04.30.08
Posted in All Categories, Bonds, Fraud, Real Estate, Stocks at 10:47 am by Michael Goode
Things are different this time. That is what I argued in my previous post on the coming mortgage crisis. Exploding option ARMs will lead to record foreclosures, which will cause house prices to further decline, which will cause many households to have negative equity. Rather than pay mortgages that are larger than house values, people will simply walk away.
One additional factor that will cause great harm to the housing market is that many stated income loans fraudulently overstated income ( I almost committed mortgage fraud myself). Bond insurers and buyers of RMBS and CDOs will force these back onto the balance sheets of investment banks and mortgage originators, leading to a further decrease in lending and an increase in lending standards. This will increase the cost of buying a house and put further downward pressure on house prices. The Market Ticker blog has a good discussion of this problem and the harm it will cause to banks.
Following are a couple more graphs to support my case that the bubble is nowhere near finished deflating. The first is the average house price to income ratio across the US, courtesy of PIMCO.
The second is a beautiful graph of home prices in every city in the Case/Shiller home price index. This comes courtesy of The Mess that Greenspan Made blog.
You can see from this graph that home prices have a long way to go before they return to pre-bubble levels. Cleveland and Detroit are back to the 2000 price levels, but the fundamental deterioration in those cities means that prices should fall further. Detroit and Cleveland have had declining populations for a number of years, and that trend continues. It is predicted that Detroit will continue to lose population and have only 705,000 residents in 2035, down from 890,000 in 2005.
Disclosure: I own real estate in St. Louis and Chicago. I have a short position in a land development company. I have a full disclosure policy.
Permalink
Posted in All Categories at 9:43 am by Michael Goode
Gene Marcial has been employed by Businessweek for a number of years, during which he has written his Inside Wall Street column. He is the main reason why I will never pay good money to subscribe to Businessweek. He has made more than a few bad calls over the years, but one of them is unforgivable. That call is his recommendation to buy Research Frontiers (REFR: $3.10 +6.90%, market cap: $51.2M) on July 30, 2007, just one day before I wrote that Research Frontiers was a ‘failed company‘. Since then, the stock is down 60% (see also my recent article on the company). The bigger problem is that Marcial was familiar with the company and wrote positively about it back in 1995 (link is not to the original article, which is not available online). A reasonable person might assume that if a company with a hot new technology just around the corner cannot get it to market in 12 years then that technology is not likely to ever be successful. Yet Marcial bought the company’s hype again 12 years later, believing that new contracts were just around the corner.
A word of advice to Mr. Marcial: it it looks like a duck and acts like a duck, it probably is a duck. If a company looks like a failed business that exists only on hype and selling more shares, then it is probably not a good idea to suggest that Businessweek readers to invest in it.
Jim Cramer’s words from The Fortune Tellers describe Marcial well: “this column has zero reliability … There he goes pumping some corrupt small-capper again.”
A word of advice to the SEC: if you see fit to prosecute short sellers who benefit from spreading rumors, why not prosecute those in the media who spread rumors? While Marcial does not directly profit from the stocks he hypes, without hype and rumor he would likely be out of a job.
Disclosure: I have no position in REFR. I do currently subscribe to Businessweek, but I used expiring frequent flyer miles to pay for it. I have a disclosure policy.
Permalink
Posted in All Categories, Fraud, Microcap, Stocks at 9:13 am by Michael Goode
Few companies can release a proxy statement to which stockholders react by dropping the company’s stock price by 15%. However, Research Frontiers (REFR: $3.10 +6.90%, market cap: $51.2M) does earn that dubious distinction. When I last wrote about Research Frontiers, the stock closed at $14.93. At a recent price of $5.19 per share, the stock is down over 64% since I called it a ‘failed company’.
While the proxy contains the standard stock options (including $900k to the chairman), stock appreciation rights, and other payments to executives, the interesting part is the company’s take on a shareholder proposal. The proposal reads in full (bold text mine):
”RESOLUTION: Provide more detail information on film
production quantities and sales.
BE IT RESOLVED: On a quarterly basis beginning within 30
days of the 2008 annual meeting with the previous quarter’s
data, the company shall separately report revenue by license
fees and royalties; and report total royalty revenue that the
licensees are required to report by their license agreement
even though it might be below minimum royalty payments.
Additionally, the company shall provide information on how
much film is produced for sale as reported by licensees as
required by their license agreement. This information can be
aggregated for all licensees so that any individual licensee’s
information remains confidential.
Rationale for adoption: While there has been reported film
production and sales going back many years, there has not
been any officially reported measure of film produced or
revenue from sales that would inform shareholders of the true
extent of the commitment by licensees to develop SPD
products. In as much as the Company is 100% dependent on
licensees for SPD film production and sales, this information
equates to the viability of the Company and the only way to
fairly value the Company. Additionally, the Company has
over the years, partnered with licensees in the release of
information about SPD products for sale and sold but there
has been no information given to independently verify this.”
Unlike most shareholder proposals, this seems like a reasonable request for Research Frontiers to provide more detail on what its licensees are actually producing. The company’s reason to reject the proposal argues that the proposal would require giving out the licensees’ proprietary information, but the proposal clearly indicates that only aggregate disclosures would be necessary. More likely, the company wants to avoid disclosing that few if any actual products are being manufactured and shipped and all its revenues are coming from license fees and not from royalties on actual products. Considering that in 2007 Research Frontiers reported $402,000 in revenue and yet boasts a large lists of licensees (see the 10k for details), I find it hard to believe that any of the licensees are shipping actual products and paying royalties.
More information:
2007 10K
2008 14A (Proxy Statement)
Disclosure: I have no position in REFR. I have never smoked reefer or coral reefs. I once took one puff on a cigarette but I did not inhale. I have a disclosure policy.
Permalink
04.22.08
Posted in All Categories, Fraud, Microcap, Stocks at 1:44 pm by Michael Goode
In 2006, the investors in Southwestern Medical Solutions (then traded on the Pink Sheets) were informed via multiple press releases of the joyous news that the FDA had approved the company’s diagnostic tests. However, the SEC alleges that these were not true:
The complaint also alleges that Southwestern submitted false and misleading information about its business to the Pink Sheets, an inter-dealer electronic quotation and trading system in the over-the-counter securities market. The complaint further alleges Hedges, Powell, and Meecham were responsible in various capacities for preparing and disseminating the false press releases and false information provided to the Pink Sheets.
See the litigation release or the detailed complaint (pdf). If history is any guide, those individuals behind the company will only be forced to pay a small fine.
Permalink
Posted in All Categories, Bonds, Fraud, Personal Finance, Real Estate, Stocks at 12:51 pm by Michael Goode
If you read the papers and watch the news, you may believe that we are in and have been in a subprime mortgage crisis for the last year or so. That is true. Many pundits are also saying that the subprime crisis is nearing its end. That is also true, to a point. Subprime mortgage troubles will not inflict that much more damage on the broader economy. However, prime and Alt-A mortgages with toxic features will cause troubles that will make the current troubles look like a walk in the park. Furthermore, broad-based declines in housing prices will start to wreak havoc on housing markets across the country.
The Cataclysmic Shift
The problem with the housing market bulls is that they are thinking within the framework of past housing downturns. The current downturn is unlike any other since the Great Depression. No other downturn has started with houses so overpriced relative to rents. Few downturns started with such reasonable interest rates. No other downturn saw double digit house price declines across the country. This downturn is different, and it is going to lead homeowners (or homedebtors, as the Irvine Housing Blog calls those who have little equity) to change their behavior in ways that only the pessimists such as myself anticipate.
The problem with most predictions is that they are linear extrapolations of the past into the future. Have global temperatures been rising? They will continue to rise at the same rate. Has crime been increasing? It will continue to increase at a similar rate. The problem is that significant change often comes suddenly. That is why no one who knows anything is worried about the gradual increases in the Earth’s temperature that will occur if global warming continues. What really scares people is the possibility (however remote) that the changes could accelerate or could cause something unexpected to happen (such as the jet stream moving or the ocean currents changing). A thorough review of the history of global temperatures reveals that such cataclysmic change is not unusual.
In the case of housing, the cataclysm will come within the next couple years. It will be fueled by two factors: option ARM mortgage recasts and house price declines. (Slate has a worthwhile take on what will happen, but its analysis is less detailed than mine.)
Why House Prices will Continue to Decline
House prices are elevated relative to rents and relative to incomes, especially in the hottest markets, such as California, Nevada, Florida, and Arizona. However, price increases in middle America have been no less astonishing. One example with which I am all too familiar is the house I just sold in the Saint Louis suburb of Maplewood. Zillow has a decent graph of the house’s value, although it is not completely correct. If you look at the county assessor’s website (and search by the address) you can see that the house sold for $100k back in 1997 and then for $188k in 2004. I just sold it for $165k. Over this period of time few renovations of note were done on the property and the neighborhood did not improve significantly. The employment situation in the area has not changed. So from 1997 to 2004 the house appreciated by 88%, while between 1990 and 1997, during great economic times, the house appreciated by only 25%. In relation to both rents and area incomes, the house is still probably 20% overvalued.
Moving from the anecdotal to the statistical, we can see that this is not an isolated situation. The chart above shows housing starts and permits for the last 30 years. Over this period the population has increased at a fairly steady rate. Since 2003 there have been too many houses built. This will lead inevitably to falling prices.
If you look at the ratio of income to house prices in the above graph (from Piggington’s Econo-Almanac), you will see that house prices are way higher than they should be relative to incomes (while this graph is for one area of California, prices are elevated relative to incomes across most of the country). While creative financing can lead to a bubble in prices, there is no way for house prices to remain unaffordable indefinitely.
Another thing to consider is that house prices remain tethered to rental prices over the long term. If renting is cheaper than buying, people will choose to rent rather than buy and house prices will fall. House prices have never been so much higher than rental prices than they are now. Above is a chart of the ratio of the OFHEO house price index to the CPI-Owner’s equivalent rent.
Another factor weighing on prices is the increase in foreclosures. Banks that own foreclosed houses are motivated sellers and they will cut the prices so that they can sell their inventory. Increasing foreclosures will increase supply and decrease prices of transactions. Why pay $200k for a house when your neighbor but his out of foreclosure for $140k? Foreclosures are actually understated because banks often don’t have the manpower necessary to foreclose and sell delinquent properties.
The foreclosure problem will soon get much worse. Considering that it often takes over half a year (and can take much longer) between when a homedebtor falls behind on a mortgage and when the house is repossessed, the current wave of foreclosures began before house prices had fallen significantly. With prices now down 20% in many areas and 30% or more in some areas, the rate of foreclosures will increase drastically over the next year. Those that need to sell and who have little equity will be unable to sell for more than they owe. Short sales are difficult, so foreclosure will be the last resort for many who need to move.
Even though asking prices for houses have fallen dramatically already, they have not fallen nearly enough: witness the low volume of house sales relative to prior years. In the graph below we can see that the spring selling season in San Diego has been a bust, as it has elsewhere (image from the Bubble Markets Inventory Tracker blog).
Option ARM Recasts
Besides falling house prices, another factor in the coming mortgage crisis is the coming recasts of millions of option ARM mortgages. Most of you will be familiar with the problem of interest rate resets on ARMs (adjustable rate mortgages). This problem is well-known. Almost all ARMs have fixed rates for the first couple years and then the rates reset to market rates. Considering the current low interest rate environment, this problem is likely overblown.
The greater problem, however, is recasts. Option ARMs allow for the choice of the size of the payment. Homedebtors can choose to pay an amortizing payment (such that their mortgage balance is reduced), an interest-only payment, or a negative-amortizing payment, where their mortgage balance increases. Recent data from Countrywide indicates that 71% of borrowers with option ARMs are only making the minimum, negative-amortizing payment. Option ARMs have provisions such that when the mortgage balance exceeds the original mortgage by 10% to 15%, the loan converts into a fully self-amortizing loan. Considering that many of these loans were made over the last few years (beginning in 2005), we should start to see a number of recasts. When a mortgage recasts, the payment size can easily double or triple. Those who could afford their payments before will no longer be able to do so.
Option ARMs are highly prevalent, especially in the most bubbly markets. See the following map and click on it for a larger version (courtesy of the Irvine Housing Blog):
The Coming Crisis
The coming crisis will be caused by option ARM recasts, falling prices, and banks’ increasing reluctance to lend. The crisis will manifest itself in people simply walking away from houses where their mortgage is worth more than the house. Considering how many people have used home equity loans to remove equity, how many have had negative amortization in their loans, and considering how small down payments became over the last few years, very few homeowners will be left with equity in their houses. Economy.com currently estimates that 9 million households have negative equity. That figure could easily double or triple as house prices fall by another 20% to 30%.
The assumption on the part of mortgage lenders, regulators, and housing market optimists is that as long as people can afford to pay their mortgages, they will. But homedebtors faced with 20% to 30% negative equity will be much better off going through foreclosure than they will paying off their debts. Helping them is the fact that in a number of states, purchase money mortgages are non-recourse debt, meaning that banks cannot sue to recover the money they lose. The sheer number of foreclosures will mean that banks will not have the manpower to go after domedebtors even when they want to do so.
The rising tide of foreclosures caused by people walking away from houses in which they have negative equity will act as part of a positive-feedback loop to increase the rate of price declines. The housing market is not getting better anytime soon and it will soon get much, much worse.
Permalink
04.17.08
Posted in All Categories, Microcap, Stocks at 11:23 am by Michael Goode
There are many people with opinions on stock brokerages, but few who have used as many as I have. While I would love it if there were one broker that was best for everyone, there is not. So here are my picks and pans. I note when I have used a broker.
Best Broker for Investors
Scottrade is far and away the best broker for long-term investors who do not trade very often. Trades are cheap ($7), nuisance fees are minimal, and fills on orders are good. There are a large number of no-transaction fee mutual funds, and trades of other mutual funds are just $17 each. There is also a low minimum balance of $500. While my account at Scottrade is currently inactive, I will likely transfer some IRAs to Scottrade from E*Trade.
Best Broker for Short Sellers
At the moment this is a tie between Think or Swim and Interactive Brokers. I have been using Interactive Brokers for awhile and I am just trying out Think or Swim. These are the only two discount brokers of which I am aware that allow short selling of stocks under $5 and OTC and Pinksheets stocks. They also both have decent systems for telling if shares are shortable. Interactive Brokers has a color-coded alert in its Trader Workstation, while Think or Swim will tell you whether a stock is hard or easy to borrow. Most brokers will not tell you that information prior to placing a short sale trade. Think or Swim and Interactive Brokers have different pricing systems, so depending upon how you trade one may be cheaper than the other.
Best Broker for Mobile Traders
While many brokerages have WAP trading platforms for mobile phone browsers, Think or Swim has dedicated applications for Blackberries, Windows smart phones, and (coming soon) iPhones. If you think you might do significant trading from your phone or PDA, Think or Swim is the best bet.
Best Brokerage for Trading Foreign Markets
While E*Trade garnered much attention when it introduced foreign trading, Interactive Brokers has been doing it longer and does it much better. Trades are cheap, market data is accurate, and Interactive Brokers allows trading in many more countries than does E*Trade.
Brokers with Interesting Fee Structures
There are many discount brokers nowadays, some with interesting or unusual fee structures. Sogotrade offers some of the cheapest trades around ($3 per trade or $1.50 per trade with a monthly fee of $10) and I find it quite easy to use (although I quit using it when I consolidated my accounts at Interactive Brokers). It also offers automatic investments so it could be a good choice for both active traders and long-term investors. Zecco offers 10 free trades a month if you have at least $2500 in equity. FolioFN allows creation of what are essentially your own mutual funds and allows you to trade those funds at very low cost. Considering the proliferation of ETFs, FolioFN seems less and less worthwhile to me.
Potentially Worthwhile Brokers
Tradeking has been rated highly by others and it has cheap trades on stocks and options. OptionsXpress is not as highly rated as it used to be, likely because its commissions have not fallen much over the last couple years. Charles Schwab is geared towards people who want a bit of handholding.
Worst Brokerages
E*Trade and Ameritrade win this dubious award. Both charge many nuisance fees and relatively high commissions. The extras that they offer are not useful to anyone who has any clue what they are doing. Furthermore, E*Trade earns a special demerit for being the broker most likely to go bankrupt, due to its ill-fated foray into mortgage-backed securities. I started out with E*Trade, although I moved most of my money out of it last summer and I will transfer a couple IRAs this summer.
Also Rans
There are a number of other me-too brokerages that don’t seem to offer much of anything that better brokers do not offer. Firstrade is pretty much identical to Scottrade, except without all the Scottrade local offices and the size of Scottrade. Ameritrade iZone is a cheaper ($5 per trade) version of Ameritrade, but it does not offer as many features as some other discount brokers and it is not nearly the cheapest. I used iZone for a year and I was not always happy with my order fills.
Disclosure: I have no position in any company mentioned. I currently have funded accounts at Scottrade, Interactive Brokers, E*Trade, and Think or Swim.
Permalink
04.08.08
Posted in Fraud, Microcap, Stocks at 2:24 pm by Michael Goode
I previously believed that MaxLife Fund Corp (OTC BB: MXFD, $17.50) was just an overvalued, over-hyped microcap. I found nothing fraudulent about the company’s actions. The company’s continuing and increasingly unrealistic optimism in press releases is leading me to consider that the company is not so innocent. Only by keeping a stream of good news flowing to the market can the company hope to maintain its inflated market cap, so it does so, regardless of the improbability of it ever achieving its forecast financial targets.
Maxlife Fund Corp just announced a new joint venture (see the joint venture agreement). MaxLife states in its 8k filing today that the goal of the joint venture with Capital Growth Planning Inc (CGP), called Maxlife – CGP Partners LLC, is to purchase up to $1 billion face value of life insurance policies (life settlements) this year. The companies expect to purchase, securitize, and then sell those policies to investors. The joint venture is legitimized by the fact that CGP has been in existence since 1969.
CGP does not have an unblemished record: two years ago the State of California issued a desist and refrain order temporarily preventing CGP from issuing certain securities in California that the company had failed to register and had sold using misleading statements. Also, CGP has traded very few life settlements, having been involved in the sale of only 55 life settlements (with a face value of $40 million) over the last two years.
Another thing to consider about the joint venture is that CGP is providing the management of the life settlements and will essentially run the JV. The only thing Maxlife Fund Corp is providing is funding. However, considering that since it has listed on the OTC bulletin board, Maxlife has raised only $500,000 from the sale of stock (see page F-13 of the 2007 10k), I find it hard to believe that it can provide the necessary funding to the JV for the JV to come anywhere close to its announced targets, at least not without seriously diluting current shareholders.
Anyone can forecast great sales. It is quite another feat to actually achieve such performance. Given the histories of MaxLife Fund Corp and CGP, I believe it unlikely that the companies’ joint venture will transact $10 million (face value) in life settlements this year, let alone $1 billion in face value of life settlements. I caution investors to put little faith in MaxLife’s projections until it shows some ability to function as a real company and not just a hype machine.
Disclosure: I am short MXFD. I have a disclosure policy.
Permalink
Posted in All Categories, Microcap, Stocks at 8:13 am by Michael Goode
One of the quandaries of finance research has been why the value premium (the tendency for low P/B or P/CF or P/E stocks to outperform the market) has not been reflected in the performance of ‘value’ active mutual funds. A new paper by Ludavic Phalippou in the Financial Analysts’ Journal argues that the reason for this is that only the small-caps and micro-caps exhibit a large value premium. What this means is that an investor should either focus on buying small cap value index funds or should buy individual micro-cap value stocks.
The article is not available free online. Following is an excerpt from the paper’s conclusion:
The premise of this article is that if the value premium is a result of both pricing errors and limited arbitrage, then the value premium should be concentrated in stocks that are both held by relatively less sophisticated investors and expensive to arbitrage. Such a concentration is suggested in the literature but has not been quantified. In this article, I show that, indeed, at least 93 percent of market capitalization is free of a value premium. Using institutional ownership (IO) as a parsimonious way to classify stocks by their mispricing likelihood, I show that the value premium monotonically decreases from a high 185 bps for low-IO stocks to a negligible 13 bps for high-IO stocks. This result also holds when returns are value weighted and, importantly, is driven mainly by the long side. Low-IO value stocks are those with the most abnormal returns. The anomaly is a value premium, not a growth discount, as is sometimes argued …
The extreme concentration of the value premium has important practical implications. First, arbitrageurs can expect to face substantial costs when trying to arbitrage the value premium, and those focusing on the stocks most held by institutional investors (the larger, more liquid stocks) will have difficulties generating arbitrage profits. The value premium concentrates where arbitrageurs usually do not go. This reason is also why studies have found that value and growth mutual funds perform the same. Second, studies that select a subsample of stocks that, for instance, either have at least two to five analysts following the stocks or are traded on the NYSE end up with a sample that is almost free of the value anomaly. Such a fact is important to bear in mind when interpreting the results found in such samples.
Permalink
04.04.08
Posted in All Categories, Alternative Investments, Microcap, Stocks at 11:30 am by Michael Goode
The old adage that sex sells may be true, but if an investor wanted to invest in publicly traded peddlers of sex (in all its legal incarnations), that investor would have only a few poor choices. While those choices may soon expand (when Penthouse goes public, as it is expected to do soon), the anti-prude investor should steer clear of this field.
The largest publicly-traded sex-related company, Playboy (PLA: $3.5701 -0.28%, market cap: $119.6M), is the quintessential poor investment. Over the last two decades Playboy stock is up 42%, while the Dow Jones Industrial Average is up 520%. Even as Hugh Heffner continues to cavort with silicone-enhanced playmates one-third his age, the company’s centerpiece magazine continues to lose subscribers.
The story is much the same at cable-smut purveyor New Frontier Media (NOOF: $2.20 0.00%, market cap: $42.8M), where the stock has appreciated 2% over the last decade. The DJIA is up 64% over the same time period. The problem with cable porn is that it will suffer the same fate as newspapers: it is going to be crushed by internet competition. So despite a cheap P/E of 15, New Frontier will likely be a poor investment.
Rick’s Cabaret International (RICK: $14.31 +0.56%, market cap: $134.3M), a chain of strip clubs (see a commercial for it here), has been kinder to its investors than the above companies. Over the last decade it has outperformed the DJIA, 270% to 64%. But Rick’s is trading now at a stratospheric P/E of 34, which is out of line with companies most comparable to it: staffing companies such as Administaff (ASF: $19.83 +0.61%, market cap: $507.1M) and Manpower (MAN: $56.88 -0.33%, market cap: $4.475B), both of which trade at P/E ratios under 15. While Rick’s provides stripping services in branded locations, it is not really that different from staffing firms that provide administrative and other services to companies. It relies upon its ability to recruit skilled workers, and its brand is far less important than the actual capabilities of its workers. Also like the staffing firms, it is vulnerable to a recession.
The last public sex company of which I am aware is the worst, yet it comes with the most wholesome reputation. This company is Berman Center Inc. (Pink Sheets: BRMC). This is a sex therapy center and website that caters to couples looking to improve their sex lives. Its eponymous founder, Dr. Laura Berman, is not only knowledgeable but also good at getting press. She has appeared on Oprah Winfrey’s show and she is a columnist for the Chicago Sun-Times. Despite the advantages the company has, its financials are a mess. The company, with a market capitalization of $12.5 million, has a book value of negative $1.3 million (see the most recent 10Q for details). The company lost $1.3 million over the first nine months of 2007 and lost $1.2 million over the first nine months of 2006. The company is also delinquent in filing its 2007 annual report.
Overall, sex makes for a poor investment, at least in terms of public companies.
Disclosure: I have no position in any stock mentioned. My disclosure policy is considered obscene in Utah, because it is transparent and it prohibits stock fraud, front-running, pump-and-dump scams, and MLM schemes.
Permalink
