan size is 2x the 80% of the median home price. That makes the maximum GSE wrapped loan a paltry $250,000 or so. Now anywhere else in the country that is a nice house, but here in my back yard, that won't buy me a three-person NorthFace tent. Sucks to be me.

The 'other' factor, and, in my mind the important factor pushing up home prices in the States United, is a change in the tax code to make capital gains from both primary and secondary residences tax exempt up to 500,000 for a married couple, every two years. It is an amazing tax break, that really only benefits the Californial market and some eastern metros, but it does encourage people to buy the biggest house they can and hope the price goes up.

[Roland]

"The GSE only repackage Conforming loans. The maximum loan size is 2x the 80% of the median home price. That makes the maximum GSE wrapped loan a paltry $250,000 or so."

Well 160 % of the median is still a lot of wood. Does that rule apply to the Federal home loan something, too ?

"It is an amazing tax break, that really only benefits the Californial market and some eastern metros, but it does encourage people to buy the biggest house they can and hope the price goes up."

Well that may create some extra froth in those areas. But overall ultra cheap money, tax subsidies, government guarantee subsidies, structured finance and inflationary expectations make a nice bubble.

[Colonâ„¢]

Originally posted by Sten Sture
If it is anything like the American version, some life insurance policies can be cancelled and the original purchasor can get their premiums repaid at some sort of anemic accrued interest.

Insurerers must include in their financial reporting a figure representing the impact that cancellations and payouts would have on their financial condition. Payouts would reduce future liabilities for death benefits, at the cost of reducing invested assets liquidated to make the payout.

That should be close.

Yep that's probably it. I was reading a little about the surrender value policies at British life-insurers in the early 90's, which was quite unfair, at the least. (but maybe you know all about that already)

[DanS]

"And remember that 7-8% is just an average that consisted of a huge bull market that made up for decades of stagnation or loss."

I think I'm now following you. Put simply, my 7-8% is not based on past performance. Just a coincidence that they might match. Rather, the nominal long-term GDP growth rate is assumed to be 6% (3.5% real growth + 2.5% unreal).

Then you plug in Buffett's assumption that earnings as a percentage of GDP is set by the US economic system to be within a certain range. Of course, this is a big assumption, but not an unreasonable one.

Then follows an observation that current and next year earnings reflect some %-age shy of the long-term expected earnings as a % of GDP.

Then take a look at forward S&P P/E, which shows a 5-6% return at current price. Adjust this return upward over the long term to take into account a reversion to earnings as % of GDP.

As a rule-of-thumb, this seems to show that 825 on the S&P is no longer irrational exuberance in comparison to what can be had from the gov't.