Commentaries

On MBS, Fed needs to point to the exit

When the medication is flowing, it’s hard to see straight.

Amid the giddiness in the markets and the cheers for the end of the recession, what often gets ignored is the fact that government stimulus is still fueling the reflation of financial markets.

Yes, the U.S. government has started to retire some programs — its backing of money market funds being the most recent. But there’s still a question mark about how it plans to wind down one of its largest supports — its $1.25 trillion mortgage-backed securities purchase plan — that is due to expire at the end of the year.

That’s dangerous, since a bungled hand-over of the market back to the private sector could derail a still fragile housing market.

This week, Ben Bernanke and his colleagues on the policy-making Federal Open Market Committee are sure to discuss how best to wind down its purchases of mortgage bonds guaranteed by state-run Fannie Mae and Freddie Mac. Some officials have already started to debate publicly whether they should pull the plug on the program before it reaches its $1.25 trillion limit.

But they shouldn’t wait to decide until November, as some now expect. They need to prepare investors elbowed aside by the government intervention. They should do this by laying the groundwork for an eventual departure, to avoid sudden spikes in mortgage rates that have been kept artificially low this year.

Unlike other initiatives, such as the Federal Deposit Insurance Corp’s insurance of bank debt, and the various lending facilities to nudge investors back into areas that had gone haywire during the financial crisis, the Fed’s direct purchases of MBS has done the opposite — it has squeezed investors out of the market.

Santander’s debt buy-back not necessarily a flop

Santander’s attempt to buy back 16.5 billion euros of asset-backed debt looks, at first glance like a bit of a flop: in the end investors only sold about 600 million euros of bonds by face value to the bank.

However, the result is not that surprising, for several reasons.

First, 16.5 billion euros was always a long shot. We don’t really know how much of the debt Santander had previously acquired in one-off trades in the secondary market, making it hard to say how much it could have bought back this time.

The tender offer, announced in July, grabbed a lot of headlines, but in fact Spanish, Dutch and other banks – Santander included – have anecdotally been quietly buying back their asset-backed debt ever since the market collapsed at the start of the credit crisis. Moreover, accounting changes introduced in Europe last year will have meant that bank investors who held the bonds won’t have had to mark the debt to market, reducing their need to sell.

Second, probably more relevant, the bonds had rallied in the secondary market after Santander’s announcement to match the levels the bank was offering in the buyback. That, combined with a recent market rally, meant that in many cases the debt was even trading above Santander’s offer price, according to an analyst.

Investors may also have taken Santander’s actions as a show of confidence in the assets backing the debt, and decided to stick it out and hope to get their money back rather than take a loss now. They may be feeling a bit more warm and fuzzy about asset-backed debt given the market’s recent rally and better liquidity as more dealers have started making markets in the debt.

The next move is up to Santander. It could keep quietly buying the debt back in the secondary market, or come out with another tender. Next time, it will have to pay up a bit more to grab investors’ attention.

Russia says “Da” to asset-backed debt

It’s interesting to see Russia proposing a new law to encourage a domestic securitisation market for consumer debt. Russia is still a novice when it comes to asset-backed debt but seems to have cottoned on to something that not all western regulators have fully grasped — securitisation may have helped get us into the current crisis, but we are also going to need it to get us out of it.

US and European banks simply don’t have enough capital to finance both the loans they kept on their balance sheet and those coming due that were previously funded in by the shadow-banking system. They need to find ways to raise new capital and transfer risk to capital market investors. In short, they need securitisation.

Calling a bottom in Spain

Is the worst over for Spanish mortgage defaults? That’s one way to interpret Santander’s offer to buy back up to 16.5 billion euros of its outstanding asset-backed debt.

The securities are trading below par – more than 40 percent in some cases before today’s announcement – allowing the bank to reduce debt by buying them back. Cash-rich banks such as HSBC have launched similar buybacks this year to profit from the ABS market dislocation, but it’s the first time a Spanish bank has launched such a large public buyback.

Santander has offered to pay slightly more than market prices, suggesting it thinks there is some money to be made by buying these bonds at beaten-up prices and waiting for the mortgages to pay off.

The buyback could also be a sign Santander believes the freeze in the European securitized debt markets is thawing.

European ABS prices have rallied sharply in recent weeks, in part because traders at investment banks have started bidding for the debt again. Some of the more beaten-up Santander MBS have gained by as much as 15 percentage points since June, according to one investor.

Santander is rumoured to have bought back ABS earlier on in the credit crisis through private one-off trades. Perhaps it wants to get hold of as much as it can now in case spreads keep rallying further.

There may also be some political capital in a large public buyback of this kind. It gives a sign of strength to the market, and shows the bank supporting the secondary market for its bonds. That may win Santander some kudos with investors when it comes to issue MBS in future.

The subprime to prime mortgage handoff

Data released by the Mortgage Bankers Association confirms the trend that prime borrowers are the ones to worry about.

While the percentage of mortgages entering the foreclosure process in the 2Q held relatively steady at 1.36%, the change in composition is noteworthy.

From the MBA press release:

While the rate of new foreclosures started was essentially unchanged from last quarter’s record high, there was a major drop in foreclosures on subprime ARM loans.  The drop, however, was offset by increases in the foreclosure rates on the other types of loans, with prime fixed-rate loans having the biggest increase. As a sign that mortgage performance is once again being driven by unemployment, prime fixed-rate loans now account for one in three foreclosure starts.  A year ago they accounted for one in five.

Another interesting bit for taxpayers – there’s been a big jump in FHA foreclosures, currently at 1.15% percent. The FHA is essentially a government mortgage insurance agency so foreclosures. While the FHA brags on its website that it’s self-funded, if the losses become too much, it’s safe to assume in the current environment that the government would extend a helping a hand.

Also, it’s the FHA that essentially took on subprime lending last month when it agreed to give mortgages with negative equity in their homes. In July, it loosened its criteria so homeowners significantly underwater could refinance into an FHA loan. These borrowers can now borrow 125% of their home’s worth, up from 105%.

UPDATE: MBA just got back to me about what’s included in their prime category and it looks like Alt-A loans are mostly categorized as prime by those banks participating in the survey. That could be skewing things since Alt-A loans by definition are less than prime and extremely loose lending standards during the boom have made them look more like subprime loans. For example, borrowers taking out an Alt-A loan could state their income rather than prove it.

Yep, the banks really are gouging their customers

Michael Saunders will get no thanks from his employers at Citicorp for pointing out how UK interest rates have swung dramatically against the borrower over the last two years.

Bank Rate has plunged by 5.25 percent since July 2007, and two-year swap rates have fallen by 4.1 percent, but surprise surprise, the only rates that have come down anything like as far are those paid to the hapless retail depositor. For many of those wanting to borrow, the price has gone in the opposite direction – if they can get the money at all, that is.

Put another way, the price of a 5,000 pound personal loan has risen by more than 9 percent relative to Bank rate. This process of price gouging is called “rebuilding bank balance sheets.”

The Fannie Mae sinkhole

Fannie Mae has reported the a $14.8 billion loss in the second quarter and is going hat in hand to the Treasury for another $10.7 billion to pull its net worth out of deficit. The release is here.

In a very quick read through, here are some of the things that jumped out:

We are experiencing increases in delinquency and default rates for our entire guaranty book of business, including on loans with fewer risk layers. Risk layering is the combination of risk characteristics that could increase the likelihood of default, such as higher loan-to-value ratios, lower FICO credit scores, higher debt-to-income ratios and adjustable-rate mortgages. This general deterioration in our guaranty book of business is a result of the stress on a broader segment of borrowers due to the rise in unemployment and the decline in home prices. Certain states, higher risk loan categories and our 2006 and 2007 loan vintages continue to account for a disproportionate share of our foreclosures and chargeoffs.

In other words, the good borrowers are having problems keeping up with their mortgages. They are Fannie, as well as Freddie’s, bread and butter.

And here’s a big shout-out to FASB :

Net other-than-temporary impairment of our Alt-A and subprime private-label securities was $753 million in the second quarter of 2009, compared with $5.7 billion in the first quarter of 2009. The quarterly decrease was primarily the result of our adoption on April 1, 2009 of a new accounting standard for assessing other-than-temporary impairment for investments in debt securities.

And lastly, the a big thanks to Treasury for being there with its $200 billion lifeline:

It’s August. Do you know where Fannie and Freddie are?

Fannie and Freddie’s regulator-in-chief James Lockhart is stepping down to spend more time with his family, Reuters reports. Can’t say I blame him. He’s been at the helm of the Federal Housing Finance Agency, formerly known as OFHEO, for three years, saw through an unprecedented de facto nationalization of the companies, and still the future of the housing finance giants remains nearly as uncertain as it did a year ago.

Will the government wind them down, will they return them to the private sector, will they stop propping up the debt markets where they operate? There’s plenty of question marks – some might say too many considering the pivotal role these companies play in the U.S. housing market. Much of the game plan set forth when the government took over Frannie nearly a year ago expires at the end of the year, making all this uncertainty doubly worrying.

Stacy-Marie Ishmael over at Alphaville pulls some nice tidbits out of a recent Moody’s report on the matter. Looks like analysts at the ratings firm see the creation of a new housing agency will be the end result.

Moody’s expect the government to decide what to do over the next 18 months. Hopefully it’s sooner rather than later.

The Citi dump

City landfills aren’t pretty places. Much the same can be said for Citi Holdings, the newly formed dumping ground for Citigroup’s most ailing and malodorous assets.

Earlier this year, the de facto government-owned bank created Citi Holdings as a repository for assets that it either planned on selling or would simply have a hard time giving away. In truth, Citi Holdings really isn’t a distinct company. It’s merely part of a PR strategy to get investors to focus on the businesses that are going well at Citi and which are housed in a so-called good bank called Citicorp.

But Citi Holdings holds the key to gauging just how long the bank will remain a ward of the state.

Now technically, things looked good at Citi Holdings in the second quarter, according to the results released today. But that’s only because Citi Holdings benefited from the closing of the Smith Barney joint venture with Morgan Stanley.

Strip away the $11.1 billion in pre-tax dollars from that deal and you get a good look at the problems that persist at Citi.

One of the biggest lines of business dumped into Citi Holding is the bank’s North American consumer lending operation, which includes homes, auto, student and personal loans. And the numbers for consumer lending are plain ugly. The group accounts for 83 percent of the $9.85 billion that Citi Holdings has set aside to cover losses on all credit and loan losses.

Particularly troubling is that the percentage of home loans to North American borrowers that are now delinquent is up to 6.52 percent. At the end of the first quarter the percentage of home loans past due was 5.9 percent and a year ago it was a little over 3 percent. Those numbers don’t suggest much improvement in the housing market and raise the prospect of ever higher delinquency rates as the unemployment rate creeps higher and higher.

L-shaped housing market?

Economists seem willing to celebrate even the most tepid economic release these days. The National Association of Homebuilders’ Housing Market Index nudged up slightly to 17 in July, up from 15. Most economists had expected 16, so this is what passes for good news.

But the improvement is tepid indeed considering the record lows the index has hit. Even most dead cats bounce more vigorously than this.

The report pointed to an improvement in the low end of the market. Joshua Shapiro at MFR believes that this segment of the market at least may be nearing a bottom. He is less sanguine about the fortunes of middle and higher priced houses.

Many economists are assuming that a stabilization in the housing market is the inevitable first step towards a recovery. I would suggest gloomier possibility. The recent period of calm could simply be a pause for breath on the way down. The fact that this decline will probably be quite slow is cold comfort.

There is still an imposing inventory of unsold homes. Unemployment continues to rise. The interest rate of the 30-year mortgage is still well above its low point. As a suffering homeowner myself, it pains me to say that an L-shaped housing market may be the best we can hope for over the next few years.