by Anonymous on 9/12/2007 09:30:00 AM

I saw another media piece on ARM resets this morning. The last time we posted on ARM resets, there came to pass some confusion about the differences among the various published numbers. My very simple purpose today is to help everyone understand why you can, legitimately, get very differing numbers, and what questions you should ask of any data so that you can understand what you’re being told.

It comes down to several questions: Are we using originations data or outstandings data, and if the latter, from what point in time? Are we looking at all ARMs, or just securitized ARMs? (Do note that investment bank sources generally focus on securitized ARMs only, because the performance of securities is their concern, not necessarily the performance of all mortgage loans.) Are we looking only at first reset, or at all resets? What prepayment and cumulative foreclosure assumptions are we using?

Here’s a very concrete example to flesh out the issues. You have a hypothetical 2/28 ARM portfolio of $1.2 million original balance. It contains 12 $100,000 loans, one originated per calendar month of 2005. Each loan will have a first rate adjustment in each calendar month of 2007. The “12-month reset projection” for this pool, considering only the first adjustment, is very simple: each month, 1 loan resets, for a dollar amount of $100,000 per month or $300,000 per quarter.

But what if you do not limit yourself to just the first reset? The 2/28 will, if it does not prepay, reset every six months after the first reset. If we assume no prepayment, then, and include subsequent adjustments, we get 1 loan resetting in January-June, but 2 loans resetting each month from July-December. Starting in July, there is 1 loan hitting its first reset and 1 loan hitting its second reset. If you simply counted resets, you would show 2 loans in July-December, for a balance of $200,000 per month. If you tried to total up the monthly balances for a year, you’d end up showing $1.8 million in resets on a $1.2 million portfolio of loans. You could say, in a certain context, that $1.8 million in resets are scheduled for 2007, but that is not saying that $1.8 million worth of loans are “at risk.”

And, of course, not every loan will survive on the books after its first adjustment. It could pay off voluntarily (refi, home sale) or involuntarily (short sale, foreclosure). If you wanted to take a vintage of originations and project out a reset schedule, you would have to make projections of prepayment and default. If you started with current outstandings, you would already have your prior prepayments and defaults removed from your pool, but you would still have to project these into the future, unless your goal was a “what if” scenario that involved no loan paying off or defaulting until its reset date.

Even if you wanted to do that, there’s no reason to assume that all reset-related defaults will be due solely to the effect of the first adjustment. It is the most wicked reset for the borrower, but the ugly fact of the 2/28 ARM is that borrowers who survive the first adjustment, possibly just barely, will get another smaller one in six months, and then another one in another six months, until the loan reaches either fully-indexed (then-current 6-month LIBOR plus margin) or its lifetime cap (usually start rate plus 6.00 points). Given the depth of the teaser discounts, the hefty margins, and the movement in LIBOR since these loans were originated, there is no reason to think many of them won’t keep adjusting upward every six months for two years until they hit indexed or capped. So the borrower who just barely survived the first reset might go down at the second one. The borrower who more comfortably survived the first reset might go down at the third one. There is a point to “cumulative” projections of resets.

However, you would still have to adjust these numbers further. You would also project index values forward (to guess when caps will come into play and loans would stop adjusting), and you would have to take into account varying margins. I could assume for our hypothetical pool that all loans have the same margin, but in the real world they don’t.

You will, therefore, see differing presentations of reset volume, and those differences may have a lot to do with prepayment speed assumptions, underlying index movement assumptions, or the weight of caps and margins in a particular pool of loans. That does not mean that someone is lying to you, although you may or may not find the underlying assumptions reasonable (assuming you can figure out what they are).

Today, Reuters reports this:

About $75 billion in adjustable-rate U.S. mortgages are going to reset in the fourth quarter, most of which will emerge next month. Of the loans resetting, around 75 percent are subprime mortgages.

As far as I can determine, this $75 billion number includes only the first reset of any ARM (the date on which it changes from “fixed to floating” rate), based on Q207 securitized outstandings, and has no prepayment adjustments. If you assume even conservative prepayment speeds, the actual number of resets will be lower. However, if you “add back” subsequent adjustments for loans that survived their first adjustment, the raw number of resets is higher. The Bank of America chart CR posted several weeks ago shows securitized plus non-securitized, which is why it has such large numbers compared to the Reuters number. I believe, but cannot verify, that it also includes only the first adjustment.

There is no “right number.” There is only a number in context.

by Calculated Risk on 9/12/2007 02:18:00 AM

From the LA Times: Economy will hover near recession, forecast says

The nation's economy will be so sluggish well into next year that any major hiccup could tip it into recession, UCLA's latest economic forecast predicts.

The end of easy credit and a further decline in home construction are sending the economy into a "near-recession," with growth hovering at just above 1% through the first three months of 2008, according to the UCLA Anderson Forecast to be released today.

The forecast presents a gloomier outlook for jobs and the housing market. The nation's unemployment rate will rise to 5.2% by mid-2008, up from the current 4.6%.

And the forecast for housing starts is grim:

The group sees [housing starts] bottoming out at 1 million units annually, down from the previous forecast of about 1.2 million.

Home construction is seen as "barely recovering" to 1.4 million units annually by the end of 2009. By comparison, housing starts peaked with more than 2 million units annually in 2005.

This is below both my forecast (1.1 million units) and the forecast of Goldman Sachs (1.1 million units).

And this is interesting:

Even the sales of office supplies -- viewed by some as an indicator of where the economy is headed -- are off, according to Pasadena-based Avery Dennison Corp.

"Short-term economic conditions are challenging," Avery's chief financial officer, Daniel R. O'Bryant, told analysts this week.

by Calculated Risk on 9/11/2007 09:35:00 PM

From Bill Fleckenstein: Leveraged Black Boxes (Fleck's Site):

Note: Excerpted with permission. SIV: Structured Investment Vehicles.

"... though London appears to be the epicenter of conduit angst these days, our homegrown Citicorp appears to have plenty of exposure. That, according to the Lord of the Dark Matter, who in an email to me rattled off the following list of its SIVs: Beta Finance, Centauri, Dorada, Five Finance, Sedna Finance, Vetra Finance, and Zela Finance. He was able to obtain a portfolio commentary for Beta Finance ...

First of all, for those folks who can't quite wrap their arms around what an SIV, SPIV, or conduit is, those names all stand for pretty much the same thing -- special-purpose entities that reside off balance sheet. Think of them as virtual S&Ls, which can be quite sizable. ... And, because they're off-balance-sheet, they operate with little regulation.

The better question is: why these entities exist in the first place, and in such size. I think we know the pat answer -- so that financial institutions can employ them and utilize even more leverage than they are legally allowed to. ... Citicorp notes that the leverage in this particular vehicle, Beta Finance, is "only 14.24 times." Thus, Citicorp, a leveraged entity, owns a gaggle of leveraged S&Ls. ...

Next, Citicorp says: "We highlight that all US CMBS exposure is super-senior." What I find interesting in that comment: They've taken pains to note that their commercial mortgage-backed paper is the highest rated -- implying that there might be a problem with lesser-rated tranches of commercial mortgaged-backed paper.

That echoes a data point provided by someone wishing to remain anonymous, who resides near the top of the lending food chain at one of the world's largest banks. The source indicated to me that commercial mortgage-backed securities will also see problems. Though I did not get the impression from her that the timing was imminent, the weakness in the commercial version of the ABX index indicates that some pain is already being dispensed, even if there has been little spilled on this subject."

Note: According to Goldman Sachs, the problem is more acute in Europe, because the European regulations allow SIVs that would be on balance sheet in the U.S., to stay off balance sheet in Europe.

Earlier this year from Fleck:
January 14, 2007:

... a former top executive at a subprime lender (whose chronicling of the unwind has been amazingly accurate and timely), told me that serious issues are developing, and that large companies like New Century Financial (NEW, news, msgs), Accredited Home Lenders (LEND, news, msgs) and NovaStar Financial (NFI, news, msgs) will, in his words, "hit the wall" very soon.

January 30, 2007:

Turning to the subprime industry, once again I heard from my friend who has been staggeringly accurate. He continues to feel that things are about to really get worse. In an email to me, he wrote: "Scratch and dent loans are killing everybody. Bids that were 92 or 93 are now low to mid-80s. It is a bloodbath, and is pressuring even strong companies to buckle. NO ONE is making any money in the market right now. We are at a point of no return for many. The next two weeks will be wild."

Note: A wild two weeks indeed as subprime blew up in early February.

March 14, 2007:

My friend in subprime updated me last night, as follows: "The Alt a space has deteriorated very quickly, but not yet public. $40 billion in subprime still waiting to find a home. No loans will be bought at attractive prices until May production as it will be underwritten to new guidelines. The triple bbb's are a mess. The hedge funds that bought it are all in trouble. ... warehouse guys and Alt a guys are now next. Alt a guys may be worse as less insurance on those loans to protect them. The loan sizes are bigger as well."

by Calculated Risk on 9/11/2007 08:54:00 PM

The comedians at the National Association of Realtors (NAR) presented another forecast today for existing home sales in 2007. Their current forecast is for sales to be 5.92 million in 2007. This is compared to their original forecast from Dec '06 of 6.4 million units in 2007. (My forecast was for existing home sales to be between 5.6 and 5.8 million units).

The NAR forecast is still way too high, even after seven straight months of negative revisions. Luckily for the NAR, they still have three more downward revisions to go.

With a sharp slowdown in 2007 sales, it is amusing to look at the headlines from the NAR. Enjoy!

December 11, 2006: Existing-Home Sales In 2007 Expected To Recover From Cyclical Low

January 10, 2007: Gradual Rise Projected for Home Sales

February 07, 2007: Existing-Home Sales To Improve, With Later Recovery For New Homes

March 13, 2007: Housing Recovery Likely This Year, But Timing Isn't Clear

April 11, 2007: Tighter Lending Standards Good For Housing, But Will Dampen Sales

May 09, 2007: Housing Forecast Changed Slightly Due to Impact From Tighter Lending

June 06, 2007: Home Sales Projected to Fluctuate Narrowly With a Gradual Upturn

July 11, 2007: Home Prices Expected to Recover in 2008 As Inventories Decline

August 08, 2007: Near-Term Home Sales to Hold in Modest Range

September 11, 2007: Mortgage Problems to Dampen Home Sales in The Short Term

by Calculated Risk on 9/11/2007 02:17:00 PM

From the Chicago Tribune: Empty offices leave landlords high and dry (hat tip Vader)

... Chicago-area office landlords are now feeling the pain as the problems spread into various channels of the commercial property industry.
...
Now, rather than anticipate big sales, commercial landlords are worrying about how to pay the debt on buildings that are generating less income than just a few months ago.

... As rents diminish and credit rating agencies lower the extravagant asset value assessments of recent years, an owner could be holding a building that is worth less than the amount owed on it.
...
"All across the country there are huge spaces where tenants aren't paying rent," [Joseph Cosenza, vice chairman of the Inland Real Estate Group] said. "In May, I was to sign a contract to buy a brand new office on the East Coast," he said. When the developer declined to give Cosenza the anchor tenant's financial statements, he walked away from the deal. "Thank God because today the tenant is gone."
...
Chicago, especially in the suburbs, has higher vacancies and lower rents than other U.S. office markets. As of midyear, the metropolitan area had an 18.5 percent vacancy rate, 532,678 square feet more put back on the market than was taken off by leasing and an overall asking rent of $22.16, still off from the high of $22.30 in 2000, according to Cushman & Wakefield of Illinois Inc.

Downtown Chicago, meanwhile, has 6 million square feet of new offices in development.

The commercial real estate (CRE) downturn will be worse in Chicago than many other areas - because of the already high vacancy rate - but it appears the expected slowdown in CRE has started.

As a reminder, in a typical business cycle, investment in non-residential structures follows investment in residential structures with a lag of about 5 quarters.

Click on graph for larger image.

This graph shows the YoY change in Residential Investment (shifted 5 quarters into the future) and investment in Non-residential Structures. In a typical cycle, non-residential investment follows residential investment, with a lag of about 5 quarters. Residential investment has fallen significantly for five straight quarters. So, if this cycle follows the typical pattern, non-residential investment will start declining later this year.

by Anonymous on 9/11/2007 12:39:00 PM

The good news? The Federal Trade Commission is talking about deceptive mortgage advertising:

“Many mortgage advertisers are making potentially deceptive claims about incredibly low rates and payments, without telling consumers the whole story – for example, that these low rates and payments apply for a short period only and can go up substantially after the loan’s introductory period,” said Lydia Parnes, Director of the FTC’s Bureau of Consumer Protection. “Home ownership is the American dream, but it can become a nightmare for consumers who don’t have the information they need to understand the terms of their mortgage.”

In warning letters, the agency is advising more than 200 advertisers and media outlets that some mortgage ads are potentially deceptive or in violation of the Truth in Lending Act. The ads, including some in Spanish, were identified in June during a nationwide review focused on claims for very low monthly payment amounts or interest rates, without adequate disclosure of other important loan terms.

The bad news?

During the past decade, the FTC has brought 21 actions against companies in the mortgage lending industry, focusing in particular on the subprime market. Several of these cases have resulted in large monetary judgments, with courts collectively ordering that more than $320 million be returned to consumers.

That's the kind of enforcement record that really scares these scumballs off, isn't it? Does anyone know what percent of the entire industry's ad budget over the last ten years $320 million is? According to Mortgagedaily.com, projected mortgage [Ed. note: Duh!] advertising expenditures just for 2007 is $152 billion. The FTC isn't putting a very heavy "inaccuracy tax" on that.

by Calculated Risk on 9/11/2007 11:37:00 AM

This Reuters commentary has some interesting statistics: Fed hazard is recession, not an immoral bailout: James Saft

Lehman Brothers figures show non-agency mortgage security issuance falling to $15 billion in August, down from $41 billion in July and $70 billion a year ago. And rates are much higher, up by 0.85 percentage points since June for prime loans larger than Fannie and Freddie's $417,000 limit.

And on mortgage applications:

Washington-based Campbell Communications carried out a survey of 1,744 mortgage brokers between August 23-31, according to Realty Times. The survey found about 33 percent of purchase loans did not come through, against 4 percent in 2004.

Even so-called prime borrowers had their closings cancelled 21 percent of the time.

This is another indicator that home sales declined sharply in August (see here and here), and probably means Mortgage Equity Withdrawal (MEW) also declined significantly (probably impacting consumption later this year).

by Calculated Risk on 9/11/2007 11:01:00 AM

From Fed Chairman Ben Bernanke: Global Imbalances: Recent Developments and Prospects. Bernanke provides an update on his "savings glut" explanation of current global imbalances.

... the current pattern of external imbalances--the export of capital from the developing countries to the industrial economies, particularly the United States--may prove counterproductive over the longer term. I noted some reasons for concern in my earlier speech, and they remain relevant today.

First, the United States and other industrial economies face the prospect of aging populations and of workforces that are growing more slowly. These trends enhance the need to save (to support future retirees) and may reduce incentives to invest (because workforces eventually will shrink). If the United States saved more, one likely outcome would be a reduction in the U.S. current account deficit and in the rate at which the country is adding to its liabilities to the rest of the world.

Second, the large U.S. current account deficit cannot persist indefinitely because the ability of the United States to make debt service payments and the willingness of foreigners to hold U.S. assets in their portfolios are both limited. Adjustment must eventually take place, and the process of adjustment will have both real and financial consequences. For example, in the United States, the growth of export-oriented sectors such as manufacturing has been restrained by the shifts in relative prices and foreign demand associated with the U.S. trade deficit. Ultimately, the necessary reduction in the trade and current account deficits will entail shifting resources out of sectors producing nontraded goods and services to those producing tradables. The greater the needed adjustment, the more potentially disruptive and costly these shifts may be. Similarly, external adjustment for China and other surplus countries will involve shifting resources out of the export sector and into industries geared toward meeting domestic consumption needs; that necessary shift, too, will likely be less disruptive if it occurs earlier and thus less rapidly and on a smaller scale.

On the financial side, if U.S. current account deficits were to persist at near their current levels, foreign investors would ultimately become satiated with dollar assets, and financing the deficit at a reasonable cost would become difficult. Earlier reduction of global imbalances would reduce the potential strains associated with financing a large quantity of international liabilities and likely allow a smoother adjustment in financial markets.

Finally, in the longer term, the developing world should be the recipient, not the provider, of financial capital. Because developing countries tend to have high ratios of labor to capital and to be away from the technological frontier, the potential returns to investment in those countries is high. Thus, capital flows toward those countries should benefit both them and the countries providing the capital.

Bernanke didn't offer any clues as to the direction of monetary policy.

by Calculated Risk on 9/11/2007 10:38:00 AM

From the NY Post: Countryslide, Mortgage Lender's Shares Plunge; Seeks 2nd Bailout

Note: You have to enjoy the Post headline. Countrywide is seeking more investments, not a bailout. This story is also on Dow Jones (not as colorful).

Countrywide Financial Corp. is putting together another multi-billion dollar bailout plan as the nation's largest home lender continues to struggle amid the global credit crunch and declines in the housing market ...
...
It's unclear at this point who exactly is involved in the investment, but sources said a group that could include J.P. Morgan and Citigroup as well as several hedge funds has expressed interest in Countrywide.

A final deal could be announced by the end of the month, sources said.
...
"The issues the economy is facing are worse than most people believe," Mozilo said in an interview last Friday with Bloomberg News.

by Anonymous on 9/11/2007 10:15:00 AM

I was so startled by the quote in this morning's WaPo from Congressman Gary Ackerman that I really had to go find his actual statement to the Financial Services Committee. It's a beaut. Ackerman apparently believes that everything the rating agencies have done arose from an intent to defraud, that investors would never have purchased these bonds with more disclosure, and that existing authority to regulate of the SEC is sufficient, but that the problem is the SEC's unwillingness to run right out and make criminal referrals before having studied the matter.

Originators then took these loans – many of which should have been assessed as much riskier than they were – and packaged them into securities to sell to investors. If there had been full disclosure, smart and careful investors would have judged that these mortgage backed bonds carried a disproportionately high level of risk. In an effort to deliberately mislead investors, however, some originators and credit-rating agencies, so-called Nationally Recognized Statistical Rating Organizations (NRSROs), colluded. First, the credit-rating firms would consult, or maybe we should say collaborate, with the originators – receiving high fees, of course – to advise the originators how to design the packaged securities to ensure that the riskiest piece of the product was adequately masked. Then, for another fee, the credit raters would assign overly favorable ratings to these mortgage-backed bonds, giving investors the impression that a neutral, unbiased party with a proven track record of assessing risk thought highly of these volatile products.

Essentially, the originators and credit raters shoved enough pigs and laying hens in with the beef herd that investors expecting prime ribs on their silver platter and money in their pocket ended up with pork ribs on their paper plate and egg on their face. The credit-rating firms were double-dipping; profiting first from helping to put these shady securities together, and then collecting fees for deliberately rating these risky products at a higher value than they were worth. It’s like hiring a judge to advise you as to how to commit an act and then paying him to decide whether you have committed a crime. My strong view is that NRSROs conspired with financial institutions to fool investors by packaging and rating securitizations in a manner that was deliberately aimed at misleading them. This is the accounting firm telling shareholder companies how to fool their investors and then getting hired as independent auditors.

That's not the free market at work. That's fraud. Fraud is a crime, not a correction.

What I find, perhaps, to be most perplexing of all is that Congress already identified problems stemming from NRSROs and passed legislation seeking to increase statutory authority to oversee the credit-rating agency industry. In the 109th Congress, the Credit Rating Agency Reform Act of 2006 was passed by the House and Senate, and was signed into law by President Bush almost exactly one year ago. This legislation granted the Securities Exchange Commission much greater authority to regulate and supervise NRSROs. To my knowledge, and as the current financial debacle makes clear, the SEC has not acted to either discipline those NRSROs that were involved in these types of practices, or to make certain that these insidious practices are thwarted in the future. The SEC simply is continuing to examine the credit-rating industry, a study that has been ongoing since before the Credit Rating Agency Reform Act became law last year.

Here's a conclusion for the SEC: you're more than a few days late and more than few billion dollars short.

The SEC has all the tools it needs to act swiftly and appropriately, but it has failed to do so. Unless the SEC demonstrates to investors, quickly and convincingly, that they intend to clean up the mess that the banks and credit-rating agencies have created, Congressional action will be necessary. This Committee and this Congress will not be passive spectators as banks and credit-rating agencies use their control of information to fool investors into believing that a pig is a cow and a rotten egg is a calf.”

I can understand why there is a problem with the rating agencies combining consulting and rating roles, just as there is a problem with accounting firms combining consulting and auditing roles. Perhaps naively, though, I wonder why we think there is always such a bright line between the two. If the rating agencies publish their methodologies and due diligence criteria, in the name of full disclosure to investors, isn't this necessarily information that issuers can use to change their practices so that their securities achieve the highest ratings? Is that in and of itself a problem, or is it only a problem if the ratings criteria are faulty? And if they are, is it necessarily because of fraudulent intent? We're all rightly impatient with too much of this "mistakes were made" line, but are we really going to hold rating agencies to the standard of either perfect prediction of credit loss or jail time?