by Calculated Risk on 9/22/2007 12:50:00 AM

From the WSJ: Macklowes On a Wire

Mr. Macklowe and his son Billy paid $6.8 billion to buy seven New York buildings from Equity Office Properties Trust. ... the sale was one the most expensive real-estate deals in U.S. history, symbolizing the skyrocketing prices paid for buildings at a time of cheap debt and demand for office buildings.

The transaction was emblematic of the lax underwriting standards of the real-estate boom. Macklowe Properties put in only $50 million of equity and borrowed $7.6 billion, according to the documents. (Mr. Macklowe borrowed more than the purchase price to cover closing costs and other fees.) The deal also had "negative debt service," meaning that the rents from the buildings weren't expected to cover the debt payments for five years ...

Talk about a leveraged transaction: borrowing $7.6 Billion for a $6.8 Billion purchase on properties that have probably declined in value. Approximately $5.0 Billion of the debt must be paid off in February.

by Calculated Risk on 9/21/2007 07:35:00 PM

Wile E. Coyote UPDATE: Video of Paul Krugman interviewed by Georges de Menil on financial markets and global imbalances. (if this doesn't work, go to this page.)

From the Financial Times: Eurozone suffers ‘worst’ jolt since 9/11

The eurozone economy has this month suffered its biggest jolt ... with global financial turmoil hitting the services sector particularly hard, according to a closely watched survey.

The unexpectedly steep fall on Friday in the eurozone purchasing managers’ index – the third consecutive monthly drop ...

... financial markets have started speculating that the next ECB interest rate move will be downwards.

With the Euro at $1.41, and an ongoing credit crunch, it is no surprise that the Eurozone economy is slowing. Yesterday I argued that if the trade deficit has peaked - as seems likely - the dollar is probably much closer to the bottom than the top.

This would be the other side of the coin: with the weak dollar, trade from the Eurozone to the U.S. will slow, impacting the Eurozone economy (although the service sector took the biggest hit in this report). This will probably lead to rate cuts in Europe - and that would also support the dollar at the current level.

by Calculated Risk on 9/21/2007 04:25:00 PM

WSJ: Harman Says Buyout Scuttled

Harman International Industries Inc. learned this afternoon that Kohlberg Kravis Roberts & Co. and Goldman Sachs Group's GS Capital Partners VI Fund LP don't intend to complete their $8 billion buyout of Harman.
...
Harman said the private-equity companies informed [Harman] that they believe there was a "material adverse change" in Harman's business and that Harman breached the merger agreement.

Harman disagrees ...

The breakup fee is $225 Million. Perhaps that is why KKR is arguing Harman breached the merger agreement - to avoid, or at least negotiate, the fee.

by Calculated Risk on 9/21/2007 03:41:00 PM

Here are the Kennedy-Greenspan estimates of home equity extraction for Q2 2007, provided by Jim Kennedy based on the mortgage system presented in "Estimates of Home Mortgage Originations, Repayments, and Debt On One-to-Four-Family Residences," Alan Greenspan and James Kennedy, Federal Reserve Board FEDS working paper no. 2005-41.

Click on graph for larger image.
For Q2 2007, Dr. Kennedy has calculated Net Equity Extraction as $140.3 Billion, or 7.1% of Disposable Personal Income (DPI). Note that equity extraction for Q1 2007 has been revised upwards to $131.3 Billion.

This graph shows the net equity extraction, or mortgage equity withdrawal (MEW), results, both in billions of dollars quarterly (not annual rate), and as a percent of personal disposable income.

It is very likely that MEW will collapse in Q3 2007, based on the tighter lending standards and falling home prices, leading, most likely, to less consumer spending.

by Calculated Risk on 9/21/2007 12:57:00 PM

From the WSJ: HSBC to Close U.S. Mortgage Unit

HSBC PLC will close its standalone U.S. subprime-mortgage business and take $945 million in related charges ...

The London banking giant will close Decision One Mortgage, which originates nonprime mortgages through brokers. Instead, the company will focus on loan origination and servicing through its HFC and Beneficial bank branches.
...
Approximately 750 people will lose their jobs ...

The beat goes on.

by Calculated Risk on 9/21/2007 11:48:00 AM

From Fed Vice Chairman Donald L. Kohn: Success and Failure of Monetary Policy since the 1950s. An excerpt on the causes of the housing bubble:

"... it is far too soon to pass judgment on what went wrong in the U.S. housing market and why. I suspect that, when studies are done with cooler reflection, the causes of the swing in house prices will be seen as less a consequence of monetary policy and more a result of the emotions of excessive optimism followed by fear experienced every so often in the marketplace through the ages. To some extent, too, the amplitude of the housing cycle was heightened by the newness of the subprime market, the fragmentation of regulatory oversight responsibility for that market, and the complexity and opacity of the newer instruments for transforming and distributing risk. Low policy interest rates early in this decade helped feed the initial rise in house prices. However, the worst excesses in the market probably occurred when short-term rates were already well on their way to more normal levels, but longer-term rates were held down by a variety of forces. And similar, sometimes even sharper, trajectories of house prices have been witnessed in some economies in which the central banks said they were paying more attention to asset prices."

Many very lengthy papers will be written on the causes of the bubble. Agree or disagree, Kohn touches on a few key points: monetary policy definitely contributed to the initial surge in prices, lax oversight - Kohn says because of "fragmentation of regulatory oversight responsibility" - allowed the bubble to expand, and speculation played a key role. I'll post on what I consider the key causes this weekend.

by Calculated Risk on 9/21/2007 02:19:00 AM

Another private equity LBO is in trouble.

From the WSJ: Harman's Suitors Sour on Buyout

The private-equity buyers of Harman International Industries Inc. are balking at completing the $8 billion purchase of the audio-equipment maker, people familiar with the matter said, as yet another leveraged buyout falls into a hostile tête-à-tête between buyer and seller.
...
Should KKR and Goldman choose to break the deal, they would have to pay a $225 million termination fee, according to corporate filings. That fee is about 2.86% of the deal's value, which is somewhat lower than other transactions of a similar size, according to an analysis by MergerMetrics.com.

Based on previous reports, the average loss on recent LBOs has been about 4% of the deal debt value, so a $225 million breakup fee is might be a bargain depending on the percentage debt. Whatever it takes to avoid more pier loans!

As an aside, the Harman business has recently underperformed expectations, probably as a direct result of the housing bust.

by Calculated Risk on 9/20/2007 09:55:00 PM

Floyd Norris writes at the NY Times: Inside the Mind of the Fed

Six weeks ago, the Federal Reserve thought the American economy would easily weather problems in the credit market. One week ago, the Bank of England warned against the risks of bailing out those who had made risky loans.

This was a week to say “never mind.”

Norris notes that the Fed and the BoE changed course, but ...

By yesterday ... the markets were moving in ways that cannot have made the Fed happy. The dollar fell — an expected result from cutting short-term interest rates — but long-term rates rose, and so did mortgage rates.

“Alan Greenspan’s conundrum is becoming Ben Bernanke’s calamity,” said Robert Barbera, the chief economist of ITG, recalling that when the Fed raised short-term rates under Mr. Greenspan, long-term rates did not follow. Now the opposite is happening, a fact that will make it that much harder to stimulate the economy.

This was my concern when I outlined a possible vicious cycle that could occur as the Fed cut rates: Watch Long Rates.

Norris goes on to highlight two recent Fed papers that we've discussed before:

Those wanting to understand the Fed’s reversal can profit from reading two papers by Fed officials, released this summer as the credit squeeze was worsening.

In total, they constitute an admission that the Fed was surprised by the housing and borrowing boom on the upside, and now fears it will be surprised on the downside.

emphasis added

by Calculated Risk on 9/20/2007 03:07:00 PM

The following graph shows the U.S. trade deficit as a percent of GDP compared to the Fed Nominal Major Currencies Dollar Index.

NOTE: The trade deficit as a percent of GDP is presented as a positive number (for easier comparison to the dollar index). The 2007 trade deficit is estimated at 5.1% of GDP. The 2007 currency index is set to the Sept value.

Click on graph for larger image.

The common pattern is a currency strengthens and the trade deficit increases. Some time after the currency peaks, the trade deficit peaks. And that is followed by a bottom in the currency. There are other factors, but that is the common pattern.

The recent increase, and extraordinary size of the U.S. trade deficit, was probably related to the housing bubble and mortgage equity withdrawal (MEW). Now that MEW is generally declining, and the U.S. economy weakening, the U.S. trade deficit will probably continue to decline.

If the trade deficit has peaked, the dollar is probably much closer to the bottom than the top. I know this may seem like heresy, especially given recent events.

The biggest short term concern is that MEW will collapse, and the trade imbalance will unwind faster than expected. A "Wile E. Coyote moment"! (see Krugman: Will There be a Dollar Crisis? )

Also, from the WSJ: World Economy in Flux As America Downshifts

"We're definitely poised to have some significant rebalancing" of trade, says Harvard University economist Kenneth Rogoff, a former chief economist for the International Monetary Fund. He had been expecting the account deficit to shrink "by maybe half a percentage point of GDP over the next twelve months. Now it seems likely it will go down by 1.5 percentage points." And, he adds, "We could see something more rapid."

Something "more rapid" could be painful. Since Americans have financed their prosperity with borrowed money, reversing that habit means a period of living less opulently.

If foreign money turns scarce and the trade deficit narrows suddenly, Americans could face a tumbling dollar, soaring interest rates and an economic downturn. That could send shock waves back through Europe and Asia if their own consumers don't make up for lost demand from the U.S., the world's largest national economy.

If it happens more gradually, the recent run of American prosperity may continue, in a more subdued way.

by Calculated Risk on 9/20/2007 11:19:00 AM

Fed Chairman Ben Bernanke testified before the House Committee on Financial Services this morning: Subprime mortgage lending and mitigating foreclosures. A few excerpts:

During the past two years, serious delinquencies among subprime adjustable-rate mortgages (ARMs) have increased dramatically. (Subprime mortgages with fixed rates, on the other hand, have had a more stable performance.) The fraction of subprime ARMs past due ninety days or more or in foreclosure reached nearly 15 percent in July, roughly triple the low seen in mid-2005.1 For so-called near-prime loans in alt-A securitized pools (those made to borrowers who typically have higher credit scores than subprime borrowers but still pose more risk than prime borrowers), the serious delinquency rate has also risen, to 3 percent from 1 percent only a year ago. These patterns contrast sharply with those in the prime-mortgage sector, in which less than 1 percent of loans are seriously delinquent.

In July Bernanke argued that what started in subprime would stay in subprime. He was wrong. Now he is arguing that the problems will be contained to subprime and "near prime" loans. More likely delinquency rates will increase in all categories as house prices fall.

The Federal Reserve takes responsible lending and consumer protection very seriously. Along with other federal and state agencies, we are responding to the subprime problems on a number of fronts. We are committed to preventing problems from recurring, while still preserving responsible subprime lending.

The Fed's job was to prevent these problems from "occurring". Preventing them from "recurring" is a tacit acknowledgment of the Fed's earlier failures.

On raising the GSE conforming limit:

Some have suggested that the GSEs could help restore functioning in the secondary markets for non-conforming mortgages (specifically jumbo mortgages, those with principal value greater than $417,000) if the conforming-loan limits were raised. However, in my view, the reason that GSE securitizations are well-accepted in the secondary market is because they come with GSE-provided guarantees of financial performance, which market participants appear to treat as backed by the full faith and credit of the U.S. government, even though this federal guarantee does not exist. Evidently, market participants believe that, in the event of the failure of a GSE, the government would have no alternative but to come to the rescue. The perception, however inaccurate, that the GSEs are fully government-backed implies that investors have few incentives in their role as counterparties or creditors to act to constrain GSE risk-taking. Raising the conforming-loan limit would expand this implied guarantee to another portion of the mortgage market, reducing market discipline further.

In general I agree with Bernanke's comments on the GSEs and conforming limits. It might be reasonable to have different limits for different areas, based on the median income for each area.

There is much more in the speech.