The Best of Doug Kass

The self-proclaimed "anti-Cramer," Doug Kass, anchors Street Insight's "The Edge," a diary about stocks and investing. As a dedicated short-seller, Kass can seek out the bear market in any environment.

This week, he discussed the subprime slide, Harley hogs and how to short.

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The Simple Math of Subprime's Slide
Originally published on March 26

It is truly remarkable how the slightest provocation (last week's "solid" home-sales headline) had the media and other permabullish types declare that the housing market has finally bottomed (again!) and that the impact on the subslime mess would be contained.

Here is a more accurate analysis of what occurred in housing last month:

"Home sales increase in the springtime month over month, every year, even if the world is ending. It's called "the homebuying season" for a reason. So you don't look at February vs. January, or April vs. March. No, just like retailers look at Christmas vs. Christmas, not Christmas vs. July, any dummy that follows the housing market looks year over year. Here's the real numbers, and headline the MSM should have reported: Dubious NAR report shows home sales continue to crater, off 3.7% vs. last year, while unsold inventory explodes by another 763,000 units and median sales price (without incentives) is down 7.6% from peak.

February used-home sales (per the dubious NAR numbers) were supposedly 387,000 units, vs. 402,000 units February 2006, down 3.7%. Inventory is now at 3,748,000, vs. 2,985,000 in February 2006, up 763,000 unwanted homes, or 25.6%. And the median sales price (without cash back or incentives) in February of $212,800 is down $17,400 from the July 2006 peak. (Here is a further analysis that underscores the weakness -- not the strength -- in the housing market. -- Housing Panic Blog

Perusing the historically misguided statements by former Federal Reserve Chairman Greenspan and NAR economist David Lereah that follow suggests almost as much denial as Simmons and Fisher registered 78 years ago -- right before the Great Depression roiled the U.S. economy.

Oops!

October 2006: Greenspan foresees a housing "bottom."

"Last week's rise in weekly mortgage applications" could signal that "the worst may be over for housing." -- October 2006.

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2006-07: Lereah on the multiple housing "bottoms" and opining on the quality of mortgage lending.

"It was very clear that the standards had deteriorated ... I'm not a lender though, I kept on saying to myself -- I guess they know what they're doing. -- March 2007.

"It appears we've hit bottom, the price drops are necessary to stir sales. It's working. ... It's important to focus on where the housing market is now -- it appears to be stabilizing and comparisons with an unsustainable boom mask the fact that home sales remain historically high." -- December 2006.

"We've been anticipating a price correction and now it's here. The price drop has stopped the bleeding for housing sales. We think the housing market has now hit bottom." -- September 2006.

"This may be the bottom. It (housing) appears May is a little better." -- May 2006.

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1928-29: Simmons and Fisher forecast continued stock market gains in the fool's paradise prior to The Great Depression of 1929.

"I cannot help but raise a dissenting voice to statements that we are living in a fool's paradise, and that prosperity in this country must necessarily diminish and recede in the near future." -- E.H.H. Simmons, president, New York Stock Exchange, January 1928

"Stock prices have reached what looks like a permanently high plateau. ... The end of the decline of the stock market will probably not be long, only a few more days, at most." -- Dr. Irving Fisher, October 1929 and November 1929

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To be sure, I am not looking for a depression in housing or for the economy -- but those who look for housing to stabilize and for an increasingly restrictive mortgage credit market to be anything other than a substantive drag on 2007-08 aggregate economic growth are just plain wrong.

It's sometimes fun to go back and look at several of the above mistaken views and hyperbole from those who should have known better, but it is even more worrisome to look at the state of housing demand and supply today, which leads to my broader economic concerns:

The explosion in mortgage delinquencies in the second half of 2006 has only recently begun to be converted from delinquencies to foreclosures (and for-sale signs). Currently, the housing market's foreclosures stand at a 40-year peak.

Economy.com estimates that there were about 400,000 foreclosures in 2006. With signs of continued rising delinquency rates thus far this year, 2007 foreclosures should be considerably higher than last year's figures. I would estimate that foreclosures in 2006-07 will add nearly 1 million units (or 26.5%) to the current level of 3.75 million homes for sale. Stated simply, most are underestimating the massive supply of homes that will be dumped on the market over the next year to two years.

While record foreclosures will assuredly lead to a rapid rise in the supply of homes available to be sold in 2007 and 2008, tougher lending standards (particularly in the subprime category that is the lifeblood of first-time buyers) will squelch housing demand. Historically, creative lending (option ARMs, interest-only, negative amortization, etc.) shored up the housing markets by allowing (indeed encouraging) otherwise unqualified borrowers to participate in the roaring residential market of the last few years. (I suppose that Anthony Hsieh, CEO of Lending Tree, might now have second thoughts regarding this quote back last year: "If you own your home free and clear, people will refer to you as a fool. All that money sitting there, doing nothing."

First-time buyers and speculators, who, before delinquencies mushroomed, were qualified for high (95% or more!) loan-to-value mortgages at below market interest rates (80% of subprime loans over the last three years were 2/28 ARMs) based on teaser interest rates are now being qualified increasingly by the mortgage interest rate charged after reset.

This is serving to effectively price out a major demand source for homes as they are no longer eligible for low down-payment, nondocumented loans that were previously granted with below market or teaser interest rates. Indeed, subprime mortgages have been the only source for a large amount of homebuyers in the last three years. No more.

Quantifying the Impact of Tightening Credit

I would conservatively estimate that about 55% of the subprime borrowers, 25% of the Alt-A borrowers and 15% of the prime mortgage lending borrowers will no longer be able to secure financing for new homes because of tightened conditions. (This will produce about a 25% drop in housing demand).

Speculators and investors -- who were responsible for nearly 20% of all home purchases in 2004-06 -- also will find it more difficult to secure borrowings, and it is likely that this buying category will revert close to its historical demand role of about 5% of all homes. (This will result in another 10%-15% drop in housing demand). Finally, end-of-economic-cycle conditions (lower consumer confidence, slowing economic growth and moderating job growth) should contribute to another 10% drop in housing demand, which is as it has done historically.

Adding together the above three influences, new home demand should fall off by almost 50% (vs. the rolling 12-month average showing a 17% drop off in 2007) even before the effect of a market inundated by record foreclosures is considered.

Precipitated by the subprime mess, the entire daisy chain of home demand is deteriorating. With the first-time buyer out of the market and increased demands of higher collateral, better credit and loan documentation, the trade-up market is also in trouble. So is the Alt-A market. And, in the fullness of time, as Nouriel Roubini surmises, a more general credit crunch remains possible.

Credit Suisse(CS Quote) projects that about $500 billion of mortgages will reset this year (60% of these are subprime loans). According to First American CoreLogic's recent study, "Mortgage Payment Reset: The Issue and the Impact," resets will produce 1.1 million additional foreclosures (and more than $100 billion of losses) over the next six years. That's nearly another 185,000 homes per year coming into supply, on top of the nearly 1 million homes foreclosed on in 2006-07!

What is particularly worrisome to me is that home prices remain inflated relative to household incomes (Merrill's Rosenberg did a good analysis on this topic last week; Today's home prices stand at the highest multiple to disposable incomes in history). We have still not resolved the high price of homes by either prices moving lower or incomes moving higher. Affordability (or the lack of) will provide another headwind to the housing recovery.

Inventories: Another Headwind of Supply

There remains too much land and finished product inventory owned by the homebuilders. The publicly held companies are positioned to weather the storm, but the more levered private companies will be a continued liquidator of land and homes. Indeed, new home-price incentives look to be on the ascent, another headwind to supply.

With housing activity dropping and resets rising, consumer confidence should dive in the months ahead, construction employment will plummet and a cessation of mortgage equity withdrawals will further grease an already weakening slide in personal consumption expenditures.

In summary, the general (and specious) notion that the subslime travesty and its concomitant impact on the extension of credit won't have an impact on the broader economy reminds me of another quote, weeks before the stock market crash of 1929 put the U.S. economy in to a Depression (with a capital D):

"In most of the cities and towns of this country, this Wall Street panic will have no effect."
-- Paul Block (president of the Block newspaper chain), Nov. 15, 1929

From my perch, investing on the basis that the subslime carnage and exploding ARMs will not affect the consumer, the economy and our equity market is a risky proposition.

Here is the economic equation as I see it:

Restrained mortgage credit plus reset mortgage rates equals more money needed to finance homes and less money available to purchase goods equals a slowing economy.

The Next Down Leg Is Upon Us

Remember, today's weak new-home sales are before cancellations, which have been running over 20% for most publicly traded homebuilders. Moreover, new-home sales provide a better market feel for the residential housing market, as they are calculated upon signing of a contract, while existing-home sales are counted when a sale is closed.

Ergo, not only will new-home sales for February end up being weaker than stated today, but the state of housing is far worse than most realize (except the publicly traded homebuilders' managements who were ignored when they suggested the spring selling season was a bust thus far).

The inventory-to-sales ratio ratcheted up (from 7.3 months in January to 8.1 months) to the highest level since January 1991 (which was not a very good year!).

The next down leg in housing is upon us. Employment, consumer confidence and retail spending will be the next victims of housing's retreat.

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Harley Hogs Feed at the Subprime Trough
Originally published on March 28 at 8:35 a.m. ET

Judging by the commentary and the virtual invulnerability of worldwide equity prices, most see only a speed bump in the recent subprime scare. There is still a general belief on the part of the investment community that the mess is a containable fluke.

I have stressed the likelihood of a subprime contagion. After all, subprime is subprime and credit is correlated. Lower-quality, more-levered lending (with less collateral) is not confined to consumer loans, credit cards, homes, recreational vehicles and autos -- as investors might soon find out.

Even motorcycle (loans) are hitting potholes!

Indeed, it appears growing credit losses and delinquencies are beginning to render Harley-Davidson's (HOG Quote) motorcycle loans, well, increasingly like hogs.

Thirty-day delinquencies (and loss trends) in Harley-Davidson's receivables book offer a clear picture that credit-quality issues are broadening as HOG's receivables experience has begun to trace a pattern of deterioration that we first began to see in subprime mortgage loans during the first half of 2006.

Harley-Davidson's 30-Day Delinquencies
4Q2006	5.18%
3Q2006	4.46%
2Q2006	3.61%
1Q2006	3.69%
4Q2005	4.83%
3Q2005	4.07%
2Q2005	3.66%
1Q2005	3.60%
Source: Lehman Bros.

As I have mentioned previously, Harley's finance subsidiary (HDFS) funded almost half of Harley-Davidson's motorcycle loans. Like subprime mortgage loans, HDFS' hog loans are pooled and securitized to institutional buyers. Unfortunately -- in credit trends and terms -- HDFS is also beginning to look more and more like New Century(NCBC Quote), Fremont(FMT Quote) and Accredited Home Lenders(LEND Quote) did in early 2006.

In 2006-07, 28% of HDFS loans in its securitized pools had FICO scores below 650, which is considered subprime, which is very close to the 21% subprime market share of total mortgage loans made the previous year.

During the company's investor day on Feb. 28, Harley acknowledged that several of the securitization pools had breached their credit-quality metrics -- like subprime, the most recent pools' credit losses and delinquencies are rising faster than expected and more rapidly than earlier pools.

This is beginning to force Harley-Davidson to fund additional cushion reserves in the triggered securitization pools, much in the same way subprime mortgage originators have had to buy back bad loans. This takes a hefty bite out of HDFS' profitability by reducing its net interest margin.

Should the recent trend of rising credit losses and delinquencies in Harley-Davidson's loan-receivable book and in the securitization pools of their financial subsidiary (HDFS) continue, tighter lending practices likely will be instituted, and institutional buyers will be less receptive to buying HDFS' securitized pools. This could serve to reduce Harley-Davidson's sales growth and profitability.

Sound familiar?

It is beginning to look like the motorcycle lending markets are no longer "born to be wild." And, not surprisingly, I am still short Harley-Davidson.

More importantly, the fungus of subprime is beginning to spread into asset classes other than housing and mortgages. Don't believe for a moment that Harley-Davidson's dealers or the parent company were any less reluctant than the mortgage brokers to serve up loans for their product.

And last time I looked, a motorcycle is a discretionary item that is far less secure and stable than a home.

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How to Short
Originally published on March 30

As a dedicated short-seller, I incorporate some basic tenets and disciplines in my portfolio management.

One of those principles is to avoid hard-to-borrow and heavily shorted stocks.

Yesterday, Dendreon (DNDN Quote) announced that the Food and Drug Administration said its Provenge drug (the first active cellular immunotherapy and the first biologic approved to treat prostate cancer) was safe and that there was "substantial evidence of efficacy."

DNDN has a float of 80 million shares; its average trading volume is about 3 million shares a day. However, short interest totals 20.3 million shares (up nearly 4 million shares from the prior month), or about 25% of the float!

I avoid heavily shorted stocks in which short interest is a large percentage of the float or shares outstanding, such as at Dendreon. To me, high short interest is a nonstarter.

DNDN closed at $5.12 a share on Wednesday (it didn't trade on Thursday) and is currently trading up by over 230% to $17 in the premarket!

DNDN is a classic example of why a short-seller should avoid heavily shorted stocks.

Fundamentals Are Fading Fast

Month-to-date, the S&P 500 index is up by over 1% in March. It is safe to say (barring an extreme event) that March will likely end up positively, which would put 13 out of the last 15 months in positive territory.

Despite this extraordinary (and historically abnormal) run, at the slightest downtick, I sense a lot of angst in the market by hedge fund operators. From my perch, this means that investors (especially the hedge fund -- and fund of fund -- kind) are far more long (or levered) than most surveys reveal.

Sentiment Studies Are Sometimes Skewed

As I have mentioned previously, I don't put much credence into the various sentiment studies, most of which can be subject to, well, very subjective interpretation. It is my view that, within the context of the investment process, sentiment studies are often simplistic, linear crutches, especially when used in a vacuum.

For example, a lot of the short-interest figures are influenced by structural market changes and the introduction of new securities that require hedges on the other side -- or investors on the other side.

Surveys can also be undependable because they often rely on relatively small samples. I am aware of instances in which the respondents simply didn't tell the truth or the surveys relied on the bias of advisors or letter writers who "teach" but don't "invest."

Finally, many -- inflicted by a bout of affirmational bias -- massage the output to produce a desired outcome (e.g., if you don't like the fact that last week the AAII Bearish percentages have moved to close to a one-year low, change your calculation to a 12-month moving average that doesn't exhibit as much of an extreme reading). You get the picture.

Also Look at Fundamentals

In conclusion, technical analysis plays an important role in the investment mosaic, but making investment conclusions solely by observing squishy sentiment measures can be dangerous to your financial health. I believe there is far too much emphasis on unreliable sentiment voodoo that can be interpreted any which way and often too little emphasis on economic and company fundamentals (which, by the way, are also open to affirmational bias).

And those fundamentals are fading faster than you can say Sanjaya Malakar.