Houston, we’ve got a disconnect.

Housing to the moon!

It’s no surprise to most readers, but banks are finally figuring out that which was already extensively investigated and reported on by SoCal bubble bloggers; that the primary determinant of foreclosure is not the point at which the buyer purchased the home, but rather all of the “wealth harvesting” that was done via refinancings and second mortgages.  Nowhere is this more prevalent than in Orange County, it seems.  Most of the area’s extravagent showings of wealth were actually extracted from home equity.

A recent study by CSU Fullerton with assistance from Fannie Mae has linked the correlation of cash-out refinancings with foreclosure.  The main takeaway:  Homedebtors who are now in foreclosure are not victims of circumstance (the prevalent thinking in Washington), but rather victims of their own selfish and greedy tastes.

The Wall Street Journal has some a great summary up by Nick Timiraos.

Michael LaCour-Little, a finance professor at California State University at Fullerton, looked at 4,000 foreclosures in Southern California from 2006-08. He found that, at least in Southern California, borrowers who defaulted on their mortgages didn’t purchase their homes at the top of the market. Instead, the average acquisition was made in 2002 and many homes lost to foreclosure were bought in the 1990s. More than half of all borrowers who lost their homes had already refinanced at least once, and four out of five had a second mortgage.

The original loan-to-value ratio for these borrowers stood at a reasonable 84%, but second and third liens left homeowners with a combined loan-to-value ratio of about 150% by the time of the foreclosure sale date.

Borrowers, meanwhile, took out around $2 billion in equity from their homes, or nearly eight times the $262 million that they put into their homes. Lenders lost around four times as much as borrowers, seeing $1 billion in losses.

“[W]hile house price declines were important in explaining the incidence of negative equity, its magnitude was more strongly influenced by increased debt usage,” writes Mr. LaCour-Little. “Hence, borrower behavior, rather than housing market forces, is the predominant factor affecting outcomes.”

What happened in SoCal over the past few years has been tragic, not only because of what happened to families, but rather that it was a tragic waste of human abilities; a misallocation of our skills into a non-productive asset.  Rather than investing time and capital into a productive enterprise, it was wastefully fed into a giant Ponzi scheme.

Unfortunately, old speculative habits die hard, as is evidenced by the dearth of investment-worthy housing in the midst of a sea of WTF asking prices.

Now that the goose that laid the golden egg is killed, cooked, and finding its way through the proverbial lower intestine of our financial system, wealth will need to be made from something other than housing.  Here’s to hoping it’s something that actually produces value for our company.  However, considering the loose monetary and regulatory policies that are still written in stone, I wouldn’t hold my breath.

There is serious potential for federal crowding out of private enterprise.  That was one of the reasons that the Great Depression lasted as long as it did.  The federal stimulus was so unevenly applied that it distorted natural incentives.

Here’s another visualization of part of the problem (added later).

California recently took the steps to reduce government deficits by raising taxes:  1% on sale tax , and raising income taxes.

It doesn’t seem that this worked out too well.

From the information that came out, California is pretty much KlusterF*(ked. With a kapital K.

From the May 09 Summary from the state controller’s office.

Compared to April 2008, General Fund revenue in April 2009 was down $6.3 billion (-39%). The total for the three largest taxes was below 2008 levels by $6.3 billion (-40.3%). Sales taxes were $452 million lower (-50.9%) than last April, and personal income taxes were down $5.7 billion (-43.6%).

That’s gotta hurt.  This recession is going to make things even more difficult.  California is wanting to start talking about legalizing pot.  Some ideas have been floated of putting a $50/oz tax on recreational use.  Nice.  At this point, California needs to do something big.  Look to have even higher taxes and even more people leave if they do.

THE fundamental causes of this recession, unique in the experience of the United States, were mortgage defaults and the consequent insolvency of major financial firms. These insolvencies, and especially fear of them, damaged normal credit mechanisms.

The self-correcting nature of markets will ultimately prevail. We should not underestimate the power of monetary policy; with the sharp increase in the nation’s money stock starting in September, monetary policy is now extraordinarily expansionary. I believe, though without great confidence, that the recession will end in the second half of this year.

Federal policy is damaging the economy’s prospects. It fails to provide the needed tax incentives for investment in factories and equipment, incentives that were central to efforts to revive the economy during the Kennedy-Johnson era and under Ronald Reagan. But government spending can’t lead the way to sustained recovery, because its stimulating effect will be offset by anticipated higher taxes and the need to finance the deficit.

I, of course, agree with this assessment (although I believe the recession could linger quite a bit longer due to the current political response). There are 2 fundamental problems with the current administration’s approach:

1. Changing the rules of the game only makes sure players will wait until they are clear on what the new rules are before they begin playing again.

2. History has told us (even though we have deflation now) that a strong increase in the money supply is inflationary. The lag time between the money creation and the effects to rising prices is measured in years, not months.

In the end, a more moderate monetary approach, with the INCREASE in foreclosures, and expedition of foreclosures and bankruptcy will speed the recovery that much faster. It’s the difference between ripping the bandaid off (which is what free markets do to minimize pain) and slowly pulling it off.

We can’t forget that FORECLOSURE AND BANKRUPTCY ARE THE SOLUTIONS, NOT THE PROBLEM.  The problem is too much debt, and the only way it can be resolved is the legal resolution as quickly as possible.  All attempts to forestall the solution are forestalling the recovery in our economy.  Once people are no longer held captive to bad bets, their discretionary income can once again be released and well-run businesses can capitalize on the demand.

A quick and useful synopsis of the problem can be found in a small regional paper from Neuces County.

In one of history’s more candid reflections, Henry Morgenthau, Jr., Treasury Secretary under President Franklin D. Roosevelt, confessed, “We have tried spending money. We are spending more than we have ever spent before and it does not work.”

Just six years after crafting the New Deal, Morgenthau declared that their efforts to create jobs and restore America’s depression-ravaged economy by expanding the federal government to unprecedented levels had been a failure. By Morgenthau’s own assessment, the New Deal saddled our country with “as much unemployment as when we started…and an enormous debt.”

More than 75 years have passed since FDR signed the New Deal into law, and many noted economists are studying the Great Depression and trying to learn from the experience. In 2004, a team of UCLA economists concluded that the policies of the New Deal, which suppressed competition and kept unemployment in the range of nine to 16 percent, actually prolonged the Great Depression by seven years.

Amity Shlaes, an economic scholar and Great Depression historian, has argued that the sheer “arbitrariness” of the New Deal actually exacerbated the crisis.

The crux of the problem is that once you start arbitrarily trying to assign a value better than the collective wisdom of markets, you create a process of compensating factors.  Yes, markets will react only temporarily to any stimulus and will eventually revert to its given path.  Any stimulus will have been wasted.

Yes, payments to “new homeowners” is an arbitrary effort, almost all of whose profits will go to homebuilders (who led us into this mess with overbuilding due to overstimulus) and bankers (who also led us into this mess with overlending due to overstimulus).

I will state categorically that from an economic standpoint, the best thing for the federal government to do is to spend its money on permanent solutions to permanent problems.  Trying to prop up housing prices only leaves us further in debt and beholden to our own currency.  This will not end well, and is getting worse with every dollar given to the Federal Government.

I am outraged at President Obama’s approach.  Unfortunately, it appears that we will have at least 4 more years of unmitigated idiocy, this time aided and abetted by our own Congress.  There is no incentive in America to work hard, do what is right and pay your bills.  Indeed, it seems, never was there a time where it was more prudent to default than now.  You will get to keep all of your past gains, and the government will continue to fund your gains in perpetuity. I’m frankly disgusted that my tax money is going to scum-of-the-earth bankers and homebuilders.

We could really do well to take our tough medicine now and get it over with so we have some growth.  Instead, we have special interests running this country with threats of financial terrorism (give me billions or I’ll blow up your economy and myself) and an out of control President just weeks after taking office.

I’ll give the President a suggestion:  Give me the money and I’ll find a better way to use it.  I’ll set up a bank that will RIGHT NOW hire people, lend to people at below market rates AND make shitloads of money all at the same time.  This absolute garbage of giving current banks TARP money was from the beginning doomed to failure.  I’d like to have loans at 0% that I can then compound 10 times and sell on the open market at 4.5%.

President Obama, I’m ready.  I’m willing.  Just give me the money.

PS, if I happen to take the money and skip town, chalk it up to learning a lesson about giving billions to an anonymous internet blogger.

The funny thing is, I remember less than a year ago, discussions about how Freddie Mac and Fannie Mae were well capitalized, preeminently prepared for any disaster, and frankly, as unsinkable as the Titanic.  Little good that has done.  We may be witnessing a historic crash of epic proportions, greater by far than the crash we have seen to date.  To put it in perspective, FRE and FNM have pretty much been the only thing that have kept the real estate market together in the US over the past year.

Consider for a moment this statement regarding the mortgage insurance statistics from the GSEs.

There are more hard numbers available to support MI’s recent surge. MICA, the trade association representing the private mortgage insurance industry, began reporting rising volume monthly after February 2007. For example, mortgage insurers wrote 190 percent more business this year, through April, than in the comparable period of 2006, when subprime/Alt-A were in their heyday.

To put that sort of gain into proper context, consider that even GSE production is only up 160 percent — and they are doing an estimated 80 percent of all new mortgage lending. By inference, MI providers have made huge gains in market share.

Let that sink in for a moment:  GSEs are doing an estimated EIGHTY PERCENT of all mortgage lending, up 160 percent.  IN AN ACTIVELY FALLING MARKET.  Any implied “worst case scenario” imagined last year of the US government bailing out the grossly irresponsible GSE lending facilities is quickly not only becoming a reality, but would represent a necessity unless the entire lending business  in the US becomes STATE OWNED.

State owned lending?

Is that such a bad idea?  I mean, we pretty much have so many controls that we expend an enormous amount of government money in oversight, what’s so wrong with giving the federal government the right to nationalize the largest lenders as they fail?

I’ll write the next part only partially tongue in cheek.

Lending is perhaps one of the great debatable rights of Americans in the 21st century.  We have become so conditioned by its availability to believe that it is owed to us.  We need it, we want it, we should have it.  If we want to create our own financial ruin, and by extension the country’s entire financial ruin, we should be able to do so.  It is our right as Americans.  By this rationale, we should allow all Americans the right to open access to low-cost lending much like clean air, clean water, food and drugs free of harmful contaminants, and an interstate transportation system.

For example, if free enterprise were required to finance our transportation systems, we would be required to pay for every trip we consume on local and long-distance roads.  This is where economics has a hard time playing the role of moral coach, because, frankly, Economics is concerned with the free market and the most efficient method of delivering the utility people desire.  Governments have typically only concerned themselves with PUBLIC NEEDS.  Therefore, the big question is, is real estate lending a PUBLIC NEED?

I am certain that many could make the argument for and against, but perhaps the question needs to be viewed in a longer timeframe.  Is lending STABILITY more important as an ongoing public need to ensure the ability to liquidate lending and homes in an orderly manner?  What controls and insurances should the government provide?  How should the government handle lending standards and manipulation?  Could there be a cross-control against lying using collaboration with the IRS?  What kinds of manipulations would this open up the home lending business to?  Would the government “crowd out” any potential competitors and therefore stifle competition?  Has the current role of home lending harmed the public more than it has helped?

In any case, the general public perception is that home lenders have harmed America, and therefore must be harshly dealt with.  I don’t agree with that.  I personally believe that the problems is on its way to being fixed by the free market, and frankly I’m not happy with the directors of the GSEs getting away with fat pensions, stock options, and the like while the public swallows the bad debt.  On the other hand, it would end, once and for all, the deceptive practices and level the playing field by nationalizing lending.  Frankly put, the government could recapitalize easier than a private entity or a stock-owned entity.

I have to say that I oscillate between incensed outrage and cold acceptance of the reality.  There is no simple answer to that.  Lending has changed forever (hopefully).

1. It seems that Bank of America essentially wrote the Dodd Bailout Bill along with Countrywide (merger expected soon). They have probably the most to gain with a generous bailout bill. It helps noone since it doesn’t resolve the fundamental problem of affordability in house, in fact it makes the problem worse. Ever wonder why the 90′s in Japan were referred to as the “lost decade”? It’s because their banking system did the same thing we’re trying to do here. Anyone else see the problem with not punishing gambling banks and housing speculators?

2. The “Subprime Six” were a group of lawmakers given special treatment in exchange for what? What exactly did Senator Dodd besides favorable treatment in his housing financing? What else could be lurking in his past? If you haven’t read about the “Subprime Six”, follow the link. Investor Business Daily, the Wall Street Journal, and the LA times have picked up the story. It’s a story of insider grift and political pandering. If it weren’t so real and true, it might remind me of one of my favorite film lines:

Stuart: Well, it’s a well-known fact, Sunny Jim, that there’s a secret society of the five wealthiest people in the world, known as “The Pentavret.” Who run everything in the world, including the newspapers, and meet tri-annually at a secret country mansion in Colorado known as “The Meadows.”
Tony: So, who’s in this “Pentavret?”
Stuart: The Queen, the Vatican, the Gettys, the Rothschilds, and Colonel Sanders before he went tits up. Oooh, I hated the Colonel, with his wee beady eyes and that smug look on his face. “Oooh you’re gonna buy my chicken, oooh…”
Charlie: Dad? How can you hate the Colonel?
Stuart: Because he puts an addictive chemical in his chicken that makes you crave it fortnightly, smartass.

3. For all of the crap that our President Bush gets, at least he has the foresight to threaten a veto to said bill. There should be no bailout, not just because it’s not fair and would embolden speculators, but because it’s destined to put our banking system in jeapordy for the forseeable future with taxpayers footing the bill. It’s generally understood that this bill has to be done and voted on by July 4th if it is to carry. Any senator that signs this (if it passes) is hopefully going to be thoroughly trounced in the upcoming elections. This is not only unreasonable, it’s unamerican. This place is going to hell in a handbasket. If something like that goes through, I’ll be posting a list of every person that voted for it and their political affiliation here as a feature story.

So, what do I recommend? I’d say get a year’s worth of food and 6 month’s worth of remaining expenses together, if our politicians have any say in it, this is going to be one whopper of a crash and accompanying recession. On the lighter side of things, our grandchildren will be still paying so that people like this can “keep” their homes (and by homes, I mean plural, because, isn’t every good American not just entitled, but guaranteed to own more than one house?).

from Interest Only – Creative Financing or Harbinger of Deflation?

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The economists over at Elliott Wave have a great write up about deflation and what causes deflation in a piece titled “What is Deflation and What Causes it to Occur?”

All deflationary periods were marked with the following conditions:
(a) All were set off by a deflation of excess credit. This was the one factor in common.
(b) Sometimes the excess-of-credit situation seemed to last years before the bubble broke.
(c) Some outside event, such as a major failure, brought the thing to a head, but the signs were visible many months, and in some cases years, in advance.
(d) None was ever quite like the last, so that the public was always fooled thereby.
(e) Some panics occurred under great government surpluses of revenue (1837, for instance) and some under great government deficits.
(f) Credit is credit, whether non-self-liquidating or self-liquidating.
(g) Deflation of non-self-liquidating credit usually produces the greater slumps.

From the article: “Self-liquidating credit is a loan that is paid back, with interest, in a moderately short time from production. Production facilitated by the loan – for business start-up or expansion, for example – generates the financial return that makes repayment possible. The full transaction adds value to the economy.”

Credit lent against homes are most definitely non-self-liquidating credit. Unless, you count the opportunity cost of renting as a form of liquidation – however this requires there to be some relationship of rents to monthly payments; something that can’t be said of current market. The relationship of these nonproductive asset backed loans to productive asset backed loans, it would seem is at its peak historically.

Reading this type of semi doom-and-gloom scholarly article makes me think about the many types of financing recently available to the public masses and what impact they might have.

It takes a bit of economic sense to understand a risk premium. A risk premium is an additional amount that a lender expects to compensate them for additional risk. If risk is considered great either a high risk premium is attached or sometimes a transaction cannot take place. We currently have some of the lowest risk premiums in history; interest rates on non-productive assets are at historical lows.

Typically, a lender requires that at some point, principal on the note must be paid back. Interest only loans are an exception to this. Why? And, why have they become popular now?

It’s easy to see why a borrower would want to take on one of these loans; why pay for something now if I can pay later. But, what’s more interesting is why are they so popular for lenders?

Human beings are a fickle bunch. Each one wanting to do something different than the other. Like watching an ant, it runs to and fro, sometimes lost, sometimes productive, but always unpredictable. But, take a step back, and the anthill is an extremely efficient, coordinated jumble of activity. A very predictable bunch. Human financial systems are similar. Each borrower is very unpredictable, but bundle a few thousand together and they suddenly become more predictable; hence the popularity of Mortgage Backed Security Bonds (MBS’s).

BUT… and you knew this was coming… you need to take even a step back to see what is going on in the macro environment. Who has all of this money, and why are they lending it at such low rates. A flat yield curve would signal that lenders see little reason require a larger risk premium for longer-term loans because they expect long-term rates to be about where they are far into the future. How often is the bond market right? Well, that’s for you to decide. Greenspan has even named it a conundrum.

So, this brings me to the title of my post. How could interest only loans signal possible deflation in the future? We already know that low-interest rates can be a signal, but what about creative financing?

Interest only loans cannot be self-liquidating in the short run. When they switch to a liquidating (fully amortized) loan, the payments jump substantially because they do 2 things at once: 1, they begin fully amortizing 2, they adjust to prevailing interest rates. One would expect that people faced with these issues would simply replace the shorter amortizing period with a longer amortizing period at the same rate. Or, they would attempt to liquidate the loan by selling. Since interest-only loans are not self-liquidating in the short run, the bond market is signalling that for the medium-term, interest rates and returns will be low, or that investors are extremely risk-averse to the stock market. The investors feel justified that any possible deflation is offset by the Fed’s moderate inflationary policy, or at least an attempt to prevent deflation. So, MBS investors have signalled that for the medium term (3 to 10 years), that they would rather take their chances with low interest rates AND non-liquidating debt.

Will this truly end as Greenspan has put it? I will leave you with one of his most famous statements on the subject:
“But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums.“

Remember, I stated:

The other is the physics of a forgiveness. Like Newton’s third law of physics, for every action there is an equal and opposite reaction. If Banks believe that they can lose up to 20 or 30% of the value of a home, they will begin to require borrowers to “self insure” by raising collateral requirements to mitigate their new risk. They will also likely offset the risk through higher risk spreads translating to substantially higher rates with stricter requirements for credit worthiness.

Bloomberg quoted the following:

We could not imagine that the policy response would be to pour napalm on the fire,” said Julian Mann, who helps manage $3.4 billion of bonds at First Pacific Advisors LLC. “I’m going to demand higher and higher rates” to buy mortgage debt if the collateral is altered, he said.

Go Julian.

BTW, banks will get their pound of flesh one way or the other.  The only thing left is for the government to start making housing payments for people.  I’d like a little of that action.  My rent is breaking me here in OC.  I’d also like to take a heloc out against my rental, go to Hawaii, buy a Hummer like my a-hole neighbor and have it paid off by the other taxpayers too.  Only, I realized that as a renter, I pay higher taxes anyway… D’Oh.

I guess the only logical conclusion left is to revert to anarchy if that happens.  I’ve been looking around for a good MAK90 like I used to have in college.  It’s hard to believe how much they’ve gone up in recent years.  Good ole Chinese manufacturing practices.

1. I feel that a seemingly arbitrary limit of access to credit imposed based on a nationwide median price is unfitting for high-cost and high-income regional areas.

2. Affordability is the issue, and indeed, I feel it should be addressed. I would rather see a local median-income based payment cap, along with mandated dti (debt to income) ratios.

3. Even by expanding the current set of available products won’t help the already under water homeowners, nor does it change the economics of the rent/buy equation.  Basically, it has little or no impact to the bubble.  If you can rent long-term in a high-priced area, why shouldn’t you have access to credit?

4.  The bubble was created by speculation and “affordability products”.  While nothing occurs in a vacuum, the bubble is not going to be reinflated without new affordability products and lax lending standards; something that is not going to happen in this environment.

5.  Indeed, I believe that like many speculators caught up in the positive frenzy of the real estate market, it is easy to be caught up in the pessimistic view as it tumbles.  One sign of the bottom is when everyone agrees that the product is no longer worthy of investment, and to be shunned.  We still have a long way to go, but there is no reason to overblow the risks and rewards.

In the end, creating more access to credit does not translate into overpriced homes.  Most of the problems created have already been solved in the debt market; a return to sane underwriting is already underway.  The pricing of housing is inconceivably out of whack, but will plummet for the next 2 or 3 years as the imbalances are worked out.

Besides, the current jumbo market is in disarray, adding sane underwriting to that market while not increasing the GSE’s limits can provide competitive air to the otherwise broken market.

This is not to say that it won’t have its faults… with a limited amount of funding going on, the GSEs will likely need to ration the available funds.  Price, however, is most often the best rationing device one can create.  Any way you look at it, the bubble has burst, nothing will change that.  In case you haven’t noticed, I’m not left-leaning that I believe everyone should be able to afford a house.  For many people, they have no propensity to be natural caretakers for an asset as costly and long-term as owning real estate.  Many of those people are already in homes they can barely afford, or worse, dashing their credit on the rocks of the “American Dream”; which up until 30 years ago was about starting their own business and succeeding financially, not owning a home.  Consider how far we have strayed from the path of free enterprise.

I believe a lot of that timing will come from Bernanke’s will to crush the housing bubble. If he doesn’t, it’ll be a long time before we can get well again. We need to take the tough medicine.

I always enjoy a discussion of how the mortgage mess that we find ourselves in can be “fixed” by using nontraditional methods.  For each of the parties arguing the solution, it often involves directly benefitting them, while the cost is to be borne by another group… “the marks”.

Mike Shedlock’s analysis of the CRL (Center for Responsible Lending) and FDIC’s proposed solutions is particluarly interesting.  His post is properly titled “The Debt Slave Act of 2005 Revisted“, which makes perfect sense considering how consumers have effectively been cut off from the one chance to make a clean break after devastating financial problems.  Instead, the newer law attempts to weed out deadbeat habitual spendthrifts from performing frequent and repeated filings to wipe the board clean every few years.  Instead, it has made it difficult enough to file bankruptcy that there is little to no possible way out.  In addition, with pledges to repay, many become debt slaves to past problems, unable to leave them in the past.

Don’t get me wrong, I’m definitely for personal responsibility in life, perhaps even too much; but the law as it currently stands puts a burden on already destitute people.  It has served to benefit lenders most of all.  So, it is with some twisted satisfaction that I read what Mish has to say on the matter… all of with which I agree.

First, he quotes a CNN Money article (shortened excerpt)

One consumer group estimates that 600,000 foreclosures could be avoided over the next two years by making a simple change to the bankruptcy code.

The Center for Responsible Lending (CRL) calls it a tweak, but it could be a significant change for homeowners and the market for mortgage-backed securities.
CRL’s proposal – reflected in a House bill recently introduced – would make changes to the regulations for Chapter 13 bankruptcies, which don’t wipe out debts, but rather establish a repayment plan.

Under current law, when a person files for Ch. 13 bankruptcy, judges cannot reduce mortgage debt owed on a person’s primary residence, although they may modify mortgages on investment property or second homes.

Under the House bill, the bankruptcy judge would have the option of reducing what the homeowner owes the lender. Say a homeowner’s property is worth less than what he owes. The judge could reduce the principal to match the home’s current market value as well as reduce the loan’s interest rate.

Mish also quotes the FDIC’s proposal:

The heat on U.S. mortgage lenders and servicers was turned up a few degrees this week when the country’s chief bank regulator publicly proposed that they permanently freeze interest rates on subprime adjustable-rate mortgages (ARMs) for many homeowners.

“Keep it at the starter rate. Convert it into a fixed rate. Make it permanent. And get on with it,” Federal Deposit Insurance Corp. Chairman Sheila Bair said in prepared remarks at an investor’s conference.

That solution is nearly as bizarre.

Now, before too many of my readers go off on rants considering how this is supremely unfair… consider 2 things:  first, if balances on loans can be decided in a court and lowered as a judge feels inclined, how many banks will want to loan money, and secondly consider what Mish has to say regarding “fixing” the ARMs:

It should not take a genius to figure out that if ARMs rates are “frozen” at a point where the market does not think rates should be, there simply will be no more ARMs offered. Furthermore, to cover the cost of existing ARMS, prices would rise on new fixed rate mortgages. Oddly enough, price fixing ARMs would not even help the person most at risk because that person cannot afford the teaser rate, let alone the cost of a current ARMS rate. Thus price fixing ARMs is a sure fired guaranteed way to cause a continued weakness in home prices, if not an actual out and out crash.

Which reminds me of the original Chuck Ponzi Law of Unintended Consequences:

If there is any chance that someone can get bailed out by someone else, they will, and you will have to pay for it from your own pocket.

Now, I’m considering that I have to add that while you may need to pay for it, anything other than letting the market deal with it efficiently will likely crash it anyway.  In the end, it is the same thing that my first Econ professor in college always said was the #1 rule of economics:  TNSTAAFL “There’s No Such Thing As A Free Lunch”.  No such thing.

I am willing to bet that any artificial means of attempting to “solve” the problem will only make it worse, both for the person they are trying to help, and the overall group of people.  The only people helped by the above solutions are those who have ALL of the following:

1. Long histories of repayment
2. Excellent credit scores
3. Lots of cash for a down payment, maybe up to 30 or 40% to prevent bankruptcy write-downs
4. Enough income to support purchases on fixed rates with lengthy work history.

This way, only the most qualified can purchase.  At current prices, there are likely only 1 to 2% of the people in the entire Southern California region who could fit this bill for an average home.  And, frankly, there is no way these people will live in an “average” SoCal home.  Imposing the suggested “solutions” will only serve to do three things:

• Depeen the credit crunch
• Crash the housing market
• induce a consumer-led recession, if not depression

The deeper the credit crunch, the harder and farther housing prices will have to fall to meet demand.  The harder and further prices fall, the more likely that good paying homeowners will walk away from an underwater mortgage.  More foreclosures dropping prices and deeper credit crunch will turn off MEW (Mortgage Equity Withdrawals) which is what has been keeping the consumer (along with their credit cards) in clothes, vacations, and Plasma TV’s.  A crumbled consumer is a crumbled economy.

When the service on debt becomes more than the income, defaults are certain.  Since US wages have been in real decline (against inflation), and the US dollar in severe decline, the loss of purchasing power has become an unbelievable crush.  Anyone who has not felt and seen the substantial inflation over the past 2 years has either been asleep or dead.  Even high-end wage earners have felt the sting of higher prices.

All of this leaves me very pessimistic about the local economy that has been so built on the fortunes of real estate.  I fear we may have much, much worse things ahead of us compared with the past few months.

“This vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent… But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low-risk premiums.”

While he didn’t do enough to prevent asset bubble from forming, at least he understands what the aftermath does.  “newly abundant liquidity can readily disappear”.

It reminds me of a post I made back in the heady days of September 2005, Greenspan’s Interesting Clarity.  Yes, nearly 2 years of blogging ago.

Where does this lead us? Well… we’re acting a bit like the japanese in our debt lending by accepting low risk premiums, and the longer this goes on, the greater the risk to all participants, lenders and borrowers. If liquidity were to be suddenly shored up by investors demanding a greater return for thier risk, or if percieved risk were to suddenly jump, borrowing would become much more difficult for buyers. Interest rates will increase accordingly. Even established buyers might not be able to purchase homes due to restricted risk premiums; all of which will only serve to slow the real estate market and put the power of purchasing into well qualified buyers.

It has been my assertion that the housing bubble was caused not by low interest rates, but by excess liquidity that banks could only farm out by lowering lending standards. It was this easy credit that was extended to a whole set of the population that had never before been entrusted with credit; this caused “neverending” demand. Much like college students that max out their first credit card, only to find that the payments exceed their income, many of today’s buyers will be unable to make payments in the future.

Our little “deflationary concern” may soon turn into a financial meltdown since problems tend to spiral: Increases of forced sales trigger lower prices, which triggers lower spending and more foreclosures; lower spending triggers more layoffs; foreclosures trigger financial losses for banks and MBS holders; financial losses triggers less liquidity; less liquidity triggers higher interest rates; which triggers more defaults on ARMs and HELOCs… the list of effects could go on forever. Our economy is increasingly dependent on house price appreciation, but 2 things keep these trees from growing to the sky.
1. Credit has limits, since some risk premium must be attached to borrowing money, and interest must be charged. Investor sentiment is everything here.
2. Even a leveling off will decrease construction jobs that will kick-off the above process, so increasing growth is necessary to keep the merry-go-round going.

As you can see, it is easier to predict WHAT is going to happen, opposed to WHEN it is going to happen.  It was surprising to me that the housing boom ended with a consumer-led paring back of purchases, as I had expected the lending environment to tighten considerably before it did.  What this likely means is that while it postphoned the inevitable crash, it will likely only amplify the severity of the downturn.  As they say, the bigger they are, the harder they fall.

However, not trying to be a Monday morning quarterback, but had the FED raised rates twice more as I had hoped they would, they would have had an additional half-point lowering room when the credit event happened.  The fact that they did not either says that they did not understand the extent of the credit market’s problems and attendant risk mongering, or they simply believed (and perhaps still do) believe that the credit markets can self-correct without affecting unemployment, or currency attractiveness.  It may be that with the weakness exhibited by the currency, Ben B. should likely be raising rates when the world is calling for cutting them.  It’s always easier to get out in front of the problem than cleaning up after the mess, but when has the Federal reserve done that since Paul Volker?

In the first quarter of this year, roughly one of every 41 subprime loans was entering foreclosure, and more than one of every six were delinquent, according to the Mortgage Bankers Association. Those are the worst mortgage default statistics since the Great Depression. And it’s likely to get worse because the 2006 crop of mortgages, which will start resetting next year, were of a particularly low quality. Many carry prepayment penalties and could reset by as much as 5 percentage points when they do adjust.

Good thing it’s “contained”, right?

Bad Weather, unseasonably good weather, or just the housing slump.

Either way, consumers are pretty much maxed out, as Market Watch tells us. None of this is surprising in light of the ongoing credit contraction and reduction of MEWs going on in the credit markets.

I highly recommend a good read of Barry Ritholtz’s take on “Retail Sales = Hard Landing?”

One of the early casualties of the downturn is Tweeter Home Entertainment who yesterday announced a possible bankruptcy filing and whose stock has dropped from over $8 to currently trading at $.35 over the past year. I surmise we haven’t seen the last of retail pain in this recession.

New Century is now Old Century and some such garbage.

New Century announced that 2000. Yes, 2000 employees will be severed tomorrow (no, not their limbs, just their jobs).

From Forbes:

Financially strapped subprime mortgage lender New Century Financial Corp., failed to receive any bids for its mortgage loan origination business, forcing it to shut down the unit and lay off around 2,000 employees, the company told employees Thursday.

The Irvine-based company, which has been preparing to sell off its assets under Chapter 11 bankruptcy protection since last month, notified employees during a conference call that they would be laid off effective Friday.

Speaking on the call, New Century President and Chief Executive Brad A. Morrice said despite a number of potential buyers for its wholesale and consumer-direct operations, “none of those potential deals have come to pass.”

Just who those original “suitors” were remains a mystery to the outsiders. I remember clearly the day that it was announced that 6 companies had thrown their hats into the ring. I guess there was a realization that little to no value remained in that portion of the business. Of course, not all is lost, the servicing arm has already lined up buyers.

It’s good to take a look back at how hopeful that really was. Irrational Exuberance?

Interestingly, last night, my wife made me watch American Idol. One of the departing contestants (I don’t know or remember who) sang the Bon Jovi hit “Blaze of Glory”.

Therefore, I dedicate this video to New Century:

No I aint looking for forgiveness
But before I’m six foot deep
Lord, I got to ask a favor
And I’ll hope you’ll understand
cause Ive lived life to the fullest
Let the boy die like a man
Staring down the bullet
Let me make my final stand

The suit, filed in Florida by Bankers Life Insurance Co., is “one of three to five in the pipeline” involving securitizations by Credit Suisse, Switzerland’s second-largest bank, said Dale Ledbetter of Ledbetter & Associates P.A., one of two law firms representing the Bankers Financial Corp. unit.

“We suspect that once people understand what occurred here, there’s going to be a lot more,” Ledbetter said. A total of $302.6 million of bonds were originally issued in the deal.

I concur. Once people understand the implications, the flood of lawsuits will make even the security packagers wary to get involved. Nothing like a little risk in the system to flush out the bad blood.

What are the charges?

Credit Suisse units caused Bankers Life to lose money by overstating how much of losses after foreclosures on the loans insurance would cover; accepting “shoddy, inferior” loans; failing to buy back fraudulent ones; and covering up delinquencies, according to a complaint filed April 23 in Tampa. Payments were being advanced on borrowers’ behalf to “maintain the illusion” defaults weren’t occurring, Bankers Life claims.

Whoah. If true, noone will touch a Credit Suisse bank with a 10 foot pole. Those are some heavy accusations of outright fraud for a company whose livelihood is based on trust in their products.

The natural question asked would be… but Chuck, haven’t you been telling us all along that many of these securities are sold with default insurance when they are packaged? I mean, insurance companies are willing to accept lower returns as long as it is guaranteed, after all state insurance commissions won’t allow risky investments, right?

Good point, readers, except in this case, the insurer denied the claim. Didn’t think that could happen? Think again:

Triad, which provided both loan and pool insurance, failed to pay claims for default loans because it claimed they were fraudulent, without responding to Bankers Life’s requests for more information, the complaint said. Bank of New York failed to report when the claims weren’t being paid, Bankers Life says.

The insurer also claims Credit Suisse misrepresented that the loans were from “highly credible financial institutions” when they were made by smaller lenders; put adjustable-rate loans in pools that borrowers couldn’t later afford; and didn’t pursue foreclosures and insurance claims appropriately.

The next question is the best… will we see any cross-defaults when more of these surface? If so, hold on for the financial ride of a lifetime… it’s gonna be a doozy.

Luckily, the guys over at Wharton (which, surprisingly have more credibility than some anonymous guy with a blog) have given the media world some soundbites to play over and over again.

We began speaking of Moral Hazard once the downturn started.  When you fix someone else’s problem, you create an incentive for that person to do the thing that caused the problem… they’ll just get bailed out again.

From Wharton’s school of Business:

“I think that for the moment, they should probably leave it alone,” says Joseph Gyourko, professor of real estate and finance at Wharton, warning that bailouts can make people more reckless in the future. “We don’t want to introduce moral hazard …. We don’t understand this very well right now, so any regulation is probably going to be wrong or imprecise.”

In fact, he says, the market is already correcting the problem. Lenders have dramatically cut their offerings of the most hazardous products –such as loans that require no down payment or proof of the borrower’s income, or those which allow borrowers to decide for themselves how much to pay each month.

Ken Thomas, a lecturer on finance at Wharton, argues that people and institutions that make risky choices are usually best left to suffer the consequences. “When we had the last big financial meltdown with stocks in 2001, did we consider bailing out those who lost money in the dot-com crash?” he asks. “We try to have markets regulate, not the government. Markets do a much better job.”

What we are seeing right now is that the markets are reacting to better information than they previously had.  Like Newton’s 3rd law of motion:  For every action there is an equal and opposite reaction.  In Economics, we say “There’s No Such Thing As A Free Lunch”

Besides, who would a bailout help?  Certainly not homeowners.  How could you weed out who where truly in trouble, and who were opportunists?  Wouldn’t that saving create a need that you would later need to feed?  What about my free lunch too?  Would I (as a taxpayer) need to pay for someone else’s indiscretion?  What about the money I lost in the stock market in 2001, can I get a refund there too?   For those subprime homeowners… many of them came to the table with bad credit and no cash.  So, they’re leaving with bad credit and no cash, is their life that much worse off, and is that our collective problem that they cannot manage money?

On the other hand, lenders wouldn’t lose a penny.  They were the ones who recklessly took risks and offered the loans to the higher credit risk for a higher return.  A bailout would only serve to line their pockets for taking outsized risks.  There’s a reason that it’s called risk in the first place.

Dodd, chairman of the Senate Banking Committee, plans to introduce legislation to protect homeowners from foreclosure and to crack down on predatory lenders who pushed high-risk loans on unsuspecting borrowers. Clinton is pushing for a federally mandated “foreclosure timeout” that would give homeowners more time to catch up on their payments, and she wants to curtail the prepayment penalties that make it hard for troubled borrowers to refinance. The National Community Reinvestment Coalition wants the Federal Housing Administration to be given new power to refinance subprime borrowers’ loans, and it wants the federal government to set up a fund for rescuing low-income homeowners.

Senator Dodd, you are treading on thin ice.  Be careful where you step.  The next one could be the wrong one.  Nothing like a good scandal to end one’s political career.  We all know you’re in bed with the financing organizations… all it takes is one false step.

Would you just love to stick something in their face that breaks it down scientifically and proves them all wrong?  Something that shows exactly how much these variables changed the cost of living here?  Wouldn’t you love to get your hands on exactly that piece of information?  Wouldn’t you love to prove in graphs and numbers that the variables they just mentioned had little to no effect on prices, while it was exactly the proliferation of ARMs that did it?

Wouldn’t you love that piece of work to include formulas such as this:

And written by a professor of finance at a California university? 

What if I told you that exactly such a paper exists that delves into California’s history of home prices discussion that includes a detailed explanation of what caused the home price explosion?  It does exist.

Here’s a rundown of the conclusions:

Well, have I whetted your appetite enough to sit through 30 minutes of mind-tearing edumuhcashun to get to the data behind the pretty little graph I pounded out?

Here it is.

Can you say Ruh roh Shaggy?

Regulators are concerned lenders are issuing mortgages to borrowers with little proof that they can repay their loan and do not fully understand the risk of increasing payments, the document states.

Subprime borrowers could find themselves unable to afford monthly payments after the initial “teaser” rate expires and make payments for taxes and other expenses if lenders do not hold such costs in escrow, the document states.

Subprime borrowers also face the risk of “losing their home,” the document states.

That pretty much describes most of Southern California.  When our affordability dipped below 6%, and much of the wealthy already live here (we’re not attracting a higher percent of millionaires than are already here), the area’s housing will stop in its tracks if documented income were required on a fully amortizing basis.

Dead Cold.

More than 80% of the loans made recently in SoCal were of the adjustable rate ilk, and I’d venture a guess than more than just a smidgen of those are due to affordability of the monthly payment.  Fully amortizing loans are currently touted as stone age devices not worthy of a modern world.  All part of the “it’s different this time” argument that is so quickly spouted by the clueless.  Just look at history if you want to know what affordability is going to look like.  Because, frankly, if the loans of yesteryear are reintroduced, so are the prices.  Incomes have not kept up with basic inflation, much less the out-of-control prices of Southern California.

The positive to all of this speculation squashing is that it will flush homes back to banks and back on the market at reduced prices.  Individuals will lose out, but the overall will be better.  Risk will once again be priced in.

The California Senate bill SB385 has been submitted on the 21st.  We’ll see if it hits any snags… although I doubt it.

According to the Federal Reserve, the guidelines are intended to:
1.  Ensure that loan terms and underwriting standards are consistent with prudent lending practices, including consideration of a borrower’s repayment capacity;
2.  Recognize that many nontraditional mortgage loans, particularly when they have risk-layering features, are untested in a stressed environment. These products warrant strong risk management standards, capital levels commensurate with the risk, and an allowance for loan and lease losses that reflects the collectibility of the portfolio; and
3.  Ensure that consumers have sufficient information to clearly understand loan terms and associated risks prior to making a product or payment choice.

The bigger question is… does it have any teeth, or is this just  another rubber stamp that goes unheeded?  The reality is that much of the lending world is frighteningly unregulated.  I’m all for deregulation, but far too many people are getting stated income, nodoc, 100% financed, negative amortization loans that will never be able to pay the reset amounts.  It amounts to speculation on housing.  Some day the piper will come for them.  That day may be sooner than many think.

What we do know is that somewhere between $1T (Yes, trillion) and $2T of mortgages reset sometime in the next 2 years.  2007 was to be the watershed year on how these bad boys perform.  Never stress tested in a down (or even lukewarm) market?  I might be going out on a limb here, but I’m forseeing a lot more foreclosures than we currently have.  If volume remains the way it is (lowest since 1998) in Southern California, bad times are on the way for homeowners.

It is for this reason that by the time ideas come to print, they are often outdated and decidedly deceptive. Just such a cover comes our way. (Hat tip and thanks to JMF of immobilienblasen, or “real-estate bubble” for non-German speakers, for bringing this to my attention)

The article “It’s A Low, Low, Low, Low-Rate World: Money is cheap. And some experts say it could stay that way for years. That’s creating opportunity—and brand new risks” is here.

This is the cover of the current issue of Business Week:
How accurate you might ask, has the mainstream media been in predicting so far in the housing bubble? Consider, for example, the cheerleading piece Time magazine published in June 2005, at the near exact top of the housing bubble:
Not surprisingly, when you go to BusinessWeeks homepage, you’ll see this little one (the arrows are mine)
If you don’t see the irony in how the 2 issues impact each other, here it is:
1. Rates are low and credit available because there is low percieved risk. Risk is perceived as low because housing prices were rising.
2. Housing prices are supported by low rates and available credit. If rates go up, housing prices will go down. They are “priced to perfection”

Reminds me of something Alan Greenspan said:

Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low-risk premiums.