Choppy trading conditions are entrenched in traders’ minds. Last Thursday’s rejection of a fresh equity index low point smacks of a selling climax. The Federal Reserve Bank decision to put in place continued open market measures to provide liquidity to those corporations who need it, and its decision to lower the discount rate, have been welcomed by investors. However, it doesn’t feel as though it’s quite enough.
A slide in government paper yields on Monday was inspired by fears that even money market funds might be tainted by subprime contagion provides another clear threat to orderly money market operations. Slap on the latest RealtyTrac Inc. data on foreclosures and we now have a recipe for an official rate cut from the Fed according to many investors.
On Tuesday rumors emanating from the bond pits at the Chicago Board of Trade (CBOT) predicted that Tuesday’s meeting between Federal Reserve Chairman Ben S. Bernanke and Treasury Secretary Henry Paulson would be the basis for an official reduction in the fed funds rate by perhaps 50 basis points.
On the other side of the globe, the Chinese authorities raised interest rates for fear of fanning further inflationary pressures. But it does show us that there is life outside the United States, and that pan-Asian demand is firm. This view was translated early in the week by a rebound in commodity currencies such as the Canadian and Australian dollars.
How should investors dissect this disconnect between the United States and the rest of the world? After all, it wasn’t just the Fed that acted to smooth money markets. The European Central Bank (ECB) was first on the scene. And it is true that some of this toxic debt is lurking on the balance sheets of banks around the globe. More specifically, what size is the domestic housing problem in light of the latest RealtyTrac data?
Many investors and economists use the subprime excuse to argue for a rate cut from the Fed. The Fed has been reasonably candid in its observation that it doesn’t really want to ease policy, but recognized that economic conditions have deteriorated. Somewhere along the line there is a disconnect concerning the behavior or anticipated behavior of the consumer going forward. On the one hand, Wal-Mart’s management tells us that the consumer is strapped for cash towards the end of the month, while Target, Staples and Dick’s Sporting Goods are executing perfectly well.
But back to the housing market, which is the solar plexus of the problem. We know that ultra-low rates spawned a housing boom. According to RealtyTrac the inventory on the market in July was nine months supply. Starting in 2005 the supply length was equivalent to just four-and-a-half months. We also know about the aggressive and creative lending practices were developed by myopic companies. Housing prices got too expensive. It should have been left at that. But no, the lenders had to fan the flames and prolong the boom. By providing “buy now, pay later” credit-repair mortgages and making them available to people who just couldn’t afford it, the situation was always bound to bust.
So now that rate resets are happening, and we have possibly 18-more months slow dripping as that happens, mortgagees find that they are faced with crippling payments, weaker home prices and have decided en masse to hand back the keys. But is this all there is to it or did something else change?
86% of U.S. states saw annualized increases in foreclosure rates in July. Californian foreclosure filings tripled to 39,019 while those in Florida surged 78% to 19,179. With a national average of around one in 600 homes heading into foreclosure, conditions in Nevada are dire where one in 199 homes fell into foreclosure in July. Foreclosures in Georgia ran at twice the national rate.
But while the link is clear between mortgage rate resets and a surge in subprime borrowers defaulting, there is fuel being poured on the fire that must present the Fed with a real dilemma. Looking at construction employment, which peaked in September 2005 when the industry employed 1.819 million workers, the tide has turned with 43,000 less workers at building sites across the nation. And that statistic is clearly becoming more evident across the individual states. In California, the unemployment rate has risen from 4.7% to 5.3% since December 2006. In Florida, the rate has risen from 3.2% to 3.9%. Earlier this year in Georgia just 4.1% of workers were out of a job. In the past six months, that rate has slowly increased to 4.5%. At the same time in Ohio, the unemployment rate has risen from 5% to 5.8%.
In the cases of both Florida and Georgia the recent jump in joblessness is just a blip on the map. Back in 2001 in pre-boom Florida, the rate peaked at 6%, while California saw 6.9% unemployment through 2002. But in the middle-American states of Michigan and Ohio, unemployment is very close to 2002 peaks.
Homebuilder Toll Brothers will announce earnings. One year ago the company announced earnings of $1.07, while consensus heading into the number today was just six cents. On Tuesday its shares slipped 3% to $21.35 following a Banc of America downgrade. Its price target cut from $29 to $19 as the analyst cut the rating from neutral to sell citing industry-wide cancellations and a loss of impetus on the demand side as new buyers fail to qualify.
Slowly but surely, the emphasis is turning from a financial market liquidity problem with its roots in the market for recycled mortgage debt, to a more macro debate over how far this will spill over into consumption.
Few can envy the Fed as it determines not only how it should intervene, but tries to look forward beyond the implosion. A key point is that in 2006 some $600 billion or only 20% of all mortgage origination went to subprime candidates. Today the default rate on subprime mortgages is also 20%. So while one-in-five homeowners have handed back the keys, many continue to make payments. But an added incentive to do so regardless of whether a reset brings about a higher payment or whether employment patterns and confidence change is that with house prices falling, more owners are finding that they are keeping up payments despite the fact that they owe more than the house is worth. This could create additional pressures if unemployment continues to rise and the problem deepens.
How this leaves the financial asset markets is anybody’s guess. Fear and greed will continue to be felt and will likely stand behind spikes in prices as we’ve already seen. The yield on the 10-year note in the aftermath of Tuesday’s reassurance from the Fed and the Treasury as delivered by Senate Banking Committee Chairman Christopher Dodd stood at 4.59%. As pressure builds on the Fed – warranted or otherwise – given the fickle state of the market it wouldn’t be outlandish to see buyers force yields down significantly further.
Recapping late-session options market developments from yesterday, last week’s news of ratings downgrades on back of an announced share buyback program had ample time to be digested by the options market. So we were particularly intrigued by the fresh volatility positioning we observed in household cleaners giant Clorox (CLX). With shares down 0.74% at $59.17, yesterday’s active options volume equaled roughly 30% of Clorox’ total open interest, and was largely centered at the January 60 straddle, where 2,000 calls were bought at $3.10. The corresponding puts traded to the middle of the market, though on premiums elevated some 25% from yesterday. The sum cost of this position, $6.40, implies a volatile upside move to $66.40 or lower to $53.60 – a curious position to take on a stock whose implied volatility rests a full 10% below the degree of price volatility that Clorox shares have shown historically.
We also observed a swift uptick in Safeway (SWY) options, which traded at more than 7 times their average daily volume – a rarity not seen since the days of merger-monger-mania earlier this summer. With shares capturing a half-percentage point gain to $32.41 yesterday, the 12,000-plus active options contracts were largely contained in what looked to us like risk-reversal activity at the March 35 strike. While many of these contracts traded to the middle of the market, making it harder to establish clear-cut buying or selling, it looks as though a trader sold 2,500 lots in the March 35 calls, against buying in the March 30 puts.
It’s unclear what might have occasioned bearish positioning of this sort – Safeway shares have been under pressure for a number of months, but recently enjoyed an analyst upgrade, pointing to the outlook for moderating food prices coupled with Safeway’s transition to upscale lifestyle stores and private-label products. Yesterday’s release of the Federal judge’s opinion in the Whole Foods/Wild Oats takeover drama, which specifically pointed to Safeway as a Whole Foods competitor in the natural foods space, may have elicited concern that the company will have to contend with a stronger market rival in the shape of a bigger, badder Whole Foods.
Rebecca Engmann Darst
Equity options analyst/Financial Writer
(203) 618-5988
