by Calculated Risk on 5/02/2007 11:18:00 AM

For what it's worth, ADP reports:

Private nonfarm employment grew 64,000 from March to April of 2007 on a seasonally adjusted basis

by Anonymous on 5/02/2007 07:00:00 AM

Freddie Mac issued its quarterly cash-out refinance report yesterday:

McLean, VA – In the first quarter of 2007, 82 percent of Freddie Mac-owned loans that were refinanced resulted in new mortgages with loan amounts that were at least five percent higher than the original mortgage balances, according to Freddie Mac' quarterly refinance review. The revised share for the fourth quarter of 2006 was also 82 percent.

"Fixed-rate mortgages averaged 6.2 percent for 30-year product and 6.0 percent for 15-year loans during the first quarter of 2007, well below the current rates offered on home equity loans," said Frank Nothaft, Freddie Mac vice president and chief economist. "Home equity loans are generally indexed to a bank's prime rate, currently averaging 8.25 percent. This interest-rate difference provides a big incentive to borrowers to use cash-out refinance as an alternative to a home equity loans. . . .

"This quarter we saw $70.5 billion cashed out, down from a revised $77.0 billion cashed out in the fourth quarter of 2006," said Amy Crews Cutts, Freddie Mac deputy chief economist. "Cash-out refinance volume is expected to decline over 2007, due to an expected 6 percent reduction in overall mortgage origination activity and a fall in the refinance share of originations to around 44 percent for the year.

"Most borrowers with prime adjustable-rate mortgages (ARMs) that were scheduled for an interest-rate adjustment sometime in 2007 have already refinanced these loans. Freddie Mac estimates that in September 2006, there were about $170 billion in prime ARMs outstanding with scheduled rate resets in 2007. As of March 2007, just over $30 billion of these loans remained active."

The Cash-Out Refinance Report also revealed that properties refinanced during the first quarter of 2007 experienced a median house-price appreciation of 24 percent during the time since the original loan was made, down from a revised 27 percent in the fourth quarter 2006. For loans refinanced in the first quarter of 2007, the median age of the original loan was 3.3 years, unchanged from the median age of loans refinanced during the fourth quarter of 2006.

by Calculated Risk on 5/01/2007 10:00:00 PM

Bear Stearns chief economist David Malpass writes in Barron's: Two Fed Hikes Loom in the Second Half

The first-quarter GDP data show residential investment just now getting back to its normal share of GDP (4.5% in the first quarter versus the 4.4% average in the 1990s).

These numbers are incorrect and apparently led Bear Stearns to believe that the housing market will stabilize soon. In fact, Residential Investment (RI) as a percent of GDP is currently 5.04% (not 4.5%) and the average in the '90s was 4.08% (not 4.4%).

How is this ratio calculated? The following table shows the ratio using both nominal and chained dollars. It appears Bear Stearns incorrectly used the chained dollars. This is incorrect because the price indexes are different for both series (RI and GDP). The correct calculation is to use nominal dollars for both series for each period (we are calculating RI as a percent of GDP for each period, so RI is normalized by GDP).

Calculating Residential Investment (RI) as a Percent of GDP
	Q1 GDP (billions)	Q1 RI (billions)	RI as Pct GDP
Nominal	$13,632.60	$687.2	5.04% correct
Chained Dollars	$11,549.10	$515.1	4.46% wrong

This graph shows RI as a percent of GDP with both actual (Blue) and the current trajectory into the future (Red). Note that the red line is just an extension of the current rate of decline, and is not a forecast.

For those that believe RI as a % of GDP will bottom out at around 4.5%, the bottom would come in Q3 2007 (at the current rate of decline). This would be the mildest housing slump on record.

For the more pessimistic, they probably believe the current bust will be the worst on record, and the bottom would then come in Q3 2008 or later (assuming current trends).

If Bear Stearns is basing their housing forecast on RI getting back to level of the '90s, they just missed by about a year.

by Calculated Risk on 5/01/2007 09:51:00 PM

From Mathew Padilla at the O.C. Register: Merrill Lynch scraps Option One's $1.5 billion credit line

The company said in a filing today that its mortgage unit lost a $1.5 billion credit line from Merrill Lynch & Co. Other investment banks reduced or rearranged their financial backing. For example, UBS cut its credit line from 1.5 billion to $750 million.

The changes in financing amount to a red flag because Option One needs to have $8 billion worth of credit lines as part of its agreement with potential buyer Cerberus. Bloomberg calculates that after the changes, Option One still has $12.25 billion of credit lines.

by Calculated Risk on 5/01/2007 02:54:00 PM

From the Voice of San Diego: Report: Recession Unlikely But More Pain in Housing

Despite "storm clouds" of near-record foreclosure and default rates, weakness in the real estate market won't be enough to trigger a recession [according to economists at the University of California, Los Angeles Anderson Forecast].

On foreclosures:

The fact that foreclosures are spiking even though home prices haven't plummeted and the economy has remained relatively strong is historically unprecedented ... the fallout from mortgage defaults will prove a "major wild card" in the next two years.

On non-traditional loans:

... economists say they are looking to coming months to see the impacts of the popular exotic loans issued in 2004 and 2005. Most borrowers hoped to refinance or sell before their low introductory rates expired, but that prospect has dimmed with the slowdown.

"The reset crisis is really going to hit its peak early this summer," Ratcliff said. "Then we'll see how bad this is going to get."

And on jobs:

The impact of the real estate slowdown on jobs is just starting to be seen, the report says.

And the good news (He is talking about both San Diego and the entire nation here):

... without another job sector poised to take a nose-dive ... [the] forecast for the nation [is still] a "long runway for the soft landing" with no likelihood of a recession.

"It just doesn't look like there is an industry that looks like it's ripe for enough job losses to trigger a recession," Ratcliff said.

And a soft landing is still very possible. Even though, as Bloomberg reports, auto sales were terrible in April, the AP reports: U.S. Manufacturing Sector Expands at Faster-Than-Expected Rate in April. The mixed bag (away from housing) continues.

by Anonymous on 5/01/2007 12:21:00 PM

The latest weather report is out on Pending Home Sales. Via CNN:

NEW YORK (CNNMoney.com) -- Problems in subprime mortgages caused a sharp drop in home sellers being able to find buyers for their homes in March, according to a trade group report Tuesday that showed the battered real estate market was much weaker than expected.

The National Association of Realtors' Pending Home Sales Index fell 4.9 percent in March, following a 1.1 percent increase in February. The index was down 10.5 percent from the March 2006 reading. . .

"Although the weather improved in March, we're starting to see the effects of a decline in subprime lending and tighter lending standards," said a statement from David Lereah, the chief economist for the trade group. "Home sales will be relatively sluggish in the second quarter, but a modest uptrend should resume during the second half of this year."

by Anonymous on 5/01/2007 08:00:00 AM

I really don't think apologists for the sorry state of business reporting should start in on me today. Nobody, I'm sure, forced Lynnley Browning of the New York Times to write a story on mortgage gain on sale accounting.

Let's remember the ground rules of media criticism. The success or failure of a given piece of writing depends on what it is intended to do and for whom. If it is intended, oh, say, to explain a fairly advanced accounting issue to non-accountants, who might care about that, say, because they are or might become investors in REITs, then the article is successful only if, by the end, the non-accountant understands the accounting issue and can apply this knowledge reliably to his or her own investments. If the purpose of the article is to accuse someone of violating accounting rules, just for purposes of entertaining people who like to read about corporate nefarious conduct, then, given the seriousness of the charge here, the article is not successful unless it is quite accurate and clearly makes the case for a willful violation of accounting rules rather than, say, a bad forecast of the market and lax due diligence on its own loans. Right?

The article, "Accounting Said To Hide Lender Losses," purports to discuss the misuse of gain-on-sale accounting. We begin:

The technique promoted by Mr. Gotschall, who stepped down as chief financial officer in 2006 but continued as vice chairman of the board of directors, allowed the company to report profits before they actually existed. The paper profits were pegged to future earnings from loan sales to institutional investors.

The results, which were nearly always prettier than those produced through traditional, conservative accounting in which profits were recorded only when cash comes through door, were then used to make more loans to risky home buyers.

Used properly, gain on sale is legal. Big investment banks routinely employ the technique when packaging securities for sale to institutional investors.

Unlike specialty finance lenders like New Century, though, Wall Street banks have deep pockets to support themselves if expected earnings from gain on sale accounting fail to materialize.

You tell me: doesn't it sound here as if the claim is that "gain on sale" was reported in a case where no sale settled in cash happened? Does it not sound as if this has something to do with securitizing mortgages? If you were a non-expert, what would you think here?

The use of gain on sale was a factor in the collapse of Enron in 2001 and of major specialty lenders in the late 1990s through this decade. Conseco, a large insurance and finance company that made loans to subprime home buyers, filed for bankruptcy protection in 2002, one of the largest corporate bankruptcies ever.

Critics say that the accounting technique remains ripe for abuse, even though federal accounting regulators tightened up the rules in the wake of Enron.

“The thing about gain on sale accounting is that you can create a machine that just manufactures earnings out of thin air,” said Richard Benson, an expert on securitization and president of the Specialty Finance Group, a financial broker.

Still with us? This gain on sale thing sounds pretty shady, doesn't it? It was an Enron thing? That's bad.

New Century, of Irvine, Calif., made money in two ways, and it used gain on sale for both.

In the first way, called “whole loan sales,” it sold pools of loans to big Wall Street investment banks. New Century made money by keeping the difference between the higher interest rates paid by subprime borrowers and the lower rates offered to the banks.

In the second way, New Century chopped up its other loans to home buyers, repackaged them into securities for sale to investors, a process called securitization. New Century then kept the pieces expected to earn money in the future, called residuals, for itself.

I suppose that if you know nothing about the business, you might think that a "whole loan" is always part of a pool, and that a securitized loan must be something other than "whole," so that must mean that the loan gets "chopped up" and therefore these securities are full of loan fragments. Someone who knows might have explained to this reporter that the term "whole loan" means the loan has not been securitized; the owner of that note owns all of it. As opposed to a securitized loan, wherein an investor owns a pro-rata share of a pool of loans, not individual whole loans. But I couldn't guarantee that this explanation would stick, in the present context, since this reporter seems dead-set on being confused about how loans get sold.

For both types of business, gain on sale allowed New Century to accelerate its profits. In 2005, the last year for which it has reported annual figures, New Century recorded income from gain on sale accounting of nearly $623 million out of a gross profit that year of $1.4 billion, according to its securities filings.

For the whole loan sales, New Century recorded up front the cash gains.

At the same time, New Century guaranteed to Wall Street investors that if the whole loans did not make as much money as it predicted — if home buyers were late with or defaulted on payments — New Century would buy back the impaired loans from the banks.

But through overly rosy forecasts, New Century underestimated how many impaired loans it would have to repurchase and how much it would need to have on hand to do that.

"If the whole loans did not make as much money as predicted"? Someone is so desperate to tie gain on sale to inflated earnings that she is wandering way far off the reservation when it comes to repurchase warranties. In any case, we have conceded here that New Century did actually record a gain "when cash came in the door." Could you forgive a reader who isn't already expert in accounting issues for being mildly confused here? Were we to introduce the concept of reserves for future liabilities (those potential repurchase warranties that all sellers of whole loans have), this might possibly clear up a little: there are cash proceeds from a sale, and there are reserves for future liabilities, and one tends to reduce the other on the books. It's the general accounting idea that no sale of an asset is "final" until there is no longer any residual liability; if there is such residual liability, that must be reflected in the gain/loss calculation.

In its second use of gain on sale, New Century booked future earnings based on its estimates of what it expected to earn from the pieces left over from the securitizations.

New Century’s problem, according to Zach Gast, an analyst with the Center for Financial Research and Analysis, was how it used gain on sale for its whole loan business. In the late 1990s, in the last downturn for subprime lenders, most abuses of gain on sale involved the securitization side.

I give up. Did New Century book gain on sale for a residual tranche of a security, or not? (Really, I'd like to know.) Are we talking whole loans here, or not? Is someone confused about the difference between mark to market and gain on sale, or not?

As the subprime market started to melt down last fall, New Century was forced to honor its guarantees to investment banks and other institutional investors and repurchase the impaired loans. It resold the loans at a loss.

But, Mr. Gast said, when New Century repurchased the loans, it recorded them at values that exceeded the fire-sale prices. In other words, New Century did not recognize upfront the losses in the impaired loans.

Mr. Gast said that New Century has “a huge number of repurchased loans that they haven’t taken losses on.” Under gain on sale accounting rules, “you should be recognizing the loss at the initial sale of the loan,” Mr. Gast said, adding that if you underestimate potential losses, you have to recognize those losses when you are forced to repurchase the loans — something New Century did not do.

At the initial sale of a loan, I should recognize the loss I would take 1) if I had to buy it back at par and 2) if I then had to resell it for less than par? I certainly always reserved for losses. If my losses were more than I reserved for, I certainly recognized that additional loss. On no planet did I ever take that additional loss on the original sale at the time of the original sale, since if I'd seen it coming, I'd have reserved for it. I guess I should be in jail with those Enron guys.

Ah, but in the last two paragraphs of the article, we get this breath of fresh clue:

Stephen Ryan, an accounting professor at New York University and an expert on securitization accounting, said that last year New Century had “underestimated the allowance for repurchase losses, which means that they overstated the gain on sale.”

“They had had a history of doing so well previously, so it’s a question of whether they didn’t expect this or of something more nefarious on the part of senior management,” Professor Ryan said.

I coulda got an A in Professor Ryan's class. What I don't understand is why I waded through this long ridiculous article to get to the point where we finally realized that we are talking about insufficient allowance for loan loss reserves. Toss out all these sinister references to Enron and chopped-up loans and subprime lending and gain on sale involving future income and it comes down to New Century having had way too much confidence in their loans and in future price fluctuations in the secondary market to have reserved sufficiently. Well, that certainly did cause them some problems. It is possible--indeed, it is likely, in my view--that New Century probably knew it should have upped its reserves but did not do so. That is bad, bad, business. I have yet to figure out why we are insisting that it's really an accounting problem.

But what did we learn about gain on sale accounting anywhere in this article except for the fortunate last-paragraph intervention of the good Dr. Ryan? Maybe we'll get lucky and Dr. Ryan will start writing for the Times. Until then, I guess the blogs will be the place where we try to remember that bad economic and business forecasts and a failure to control your loan pipeline to minimize your repurchase liability are not the same thing as cooking the books, and it matters that we understand this distinction.

by Calculated Risk on 4/30/2007 04:51:00 PM

From CNNMoney: Bullish real estate economist to step down

Mentioned in the article: David Lereah Watch

by Calculated Risk on 4/30/2007 04:01:00 PM

From Bloomberg: U.S. Office Vacancy Rates for the First Quarter

The U.S. office vacancy rate rose in the first quarter, according to CB Richard Ellis. ... The rate was 12.8 percent in the first quarter, up from 12.6 percent the previous quarter. The rate was 13.6 percent a year ago.

Is this the beginning of the end for CRE? Let's connect a few dots:

1) Non-residential structure investment has been booming for the last few years. Commercial rents have been rising and office vacancy rates have been falling.

2) However, in the typical cycle, non-residential investment follows residential investment, with a lag of about 5 quarters. Residential investment has fallen significantly for four straight quarters (following two minor declines). So, if this cycle follows the typical pattern, non-residential investment will start declining later this year.

3) The WSJ noted earlier this month that demand was "sluggish" for office space. The current office space absorption rate is about 8 to 10 million square feet per quarter, but "... developers will open 76 million square feet of new office space by the end of this year." Since supply will grow significantly faster than the absorption rate, vacancy rates will rise.

4) Many banks are over-exposed to CRE lending. With rising vacancy rates, defaults will probably start to rise for CRE loans.

And remember, non-residential investment is the great hope of the soft landing view. That is why many economists are watching non-residential investment closely. From Professor Hamilton: Consumption smoothing and economic slowdowns

... the key thing to watch is nonresidential investment. I was very worried when this had made a negative contribution to 2006:Q4 GDP growth, and relieved that its contribution to 2007:Q1 is back into positive territory.

And from Paul Krugman at the NY Times: Another Economic Disconnect. (Note: Excerpts are available at Economist's View).

... with housing still in free fall and consumers ever more stretched, optimistic projections for the economy depend on vigorous growth in business investment. And that doesn’t seem to be happening.

And if office vacancy rates continue to rise, combined with a significant increase in supply coming this year and next, a further reduction in business investment (especially for structures) is probable.

by Anonymous on 4/30/2007 10:10:00 AM

For reasons I do not fully understand--I am just a mortgage punk, you know--AHM has lowered guidance for the second time in about a month, while it reports that the problems are stabilizing.

While I am disappointed by our company’s results, our company will always be susceptible to significant disruptions in the secondary mortgage market. It does appear that the secondary market is stabilizing. During April, more loan buyers have been bidding to buy our loan pools. Additionally, spreads on some junior mortgage securities have retraced a portion of the sharp widening that occurred in March, junior mortgage securities are trading in a more orderly fashion, and the ABX index is off its lows. We will have to see how market conditions develop as the year progresses. For now, however, our company’s working assumption, which is incorporated into our earnings guidance, is that our gain on sale margins, excluding delinquency related charges, will continue near the low levels we experienced during the first quarter.

While our company remains susceptible to disruptions in the secondary mortgage market, we can and have taken actions to reduce our delinquency related charges. It is important to note that most of our company’s delinquency related expenses are not due to delinquency in our portfolio, but instead result from early payment defaults on loans sold that we were required to repurchase, or on loans we hold pending sale. Indeed, 87% of the first quarter’s delinquency related charges stem from our loans held for sale, not our portfolio. Moreover, the vast majority of our delinquent loans held for sale are due to our previously offering a particular type of product, namely stated income loans where a high portion of a home’s value is borrowed. These types of loans have accounted for approximately 15% of our loan production, but resulted in 73% of our delinquent loans held for sale at March 31, 2007.

Our company discontinued offering the high loan-to-value, stated income loans that resulted in the great majority of our delinquency related charges, generally in late February. As a result, our company is now in a “tail” period that will include repurchasing loans that were recently sold and are still inside the period in which our sale is subject to repurchase, which is usually three months. As the tail period winds down, our company’s delinquency related charges should begin to diminish.

During the first quarter, our company’s delinquency related charges were increased both due to reserving for new delinquencies and due to reserving because we increased the loss severity assumption for all delinquent loans held for sale. Increased severity assumptions are due to ongoing weakness in home prices and long home marketing periods. This change in assumptions is the reason first quarter delinquency related charges were disproportionately greater than increases to delinquent loans held for sale. During the first quarter, our company increased the loss severity assumption associated with our contingent reserve for repurchases.

One bright note for the first quarter and for April of 2007 is that our loan application volume remains reasonably strong despite our no longer offering those products that resulted in higher delinquency. Our application volume appears to be benefiting from reduced competition and strong demand for refinancing. Based on current application run rates, our 2007 loan production volume guidance of $68 billion to $74 billion remains unchanged.

So the bright note is that AHM is picking up the apps that used to go to the real nuts, who are now out of the market, plus all those folks who really, really need a refi about now? 'Kay.