SMACKDOWN WEEK: Interlude

A couple commentors mentioned upcoming option ARM resets as a reason to be more bearish on housing. I wanted to make some quick comments about that.

First let me say that option ARM resets are a tricky thing. Most ARMs were underwritten in 2005 to early 2007. During 2005, 12-month LIBOR averaged 4%, during 2006 5.33% and in 1H 2007 it averaged 5.33% again. So the reset itself isn't a worry at all.

Its the recast that matters. The switch from the "Option" period to the full amortization period. The tricky part there is that most option ARMs have a 5-year "Option" period. That would mean that 2010 would be a big year for recasts, and 2011 even bigger. We wouldn't "burn out" on these things until mid 2012.

However, most option ARMs also have a provision where if the negative amortization gets to 15% (i.e., you owe 115% of the outstanding balance), it automatically reverts to the fully amortizing amount. Certainly if a borrower has managed to fall that far behind within the first couple years, the odds that that loan winds up in foreclosure is pretty high. Anyway, it throws off the theory that there is suddenly going to be a bunch of recasts in 2010 and 2011. Many of those loans are already recasting because of the neg-am element.

Here is how I see it. I track a large group of whole loan "prime" mortgage securitizations. My group is from 2006 and about half are Option ARMs, the rest are full amortization ARMs. Most are also limited documentation. So while the credit score said prime, everything else about the loan said "questionable." I created this grouping back in 2007 to track how seemingly good borrowers who took out bad loans performed. Its a pretty good gauge of how Option ARMs are doing.

The 90+ delinquency (which includes foreclosures) is currently 11.5% of the original balance for the whole group. The figure continues to climb month-by-month but the pace has slowed considerable. The last 5 months its increased by about 0.3% per month, vs. over 1%/mo. during most of 2008. So that's point 1, that the pace is clearly declining. Worth noting that the pools with mostly option ARMs are about 2.5 times the delinquency level of the full amortization loans.

Second, I track a similar group of sub-prime loans. That series has completely burned out, with the 90+ figure sitting at 17.5% for the last six-months. So basically what's going to happen in sub-prime has already happened.

Put these two together and you could conclude that the continuing rise in price foreclosures is just making up for the lack of rising sub-prime foreclosures. I don't know if the math of that exactly works, and I am sure that the sub-prime and prime loans were not typically in the same neighborhoods, but point is that a lack of new sub-prime foreclosures is at least something of an off-set.

If you drill down into some specific Option ARM deals, you find some very interesting info. Here are some stats on one of the deals in my list.

Pool Factor: 63.2% (meaning 36.8% has paid off)
# of Loans: 496
WALTV: 83.5% (so few loans are being forcibly recast)
90+ Delinq: 39.5%

Now here is what's interesting to me. 37% of this loan has paid off. Another 40% is not paying. That means the potential new problems are only 23% of the remaining principal. I pull several other deals with the same kind of circumstances. What we're seeing here is that the loans that never should have been made are already turning bad (the 40%). The loans that were made to actual good borrowers are paying off rapidly. What remains in between isn't a very large number.

That's the facts as I see them. I'd love to hear the other side. Just post a comment!

SMACKDOWN WEEK: Slimy? Mudhole? My home this is!

MORE BEARISH: CONSUMER SPENDING

MORE BULLISH: HOUSING

CONSUMER SPENDING

I'd like to start by describing my generic view of consumer decision making. People make decisions based on their own circumstances. So whether the Solos decide to buy Jaina and Jacen a new summer wardrobe or to keep the ragged stuff from last year is all about how the Solos are doing. The fact that unemployment is rising galaxy wide isn't an important factor in their decision making. Obviously if Han is worried about his job in particular, that would make a difference, but if he expects the smuggling market to remain strong, 5% overall unemployment or 7% or 10% isn't going to impact their decisions. Not by a large degree anyway.

I'll put this another way to illustrate the point. What if unemployment were especially low? Han could still lose income for one reason or another. People still lose their jobs in good times. So I argue that the Solo family's spending habits are a function of their specific income level and perceived stability. A poor macro picture in and of itself isn't relevant.

What's the conclusion for overall spending? Its that statistics like consumer confidence is over-rated. I've looked at the correlations, and consumer confidence is, at best, a coincident indicator. In other words, consumers don't lose confidence and then the economy weakens. The economy weakens and then consumers feel less confident. That tells you the confidence in and of itself has no bearing on economic activity. One doesn't cause the other.

I think Cash for Clunkers is an illustration of this point. Consumer confidence is still quite low, but give them a good enough deal on a car and they're ready to buy. Ready to take on a major financial commitment despite this purportedly weak sentiment. (Don't through me comments suggesting that I liked this program, I didn't. I'm just making a point.)

I have a similar view of the wealth effect, be it from financial assets or one's home. It all depends on an individual's situation. Let's zoom our targeting computer onto home values. There is a certain segment of the population that was using home equity to fund spending. Clearly that group will have to pare back spending. But there is a large segment of people for whom that peak value in homes is a meaningless number. I bought my house in 2001. It probably rose in value through 2006, then has fallen a solid 15 or 20% since. But none of that matters since I've never taken any equity out. I've just been sending my checks in every month.

I'll go even further and say that for most people, the biggest influence on how much money they choose to spend is how much money is currently in their checking account. The candy bar was called "Pay Day" because people celebrated Pay Day by buying stuff like candy bars! That is to say most people make decisions based on very short-term considerations. Not high-minded thoughts like "I've lost money in my 401(k) and I therefore need to save more if I'm going to retire in 29 years." For most regular Joe Americans, they can't (or choose not to) think that far ahead.

Point here is that if you take a consumer with a fairly stable job and good home equity, they aren't doing anything differently today than they did two years ago.

If I stopped here you might think I'm pretty bullish on consumer spending. In the short-run, I'm probably more bullish than a lot of people. But in the intermediate term, a number of factors are going to retard growth in consumption in a profound way.

Let's take my presumption above as truth, that most people make consumption decisions based primarily on how much cash they currently have access to. In the short-run, maybe that hasn't changed much. Like I said, if you didn't spend your home equity, it doesn't matter that your home value has declined a bit. That is, until you want to move. Then you need to come up with more cash to make your next down payment. I said that people might not change their current buying habits just because their 401(k)s declined, but eventually when they do to retire, they are going to have less money. For people closer to retirement, they are either going to have to save more aggressively or keep working, which is de facto savings.

Then there is the reality that consumer credit is going to be harder to come by. We know home equity loans are going to be more difficult just because of the lack of equity. But we also know that generally retail credit is not going to reach the same levels seen during the securitization boom. There just won't be enough capital to fund it at that same level. The reality is that these "0% financing for 12 months" deals were quasi-price reductions, but typically banks were involved in supplying the credit. I think those kinds of deals will be less prevalent. Not non-existent, but less common.

Taxes are another issue. I expect both federal and local tax rates to increase in the coming years. The feds might only target the rich, but locals will probably target more insidious increases, like sales tax or governmental fees. Clearly if we increase the price of everything by 1%, that's going to impact consumer spending.

Finally, I think we're going to enter a phase where unemployment is going to remain fairly high for an extended period. I don't think we'll stay at 10% for too long, but I think we'll still be above 7% at the end of 2010. Maybe even well into 2011. So even under my thought that consumers react to their own circumstances, more consumers are being impacted by "circumstances" than in past recessions. In fact, if more workers stay in the work force past normal retirement age, that increases the size of the work force and thus keeps unemployment high.

Bruce Kasman of J.P. Morgan back in April said he thought the economy was going to bounce into malaise. I think consumer spending will be similar. Consumers have some degree of pent-up demand for goods which will create a deceptive bounce in the next few months, but then we level out into a mediocre growth rate.

HOUSING

Somewhat paradoxically, my view of housing is pretty bullish, at least when contrasted with mainstream opinions.

First, you have to think about what caused the housing bubble/crash in the first place. I'm not talking about the deeper underlying causes, which we can debate, but the more proximate causes.

• Lending conditions become too easy, causing demand to increase
• Supply increases in response, both from new starts and rehabs
• Losses from sub-prime cause banks to pull back lending, demand falls
• Foreclosures rise, largely because of loans made to borrowers who could not afford regular payments and/or reset levels.
• Builders/rehabs still have a substantial supply over-hang. They can't destroy supply as demand falls, so prices fall.

The housing problem is therefore no more complicated than a simple supply/demand imbalance. In fact, one could argue that the supply/demand imbalance wasn't even that large, but that the contagion was great because of the impact on the financial system.

So predicting an end to generalized home price declines is as simple as determining when supply is meeting demand.

Ask yourself, how did we know supply was not matching demand before? Because even as prices fell, demand didn't seem to pick up. We can see this in housing transactions. From March 2007 through January, existing home sales declined from 5.75 million units to 4.05 million units. Perhaps more telling is the fact that the figure only showed an increase in 5 out of 21 months. New home sales show a similar pattern although more severe. Units fell from a peak of 1.4 million units to a paltry 329,000.

Since that time we've shown pretty strong increases in both series. New home sales are up 17% off the bottom, existing up 6.7%. Both series have increased 4 out of the last 5 months.
Demand is meeting supply.

It doesn't really matter that total demand is much lower than in the past. Not in terms of home prices. If you are talking in terms of contribution to GDP or some such, then yes, overall activity isn't adding to GDP like it once did. But in terms of home prices continuing to decline, as long as supply meets demand, there isn't any reason to expect more declines.

I also consider the Case Shiller Index, which looks like its bottomed. I have long argued that that index is fraught with lags and other data problems. But if its lagging, then you'd say that housing might actually be better than indicated. Absent some catalyst to the negative, I don't see homes continuing to decline.

This isn't to say that home prices will start rising in spectacular fashion. I think demand is just now meeting supply because buyers think homes are cheap. If they were to rise above "cheap" then buyers would pull away. Plus all the problems consumers have that I mentioned above apply to housing. But inflation-level home price increases are perfectly reasonable.

The best argument for another leg down in home prices is accelerating prime foreclosures. I can't deny that prime foreclosures are high and rising. But I also think there is a substantial difference between a classic foreclosure and a bad loan foreclosure.

This downturn started when a set of loans, most of which never should have been underwriten (i.e. no doc loans), started going bad. A good percentage of these loans were de facto investment loans, even if they were supposedly underwritten with a residence pretense. For this and other reasons, these loans were not only bound to go bad, but they were bound to produce above-average losses for the lending bank. Think about a half-completed rehab gone bad. What can a bank do buy sell it as aggressively as they could?

Furthermore, these loans were concentrated in particular areas. If you wanted to do a flip, you did it in a "hot" neighborhood. So when they started going bad, all the banks were trying to sell houses in the same general areas within a given city. This is a factor that I think hasn't gotten enough attention. You have 10 houses on the same block for sale, each chasing the rest of them lower and lower trying to get the one buyer who wants to live there. Obviously this is a recipe for some ugly price changes.

I'm not here to say that all of the bad loans went to sub-prime borrowers. Look at any option-arm securitization and you'll see "prime" borrowers. The reality is that if someone took out a truly bad loan, one that the borrower never really could have afforded, then the loan must be at least two years old by now. By August 2007, the mortgage securitization market was already in shambles and the joke of the NINJA loan was already well known. I'd guess that July 2007 was about the last time you could get a classic no-doc mortgage. So in order to claim there is a wave of mortgage defaults coming, you have to explain to me why these people would default now instead of a year ago.

Now of course, we have unemployment rising and that certainly has an impact on foreclosure rates. But this is totally different than the bad loan foreclosures, in my mind. Unemployment-type delinquencies are more likely to be resolved through a modification. The borrower eventually finds a job and can resume payment. In addition, those foreclosures would be more spread out. Again, I think people underestimate the impact of concentrated foreclosures. If there is one foreclosure in your neighborhood, it doesn't destroy the value of all the other homes. Six or seven is a different story.

Next time on SMACKDOWN! Uh... I'll decide tomorrow!

Home Prices: A little higher! A little higher!

I'm getting tired of hearing that home prices still need to fall further. You can be the most bullish guy in the whole world on housing and you'd still have to admit that statistically home prices have to keep falling.

Consider how the major home price indices, both the FHFA and Case-Shiller, use repeat sales to calculate home price changes. Basically they look for homes that have sold twice, and measure the price change between the two sales periods. So if a home sells to the Skywalker family in 2004 for $100,000 and then to the Organa-Solo family in 2007 for $115,000, we'd call that one data point indicating that homes rose by 15% over those three years. (Do we think that Amidala's house was foreclosed on after she died? Or was there family money there?) Combine this with millions of other data points, and you can get some pretty solid estimates.


Now, I don't know of any better way to measure home price changes. Certainly I don't like using appraised values, especially in a market like this one. But the paired sales method is bound to lag reality in a market like this one.


Consider what we have in housing. Too many houses were built, and too many borrowers got funding that shouldn't. The former means there is too large a supply of homes, and the later means that foreclosures are creating even more supply of homes!


We in the financial business are used to things moving fast, but the housing market doesn't work like that. The foreclosure process is slow, and given the ever-changing world of government programs, I think many banks have been especially slow to initiate foreclosures. On top of that you have loan mods, a large percentage of which will re-default. For these reasons and others, I'm sure we will still be dealing with large numbers of foreclosures a year from now.

And remember that foreclosures aren't going to be evenly distributed across the country. They will be focused in areas where the bubble was worst. In other words, areas where there was already too much supply from builders! Areas where the gap between supply and demand is widest.

Demand for housing is also quite inelastic. I already have a home. Lower prices in and of itself doesn't incent me to buy another house, because I'd have to sell the one I have anyway. It isn't like when the Gap needs to clear out excess sweater inventory. They can make everything half off and unload it all. America needs to do a half-off homes sale, but can't actually get anyone to come to the mall to buy.

So it is inevitable that as actual transactions start to pick up, those transactions will show lower and lower prices, especially where foreclosures are high. Even when the housing situation stops getting worse, statistically, prices will keep falling. But we can't get to a bottom unless transactions pick up (which they have), and inventories are cleared out. The fact that increased transactions largely represent increased foreclosures is neither here nor there. We know foreclosures are coming. Let's get them out of the way.

Put all this together, and I'm watching stats like Existing Home Sales and NAHB confidence survey much more closely than today's Case-Shiller Index. On that basis, its reasonable to see the decline in housing finally abating. But only a fool would say that prices are about to bottom.

Moral Hazard: I dunno... I can imagine quite a bit

In reading my post from Monday on mortgage bailouts, one commenter mentioned moral hazard. I feel like this is becoming an over-used term, and I'd like to state Accrued Interest's official position on the subject.

According to the most authoritative source I could find (Wikipedia)...

"Moral hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions."

Any time risk has shifted in any way from one party to another there is potential for moral hazard. Someone who has health insurance that pays for all prescriptions probably winds up using more prescription drugs. That's one example of moral hazard.

In the case of a bailout, it is usually not the bailout itself, but the implication of the bailout. Its the precedent set that is problematic. So for example, when a rich kid crashes Daddy's car into the neighbor's tree, and Daddy just buys another one, the kid makes an assumption about the future. He assumes that Daddy will keep bailing him out of jams.

So let's look at two simplified examples of a housing-related bailout. In one corner, let's say that banks are forced to write down all upside down mortgages by 20% and in exchange, the government agrees to take all subsequent losses on the loans. The banks who made bad loans suffer a good deal from this, but perhaps not as much as they would have otherwise. This isn't exactly Daddy buying them a new car. More like Daddy paying for the damage the kid did, but making him ride the bus to school from then on. We can debate whether those are adequate consequences or not, but certainly the banks didn't expect to take a 20% loss on those loans when they first made them.

The same goes for bond holders. They suffer losses much greater than they anticipated when they bought the bond. Maybe not as large as might have otherwise been, but still large.

The borrowers who took out loans they knew they couldn't afford get completely bailed out here. Maybe they don't get a new car, but Daddy's repairs the old one and things continue as they had before. The borrower gets something for nothing.

Now compare that with some program that encourages people to buy foreclosed homes in a big way. What you've done is alter the demand curve for homes by making them both more affordable for end buyers and making a buy to rent investment more attractive.

In this case, the borrower is probably no better off. S/he was already foreclosed upon. He really doesn't care what happens to his house after that. The bank is clearly better off, because they get a better price on their REO portfolio. Investors too. Both have their loss severity reduced.

But all the guilty parties wind up suffering a fair amount under such a plan. In other words, every one involved regrets their actions.

Now let's take a step back. We know that the government is going to interfere in the housing market. No matter what is done, there will be moral hazard involved. I'd like to see moral hazard limited by making sure that all involved in the mortgage lending process suffer to a significant degree. We want everyone involved to be saying (sarcastically) to themselves "This is some rescue!"

What we don't want is for either the lender or the lendee to say, "That wasn't such a chore now was it?" We don't want one party to bear all the risk, nor to have the government take away all the pain from any one group of participants.

You can reduce the supply of foreclosed properties either by preventing the foreclosure or by having someone buy the foreclosed properties. Any program which prevents foreclosures is benefiting the lendee at either the lender or the tax payer's expense. By encouraging investors to buy foreclosed properties, you are giving the primary benefits to an uninvolved third party.

I think that translates to less moral hazard.

Housing Legislation: Short help

The Frank/Dodd housing proposal, while not law yet, looks to be headed there. While it seems the proposal will have some non-zero impact on the housing market, I'd vote against it. Quickly, here are my problems with the proposal:

• The key element is that the government will trade a GNMA security for a troubled loan as long as the bank holding the loan agrees to write down the principal to 85% of the assessed value of the home. This could be a very large write down in many cases. Say I bought a $300,000 home at the peak and put 5% down. Let's say the appraised value has fallen by 15%, so the house is worth $255,000. Now the bank has to write the loan down to 85% of that ($216,750) in order to participate in the Frank/Dodd program. What started out as a $285,000 loan must be written down by $68,250, or 24% of the original loan amount. Banks are going to be very reluctant to participate in this program. Why not roll the dice and hope that the borrower keeps paying?
• Given the above, any loan the bank does decide to put into the GNMA program will be of the truly toxic waste variety. So tax payer costs will be significant.
• Even if the proposal were to be signed into law today, most analysts agree that the book on 2008 foreclosures is already written. The foreclosure process is always a lengthy one, and currently servicers are swamped, so its taking longer than usual. So the proposal won't start having an impact until 2009.
• By that time, we'll be nearing a "burn out" on bad mortgage foreclosures. By this I mean, at some point, all the really bad loans from the 2005-2007 period that are going to default will have defaulted. By mid-2009, it will have been two full years since the sub-prime blowups started. That should be enough time for the overwhelming majority of the loans to borrowers who really can't afford the loan to be ferreted out. From that point on, loan foreclosures will probably be above average for a while because of the lack of equity, but the pace should decline.
• By early 2009, homes in the most bubblicious areas will be down 25-40%. So the amount banks have to write down to stick these loans to the government will be very large indeed. The risk/reward may be to retain the loans and hope that most of your borrowers keep paying, or to work out a separate modification rather than participate in the Frank/Dodd program.
• Put the last three points together, and most banks will figure they've already foreclosed on the properties they might have originally put into the Frank/Dodd program, and what remains is worth keeping.
• I'm not even mentioning the obvious moral hazard, which is another issue entirely.

So this housing proposal, at least as far as helping home owners, is a lot of political posturing without much eventual impact. So I'd vote against it.

What kind of government intervention might actually work? What the housing market needs is a reduction in supply. We're slowly getting to a place where new construction isn't so much a problem, but as I've alluded to above, I think we're about a year to 18-months away from the peak in foreclosures. So that's going to remain a problem.

Normal household formation won't soak up the supply for a while. A recent report from Lehman Brothers indicated that there will be 4 million units which need to be absorbed by the end of 2009, both foreclosures and new home construction. About 1 million can be taken down by normal household formation. That leaves 3 million homes to sell, a pretty big nut to crack.

Demand could come from either current renters becoming home owners or investors. In both cases, prices need to drop a large degree to stimulate demand for 3 million marginal homes. For what its worth, the Frank/Dodd proposal is estimated to help 500,000 home owners. That still leaves a pretty big nut to crack!

There is actually a relatively simple way for the government to help soak up this demand quickly. Make investing in a home more attractive. In other words, make buying a foreclosed property for the purpose of renting it out a more attractive investment. It could work any number of ways: there could be a large tax rebate to the investor, FHA could offer cheap loans, etc.

It could even be structured such that the financial system was strengthened in the process. Say the government allowed anyone who bought a foreclosed property to write off 20% of the purchase price on their taxes, but in order to qualify, the buyer has to have at least 20% equity in the home. The result would be a deleveraged housing sector. Most alternative proposals involve the government helping to provide down payments. But that doesn't deleverage anything, only shifts the leverage to the government.

Anyway, my idea is politically untenable, since it would help wealthy investors make money on the back of a displaced homeowner. So it isn't likely to happen. There have been similar programs enacted in urban areas, under the auspices of reducing urban blight. So it might be that some local municipal housing agencies attempt such a thing.

By the way, while I doubt the Frank/Dodd proposal helps much in terms of housing prices, it probably will help in terms of certain sub-prime securities. As I said above, banks will most likely transfer the worst of their loans to FHA under the proposal, i.e., the ones they securitized. Most of the A and BBB-rated sub-prime bonds from 2005-2007 are toast anyway, but the senior stuff trading at 50% of par could see some significant benefit. Too bad it'll be too late for Ambac and MBIA...