by Calculated Risk on 11/16/2007 03:22:00 PM

Note: Danielle DiMartino was warning about a housing bubble a couple of years ago when she worked for the Dallas Morning News. She now works for the Federal Reserve Bank of Dallas.

Here is DiMartino's current Economic Letter (with John V. Duca): The Rise and Fall of Subprime Mortgages (hat tip Kett82)

Here is the Dallas Fed reset chart. This shows most of the reset problems for subprime are still ahead of us.

Note that this chart doesn't include the second wave of resets for Option Arms coming around 2010. See here for a longer term chart.

Here is their conclusion:

The rise and fall of nonprime mortgages has taken us into largely uncharted territory. Past behavior, however, suggests that housing markets' adjustment to more realistic lending standards is likely to be prolonged.

One manifestation of the slow downward adjustment of home prices and construction activity is the mounting level of unsold homes. The muted outlook for home-price appreciation, coupled with the resetting of many nonprime interest rates, suggests foreclosures will increase for some time.

The sharp reversal of trends in home-price appreciation will also dampen consumer spending growth, an effect that may worsen if the pullback in mortgage availability limits people's ability to borrow against their homes.

Although recent financial market turmoil will likely add to the housing slowdown, there are mitigating factors.

First, the effect of slower home-price gains on consumer spending is likely to be drawn out, giving monetary policy time to adjust if necessary.

Second, the Federal Reserve has been successful in slowing core inflation while maintaining economic growth. This gives policymakers inflation-fighting credibility, which enables them to coax down market interest rates should the economy need stimulus.

Third, even if the tightening of mortgage credit standards undesirably slows aggregate demand, monetary policy could still, if need be, help offset the overall effect by stimulating the economy via lower interest rates. This would bolster net exports and business investment and help cushion the impact of higher risk premiums on the costs of financing for firms and households.

by Calculated Risk on 11/16/2007 11:15:00 AM

From Fed Governor Randall S. Kroszner: Risk Management and the Economic Outlook. First, on monetary policy:

... one feature of monetary policy to keep in mind is that, all else equal, each successive action in the same direction tends to lower the incremental benefits and to raise the incremental costs of additional actions. ...

... in September and again in October ... the FOMC [lowered rates] ... With those actions, however, the downside risks to economic growth now appear to be roughly balanced by the upside risks to inflation.

That is the clearest statement yet that the Fed (at least Kroszner) does not expect a rate cut any time soon.

After saying that the risks are balanced, Kroszner then says the economy is heading for a "rough patch":

In the near term, the economy will probably go through a rough patch during which a number of economic data releases may be downbeat. Home sales seem likely to weaken further ... a further weakening of demand is likely to prompt additional cutbacks in construction.

... conditions for subprime borrowers will get worse before they get better. First, the bulk of the first interest rate resets for adjustable-rate subprime mortgages are yet to come. On average, from now until the end of 2008, nearly 450,000 subprime mortgages per quarter are scheduled to undergo their first reset, eventually causing a typical monthly payment to rise about $350, or 25 percent. Second, the weakness in house prices and the resulting limit on the build-up of home equity will hinder the ability of subprime borrowers to refinance out of their mortgages into less expensive loans; as a result, more borrowers will be left with a mortgage balance that exceeds the value of the house.

The likely consequences of these two factors--imminent interest rate resets and the difficulty of refinancing--will be yet higher rates of delinquencies and foreclosures over the next several quarters and, in turn, additional downward pressure on house prices. The overhang of unsold homes also will weigh heavily on the prices of newly built and existing homes. ...

Elsewhere in the economy, increases in consumer spending can be expected to be limited for a while by the effects of sluggish home prices on household balance sheets. Consumer spending will also be constrained, although probably to a lesser extent, by the drain on aggregate purchasing power caused by mortgage resets; that drain will likely be exacerbated by the current run-up in energy prices. Meanwhile, heightened uncertainty in the business sector could lead to reductions in capital spending plans.

This reminds me of a teeter totter; it can be balanced with a few pounds at each end, or with hundreds of pounds at each end. If the risks are balanced, the concerns about inflation must be significant.

Consider these two stories from FedEx and UPS. From the WSJ: FedEx Cuts Earnings Outlook

FedEx Corp. lowered its earnings outlook Friday, citing high fuel costs and weakness in its less-than-truckload freight business.

The Memphis, Tenn., company had already cut its earnings forecast in September and said it would reduce capital spending ...

And from Reuters: UPS to hike delivery charges by 4.9 percent

Package delivery company United Parcel Service Inc said on Friday it was raising its prices for 2008 by about 4.9 percent, matching a planned hike by rival FedEx Corp ...

Economic weakness and rising prices. A teeter totter balanced with significant weight on both ends.

by Calculated Risk on 11/16/2007 10:40:00 AM

From Bloomberg: Goldman Sees Subprime Cutting $2 Trillion in Lending

The slump in global credit markets may force banks, brokerages and hedge funds to cut lending by $2 trillion and trigger a ``substantial recession'' in the U.S. ...

``The likely mortgage credit losses pose a significantly bigger macroeconomic risk than generally recognized,'' [Jan Hatzius, chief U.S. economist at Goldman] wrote. ``It is easy to see how such a shock could produce a substantial recession'' or ``a long period of very sluggish growth,'' he wrote.

Hatzius also wrote (not in article) that Goldman Sachs' working assumption is home prices will "fall 15% peak to trough ... if the economy stays out of a full-blown recession".

by Anonymous on 11/16/2007 10:05:00 AM

From National Mortgage News, via Clyde:

Nearly one in three buyers between June 2006 and June 2007 had no skin in their deals, according to new research that represents further evidence of the poor quality of loans that helped fuel the rising tide of delinquencies and foreclosures. Though the study of nearly 10,000 transactions by the National Association of Realtors did not note whether the loans were prime or subprime, it found that 29% of all buyers -- and 45% of all first-timers -- financed the entire purchase price. Somewhat surprisingly, considering that they usually have money from the sale of their previous residence to put into the transaction, 18% of repeat buyers also put up none of their own money.

The NAR press release is here.

I note that in the Greenspan-Kennedy method of calculating MEW, those transactions where a repeat buyer receives sales proceeds for an existing home in excess of the existing mortgage amount, but does not use those proceeds to reduce the mortgage amount on the next home purchase, will end up counting as MEW. It is, after all, equity extraction: the equity from the previous home is "extracted" in the sale, but does not become equity in the new home. This means that the loss of 100% financing for purchases will lower net MEW, just as the loss of some cash-out refinancing options will.

by Anonymous on 11/16/2007 08:35:00 AM

Floyd Norris sums it all up:

We should have known something was strange.

by Anonymous on 11/16/2007 08:16:00 AM

Bloomberg reports (hat tip to Bob_in_MA) that the GSEs are adding additional Loan Level Pricing Adjustments (in Fannie-speak) and Postsettlement Delivery Fees (in Freddie-speak) for loans delivered on or after March 1, 2008. What's new and different about these new fees is that they apply to "standard" loans; there are already pretty serious fees being charged for the ones made under the special A Minus/Expanded Approval/"Flexible" programs.

Specifically, they apply to any mortgage with an LTV greater than 70% and FICO less than 680. They range from 75 bps for loans in the 660-679 FICO bucket to 200 bps for loans with FICOs less than 620. These new fees are also cumulative, so they apply on top of the existing fees the GSEs charge for things like high-LTV cash-outs (50 bps for LTVs between 70% and 80% and 75 bps between 80% and 90%). So today, a borrower with a low-average FICO of 675 can get a cash-out up to 90% LTV with a 75 bps fee; that will turn into a 150 bps fee next March.

As most borrowers, especially refinancing borrowers, don't pay points in cash, these fees will either end up as points that are rolled into the loan balance or as higher interest rates. Assuming a rough price:rate ratio of 3:1, that means a note rate 0.25% higher for our hypothetical "average" cash-out borrower.

The Bloomberg article also indicates that Freddie is lowering its maximum LTV for properties in a declining-value market. Actually, the rule in question (reduce maximum LTV by five points in declining markets) has been around since Hector was a pup for Fannie and Freddie and lots of other investors; Freddie is dusting it off and reminding everyone that it exists. For those of you who have become appraisal-issue addicts, here's what Freddie's Bulletin says:

We use http://www.ofheo.gov/hpi_download.aspx to help identify declining markets. This is an example of a tool you may use to help in determining whether a Mortgage is subject to our maximum financing limits.

Underwriting expectations – maximum financing in declining markets

With respect to underwriting requirements, when the property securing a Mortgage is located in a declining market, Sellers must:

􀂄 Determine whether any contributions are interested-party contributions as described in Section 25.3, if any contributions are offered.

􀂄 Determine the maximum interested-party contribution limits based on the lower of the appraised value or the sale price, if applicable

􀂄 Adjust the sale price of the property by deducting the total dollar amount of any sales concessions from the sale price of the property. Sales concessions are defined in Section 25.3.

􀂄 Calculate the LTV/TLTV ratio based on the lower of the appraised value or the adjusted sale price.

􀂄 Restrict the maximum LTV ratio to at least five percent less than the maximum ratio allowed for the transaction. If there is layering of risk, the Seller should consider higher restrictions to the maximum allowable ratio to address market conditions and the risk in the transaction.

That's not new; old underwriting hands can recite these rules at cocktail parties if you are silly enough to encourage them. This bit, though, is new:

Interested party contributions in the form of financing and sales concessions are becoming more common due to market conditions. Currently, we require that maximum financing concessions be determined based on the LTV ratio of a Mortgage. Because maximum financing concessions and lower Borrower contributions are particularly prevalent in transactions with secondary financing, we are changing our guidelines to require that maximum financing concessions be based on TLTV ratio when secondary financing is present, and LTV ratio when there is no secondary financing.

Translation: no more getting around financing concession rules by structuring the loan with a low LTV and a high CLTV (TLTV in Freddie-speak). Whether this will be a big deal or not depends on how many subordinate-financing lenders are still standing in March 2008, of course.

It is fairly typical for the GSEs to make major changes to their rules with a fair amount of lead time: they try not to reprice loans that were already approved or committed to a customer or in the lender's MBS pipeline. Still, these March deadlines are for loans delivered to the GSEs on that date, not loans made on that date. Therefore, these pricing adjustments will be made to lender rate sheets signficantly before March. Merry Christmas.

by Calculated Risk on 11/15/2007 11:54:00 PM

The cover story in The Economist: America's vulnerable economy

IN 1929, days after the stockmarket crash, the Harvard Economic Society reassured its subscribers: “A severe depression is outside the range of probability”. In a survey in March 2001, 95% of American economists said there would not be a recession, even though one had already started. Today, most economists do not forecast a recession in America, but the profession's pitiful forecasting record offers little comfort. Our latest assessment (see article) suggests that the United States may well be heading for recession.

Does the cover curse apply to The Economist? In this case, I think a U.S. recession is likely (I agree with The Economist), but I'm not so sure about the decoupling theory.

From the Financial Times: China fears impact of US slowdown

China’s commerce ministry warned on Thursday that a slowing US economy would trigger a drop in Chinese exports that would mark a “turning point” for China’s rapid economic growth.

A global economic slowdown ... “will be the biggest challenge to China’s economy next year”, a report from the ministry’s policy research department said.

The report is Beijing’s first public comment on what repercussions it expects from the global credit crisis and a sign that the government does not support the view that Asian growth has “decoupled” from the US. “If demand in the US drops further, Chinese exporters will be devastated by a rapid and continuous fall in orders,” the report said.

That doesn't sound like decoupling to me.

by Calculated Risk on 11/15/2007 06:29:00 PM

From the Downey Financial 8-K released today. (hat tip Greg and others)

Click on graph for larger image.

This would be a nice looking chart, except those are the percent non-performing assets by month.

Yes, by month!



Note: So much news today ... Starbucks, J.C. Penny, Alltel Banks Cut Loan Sale Size a Second Time and much more. Clearly the economy is slowing sharply.

by Calculated Risk on 11/15/2007 02:58:00 PM

From DataQuick: Bay Area home sales drag along bottom

Bay Area home sales remained at their lowest level in decades last month, the result of mortgage market turbulence and hesitant buyers. Prices continued to hold up best in core markets, while declines steepened in some inland areas, a real estate information service reported.

A total of 5,486 new and resale houses and condos were sold in the nine-county Bay Area in October. That was up 9.4 percent from 5,014 in September, and down 35.7 percent from 8,532 for October a year ago, DataQuick Information Systems reported.

Sales have decreased on a year-over-year basis the last 33 months. Last month was the slowest October in DataQuick's statistics, which go back to 1988. Until last month, the slowest October was in 1990 when 6,443 homes were sold. The strongest October was in 2003 when sales totaled 13,392. The average for the month is 8,930.
...
The median price paid for a Bay Area home was $631,000 last month, up 1.0 percent from $625,000 in September, and up 2.4 percent from $616,000 for October last year. The median peaked at $665,000 last June and July.
...
Foreclosure activity is at record levels ...

by Calculated Risk on 11/15/2007 01:11:00 PM

This post is a followup to: Bloomberg's Berry: No Recession (Hat tip NJ_Bob for graph ideas)

One of the questions raised by the Bloomberg article is how much more equity can be borrowed on U.S. household real estate. Based on the Fed's flow of funds report, the percent of homeowner equity was at a record low of 51.7% at the end of Q2 2007.

However, according to the Census Bureau, 31.8% of all U.S. owner occupied homes have no mortgage. You can't do a direct subtraction because the value of these paid-off homes is, on average, lower than the mortgaged 68%. But we can construct a model based on data from the 2006 American Community Survey (see table here).

Click on graph for larger image.

This graph shows the distribution of U.S. households by the value of their home, with and without a mortgage. This data is for 2006.

By using the mid-points of each range, and solving for the price of the highest range (to match the Fed's estimate of household real estate assets at the end of 2006: $20.6 Trillion), we can estimate the total dollar value of houses with and without mortgages.

Using this method, the total value of U.S. houses, at the end of 2006, with mortgages was $15.27 Trillion or 74.2% of the total. The value of houses without mortgages was $5.32 Trillion or 25.8% of the total U.S. household real estate.

Since all of the mortgage debt is from the houses with mortgages, these homes have an average of 36% equity. It's important to remember this includes some homes with 90% equity, and some homes with negative equity.

The following graph shows the impact of falling house prices on the percent aggregate equity.

At the end of 2006, aggregate equity for mortgage holders was 36%.

If household assets fall 10%, and liabilities stay the same, the percent equity will fall to 28.9%. If household assets fall 20%, the percent equity will fall to 20%.

If assets fall 35%, there will be no equity in the aggregate - households with positive equity will be offset by households with negative equity. Although I don't expect prices to fall anywhere near 35%, even a decline of 10% will probably severely limit the ability of marginal homeowners to borrow from their home equity.

This is based on 2006 data. Mortgage equity borrowing was still strong through the first three quarters of 2007 (Q3 estimated), and the situation is even worse now.