ES -- DX/CL -- isee -- cboe put/call -- specialist/public short ratio -- trinq -- trin -- aaii bull ratio -- abx -- cmbx -- cdx -- vxo p&f -- SPX volatility curve -- VIX:VXO skew -- commodity screen -- cot -- conference board

Monday, December 31, 2007


2008: the return of hardship

from mish -- the increased angst of american credit card debtors has been likely fallout of the credit contraction, as many were financing large structural or revolving debts with home equity lines of credit (HELOCs). HELOCs are just second lien mortgages -- and while easily obtained for incredible amounts vis-a-vis actual home equity during the boom of 2003-2007, standards have changed.

Until recently, credit card default rates had been running close to record lows, providing one of the few profit growth areas for the nation's banks, which continue to flood Americans' mailboxes with billions of letters monthly offering easy sign-ups for new plastic.

But what is coming into sharper focus from the detailed monthly SEC filings from the trusts is a snapshot of the worrisome state of Americans' ability to juggle growing and expensive credit card debt.

In the wake of the jump in defaults on subprime mortgage loans made to borrowers with poor credit histories, banks have been less willing to allow consumers to consolidate credit card debt into home equity loans or refinanced mortgages. That is leaving some with no option but to miss payments, economists said.

Investors also are backing away from buying securitized credit-card debt, said Moshe Orenbuch, managing director at Credit Suisse. But that probably has more to do with concerns about the overall health of the U.S. economy, he said.

"It's been getting tougher to finance any kind of structured finance - mortgages, automobile loans, credit cards, student loans," said Orenbuch, who specializes in the credit industry.

mish rightly notes that this is the onset of deflation. the federal reserve can lower short rates all it wants, but policy power over longer rates was sold to foreign central banks over the last two decades -- and in any case, rates are simply not the same as availability. it is very probably beyond the power of central banking to perpetuate this level of general indebtedness. in the end, a paradigm shift must come.

i was drawn to the year-end missive of minyan peter, whose sophisticated views of banking have been valuable all year but whose assessment of what lies ahead is probably much more profound.

I believe that in time, historians will define the last twenty years in America as the “Age of Aspiration” where, thanks to unprecedented levels of credit, Americans could become anything they wanted. Where, thanks to zero percent down debt and a seemingly robust economy, we could own bigger homes, fancier cars, and more lavish vacations – where our bounty was limited only by the boldness of our wants.

Well, I, for one, believe that our Age of Aspiration is ending. And, with its conclusion, we must, for the first time in almost a generation, begin to reconcile our wants with our means. We must choose what to do without, rather than what more to do with.

But I would suggest that few of us are prepared for this challenge. Why? Because abundance relieves each of us from having to prioritize what is important. When anything is possible, everything is possible. Few of us have really had to choose.

As I look ahead to 2008, though, I believe that each of us, the communities we live in, and the organizations and companies we serve, are going to have to make choices. We are going to have to separate what is most important from least, and act accordingly. Where life was once limitless, it will now be constrained.

And, like it or not, all of us will need to return to our vocabulary a simple phrase that I believe has been lost over the past twenty years: “I can’t afford that.”

he is describing, while avoiding the word, the return of hardship.

the united states has been, particularly under the bush administration but in general since the 1980s, a gradually bifurcating society. a relatively small number of americans have done very well indeed in building wealth, while a great many have been able to emulate (but not replicate) that material success by building debt. the two have seemed quite similar from a distance -- my wife and i have been amazed to see the kinds of homes some friends and acquaintances have bought, the kinds of cars they drive, the sorts of plans they've made, while privately understanding that they pull in less income than we do. it's been particularly hard for her at times to accept that we are not doing something wrong, that accumulating control of assets can be done in one of two manners and that the latter, impermanent fashion was becoming so widespread. we even mortgaged a condo in chicago on a 5-year ARM between 2002 and 2006, in what amounted to an effort to quell her disquiet that (fortunately, thanks to a new arrival and relocation) ended decently.

the unfolding disaster in housing, however, began to make concrete a lot of things that previously i had only been able to talk to her about in the abstract in what sometimes must have seemed to her mere excuses not to live well/excessively (depending on whose definition was being used). and as the outrageous sheer scale of american social credit profligacy is slowly comprehended, particularly as associated with housing, as aspect after aspect -- gravity-defying mortgages, strange and heady commerical development in both city and suburb, zero-interest five- and even six-year car loans, literally standardless credit card solicitation -- begins to reveal its dark underbelly as the mechanism of securitization seizes and ruptures under the duress of wild, unanticipated but equally inevitable default rates, i feel as minyan peter apparently does. the growing american bifurcation that has been papered over by debt in the last decade will now be rendered plain, and the haves will be remorselessly sorted and separated from the have-nots.

much of what has transpired so far has been concentrated in the financial and real estate sectors of american and european economies. it is spilling over into statehouses, as has been previously discussed in association with the monolines. it will this year sincerely overspill into the daily lives of most americans -- the scale of the problem is simply too large for any kind of real compartmentalizing, as has been seen in the joke made of the word "contained" in 2007. as such, i expect that this coming year will be remembered for its difficulty more than anything else.

Labels: , , , ,

Wednesday, December 26, 2007


a walk in the park

taking the measure of the credit contraction is an exercize in probability-weighting, but there should be no doubt where the worst case scenario lies. this uk telegraph article stares over the edge into the abyss, and sees disaster within several weeks if creative solutions are not implemented.

Labels: ,

Friday, December 21, 2007


ubs facing shareholder revolt

via the financial times, it looks like the sovereign wealth put is going to be more complicated than some imagined, even as morgan joined the party and merrill apparently will, being invited by the government of singapore.

The FT has learned that the mystery Middle Eastern investor ploughing SFr2bn ($1.73bn) into UBS’s recapitalisation is from Saudi Arabia. Details of the Saudi royal family’s involvement were unclear but one banker said Prince Sultan, the crown prince and defence minister, was instrumental in the deal. The investment is understood to be the result of a long relationship between the private banking arm of UBS for the Middle East, headed by Michel Adjadj, and the Saudi royal family. The investor’s insistence on anonymity was among concerns raised by UBS shareholders on Thursday. One influential Swiss institutional investor urged shareholders to reject the proposal to raise SFr13bn from sovereign wealth funds. A second demanded a special audit of the bank’s losses. The danger of a revolt at the UBS special shareholders’ meeting in February to approve the measures prompted the Swiss National Bank to take the unusual step of recommending the recapitalisation.

there's something distinctly strange about seeing foreign governments repeatedly step where private investors fear to tread. are the governments taking good investment opportunities at depressed prices? or are they making questionable decisions that are illustrations of the agency problem of government? perhaps they feel that they have to take opportunities to purchase american hard assets where they can, having seen china in 2005 denied the right to purchase unocal with a helping hand of the xenophobic wing of the american media, thereby demonstrating that the ultimate return on investment for vendor financing may be even worse than expected.

Labels: , ,


chrysler is going away

via calculated risk.

The banks, led by JPMorgan Chase, and including Goldman Sachs Group, Bear Stearns, Morgan Stanley and Citigroup, have tried several times to sell some of these loans, and each time the offering has been postponed. In November, the banks tried to sell a portion of the debt at 97 cents on the dollar and found no takers. With the news that Chrysler's financial situation is "serious", the value of these loans has probably dropped sharply.

this is the worst-case scenario for the involved banks -- a classic m&a failure leading to an irretrievable pier loan.

mergers and acquisitions is a line of bank business that i haven't written as much about as some others, but is has been a revenue keystone for american money center banking that has almost completely gone away since july. i was frankly shocked to see sam zell complete the deal for tribune company in this environment, as it shows some pipeline m&a business is getting done. but the failure of the chrysler deal is likely the punch in the nose that will keep bankers whimpering in their doghouses for some time to come. it's all just another aspect of the credit crunch that first surfaced in the first quarter of 2007 and has since deepened in spite of ever-larger central bank liquidity injections.

american automaking has been in decline for many years, and could well be following the path of american steelmaking. i noted back in 2005 the day the debt of general motors and ford were cut to junk. i didn't appreciate at the time that many institutions could sell their downgraded holdings in the carmakers and redeploy capital to highly-rated mortgage backed securities and CDO tranches which were being churned out of the housing and financial sectors en masse at that time. that, of course, isn't working out very well for them.

chrysler employs some 130,000 people, many of whom are having a pretty uncertain christmas. god bless and good luck to them all.


Thursday, December 20, 2007


taking the measure of credit contraction

this deserves more attention than i have time at the moment, but one of the impressions i have with respect to the credit mess is that very few attempts at grasping the true scale of the problem have yet surfaced. we are simply too early on in the credit unwind for respectable analysts to risk reputations with what would seem today outrageous loss estimates.

however, though the landscape is also littered with disasters that never were, the history of financial crises demonstrates that initial loss estimates for public consumption -- such as the sophmoric dimwittery put forward by former game show host ben stein today -- eventually end up being minor fractions of the total damage with great regularity.

being aware of that, some outlier thinking is welcome -- and calculated risk offers it.

One of the greatest fears for lenders (and investors in mortgage backed securities) is that it will become socially acceptable for upside down middle class Americans to walk away from their homes.

If every upside down homeowner resorted to "jingle mail" (mailing the keys to the lender), the losses for the lenders could be staggering. Assuming a 15% total price decline, and a 50% average loss per mortgage, the losses for lenders and investors would be about $1 trillion. Assuming a 30% price decline, the losses would be over $2 trillion.

Not every upside down homeowner will use jingle mail, but if prices drop 30%, the losses for the lenders and investors might well be over $1 trillion (far in excess of the $70 to $80 billion in losses reported so far).

i'm personally convinced by the implications of price-to-relative-metrics that a 30% nationwide real correction in house prices is not only a possible but likely destination. indeed, given the incedible and widespread excesses of the boom, with long-lasting trouble in american and european banking likely in my opinion to bring durable credit contraction and deflation, the possibility of significant overshoot -- that is, a regression well beneath the mean before a rise back up to the mean is experienced -- is altogether possible. as i've said previously, it concerns me deeply the ease with which mainstream forecasts of 20-30% nominal price declines have been elicited from major research houses. the implication, as above, is that the true scale of the decline is likely to be significantly worse.

one has only to look as far as jan hatzius' calculus to understand the implications -- with something on the order of $1.5tn in losses, the credit contraction implied by the current velocity of money would be on the order of ~$15tn. that would be some 35% of all outstanding money supply (that is, m3 plus bank credit plus government debt). that is an evaporation of money supply at least on the order of the banking catastrophe of 1931-33, when m2 contracted by about 30% and broader inclusion of credit supply probably significantly more.

futhermore, one has to be aware that this is not really worst-case thinking. paul krugman notes that a 30% nominal price decline over the next few years would put some 40% of american mortgagees underwater on their home. with most americans living in non-recourse states -- where the lender cannot pursue the defaultee, and the borrower effectively has a moderately-priced option to own which is going well out of the money -- and about $21tn in mortgage debt outstanding, one can eyeball that $1.5tn in mortgage credit losses could clearly be significantly worsted.

this line of thinking quickly leads to staggering consequences, but the enormity of the problem is not to be ignored by the prudent. it is one thing to experience a bubble and bust in paper assets such as stocks fueled mostly by margin lending, which exists at the periphery of the financial system. it is quite another, however, to experience a true credit bubble that widely infects home mortgages, commerical real estate, zero-percent auto loans, massive unsecured credit card lending -- the pretenses of all being predicated on steady asset inflation, and the conditioning of the population to expect and indeed rely on inflation to make their profligacy if not sustainable then endurable.

with the onset of deflation, the pernicious stubbornness of credit -- which happily expands with rising collateral values but obstinately refuses to recede with asset declines -- may well reverse decades of fiscal and social conditioning and change the very way we think.

though the stage may well be set for its arrival, it remains to be seen if anything like a full-fledged debt-deflation will materialize. i for one think the great depression was truly 'great' and that the model for asset price deflation this time around is likely to be found among other, lesser examples (including perhaps 1990s japan, which i cursorily cited here). but a wise investor will at least consider the possible downside from here -- and should not be reticent to admit that, while not the end of the world, it is truly intimidating and more likely to materialize than at any previous point since at least the mid-1960s and perhaps since the late 1920s.

Labels: , , ,

Great post Gaius,
Fixed-rate mortgages are definitely the "loan of choice" by today’s homeowners seeking a refinance mortgage. About 85 percent of refinance mortgages in recent months have been fixed-rate loans. The attractions of a fixed rate mortgage are a principal and interest payment and an interest rate that remain the same for the entire length of the loan. That stable predictability is what entices so many people to choose it, and its safety and reliability will afford the homeowner peace of mind. :)


------ ------- ------

Post a Comment

Hide comments


end of the monoline

that's probably the easiest post title i'll ever have. monoline bond insurer MBIA today revealed -- after having hidden -- the fact that it is exposed to $8.1bn in CDO-squareds (or CDO^2s).

``We are shocked management withheld this information for as long as it did,'' Ken Zerbe, an analyst with Morgan Stanley in New York, wrote in a report yesterday. ``MBIA simply did not disclose arguably the riskiest parts of its CDO portfolio to investors.''

MBIA's ``eleventh-hour'' disclosure ``ignites concerns all over again about the prospect for future losses,'' Kathleen Shanley, an analyst at bond research firm Gimme Credit in Chicago, wrote in a report. She said outside investors didn't know about the CDOs-squared, which she called the riskiest type of CDO.

these are CDOs of the least-marketable tranches of CDOs, and one might quickly conclude they are now worth nothing. and while that may not be true, the very fact that MBIA holds $7bn in equity beneath some $30bn in CDOs and $650bn in total insurance is enough to make plain that it -- along with other monolines -- no longer merits a triple-a rating. without a triple-a rating, there's little point in the existence of a monoline. and the forbearance of the ratings agencies cannot last forever.

i think nouriel roubini has it right -- if the very existence of your business is predicated on a triple-a rating, you cannot merit a triple-a rating. the world of municipal finance can function without bond insurance, and it will shortly have to, though there might be significant losses as institutions are compelled to sell for regulatory reasons where they have up until now held fast.

in the longer run, i suspect borrowing for smaller and weaker communities will become significantly more expensive -- at exactly the wrong time.

more immediately vexing will be the default risk that many banks which own these CDOs and CDO^2s will, after having been laid off on the insurers, return to their own balance sheets and have to be reserved against. this should further exacerbate the capital hoarding that is at the core of the credit crunch.

Labels: , ,

I've said the monolines business model is senseless since 2002, when I was introduced to them by an article in the WSJ describing a dispute between Bill Ackman (BA) of Gotham Partners and MBIA. In my opinion, BA was right on all counts. That the monolines have survived another five years only shows how slowly markets work.

------ ------- ------

Post a Comment

Hide comments


house prices changes

from OFHEO is a tidy little utility for comparing nominal house price changes using their database. the data require a deflator to be translated into real terms. as a method of estimating the size of local house-price bubbles, it can join local estimates of price-to-rent and price-to-income in giving ballpark estimates of what to expect as things normalize with the return of something like credit underwriting standards.

as it stands, from current prices, median-price-to-median-income looks set to revert some 30-35% to get back to its pre-2002 standard, while price-to-rent looks more like a 25% reversion to get back to 2001 levels. paul krugman, on similar grounds, is expecting a national 30% reversion -- and that ignores the possibility of overshoot in reversion.



first quarterly losses in seven decades

first it was morgan:

Chief Executive Officer John Mack called the fourth-quarter loss of $3.56 billion, the first in the New York-based firm's history, ``embarrassing.'' He'll forgo his bonus for the year, the company said today in a statement.

morgan was founded in 1935.

now it's bear:

Bear Stearns Cos., the No. 5 U.S. investment bank, said Thursday a bigger-than-expected writedown in its mortgage portfolio caused the first quarterly loss in the company's 84-year history.

Bear Stearns also said members of its executive committee, including Chief Executive James Cayne, will not receive bonuses for 2007.

bear was founded in 1923. that provides some really strange context for the depth of the troubles we are now seeing -- folks who never lose money (or at least never report as much) are in fact losing money. a big part of that, however, is the fact that these houses, long private, went public in the 1980s (bear in 1985, morgan in 1986) and earnings smoothing is considerably more difficult in the public arena.

morgan further raised $5bn from the china state sovereign wealth fund, following citi and ubs, and is paying a punitive 9% on the convertible preferred issues. china now owns just shy of 10% of morgan. here's more from mish.

it very probably won't be the last such investment, but i sincerely doubt the pace of sovereign wealth purchasing can keep up with writedowns.

Labels: , ,

Wednesday, December 19, 2007


is this a buy point?

god help me, it might be.

the index has revisited its consolidation zone from november in price, where i evacuated my shorts and started putting on long positions. but is showing clear positive divergences across the board -- net points gained, net volume, net advancing issues, issues trading over their 30-day moving average, issues trading over their 150-day moving average (not shown), and mcclellan oscillator to boot.

moreover, improved participation shows in issues within 5% of new 65-day highs, issues within 5% of new 65-day lows, new 65-day lows, 65-day new highs minus new lows, and all the corresponding 20-day measures to boot (not shown, except 20-day new highs minus new lows).

even better, a similar (but less clear) picture emerges from these same measures applied to the s&p 500. index price there has not yet plumbed its november lows, but most of the positive divergences are there from similar price levels in november.

further still, isee sentiment moving averages are continuing to improve in general from what looks to have been a bottom coincident to late november.

my longer-term pessimism is severe, no doubt. but can i imagine the narrower equity indexes rallying on momentum terms headed into january, in defiance of any and all economic concerns? absolutely. it's already happened once, and there's gas in the tank.

Labels: ,


krugman on the credit crunch

beginning with a general history dating back to the tech bust of 2000 and the flood of foreign capital that fueled (along with ratings agency complicity in accessing institutional capital pools) securitization -- including a debunking of 1998 comparisons (solvency, not liquidity) -- followed by a synopsis of what's been done (and not worked), including a dismissal of the paulson plan as insufficient ("worth a few billion") -- an effective dismissal of comparisons to the s&l crisis, as bad debts were then held by good depositors to the tune of $150bn, but bad debts are now held by "a lot of very undeserving investors" -- and what happens next.

krugman's guess sounds very similar to my own -- capital markets will remain crippled as asset deflation takes hold over the course of several years, with a window opened (in the q&a) to the 1930s.

but note this excellent theme from a dash of insight -- periods of extreme distress are often characterized by an increasing transparency of previously-opaque problems without a transparency of future solutions. it seems to me that we entered a phase of increasing transparency of problems and associated pessimism in july. so far, solution transparency has been very disappointing -- i've seen nothing in public policy that yet admits to the fact that this is a true banking solvency crisis, and until someone important does admit that we will go on implementing liquidity cures to the patient to little effect.

that may not last. there may be an attempt eventually at solvency cure -- a bank recapitalization. and that would be a start, perhaps, to solution transparency and a chance at optimism.

but it needs to be said that even solution transparency may be intrinsically disappointing. i recently had a gratifying exchange with stagflation mark, a frequent commenter at calculated risk and proprietor of illusion of prosperity in the comments here. his point of view on the direction of future events is in his name, but i think examining marc faber's figure 10 leads me to a different conclusion, a disorganized manifesto of which i can cut from the thread.

i would submit that, in accordance with irving fisher's theory of debt-deflation, the essential feature by which a recession becomes a debt-deflation is an initial condition of excessive debt.

as a percentage of gdp in the late 1960s, as seen on the chart, that condition simply did not exist on a scale equivalent to either 1929 or 2007. moreover, i suspect that if one could run that chart back to periods around 1814, 1836, 1865, 1892 -- years preceding the onset of deflationary periods -- one would see similar debt-to-gdp spikes waiting to be resolved.

... the more subtle point you're making, i think, is that the ease with which money supply can force credit expansion has improved so as to make infinite credit expansion possible. again, i just wonder.

the fed has a balance sheet to maintain which constricts eventually its ability to engage in lending programs like we have seen announced today.

and there are moreover limits to what it can do with its monetary monopoly. in the 1970s inflationary depression, the ratio of total money-plus-credit to m1 was about 11x. today, that ratio is closer to 40x. the government also in the 1970s governed the largest creditor nation on the planet; today, it governs the largest debtor nation -- and the difference is paramount.

i think the salient question is, "from that kind of ratio, can the fed print enough currency fast enough (from a policy-response viewpoint) to counteract a severe contraction in fractional reserve lending, i.e. a slowing in the velocity of money? and do so without forcing an international debt repudiation that would effectively decapitalize the american banking system by another path?"

i frankly don't think the policy response will be nearly fast enough to stave off the onset of deflation and put both borrowers and lenders into a debt-averse mindset. and even if they did, it would spark an international t-bond and agency debt repudiation that would force the american government into insolvency.

... the banks in japan (for example) needed balance sheet repair (ie, a way to reduce liabilities faster than assets were being written down), not balance sheet expansion (access to more cheap credit, which was more likely to further impair capital ratios in a falling asset price environment). the banks' attempt to do just that is why japan got credit contraction and deflation -- they let zero percent fund a relatively small carry income from foreign lending, which (along with incredible regulatory forbearance and periodic government treasury bailouts) slowly recapitalized them once asset price declines stopped destroying capital at a rate more rapid.

the result looked in japan like near-0% interest rates all the way out the curve, monetary base growing 25% a year, but m2+CDs growing at just 11% and bank credit declining year after year for a decade. even a recapitalization of the banks by government that amounted to 12% of gdp in 1999 did not break the domestic contraction, as it was merely held as a reserve against expected future asset price declines or lent out overseas.

in the united states, current credit levels were furthermore created in part by the shadow banking system of securitization -- including many institutionals and hedgies. these holders will not have access to fed funds or (very likely) rescue, and they won't have a way to recapitalize [via carry]. many will probably stop lending entirely, radically reducing the availability of credit.

in short, i suppose, nominal credit rates are not the same as credit availability. we have had a period of low nominal rates, negative real rates and incredible availability; that could well be followed by a period of zero nominal rates, high real rates and incredible unavailability.

... mab above discussed a fiscal response to private debt liquidation -- essentially the conversion of bad private credit into government credit, a wholesale recapitalizing of the system. i don't see this as likely -- outstanding government debt is in the area of $9tn now, and replacing a 20% contraction of [probable] private credit (taking m3 plus bank credit less m1 as a loose approximation, and hardly out of the realm of possibility from these heights) would more than approximately double real government liability and amount to a bailout on the order of 300% 75% of gdp. such a move or anything like it would probably force foreign treasury debt repudiation (imo) and quite possibly a dollar crash -- which would force a federal book balancing and cut the united states off from most of the imports it depends on for the orderly functioning of its society.

even if the capacity exists, this isn't something i think the united states is likely to hazard, dependent as it is on international trade for basic goods.

i think instead it will have to allow significant private credit contraction to progress while moderating it with whatever narrow-money-supply inflation it can get away with internationally, combined with cuts to extant spending plans such as medicare. as a large international debtor with a manufacturing base that has moved to china, it seems to me that it has little choice.

that would seem to me to imply general deflation of a kind seen perhaps not in 1929-1933 but in longer periods like that seen from 1865-1896.

... i think the health of the banking system is critical, as it is the vehicle of velocity and rising velocity is obviously necessary to hyperinflation as declining is to deflation. with banks in america now overextended and tightening lending standards to a public that is deeply indebted, coming off a period where velocity was very high and credit standards nearly nil, it's hard for me to see inflation as the likely next step even if the government starts increasing the monetary base as a stimulant.

Labels: , ,


ACA cut to junk

per bloomberg:

MBIA Inc. and Ambac Financial Group Inc., the world's largest bond insurers, had the outlook on their AAA credit ratings lowered to negative from stable by Standard & Poor's, while ACA Capital Holdings Inc.'s guaranty ranking was cut to CCC from A.

S&P also reduced its outlook for Financial Guaranty Insurance Co. and XL Capital Assurance Inc. to negative. The actions were ``prompted by worsening expectations'' for insured nonprime residential mortgage bonds and collateralized debt obligations of asset-backed securities, New York-based S&P said in a statement.

``The hits keep coming,'' said Gregory Peters, head of credit strategy at Morgan Stanley in New York. ``It's been our view that these guys are in a much more difficult predicament than investors or the companies themselves believed.''

earlier comments on ACA here and here. some of the effect has surely been priced in, and some owners of affected issues have insured again with other insurers. the question is rapidly becoming, however, if any of these insurers will see the other side of this credit event.

in truth, many municipal bond issues would go off just fine without insurance. but there could hardly be a worse time for the backup to fall away, as sub-federal governments of every denomination are facing a falloff in tax collection as economic activity slows. a lot of spending plans will be revised, and some not-insignificant number of issues which were to be serviced by receipts that are no longer there are going to be pressured.

the other, perhaps more important effect will be seen in loss reserving at banks and investment banks. canadian imperial bank of commerce is the first of several who will have to set aside capital reserves to cover risks which were previously insured and therefore not reserved against. this may not happen suddenly -- many banks will be sure to have doubled up their insurance with contracts with other guarantors, in spite of what were probably punitive rates.

Labels: , ,

Tuesday, December 18, 2007


ECB injects $500bn

it's an unfathomable number to put behind coordinated liquidity injections. it's beyond large. and it won't help in the end.


Impact of the ECB's move on the US yield curve was negligible. The short end of the curve actually rose a couple of basis points. Banks in the US are continuing to hoard cash.

because, as has been noted, this is a solvency crisis, not a liquidity crisis (though liquidity has certainly been one of the casualties). banks cannot borrow their way into capital-strong positions, and bank undercapitalization is the core issue.

what it likely will do, however, is push a boom into equity bids between here and year-end. welcome to your santa claus rally -- i hope.

Labels: ,

Friday, December 14, 2007


citi brings its SIVs home

per bloomberg:

Citigroup Inc. will take over seven troubled investment funds and assume $58 billion of debt to avoid forced asset sales that would further erode confidence in capital markets. Moody's Investors Service lowered the bank's credit ratings.

The biggest U.S. bank by assets will rescue the so-called structured investment vehicles, or SIVs, taking responsibility for their $49 billion of assets, the New York-based company said in a statement late yesterday.

citi worked hard to reduce the obligations by selling off bits to junior shareholders, so this represents what's left. given the failure of the super-SIV, citi had little real choice except accepting forced liquidation. it represents a nominal loss of $9bn -- $49bn in assets less $58bn in debt -- but the assets generally have no bid, and so the real loss is much, much greater.

some are calling it the end of the SIV problem, but i think it's more accurate to say that it's just another step in the deterioration of the banks -- that is, the problem is still there, and the losses are coming; it's just been folded into the bank problem.

the likely result is more capital hoarding by citi and similarly afflicted banks, which means less lending, which means a continuation of a deflationary credit contraction.

next up: the conduits, unleveraged versions of the SIV to which citi and many other banks have explicit credit-backing requirements which have been expanding bank balance sheets for the last few months. conduits are a much larger slice of the credit pie, and so represent another very real threat to the sponsor banks even though the leverage problem isn't nearly so acute.

and that in addition to, for citi particularly, its involvement in at least $25bn in commercial-paper-issuing CDOs stuffed with near-worthless subprime paper.

and then one must consider the inevitable start of writedowns related to RMBS and whole-loan portfolios for banks like citi, and it becomes evident that the troubles are really only beginning for the banks.

Labels: , ,

Thursday, December 13, 2007


ACA close to default

via calculated risk, bloomberg relays concerns at CIBC that ACA is going belly up on its insurance obligations to that bank.

ACA's default could have massive ramifications for wall street banks. lehman has already been purchasing secondary CDS protection for its ACA-counterparty CDOs, probably at massive rates.

Labels: , ,

Wednesday, December 12, 2007


central banks to coordinate efforts to sustain unsustainable lending

per marketwatch:

The Fed said it would inject cash into money markets through some term-auction facilities.

"Under the term-auction facility program, the Fed will auction term funds to depository institutions against a wide variety of collateral that can be used to secure loans at the discount window," the Fed said in a statement.

"By allowing the Fed to inject term funds through a broader range of counterparties and against a broader range of collateral than open-market operations, this facility could help promote the efficient dissemination of liquidity when the unsecured interbank markets are under stress," the Fed said.

The Fed will also establish foreign exchange swap lines with the European Central Bank and the Swiss National Bank.

These arrangements will provide $20 billion to the ECB and $4 billion to the Swiss National Bank.

The first auction of $20 billion will be held on Monday. This auction will provide 28-day term funds maturing on Jan. 17.

The second auction of up to $20 billion is scheduled for Thursday, Dec. 20. This auction will provide 35-day funds maturing on Jan. 31. The third and fourth auctions will be held on Jan. 14 and Jan. 28. The amounts will be determined next month.
The Fed said it may conduct additional auctions in subsequent months, depending in part "on evolving market conditions."

part of the issue troubling the fed recently has been the reluctance of banks to tap the discount window in spite of obvious signs of huge interbank stress and the fed's own efforts to expand the acceptable collateral and reduce the punitive markup on the discount rate. institutions in trouble are very probably afraid of making that trouble explicit by going to the fed hat in hand and sparking a run that destroys them. some discount window loans have apparently been taken through intermediary banks of "unquestionable" strength to disguise the ultimate troubled borrower, but there's enough friction and fear there to have made that borrowing limited, and made the federal home loan bank system (or FHLB, where borrowing is low-profile) much more popular. however, FHLB has expanded its balance sheet incredibly, and must be in a difficult position to offer more help.

so the fed here is essentially disintermediating those big banks and using an anonymous auction to go more directly to the problem. as relayed by bloomberg:

``By allowing the Federal Reserve to inject term funds through a broader range of counterparties and against a broader range of collateral than open market operations, this facility could help promote the efficient dissemination of liquidity when the unsecured interbank markets are under stress,'' the Fed statement said.

it is also lending billions in dollars to european banks to ease the very high demand for dollar loans in europe reflected in the ridiculous LIBOR spread.

this is a more focused (and desperate and scared, as floyd norris surmises correctly) effort to reliquify the interbank credit markets that have been freezing up for months, and clearly an adjunct to yesterday's rate cut. the market spiked higher this morning on the news, erasing most of yesterday's post-cut selloff.

it's good to see the federal reserve responding creatively to specific problems, but i can't help but note that this doesn't fix the underlying problem: too much debt, not enough income, not enough collateral, not enough capital. at best, success will be measured by the degree to which the credit collapse is slowed and eased in speed and degree. this because continued credit maintenance, much less creation, is dependent on two things that no longer exist (as noted by yves smith): the health of the securitization model, and strong capital positions in banking.

so save a thought for this: what if it doesn't work?

Under the repo/fractional reserve system the debt can be hidden because it is spread out among many banks. The Fed lending $10 billion (and thus their balance sheet rising by $10 billion) will turn into $500 billion as other banks lend that money out and only keep a fraction of it for themselves. This is not working. Under the “new” plan the Fed will lend directly to each bank. If they want to create $500 billion of new credit the Fed’s balance sheet will increase $500 billion.

This will be obvious to foreigners just like a big cut in the discount rate. This is why gold is up this morning in response to this “new” plan which is really just a hidden discount rate cut: if the Fed is willing to pervert its balance sheet to this extent the dollar will fall.

this is the reason deflation (at least in assets and probably generally) remains the foremost concern in my mind in spite of government efforts at reflation/continuing inflation. marketwatch's irwin kellner thinks as i do -- that we may well be caught in a liquidity trap.

You can lead a horse to water, but you can't make it drink.

We learned this in the 1930s, when, after first shrinking the money supply enough to pull prices down by about 25%, the Federal Reserve of that era tried to force-feed liquidity into the economy with the hopes of pushing it out of its slump.

It didn't work. Lenders were reluctant to lend, while potential borrowers did not want to borrow.

Banks were struggling under mountains of loans gone sour and were in no frame of mind to throw good money after bad. For their part, most firms were not willing to assume new debts, since falling sales and earnings led them to conclude that there was little productive use they could make out of these borrowed funds.

The great economist John Maynard Keynes dubbed this phenomenon a "liquidity trap." It was perhaps the first realization that the Fed's powers were not as great as previously thought.

indeed they are not, as kevin depew knows.

What is important is not that the BIS failed to stop financial crises, but why. The answer is that markets eventually chew through fiscal and monetary intervention in spite of us. So frequently, in fact, almost always, the cure is far worse than the disease. Just something to think about.

Labels: , ,


super-SIV fails

or has effectively failed, having been reduced from $100bn to $30bn in proposed assets within two weeks, per cnbc via calculated risk. this effectively shreds previous optimism and confirms the opinion of skeptics.

that further explains citi's attempts to liquidate. treasury secretary paulson may as well give up on the six-week-old proposal now, as it is being rejected by the marketplace. SIV losses are coming, and citi will have to find a way to deal with them.

Labels: , ,

Tuesday, December 11, 2007


fed cuts another 25bps; market tanks

"behind the curve" is the new "contained"!

there's apparent concern that the fed doesn't understand the depth of the housing problem. says mish, says pimco's bill gross and paul mcculley, says screamin' jim cramer, and says the stock market -- the latter two of which at least were certainly looking for more from the central bank as recession forecasts become widespread.

of course, on the flip side, there is speculation that large foreign debt-holders are pressuring the fed to do something to prevent the crash in the dollar. that something may be a slowing of rate cuts.

as noted by mish yesterday, the recent rate cut by the bank of england was met by a bizarre rise in short pound-denominated rates. that was not the reaction in america today, but it illustrates the fact that credit market participants are extremely paranoid now (and not without cause). there's a lot of plain old terror out there. it isn't every day you see the words "liquidity trap" made relevant to current affairs.

i remain profitably long from buy points on november 13 and 16 and (despite having been early and anxious!) continue to be optimistic in spite of it. some of the reasons why are here. there's also the question of isee sentiment, shown here, which is coming off oversold lows and has not rebounded yet to anything like overbought highs. add all that to the anecdotal instances (too few data points to call it a study) compiled by folks feeding the kirk report, confirming the probability of a near-term bounce, and despite today's selloff i still would expect at least a retest of yesterday's high point if not explicitly higher prices based on technical conditions and historical parallel.

Labels: , , ,


fdic institution directory

for examining banks, such as citi, countrywide or m&i.

Labels: ,


morgan joins goldman on the call

recession is likely, via calculated risk, with a direct link here to richard berner's report.

We’re changing our calls for US growth and monetary policy. Since the shock of tighter financial conditions surfaced in August, we’ve incrementally reduced our outlook for future growth. But the time for incremental changes is over. A mild recession is now likely: We expect domestic demand to contract by an average 1% annualized in each of the next three quarters, no growth in overall GDP for the year ending in the third quarter of 2008 and corporate earnings to contract by 5-10% over that longer period. Three factors have tipped the balance to the downside: Financial conditions continue to tighten, domestic economic weakness is broadening into capital spending, and global growth — for us, long the key bulwark against a downturn — is slowing.

berner's change of view follows that of goldman's jan hatzius here and here.

for some time, optimistic views of the potential of home price declines have hinged on continued economic expansion in the united states and globally, both in terms of steady job growth and capital relief for american banks. i've considered those hopes probably futile in the face of the monstrosity of the credit bubble that is now beginning to unwind, and evidence enough to convince both hatzius and berner has apparently accumulated.

it's becoming more and more likely that house prices will fall very dramatically nationwide -- mean reverting by 30, 40, even 50% or more over the course of coming years as sources of credit and funding continue to be choked off. another step in that direction was recently taken by fannie mae as it attempts to limit its exposure to the markets most afflicted by asset deflation. this of course in tandem with washington mutual's expectation that 2008 nationwide mortgage origination will fall a stunning 40%. in these areas where prices most egregiously dislocated from incomes under the influence of gross credit underwriting distortions, i'd expect the unwind to be much more severe still. nationally and quite probably internationally, the result will be very damaging economically and financially if not (as is quite probable at times) disorderly and chaotic. and on an individual level, as freddie mac ceo richard syron is aware, a lot of tragedy will unfold.

While the mortgage crisis has brought a rising wave of foreclosure notices into public view, less evident have been "pictures of people standing with furniture on the lawn" after being forcibly evicted from their homes, Syron said. "As that begins to happen, and it will happen, I am afraid of the impact that this has."

much will depend on whether or not the united states government manages to effectively bail out its banks (to the likely tune of trillions of dollars in malinvestment, when all is said and done) and can somehow force both 1) a heavily-indebted consumer base to continue borrowing in the face of higher credit costs, and 2) a beleaguered financial system to continue offering credit in the face of higher risk. and do so while managing not to compel foreign creditors to flee american debt instruments (as they already may be moving toward).

if they can, it at best delays (again) an inevitable and overdue credit contraction for american society, making the ultimate outcome yet more disastrous. if not, i sincerely doubt there is much it will do to prevent a classic debt-deflation depression -- though not perhaps on the order of the great depression, at least comparable to previous depressions such as that of 1837, 1873 or 1893.

early signs are not good, as berner notes:

... compared even with a few weeks ago, financial conditions have tightened significantly further as the price of credit has risen and lenders have made credit less available. Money-market rates have risen significantly, and yield spreads over those money-market rates on loans have stayed high or widened. Three-month dollar Libor-OIS spreads have jumped by 60 bp to 100 bp over the past month, so that Libor rates in that tenor are merely 20 bp lower than where they were in the spring. Some of that jump in Libor rates reflects the transitory impact of year-end precautionary demands for liquidity. But we think that some also represents a more fundamental deleveraging and re-intermediation of the banking system that will last well into 2008 (see “Funding Pressures: More Fundamental than Turn of Year,” Global Economic Forum, November 19, 2007).

UPDATE: merrill's david rosenberg in on the fun too.

"We reiterate that real estate deflations are unique and have never ended well for the consumer, the credit market or the economy. We can identify only five periods post WWII when the real value of housing assets turned negative on a year-on-year basis. All of these time periods inevitably included a consumer downturn. Maybe it will be different this time, but we fail to see why," Mr Rosenberg concluded.

Labels: , ,


citi quietly liquidating its SIVs

with participation interest in the paulson super-SIV looking weak, citi is trying to reduce its potential SIV exposure by other means.

Citi on Monday refused to comment on asset sales by its seven SIVs – all of which have been put on watch for downgrades by the rating agencies – but people familiar with the vehicles say their size has been cut from $83bn at the end of September to about $66bn largely by selling pro-rata portions of a SIV’s portfolio of assets to investors in the most junior notes at market values. Citi is also talking to some investors about directly swapping their holdings for underlying assets.

i'd like to know what citi considers as "market values".

junior investors are in line to be wiped out, so one can see their incentive in liberating whatever they can from frozen SIVs and taking the losses themselves while forestalling forced liquidation. it's hardly a good thing -- but, as citi is surely pointing out to all investors in the SIVs it administrates, citi is under no obligation nor really in a position to take the losses, nor even to fund the SIV by taking it on-balance-sheet and preserving it from no-holds-barred liquidation. this is strictly a case of investors taking the most immediate of a lot of awful resolutions.

meanwhile, plans for in-kind redemptions of SIV-similar assets are becoming all too common in enhanced-cash stable value funds, though actual money market funds have so far seen cash bolstering by their bank affiliates thusfar. no one investing in these things could have imagined that they'd be looking at losses, in some cases very significant losses.

Labels: , ,

Monday, December 10, 2007


wamu follows ubs and citi

via calculated risk, another cut dividend, more capital raising at punitive rates, more "restructuring". this is just the beginning of washington mutual's capital and legal odyssey, and i will be surprised if it (or countrywide) survive.

more from housing wire.

WaMu’s take on near-term industry performance was unabashedly bleak, with the thrift saying it expects national mortgage originations to shrink to $1.5 trillion in 2008, down about 40 percent from an estimated $2.4 trillion this year.

... I’m sure I don’t need to tell HW readers that these are huge changes at a very large bank; but perhaps the largest news here lies in the old adage that “actions speak louder than words.”

Closing retail loan centers and shuttering processing centers isn’t typically something that’s done unless you are certain you’re facing a protracted downward cycle; pulling back on retail, precisely when everyone in this industry is focused on retail origination, should speak volumes regarding WaMu’s expectations.

Labels: , ,


ubs follows citi -- bank failures are certainly coming

on the heels of citi, another major bank with deep exposure to the credit bubble pays for capital from a sovereign wealth fund, this time singapore, with the added step of eliminating the dividend payout. the $10bn writedown is something of a catchup for ubs, as it has held out for balance sheet opacity in the face of mark-to-market pressure and avoided writeoffs commensurate with even the limited current-industry-standard recognition of its very considerable exposure until today.

can the asian and oil state bailout/wealth transfer prevent a credit bubble unwind? again, i doubt it -- and i further deeply doubt that writeoffs are over for ubs, in spite of official optimism. this is a first-rate capital scavenging move, and no bank cuts its dividend to zero with a 12% tier one capital ratio unless they expect significant writeoffs to eat that capital.

and even if the big boys somehow negotiate the straits, a great many smaller banks are about to be dashed upon the rocks. subprime is, of course, just one leading aspect of a much larger credit bubble that is in the process of unwinding. another leader was corporate financing such as bridge loans and leveraged buyout capital. but other aspects are lagging these -- alt-a and prime mortgages, credit cards, auto loans, and of course commerical real estate -- and those lagging aspects are just starting to come home now. worst of all, as is normal following a massively excessive credit bubble, the timing is perfect for precipitating bank failures as most bank balance sheets are incredibly extended.

what that means is probably unimaginable to most americans, but here it is. via calculated risk and floyd norris of the new york times:

Figures compiled by the Federal Deposit Insurance Corporation ... show that both midsize and small banks had construction loans outstanding that were greater than their total capital. A decade ago, such loans were equal to only a third of capital for those banks.
Now ... more than 3 percent of all construction loans are classified as being nonperforming, or have borrowers that are behind on their payments. That is the highest proportion in a decade.
“I think there will be a wave of bank failures in the not-too-distant future,” [Matthew Anderson, a partner in Foresight Analytics] added, “although probably not on the order of the 1980s and 1990s. You had a lot of high loan-to-value lending going on in markets that have soured significantly.”

When construction loans go bad, they can go very bad, in part because it can take a long time to slow them down after markets begin to weaken. Construction projects, once begun, are useless if not finished.
During the Paulson Q&A on Friday, he was asked: "Do you anticipate bank failures like England saw with Northern Rock?" Paulson gave a non-answer, and the reason is probably because there are several bank failures in the offing.

Labels: , ,

Friday, December 07, 2007


the mark hanson letter

on the heels of hank paulson's latest batch of save-the-day malarkey, we have this -- an explosive letter to marketwatch columnist herb greenberg from mark hanson, a california wholesale mortgage maker.

i'll just cut-and-paste the whole thing verbatim, so important and so chilling to read is hanson's vision of what awaits -- thanks to second-lien mortgages, negative amortization pay-option ARMs, and hybrid interest-only intermediate-term ARMs, none of which are subprime.

The Government and the market are trying to boil this down to a ’sub-prime’ thing, especially with all constant talk of ‘resets’. But sub-prime loans were only a small piece of the mortgage mess. And sub-prime loans are not the only ones with resets. What we are experiencing should be called ‘The Mortgage Meltdown’ because many different exotic loan types are imploding currently belonging to what lenders considered ‘qualified’ or ‘prime’ borrowers. This will continue to worsen over the next few of years. When ‘prime’ loans begin to explode to a degree large enough to catch national attention, the ratings agencies will jump on board and we will have ‘Round 2′. It is not that far away.

Since 2003, when lending first started becoming extremely lax, a small percentage of the loans were true sub-prime fixed or arms. But sub-prime is what is being focused upon to draw attention away from the fact the lenders and Wall Street banks made all loans too easy to attain for everyone. They can explain away the reason sub-prime loans are imploding due to the weakness of the borrower.

How will they explain foreclosures in wealthy cities across the nation involving borrowers with 750 scores when their loan adjusts higher or terms change overnight because they reached their maximum negative potential on a neg-am Pay Option ARM for instance?

Sub-prime aren’t the only kind of loans imploding. Second mortgages, hybrid intermediate-term ARMS, and the soon-to-be-infamous Pay Option ARM are also feeling substantial pressure. The latter three loan types mostly were considered ‘prime’ so they are being overlooked, but will haunt the financial markets for years to come. Versions of these loans were made available to sub-prime borrowers of course, but the vast majority were considered ‘prime’ or Alt-A. The caveat is that the differentiation between Prime and ALT-A got smaller and smaller over the years until finally in late 2005/2006 there was virtually no difference in program type or rate.

The bailout we are hearing about for sub-prime borrowers will be the first of many. Sub-prime only represents about 25% of the problem loans out there. What about the second mortgages sitting behind the sub-prime first, for instance? Most have seconds. Why aren’t they bailing those out too? Those rates have risen dramatically over the past few years as the Prime jumped from 4% to 8.25% recently. seconds are primarily based upon the prime rate. One can argue that many sub-prime first mortgages on their own were not a problem for the borrowers but the added burden of the second put on the property many times after-the-fact was too much for the borrower.

Most sub-prime loans in existence are refinances not purchase-money loans. This means that more than likely they pulled cash out of their home, bought things and are now going under. Perhaps the loan they hold now is their third or forth in the past couple years. Why are bad borrowers, who cannot stop going to the home-ATM getting bailed out?

The Government says they are going to use the credit score as one of the determining factors. But we have learned over the past year that credit scores are not a good predictor of future ability to repay. This is because over the past five years you could refi your way into a great score. Every time you were going broke and did not have money to pay bills, you pulled cash out of your home by refinancing your first mortgage or upping your second. You pay all your bills, buy some new clothes, take a vacation and your score goes up!

The ’second mortgage implosion’, ‘Pay-Option implosion’ and ‘Hybrid Intermediate-term ARM implosion’ are all happening simultaneously and about to heat up drastically.

Second mortgage liens [otherwise known as HELOCs, or home equity lines of credit] were done by nearly every large bank in the nation and really heated up in 2005, as first mortgage rates started rising and nobody could benefit from refinancing. This was a way to keep the mortgage money flowing. Second mortgages to 100% of the homes value with no income or asset documentation were among the best sellers at CITI, Wells, WAMU, Chase, National City and Countrywide. We now know these are worthless especially since values have indeed dropped and those who maxed out their liens with a 100% purchase or refi of a second now owe much more than their property is worth.

How are the banks going to get this junk second mortgage paper off their books? Moody’s is expecting a 15% default rate among ‘prime’ second mortgages. Just think the default rate in lower quality such as sub-prime. These assets will need to be sold for pennies on the dollar to free up capacity for new vintage paper or borrowers allowed to pay 50 cents on the dollar, for instance, to buy back their note.

The latter is probably where the ’second mortgage implosion’ will end up going. Why sell the loan for 10 cents on the dollar when you can get 25 to 50 cents from the borrower and lower their total outstanding liens on the property at the same time, getting them ‘right’ in the home again? Wells Fargo recently said they owned $84 billion of this worthless paper. That is a lot of seconds at an average of $100,000 a piece. Already, many lenders are locking up the second lines of credit and not allowing borrowers to pull the remaining open available credit to stop the bleeding. Second mortgages are defaulting at an amazing pace and it is picking up every month.

The ‘Pay-Option ARM implosion’ will carry on for a couple of years. In my opinion, this implosion will dwarf the ’sub-prime implosion’ because it cuts across all borrower types and all home values. Some of the most affluent areas in California contain the most Option ARMs due to the ability to buy a $1 million home with payments of a few thousand dollars per month. Wamu, Countrywide, Wachovia, IndyMac, Downey and Bear Stearns were/are among the largest Option ARM lenders. Option ARMs are literally worthless with no bids found for many months for these assets. These assets are almost guaranteed to blow up. 75% of Option ARM borrowers make the minimum monthly payment. Eighty percent-plus are stated income/asset. Average combined loan-to-value are at or above 90%. The majority done in the past few years have second mortgages behind them.

The clue to who will blow up first is each lenders ‘max neg potential’ allowance, which differs. The higher the allowance, the longer until the borrower gets the letter saying ‘you have reached your 110%, 115%, 125% etc maximum negative of your original loans balance so you cannot accrue any more negative and must pay a minimum of the interest only (or fully indexed payment in some cases). This payment rate could be as much as three times greater. They cannot refinance, of course, because the programs do not exist any longer to any great degree, the borrowers cannot qualify for other more conventional financing or values have dropped too much.

Also, the vast majority have second mortgages behind them putting them in a seriously upside down position in their home. If the first mortgage is at 115%, the second mortgage in many cases is at 100% at the time of origination — and values have dropped 10%-15% in states like California — many home owners could be upside down 20% minimum. This is a prime example of why these loans remain ‘no bid’ and will never have a bid. These also will require a workout. The big difference between these and sub-prime loans is at least with sub-prime loans, outstanding principal balances do not grow at a rate of up to 7% per year. Not considering every Option ARM a sub-prime loan is a mistake.

The 3/1, 5/1, 7/1 and 10/1 hybrid interest-only ARMS will reset in droves beginning now. These are loans that are fixed at a low introductory interest only rate for three, five, seven or 10 years — then turn into a fully indexed payment rate that adjusts annually thereafter. They first got really popular in 2003. Wells Fargo led the pack in these but many people have them. The resets first began with the 3/1 last year.

The 5/1 was the most popular by far, so those start to reset heavily in 2008. These were considered ‘prime’ but Wells and many others would do 95%-100% to $1 million at a 620 score with nearly as low of a rate as if you had a 750 score. No income or asset versions of this loan were available at a negligible bump in fee. This does not sound too ‘prime’ to me. These loans were mostly Jumbo in higher priced states such as California.

Values are down and these are interest only loans, therefore, many are severely underwater even without negative-amortization on this loan type. They were qualified at a 50% debt-to-income ratio, leaving only 50% of a borrower’s income to pay taxes, all other bills and live their lives. These loans put the borrower in the grave the day they signed their loan docs especially without major appreciation. These loans will not perform as poorly overall as sub-prime, seconds or Option ARMs but they are a perfect example of what is still considered ‘prime’ that is at risk. Eighty-eight percent of Thornburg’s portfolio is this very loan type for example.

One final thought. How can any of this get repaired unless home values stabilize? And how will that happen? In Northern California, a household income of $90,000 per year could legitimately pay the minimum monthly payment on an Option ARM on a million home for the past several years. Most Option ARMs allowed zero to 5% down. Therefore, given the average income of the Bay Area, most families could buy that million dollar home. A home seller had a vast pool of available buyers.

Now, with all the exotic programs gone, a household income of $175,000 is needed to buy that same home, which is about 10% of the Bay Area households. And, inventories are up 500%. So, in a nutshell we have 90% fewer qualified buyers for five-times the number of homes. To get housing moving again in Northern California, either all the exotic programs must come back, everyone must get a 100% raise or home prices have to fall 50%. None, except the last sound remotely possible.

What I am telling you is not speculation. I sold BILLIONs of these very loans over the past five years. I saw the borrowers we considered ‘prime’. I always wondered ‘what WILL happen when these things adjust is values don’t go up 10% per year’.

we're about to find out, but i think the answer is probably a beleaguering credit unwind, corresponding deep asset deflation and economic depression. i've frankly become quite disconcerted hearing mainstream houses like goldman sachs referencing the possibility of a 30% decline in nationwide home prices so early in the correction. the final extent of the losses in events such as these are typically underestimated to the very last, often spectacularly so in the early going. the ease with which mainstream opinion is moving toward 20-30% home price declines implies, from my viewpoint, that ultimate losses could be considerably higher.

it's been noted here before that, for OFHEO national home prices to return to trend, they have to fall in excess of 40%. national statistics on relative metrics such as price-to-rent ratio imply by reversions to the mean similar if not greater declines (and, given the calculus, it stands to reason that it will happen). and then of course there is the probability of an overshoot in price correction, which is a normal feature in asset price movements around a mean -- which brings immediately to mind the advice of sir john templeton from 2003: "After home prices go down to one-tenth of the highest price homeowners paid, then buy."

in truth, no one knows where prices are going. it seems highly probable that they will decline and significantly, as the credit expansion that fuelled asset price gains now becomes a credit contraction and deflationary. but the final level will have to be smoked out as events unfold.

Labels: ,

Thursday, December 06, 2007


more on the paulson rate freeze

UPDATE: so useful it goes at the head of the post -- thank you calculated risk.

the idea of a rate freeze began in california and was quickly followed by a national plan backed by the treasury. on the whole, it is seen by many as prelude to an industry bailout and many others as doomed to fail. but at least some details are starting to emerge. per bloomberg:

Federal regulators and U.S. lenders agreed to freeze interest rates on subprime mortgages for five years to stem rising foreclosures, said a person familiar with the measure.

The freeze may apply to mortgages issued between January 2005 and July 2007 that are scheduled to reset between January 2008 and July 2010, said a person familiar with the plan. Borrowers whose credit scores are below 660 out of a possible 850 and haven't risen by 10 percent since the loan was sold will be given priority.

Those with scores above 660 will be more closely scrutinized to determine whether they are eligible or must continue making payments under existing terms, said the person. Most U.S. banks use FICO credit scores, a product of Minneapolis-based Fair Isaac Corp., to judge a borrower's ability to repay loans. Scores determine the interest rate charged to a customer.

tanta at calcluated risk quickly divined the meaning of this definition of "subprime":

Saying that efforts will be "prioritized" by FICOs under 660 is a way to try to target this effort to what we would consider "subprime," regardless of how the loans might be described by a servicer or in a prospectus.

And that, really, is a way to target the "freeze" to start rates that are already pretty high. I think some people are getting a bit misled by the idea of "teaser" rates here. As Bloomberg reports quite correctly, the loans being targeted have a start rate in the 7.00% to 8.00% range. (My back-of-the-envelope calculation is a weighted average of about 7.70%, with a weighted average first adjustment rate of just over 10.00%.) Nobody wants to come out and say that "Hope Now" is all about freezing just the highest initial ARM rates that there are, but that's in fact what it's about.

So asking, in essence, why we are "rewarding" people with the worst credit profiles is, really, missing the point. The point is that the cost of this goes directly to investors in asset-backed securities, and those investors are being asked to forgo 10% (the reset rate) and take 7.70% (the current or start rate). They are not being asked, say, to forgo 7.70% and take 5.70%, which is roughly what it would be if this "freeze" were extended to the significantly-over-660 crowd (Alt-A and prime ARMs).

So far, I'm prepared to believe assurances that this will not involve taxpayer subsidies: the cost of this is, actually, going to be absorbed by investors in mortgage-backed securities. This is why "good credit" borrowers are not going to be "rewarded" -- because investors cannot be brought to forgo that much interest. Somebody did the math, and somebody concluded that freezing a rate that is still about 200-250 bps over the 6-month LIBOR isn't going to be a disaster (at least not compared to having to foreclose these things).

so folks with higher credit scores are essentially ineligible, largely because investors aren't that desperate yet.

as we have recently come to understand, even many "subprime" borrowers in fact have decent credit but also bought too much house and carry a too-high-for-prime loan-to-value ratio. these people won't be aided, even though they exemplify the nature of the problem. what is happening is just not much to do with low-credit-score borrowers -- that's a fallacy that confirms many middle-class prejudices but does not model reality. the problem is here:

The fact is that huge numbers of people who have “prime” mortgage loans couldn’t refi or sell right now to—literally, for some of the uninsured—save their lives. They may well still be making payments on the mortgage, but they’re rapidly approaching upside-down if they’re not there yet, they’ve spent the proceeds of the previous cash-outs that kept up the lifestyle or just kept life together, and if the truth were known about credit card balances, their current FICOs probably aren’t the envy of the neighborhood either. They are, in short, subprime. They just don’t recognize themselves in the stereotype of the deadbeat serial bankruptcy filer or the undocumented immigrant or the waitress in the McMansion or whatever extreme case you can dredge up and label “typical” for subprime. They are, increasingly, “us.”

and that touches on the other lethal qualifier for the plan, as pointed out by mish:

Loan to value must be less than 97%.

in other words, if you're upside-down in your mortgage, you're not eligible. chances are if you bought a house in 2005, 2006 or 2007 with 5% down or less, you're upside-down thanks to nationwide price declines. if you're in florida or california -- the epicenters of the housing bubble -- chances are good that you're upside-down even if you put 20% in. but of course no one did, particularly in those states at those times, particularly if their FICO score was under 660.
UPDATE: with this followup, mish clarifies that in fact (and more sensibly) it's the other way around -- LTVs of greater than 97% are eligible.

and there is further this trenchant point via housing wire, as to what the big-picture effect of the rate freeze is as proposed, what might be coming, and what one can expect with regards to mortgage availability going forward.

There is, first of all, clearly the “so what?” factor. After all of this analysis, we’re still talking about a pretty small population of borrowers, in my opinion. Certainly not enough to stem the tide; after all, this is no longer about subprime resets. The problems we’re seeing are driven moreso by lost equity, high leverage, and borrowers finding themselves upside down even if their payments aren’t resetting.

Something tells me that if all this effort entailed helping just some small segment of borrowers, the ASF would not be working in lock-step with Wall Street to develop and implement standard criteria for reporting loan modification activity.

Does that make this effort a blueprint for future efforts, then? If so, borrowers had better pray they’ve got a conforming loan — because there won’t be much in the way of liquidity elsewhere if investors are sent such a message.

so it's understood -- the rate freeze as proposed helps too few people to make a dent in the problems, with newsday reporting estimates on the order of just 10% of subprime borrowers; helps some people who may represent appropriate objects of pity but who are not the typical cases of this crisis; and if it is expanded to help the people who do exemplify the problem in large numbers, mortgage investors will in all likelihood completely evacuate the field for anything but prime conforming which can be marketed to fannie mae and freddie mac. moreover, it is easy to see the incentive offered to many on the verge to destroy their credit scores in an effort to qualify for relief -- once again, responsibility being punished.

UPDATE: to the point raised by bill fleckenstein, tanta again:

From what I have seen about the plan to date, it is clear to me that it is in fact structured with the overarching goal of making sure that it stays on the allowable side of the existing contracts. I proceed from the assumption that nobody could write such a convoluted and counter-intuitive plan if that wasn’t the goal. So everyone who is thinking, “Gee, we’re violating contracts and we still don’t get much out of it!” is thinking the wrong thing, in my view. It’s more like “Gee, we don’t get much out of it when we don’t violate contracts.”

... [I]t’s not that we’re necessarily replacing the old-fashioned case-by-case mods with the fast-track “freeze” mods. We’re creating a way of segmenting the borrower class so that one class of borrowers can be presumed to meet all the requirements in the PSAs for modifications.

so the mechanics of the proposal are really to standardize who can have their loan modified without violating existing contracts or disqualifying certain tax elections in participating loan pools (that is in effect, default must be reasonably foreseeable -- among other things, the borrower is unable to refinance), as well as meet credit score and reset payment increase tests. but the existing contracts are fairly carefully designed to protect investors from the actions of servicers, not get them to take large loss burdens. and that fact in effect blocks this proposal as a real avenue to widesread help.

as is, then, this measure will very likely do little or nothing to even mitigate the credit unwind in housing, much less "stop" or "solve" it. as i said previously, it's even probable that many homeowners who qualify for a rate freeze will mail their keys to their mortgage servicer anyway, once they realize that they are not making headway on principal even as the price of the asset continues to fall away. (this is not, after all, real debt forgivenesss but the mere delaying of rate resets.) but we'll have to wait and see if an expansion of the program comes to light later on, as it appears the groundwork of such a thing might be being laid.

but the plan's greatest potential adverse effect, it seems to me, is precisely that possibility of future wholesale expansion upon the investors who would being asked (perhaps forced, before any bailout materializes) to forego income that they purchased in buying these loans and take the corresponding writedown. who cares about big-money investors? well, let's put names to them: citigroup, ubs, bank of america, bear stearns, fannie mae, freddie mac -- and virtually every insurance company, pension fund or endowment in the western world. the very spine of the united states, in many ways.

these entities are already awash in losses and desperately seeking capital. both freddie mac and fannie mae have slashed dividends and started issuing preferred shares paying punitive rates to raise cash.

now the plan could be to kick them again?

to be sure, the plan as it is is written by investors as much as anyone and represents no real threat to them (and therefore very little real relief to mortgagees). indeed, as one commenter at calculated risk noted, "it's already clear this has nothing to do with helping out borrowers for their sake, no matter what Bush and Paulson say -- it's entirely about minimising the damage to the securitisation industry and arguably to the wider economy." the plan keep people in their homes, playing on whatever sentimental attachment they have to the place to keep them paying on mortgages that they have little realistic hope of getting out from under. but with an eye forward to expanding the plan into meaningful debt relief, one has to be very wary of the unintended consequences. mark thoma channels the wall street journal and points out the essence of the issue:

This helps to highlight that while the Bush/Paulson plan to freeze the interest rate on some subprime loans may help some homeowners, subprime loan defaults are not the primary problem for the economy. The main worry is that banks and other lenders will pull back on loans of all type and cause a slowdown of investment and economic activity.

keeping the credit unwind orderly is job one, not saving some millions of american mortgagees who stupidly believed that something too good to be true wasn't. that's going to be hard enough to do, frankly, without adding to the misery of pressured capital. paulson's extant proposal, though it does little to really aid the beseiged masses, doesn't. learning the lessons of easy credit will be painful for those would-be homeowners; but pushing major financial institutions toward failure in an effort to engage in election-year populism could be vastly more so -- not just for them, but for all of us.

Labels: , ,

This page is powered by Blogger. Isn't yours?