Michael Vranos & Ellington Management Bullish On Housing ~ market folly

Monday, March 29, 2010

Michael Vranos & Ellington Management Bullish On Housing

Earlier this morning, we posted up hedge fund Ellington Management's 2010 equity outlook. Now that you've had a chance to digest their overall stance on things, we wanted to shift focus to one of their specific theses. Brace yourself: Ellington Management is bullish on housing (gasp). Now, why should you care? Well, Ellington Management is the hedge fund founded by Michael Vranos that primarily focuses on mortgage backed securities (MBS). Not to mention, Vranos was previously head of MBS trading at Kidder Peabody. So, they're pretty experienced in the arenas of MBS & housing and we thought we'd use this post to outline their views with an attached slide-deck at the bottom.

Firstly, a broad overview. Focusing specifically on the US, Ellington believes that a 'new normal' or 'jobless recovery' are unlikely. They see excess growth for sectors with cyclical or secular tailwinds (housing, smartphones, infrastructure) and in-line growth from the consumer sector with high-end consumer names outperforming low-end consumer names. That helps frame their overall stance, but let's dig into the specifics.

Vranos' hedge fund argues that foreclosures are only ownership transitions and that they do not create new houses. As such, they believe that these foreclosures (and shadow inventories) are already baked into the various numbers you see floating around. Additionally, they argue that the supply/demand dynamic in housing is dependent on the number of houses versus the number of households (instead of who owns the houses). This is contrary to our assertion in December of '09 that housing inventories were still too high. Ellington then goes on to graph out the absorption of foreclosures and argues that demand for said foreclosures is likely to grow.

So, their overall conclusion is that inventories are declining despite foreclosure activity. Total inventories declined 13% in 2009. Ellington argues that in order for inventories to increase further from here, you have to see an increase in foreclosures. But they then point out that "foreclosures flat with the prior year do not lead to an increase in inventories." Ellington actually expects distressed sales to increase in 2010 by 500,000 to 1 million units and thinks foreclosures are likely to peak in 2010, a move that would mean a further decrease in inventories in 2011. At the same time, they point out that distressed sales will continue for the next 3 to 4 years as various borrows continue to default. There's no denying we're not out of the woods yet, but they see encouraging signs in the sector.

Their main argument here is that housing inventories are declining despite foreclosure activity. Overall, here's the summary of their stance in an embedded slideshow. RSS & Email readers will need to come to the site in order to view it:

So, definitely an intriguing position. But then again, we can't say that we're surprised. In Ellington's 2010 equity outlook we noted that they seem to be contrarian in their approach as they prowl for crowded trades just begging to unwind. Throughout 2007 and 2008, housing was the mother of all shorts. While many argue that there is still more downside to come, Ellington has taken a different stance. Fellow hedgie Dan Loeb and his Third Point share this constructive approach (at least to some extent) as they have been net long mortgage backed securities. So, only time will tell what truly happens, but an interesting argument nonetheless.

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