In a note to file under the “Playing for Time” theme, the Curious Capitalist notes:

First American CoreLogic has taken a look at the effect of the government’s efforts to drive down mortgage interest rates, which, among other things, makes for easier refinancing. According to the loan analytics company, in the first half of 2009, refinancing homeowners set themselves up to save some $11.5 billion over the next five years. The typical person who refinanced was able to drop his monthly payment by $120 a month, a reduction of 10.5%… The value of mortgage originations hit $664 billion in the second quarter, and 69% of that was refinancing (by contrast, 37% of origination activity was made up of refis in the last quarter of 2o08). Fair or not, the government’s plan at least worked.

Reconcile this with one of the headlines on the site of Connecticut’s new candidate for U.S. Senate, Peter Schiff, which reads, “What America has succeeded in creating is not an economy impervious to shocks, but merely one which enables their consequences to be postponed to a later date.” I’ve spoken briefly with Peter before, and I’ve read his books, but I’m by no means in complete agreement with his views - yet in this instance, what he says is a perfect application to what the banking system is doing with the blessing of our government. Their strategy? Between the PPIP and mortgages, let’s sell as many options as we can now, book a benefit, and hope the adverse scenario that results in our option position(s) taking losses doesn’t occur.

I’ve wondered before whether or not we can carry trade the U.S. consumer back to health by attempting to force Treasury rates and other borrowing rates to converge; I’m not sure, but we’re certainly giving it the old college try.

If the typical person refinancing can save an extra $120/month, where does the money come from? It’s money that mortgage lenders aren’t making anymore in a lower interest rate environment. Now, the yield curve is steep, and short rates are near zero, so the relative change in rates is still helping banks. But at the same time, we’re more heavily leveraging banks to low rates; net interest margins might be getting fat at present, but they will compress and then some when rates inevitably rise. Zero, as James Grant has said, is the wrong rate for any economy, but more and more, I’m leaning toward believing that short rates stay extraordinarily low because of the idea that the economy depends on it - even when reality is that it aids speculators much more than the economy as a whole.

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One phrase I keep coming back to is “playing for time” – I see it as a good description of the strategy (or lackthereof) underlying most of the economic policy decisions that emanate from Washington.

What areas are being targeted, and how is it being accomplished?

Real Estate

Autos

Banks and Other “Financials”

The entire point of playing for time is to increase optionality. More information becomes available, and perhaps the economic situation will change for the better. But keeping businesses alive comes with indirect costs – more competition reduces the ability of healthier firms to pick up profitable customers – and with an implicit backstop from the government, borderline financial companies are incentivized to take more risks than usual.

The immediate result of those actions is to accelerate consumption, defer pain (losses), or interfere in allowing the market to set the prices it would otherwise set. To loosely quote a recent note from David Rosenberg, only in America are policies that encourage excessive consumption celebrated as a success. Yet that’s exactly what’s being done through a program like Cash for Clunkers, and the public reception has been very enthusiastic – a dangerous turning point in the series of bailouts.

I’m wary of data (and interpretations) suggesting that recovery is at hand, because uneconomic activity can only be encouraged for so long. That’s a lesson the Fed should have learned from previous heroic rescues during downturns, but chooses not to, because the expedient solution is to shovel money into any area of the economy that will take it.

Home prices, which undoubtedly went through an enormous bubble, are now the subject of a great experiment in controlled deflation. “Affordability” products sprung up earlier in the decade, when buyers had no savings for a down payment. Those turned out to have disastrous consequences, and yet policy now is directed toward offering what amounts to down payment assistance via a tax credit, and artificially low mortgage rates through the Fed’s market operations. We’ve been down this road before…

Boosting GDP for one or two quarters with the $3 billion (at present) Cash for Clunkers will quickly be revealed as wasted money; there are only so many new cars that people need. Most shrewd observers have realized by now that the program will skew statistics favorably for a time, without doing any real good. Of course, if the point is to save the “American” automakers, the program has been a failure on that front too.

The silent bailout of the financial system through zero interest rates and guaranteed debt is more pernicious – the TLGP, for instance, is estimated to be a $24 billion gift to those using it. And yet, little will be said about that as long as the impact on the Treasury’s borrowing costs remain marginal. Can we carry-trade weak financial institutions to profitability by leveraging the U.S. government’s borrowing ability? Likewise, can we store the health of balance sheets by stealing from savers through interest rates effectively at zero? We’re certainly trying.

Across sectors, there are many companies awaiting a turn in the cycle – and the only reason they’re still around is due to the good graces of the government. But cycles don’t truly turn until fewer people are around to looking at them, and it’s doubtful policymakers are willing to adopt this position and let liquidations occur. Playing for time comes at a cost – on a personal level, it means delaying decisive action that stands a chance of accomplishing something. I can only imagine what it will mean for the country as a whole.

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If you needed something to temper the bullishness that’s gripped the markets, here it is… wallboard maker USG reported second quarter earnings yesterday. From the conference call:

Looking ahead at the remainder of 2009 and into next year, we are not expecting much improvement in our markets. More specifically, we are planning for low levels of residential construction, though some stabilization seems on the horizon, a continuing slowdown in repair and remodel and a fairly significant drop in new non-residential construction.

The new residential construction market has fallen so far that there’s really not much more room for further declines. The market appears to be stabilizing and the June starts figure of 582,000 is somewhat encouraging, but there’s no evidence yet of a meaningful rebound.

Looking down 2009, stability in the new residential and repair and remodel markets will be a welcome relief. The major area of concern right now is non-residential construction. It declined on the second quarter and is likely to continue declining for the next several quarters.
-USG CEO Bill Foote

With USG’s last earnings report, I noted that unit pricing for wallboard was still improving, despite falling demand and a huge amount of excess capacity in the industry. While giving kudos to USG for being able to raise prices, it was a puzzling phenomenon and one that wasn’t sustainable. This quarter, the amazing levitating pricing power came to a halt, and slipped back half a percent, to $120.79/msqft. While far from huge, it snaps a string of four consecutive quarters where average realized price rose, although the streak of consecutive quarters with declining shipments hit five.

USG is also carefully monitoring their liquidity after having to accept $400 million in new capital at a high interest rate and on heavily dilutive (35% or so) terms. CapEx is forecast to be $50 million annually over the next two years, an extremely low figure relative to earlier spending. There’s been too much building in the wallboard industry, USG included, and their plants are on the newer side – this shouldn’t be a problem, but it is an indicator that they don’t expect a material improvement in cash results and are being extremely cautious. Various non-strategic asset sales were also discussed, with the hope of raising an extra $50 to $100 million.

Another exchange of note: commercial demand is expected to be down 20% to 25% year-over-year, but are there pockets of residential real estate that are less bad?

I’m sure it won’t come to any surprise Florida, Arizona, Nevada are still under extreme demand pressure, and the outlook is a pretty tough market. The inner mountain area is a good area. The Midwest area is still fairly solid and pockets in the Northeast.
-USG COO Jim Metcalf

To conclude, a few updated charts relating to various data on USG’s operations and stock performance. First, wallboard prices, the stock price, and the historical price-to-sales (P/S) – even if things look grim, the P/S multiple has been steadily improving, and that’s not because sales are going up.

On to quarterly financial results – again, management deserves credit for controlling what can be controlled. End user markets are terrible, but losses have narrowed and the cost structure is such that a $400 million drop in comparable quarter revenue didn’t move the needle on operating loss.

Finally, a chart of wallboard volumes and how shipment rates have changed. The year-over-year decline was the worst seen at any point in this cycle, and the quarter-over-quarter numbers were marginally worse than last time as well.

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Disclosure: No personal position in USG. Some chart data sourced from Gridstone Research.

When Fed Chairman Ben Bernanke coined the term “green shoots” of recovery during his 60 Minutes interview, it became entwined with the improbable – both in terms of timing and magnitude – rally taking place in the stock market. The S&P 500 went from a low of 666 to peak over 950, and green shoots abounded. Prices have slid back since then, because the perception of green shoots hasn’t matched with the reality of nobody involved in business seeing the same thing.

On DailyFinance, I devote time to tracking what influential people in business and finance are saying about the markets, and I haven’t heard any of the outright optimism that a 40% rally is predicated off of. Warren Buffett said that the economy is still in shambles, Mohamed El-Erian of PIMCO said that low interest rates will be necessary “for a long time” to heal the economy, and American Express CEO Ken Chenault hoped for growth resuming in the second half of 2010. Elsewhere, the KB Home (KBH) conference call and other data showed no bottom is in for housing, and the Homebuilders ETF (XHB) is down more than 20% from its recent highs.

The predominant view is that business activity has stabilized on a month-over-month basis, but that still means it will be down year-over-year for at least several more quarters. The market pendulum seems to be swinging back to favor this view as opposed to an outright recovery, and many of the leaders that bounced hard are suddenly struggling. Any sort of sustained earnings momentum is going to be a phenomenon down the line, and expectations still look generally high for the second quarter.

Anecdotally, a number of people who told me they were liquidating stock holdings and/or switching to bond funds during the market meltdown have now started wading back into stocks in the last month. The plural of anecdote might not be data, but the extent of the rise and the evaporation of the excessive fear that existed going into March has made bargains much harder to find. My portfolio value is at an all-time high, though I’m now 50% cash and ambivalent as to what to do – a topic I’ll have to look at another time.

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