by Anonymous on 2/12/2008 08:35:00 AM

It just looked like it to impartial observers. From IndyMac's shareholder letter:

Who is to blame for the mortgage industry's financial losses and also the record number of Americans losing their homes?

All home lenders, including Indymac, were a part of the problem, and, as Indymac's CEO, I take full responsibility for the mistakes that we made. However, objective reviewers of this mortgage crisis understand that home lenders and mortgage brokers were not the only ones responsible. Systemic problems in our secondary mortgage markets and credit markets, and our government's over-stimulation of the housing market via monetary and tax policies (the capital gains tax break on home sales encouraged speculation), were all major factors that contributed to the problem. Indymac and most home lenders were not "greedy and stupid". Most of us believed that innovative home lending served a legitimate economic and social purpose, allowing many US consumers to be able to achieve the American dream of homeownership ... and we still do.

Homeownership is the main way we Americans accumulate wealth, and, in fact, a recent Federal Reserve Bank study shows that homeowners on average have 46 times the personal wealth of renters. As innovative home lending and loan products became more widespread, the result was more people succeeding (in homeownership) and more people failing (losing their home) than ever before. But everyone, including both the government and consumer advocate groups who encouraged this lending via enforcement of CRA lending requirements, also bought into the concept that, if lenders and investors could properly price this increased risk, the higher number of failures was worth the social and economic goals of expanded homeownership. And it worked for many years; the homeownership rate, which had not moved in several decades, expanded from 64% to 69% from 1994 to 2006, allowing 4 million additional Americans the opportunity to have the American dream and build wealth.

However, in retrospect, like many innovations (e.g., the Internet, railroads, etc.), innovative home lending went too far. The housing bubble, caused primarily by the low interest rates for ARM mortgages fostered by the Fed's accommodative monetary policy and even lower rates for fixed/long-term mortgages due largely to tremendous global liquidity, combined with strong demand by institutional investors for assets with higher yields, resulted in a "systemic" underestimation of credit risk. This systemic underestimation of credit risk was not just for mortgages but for many forms of credit. By way of example, Indymac (and many other major financial institutions) has for years used one of the major credit rating agencies' models to assess and price credit risk on home loans. This model estimates expected lifetime losses on a loan level basis, and we closely monitor these average estimated lifetime losses for all of our loan production (that can be evaluated) on an ongoing basis. This particular rating agency revised its model in November 2007 (from version 6.0 to 6.1). Applying version 6.0 to our Q4-06 production (the version in place at that time) indicated an average expected lifetime loss rate of 0.88%, which we felt was a reasonable level of expected losses at which we could properly and adequately price the loans. However, now applying the updated version 6.1 to this same Q4-06 pool of loans results in an average expected lifetime loss rate of 1.88%, a 114% increase in expected losses in one year. This clearly indicates the extent to which the systemic underestimation of credit risk took place in the mortgage markets. As we began to realize this, we tightened our guidelines throughout the last year, with the result that our average expected lifetime loss rate for Q4-07 declined to 0.45% based on version 6.1, a 76% reduction in credit risk as compared to Q4-06, boding well for the future credit quality and related credit provisions/costs of our new business model.

Why didn't mortgage lenders see that things were going too far?

Lenders didn't see that things were going too far, partly because we were too close to it, but mostly because objective evidence of this credit risk did not show up in our delinquencies and financial performance until it was too late to prevent significant losses. And there were many events along the way that confirmed for those of us who believed that innovative home lending was possibly a paradigm shift (similar to widespread ownership of stocks by consumers) and definitely a legitimate marketplace: major financial institutions were offering these products and spending billions to purchase companies who specialized in these products; Wall Street firms and broker/dealers of major banks were underwriting our and others' transactions and also spending billions as recently as 2006 to buy non-GSE lenders in order to vertically integrate their home lending and securitization activities; major mortgage and bond insurers were insuring individual mortgages and pools of mortgages or bonds created from these mortgages; major credit rating agencies were providing strong ratings on our and others' transactions; and major investors around the world were purchasing these mortgage-backed bonds and even CDOs backed by these bonds (something we home lenders had no involvement in or awareness of). Very few in the private sector or in government predicted that the bursting of the housing bubble would be so severe and would result in the current wave of delinquencies, foreclosures and credit losses and the eventual collapse of the non-GSE secondary market ... even for high credit quality, full-documentation, jumbo home loans.

It is also important to understand that the rapid rise in housing prices is one of the key culprits in this current housing and mortgage crisis. In modern times, housing prices have declined in certain regions of the country but never on a nationwide basis. As a result of this fact and the important social and economic benefits that are clearly derived from homeownership, the government (first through FHA/VA programs and then through the GSEs) encouraged a USA mortgage market built upon very high leverage, with LTV ratios nearing 100% for first-time homebuyer programs. However, as home prices decline, either regionally or nationally, the leverage in a home loan, combined with the leverage of a financial institution or securitization structure, can result in significant losses for financial institutions, investors and consumers. Add to this mix a housing market that has not had a single regional market decline in over 15 years and, in fact, had a huge boom in prices from 2003 to 2006, and you can begin to understand how home lending was impacted. Automated risk-based models, on which the entire market relied, replaced portions of traditional underwriting and credit evaluation, and only in retrospect is it now clear that these models did not perform as predicted during a period of severe economic stress. As events unfolded, this proved to be particularly the case with respect to programs such as piggyback loans and high LTV cash-out refinance transactions, including home equity and second mortgages.

I have, of course, never claimed that it was merely the lenders at fault, not Wall Street or the Fed or the rating agencies or other culprits. Nonetheless, I am still capable of being amazed that the party with the most information about the loans is still willing to blame the party with probably the least information (the rating agencies) for the faulty loss estimates. Yes, the rating agencies should have demanded more information. I say this as someone, like Michael Perry, who knows damned good and well that there is much more information to be had.

I'll skip the part about how we didn't know about those CDOs because it's early in the day and I need more coffee before I can wrap my mind around the implications of that.

Otherwise, for practical matters:

In addition, to prevent consumers from making the wrong mortgage choice in the future, Indymac has decided to adopt as our policy that borrowers without $50,000 in demonstrated liquid assets or $250,000 in demonstrated net worth are not eligible for the following products(2):
1. ARM loans with initial fixed terms of less than five years.
2. Loans with negative amortization or prepayment penalties.
3. Limited documentation loans.

"To prevent consumers from making the wrong mortgage choice." God help me.

by Anonymous on 2/12/2008 08:08:00 AM

We welcome Vikas Bajaj and Louise Story of the New York Times to the clubhouse. Budge over, everyone.

From "Mortgage Crisis Spreads Past Subprime Loans":

The credit crisis is no longer just a subprime mortgage problem.

Word.

As usual, I enjoy the borrower anecdotes. These are, you remember, prime-credit well-educated borrowers with good jobs. What does this heretofore under-recognized not-just-subprime group have to say about the pickle it's in?

Ms. Harris, who has a new home in a neighborhood in which the builder is slashing prices to move vacant units:

In addition to the declining value of her home, Ms. Harris, 53, will soon be hit with a sharply higher house payment. She has an option adjustable-rate mortgage, a loan that allows borrowers to pay less than the interest and principal due every month. The unpaid interest gets added to the principal balance. She is making the minimum monthly payments due on her loan, about $2,400.

But she knows she will not be able to pay the $3,400 needed to cover her interest and principal, which she will be required to pay once her loan balance reaches 115 percent of her starting balance. And under the terms of her loan, which was made by Countrywide Financial, she would have to pay a prepayment penalty of about $40,000 if she chose to refinance or sell her home before May 2009.

She said that she now wishes she had taken a traditional fixed-rate loan when she bought the home.

She cannot afford a fully-amortizing principal and interest payment. So she wishes she had taken a loan that would have required a fully-amortizing principal and interest payment from day one?

Mr. Doyle has a "six-figure" income and is upside down with a $740,000 loan.

In refinancing their home in 2004, Mr. Doyle and his wife were doing what millions of other homeowners did in the last decade — tapping into the rising value of their homes for home improvements, paying off credit card debt, college tuition and for other spending.

The Doyles took advantage of the housing boom by refinancing their home nearly every year since they bought it in 1995 for $275,000. Until their most recent loan they never had a problem making their payments. They invested much of the money in shares of companies that subsequently went bankrupt.

Still, Mr. Doyle does not regret refinancing in 2004. “My goal was clear: I wanted to help my daughter go through college,” he said. “It wasn’t like it was for us.”

Is that, one wonders, what Mr. Doyle thinks is the difference between those subprime people and "us"? That while the subprime people hopelessly bungled their finances for selfish reasons, the prime people hopelessly bungled their finances for unselfish reasons?

I am tempted to say that the real difference between prime and subprime borrowers is that in the former case the denial lasts a lot longer.

(Hat tip Bode & Buzz.)

by Calculated Risk on 2/11/2008 07:58:00 PM

From the WSJ: Macklowe Receives Default Notice As His Debt Negotiations Stall

New York developer Harry Macklowe was served a notice of default Monday and the possibility of a foreclosure action loomed larger as his negotiations with his lenders over $7 billion of debt on seven Manhattan buildings bogged down ...

This is a story we've been following since last September. It appeared Macklowe bought these buildings right at the top of the commercial real estate cycle using short term financing. As the loans come due, Macklowe has been unable to refinance because the properties are clearly upside down.

by Calculated Risk on 2/11/2008 06:11:00 PM

From the WSJ: Lenders Team Up on Plan To Prevent Foreclosures

Prodded by politicians alarmed by a surge in defaults, six major mortgage lenders are due to announce Tuesday another effort to prevent foreclosures.

Under the latest plan, dubbed Project Lifeline ... the lenders are to seek contact with homeowners who are 90 or more days overdue on their mortgages. ... Unlike the recently announced plan to freeze interest rates at current levels on certain subprime loans, this latest drive would involve all kinds of home loans...

The participating banks are Bank of America Corp., Citigroup, Countrywide Financial Corp., J.P. Morgan Chase, Washington Mutual and Wells Fargo & Co. -- all members of the so-called Hope Now Alliance. They are working with the U.S. Treasury and Department of Housing and Urban Development. Those two departments scheduled a briefing on the plan for 11:15 a.m. Tuesday.

Countrywide unveiled another subprime plan workout today, from MarketWatch: Countrywide debuts subprime 'workout' plan (hat tip Anthony)

The Calabasas, Calif.-based company is teaming up with the Association of Community Organizations for Reform Now, the advocacy group also known as Acorn, to expand an existing $16 billion program to help subprime borrowers avoid foreclosure and work out more manageable rates on their mortgages.

We're all subprime now!

by Calculated Risk on 2/11/2008 12:33:00 PM

The usual real estate refrain is location, location, location. But right now, inventory is the key to understanding the housing market.

As I noted yesterday in Housing as an Engine of Recovery, housing usually leads the economy both into and out of recessions. But for this year I argued:

... given the current fundamentals of housing – significant oversupply, falling demand – it is very unlikely that housing will act as an engine of growth any time soon. We need to see a significant reduction in supply before there will be any increase in residential investment.

So, for those expecting a 2nd half recovery in the economy, I believe they need to look elsewhere for growth – and they need to argue this time is different, i.e. that the economy will recover before housing ...

So let's look at inventory, but first a funny quote:

"[T]he homebuilders have basically stopped building -- they are building one-quarter of the homes they did in 2006 -- we are going to run out this year."
Jim Cramer, 01/31/2008

That is factually wrong on every point. The homebuilders have not stopped building, they are building far more than one-quarter of the homes they built in 2006, and - most importantly - the housing market is not going to run out of inventory any time soon.

There are several different ways to look at housing inventory. The most frequently mentioned measures are new and existing home inventory levels released monthly by the Census Bureau and National Association of Realtors (NAR) respectively.

The first graph shows new home inventory in December - houses for sale, seasonally adjusted (SA) – from the Census Bureau.

Click on Graph for larger image.

The 495,000 units of inventory for sale at the end of December is slightly below the levels of last year.

At first glance it appears new home inventory is declining. However there are a couple of important issues with new home inventory. First, the Census Bureau ignores cancellations (here is the Census Bureau description of how they handle cancellations), so during periods of rising cancellation rates, the Census Bureau overstates New Home sales and understates the increase in inventory. Conversely, during periods of declining cancellation rates, the Census Bureau understates sales. Second, new home inventory excludes many condominiums, and in certain communities (like Miami and San Diego) there are anecdotal stories of a glut of condos.

By my calculations, based on cancellations, the inventory of new homes is currently understated by about 100K. Unfortunately there is no available data source to adjust for excess condos.

New home inventory is just a small part of the picture. The next graph shows nationwide inventory for existing homes. Note: Unlike the new home inventory data, the existing home inventory data is not seasonally adjusted.

According to NAR, inventory was down slightly at 3.905 million homes for sale in December.

Total housing inventory fell 7.4 percent at the end of December to 3.91 million existing homes available for sale, which represents a 9.6-month supply at the current sales pace, down from a 10.1-month supply in November. “The fall in inventory in December is encouraging, but inventories remain elevated and buyers have a clear edge over sellers in many markets,” Yun said.

The typical seasonal pattern is for existing home inventory to decline sharply in December (usually by about 13%), as homeowners take their homes off the market for the holidays. So, not only is this the highest yearend inventory in history, but the December decline was less than normal (only 7.4%).

Another way to look at excess supply is to use the homeowner and rental vacancy rates from the Census Bureau.


The third graph shows the homeowner vacancy rate since 1956. The current rate is 2.8%, well above the recent normal rate of about 1.7%. There is some noise in the series, quarter to quarter, but it does appear the vacancy rate has stabilized.

This leaves the homeowner vacancy rate about 1.1% above normal, or about 825 thousand excess homes.

Sometimes rental units are a reasonable substitute good for single family homes. So we also need to consider the rental vacancy rate, and calculate the excess rental units.

The rental vacancy rate declined to 9.6% in Q4, from 9.8% in Q3. The rental vacancy rate has been trending down slightly for almost 3 years (with some noise). This was due to a decline in the total number of rental units in 2004, and more recently due to more households choosing renting over owning.



It's hard to define a "normal" rental vacancy rate based on the historical series, but we can probably expect the rate to trend back towards 8%. This would suggest there are about 560 thousand excess rental units in the U.S. to be absorbed.



Here is a rough estimate of the excess inventory:

Source	Units
Rental Units	560,000(1)
Vacant Homeowner Units	825,000(2)
Excess Builder Inventory	250,000(3)
Total	1,635,000

(1) According to the Census Bureau there are 35.12 million rental units in the U.S. If the rental vacancy rate declined from 9.6% to 8%, there would be 1.6% X 35.12 million units or about 560,000 units absorbed.
(2) Based on the homeowner vacancy rate declining from 2.8% to 1.7% on 75 million units.
(3) Based on a return to 5 months of hard inventory (completed or in process). 100,000 additional units are included based on rising cancellation rates.

Until the level of inventory declines significantly, housing prices will continue to decline and the outlook for new residential investment will remain grim.

by Calculated Risk on 2/11/2008 12:09:00 PM

From PMI's SEC filing:

As disclosed in our Quarterly Report on Form 10-Q for the quarter ended September 30, 2007, our U.S. mortgage insurer, PMI Mortgage Insurance Co. ("PMI") initiated pricing and underwriting guideline changes in 2007 with respect to, among other loan products, loans with loan to value ratios in excess of 97.00% ("Above 97s"). These pricing and underwriting guideline changes were based upon PMI's review of its portfolio and in response to substantially higher demand for mortgage insurance coverage of Above 97s. As a result of these changes, the percentage of Above 97s in PMI’s new insurance written declined in the fourth quarter of 2007 to 21%, compared to approximately 32% of PMI's primary new insurance written for the full year of 2007.

Effective March 1, 2008, PMI will institute additional underwriting guideline changes which will, among other things, preclude future mortgage insurance coverage by PMI through its primary flow channel of Above 97s.
emphasis added

PMI was already tightening their underwriting standards, but this is significant further tightening.

by Calculated Risk on 2/11/2008 10:28:00 AM

From the AIG SEC filing this morning:

... as a result of current difficult market conditions, AIG is not able to reliably quantify the differential between spreads implied from cash CDO prices and credit spreads implied from the pricing of credit default swaps on the CDOs, and therefore AIG will not include any adjustment to reflect the spread differential (negative basis adjustment) in determining the fair value of AIGFP’s super senior credit default swap portfolio at December 31, 2007. ...

AIG has been advised by its independent auditors, PricewaterhouseCoopers LLC, that they have concluded that at December 31, 2007, AIG had a material weakness in its internal control over financial reporting and oversight relating to the fair value valuation of the AIGFP super senior credit default swap portfolio. AIG’s assessment of its internal controls relating to the fair value valuation of the AIGFP super senior credit default swap portfolio is ongoing, but AIG believes that it currently has in place the necessary compensating controls and procedures to appropriately determine the fair value of AIGFP’s super senior credit default swap portfolio for purposes of AIG’s year-end financial statements.

by Calculated Risk on 2/11/2008 02:55:00 AM

From the Financial Times: Subprime losses could rise to $400bn

... Peer Steinbrück, German finance minister, said the G7 now feared that write-offs of losses on securities linked to US subprime mortgages could reach $400bn.

This is the first government forecast that is close to the losses projected by several economists. Last November, Goldman's Hatzius forecast losses of up to $400 Billion:

Losses related to record home foreclosures using a ``back- of-the-envelope'' calculation may be as high as $400 billion for financial companies, Jan Hatzius, chief U.S. economist at Goldman in New York wrote in a report dated yesterday.

And last December, Merrill's Rosenberg forecast $500 Billion in mortgage losses:

“It is the sum of projected losses of $250 billion in subprime loans, [about about 18% of the $1.4 trillion subprime market], $50 billion for Alt-A loans, $100 billion in negative amortization mortgage-backed security option ARMS, and $100 billion in synthetic CDO losses (synthetic CDOs gain credit exposure to the underlying subprime assets via credit default swaps).”

One of the difficulties in comparing loss projections is in clarifying which losses are being included in each projection. Note that Rosenberg only projected $250 billion in subprime losses, but it's possible that the German Finance minister is grouping all losses as "subprime". Heck, we're all subprime now anyway!

by Calculated Risk on 2/10/2008 07:31:00 PM

The Financial Times reports: IT spending forecasts cut on recession fears

Global spending on IT goods and services is expected to grow ... 6 per cent ... according to Forrester Research ... This represents a significant slowdown from 12 per cent growth last year.
...
“Our forecast is premised on a mild recession in the US economy in the first two or three quarters of 2008, caused by a shrinking housing sector and tapped-out consumers reining in their purchases due to higher interest rates, energy costs and consumer debt services. Anecdotally, we are hearing that this is beginning to filter through to chief information officers, and it is clear the level of caution is rising.” [Andrew Bartels, author of the Forrester report said]

There are three main areas of investment: residential (in a depression), non-residential structures (there is strong evidence of an imminent slowdown) and equipment and sofware. According to Bartels, he is hearing stories of rising caution among CIOs; not good news for investment or the economy.

by Calculated Risk on 2/10/2008 04:00:00 PM

Update: Professor Krugman adds some more and suggests I'm too optimistic: Postmodern recessions

Post-moderation recessions haven’t been deliberately engineered by the Fed, they just happen when credit bubbles or other things get out of hand.

And while they haven’t been as deep as the older type of recession, they’ve proved hard to end (not officially, but in terms of employment), precisely because housing — which is the main thing that responds to monetary policy — has to rise above normal levels rather than recover from an interest-imposed slump.

Note: Don’t miss Tanta’s post this morning: Let's Talk about Walking Away.

I've written extensively about using housing as a leading indicator for recessions. Last year, at the Jackson Hole conference, Professor Leamer of the UCLA Anderson Forecast presented a very readable paper on this topic: Housing and the Business Cycle

The following graph shows that housing usually leads the economy into recession.

Click on graph for larger image.

This graph shows New Home Sales vs. recessions for the last 45 years. New Home sales were falling prior to every recession, with the exception of the business investment led recession of 2001.

Note that the escalation of the Vietnam War in the '60s kept the economy out of recession, even though New Home sales were falling. I've also indicated the probably current recession - possibly starting in December (as shown on graph).

But here is a key point: not only does housing usually lead the economy into recession, but housing is usually an engine for recovery as the economy emerges from recession.

The second graph is constructed by normalizing new home sales at the end of the last six recessions. Then the median is plotted as a percent from the recession bottom. Note that month zero is the last month of each recession.

This shows that typically housing bottoms a few months before the rest of the economy - and then acts as an engine of growth coming out of the recession.

The third graph is the data for each of the last 6 recessions. Notice that housing didn't boom coming out of the 2001 recession (an investment led recession), and faltered following the recession ending in July 1980 (green line) because of the double dip recession of 1980 and '81/'82.

For the last 6 recessions, housing bottomed 2 to 9 months before the end of the recession.

Given the current fundamentals of housing – significant oversupply, falling demand – it is very unlikely that housing will act as an engine of growth any time soon. We need to see a significant reduction in supply before there will be any increase in residential investment.

So, for those expecting a 2nd half recovery in the economy, I believe they need to look elsewhere for growth – and they need to argue this time is different, i.e. that the economy will recover before housing this time.

More likely the economy will remain sluggish well into 2009 and the effects of the recession will linger. It is possible that fiscal and monetary stimulus will provide some 2nd half boost to GDP, but if that does take the economy out of an official recession, then I believe a double dip recession (or something that feels like one) is very probable.

Housing is still the key to the economy. And the housing outlook remains grim.