by Calculated Risk on 11/12/2007 05:20:00 PM

From Dow Jones (no link yet): Fitch Downgrades $37.2B Of CDOs, Slashing AAAs to Junk

Fitch Ratings downgraded Monday the credit ratings of $37.2 billion of global collateralized debt obligations, with more than $14 billion worth of transactions falling from the highest-rated AAA perch to speculative-grade, or junk, status.
...
The rating agency said more than 60 CDO transactions are still on watch for potential downgrade, with a resolution due on or before Nov. 21.

On Monday, nearly $20 billion worth of transactions was cut from investment-grade to junk, said Kevin Kendra, managing director at Derivative Fitch.

From AAA to Junk in one fell swoop!

by Calculated Risk on 11/12/2007 04:53:00 PM

In his most recent post, Professor Roubini commented on the impact of less homeowner equity extraction on consumption.

Note that Roubini calls equity extraction HEW (Home Equity Withdrawal) and I usually refer to it as MEW (Mortgage Equity Withdrawal). MEW has been used for years, but HEW is a more accurate description.

Roubini writes:

... there is the effect of home equity withdrawal (HEW) on consumption. There is some debate in the literature on whether the effect of HEW is a proxy for the wealth effect or an additional and separate effect. Again the literature has a variety of estimates ranging from 50% of HEW being consumed according to Greenspan-Kennedy to 25% of it being consumed according to other studies. The appropriate measure of HEW is also important: gross or net, overall or active. HEW peaked at $700 billion annualized in 2005 and has dropped to about $150 billion by Q2 of 2007. So, the fall in consumption – assuming unrealistically no further fall in HEW from now on – would be $275 billion based on the Greenspan-Kennedy estimates or about $140 billion according to the more conservative estimates. Evidence suggests that this effect of HEW on consumption occurs with lags; that is why we have not yet seen its full effects on consumption as late as Q3. Rather, we will see its effects in the next few quarters. Another interpretation – according to Zandi – is that HEW (measured in a different way) has started to fall only in the recent quarters; so again the effect of falling HEW on consumption will be observed mostly in 2008.

First, for those that want to follow along, here is a copy of the Kennedy-Greenspan data for Q2 in Excel. NOTE this request from the Fed:

These data are the product of a research project undertaken by James Kennedy and Alan Greenspan. The data are not an official publication or product of the Federal Reserve Board. If you cite these data, please reference one of the two papers that Jim wrote with Alan Greenspan. For example, a reference might read something like this:

"Updated estimates provided by Jim Kennedy of 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."

Here are the Seasonally Adjusted Annual Rate (SAAR) Kennedy-Greenspan estimates of home equity extraction through Q2 2007, provided by James 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.

For Q2 2007, Dr. Kennedy calculated Net Equity Extraction as $494.4 Billion (SAAR), or 4.9% of Disposable Personal Income (DPI).

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

Roubini is suggesting the MEW has declined significantly in Q2. I think this is incorrect. Roubini wrote:

HEW peaked at $700 billion annualized in 2005 and has dropped to about $150 billion by Q2 of 2007.

According to Dr. Kennedy, MEW was about $140 Billion in Q2 2007 (or a seasonally adjusted annual rate of almost $500 Billion). So MEW hasn't fallen very far yet! This actually makes Roubini's argument even stronger. So I'd argue the following sentence is also incorrect:

So, the fall in consumption – assuming unrealistically no further fall in HEW from now on – would be $275 billion based on the Greenspan-Kennedy estimates or about $140 billion according to the more conservative estimates.

In fact I expect MEW to fall signficantly starting in Q4 2007. As of Q2, 2007 the consumption impact of falling MEW (using 50%) would be closer to $25 Billion per quarter ($100 Billion annualized), and even though there appears to be a lag from equity extraction to consumption, most of the decline in equity extraction is still ahead of us.

In fact it appears MEW was strong in Q3 based on my advance estimate. Using the Q3 GDP data from the BEA, my advance estimate for Mortgage Equity Withdrawal (MEW) is approximately $520 Billion (SAAR) or 5.1% of Disposable Personal Income (DPI). This would be slightly higher than the Q2 estimates, from the Fed's Dr. Kennedy, of $494.4 Billion (SAAR), or 4.9% of Disposable Personal Income (DPI).

The actual Q3 data for MEW is released after the Flow of Funds report is available from the Fed (scheduled for December 6th for Q3).

Click on graph for larger image.

This graph compares my advance MEW estimate (as a percent of DPI) with the MEW estimate from Dr. James Kennedy at the Federal Reserve. The correlation is pretty high (0.90, R2 = 0.81) but there are differences quarter to quarter. This does suggest that MEW was at about the same level in Q3 as Q2. We will have to wait until September to know for sure.

MEW will probably decline precipitously in the Q4 2007, with a combination of tighter lending standards and falling house prices. The impact of less equity extraction on consumer spending is still being debated, but I agree with Roubini that a slowdown in consumption expenditures is likely.

by Calculated Risk on 11/12/2007 02:37:00 PM

From John Hussman (hat tip Duceswild): Expecting a recession

In recent months, I've repeatedly noted that while recession risks were gradually increasing, there was not sufficient evidence to expect an imminent economic downturn. Most economists still believe this. On Saturday, the consensus of economists surveyed by Blue Chip Economic Indicators indicated expectations that growth will be sluggish into next year, but that there will be no recession. Unfortunately, the economic consensus has never accurately anticipated a recession. For my part, the outlook has changed. I expect that a U.S. economic recession is immediately ahead.

From Nouriel Roubini: The Coming US Consumption Slowdown that Will Trigger an Economy-Wide Hard Landing

Any recession call for the U.S. is clearly dependent on US consumption faltering. Since residential investment is only 5% of even a worsening housing recession cannot – by itself – trigger an economy-wide recession. Rather, since private consumption is over 70% of aggregate demand a sharp and persistent slowdown in consumption growth – below 1% or even negative - is necessary to trigger a full blown recession.

In this regard, evidence is mounting that a debt-burdened and saving-less US consumer – that until recently used its home as an ATM and borrowed against its housing wealth - is now on the ropes and at its tipping point.

... a sharp slowdown in consumption growth will be the last straw that will trigger an economy wide recession. Expect Q4 growth to be 1% or below and this growth further to accelerate into negative territory by H1 of 2008.

And Roubini on the housing wealth effect:

... there is the wealth effect of falling home values. Estimates of such a wealth effect range in between 5% and 7% of the change in wealth ... The total wealth effect of housing on consumption also depends on how much home values will fall. Current estimates range between a consensus of at least 10% price fall, some suggesting a 15% fall and some – like myself and others – arguing that home prices will fall 20% or more. According to Fed data, the market value of the US residential housing stock was $21.0 trillion at the end of the second quarter of 2007. Thus, the fall in housing wealth could be in the $2 trillion (for a 10% drop in home prices) to $4 trillion range (for a 20% drop in prices). At $2 trillion and with a 5% effect one gets a fall in real consumption of $100 billion; with $4 trillion and with a 7% effect you get a fall in consumption of $280 billion.

I'll get back to Roubini's discussion of the impact of home equity withdrawal on consumer spending.

Note that Roubini has been pretty bearish for some time, but I believe this is a new position for John Hussman.

by Calculated Risk on 11/12/2007 12:10:00 PM

According to the BLS, residential construction employment has only declined 6.5% from the peak employment in 2006 (221,900 fewer jobs). This is surprising because housing completions are off about 37% from the peak.

Click on graph for larger image.

This graph shows starts, completions and residential construction employment. (starts are shifted 6 months into the future). Completions and residential construction employment were highly correlated, and Completions typically lag Starts by about 6 months.

The puzzle is why residential construction employment hasn't fallen further.

The following article from the Beaufort Gazette provides some clues: Housing meltdown hammers construction industry

Beekman Webb put a classified advertisement in the newspaper a couple of weeks ago for a carpenter's assistant and "had about 50 calls in three days."

"I was just covered up, and I was the only ad in the paper at the time looking for carpentry help," said Webb, who has his own Beaufort-based construction company.

"I had people from Hilton Head (Island) that told me they'd been in business for 15 years with a bunch of employees and now they're just looking for a job as a carpenter," he said.

The housing market slump has had a trickle-down effect on the area's residential construction industry, according to local builders. Gerald Neal, owner of Neal's Construction in Beaufort, first noticed the slowdown earlier this year.

"It's real tough times for those guys -- the (residential construction) subcontractors. They're having a rough time," he said.

The local commercial construction industry has not been hit quite as hard, according to Neal, which has made him change the way he operates his business.

"I used to do 20 percent commercial. Today, I do about 60 percent commercial, 40 (percent) residential," Neal said.

This hits on two of the explanations for the residential construction employment puzzle: many workers have moved to commercial work (note that Neal has moved from 20% percent commercial to 60% commercial), and many workers are underemployed.

Other possible reasons for the employment puzzle are that the BLS has not correctly accounted for illegal immigrants working in the construction industry, and the BLS Birth/Death model might have missed the turning point in residential construction employment.

There is some merit to to all of these arguments, and I think the answer will be some combination of these explanations. The concern now is that if commercial construction spending slows, as appears likely from the recent Fed loan survey, then workers that have moved to commercial construction will have no work opportunities.

This was the concern expressed by the director of forecasting of the NAHB in August. From Reuters: Construction job losses could top 1 million

"The ability of nonresidential to continue absorbing additional workers is going to be limited, and that's going to put downward pressure on construction employment overall," [Bernard Markstein, director of forecasting at the National Association of Home Builders] said, adding that cuts may be deeper than in the 1990s.

by Calculated Risk on 11/12/2007 09:38:00 AM

Back in July, Bernanke suggested the subprime related losses would be in the $50 Billion to $100 Billion range:

"Some estimates are in the order of between $50 billion and $100 billion of losses associated with subprime credit problems," [Bernanke] said (July 19, 2007).

Last week, the Royal Bank of Scotland pegged the total losses at $250 Billion to $500 Billion:

``This credit crisis, when all is out, will see $250 billion to $500 billion of losses,'' London-based Janjuah said.

Now from Bloomberg: Subprime Losses May Reach $400 Billion, Analysts Say

Losses from the falling value of subprime mortgage assets may reach $300 billion to $400 billion worldwide, Deutsche Bank AG analysts said.

Wall Street's largest banks and brokers will be forced to write down as much as $130 billion because of the slump in subprime-related debt, according to a report today by Mike Mayo, a New York-based analyst. The rest of the losses will come from smaller banks and investors in mortgage-related securities.

As I've noted before, Mayo has really been on top of the Wall Street losses.

Also these losses don't include the coming $2+ Trillion in household net worth losses due to house prices falling over the next couple of years.

by Calculated Risk on 11/12/2007 09:30:00 AM

From MarketWatch: Citi downgrades E-Trade to sell rating (title hat tip Herb Greenberg)

"We estimate that trying to liquidate E-Trade's loan and ABS portfolio would result in over $5 billion of losses, more than wiping out tangible equity," Citi analysts said.
...
"Bankruptcy risk cannot be ruled out," they said.

A "sell" rating and the B-word. Watch out for the death threats.

by Calculated Risk on 11/12/2007 12:19:00 AM

From Eric Dash at the NY Times: Some Wonder if the Banks’ Stabilization Fund Will Work

... Will it actually help?

The answer, some analysts and big investors say, is probably not much. The backup fund will not save troubled structured investment vehicles, or SIVs, that hold billions of dollars in packaged loans, though it could delay their demise. It may help calm the turbulent credit markets by preventing a sharp sell-off of securities ...

The hope is that the backup fund will allow time for asset prices to recover, although most market analysts call that improbable. But if the backup fund helps SIVs avoid sell-off, those investors may lose less money. Prices vary, but even amid a deteriorating market, some analysts say that the bulk of SIV assets are still fetching between 97 cents and 98 cents on the dollar.
...
The backup fund will not purchase the most distressed assets in the SIVs. Bank organizers agreed that it would not accept any subprime mortgage-related assets and only certain types of risky complex instruments like collateralized debt obligations.
...
“Will this resolve the basic issue of the assets of the SIV trading below what they were originally?” asked Steven Abrahams, the chief interest-rate strategist at Bear Stearns. “No, it defers the day of reckoning.”

It doesn't sound bad with assets "fetching between 97 cents and 98 cents on the dollar", however, because of leverage, this puts the SIVs right on the threshold of a possible enforcement event.

As noted in my earlier SIV post, Fitch rated SIVs average 14 times leverage. So, if an SIV had $1 Billion in capital, and an additional $14 Billion in leverage (mostly from selling commercial paper and medium-term notes), the SIV would hold $15 Billion in assets. If the typical asset was "fetching between 97 cents and 98 cents on the dollar", that would be a loss of $300M to $450M, or a loss of 30% to 45% of capital (from the $1 Billion) giving a NAV of 55% (97 cents on the dollar) to 70% (98 cents on the dollar).

According to Fitch, if the NAV for an SIV falls below 50%, then the fund might face an enforcement event, and it might have to be liquidated. Once the assets of one fund were liquidated - say at 96 cents on the dollar - that would mean the NAVs for other SIVs would probably fall below 50% - and they might also have to be liquidated, further depressing prices.

by Anonymous on 11/11/2007 05:26:00 PM

Angelo Mozilo, February 4, 2003, Washington, DC:

As we had envisioned in 1992, House America offers unique loan products that have been specifically designed to meet the needs of minority and low- to moderate- income borrowers. But it also does more. It has become not just a lending program, but a more comprehensive effort that devotes considerable intellectual and financial resources to increasing homeownership among minority and low- to moderate-income individuals and families.

It is an effort that includes a counseling center which provides free services by phone in a comfortable, no obligation environment where people can obtain information about the home-buying process. It is an effort that, in addition to providing loan products with flexible underwriting criteria such as home rehab loans, also specializes in being able to layer financing programs through participation in hundreds of down payment and closing cost assistance programs. House America also offers other tools to ensure that we are doing everything in our power to expand the opportunities for home-ownership. It is an effort absolutely committed to education and outreach, both in English and Spanish, both online and in local communities, both at local home-buyer fairs and at lending workshops, and with our many partners, like Fannie Mae, Freddie Mac, FHA, the Congressional Black Caucus, the National Council of La Raza, AFL-CIO, and faithbased groups across the Country, just to name a few.

I want to specifically and especially recognize Franklin Raines and his entire team at Fannie Mae for providing a great deal of the resources that have made it possible for us to achieve our House America objectives.

In 1993, Countrywide opened four dedicated House America retail branches, and now we have 23 staffed with local and diverse professionals in major metropolitan areas all across the Country.

It is an effort that has enabled Countrywide to become the number one lender to Hispanics for the last 6 years and the number one lender to African Americans for the past 3 years.1 It is an effort that is helping create, if you will allow me to paraphrase, a Field of American Dreams. “If you build it, and build it right, they will come.” Finally, House America is an effort that, as you can tell, makes all of us at Countrywide extremely proud. I could talk about it all night, but I won’t.

But I want to make the point that this outreach effort is imperative. Fortunately Countrywide isn’t alone – there are other mortgage lenders and financial institutions that are all making positive contributions. And the lesson we can take away from this is the following: for a long time, when it came to increasing low-income and minority homeownership, the message has always been “we should,” or “we must.” But the fact is, “we can,” and “we are.”

Now, we must take the energy and expertise and the ideas and the innovation that we’ve brought to increasing the overall homeownership rate, and apply them to creating reasonable parity among homeowners. It is time, once and for all, to narrow and ultimately eliminate the homeownership gap. I believe we can eliminate the gap and it is, in large part, why I got into this business. [Emphasis added]

Angelo Mozilo, October 29, 2007, Los Angeles:

In just the period from second quarter 2005 to second quarter 2007, California delinquency rates have climbed more than 180 percent. But State Treasurer Bill Lockyear said that while he anticipates some economic ripple effect across the state, "it's still too early to measure." Next year, California’s deficit is expected to reach $9 billion, he noted, and while the subprime effect will be "significant," he anticipates that the state will be shielded by its strong and diverse economy.

Countrywide's Chairman and CEO, Angelo Mozilo, took pains to explain what precipitated the subprime problem. First, he said, easy money began to drive up home prices at the start of the decade. When the Fed began to raise interest rates -- after some six or seven times, in fact -- people suddenly began to scramble to get into houses before the next rate hike. In addition, lenders were facing pressure from minority advocates to help people purchase homes. Lenders felt pressure to lessen their loan standards.

by Calculated Risk on 11/11/2007 10:09:00 AM

NOTE: See update on NAV in post.

From the NY Times: Banks Said to Agree on Credit Backup Fund

The country’s three biggest banks have reached agreement on the structure of a backup fund of at least $75 billion to help stabilize credit markets ...the proposed fund could begin operating by the end of December ...

Henry M. Paulson ... acknowledged that the proposed backup fund would not rescue troubled SIVs, only lead to a longer and more orderly demise.

Originally the Super Fund was going to buy only the best assets from the SIVs to provide liquidity - but I guess people realized that wouldn't help. Now, apparently, the Super Fund will buy anything:

... the fund will not distinguish between the assets it buys from each SIV; instead, it will assign the same risk level to all their troubled securities.

If the Super Fund will buy anthing, it will likely end up with the worst assets. From Reuters: Fitch may cut Citi's Sedna-managed SIV notes

Fitch Ratings on Friday said it may cut its ratings on notes from a structured investment vehicle managed by Citi Alternative Investments, called Sedna Finance ...

"The rating action reflects Fitch's view that significant refinancing requirements in the first quarter of 2008 might have to be covered by asset sales, leading to a realization of net asset value (NAV) losses," Fitch said in a statement.

The NAV of the notes is now 72.5 percent, Fitch said.

"Fitch recognizes that there is no imminent pressure for Sedna Finance to sell assets, as the vehicle is funded into January 2008," Fitch said. "However, significant amounts of funding mature in the first quarter of 2008."

This low NAV isn't unique to assets held by Citigroup managed SIVs. On a conference call on Thursday, Moody's says some SIV NAVs have fallen below 50%

... that the average NAV across the SIV sector has fallen from 101% at the beginning of July to 71% at the beginning of November

UPDATE: I misread the NAV here, and the difference is important. (hat tip jck at Alea Blog) From Fitch Ratings: Rating Performance of Structured Investment Vehicles (SIVs) in Times of Diminishing Liquidity for Assets & Liabilities See: NAV Deterioration on page 11.

As the prices of the underlying assets of the SIV decline the NAV of the capital note reduces at a magnified level due to the 14 times leverage found on average within the SIV market. Hence, a 0.5% price drop on all assets across the portfolio would result in the NAV declining by 7%.

Click on graph for larger image.

During the past 10 weeks, Fitch has observed the NAV of each SIV to decline. The above chart presents the weighted-average NAV of the Fitch-rated SIVs. In early July, the weighted-average NAV was slightly above par. However, over the past ten weeks it has reduced down to 76%.

So, using a NAV decline to 71% (from Moody's), the underlying asset losses are around 2% for an average SIV. With the NAV at 50%, the loss would be closer to 3.5%.

This reminds me of when Bernanke talked about an "orderly" decline in the housing market:

... Federal Reserve Chairman Ben S. Bernanke said [May 18, 2006] that the U.S. housing market ... slowdown is "moderate" and "orderly" ...

Now Paulson is talking about an "orderly demise" for these SIVs.

Perhaps "Orderly" is the new "Contained".

by Anonymous on 11/11/2007 09:18:00 AM

If you are a veteran of the United States Military (and thank you very much), or if you have ever attempted to moderate blog comments, you will find the following video too painful to watch. For everyone else I expect it's a scream.

(Via Balloon Juice)