Tuesday, August 14, 2007

I have altered the deal. Pray I do not alter it further.

Say you are sitting at home, relaxing on the couch after a tough day in the market. You've just settled in with a nice glass of wine to watch a TiVO'ed episode of "Top Chef" when you get a knock on the door. "A caller? At this hour?" you say.

You open the door to find a stocky man wearing a short-sleeved button down shirt. By the look of the name embroidered on the shirt, the man's name is George. But your eyes move quickly away from George and to his partner, who appears to be rigging a tow cable to your car. You are understandably a bit panicked. "What the hell is going on? Why is he trying to tow my car?" you exclaim.

"Sir," George begins, "we've come to repossess your car."

"Repossess? I just bought this car last month. I haven't missed a payment. Hell, a payment hasn't even come due yet!"

"Well sir, you see, your loan value is too large."

"I'm sorry, what?" You assume you misheard him, as you were distracted by George's partner putting a nice scratch in your bumper with his hook.

"I said your loan value is too large."

You stare at him blankly for a moment. "You're saying my car is too expensive?"

"No, I said your loan was too large."

"But I just negotiated the terms of the loan a few weeks ago. I put 10% down exactly as was negotiated."

"Well, the finance company has decided that loans of your size are too large." George is clearly becoming exasperated at your inability to see his point.

"Why the hell did they approve the loan in the first place?" You are feeling an increasing sense of urgency as George's partner has finished hooking up your car to his truck.

"Well, at the time the loan seemed appropriate. Now, it seems too risky."

"Look, I make very good money. I have an impeccable credit score. There is no reason why I shouldn't be given a loan for this car."

George is a little perturbed. "That isn't the point sir. We recently took very large losses on car loans just like yours."

"You're telling me people are buying luxury cars and defaulting on the first payment?"

"Yes. And we can't take the chance you do the same. After all, those borrowers in default all made good money as well. Or at least they claimed to make good money. Turns out they were all penniless." George shakes his head. "How were we to know?"

"You mean they forged their W2's?"

"No. But they promised us they made enough money to pay the loan. And really, they seemed like honest people."

"You took their word for it? Look I have pay stubs. Tax returns. Bank statements. Whatever you want!"

George obviously doesn't appreciate your insinuation. "Sir, we simply cannot afford to take losses on your loan too. We'll be taking your car now. Good day."

OK, so obviously this story is a joke. But what would happen if this story were real? What if auto finance companies would no longer lend for cars above a certain price? Basically there would be no more luxury car market.

Today, liquidity is so bad in the mortgage market that banks cannot securitize high-quality prime loans that are above the Fannie Mae/Freddie Mac conforming limit ($417,000). To put that in perspective, I'd say most single-family homes in nice neighborhoods the suburbs of most East Coast cities are over that price. I'm sure large portions of California and Florida are as well. If this poor liquidity in secondary MBS continues, there will be no loans available to buy these homes. Consider the consequences. No market at for housing transactions in the largest population centers in the U.S. Someone wrote in a comment that the housing crunch could never cause another Depression, but honestly. What if there were no market for homes in the entire East Coast. Not lower prices. No market at all.

Our economy is dependent on credit. Let me reiterate. D-E-P-E-N-D-E-N-T. A very large percentage of economic activity in the U.S. is done on credit. If credit is unavailable, the economy shuts down.

There are two simple solutions. First, raise the conforming limit for Fannie Mae and Freddie Mac and allow both to increase their portfolio size. Second, make it possible for banks to retain quality loans on their balance sheet in cases where they cannot sell the loans. This prevents a liquidity crunch from taking down an otherwise sound financial institution. How to do this?

Pour money into the financial system. Fire up the printing presses Ben. Hang a neon sign above the discount window that says "Eat At Ben's!"

This is not a bail out of the sub prime problem. Not at all. This is making sure that sound banks have enough liquidity to remain in business, even when a normal source of liquidity is shut off.

There was a rumor today that the Fed was going to cut rates. As in today. Obviously that didn't happen. But if this seizing up of the market continues, mark my words, the Fed will cut.


Anonymous said...

I'm very interested in the Post you did on States Issuing Taxable Municipal Bonds for Mortgage refinancing and would like to ask you a few questions. Could you email me, and then I'll email you my questions,




Anonymous said...

Use the GSEs to prop up hyperinflated home prices? The GSEs are already wobbly enough with their inability to publish financials. How many of those borrowers can whip up $200K in downpayment to meet LTV ratios?

Or are you saying we need the GSEs to suck up all of the toxic waste, ensuring their own insolvency, eliminating buyers of GSE paper, so they go under and the taxpayer can foot the bill?

If the GSEs go under, it's game over. Policy should be driving to protect them, not expose them to further risk.

Accrued Interest said...

1) Describing prime mortgages above the conforming limit as "toxic waste" is wholly inaccurate.

2) The borrower only needs to come up with $200,000 in down payment if s/he buys a $1mm home. I'm talking about houses above $417,000. So your LTV example is a bit extreme.

3) If you allow the market to completely freeze up, such that there is no market for homes at all, that isn't proping anything up. Its allowing the market to function.

Anonymous said...

I don't see the analogy. A luxury car is not money. A luxury car is mostly a big fat profit margin, and a carmaker can afford to take a big haircut on a loan for it.

But money is money. It has to be paid back.

Anonymous said...

As you say, there's currently no market for non-conforming high quality mortgages, and the fallout from that situation sustaining itself is disastrous. So far agreed.

But what about the current market suggests that this cannot correct itself in the next 3-6 months? I'm assuming that the real problem in the market is the misunderstood credit-grade assessments, and failed mortgage companies are just a symptom not a cause (I read something to that effect by Bill Gross, maybe it was you who linked to it - don't remember).

I guess I'm asking whether it's reasonable to expect the mortgage market to self-correct, and if not why not? In other words, why is there no market for these ostensibly high-quality mortgages?

P.S. Love your blog, and look forward to reading it every day. It's a free education.

hollywood said...

the pig men with their hedgies and their banks are not sound financial institutions. they made bad loans! this is a bank run on banks!

after the greed, comes the irony...

bad capitalist

no martini

JohnDiddler said...

great story but one thing i promised myself is: if i ever buy a luxury car (BMW, Mercedes), i'm paying cash. what's the point of status symbols on credit? flashy nagbob.

Anonymous said...

What about the third simple solution?

Take away the government charter for Freddie and Fannie.

Make them completely private companies.

Then they can buy whatever laons they want.

Accrued Interest said...

Can it correct itself? Maybe. I just don't think the Fed will take that chance. I think the failed originators and hedge funds to date have been all a legitimate market correction. Not something the Fed should get involved with. But Countrywide's announcement was a big wake up call. Guys like New Century are reaping what they've sown. Countrywide does enough prime business that they ought to have liquidity for their prime loans.

As for taking away the GSE's line of credit, I love it. But that's only a "simple" solution in theory. Politically that would be complicated and probably take too long to make a difference here.

Anonymous said...

there is one more solution. Stop all the government intervention and let the housing price fall. Market sometimes might seem cruel, but it is the most efficient. do not waste tax payer money any more. Let bankers, hedgies, and all wall street learn their lessons. Painful, yes; unforgettable, probably not, but may be good for a generation; unbearable, certainly not.

Accrued Interest said...

The Fed involvement doesn't cost tax payers anything.

Anyway, I don't think the Fed will be targeting housing prices. I think they will try to maintain liquidity.

Robert said...


I must respectfully disagree. The Fed's involvement/intervention DOES cost the taxpayers something.

Sure, it is indirect and it occurs over time, but there are certainly costs that must be absorbed by the citizens of this country. All intervention has consequences. There is no free lunch.

Accrued Interest said...

If you mean the extra money put in the system causes inflation, then yes. There is a cost. Sure.

But I really think people who are downplaying this liquidity crunch are not thinking it through to its logical conclusion.

I also don't get this "learn your lesson" stuff. What will the lesson be if we let Countrywide go bankrupt because they can't sell good loans? That the consumer loan business is a bad business? Regardless of the quality of the borrower?

We are talking about a potential bank run. Why can't we agree that a run on bank assets due to nothing but unadulterated fear is a bad thing?

Anonymous said...

"Why can't we agree that a run on bank assets due to nothing but unadulterated fear is a bad thing?"

Are you trying to say that there is no logical basis for this fear, kind of like a "the only thing we have to fear is fear itself" thing?

I would suggest that the fear is based upon something very real: the fear of having your assets marked to market and having your fund exposed as being worthless or near worthless. Also the fear is based upon lending to another bank and not knowing if that bank will be BK tomorrow.

This is NOT a liquidity issue, and instead is an insolvency issue. Therefore, whatever the Fed does won't help short of pure monitizing which also won't help and will just create much larger problems. I love your blog but sometimes I'm not sure you know what time it is in terms of the great credit cycle unwind.


Anonymous said...

Banks are illiquid because they made too many loans to borrowers who can't repay. I disagree 100% with you - Countrywide deserves to go bankrupt for their part in promoting bad loans, and should be shorted right into the ground. I'd rather see them dead tomorrow; anything longer simply prolongs the return to the mean. New Century? BK. I also hope the next Congress brings back Glass-Steagall in all its rousing glory, because the last decade suggests to me that the lot of you simply can't contain yourselves.

Your belief that somehow it's your inalienable right to privatize the gains of your industry but socialize your losses is intriguing at best. Why should I voluntarily throw away my purchasing power because you lost a number of risky bets?

What does it mean when Countrywide goes BK? It means banks need to pay attention to who they loan to. For the past 2 decades, moral hazard has been in play for far too long.. and you're clearly overextended. Tough. The ball's in your court, not the Fed's - go do business the way you did for 30 years after world war 2.. make conservative loans to people with good credit who can prove their income.

Accrued Interest said...

I think there are parts of my case for Fed intervention that I'm not communicating well. I'm going to think about it and write a full post later tonight or tomorrow.

Salmo Trutta said...

Just while William Poole President of the "maverick" Federal Reserve Bank of St. Louis announced that inflation is still the overriding consideration, commercial paper fell 91b as of the week 8/15. This volume is lower than the figure reported previously on 6/20. (2 years ago that figure was 158b) The commercial paper segment of the money supply is all of the sudden headed south.

Anonymous said...

I had a long post about bookies, laying off bets and so on, but there's a Tom Lehrer line that sums it up better.

"Do not make book if you cannot cover bets".

Whats happened is that a bunch of originators have taken bets on some combination of housing prices going up, economic circumstances being good and their clients not lying to them, not because they can personally cover those bets, but because they think they can bundle up and on-sell those bets.

The "renogotiation" is not affecting old contracts - it's affecting new ones.

It isnt your luxiry car getting repo'd, it's your dealer telling you that you now need to deal in cash.

Sucks to be you, but thats why you get paid the big bucks, right ? It's not as if this sort of thing has never happened before (*clue* 1907).

Anonymous said...

Another equity question for the bond guy; please accept my apologies in advance.

For you equity PA, have you looked at all at the mortgage insurers, namely RDN? I ask you this, because, frankly, I'd think this would be a fixed-income like analysis based on what these guys do.

If you look at RDN's 9/5/07 presentation, it's striking how much of a discount RDN is trading at to reported book value. Currently, it's over 50% (~$25 PPS vs. ~$51 BV/share). Granted, that book value will deteriorate over the next year or so, but the question is -- by enough to unacceptably reduce their margin of safety?

Then, one could make the argument that once this current storm passes, their business prospects might actually improve.


Anonymous said...

We cannot sustain 800 bilion a year trade deficits. We cannot export our way out of this mess. The only answer is a sharply lower dollar to drive manufactruing home and to lower the trade deficit. The dollar has much farther to fall. What you are seeing is a long term effort (it will take 20 years) to get the trade deficit back under 1% of GDP. We are currently running a trade imbalance of nearly 6% of GDP. No nation can do this. The IMF would be stepping in to help any nation if its trade impalance went to 6% of GDP becuase its currency would collapse! The U.S. is different, but still we cannot sustain a trade deficit of this magnitude. People must understand, when we buy an item from say China, we pay in dollars. The Chinese company we just bought from them goes to an Exchange Bank in China and converts those dollars to Yuan. The Chinese banking system (Chinese Government) is now sitting on the dollars. They can either 1, buy oil, 2, buy Treasuries, 3. buy U.S goods, 4. buy U.S. Corporations, 5. other. Over time if we (the U.S. ) contiue to run a trade deficit we could simply be completely bought and controlled by foreigners. Warren Buffet has explained the situation as being like a rich Texas farmer who loses a small piece of his land year after year and never notices for a while. When he then notices, tragedy sets in because he no longer controls his land. So in sum, we need to get the trade deficit way down. This is why the Fed has abandoned the dollar. It wil be going down for the next 20 years. That is how long it is going to take to correct this imbalance mess.