I disagree completely with this video’s conclusions. I will explain why in my next post. Still, it’s pretty darn creative and worthy of posting here.
Perish the thought. Between them the two companies back well over $4 trillion of residential mortgages in the U.S. Underneath this pile of debt the companies have a tiny capital cushion of about $40 billion each. And that counts the $6 billion Freddie recently raised in a preferred stock offering.
Bernard Ducalion did some great work over on Bear in Mind regarding Fannie Mae’s exposure to high risk loans. Though it’s difficult to piece together the current composition of Fannie’s mortgage portfolio–they don’t make it easy, what with varying disclosure in the Ks and Qs they just released–it’s clear Fannie has plenty of exposure to high risk loans.
Try $300 billion of stated-income liar loans (i.e. Alt A), $200 billion of interest only loans, $120 billion of subprime, and $330 billion of >80% LTV loans. They like to play games with the subprime definitions to boot. In the K dated 12/31/06, they have a table that says 5% of their book is loans to borrowers with a credit score below 620. Yet they claim that their “subprime” exposure is a mere 0.3% of the book. I spoke to an IR rep at Fannie, told him that I thought the standard industry definition of a subprime loan is one with a FICO below 620. He said there are other factors that you have to consider and that not all loans with rock-bottom FICO scores should be considered subprime. Really? What WOULD you call a loan made to a borrower with a terrible credit history?
But I digress. The loan categories above aren’t discrete–some high LTV loans qualify as subprime, for instance–so you can’t add them up to get Fannie’s total exposure to high risk loans. But Bernard notes that even if you take a conservative estimate like $400 billion in total exposure, it would take only a 12% fall in value for that chunk of the portfolio in order to wipe out Fannie’s capital entirely.
It’s not quite as simple as that, since Fannie’s book of mortgages isn’t valued on a mark-to-market basis. The decline in value happens more slowly, as credit events like foreclosure actually occur and losses on the mortgages are REALIZED. That’s the way it was explained to me by their rep anyway. Fine. Yet if prices continue to fall as they have been, more and more mortgage vintages will end up upside down and foreclosures will skyrocket, driving huge losses at Fannie.
I replicated Bernard’s Fannie analysis with Freddie. They’re still mired in the accounting scandal that hit both companies so they haven’t filed a Q or K in years. But they do publish a very interesting report on their website that lists their own exposure to high-risk loans. See the larger report dated November 20th, here. Also the “slide presentation” that was released with Q3 earnings.
The two documents suggest that Freddie has $130 billion of Alt A, $150b of interest-only, $70b of loans with FICOs below 620 and $110 billion with LTVs greater than 90%. And these numbers are only for the “guarantee” portfolio; if you include the mortgages that Freddie has purchased, there are another $105b of subprime loans there and $54 billion of Alt A. These last are described as non-agency and the Freddie rep I spoke to said something about how they don’t recognize losses on these particular securities. I was confused by this comment and pressed her: “they’re on your balance sheet. If they have to be marked down as homes go into foreclosure, then the reduction in the value of the asset on the asset-side of the balance sheet must be double-booked as an equal reduction in the company’s equity correct?” Yes, she said. A reduction in equity would be a direct hit to the company’s capital balance.
Again, some loans are in multiple “problem” categories and can’t be double-counted, but you get the idea: clearly Freddie has significant exposure over and above its capital cushion of $40 billion.
I also asked the Freddie rep for clarification on two comments CEO Richard Syron made in the Q3 earnings release. One: they expect $10-$12 billion of credit losses–big, but hardly life-threatening. Two: he anticipates a nationwide drop in house prices of 10%.
My question for IR was whether the loss estimate was based on the housing price estimate. The IR rep confirmed that it was. If house prices decline more than 10%, then their losses will be much larger. Funny how the CEO told investors that the $10-$12 billion loss estimate was pessimistic.
Clearly there wouldn’t be a linear relationship b/t credit losses and house price declines. As prices decline further, a much larger portion of mortgages will be under water. If we get the 30% decline nationwide that some have forecast, it won’t be just the problem loans that cause problems. Plenty of so-called prime loans will be under water and you’ll see “good” credits walking away from mortgages.
If house prices decline 30%, Fannie’s and Freddie’s capital cushions will clearly be wiped out. And taxpayers will have to take on their debts.
Besides being a huge hit for taxpayers. Can you imagine the crisis of confidence that might ensue if these two guys go under? Fully 49% of Fannie’s debt is supplied by foreigners. Fascinating huh? Half of the money Fannie plows into financing the American Dream is provided by foreigners.
It’s possible to see a dollar crisis in that situation as the Fed tries to inflate the economy out of trouble while foreigners punt Fannie/Freddie debt along with other dollar-denominated assets.
Two good quotes from Wednesday’s news. The first from the NYT Op-Ed page:
While the bubble was inflating, self-serving explanations were offered for why traditional formulas of home valuation no longer applied. As it turns out, the laws are still in effect. These traditional measures, like the relationship between home prices, rents and income, indicate that prices need to fall at least 30 percent more nationally. The sooner this balance is achieved, the sooner lenders will again commit capital.
30%? That seems to be a common number being thrown about. As the quote mentions, historically, home prices have been tied to incomes. Makes sense right? Folks spend a portion of their income on housing, as they do food, electricity, transportation, etc. As incomes rise, people are able to spend more on houses and prices rise. Marketwatch published an interesting article noting that median home prices are currently 3.5x median family incomes, down from a recent peak of 4.2, but still well above the average of 2.8x seen during the period 1984-2000. And 2.8x is the AVERAGE, meaning there are times when the number falls BELOW the average, as in the 1970s, when the number fell to 2.3x median income. It’s another 20% down to 2.8x from 3.5x; which would be a 40% fall from the peak. Incomes could rise, though who thinks that’s likely to happen with the economy teetering on the brink of recession?
That brings us to our second quote for Wednesday, this one from the Journal:
Home prices in 10 major metropolitan areas in October were down 6.7% from a year earlier, according to the S&P/Case-Shiller home-price indexes, released Wednesday by credit-rating firm Standard & Poor’s. That exceeded the previous record year-to-year decline of 6.3% in April 1991, when the economy was emerging from a recession.
So we’re well on our way, with home prices down nearly 7% in the top 10 metropolitan areas as of October.
Anyone else remember the folks that said housing prices “never” decline? That immigration would keep housing prices going up? That, for instance, boomers retiring would always make Florida real estate a good investment? I do.
For anyone who thought commercial real estate was going to escape the subprime mortgage meltdown, time to wake up and smell the roses. This article from the WSJ doesn’t have a lot of new info so much as juicy tidbits describing how easy credit blew up a commercial real estate bubble the same way it blew up a residential one.
I don’t think anyone seriously believes commercial real estate isn’t going to get sucked into the abyss. So many aspects of that market, shopping malls for instance, are derivatives of the residential world. And of course, the same credit crunch that has erased easy credit to buy homes has also eliminated credit to buy commercial property. It’s amazing to me that banks lent Harry Macklowe $7.1 billion to buy Equity Office properties that Blackstone flipped. Those buildings were purchased at record cap rates. How much equity did he have to put down? $50 million. Less than 1%. He’s now looking for “an equity partner.”
Reports of commercial property sale prices from earlier this year made it clear that rents weren’t substantial enough to pay back debt service. To believe they’d actually make money after paying such high prices, buyers had to assume two things: substantial growth in rental prices along with continued capital appreciation for the underlying property. Sounds a bit like speculation in the residential real estate world doesn’t it?
The larger focus of the story is about Centro Properties Group, the Australian firm that paid up for up for U.S. strip mall owner New Plan Excel. Centro paid too much and is now struggling to roll over their debt.
Quoting the most interesting part of the article:
….The predicament facing Centro, Mr. Macklowe and numerous others underscores the state of the once-unflappable commercial real-estate market. For the past few months, the sector has been in a state of near-paralysis, as financing has nearly dried up. The number of major properties sold is down by half, and many worry that the market will continue to deteriorate as property sales remain slow, prices continue to drop and deals keep falling apart.
“Where we’re really in a fog is on the capital markets side,” said Michael Giliberto, a managing director of J.P. Morgan Chase & Co., on a conference call last week about the state of the commercial real-estate market.
The CMBS market was the engine that drove the commercial real-estate boom. Over the past few years, the issuance of CMBS allowed banks to get rid of the risk on their books, lend with cheaper rates and looser terms and that made it easy for private-equity firms to do huge real-estate deals.
Between 2002 and 2007, CMBS issuance rose to an estimated $225 billion from $52 billion, according to Commercial Mortgage Alert, a trade publication that compiles its own statistics.
Real-estate investors aren’t the only ones feeling the pain. Many big banks issued short-term loans to buyers and planned to sell them off later, much the way they do with loans made to private-equity buyout shops. But the banks have gotten stuck with an estimated $65 billion in fixed- and floating-rate loans on their books, according to J.P. Morgan. Some of the largest issuers have been Lehman Brothers Holdings Inc., Credit Suisse Group and Wachovia Corp.
Lehman has said that about half of the $79 billion in mortgage debt it was holding at year-end is CMBS-related. Wachovia and Credit Suisse declined to comment.
You’ve gotta love that Journal drawing of Macklowe: Scrooge straight out of central casting.
Anyway, securitization lavished easy credit on the commercial real estate world with “CMBSs” just as it did the residential world with “MBSs.”
And of course the private equity world reached dizzying heights due to the financing terms available. Who can recall the days of Leon Black at Apollo Mgmt burdening his companies with new debt so that he could pay himself and his investors dividends? The cash-out refi writ large. Anyone else remember reading arguments from the private equity guys about how they were “adding value” by bringing in new mgmt and helping companies escape SOX 404? Sure fellas, financial engineering using cheap, unlimited credit had NOTHING to do with your success.
So my buddy at Lehman who thinks losses could top $450 billion (see previous post) is looking bullish. The article below says the folks at Barclay’s are now saying $700 billion. And that’s before factoring in losses in commercial real estate. Lest we forget there was a bubble brewing there too, with cap rates at record lows, we would be remiss to forget there will likely be hundreds of billions in additional losses there.
Of course losses are compounded as bank capital dwindles. With each writedown that banks have to take, with each troubled/distressed asset they have to bring onto their balance sheet, their core capital positions deteriorate, reducing there ability to make new loans.
The article below is fascinating in its predictions. The idea that we’re perilously close to another credit crunch on the order of 1929 is clearly not something that is registering with the general public. Yet look at how the big boys are playing this. Central Banks are literally flooding the system with liquidity, yet banks are still refusing to lend to one another b/c they’re not confident that other banks are actually solvent.
This is the crucial point that defines this crisis, and makes it so dangerous. Prof. Roubini has been saying it for some time. The fundamental problem in the banking system isn’t a lack of liquidity, though that is a problem. It’s insolvency.
Imagine a rumor is floated that Imaginary Bank is in trouble because there are loans on its books that have gone bad. In hypothetical #1, the rumor is false: the loan is performing just fine. In hypothetical #2, it is true, the loan is not performing.
Remember the fundamental function of a bank is to take depositors’ money and lend it out to borrowers. If, as in hypothetical #2, the bank lends depositor funds to borrowers that go bust, a bunch of subprime homebuyers for instance, there’s no getting depositors’ cash back. The bank is insolvent. No amount of temporary liquidity shots (short term loans from the Federal Reserve say) is going to get depositors money back. Folks make a run on the bank and find that there cash is gone, never to be recovered.
But what if the rumor causes a bank run, where depositors demand all their money back, yet the loan the bank made with depositor money is performing just fine. In that case, a temporary shot of liquidity will enable the bank to give depositors’ money back while collecting payments on the loan it made. After the loan is paid back, the temporary liquidity provided by the Central bank can itself be paid back.
But in this Brave New Subprime World, the problem isn’t a temporary issue of liquidity; it’s a permanent problem of insolvency. Lots of banks are going to go bust folks. The smart money, that is other banks, don’t know who’s holding the problem loans. They don’t know who’s insolvent. That’s why they’re refusing to lend to one another and you see a huge spread between target short term rates set by Central Banks and actual short-term rates that banks are charging one another. They perceive more risk in the system and are demanding higher interest rates to offset that risk.
Here’s the article from the Telegraph:
Crisis may make 1929 look a ‘walk in the park’
Twenty billion dollars here, $20bn there, and a lush half-trillion from the European Central Bank at give-away rates for Christmas. Buckets of liquidity are being splashed over the North Atlantic banking system, so far with meagre or fleeting effects.
As the credit paralysis stretches through its fifth month, a chorus of economists has begun to warn that the world’s central banks are fighting the wrong war, and perhaps risk a policy error of epochal proportions.
“Liquidity doesn’t do anything in this situation,” says Anna Schwartz, the doyenne of US monetarism and life-time student (with Milton Friedman) of the Great Depression.
“It cannot deal with the underlying fear that lots of firms are going bankrupt. The banks and the hedge funds have not fully acknowledged who is in trouble. That is the critical issue,” she adds.
Lenders are hoarding the cash, shunning peers as if all were sub-prime lepers. Spreads on three-month Euribor and Libor – the interbank rates used to price contracts and Club Med mortgages – are stuck at 80 basis points even after the latest blitz. The monetary screw has tightened by default.
York professor Peter Spencer, chief economist for the ITEM Club, says the global authorities have just weeks to get this right, or trigger disaster.
“They still have another couple of months before this starts imploding. Things are very unstable and can move incredibly fast. I don’t think the central banks are going to make a major policy error, but if they do, this could make 1929 look like a walk in the park,” he adds.
The Bank of England knows the risk. Markets director Paul Tucker says the crisis has moved beyond the collapse of mortgage securities, and is now eating into the bedrock of banking capital. “We must try to avoid the vicious circle in which tighter liquidity conditions, lower asset values, impaired capital resources, reduced credit supply, and slower aggregate demand feed back on each other,” he says.
New York’s Federal Reserve chief Tim Geithner echoed the words, warning of an “adverse self-reinforcing dynamic”, banker-speak for a downward spiral. The Fed has broken decades of practice by inviting all US depositary banks to its lending window, bringing dodgy mortgage securities as collateral.
Quietly, insiders are perusing an obscure paper by Fed staffers David Small and Jim Clouse. It explores what can be done under the Federal Reserve Act when all else fails.
Section 13 (3) allows the Fed to take emergency action when banks become “unwilling or very reluctant to provide credit”. A vote by five governors can – in “exigent circumstances” – authorise the bank to lend money to anybody, and take upon itself the credit risk. This clause has not been evoked since the Slump.
Yet still the central banks shrink from seriously grasping the rate-cut nettle. Understandably so. They are caught between the Scylla of the debt crunch and the Charybdis of inflation. It is not yet certain which is the more powerful force.
America’s headline CPI screamed to 4.3 per cent in November. This may be a rogue figure, the tail effects of an oil, commodity, and food price spike. If so, the Fed missed its chance months ago to prepare the markets for such a case. It is now stymied.
This has eerie echoes of Japan in late-1990, when inflation rose to 4 per cent on a mini price-surge across Asia. As the Bank of Japan fretted about an inflation scare, the country’s financial system tipped into the abyss.
In theory, Japan had ample ammo to fight a bust. Interest rates were 6 per cent in February 1990. In reality, the country was engulfed by the tsunami of debt deflation quicker than the bank dared to cut rates. In the end, rates fell to zero. Still it was not enough.
When a credit system implodes, it can feed on itself with lightning speed. Current rates in America (4.25 per cent), Britain (5.5 per cent), and the eurozone (4 per cent) have scope to fall a long way, but this may prove less of a panacea than often assumed. The risk is a Japanese denouement across the Anglo-Saxon world and half Europe.
Bernard Connolly, global strateg
ist at Banque AIG, said the Fed and allies had scripted a Greek tragedy by under-pricing credit long ago and seem paralysed as post-bubble chickens now come home to roost. “The central banks are trying to dissociate financial problems from the real economy. They are pushing the world nearer and nearer to the edge of depression. We hope they will eventually be dragged kicking and screaming to do enough, but time is running out,” he said.
Glance at the more or less healthy stock markets in New York, London, and Frankfurt, and you might never know that this debate is raging. Hopes that Middle Eastern and Asian wealth funds will plug every hole lifts spirits.
Glance at the debt markets and you hear a different tale. Not a single junk bond has been issued in Europe since August. Every attempt failed.
Europe’s corporate bond issuance fell 66pc in the third quarter to $396bn (BIS data). Emerging market bonds plummeted 75pc.
“The kind of upheaval observed in the international money markets over the past few months has never been witnessed in history,” says Thomas Jordan, a Swiss central bank governor.
“The sub-prime mortgage crisis hit a vital nerve of the international financial system,” he says.
The market for asset-backed commercial paper – where Europe’s lenders from IKB to the German Doctors and Dentists borrowed through Irish-based “conduits” to play US housing debt – has shrunk for 18 weeks in a row. It has shed $404bn or 36pc. As lenders refuse to roll over credit, banks must take these wrecks back on their books. There lies the rub.
Professor Spencer says capital ratios have fallen far below the 8 per cent minimum under Basel rules. “If they can’t raise capital, they will have to shrink balance sheets,” he said.
Tim Congdon, a banking historian at the London School of Economics, said the rot had seeped through the foundations of British lending.
Average equity capital has fallen to 3.2 per cent (nearer 2.5 per cent sans “goodwill”), compared with 5 per cent seven years ago. “How on earth did the Financial Services Authority let this happen?” he asks.
Worse, changes pushed through by Gordon Brown in 1998 have caused the de facto cash and liquid assets ratio to collapse from post-war levels above 30 per cent to near zero. “Brown hadn’t got a clue what he was doing,” he says.
The risk for Britain – as property buckles – is a twin banking and fiscal squeeze. The UK budget deficit is already 3 per cent of GDP at the peak of the economic cycle, shockingly out of line with its peers. America looks frugal by comparison.
Maastricht rules may force the Government to raise taxes or slash spending into a recession. This way lies crucifixion. The UK current account deficit was 5.7 per cent of GDP in the second quarter, the highest in half a century. Gordon Brown has disarmed us on every front.
In Europe, the ECB has its own distinct headache. Inflation is 3.1 per cent, the highest since monetary union. This is already enough to set off a political storm in Germany. A Dresdner poll found that 71 per cent of German women want the Deutschmark restored.
With Brünhilde fuming about Brot prices, the ECB has to watch its step. Frankfurt cannot easily cut rates to cushion the blow as housing bubbles pop across southern Europe. It must resort to tricks instead. Hence the half trillion gush last week at rates of 70bp below Euribor, a camouflaged move to help Spain.
The ECB’s little secret is that it must never allow a Northern Rock failure in the eurozone because this would expose the reality that there is no EU treasury and no EU lender of last resort behind the system. Would German taxpayers foot the bill for a Spanish bail-out in the way that Kentish men and maids must foot the bill for Newcastle’s Rock? Nobody knows. This is where eurozone solidarity stretches to snapping point. It is why the ECB has showered the system with liquidity from day one of this crisis.
Citigroup, Merrill Lynch, UBS, HSBC and others have stepped forward to reveal their losses. At some point, enough of the dirty linen will be on the line to let markets discern the shape of the debacle. We are not there yet.
Goldman Sachs caused shock last month when it predicted that total crunch losses would reach $500bn, leading to a $2 trillion contraction in lending as bank multiples kick into reverse. This already seems humdrum.
“Our counterparties are telling us that losses may reach $700bn,” says Rob McAdie, head of credit at Barclays Capital. Where will it end? The big banks face a further $200bn of defaults in commercial property. On it goes.
The International Monetary Fund still predicts blistering global growth of 5 per cent next year. If so, markets should roar back to life in January, as though the crunch were but a nightmare. There again, the credit soufflé may be hard to raise a second time.
FT is reporting that the Saudis are planning their own sovereign wealth fund that will “dwarf” Abu Dhabi’s $900 billion fund. They don’t give a number, but the verb “dwarf” suggests we’re talking multiple trillions of $.
All those years of living beyond our means, of running trade deficits in the hundreds of billions per quarter may finally be coming home to roost.
Look at these dollar values for the assets of sovereign wealth funds, courtesy of the WSJ:
That’s $2.1 to $2.8 trillion, before including the Saudi fund. In a report published back in October, Merrill projected that SWF assets would increase to nearly $8 trillion by 2011. With another 2 or 3 trillion from the Saudi’s we’re well on our way. And clearly the SWFs don’t control the majority of reserves held abroad. There’s trillions more parked in various government paper just sitting in foreign government bank accounts.
The money being invested to bail out investment bank balance sheets–$5 billion from China going to Morgan Stanley, $10 billion from Singapore for UBS, $7.5 billion from Abu Dhabi for Citigroup, and undisclosed billions also from Singapore to be invested in Merrill–is chump change for these SWFs. And of course their coffers are growing every day that we continue to run a current account deficit.
A substantial portion of these SWF assets, indeed most of the reserves held by the governments behind the SWFs, are likely denominated in dollars. Each of those dollars is a claim on American property. A claim that we have to respect if our property laws mean anything at all.
Back in March 2007, the Treasury Dept. claimed in a report that foreign ownership of U.S. assets (stocks, treasury bonds, corporate bonds etc.) was $7.8 trillion as of June 30, 2006, up from $6.9 trillion the year before. Not all of that is held by governments of course. But clearly foreigners’ claims on America’s productive resources are huge and growing quickly.
For years the Fed has been increasing the money supply as measured by M3 at a rate that far exceeds inflation. I imagine one reason inflation has stayed low is that so many of these dollars are simply going abroad; they aren’t competing for goods here at home. But there’s no free lunch of course, and dollars have to come back.
This is a theme that I plan to follow on this blog. Something I call The Great Reversal. Once upon a time, in the late 19th century and before WWII, the U.S. was a great industrial nation whose economic growth was largely driven by production rather than consumption. But in an age of a strong dollar and expanding free trade, production has moved to places where it could be done more cheaply. China for instance. Of course America is still a great industrial power, but less so as a % of our overall economy than once upon a time.
Consumption and free trade have led to our dollars going abroad. The Great Reversal is now in process. As new industrial powers like China see their standard of living and the value of their currencies increase, their economic growth will increasingly be driven by consumption. They’re going to spend the dollars they’ve saved…..to buy large stakes in great American companies, for instance.
I call it The Great Reversal because the the flow of dollars is going to reverse. Americans will be spending less of their savings on foreign-made goods, while foreigners will be spending more of theirs on American-made ones. This is the great economic challenge–and the great economic opportunity–of our times.
Last week the WSJ published a great article about vulnerable California borrowers who’d been taken advantage of by a shady lender. A similar story in the NYT a month ago described how Countrywide deliberately steers borrowers into “high cost…unfavorable” loans in order to maximize their own profits. These stories are variations on the same theme: informed lenders taking advantage of uninformed borrowers. Yet they don’t tell the whole story. Borrowers share blame for taking on mortgages they couldn’t afford in the first place.
In the subprime age, mortgages are dangerously risky, potentially ruinous financial arrangements. And borrowers need to be protected not only from unscrupulous lenders, they need to be protected from themselves. Why can’t we hold mortgage lenders to the Prudent Man Rule or some other legal standard of care?
Today the Fed stepped in, using its authority under the Home Ownership and Equity Protection Act, to prohibit “deceptive” or “unfair” lending practices. First of all, this new regulatory regime is laughably tardy. Lenders have already stopped making subprime loans or gone out of business entirely. There’s no industry left to regulate.
But let’s imagine the Fed had issued this guidance in a more timely manner, say in 2004. What’s the point? Not only to prevent lenders from taking advantage of borrowers, but to prevent lenders from ENABLING borrowers. No stated income loans. That’s great. It prevents lenders from putting borrowers into loans they have no expectation of paying back in the first place.
But these regulations seem like a half measure. If lenders hadn’t been able to sell stated income loans, they’d have found other “innovative” ways to extend credit to the most unworthy borrowers. Why not take this regulatory effort a step farther and impose some legal standard of care on lenders? Make lenders liable if they knowingly put borrowers into less favorable—i.e. more profitable—loans.
Arguments against legal standards of care like “fiduciary duty” seem to me to be the following:
1. It will be a class-action bonanza.
2. It will reduce the availability of credit.
3. Most buyer/seller relationships aren’t regulated with any legal standard of care. It’s up to the borrower to make an informed purchase.
Taking those arguments in turn:
1. I don’t like the tort bar very much myself. Lawyers typically aren’t protecting consumers, they’re lining their own pockets. But I have to believe that the threat of class action lawsuits would act as a deterrent against flagrantly crooked lending practices.
Of course, rather than stopping crooked lending practices, it might just make legal fees a new cost of doing business, which would be passed on in higher interest rates to borrowers. But the silver-lining of higher interest rates is that it hampers credit expansion. And contrary to popular opinion, less credit is precisely what we need to repair the economy.
2. Marginal borrowers who were enabled by cheap credit to buy more house than they could afford shouldn’t have gotten credit in the first place. If new regulations reduce the availability of credit, preventing those who shouldn’t own a home from buying one, that strikes me as a good thing.
3. We’re not talking about a $20,000 car loan here. We’re talking about a $300,000 home loan. Not only is a mortgage a huge financial commitment, it’s also, perhaps, the most complex financial arrangement most Americans will ever enter into. The late Fed Governor Edward Gramlich said it best when he wondered why the most complex mortgage loans were being sold to the least sophisticated borrowers. Why? B/c they don’t know they’re being taken to the cleaners.
All this business that we don’t want to regulate Wall Street in a way that inhibits “financial innovation” strikes me as so much hogwash. When was the last time an investment banker added value to ANY financial transaction? Bankers don’t innovate, they expropriate.
I’m overstating my case a bit of course. Like equity capital, availability of credit is a crucial financial lubricant that drives economic development. Making credit widely available is a key to sustainable economic growth. Yet, credit can be as dangerous as it is important. It needs to be handled prudently, both by lenders and by borrowers.
With Citigroup bringing $49 billion of distressed SIV assets onto its own balance sheet, after taking billions in losses already, one wonders: just how much in losses are we sitting on?
An interesting chart from Marketwatch published the other day:
|Merrill Lynch||$8.4 bln|
|Morgan Stanley||$4.6 bln|
|Bank of America||*$3.3 bln|
|Deutsche Bank||$3.1 bln|
|Royal Bank of Scotland||$2.6 bln|
|Bear Stearns||$1.9 bln|
|Credit Suisse||$1.9 bln|
|JP Morgan Chase||$1.6 bln|
|Goldman Sachs||$1.5 bln|
|Wachovia Bank||$1.1 bln|
|Lehman Bros.||$0.7 bln|
Data: Companies, since Q3 * Est.
A friend–who works in structured finance (i.e. packaging/selling of asset-backed securities) at one of the better-performing banks on this list–estimates the financial world is sitting on $450 billion of writedowns. Not all of that is at the major Wall Street Banks in the list above. Other banks abroad have very high exposure. And many writedowns, in hedge fund portfolios for instance, we may never hear about.
But the extent of losses is much larger. Thinking in the grandest of terms, how far do house values have to fall? Forget bank balance sheets. What about Joe Homeowner’s balance sheet? The WSJ offered a stark estimate earlier this week:
Up to $6 billion of losses if house values decline 30%. And some think that is a baseline estimate. If you look at the historical price movement of housing, it tends to move in tandem with the general price level. That is until the earlier part of this decade when lax lending standards helped DOUBLE the value of housing while price inflation stayed relatively tame. To bring house values back in line with the price level, the thinking goes, they have to fall about 30%. $6 billion.
$450 billion seems like just a fraction of what’s going to be lost.
Stocks fell $7 billion from their peak. But look at the leverage factor. Houses are bought with debt; stocks can be, of course, but largely weren’t in the late 90s. [Thank God: a key driver of the Crash of '29 was the astounding volume of margin debt that people took on]. The moral of the story is that if an asset price bubble bursts, the situation is much more painful for someone who invested borrowed money. In the NASDAQ crash of ’01-’02, plenty of trading profits were wiped out. But most folks went back to $0, they didn’t have $100k of “negative equity” as many certainly will when house values fall back to reality.
So $6 billion seems like a lot to lose. But that’s just residential real estate. What about commercial real estate? Remember earlier this year when Blackstone bought and flipped the Equity Office portfolio of buildings at record prices? Expect to see billions more in losses when deteriorating economic conditions force a collapse in frothy commercial real estate markets…..
BKUNA (see post below) isn’t the only bank with low quality earnings that rely on negative amortization. Remember: negative amortization is the amount of interest due on a mortgage that the borrower defers to future periods. Accounting rules allow banks to count these “deferred payments” as current income. But if borrowers default on their loans, if they never make payments in cash, then “income” previously recognized has to be reversed.
Say I’m carrying a balance on my credit card; I owe interest on that balance. If I’m not paying my bill on time–if I’m making the minimum payment each month, for instance–then I’m “deferring” interest payments to the future. Wouldn’t it seem foolish for the credit card company to treat my “deferred” payments as income today? Banks that sold option ARMs are doing exactly this: watching the unpaid balance on their mortgage loans rise while counting nonpayments as income today.
If home values are increasing and borrowers can refinance, then there’s little risk to the bank that the loan amount won’t be paid back. But home prices are now falling across the nation. And defaults are rising…….
Banks that relied heavily on option ARM mortgage originations (BankUnited, Downey Financial, Luminent Mortgage, Countrywide, even Washington Mutual) are all in serious trouble…..and their stock prices reflect this. Research firm CFRA was on top of this problem back in 2006. People who went short on their research did very well.
A great article from the WSJ on poor quality earnings at banks:
This Game Theory
Is Cautionary Tale
By HERB GREENBERG
December 8, 2007; Page B3
The reality of Generally Accepted Accounting Principles, or GAAP, is that they give companies just enough rope to hang themselves and their investors, if they so please. Much of GAAP is so subjective that you could drive side-by-side snow plows through the gray areas.
That is something to keep in mind if, with the latest wave of write-offs, you believe it is time to start bargain hunting among the most beaten down financial-services companies tied to the mortgage blowup. The time may very well be right, but a recent report by Gradient Analytics warns that financial-reporting practices of some of these companies yesterday and today could still come back to bite investors tomorrow.
Gradient, a Scottsdale, Ariz., research firm that caters to mutual funds and hedge funds, was early to spot accounting issues at Krispy Kreme Doughnuts, Biovail and Children’s Place Retail Stores, among others, and their stocks subsequently tumbled.
“I think for a number of years they played games,” Donn Vickrey, a former accounting professor who co-founded and is now editor-in-chief of Gradient says about the financial-services companies.
By “playing games” he means a tendency during the mortgage boom “to report numbers that were artificially high.” There were a variety of ways to do that, all of them completely legitimate and blessed by the gods of financial accounting rules — otherwise known as the Financial Accounting Standards Board.
One of the most-popular tactics was front-loading income and cash flows through what is known as “gain on sale” accounting, as loans were packaged and sold to other investors. The amount recognized largely reflected what the company expects to receive at some point in the future, based on predictions of such things as delinquencies, prepayments and interest rates. It is totally discretionary; the more conservative the predictions, the lower the gain.
Just as companies may have been reporting numbers that were too high, Mr. Vickrey believes some might now be reporting losses and charges that are artificially low, hoping they will somehow get bailed out before the situation worsens.
This is being done, he believes, by such things as deferring recognition of losses; transferring mortgages that are likely to default from one part of the balance sheet to another, where management has more discretion in determining the seriousness of the loss; somehow concealing “the aftereffects” of aggressive gain-on-sale accounting, and reliance on interest income from negatively amortized mortgages — those in which the amount owed rises if payments don’t cover all the interest due, which in this environment at best appears dicey.
Much of this, he says, involves meeting “the bare minimum letter of GAAP, but not adhering to the spirit of GAAP.”
Among the five biggest companies involved in mortgage securities, Gradient believes Washington Mutual and Countrywide Financial have been the most aggressive, with Washington Mutual edging out Countrywide as having “the most risk for a material misstatement.” Washington Mutual didn’t respond to requests for comment.
Countrywide said its accounting is appropriate and it has taken steps to reduce risk.
Gradient warns that Washington Mutual may not be properly valuing loans it is holding for investment purposes. As a result, reserves for future losses may be too low.
While the company boosted its loss provision in the third quarter, the Gradient report says “the increase appears to be too little too late as the allowance for loan losses has failed to keep pace with the increase in nonperforming loans.”
Meanwhile, in recent years, interest from negatively amortized mortgages leapt as a percentage of interest income to 7.2% for the first nine months of this year from 1.8% in the same period two years ago. Not only is that income unsustainable, Gradient says, but more prone to write-offs, especially if there are increased delinquencies and defaults.
Then there’s the high level of gain-on-sale income in prior years “that may signal additional risks to come.”
Washington Mutual, the report says, ranked second behind only Countrywide in terms of its reliance on gain-on-sale. Countrywide has been on Gradient’s screen for four years because of a variety of earnings-quality issues.
As with Washington Mutual, Gradient now wonders whether there could be “hidden losses” among loans held by Countrywide for investment. While reserves as a percentage of nonperforming loans have been rising, hitting 63.4% as of Sept. 30, Gradient says they still lag behind peers, including Washington Mutual. Countrywide disagrees, and says that “when all of the relevant factors are considered, our ‘reserves’ are comparable to our competitors.”
Like Washington Mutual, Gradient says Countrywide suffers from “low quality income” related to negative-amortized loans. “Unfortunately,” the report says, in trying to determine its exposure, “Countrywide does not provide as much detail as other firms we surveyed.”
While the stocks of these companies and others have fallen considerably, Mr. Vickrey believes “a lot remains to be revealed.” Can’t wait.
And now for something completely different. From time to time, we at optionARMageddon like to talk about subjects besides real estate. Below a piece about immigration. Your editor will share his own views on the matter in a comment to be posted in a few days.
Immigration: A Long View
By John Winkler
In the Republican debate at the end of November the candidates wasted no time pummeling each other on the issue of illegal immigration. And they repeatedly descended into silliness with their accusations of “sanctuary city” versus “sanctuary mansion.” For a while you got the idea that there aren’t any other important issues.
We can safely assume the Republicans are doing this because polls show this is THE issue for likely GOP primary voters. And it is an emotional issue– raising questions of illegality, crime, use of scarce resources.
But I have never heard anyone discuss the longer term implications of a situation that has come close to destroying other countries, which in a few years could become an unslayable dragon. Call it the Canadian/Belgian paradigm.
It was not so long ago that Canada was nearly riven in two by the social and linguistic divisions among its two primary population groups– francophones and anglophones. The Parti Qebecois became a real force in national politics and came close to winning a vote in favor of national schism. More recently the French speakers have come to their senses, realizing they get much more from the Canadian federation than they lose. But if they had won that vote we might now have two countries just to the north of us.
The Belgians are not doing as well. Flemish speakers in Flanders comprise 60% of the country’s population, with French speaking Walloons the rest. The government has been in crisis for months, as repeated attempts to create a coalition government have failed.
There are obvious similarities between the two countries. In Canada the linguistic split is a proxy for something much deeper. French speaking Quebec is generally poorer, less developed, and its people by and large have lower prospects than their English speaking counterparts. And that has engendered significant anger and jealousy.
In Belgium the government is paralyzed. It is still being run by parties who were thrown out in June, because their designated successors have been unable to form a coalition. As in Canada, the French speakers have fewer economic prospects. Unemployment among them is double, and twice as many Walloons as Flemings have government jobs.
In both countries the basic issue is the same– a nation riven by lingustic differences which are symbolic of economic divisions in which one group feels disenfranchised by another and in which the two linguistic groups tend to congregate in restricted, well-defined areas
It doesn’t take a trained futurist to see the possible similarities in this country. Spanish speakers, illegal or not, are by far the fastest growing population group in the US. And they are beginning to have a huge influence on business, culture and politics. Even though many do learn English, there is a strong tendency to stay within their culture rather than assimilate.
Spanish speakers are distributed around the nation– not confined in a single geographical area. But there is a huge and growing concentration in parts of the west and southwest. Go into any store in Nogales and you will not have an easy time finding a clerk who is fluent in English. I’m not talking about Nogales, Mexico but Nogales, Arizona. The stores on the strip malls all have American names, but most of the people in them, both customers and workers, speak Spanish.
It is a reasonable assumption that in 10, 20,30 years the culture and politics of the area will be controlled by Spanish speakers. Nothing wrong with that. But there is always the danger of the great What If. What if the Spanish speakers do not fully participate in the American economy in equal measure to other groups? What if they become a permanent underclass? What if, in their anger and frustration, those people decide they are more Spanish than American, that their real national home is not the US but Mexico? And what if they decide to have a plebiscite on secession, or on transferring the southwestern states back to Mexico where they came from not that long ago? And what if they decide in the affirmative?
Mr. Winkler is a writer at ABC 7 News in Chicago. Prior to that he was a producer on World News Tonight with Peter Jennings. He’s been with ABC 36 years.
I love 10-Ks. You know those annual filings that public companies are required to make with the SEC? BankUnited Financial (stock ticker: BKUNA) published theirs last week and it makes for some fascinating reading. BKUNA’s loan book is clearly a real estate disaster story worthy of an optionARMageddon post. And, according to the 10-K, they claim not to have been involved in subprime. That is an interesting theme developing of late: plenty of lenders that avoided subprime debt entirely are still in deep trouble. American Home Mortgage? Bankrupt. Fannie and Freddie? Cutting their dividends and “hurrying” to raise capital. Even “prudent” lenders are getting hammered by real estate’s implosion. Did BKUNA lend “prudently?” Check out the 10-K for yourself. Forthwith: my favorite nuggets.
[By the way, this post should not be construed as offering any sort of investment advice.]
To start off, a little background on the company. BKUNA is a Florida bank that takes deposits and borrows money which it uses to fund mortgage loans. In 2007, 61% of their loans were for properties, primarily one-to-four family residential properties, in bubbly Florida. 7% of their loans were in California, another bubble state and 5% were in Arizona, yet another.
So how have their loans been performing? Well, uh, worse. Non-performing assets is a way to look at it. These include past due and delinquent loans as well as “owned” real estate–i.e. foreclosed homes now owned by the bank.
I would say the trend is up. But the $209 million of BKUNA’s so-called “non-performing assets” at the end of FY 2007 represent only 1.4% of the bank’s total assets. That’s up 9x from 0.16% last year, but why worry about 1.4% of the loan book?
Negative Amortization–why more than 1.4% of BKUNA’s loan book is at risk.
NegAm is an ugly term that refers to a pretty simple concept. Loans with “options” (an option ARM, e.g.) give the borrower the “option” to pay back less than the full interest and principal payment in a given month. Any unpaid interest and principal is added to the total outstanding loan balance. The concept is similar to making the minimum payment on your credit card. Whatever you don’t pay gets added to your balance. And as your balance grows, so does the amount of interest you owe. Now imagine if the interest rate on your credit card was going to jump after a couple years. Not only do you have a higher balance, the interest rate charged on the higher balance is higher. Now we get to the ARM in option ARM….it stands for, of course, adjustable rate mortgage.
To sum up, NegAm option ARMs are loans where the borrower is making a minimum principal and interest payment on his mortgage, consequently the total mortgage balance is INCREASING and to make matters worse the interest rate on that mortgage balance is set to explode upward in a couple years time. Not a big deal if home values are increasing and you can refinance. But what if home values are falling and you can’t? You get a real estate disaster.
So what percentage of loans are “negatively amortizing” at BKUNA?
Would you believe 55%?
Yup. According to the footnotes of the 10-K, page 49, $6.7 billion worth of mortgages (out of a total loan book of $12.2 billion) are “negatively amortizing.” So you have to ask yourself, doesn’t it seem like 55% of the loan book is at risk, not just the 1.4% labeled “non-performing?”
It’s one thing to skip a payment on a $10,000 credit card balance, quite another to skip a payment on a $400,000 mortgage. Over time the loan balance can grow to as much as 125% of the original amount, $500,000 in our example. In the meantime, housing prices are falling and your home isn’t worth $400,000 anymore. It’s worth $300,000 (if you can sell it at all). So now you owe $500,000 on a home that’s worth $300,000. What happens to the bank? Well they foreclose on the home and write down the loan.
I’m oversimplifying things here, but obviously it’s a bigger deal to skip a payment on a $400,000 mortgage balance than a $10,000 credit card balance.
BKUNA says they weren’t involved in subprime lending, presumably b/c none of its loans were granted to borrowers with credit scores in the “subprime” zone below 620. In fact nearly 50% of BKUNA’s borrowers have scores above 700. Yet how valuable is a high credit score for a borrower who isn’t paying back the full cost of his loan?
Indeed, you have to question whether these loans weren’t indeed subprime. Of BKUNA’s
$10.2 billion of one-to-four family residence loans outstanding at the end of FY 2007, only 18% were classified as “full doc, employment verified.” 42% were classified as “stated income/employment verified.” How DO you verify someone is employed without having them produce a pay stub or other proof of income?
Anyway, another 31% of loans were to borrowers for “low doc employment verified” loans. And 9%, or $1.0 billion were for “no doc” loans.
That’s right: BKUNA has $1.0 billion loaned out to folks they know virtually nothing about.
The Stock Price
BKUNA may be reporting that only 1.5% of its loan book is “non-performing,” but investors seem skeptical:
Is this developer having trouble finding even ONE buyer for a new condo?
Please send us the crazy offers you’re seeing in your area. No closing costs and a free granite countertop are great. But I want a Lexus!
A delicious theme of the subprime debacle is that otherwise smart people, who ARE PAID TO KNOW BETTER, got themselves and their investors involved in dodgy debt. Like Florida’s Local Government Investment Pool. Money fund managers who put investor capital in CDO debt, SIV commercial paper and similarly sketchy instruments deserve their own circle in mortgage hell. Investors like a good yield in a money market fund, sure, but at the end of the day, do we care so much about that extra 25 basis points that we’re willing to put our capital at risk? Money market funds are supposed to be ultra safe. That’s why people buy them. We’ve heard fund managers argue that Moody’s rated this stuff ‘AAA.’ It’s not their fault if the paper turned out to be unsound. Come on: take some responsibility guys. Investors don’t pay you to outsource investment decisions to Moody’s!
You want a high yield money fund that doesn’t carry added risk? I recommend Vanguard’s Prime Money Market Fund. They offer you a better yield for the right reason: the expense fee they charge is lower. You, the investor, get the incremental yield. I happen to be a very satisfied investor in Vanguard’s Prime MMF and am pleased, without any sort of compensation from them, to recommend it to others.
[An aside: it was also refreshing that a Vanguard phone representative could tell me that the Prime fund had no investments in risky asset-backed paper. The rep at Fidelity I spoke to had no idea what a mortgage backed security is.....]
This is an op-ed, but no doubt the WSJ editorial page doesn’t stray too far from this opinion themselves…..one thing we have to worry about is becoming the next Japan. Remember their real estate bubble in the late ’80s? When the land underneath their royal palace was worth more than the state of California? That bubble burst, but instead of forcing the financial system to digest all it’s bad debt, the Japanese authorities allowed them to continue carrying it on their books. Here we are 17 years later and the Nikkei is still half what it was back then. If we prevent the real estate reckoning from cleaning up the mess we’ve created for ourselves, in the debt markets, in home values, etc., we risk long-term stagnation ourselves. The short-term pain will likely be greater, but at least we will have taken our medicine.
No Bailouts for Borrowers
By ANDY LAPERRIERE
December 4, 2007; Page A21
As the housing market continues to deteriorate, the pressure to respond is growing in Washington. A Treasury Department plan — to work with mortgage servicers to streamline the process for modifying loans for subprime borrowers who can’t afford higher monthly payments — has been in the news the past few days. Yesterday Hillary Clinton announced a plan for a 90-day moratorium on foreclosures and a five-year freeze on mortgage payments for subprime borrowers. It won’t be long before demands are made — including from Wall Street — for a taxpayer bailout of homeowners facing foreclosure.
A taxpayer bailout of distressed homeowners would be expensive, unfair to the vast majority of homeowners and renters who have made prudent financial decisions, and set a troubling precedent that would invite reckless behavior in the future. What’s more, a bailout will not stop the inevitable correction in home prices, and is unlikely to prevent the associated economic repercussions.
The primary argument for a taxpayer bailout is based on a myth — that subprime borrowers are falling behind on their mortgages because interest rates on their adjustable rate mortgages have spiked, making their monthly payments unaffordable. In fact, the vast majority of delinquent subprime borrowers are still paying introductory teaser rates (about 8% on average, a below-market rate for borrowers with checkered credit histories). In other words, for most of these borrowers, their monthly payments have not yet gone up.
It is true that many subprime borrowers were sold a toxic mortgage by unscrupulous mortgage brokers. However, the primary reason for the spike in subprime delinquencies so far is that many subprime borrowers have taken on more debt than they can pay back using any reasonable interest rate.
According to Credit Suisse, the typical subprime mortgage starts at 45% of pre-tax income — before the rate resets. After the first reset, the mortgage payment generally increases to about 55% of gross income (and can go up from there). Many of these loans can’t be restructured or modified; the only way the most distressed subprime borrowers will be able to stay in their homes is if the lender or the taxpayers forgive a significant amount of their mortgage debt.
Since so many borrowers — and not just subprime borrowers — would need to receive substantial debt forgiveness to make their mortgages affordable, a bailout fund would be expensive, likely costing taxpayers hundreds of billions of dollars. At a time when Congress should be trying to confront the trillions of dollars in unfunded Social Security and Medicare obligations, a mortgage bailout would be fiscally irresponsible.
An important factor that would magnify the cost of a bailout is that it’s difficult to know in advance who will default on their loans, and therefore to whom the aid should be targeted. By what standard would the government distribute this aid? What would qualify a homeowner as financially distressed? Should a bailout be limited to subprime borrowers, people who, by and large, have a history of not paying their bills on time? Why not extend the taxpayer’s largesse to prime borrowers, many of whom also face large payment increases associated with rate resets?
A majority of subprime loans during the past few years have been cash-out refinance loans. Many subprime borrowers have extracted, through cash-out refinancing, much more than they ever put into the house in the form of a down payment. Would they be eligible for a bailout? How about people who chose a “stated income” option, so they didn’t have to document their income and lied on their loan applications?
Would a bailout fund be limited to those with certain incomes or home values? Would there be an asset test, or would people with two brand new cars in the driveway or six-figure stock portfolios qualify? What kind of asset test?
It is self-evident that any bailout fund will be complex to administer, as well as arbitrary and unfair. While the plight of many who were caught up in the housing mania is tragic, a bailout package would almost certainly reward the least deserving. Those facing the greatest risk of foreclosure — and presumably those who would get most of the taxpayer aid — are those who bought a much more expensive house than they could afford, spent the equity of their once-affordable home, or lied about their income to qualify for a loan they otherwise would not have received.
Ironically, if passed into law, a bailout would come at a time when many investors are urging Federal Reserve Chairman Ben Bernanke to exercise restraint in responding to recent financial market turmoil. They argue that one important reason investors have taken on excessive risk (say, buying risky subprime mortgages with leveraged funds) was the perception that the Fed would step in and cut the fed-funds rate if asset prices fell, as it has done repeatedly during the past two decades. Economists call this moral hazard. Obviously, the federal government would set a troubling precedent and encourage irresponsible behavior in the future by bailing out homeowners (and, indirectly, lenders and investors).
Some say the government did exactly that during the S&L bailout of the 1980s, but that is not true. The bailout was for innocent depositors who were guaranteed protection of their funds under federal law. The managements and investors of the savings and loans that became insolvent were not bailed out. They lost their jobs and their investments.
The argument will be made that, despite the high cost, inherent unfairness, and moral hazard associated with a bailout, allowing a spike in foreclosures will push home prices down and possibly send the economy into a recession. Therefore, Congress should create a taxpayer bailout fund to soften the economic blow from the housing bust.
Theoretically, a timely and well-designed bailout might slow the descent of home prices and mitigate the associated economic fallout — but one ought to be deeply skeptical of the effectiveness of a proposal that, at root, is designed to repeal the laws of supply and demand. Home prices were driven to unsustainable levels during the housing boom because imprudent loans created artificial demand for housing. It is inevitable that home prices will fall as that artificial demand is withdrawn.
Congress and the Bush administration are in the process of taking measured steps, such as expanding eligibility for FHA loans and working with industry to streamline the process to modify loans, to help distressed borrowers where they can. To be sure, these proposals will have only a modest impact. But policies designed to suspend the laws of economics inevitably produce unintended consequences. Today’s housing bust is itself the unintended consequence of an easy Federal Reserve monetary policy designed to cushion the economy from the fallout of the bursting of the tech bubble. Congress should reject a taxpayer bailout.
Mr. Laperriere is a managing director in the Washington office of ISI Group.