Banks, mortgage bondholders, and in our opinion the entire housing market just got a victory. The Senate defeated a bill that would allow judges to modify terms of mortgages in bankruptcy proceedings.

We have been of the opinion for some time that passage of this legislation would throw yet another wrench into tight credit markets and slow the eventual recovery in housing. Why? The end buyers of mortgage securities are one of the most important links in the securitization engine. Securitization (turning loans into bonds) allows mortgage credit to grow and flow freely around the globe. If judges were granted the ability to arbitrarily change contractual mortgage terms, balances, limit foreclosures etc, mortgage bond buyers will be less likely to purchase mortgage based debt in the future. Or, they will simply demand higher interest rates to compensate for the increased risk of a third party changing the terms of their bond during their ownership.  This of course will raise  mortgage costs,  and slow the flow of capital, and continue to depress home prices even further.

Since market lows set in July 2008, Berkshire equity portfolios have increased smartly and exceeded the return of the S&P 500 by a meaningful margin. Year to date results are also favorable vs. the market.    

There are two main drivers behind the results. The first is a fairly serious, yet incomplete correction in energy and materials related stocks. The price of crude oil has declined by over 20% since its high set in July. Gold is down and the dollar is enjoying a rally. Momentum, at least for now, looks like it has left the bullish oil trade. For example, despite threatening the movement 800,000 barrels of oil a day, Russia’s aggression towards Georgia didn’t cause much of a spike in the price of oil. Prices actually continued to decline. A few months ago, when the momentum was at a fever pitch, we suspect the price spike might have been greater surrounding a geopolitical event such as this.  

There is also evidence of true “demand destruction.” Higher prices have caused substitution and lower demand. U.S. drivers drove 9.88 billion less miles than they did last year*, a 3.7% drop. Commuting volumes in public transportation systems are way up. Employers are, in some cases, allowing 4 day work weeks to ease the costs of a five day commute. Companies are reworking their logistics and distribution systems to cut down on energy costs. Dealers can’t give away an SUV. Economic activity in Europe and China is slowing. Fueling the decline (or perhaps causing it) is a rebound in the dollar based on the premise the European Central Bank may have to lower interest rates, or is not in a position to raise them.  While slowing world wide demand is good for mollifying the news flow, keep in mind the US is by far and away the largest consumer of energy, chugging down 25% of daily oil volumes. China consumes about 8% of the total.  

The second cause for favorable results is a rebound in financial related stocks held in portfolios.  Our analysis and valuation framework strongly supported our opinion that bank stocks would likely bottom in mid-summer. It certainly looked like capitulation and panic selling the morning of July 15. For a few days in early July, it was not uncommon to see price swings of 25% in financial stocks in one day. Swings like this in (either direction) are indicators investors are not acting in any type of rational manner. It indicates they are merely reacting violently to whatever stinger headline or doomsayer happens to make it on CNBC. We used the volatility to our advantage by selectively adding to financials across portfolios.  We increased positions in Sovereign, and National City. We also added a new position in Merrill Lynch. Since then, many financials have rallied sharply and despite the large move, we still believe they are undervalued.  

^{*US Department of Transportation}

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