Making money on tanking RE

[EJ]

Some suggestions were posted on another thread about how to choose investments that would exploit the coming RE crash and recession. Daniel had suggested the following positions:

1. Take the short side on CME San Diego housing futures, that’s a first no brainer.
2. Short the stock market indexes (either SPY or the cubes, they’ll all drop like stones in the upcoming recession).
3. For more bang-for-the-buck, take the short side on S&P E-mini futures. This is the same as #2, but with a lot more leverage.
4. Buy some out-of-the-money puts on the builders, as they’ll certainly go under.

With my limited investment experience and understanding, these sound like great ideas to me. I have never shorted a stock (or index), used options, puts or futures. Can someone direct me to some low fee brokers to ‘place my bets’? What are the risks other than the market not behaving how I am predicting? Also, at the risk of sounding even more ignorant: what are E-mini futures?

Thanks for any insight!

[Daniel]

My suggestions were somewhat tongue-in-cheek. I am certainly not following any one of them. But super-bears probably should.

[Anonymous]

Now is a great time to start “betting” on the downturn with shorts/puts because the homebuilders have rallied over the last two weeks.

I suggest starting with a small amount just to get your feet wet and learn the process. After you understand it better, maybe you’ll gain confidence to play a little more seriously. The opportunity is hard to ignore.

[equalizer]

Lets look at one homebuilder

DRhorton (DHI)close At 4:01PM ET: 22.71

PUT OPTIONS Expire at close Fri, Jan 18, 2008

Strike Symbol Last Chg Bid Ask Vol Open Int
15.00 YRIMC.X 1.40 0.00 1.10 1.25 1 279
20.00 YRIMD.X 2.45 0.35 2.70 2.80 123 4,816

So if you’re very bearish about DHI, a 20 put would pay if DHI drops to 17 or less in 1.5 years. If they return land options and/or reduce prices more then it could work. Problem is that some deep value managers are starting to buy homebuilders, so they must see some value here. Its a big risk since the stocks are sitting at only 5 times earnings.

[ybc]

I will not short DHI, or any home builder stocks. The reason is that the current market price (Market cap is $7.1B)is very close to their book value. for DHI, book is about $6 billion with Tangible book about $5.3 billion. So P/TB is only 1.3x. Now most of their book is in inventory, which they made about 27% gross margin in the latest quarter, and 16% operating margin. So they could reduce price/give incentives to move inventory and still make money. About 13% of their tangible boook is long-term investment, which could be option to buy land. While some of that might be written off, probably not all of it.

So for DHI drops to 17, it’ll get close to its tangible book. It’ll be more likely worth more than that over the long run. That’s why it’ll attract a value buyer, not because it sells at 5x earnings – earnings can disappear fast. I personally will likely be a buyer if it’s sold below tangible book.

Personally, I own some long-term puts on CFC (country wide financial). It sells at 1.6x book (was 1.8x when I bought the put), and its balance sheet has expanded rapidly in the last several years. Because it has more financial leverage, higher loss on its mortgage portfolio will do real damage to its book, so I think that it’s a better bet. And I think tha t plenty of knowledgeable people commented on its lax lending practice — I think that these lenders have to retain some risk (usually the highest risk portion) before they sold their portfolio to investors.

They are bets indeed — DHI could very well drop below its tangible book, and CFC could very well stay high. But I think that the odds favors CFC on the short side.

[Anonymous]

I’m strickly on the investing sidelines, but I think CFC’s a good bet. What about shorting GM? Here is why I think it might be a good idea. Recent news says the Cereberus deal is running into regulatory problems.

“GM also said the closing of the $14-billion deal to sell a 51-percent stake in GMAC to an investor consortium led by hedge fund Cerberus Capital Management could be delayed beyond the fourth quarter because of difficulty in obtaining needed regulatory approval”

I figure the deal is already priced in. I think if the deal fails (not a big if, by the way) then ResCap ratings will be junk bond with huge implications on the business because ResCap has been the primary profit center for GM.

http://news.yahoo.com/s/nm/20060802/bs_nm/autos_gm_gmac_dc_3

[equalizer]

ybc

you are correct about earnings. Just read article somewhere that during 90s downturn some builders went without profit and Price/Book bottomed at 0.5-0.7 ratio.
Of course book values may be under/overstated now with land costs on books, so thats where your Marty Whitman types (Third Avenue Value fund manager) come in.

About CFC, have you read interviews with their CEO mozilo? heres an old ione in Businessweek Mar 06,

“How severe are the price declines you are expecting?
MOZILO: I would expect a general decline of 5% to 10% throughout the country, some areas 20%. And in areas where you have had heavy speculation, you could have 30%. We will see…sellers back off from the prices they have been demanding. A year or a year and half from now, you will have seen a slow deterioration of home values and a substantial deterioration in those areas where there has been speculative excess.”

Admitting there is a bubble one would think that he would have protected his company. However, it appears he has either sold half or all his stock for $6M in May/June 06. [Someone please confirm.] Looks like he sees no upside!!

[PD]

I bet the inventory they show on their books is valued at peak prices.

If they begin giving big incentives but keep the base price the same, then I assume they can continue to report that the unsold inventory is worth the base price when it is actually worth less.

[ybc]

For accounting purpose, you can only value your inventory at cost (land, fees, material and labor). That’s why they realize a gross profit when they sell. In fact, if there is convincing reason that says your inventory is worth less than cost, then you take a charge, called “inventory write off”. So depending on the quality of their inventory, i.e. how many are built on spec, how many cancellation, etc, price needs to go down quite a bit for them to take a charge on inventory.

Yes, it’s possible that these homebuilders lose money for a while, and the psychology takes the market price way below book value, and the book may decline too if they take charges/lose money. From an investment point of view, that’s a time to buy. To bet that it’ll happen within a certain time frame is a bit risky (as what buying a put is about) in my mind. These home builders stock have come down a lot already.

I won’t short GM either (in fact, I bought GM at around 19 in December last year). Charlie Munger once commented on that one shouldn’t short a stock of 15B market cap with 200B in revenue when someone asked him about GM. Its problems are deep, but well known. Things can go wrong, but can go right as well. If it can somehow address its legacy cost issue (i.e. health care for retirees, pension actually isn’t too bad ’cause it has a well funded pension), then the stock should be worth more than today’s price. It has a high short ratio for a while, so many hedge funds got burned on the short side.

CFC is a different story. Even though the CEO may recognize the risk, individual loan officers may still be motivated to generate a loan and get a bonus/commission. Wall Street’s pressure on them to is continue to grow. It has come down 15% from its peak, while DHI has dropped about 45%.

Again, anyone buying options should be ready to lose it all, even as you do all the calculations trying to make money.

[PerryChase]

About GM and healthy care costs, I find it interesting that larges corporations are now moving towards supporting health care reform because some form of universal health care will allow them to shift health care costs to the public.

One reason auto-plants and other manufacturing are viable in Canada is that businesses don’t have health care expenses.

Health care is a big burden that American businesses have to shoulder.

[Anonymous]

Chris Johnston

EJ THe E-mini futures are the electronic mini version of the S&P 500 futures contract. They are 1/5 the size of the full size Pit contract. This market has tremendous liquidity, and has grown immensely in popularity in the last 5-7 yrs.

Taking a short position there would be akin to just shorting the general stock market. I use these contracts, and just do 5 of them for every one big contract that I would trade. For example, if I wanted to short 5 big ones, I take 25 mini’s. The reason I do that is that the fills are much better, there is virtually no slippage on stops. The average Joe is better off shorting the SPY’s if they think stocks overall will drop. With futures you will have to keep rolling your postion over to the current lead month if you hold the position for awhile. The SPY’s are a stock proxy, and as a result have no contract length, hence no need to roll the positions constantly.

Any of the big brokers E-Trade, Ameritrade, Schwab, etcc allow you to short stocks. Some have slightly different paramaters for margin, so you need to check that. For the E-Mini’s you are going to have to go to a futures house. THe big ones are Lind-Waldock, Edf Mann, Alaron, Tradestation, and Interactive Brokers(crooks). Tradestation is pretty cheap, and the service is good. Interactive Brokers are notorious for system outages that hose clients. The first 3 have higher commissions.

Read poways post on the housing futures, she has a quote from me in that. Also, the homebuilders may be good shorts, but their ratios are very attractive. At some point the big boys are going to start buying these. As a result, you might get a bounce in them in the fall, when the overall market rally takes place. We have dropping long rates here all of the sudden, so a stock rally is likely in the fall, unless the bonds fall out of bed here. That does not seem likely at this time of the year. Seasonally, they typically rally ( rates drop) at this time of the year.

Shorting them here is a momentum play, which can pay off but is more risky. Kind of like buying real estate in 2003. It went on for a bit, but then the music stopped. The other post on the ratios was dead on.

[Daniel]

Quick comment: E*Trade also allows you to trade futures (E-minis on S&P, cubes, and Russell, and also Forex futures). Commissions are low.

Disclaimer: before trading futures, make sure you know what you are doing. If you’re not sure, consult a pro (our friend Chris Johnson here).

[Author]

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