by Calculated Risk on 12/14/2007 11:49:00 AM

Update: Also see Krugman's blog: Why negative equity matters

[T]he problem with the markets isn’t just a lack of liquidity — there’s also a fundamental problem of solvency.
Paul Krugman, NY Times, Dec 14, 2007

Paul Krugman writes in the NY Times: After the Money's Gone

First, we had an enormous housing bubble in the middle of this decade. To restore a historically normal ratio of housing prices to rents or incomes, average home prices would have to fall about 30 percent from their current levels.

The WSJ recently had a series of graphs titled: Genesis of a Crisis. Here is the chart of the Price to Rent ratio.

Click on graph for larger image.

This graph is based on a ratio of the OFHEO house price index to personal consumptions on rent. Note: Later today I'll post a graph based on the Case-Shiller index.

As Krugman notes, house prices would have to fall about 30% to bring the Price to Rent ratio back to a more normal ratio.

Krugman:

Second, there was a tremendous amount of borrowing into the bubble, as new home buyers purchased houses with little or no money down, and as people who already owned houses refinanced their mortgages as a way of converting rising home prices into cash.

The Fed recently released the Q3 Flow of Funds report. The report showed that household percent equity was at an all time low of 50.4%.

This graph shows homeowner percent equity since 1954. Even though prices have risen dramatically in recent years, the percent homeowner equity has fallen significantly (because of mortgage equity withdrawal 'MEW'). With prices now falling - and expected to continue to fall - the percent homeowner equity will probably decline rapidly in the coming quarters.

Also note that this percent equity includes all homeowners. Based on the methodology in this post, aggregate percent equity for households with a mortgage has fallen to 33% from 36% at the end of 2006.

Krugman:

As home prices come back down to earth, many of these borrowers will find themselves with negative equity — owing more than their houses are worth. Negative equity, in turn, often leads to foreclosures and big losses for lenders.

And the numbers are huge. The financial blog Calculated Risk, using data from First American CoreLogic, estimates that if home prices fall 20 percent there will be 13.7 million homeowners with negative equity. If prices fall 30 percent, that number would rise to more than 20 million.

That translates into a lot of losses, and explains why liquidity has dried up. What’s going on in the markets isn’t an irrational panic. It’s a wholly rational panic ...

From the post Professor Krugman mentions: Homeowners With Negative Equity

The following graph shows the number of homeowners with no or negative equity, using the most recent First American data, with several different price declines.

At the end of 2006, there were approximately 3.5 million U.S. homeowners with no or negative equity. (approximately 7% of the 51 million household with mortgages).

By the end of 2007, the number will have risen to about 5.6 million.

If prices decline an additional 10% in 2008, the number of homeowners with no equity will rise to 10.7 million.

The last two categories are based on a 20%, and 30%, peak to trough declines. The 20% decline was suggested by MarketWatch chief economist Irwin Kellner (See How low must housing prices go?) and 30% was suggested by Paul Krugman (see What it takes).

As Krugman notes: The current crisis is not a liquidity problem, it is a solvency problem.

by Anonymous on 12/14/2007 10:50:00 AM

BusinessWeek sums it up: "Dog Days at Cerberus."

Here's one for the Things You Have To Read A Couple of Times At Least To Assure Yourself That It's Not Just You File:

Now, say sources close to Cerberus, the $26 billion firm has slowed its pace of dealmaking with the credit crunch in full force. It's also focusing more rigorously on the troubled holdings in its portfolio—some of which may have blindsided the firm. The situation has prompted concern that Cerberus' returns may suffer. This comes at a time when all players are under pressure. "Industry returns have been extraordinary, 20% to 30% a year," says Katharina Lichtner, managing director of the private equity advisory firm Capital Dynamics. "Returns will come down, revert to a more normal 16%."

And what kind of socially redeeming value will Cerberus be adding to the mortgage biz for that perfectly normal 16%?

It's unclear just how much work it will take to fix GMAC, the financing arm of General Motors (GM). A Cerberus-led group paid $14 billion for a 51% stake in September, 2006. Cerberus wasn't exactly an industry newcomer. It had a front row seat at the subprime show with Aegis Mortgage, a lender it took control of in 1996. Yet Cerberus jumped into GMAC at exactly the wrong moment. Price defends the move: "There was one time to buy GMAC. We wanted it and took action."

The short story? Aegis filed for bankruptcy in August, and GMAC's mortgage group ResCap has been bleeding red ink. Cerberus watched GMAC continue to make subprime loans in the first quarter but has since reined it in. It wasn't fast enough to prevent the pain. ResCap has lost $3.4 billion so far this year, forcing GMAC to pump $2 billion into the business to help it survive the mortgage mess. And Lehman Brothers analyst Brian Johnson forecasts an additional $1.3 billion hit this quarter and $600 million in 2008. "I don't think anyone is panicked," says one Cerberus insider. But "we sure as hell didn't expect GMAC to be what it turned out to be."

Those problems may put a kink in the firm's strategy. Cerberus, which also owns 80.1% of struggling automaker Chrysler, wants to merge the lending operations of both companies. By doing so, it could reap massive savings on back office and loan processing operations, boosting returns at both GMAC and Chrysler.

Cut back office at a mortgage servicer. Put people who can service car loans in charge of mortgage loans. That's exactly what we need right now. Dog days at Cerberus, or just doghouse for the rest of us?

Let me just observe that GMAC's mortgage servicing unit was already pretty "stripped down" in its heyday. That was its business model: cheap servicing. I can't wait to see what happens when you make it cheaper.

by Anonymous on 12/14/2007 09:50:00 AM

In case you were paying attention to big news yesterday (yeah, we're lookin' at you, Citi) and missed the RepoBus, don't miss the RepoBus. Tragedy as farce. It always gets there in the end.

I forgot who sent me the link to that article yesterday. So I'll just hat tip everybody, the innocent as well as the guilty. It ought to be a fun day.

by Calculated Risk on 12/13/2007 06:48:00 PM

From the WSJ: Citigroup to Bring $49 Billion From SIVs Onto Its Balance Sheet

Citigroup ..., is bailing out seven struggling investment entities, bringing $49 billion onto its beleaguered balance sheet and further denting its depleted capital base.
...
The move could be the death knell for an industry-wide effort to create a rescue fund for the SIVs. ...

The move underscores how quickly Vikram Pandit, who was named Citi's new chief executive on Tuesday, is moving to tackle the myriad problems facing Citigroup. Just two days into his tenure, Mr. Pandit decided to bring the SIV assets onto the bank's balance sheet ...
...
By bringing the SIV assets on its balance sheet, Citigroup's already-depleted capital levels will come under further stress.
...
A Citigroup spokeswoman declined to comment on possible dividend cuts or capital-raising plans.

by Calculated Risk on 12/13/2007 04:33:00 PM

From CFO.com: Employees Raiding 401(k)s, CFOs Say (hat tip Lyle)

The latest Duke University/CFO Magazine Global Business Outlook Survey, which polls 573 finance chiefs in the U.S. and 1,275 globally, finds that year-end employee bonuses will fall by 10 percent this year compared to 2006. That decline could be especially painful at a time when more employees are dipping into their retirement accounts in order to pay bills.

The survey finds that nearly 20 percent of companies have seen increased hardship withdrawals from 401(k) accounts, often to cover mortgage payments or to avoid personal bankruptcy.

"In the last four or five months we have seen an absolute onslaught of people trying to do hardship withdrawals and loans out of 401(k)s," Mark Anderson, CFO of Granite City Electric, told CFO magazine in October. "What has happened with housing and the economy has really blown up for people at the lower end of the spectrum."

CFOs attribute the 401(k) withdrawals to the effects of the shaken credit markets and higher costs of living, among other reasons. Those concerns have affected companies from top to bottom. Nearly a third of CFOs polled in the survey said their firms have been directly hurt by credit conditions.

This article is from last week. With home equity extraction slowing, consumers are turning to other sources for cash, like credit cards and 401(k) withdrawals. Whatever the source, it appears - at least in November - that they are still spending.

by Calculated Risk on 12/13/2007 12:31:00 PM

From the Fed weekly report on commercial paper this morning, here is the discount rate spread:

Click on graph for larger image.

Worse than August.

Worse than 9/11.

UPDATE: A simple explanation of this chart: This is the spread between high and low quality 30 day nonfinancial commercial paper.

What is commercial paper (CP)? This is short term paper - less than 9 months, but usually much shorter duration like 30 days - that is issued by companies to finance short term needs. Many companies issue CP, and for most of these companies the risk of default is close to zero (think companies like GE or Coke). This is the high quality CP. Here is a good description.

Lower rated companies also issues CP and this is the A2/P2 rating. Correction: This doesn't include the Asset Backed CP - that is another category and is even at a higher rate (see commercial paper table).

The spread between the A2/P2 and AA paper shows the concern of default for the A2/P2 paper. Right now the spread is indicating that "fear" is very high. It is actually very rare for CP defaults, but they do happen (see table 5 in the above Fed link).

by Calculated Risk on 12/13/2007 11:48:00 AM

From Jonathan Weil at Bloomberg: CIBC's Big Subprime Secret Might Cost Billions (hat tip Justin)

CIBC last week [said some company] is insuring $3.47 billion, or about a third, of the collateralized- debt obligations it holds that are tied to U.S. subprime mortgages.

The [insurer]'s identity matters because the bank said these hedged CDOs were worth just $1.76 billion at Oct. 31, down almost half from their face amount. If the guarantor goes poof, CIBC loses its hedge on these derivative contracts. And the Toronto-based bank would have to recognize the loss, which is growing.

If ACA is the insurer, this would be bad for CIBC ... ACA Financial ... had $425.5 million of statutory capital at Sept. 30 and $1.1 billion of so-called claims-paying resources to back its guarantees -- for all its customers. That's not enough to cover the CDOs in question at CIBC.

Weil is speculating that ACA is the counterparty to CIBC, but it does seem likely.

I've also been told that on the Lehman conference call this morning, a Lehman executive said (paraphrased by source) that they "don’t have visibility into--and can’t count on--some counterparties so they have bought CDS’s to hedge that exposure."

by Calculated Risk on 12/13/2007 11:33:00 AM

From Financial News: HBOS pain takes UK bank writedowns to £2bn in a week (hat tip Barley)

HBOS has become the fourth UK lender in a week to announce a multi-million pound writedown on the back of the turmoil in global credit markets, taking the total written off by UK banks in the last seven days to almost £2bn (€4bn).

The bank this morning said it wrote down £520m on its investments, three days after Lloyds TSB revealed a £200m hit on its own portfolio and a week after Royal Bank of Scotland reduced the value of its assets by £950m as a result of its exposure to US sub-prime.

Northern Rock continued to add to the woes of the UK banking sector, saying this morning it had written down its collateralised debt obligation portfolio by £281m.

And the beat goes on ...

by Calculated Risk on 12/13/2007 11:00:00 AM

Click on graph for larger image.

Office vacancy rates have spiked in California's Inland Empire and Orange County according to the USC Lusk Center’s Casden Real Estate Economics Forecast.

Jeff Collins at the O.C. Register reports: USC sees vacancies chilling O.C. office rents in ‘08

Construction of new office buildings and layoffs in the financial services and mortgage industries will keep office vacancies high in Orange County through 2008, halting the upward spiral of lease rates, according to the USC Lusk Center’s Casden Real Estate Economics Forecast.

But despite a slight slowdown in sales and rent increases, industrial real estate should remain strong next year, with continued low vacancies, added Delores Conway, director of the Casden Forecast.

Tighter credit, almost no job growth, and falling consumer confidence is leading to a lot of uncertainty, Conway explained. But the slowdown will amount to “a short-term adjustment,” even in the office sector.

Note that the Casden Forecast doesn’t expect a recession next year.

by Calculated Risk on 12/13/2007 09:15:00 AM

From CoStar: TROUBLE IN TEXAS: Huge Multifamily Owner Nears Collapse (hat tip Nick)

MBS Cos., one of the largest multifamily property owners in the country, is delinquent, in default or in danger of becoming so, on more than $900 million in loans.

... if MBS defaults, it ... will ... generate a huge spike up in CMBS delinquencies, expected to be reported this week or next.

PNC Financial Services Group originated almost all of the loans made to MBS Cos., about 90% of MBS's total loan exposure. Most of those loans are no longer on PNC's books because they were off-loaded into commercial mortgage backed securities (CMBS) ...

As of last month, Smuck-affiliated companies had as many as 65 other loans totaling more than $900 million spread across 36 CMBS deals. Most of the loans were taken out since 2000, some as recently as this year. Nearly two-thirds of those were reported to be at least 30 or more days delinquent ...