by Anonymous on 4/28/2007 08:45:00 AM

Our friend Brian sent me a Bloomberg transcript (no link yet) of comments made by Lewis Ranieri at the recent Milkin Institute Conference on financial innovation, subprime lending, and the housing market. Lewis Ranieri, if you don’t know, is generally given a large part of the credit for creating the private MBS market, and would have to be considered, by anyone’s standards, a highly-informed participant in the mortgage credit markets.

Ranieri isn’t a happy camper, it seems, about structural problems in the industry.

Note: This is a rush transcript, not a final one, of oral remarks. I have edited slightly only to remove a few repetitions and asides characteristic of spoken presentations and to correct a few phonetic transcriptions. All my editorial changes are indicated by ellipses and brackets.

People asked, you know, is financial innovation, you know, reaching a stabilization point in housing and I think the last four years shows that's not true. It's been a halcyon period in terms of taking financial innovation and using it to put housing much more deeply into the population. I mean, we've been able to franchise many, many more lower middle income and minority home--individuals into home ownership, over the last four years, than probably, in the 10 or 15 years prior to that.

Unfortunately, we're now facing a trial, which in many ways, I think, will determine how well we can continue to innovate into the future and part of it is [subprime] . . . And we also have the typical regulatory reaction to a potential series of risks, in terms of passing somewhat more restrictive legislation. And some might argue [this] is exactly the point in the cycle where we don't, particularly, need it but I think the real key of navigating through this is being able to deal with what is euphemistically called the subprime mess.

The subprime mess is simply - and first, I think the important thing to understand, is this a creature of a very narrow window. It starts at the end of the third quarter of '05 and carries through, principally, the fourth quarter of '05 and '06. And what it is, is that in those five or six quarters, a series of attributes which were largely in existence already, took on a life . . . of their own and in combination, created risk layering, which on one hand, enabled many, many people to get into housing who might not otherwise have.

And on the other hand, unfortunately, put many, many people into houses they couldn't afford and not simply lower middle income people but combination, the layering, was also attributable to many middle income borrowers. In fact, at - we had a two-day conference in Washington yesterday, which was called the Housing Round Table. It's all the participants in housing and we get together three times a year and at that there was an argument from a number of the economists in the room.

As I said earlier, we're in a housing recession but more importantly, they argued that looking at the production, the subprime production, in those five or six quarters that as much as 50 percent of that production could have gone to the agencies, meaning, Fannie, Freddie and FHA. That's a pretty profound statement because a subprime loan is, at best, [an] eight plus coupon.

And usually, there's a second mortgage with a 12 coupon, so you're talking about an average coupon, a little bit over nine and you know, an agency piece of paper would've been a 6.5, so if you translate that into what he said, in another way, he was arguing that half these loans, the homeowner could have been put into a coupon at 6.5 versus 9.5 and that led to the question, the 800-pound gorilla in the room we dealt with, is the system broke?

Is there a problem, you know that it's not simply a function of normal economics but is there a break in the system, you know, what is the responsibility of the system to deliver . . . the appropriate, you know, housing finance structure? The real dilemma for me and I think the real issue . . . will be, we've never had to do substantial restructurings in housing in mortgage securities.

They were always in portfolios, and that made it very easy or at least, we didn't have to get 409 people or we didn't have to rent the Nassau Coliseum to have a bondholders meeting; we could do it very quickly. The vast majority of these loans, all of these theoretically, problem loans, are in securities, which have been tranched and then tranched and then re-tranched . . . [in] mortgage securities and then some tranch is put in CDOs. In a very long meeting, last Monday, where we tried to collect virtually everybody in a room, it became evident that there are a whole host of unforeseen technical problems if you try to restructure or do large amounts of restructuring within the security, some of which, we had never even heard of or thought about.

One of the accountants - you know, it will not be unusual, in some of these pools to have to restructure a third or more of the pool and we only have four [big accounting] firms and we had three of them in the room and one of them raised his hand and said, well you can't do that. If you restructure that many loans, you're going to taint the Q election and FAS 140 and what he was basically saying in English for the rest of [us] poor fools, was that there is a presumption when you - when a bank sells loans, into a securitization that it sold the loans . . . And what he was saying is wait a minute, if you guys can restructure all these loans without going back to bondholder, you obviously have control and you've just tainted 140 and Q election.

Boy that was a big deal and I'll use that as a simple example of one other I'll give you, is the ability to put everybody in a room, even if you could find them all and get their assent, is slim - I mean it's not very practical.

Well, wait a minute; we have to restructure the loans. The worst thing you can think of is freezing the pool and not being able to do what we need to do and I don't know how long it would take us. I mean, you know you've just basically told us we now have a problem that we don't quite exactly know how we're going to fix - and another example of how crazy we can get is, when we restructured mortgage loans, in the past and we've done this many times, we actually really know what to do.

We restructured the loans and it was always better to negotiate around the borrower, assuming there was a borrower and for purposes of this conversation, we're talking about homeowners, not speculative buyers, flipper and all the other guys playing games; we're talking about people who bought a home and live in it and we, historically, structured those loans. We never send out a 1099.

We basically assume that was a renegotiation, end of story because it was in our best interest, as the lender, to do that but in a mortgage security, you don't have that freedom because you've got get the outside accountants to sign off and the outside lawyers and the outside accountants and lawyers said, time out and I volunteered and said, well, wait a minute. I've been doing it this way all along and one of my friends [who is] now running one of the best of the combat servicing operations says, well, I'm doing that now, too and we were told, well you're doing it wrong. You've got to send out a 1099.

That's an incredibly dopey idea. We're restructuring a loan around a borrower; he can't afford the loan and now we're going to take the NPV of the change and send him a tax bill so the IRS can chase him . . .?

So let’s consider Ranieri’s question: is the system “broke”?

There is a credible estimate that as much as half of recent subprime production could have qualified for a GSE-style loan at a much lower interest rate. That means, among other things, that the “risk premium” these borrowers are paying is likely causing their defaults; if they weren’t subprime the day they got the loan, they are now. The theorists of "perfect" pricing of credit risk have some explaining to do. It is not unlikely that they will have the opportunity to explain that in court, as I for one can think of few more likely class actions than a group of borrowers who qualified for a prime or near-prime loan and got steered to some subprime exploding ARM.

Someone who is considered “the father of MBS” did not anticipate the difficulties of modifying securitized loans, given the constraints of the true-sale requirement (which means that the sponsor/servicer cannot “control” the collateral, and you’d have to get 400 bond holders in the Coliseum to vote on a loan modification). This is to say that a mortgage financing mechanism intended to mitigate risk is less able to respond quickly enough and efficiently enough to stave off losses than an unsecuritized portfolio or a simple agency pass-through.

Bondholders who may well understand that it is in their best interest to allow modifications of loans will discover what it will cost in legal and accounting fees to do that, costs that are there only because these loans are securitized; a similar restructure of a portfolio would not have those costs. Risk “dispersion” means never being able to get all your risk holders into the same room to hammer out a plan.

Some senior bondholder is going to sue some issuer for SFAS 140 violations (modifications, with or without a 1099) that were intended to cut the losses for the subordinate holders, but which would have the effect of maintaining some credit support for the senior notes, too. Besides the simple extraction of legal fees here, you have a situation in which losses will simply continue to mount while each tranche and the sponsor argue in court about whose interest is or is not being served. Meanwhile, borrowers get further behind.

There is always, of course, the option of foreclosing rather than working out, but bondholders are likely to get paid less for that, even if they don’t happen to care about the homeowner or the macro effects of that much foreclosed property. Securitization of loans did not, actually, eliminate the risks inherent in property markets; it seems to be capable, in fact, of magnifying those risks.

I’d go for “broke.”

by Calculated Risk on 4/27/2007 07:14:00 PM

Earlier today I pointed out some important good news in the GDP report; both components of non-residential investment rebounded slightly.

This post compares residential investment with both of the components of non-residential investment: structures, and equipment and software.

Important Note: On both graphs, residential investment is shifted into the future. Historically investment in non-residential structures follows residential investment by about 5 quarters, and investment in equipment and software follows residential investment by about 3 quarters. For more on these lags, see: Investment Lags.

Click on graph for larger image

The first graph shows the YoY change in Residential Investment (shifted 3 quarters into the future) and investment in equipment and software. The normal pattern would be for investment in equipment and software to now turn negative.


The second graph shows the YoY change in Residential Investment (shifted 5 quarters into the future) and investment in Non-residential Structures. The normal pattern would be for investment in non-residential structures to turn negative later this year.

Since the typical pattern is for non-residential investment to follow residential investment, the onus is on those arguing that this time is different than "typical". I should include myself since I've only put the odds of a recession at a coin-flip - so I'll try to explain why I think a soft landing is possible (the other side of the coin).

I think one of the keys to '07 is investment in non-residential structures. It is possible that the big investment slump in the early '00s has left many markets with too little supply of commercial and office buildings (and other non-residential structures). There have been several articles recently about rising commercial and office rents and low vacancy rates. As an example, from the LA Times: Businesses pinched as commercial rents soar in Southland

Sizzling demand for offices, warehouses and retail space is hitting Southern California and other major urban centers. ...Office rents have climbed more than 25% on average in the last three years in much of Los Angeles County.
...
Vacancies have plunged to well below 10% in many areas, making it harder for businesses to find space. Only 3% of the region's industrial space — used for warehouses and factories — is available, a level that is considered drastically low.

Therefore it is possible that investment in non-residential structures will decouple (at least somewhat, and for a short period) from the typical pattern.

For equipment and software, I think we are still in a technology fueled productivity boom, so it is possible that investment in software and equipment will stay healthy, and not follow residential investment. This is what happened in the '90s (first graph); residential investment slumped somewhat, but investment in equipment and software stayed strong.

Of course the typical pattern may hold, and then the U.S. will most likely have a recession.

by Calculated Risk on 4/27/2007 12:50:00 PM

The Census Bureau reports the Homeowner Vacancy Rate was a record 2.8% in Q1 2007. Rental vacancy rates also increase to a near record 10.1%.

Click on graph for larger image.

This graph shows the recent surge in the homeowner vacancy rate. This is further evidence of the significant supply overhang in the housing market.

Fannie Mae economist David Berson has estimated the overhang at 600K units. This data from the Census Bureau suggests the overhang may be closer to my estimate of 1.1 to 1.4 million units.

by Calculated Risk on 4/27/2007 10:16:00 AM

The good news in the Q1 2007 GDP report was that private non-residential investment rebounded slightly. As I noted yesterday, investment slumps correlate very well with recessions. The following graphs are an update to previous graphs and include Q1 2007 (note these are year-over-year changes, not quarter-by-quarter).

Click on graph for larger image

The first graph shows the change in real GDP and Private Fixed Investment over the preceding four quarters, shaded areas are recessions. (Source: BEA Table 1.1.1)

A couple of observations:

1) Since 1948, private fixed investment has fallen during every economic recession.

2) Private fixed investment has fallen 13 times since 1948 (14 including the current slump), with only 10 recessions.

So what happened during the periods around 1951, 1967 and 1986 to keep the economy out of recession? These are the periods when private investment fell, but the economy didn't slide into recession. The answer is generally the same for all three periods: a surge in defense spending. The defense spending in the early '50s was due to the Korean war, in the mid '60s the Vietnam war, and in the mid '80s a general defense build-up helped offset a small decline in private investment. The mid '80s also saw a surge in MEW (mortgage equity withdrawal) that also contributed to GDP growth.

The second graph shows the separation of private fixed investment into residential and nonresidential components.

This graphs shows something very interesting: in general, residential investment leads nonresidential investment. There are periods when this observation doesn't hold - like '95 when residential investment fell and the growth of nonresidential investment remained strong.

Another interesting period was 2001 when nonresidential investment fell significantly more than residential investment. Obviously the fall in nonresidential investment was related to the bursting of the stock market bubble.

However, the typical pattern is residential investment leads non-residential investment, so the current slowdown in non-residential investment is not unexpected.


The final graph is the YoY change in New Home Sales from the Census Bureau.

Note: the New Home Sales data is smoothed using a three month centered average before calculating the YoY change. The Census Bureau data starts in 1963.

Some observations:

1) When the YoY change in New Home Sales falls about 20%, usually a recession will follow. The one exception for this data series was the mid '60s when the Vietnam buildup kept the economy out of recession. Looking solely at this graph, one might expect the economy to already be in a recession - however these models are just guidelines, not perfect predictors. The pace of the current decline in new home sales hasn't been extremely high (only 20% YoY decline), and the slower the slump, the more the rest of the economy can absorb the impact.

2) It is also interesting to look at the '86/'87 and the mid '90s periods. New Home sales fell in both of these periods, although not quite 20%. As noted earlier, the mid '80s saw a surge in defense spending and MEW that more than offset the decline in New Home sales. In the mid '90s, nonresidential investment remained strong.

And that brings us back to this piece of good news in the Q1 GDP report: Non-residential investment rebounded.

Real nonresidential fixed investment increased 2.0 percent in the first quarter, in contrast to a decrease of 3.1 percent in the fourth. Nonresidential structures increased 2.2 percent, compared with an increase of 0.8 percent. Equipment and software increased 1.9 percent, in contrast to a decrease of 4.8 percent.

Perhaps non-residential investment will stay positive and help keep the economy out of recession. Later I'll review the typical lags between residential and non-residential investment.

by Calculated Risk on 4/27/2007 10:01:00 AM

MarketWatch has the headlines: GDP slows to 1.3% growth in first quarter, Inflation rages at fastest pace in 16 years, data show

Click on graph for larger image.

This graph shows Residential Investment as a percent of GDP since 1960. The median is 4.5% of GDP. Currently RI is still above 5% of GDP.

RI peaked at 6.3% in the second half of 2005.

If this housing bust is similar to previous busts, RI as a percent of GDP will bottom in the 3.5% to 4.0% range.

More on investment soon.

by Anonymous on 4/27/2007 06:58:00 AM

As a boomer, I am always interested in an historical view of things, even if it grates on the nerves. Since the phrase "the medium is the message" marked a profound shift in the understanding of culture for, um, us boomers old enough to remember Marshall McLuhan, I present the following advice to real estate brokers without further snark. "Are You Really Reaching Consumers?":

RISMEDIA, April 4, 2007-Do you speak boomer? If that's your only generational language, you are in big trouble. Gen X and Gen Y consumers don't speak your language, and, 120 million strong, they now constitute the largest demographic in the real estate market.

Simply put: As consumers become increasingly computer savvy, brokers are finding they are no longer in charge. Those brokers who don't keep up are in danger of becoming, well, endangered. But it's not just a matter of disseminating information; the medium is the message. . . .

"They are techno-literate and techno-fused," says Dallas-based consultant John Ansbach. "Gen X grew up as computers grew up. Gen Y is techno-fused. They don't know how to do anything without computers. The latch-key effect for both is a profound sense of: I can do it on my own, given the right tools. Gen X and Y-ers believe in their heart of hearts if they had enough coffee and access to the Internet, they could learn to fly the space shuttle."

Of course, Anspach maintains, this is "not reality. A real estate transaction is a complicated financial process that does require significant expertise. Consumers don't get this message, and certainly not from the media that has further told these consumers Realtors are anti-competitive and greedy and, by the way, you may not even need them."

These forces have combined "to create a perfect storm for brokers. You can fight it, or you can change, adapt and be successful with the right strategies," says Ansbach.

by Calculated Risk on 4/26/2007 02:57:00 PM

Update: add Defense spending vs. investment (note: graph scale kept the same to compare two graphs. YoY change in defense spending during Korean War went off graph). Oops, I switched the colors for investment spending. Sorry. Red in first graph is shown as blue in the second graph.

As a preview to the Q1 2007 GDP report to be released tomorrow, here is an historical look at private fixed investment vs. recessions.

"[A] major area of concern in the near-term outlook, and one that perhaps could pose noticeable downside risks, is business investment."
Fed Governor Frederic S. Mishkin, April 20, 2007

Click on graph for larger image.

This graph shows the YoY change in real GDP and Private Fixed Investment through Q4 2006; shaded areas are recessions. (Source: BEA Table 1.1.1)

A couple of observations:

1) Since 1948, private fixed investment has fallen during every economic recession.

2) Private fixed investment has fallen 13 times since 1948 (14 including the current slump), with only 10 recessions.

So what happened during the periods around 1951, 1967 and 1986 to keep the economy out of recession? These are the periods when private investment fell, but the economy didn't slide into recession. The answer is generally the same for all three periods: a surge in defense spending. The defense spending in the early '50s was due to the Korean war, in the mid '60s the Vietnam war, and in the mid '80s a general defense build-up helped offset a small decline in private investment. The mid '80s also saw a surge in MEW (mortgage equity withdrawal) that also contributed to GDP growth.

Tomorrow I'll add Q1 2007 and break the investment data down by category.

by Calculated Risk on 4/26/2007 12:20:00 PM

From the WSJ: Home Equity Stalls

After years of piling debt on their homes, Americans are becoming more cautious about using them as a piggy bank.
...
The amount borrowers owe on their home-equity lines of credit has slipped in the past six months, to $561 billion at the end of March, the first such decline since 1999, according to new data from Equifax Inc. and Moody's Economy.com Inc. Although that decline was partly offset by a pickup in fixed-rate home-equity loans, total home-equity borrowing rose just 9% in the 12 months through March, well below the 21% average annual growth rate of the past five years.

... the slowdown in home-equity borrowing is leading to weaker sales in some markets for autos, building materials and electronics ...

This is one of the keys going forward - the impact of less home equity extraction on consumer spending.

by Calculated Risk on 4/26/2007 11:32:00 AM

From Reuters: US homebuilder cash flows a ratings threat-Moody's

Less than half of Moody's rated home builders posted positive cash flows for the year through the end of 2006 ...

This "underscores a potentially serious problem and signals that their current ratings may be too high," said Moody's Vice President Joseph Snider.

by Anonymous on 4/26/2007 10:39:00 AM

I've fought harder to log into Blogger this morning than Mr. Tan Man has to liquidate his shares. Sorry. You need a place to discuss the earnings releases? Here it is.

CR Update:
IndyMac profit slumps 34% as mortgage business takes hit

California mortgage lender IndyMac Bancorp said Thursday its first quarter profit fell 34% as mortgage profits took a hit from a shakeout in the subprime, or least creditworthy sector of the market. ... "With respect to mortgage banking revenue margins, the spread widening in the private mortgage-backed securities markets that occurred in the first quarter will continue to impact margins in the second quarter," IndyMac President Richard Wohl

Countrywide profit falls 37 pct, cuts forecast

Countrywide Financial Corp. on Thursday said first-quarter profit fell 37 percent and cut its 2007 earnings forecast, reflecting difficulties for the largest U.S. mortgage lender in a weakened housing market.

Beazer Homes swings to loss, withdraws `07 view

Beazer Homes USA Inc. swung to a fiscal second-quarter loss and backed off its 2007 profit forecast in the face of slumping housing prices, but the stock rose in early dealings Thursday.
...
"We continued to experience extremely challenging operating conditions," Chief Executive Ian McCarthy said in a statement. "Most housing markets across the country continue to experience lower levels of demand coupled with higher levels of inventory, resulting in increased competition and continued significant discounting."

He said that the company was "pleased" with its latest quarter's orders, but that so far this spring selling season it's "yet to see any meaningful evidence of a sustainable recovery in the housing market, and we expect current conditions will continue to put pressure on home builders' operating results."