Thursday, January 03, 2008

That name no longer holds any meaning for me

Words have the power to both destroy and heal.
-The Buddha

In thinking about where the economy, Fed, and markets will be going in 2008, I find my thoughts dominated by considerations of liquidity. Readers have heard me use the term "liquidity crisis" or "credit crunch" during 2007, but have rarely (if ever) seen me use "credit crisis" or "solvency crisis." This is purposeful.

Why do I avoid calling this a credit or solvency crisis? Surely I am not here to downplay the problems we're having in residential lending, or even consumer finance in general. I hardly need to enumerate the many problems in consumer lending. I think mortgage foreclosures will break all records in 2008, probably by a long shot. In addition, other types of consumer lending have and will suffer as well. Consumers have been using equity in their homes to help bail them out of other types of debt for many years, but in 2008, this option will be largely unavailable. The result will be weak performance in everything from auto loans to credit cards.

So are there large numbers of insolvent consumers? Sure. Is it going to create a pretty big problem for the economy generally. Yes. Recession? Maybe, just depends on what else goes right or wrong for the economy. Crisis?

I have a hard time with the word crisis here. Maybe I'm hung up on mere semantics. In my mind, a marriage in crisis is one where divorce is an imminent possibility. Not one where the couple just had a big ugly fight. A political crisis is one where the government might collapse. Not where an election is peacefully contested in the courts. To me, that word "crisis" suggests that action must be taken to avert some sort of disaster.

But what's the disaster right now? Consider these simple facts.

1) Most sub-prime ARM loans had a 2 or 3 year fixed-rate period. Therefore the only loans to reset during 2007 were made in 2005. Prime ARM's typically have a 3, 5, or 7 year fixed-rate period.

2) However, the sub-prime delinquencies in 2006 are the real problem. 2005 isn't showing a radically different pattern than past periods.

Notice the much steeper curve displayed in the 2006 vintage, which is like nothing else on the whole board.

3) In 2006, half of all sub-prime purchase mortgages were made with low or no documentation of income.

4) The Case-Shiller home price index is down 6.1% YOY. It registered its first negative reading in January 2007.

5) Conditions that normally precipitate higher delinquencies, namely unemployment, are not currently a problem.

So let's try to reconcile these three facts with how we'd expect a "normal" borrower (prime or sub-prime) under "normal" circumstances to behave. Normal people buy a house because they want to live there. Sure the fact that homes have historically been a positive investment plays a part, but for most people, their house is their home.

There will be some "normal" borrowers looking at negative equity, either now or in the near future. Of course, if that borrower never paid any attention to home prices around him/her, and just kept paying the mortgage bill every month, the negative equity would be of no moment. Remember if a "normal" borrower living in the house decided to walk away, they'd need to find someplace else to live. Given how badly defaulting on your home will mar your credit rating, the "normal" borrower would be loathe to just walk away, even if s/he is significantly underwater, as long as s/he can make the payments.

Plus, there aren't very many "normal" borrowers who would be underwater right now. Using Case-Shiller's data, only borrowers who put less than 6% down and bought their house late in 2006 would have negative equity currently. Perhaps borrowers in the "boom then bust" areas are more likely to be in a negative equity position. But still, we're talking about a relatively small number of "normal" borrowers.

So where are all these delinquencies coming from? And what does that say about what 2008 will hold?

First I think you have people who are delinquent for "normal" reasons. They've lost their job, they've gotten sick, they gambled away their starship, whatever. This caused them to rack up some credit card debt. In the past this borrower was able to tap home equity and get out of trouble. Unfortunately, the borrower isn't able to do this currently, both because lending conditions are very tight and because the borrower might not have adequate equity.

Like I said, this group probably isn't the lions share of the marginal delinquencies, because we aren't seeing macro events which would cause these events to happen on a large scale.

No, I think the bigger problem is investors. If you buy a property solely for investment purposes, then all the rules of a "normal" investor are out the window. I think many investors bought properties with little to no down payment. Investors were more likely to get involved in hot neighborhoods, where prices have probably been hit hardest lately.

Many investors just don't have the option of sitting on the property. If you bought an investment property but also had a house you are living in, you may not be able to afford two mortgages indefinitely. And you probably can't rent the place for the same amount as your mortgage payment. It might be that you can save your actual home by just walking away from your investment property. For the investor, the jingle mail option may just be the best of a bad situation.

So back to the "crisis" question. It is these speculators who are insolvent. So what we have are people who speculated in houses and lost. We have are banks who lent to the a fore mentioned speculators and have lost too. Bear in mind, these banks are the ones who agreed to limited documentation of income (perhaps so the speculator could claim this would be his/her primary residence?) or minimal down payments.

What we also have are brokerage firms who warehoused bonds backed by these speculation loans, assuming they'd be able to unload them into a CDO. They've lost too. We have banks buying AAA-rated CDO^2, who never asked why CDO^2 spreads were so much wider than other AAA product. Guess what? They've lost too. We have money markets buying securities they didn't understand. Losers. We have hedge funds who took already leveraged CDO and ABS product, and leveraged it some more! Loo--oo--oooooooser!

All this isn't a crisis. Its how the credit cycle works. When credit becomes too easy, bad loans get made. People get hurt. But that's the way of the world. You move on.

Where a crisis could develop is when the innocent are hurt just because capital becomes tight. Where a good borrower can't get a mortgage loan. Where a solid commercial real estate project can't roll over its bridge loan because banks are short on capital. That's where the real crisis can get going. Foreclosures happen that didn't need to happen, driving the price of assets lower. Lenders start taking losses on good loans, and suddenly are unwilling to lend to anyone. Investors struggle to value assets, not because of unknown losses, but because of unknown liquidity. Bids disappear.

That's a crisis.


Daniel Newby said...

I read somewhere that companies in Germany are having to finance some of their suppliers because the banks no longer will, with those that can get operating credit being forced to report their balance sheets weekly. How far does this have to progress before it's a crisis?

Anonymous said...

Martin Feldstein in his speech at Jackson Hole this past Sept noted

"Starting in 2001, the combination of lower mortgage rates and the rapid rise in house prices led to widespread refinancing with equity withdrawals, a practice heavily promoted by banks and mortgage brokers. { Someone who obtained a mortgage at 7.7 percent in 1997 could refinance at 5.8 percent rate in 2003 and extract substantial cash at the same time. }

{A massive amount of such refinancing and equity withdrawal occurred.} In 2005 40 percent of existing mortgages were refinanced. The Flow of Funds data imply that the mortgage equity withdrawals between 1997 and 2006 totaled more than $9 trillion, an amount equal to more than 90 percent of disposable personal income in 2006.

This new borrowing was used to pay down other non-mortgage debts, to invest in financial assets, and to finance additional consumer spending."

The crisis is the ability of homeowners to service the acquired mortgage debt created during these credit happy periods. Folks in every part of the country and all economic levels have create this debt structure. Additional shocks to the economy are arriving all the time with higher oil cost creating drag on economic growth.

Iggy said...

Did you mean semantics instead of symantics? Unless it's a pun I missed. =) Total agree on the speculators, and the real crisis being the over punishment.

cak said...

As Mark Twain said, “A cat who sits on a hot stove will never sit on a hot stove again. But he won’t sit on a cold stove, either.”

Now, according to some folks, there is no liquidity crisis, that financial institutions are flush with cash. Great. And they're holding on to it, why?

I guess its the cold stove phenomenon back in play.

So, once again, the Fed will end up being the lender of last resort.

During the crash of 1987, when the cash flush banks cut off lending to desperate NYSE floor specialists who, by law, were required to purchase dive bombing shares no matter what the price, it was Greenspan and the Fed forced to hold the hands of scared private bankers and guarantee loans to Wall Street.

Then, as now, the cash flush bankers need to be spoon fed by Bernanke and told it's ok to pull the cash from under the mattress.

In the next few days, Washington will once again step into the economy. Bush will unveil new economic stimulus incentives. I'm not sure what these will be but Bush 101 Economics usually entails tax cuts. So I'm thinking tax cuts for subprime, and low income families. He may propose a business tax cut. Or capital gains tax cut.

But, something else could be brewing here too. I wonder if another Resolution Trust Corp is in the offing.

flow5 said...

“Where a crisis could develop is when the innocent are hurt just because capital becomes tight. Where a good borrower can't get a mortgage loan. Where a solid commercial real estate project can't roll over its bridge loan because banks are short on capital. That's where the real crisis can get going”

The conventional wisdom: “What is necessary is precisely what was necessary from 1990, to keep short term interest rates low enough to allow enough of a difference between banks borrowing short and lending long at higher rates to re-build balance sheets. There is no reason why such a policy will be any more inflationary than after 1990 when the Fed lowered the funds rate to 3% and before the Fed finally raised the funds rate from 3% in January 1995 – ANNE”

CBs do not loan out TDs, DDs or the equity of bank owners. CBs acquire earning assets through the creation of new money. When CBs make loans to, or buy securities from, the nonblank public, new money-DDs-are created in the banking system.

The aggregate lending capacity of the CB system is determined by the monetary policy of Federal Reserve authorities. It is in no way dependent on the savings practices of the public. People could cease to hold any savings in the CBs and the legal lending capacity of the CB system, given our current institutional arrangements, would be unimpaired.

Insofar as there is an interest-rate solution to the problems of the housing industry, I would recommend that interest ceilings on savings accounts be placed on all types of TDs in CBs. Existing Ceilings should be lowered-gradually (REG Q in reverse).

This action would decrease the proportion of TDs to DDs, increase the flow of funds available to the so-called thrift institutions-and vastly reduce the costs and increase the profits of the CBs.

This would seem one of those rare instances in which public policy could simultaneously serve the welfare interest of the mortgage borrowers, and the profit interests of the specific groups immediately affected.

TallIndian said...

It isn't supposed to be said in polite company, but financial institutions make a significant portion of their income by selling enormous amounts of deep out-of-the-money put options (on credit spreads, on interest rates, or currency rates, on prepayment rates on equities, what have you).

Nine years out ten, this strategy will make gobs of money. The tenth year the institution usually loses that amount and more.

Accrued Interest said...


But that's exactly my point. Banks being unwilling to lend for normal business activity is a liquidity crisis. That people are suffering due to bad credit decisions isn't a crisis.


Forgot to spell check. Obviously I had my security software on my mind when I was writing :).


The cold stove analogy is a good one.

Anonymous said...


I have to say, I think this post is a little simplistic.

Sure investors are making up a large portion of defaults, but lets not forget that ownership rates are at well above long term averages in the US.

The benign credit environment since 2003 has allowed millions of people to buy homes they otherwise would have been unable to afford. Many more were able to retain homes they otherwise would have lost, as evidenced by well below average default rates in recent years. Call it pent up mortgage defaults.

It difficult to verify, but I would bet that it is these people, along with reckless investors, who are defaulting en masse. Mass bankruprtcy in this income group could be called a crisis, no?

Given the slowing in the economy and the potential for recession, how far away are the job losses?

This is an ugly situation that is potentially going to get a lot worse fast. Assuming that the damage is limited to home flippers is wrong IMO.

Accrued Interest said...

Insurance Guy:

Here is my question: if you bought too much home in 2003, why is it that you are suddenly unable to pay your mortgage now? Maybe some ARM borrowers are facing higher resets, but ARMs were not terribly popular products until more like 2004-2005. Sub-prime ARMs from 2003 would have reset already. I don't know why a fixed-rate borrower from 2003 would suddenly default.

Anonymous said...

quick question. How do the CDO^2 position look from an event perspective for MBIA? I am curious to understand what define default or event and how it might be viewed. My assumptions is a CDS default requires full payment, a Muni default lets the insurer make the payments over time. What happens with a CDO?

Accrued Interest said...

ABS-oriented CDS are more like muni insurance than normal corporate CDS, in that the insurer only has to pay any lost interest and eventually has to pay principal at maturity.

This is because ABS (including CDOs) don't have a single default event like a corporation does. The corporation files for bankruptcy. An ABS just has more losses than was projected and can't pay all of the promised interest. THis is what MBIA means when they say there is no "acceleration event."

I wrote a post on this topic...

Anonymous said...

AI: This is one of my favorite posts.

I particularly appreciate your "Banks being unwilling to lend for normal business activity is a liquidity crisis" comment. It helped me understand your posts since August better.

@insurance guy
I advise you against attributing unambiguously incompetent lending practices on a faceless generality like "The benign credit environment since 2003". I perceive such explanations as red herrings, if not fraudulent manipulation by culprits seeking to escape some well-deserved scrutiny.

Prevailing interest rates were higher when loans were made to Penn Central in the late 1960s, or to Penn Square in the 1980s. They were just bad loans.

1) Your "nonblank public" always throws me. I prefer nonbank public.

2) I hope others benefit as much as I have from your posts. Your reminder that "CBs acquire earning assets through the creation of new money" is a good contribution.

3) Regarding your "I would recommend that interest ceilings on savings accounts be placed on all types of TDs in CBs", I'm opposed to a government intervention that would fix prices to the advantage of CBs [commercial banks]. I would much prefer 100% reserve requirements on DDs [demand deposits] and no reserve requirements on TDs [time deposits] and remove FDIC insurance on CDs (I don't think TDs are covered by FDIC, but please correct me if I'm wrong). If the CBs need a profit on DDs, then let them charge a fee for checking accounts.

I am quite comfortable buying a CD from my credit union at 5% when they're making mortgages at 6.5% to 8%. I would not buy a CD paying 6% because the credit union's earnings, for my risk tolerance, are inadequate to cover the obligation. Government intervention to maintain a desired price level is inferior to allowing the market to determine valuations.

Anonymous said...


I don't think resets are the problem so much as the inability to now refinance.

I guess some would argue that since many could not have afforded homes anyway except for the exceptional credit environment

(any better psychodave? - I certainly don't want to make the lending sound "normal" or "good" in any way - agree that many fraudulant practices took place as well as many ridiculous underwriting practices)

that it shouldn't be a problem that many are now losing those homes. I think this is flawed logic. In many cases, those home buyers would have been far better off as renters. Losing a home means that any savings that might have been built up while renting is gone, credit histories will be scared for years, not to mention the psychollogical blow of "losing your home".

This is a crisis IMO and only going to get worse.

Anonymous said...

"any better psychodave?"[insurance guy]
errm, No, not much.

I was hooked by your insightful "Losing a home means that any savings that might have been built up while renting is gone". AI's blog does attract some quality.

As far as your "the psychological blow of 'losing your home'", I prefer to paraphrase AI and say "For the speculator, the jingle mail option may just be the best of a bad situation." I think most of the homebuyers that will be losing their homes were speculators, not homeowners. The biggest problem is that the ones suffering from any "psychological blow" didn't even know they were speculating.

Its like the movie 6th SENSE, "they're dead [speculating] and they don't even know it".

This in no way mitigates the intensity of the emotional trauma, which you were good enough to point out. You offered a worthy alternative viewpoint to AI's "Bad loans get made. People get hurt. Its how the credit cycle works. You move on."
Thanks for your contribution.

Anonymous said...

I think there are two flaws in this analysis. First you have looked at average HPD to conclude that most "normal" borrowers would still have equity in their house. This ignores the correlation of subprime lending with bubble markets (CA, FL, AZ, NV, etc) that have depreciated by far more than 6%. There are many normal borrowers in the 06 and 07 vintage loans that are well under water in these markets. Even the real esate ad selling Sacramento Bee is admitting in print that prices are down 25% since 2005.

Second, the problems are not limited to subprime. Though they are not at the extremes of subprime, Alt-a and Prime ARMS are seeing rapid increases in delinquencies. Prime home equity is deteriorating rapidly.

Finally, all of this has taken place (so far) in an environment of sub 5% unemployment. Doesn't that speak volumes to you about how awful the underwriting was in that last 2-3 years? Talk to any mortgage guy worth his salt and he will tell you that the real killer in mortgage credit is job loss. It looks to me like the job market weakened materially in the last couple of months. Imagine where default rates can go if we have 1-2 million people thrown out of jobs and a heavily constrained mortgage financing market.

PS: Credit Sights has stats that show a spike in 2005 vintage subprime delinquencies in the last 3 months, that seems to vary from what you show. That makes sense to me as the people hitting reset dates with late 2005 vintage subprime loans probably found there was no refi market for them. Not sure what data sets drive the two analyses, but there is at least one that draws a different conclusion.

Accrued Interest said...

I guess the distinction is "problem" vs. "crisis." I mean, I know some people will lose their homes for reasons that are not entirely their fault. That's a damn shame, and I'm sure its a crisis for them, but it doesn't automatically mean it a crisis that the government needs to fix.

Your point about people not being about to refi is fair, but I think that will account for a marginally higher default rate each year going forward. I don't think it explains people defaulting within 12 months of getting a loan.

I mean, look at the default curve for 2003 and 2004 vintages. They look pretty normal.

Anonymous said...

But those vintages look normal because anyone who took out a loan in those years that ran into trouble could refi their way right out of the problem. That was true right up until this year.

That's why 2006 looks so bad. Much of that 2006 year consists of refi'd 03, 04, and 05 buyers. Pent up defaults.

Sivaram V said...

One of the things that will likely weaken the blow for ARMs is the fact that long bond yields, as well as shorter rates, are declining and will be quite low by the middle of this year in my opinion...


Anyway, I have an off-topic question for AccruedInterest and any other with an opinion. My question is...

Is it sensible to expect CDOs of RMBS to perform better than straight RMBS over the next few years? I'm talking about on an aggregate case where you randomly look at a bunch of RMBS, and a bunch of random CDOs (I'm not necessarily talking about the RMBS underlying a particular CDO. If you just look at a CDO and its underlying RMBS then the RMBS should obviously be better (since CDOs typically get paid after most of the RMBS tranches)).

I know it all depends on the details but just assume the details are similar.

Let me give some background info and my thinking...

I'm contemplating investing in either MBIA or AMBAC (or both). Initially, I thought MBIA was safer because it had mostly RMBS exposure, whereas Ambac has heavy CDO exposure. But lately, given that the rating agency stress tests had Ambac outperforming, I'm coming around to the thinking that CDOs may be safer.

Is it possible that CDOs work as they were intended to in the first place? Namely, wasn't the whole point of CDOs to pool assets and spread out the risk? Is it possible that this actually lowers risk? Is it possible that CDO investors will end up better off than the actual RMBS investors when all is said and done? Are those calling for the death of CDOs being premature?

Anonymous said...

I don't deny that many of the defaults come from investors. But I do think a solvency crisis is currently impacting American consumers and is about to get a whole lot worse.

I don't know what the government should do about it - aside from working towards an adequate social safety net including universal healthcare. People who fail, need social resources to help get back on their feet. Healthcare, welfare and education - not debt bailout, is where the governm,ent should focus in my view.

Anonymous said...


Maybe we're just talking about a difference in terminology. If you're defining "crisis" as event requiring specific government intervention, I would agree with you.

And great blog by the way, as always.

Accrued Interest said...

Yeah we might just be arguing about words, which is why I stuck that quote at the top of the post.

Anyway, negative HPA is going to impact economics for a while. As you point out, the refi out of other debts trade is not going to be available. This will cause higher default rates on all types of consumer debts. And that will cause banks to be more cautious about lending to everyone. Even a good borrower can lose his job and wind up in trouble. Banks are going to have to consider this.

To me what we're going to get in 2008 is either a recession or near recession as the economy adjusts to this new reality. There might be somewhat fewer job losses than in some past recessions. But given that access to capital for new projects (financial or industrial) will be scarse, you're going to see slower growth. And growth will be somewhat slower than normal for a while probably.

So yeah, I know its going to be bad. Maybe I'm too much of an Austrian economist, but recessions sometimes have to happen to wring out bad investments. I don't expect the Fed to "avert" a recession, I merely expect them to maintain enough liquidity to make sure it doesn't turn into something much worse than a recession.

flow5 said...
This comment has been removed by the author.
Unsympathetic said...

AI, the other important part of returning faith to the system is the installation of appropriate regulation throughout the lending pipeline. 20% down, 37% DTI, FICO no longer used as a metric for credit scoring, etc.

Problem is, I'm just not seeing the Bush administration give anything other than lip service to this need.

How/when, then, do you think regulations will be enacted? Hour 1, day 1 of the next US president?

Anonymous said...

What I can call a crisis is paying two mortgages, having started the divorce proceedings and a big headache about finding a nice HREF="" REL="nofollow">realtor in Toronto. Can anybody predict any improvment regarding properties in 2008?

Accrued Interest said...


I expect a mountain of new regulation if a D wins in November. A smaller mountain if a R wins, because the D's will still control congress.