by Calculated Risk on 2/25/2008 03:53:00 PM

We've been debating in the comments whether the Commercial Real Estate (CRE) bust would be similar to the Residential Real Estate bust.

Richard Berner at Morgan Stanley writes that the "contraction in [CRE construction] outlays will be shallow", see: Recession Claims Its Next Victim: Commercial Construction

Recession is about to claim its next victim: Commercial construction. A downturn in such activity would represent a significant turnaround from last year’s boom: Although nonresidential or structures investment accounted for only 3.4% of (nominal) GDP, the 16% jump in real outlays contributed half a point to overall real GDP growth over the four quarters of 2007. Such a gain — the sharpest 4-quarter rise since 1984 — is unsustainable, and we think this economic asset is about to turn into a liability. Tighter financial conditions, uncertain tenancy, rents, and property values all will contribute to a downturn in office, retail and warehouse activity. Soaring construction costs are also a negative. Weakness is already showing: Nonresidential construction starts tumbled 13% from a year ago in January, according to Reed Construction Data.

Despite these hurdles, we think that the contraction in outlays will be shallow by historical comparison. The key factor limiting the downturn in traditional commercial construction is that the overall growth in supply for much of this expansion has been modest by historical standards. The “capital discipline” theme that governed corporate spending in this expansion partly extended to construction as well. For example, commercial construction excluding healthcare facilities rose by only 3.9% annualized over the past five years.

But discipline seems to have faded over the past year, when construction accelerated in virtually all categories, and with the slowdown in business activity, vacancy rates have begun to rise. There are clear pockets of excess in financial services office building and in retail and lodging. A slowdown in office employment and shakeouts in retail and wholesale activity may pressure rents just as lenders and investors tighten credit availability and raise its price. However, mining, power, and healthcare construction may buck the trend.

This is similar to my view that the CRE bust is here, but that it will not be as bad as the residential bust - simply because CRE wasn't as overbuilt as residential.

by Calculated Risk on 2/25/2008 02:41:00 PM

From Standard & Poor's: S&P Takes Additional Bond Insurer Rtg Actions (no link)

NEW YORK (Standard & Poor's) Feb. 25, 2008-Standard & Poor's Ratings Services today took rating actions on several monoline bond insurers following additional stress tests with respect to their domestic nonprime mortgage exposure.

The financial strength ratings on XL Capital Assurance Inc. (XLCA) and XL Financial Assurance Ltd. (XLFA) were lowered to 'A-' from 'AAA' and remain on CreditWatch with negative implications;

The financial strength rating on Financial Guaranty Insurance Co. (FGIC) was lowered to 'A' from 'AA' and remains on CreditWatch with developing implications;

The 'AAA' financial strength rating on MBIA Insurance Corp. was removed from CreditWatch and a negative outlook was assigned;

The 'AAA' financial strength rating on Ambac Assurance Corp. was affirmed and remains on CreditWatch with negative implications; and

The 'AAA' financial strength ratings on CIFG Guaranty, CIFG Europe, and CIFG Assurance North America Inc. were affirmed and retain a negative outlook.

The downgrades on XLCA, XLFA, XL Capital Assurance (UK) Ltd., and Twin Reefs Pass-Through Trust (a committed capital facility supported by, and for the benefit of, XLFA) reflect our assessment that the company's evolving capital
plan has meaningful execution and timing risk.

The downgrades on FGIC, FGIC Corp., and Grand Central Capital Trusts I-VI (a committed capital facility supported by, and for the benefit of, FGIC) reflect
our current assessment of potential losses, which is higher than previous estimates.

The removal from CreditWatch of, and assignment of negative outlooks on, MBIA Insurance Corp., MBIA Inc., and North Castle Custodial Trusts I-VIII (a committed capital facility supported by, and for the benefit of, MBIA) reflect MBIA's success in accessing $2.6 billion of additional claims-paying resources, which, in our view, is a strong statement of management's ability to address the concerns relating to the capital adequacy of the company.
...

by Calculated Risk on 2/25/2008 02:14:00 PM

Here is a graph of Not Seasonally Adjusted existing home sales for 2005 through 2008.

Click on graph for larger image.

This graph shows that sales have plunged in January 2008 compared to the previous three years. This also shows that January is typically the least important month of the year for existing home sales.

The data for March will be much more important since that is the beginning of the Spring selling season.

The second graph shows existing home sales, on a Seasonally Adjusted Annual Rate (SAAR) basis since 1993.

January 2008 (4.89 million SAAR) was the weakest January since 1998 (4.37 million SAAR).

Finally the inventory increase of about 5% from December to January was typical. Last year, from December 2006 to January 2007, inventory increased 2.5% (from 3.45 millon to 3.539 million). The total inventory increase in 2007 was almost 33% from December 2006 to July 2007 (4.561 million).

A similar inventory increase this year would put inventory at 5.2 million or about 15% above the all time record set last July.

by Calculated Risk on 2/25/2008 11:43:00 AM

Goldman Sachs, in a research note this morning, noted that they expect "major write-downs" in leveraged loans this quarter. They estimated leveraged debt write-downs this quarter of $1B to $2B for several firms, with write-downs at Citi of $2.2B and Merrill of $1.3B.

Update: This is just the leveraged debt write-downs. Total write-downs at Citi could be $12 Billion (see MarketWatch: More credit costs seen weighing on banks, brokers)

They also noted there will be significant write-downs for RMBS and CMBS (residential and commercial mortgage backed securities) with special concern about CMBS.

Of course Goldman doesn't cover Goldman. But others do ...

From the WSJ: Goldman's Profit Magic May Be Fading

One of the biggest worries is Goldman's large exposure to leveraged loans, which totaled $42 billion at the end of the firm's last quarter, according to analyst calculations. During the deal boom, Goldman was a huge player in financing private-equity buyouts. But investors started to avoid buyout loans last summer, causing the debt to pile up on balance sheets and their market values to drop.

The result: Goldman is in the sort of sticky situation it largely avoided with subprime mortgages. The firm's leveraged-loan exposure is equivalent to 1.1 times its net worth, versus an average of 0.7 times for U.S. brokerage firms, according to Credit Suisse analyst Susan Roth Katzke. Write-downs on leveraged loans could total as much as $1.7 billion in the current quarter, Mr. Trone estimates.

And it could be worse if one or more of the large LBO companies defaults on their debt. As the WSJ noted:

[A]larming news, like the bankruptcy filing of a company overwhelmed by its LBO-related debt, would raise the specter of more steep markdowns.

by Calculated Risk on 2/25/2008 10:49:00 AM

This morning, Lowe's reported same-store sales declined 7.6% for the quarter.

But sequentially sales are even worse.

From the Lowe's conference call:

Same Store sales fell 4% in November (YoY)

Same store sales fell 9% in December

Same store sales fell 11% in January

CEO Niblock said he was "a bit surprised" by the weakness.

by Calculated Risk on 2/25/2008 10:00:00 AM

The NAR reports that Existing Home sales were at 4.89 million (SAAR) unit rate in January.

Existing-home sales – including single-family, townhomes, condominiums and co-ops – slipped 0.4 percent to a seasonally adjusted annual rate1 of 4.89 million units in January from an upwardly revised level of 4.91 million in December, and are 23.4 percent below the 6.44 million-unit pace in January 2007.

Click on graph for larger image.

The first graph shows monthly sales (SAAR) since 1993.

This shows sales have now fallen to the level of July 2000.




The second graph shows nationwide inventory for existing homes. According to NAR, inventory increased to 4.19 million homes for sale in January.

Total housing inventory rose 5.5 percent at the end of January to 4.19 million existing homes available for sale, which represents a 10.3-month supply at the current sales pace, up from a 9.7-month supply in December.

The typical pattern is for inventory to decline in December, and then start to rebound in January. This is probably just the beginning of the inventory build for 2008.

I'd expect record levels of existing home inventory later this spring and summer.


The third graph shows the 'months of supply' metric for the last six years.

Months of supply increased to 10.3 months. This follows the highest year end months of supply since 1982 (the all time record of 11.5 months of supply).

Even if inventory levels stabilize, the months of supply could continue to rise - and possibly rise significantly - if sales continue to decline.

More later today on existing home sales.

by Calculated Risk on 2/25/2008 09:19:00 AM

From the WSJ: Lowe's Posts Lower Net Amid Housing Downturn

Lowe's Cos.'s fiscal fourth-quarter net income slumped 33% on continued sales weakness, which the home-improvement retailer expected to persist for several more quarters.

... same-store sales declined 7.6%.

Chairman and Chief Executive Robert A. Niblock said sales were below expectations "as we faced an unprecedented decline in housing turnover, falling home prices in many areas and turbulent mortgage markets that impacted both sentiment related to home improvement purchases as well as consumers' access to capital."

He went on to say "the next several quarters will be challenging on many fronts as industry sales are likely to remain soft."

In an earlier post, I noted that real home improvement spending had held up pretty well.

This graph shows the major components of residential investment (RI) normalized by GDP.

Click on graph for larger image.

The largest component of RI is investment in new single family structures. This includes both homes built for sale, and homes built by owner.

The second largest component of RI is home improvement. This investment could be seriously impacted by declining mortgage equity withdrawal (MEW) over the next few quarters.

This data is from the Bureau of Economic Analysis (BEA), supplemental tables. (see Section 5: Table 5.4.5AU. Private Fixed Investment in Structures by Type, near the bottom).

by Calculated Risk on 2/24/2008 04:41:00 PM

From Financial Week: Commercial property values in for steep drop, says loan liquidator

In what may well be a sign of things to come, Mission Capital Advisors said it is accepting bids for a $131.2 million portfolio of non-performing loans secured by commercial mortgages foreclosed on by a Midwestern bank.

... [David Tobin, a principal at Mission Capital] predicted commercial property values are heading for a steep fall due to the rising tide of troubled portfolio sales by banks, as they move to get non-performing assets off their books.

... Eventually, Mr. Tobin believes the declines in the commercial real estate market could mimic those being registered in the residential market now.

The CRE slowdown is here, but I don't think the CRE bust will be as bad as the residential bust.

by Calculated Risk on 2/24/2008 12:16:00 PM

A robber in a ski mask blamed the bank for what he was about to do, The Associated Press reported Feb. 22.

"You took my house, now I'm going to take your money!" the assailant hollered. Talk about a reverse mortgage!

The FBI plans to review the bank's foreclosure records for clues.

The suspect is presumed to be ARM'ed and dangerous.
(hat tip Sam frm SNL)

by Anonymous on 2/24/2008 12:15:00 PM

I am generally impressed with the quality of Andrew Davidson & Co.'s analysis of mortgage securitization issues. This particular instance, however, leaves me shaking my head. Certainly I give them credit for trying to find constructive suggestions to make, but I don't think we've drilled down far enough into the issues yet.

This does start out right, I think:

The standard for assessing securitization must be that it benefits borrowers and investors. The other participants in securitization should be compensated for adding value for borrowers and investors. If securitization does not primarily benefit borrowers and investors rather than intermediaries and service providers, then it will ultimately fail.

The trouble is that the standard case for how securitization of mortgages benefits borrowers is simply the observation that it makes capital available for lending at reasonable rates of interest. But that's hardly a benefit if it makes too much capital available for lending at too cheap a cost: supply chases down ever more implausible types of borrowers with ever more implausibly "affordable" mortgages, with ever more aggressive solicitation tactics. We're all learning a lot about the costs to all of us of unlimited mortgage money being provided to the financially weakest of us. Therefore securitization's benefits have to be more than just the provision of capital and the lowest possible interest rates; if securitization cannot function to rationalize lending practices by creating "best practice" lending guidelines and loan product structures outside of which its generous capital is not available, then it always has the potential to blow devastating bubbles.

There's a lot in this essay, but for the moment I just want to focus on the analysis and recommendation for dealing with the front-end part of the problem:

At the loan origination stage of the securitization process, there was a continuous lowering of credit standards, misrepresentations, and outright fraud. Too many mortgage loans, which only benefited the loan brokers, were securitized. This flawed origination process was ignored by the security underwriters, regulators, and ultimate investors. . . .

First, originators should be held responsible for the quality of the origination process. Investors in mortgage‐backed securities rely on the originators of loans to create loans that meet underwriting guidelines and are free of fraud. Borrowers rely on originators to provide them with truthful disclosures and fair prices.

Notice how, in the first paragraph, we slip in the first two sentences from "the quality of the origination process" (something quite obviously under the control of the originator) to "underwriting guidelines," which in any securitization practice I know of are either outright stipulated by the issuer in all respects (Ginnie Maes, standard-contract Fannies and Freddies, a lot of private pools) or are at best negotiated between lender and issuer (most private pools, some GSE business). Once the guidelines are either published by the issuer or agreed to in negotiation between issuer and originator, then it is indeed the originator's job to meet them.

But a whole lot of these loans that are failing right now were originated as 100% CLTV stated-income loans, because the guidelines agreed to by the issuer allowed that. I am scratching my head over the logic here: I spent most of the early years of this decade, just as a for instance, blowing my blood pressure to danger levels every time I looked at the underwriting guidelines published by ALS, the correspondent lending division of Lehman. ALS was a leader in the 100% stated income Alt-A junk. And I kept having to look at them because my own Account Executives keep shoving them under my nose and demanding to know how come we can't do that if ALS does it. I'd try something like "because we're not that stupid," and what I'd get is this: "But if ALS can sell those loans, so can we. All we gotta do is rep and warrant that they meet guidelines that Wall Street is dumb enough to publish." Every lender in the boom who sold to the street wrote loans it knew were absurd, but in fact they had been given absurd guidelines to write to. What on earth good did it do to have those originators represent and warrant that they followed underwriting guidelines to the letter, when those guidelines allowed stated income 100% financing on a toxic ARM with a prepayment penalty?

Currently, investor requirements are supported by representations and warranties that provide for the originator to repurchase loans if these requirements are not met. However, when there is a chain of sales from one purchaser to another before a loan ends up in a securitization, investors may find it hard to enforce these obligations. Similarly, borrowers who have been victimized by an originator may have nowhere to go to seek redress if the company that originated their loan goes out of business. Some in Congress are proposing “assignee liability” as a solution to this problem.

Investors don't "find it hard to enforce these obligations" unless they did zero financial due diligence on the last party in the chain. The way it works, your contract is with the last party to own the loan. If you bought loans from Megabank who bought them from Regional Bank who bought them from First Podunk who bought them from Loans R Us who funded the application for a broker, your contract is with Megabank and if the reps are false, Megabank supplies the warranty (the repurchase or indemnification). Megabank can go collect from Regional, who can go collect from Podunk, as far back as it takes to find the original misrep. It's always possible, of course, that the broker made true reps to Loans R Us, who made true reps to Podunk, but it was Podunk who misrepped to Regional (because Podunk bought under a set of guidelines that might have worked with some other investor, but then decided to slip these loans into a deal with Regional, even though Regional published different rules). The assumption that it is in fact always the first originator (the one who closes the loan) who fails to follow guidelines is a huge logical flaw. The contract theory underlying this--that A in contract with B can enforce terms against D who was in contract with C who was in contract with B--startles me as well.

This necessity of "chained pushbacks" certainly does cause grief: eventually, bad loans get back to the originator, but not nearly soon enough. It could take two years for the thing to work through, and delaying negative consequences is never a good thing in terms of keeping incentives aligned properly. But it doesn't hurt investors: they get paid back at par right away from the first party in the chain. In fact, that may explain why, as a rule, they've never particularly cared about the whole problem of "aggregating," or having whole loans work their way from small local originators into the hands of large financial institution counterparties before they are securitized. The investors think, more or less correctly, that their risk is covered because while the loans might have been originated by Loans R Us, net worth $37,000, they were sold to the investor by Megabank, net worth o' billions, and that takes care of the counterparty risk. Which is to say, it puts the counterparty risk on Megabank, who puts in on Regional, etc.

The obvious thing for security issuers to do, if they want direct liability of the loan originator, is to buy the damned loan from the loan originator. Or, maybe:

Assignee liability, however, may create risks for investors and intermediaries that they are unable to assess. As an alternative to assignee liability, an updated form of representations and warranties – an origination certificate – would be a better solution. An origination certificate would be a guaranty or surety bond issued by the originating lender and broker. The certificate would verify that the loan was originated in accordance with law, that the underwriting data was accurate, and that the loan met all required underwriting requirements. This certificate would be backed by a guarantee from the originating firm or other financially responsible company.

The origination certificate would travel with the loan, over the life of the loan. By clearly tying the loan to its originators, the market would gain a better pathway to measure the performance
of originators and a better means of enforcing violations. Borrowers would also have a clear understanding of whom to approach for redress of misrepresentations and fraud.

While risk arising from economic uncertainty can be managed and hedged over the life of the loan, the risks associated with poor underwriting and fraud can only be addressed at the initiation of the loan. Such risks should not be transferred to subsequent investors, but should be borne by those who are responsible for the origination process.

Wall Street security issuers don't want to buy loans directly from any given originator, because that would require them to have loan purchase and sale agreements with a bazillion little counterparties. They like the idea that Megabank has agreements with one hundred counterparties, who each has agreements with one hundred counterparties, etc. The cost of all this managing of relationships and moving loans up into the biggest buckets--the "aggregator" bucket--never goes away, it just isn't carried operationally by Wall Street.

So the idea here is to keep the middle-men and intervening aggregation of whole loans, but to make sure the original party who closed the loan never gets off the hook by having that party issue some kind of surety bond that would be guaranteed by somebody. So Loans R Us, assuming it has enough capital to back a guarantee, issues this certificate stating that it followed ALS underwriting guidelines to the letter. The loan blows up because ALS underwriting guidelines are stupid. Now what?

And of course this is simply meaningless in the context of originators who go out of business. Go ask the monolines how much a credit guarantee is worth if the counterparty doesn't have any money. As it currently is, regulated depository loan originators are required to reserve for contingent liabilities on loan sales: if you have the risk you might have to repurchase a loan, you have to reserve something for that. State-regulated non-public non-depositories may not have such strict requirements, or may not have them enforced. So if you want to assure that originators appear to have the financial strength to make reps and warranties, then you need to look into financial and accounting requirements for originators. Forcing them to come up with a surety bond--putting investors ahead of the originator's other creditors in a potential bankruptcy because said investors don't want counterparty risk--is a bit much.

That's one of those few cases were you can, in fact, pretty much guarantee that credit costs to consumers will rise unnecessarily. If you just want originators to keep skin in the game, there's this old-fashioned way of securitizing loans called "participations" that you might look into. In that case, the investor only buys a fraction of the loan asset (not a fraction of a security, a fraction of a loan), with the originator retaining some percentage interest. That shares the risk between two parties, but also the reward: if you retain a 10% participation interest in a loan you sell, you get 10% of the monthly payment. If you buy 100% of a loan and collect 100% of the payment, and yet you force the seller of the loan to warrant its risk forever, that seller will find some way to be compensated for that--meaning more points and fees to borrowers.

The idea of assignee liability is that you did, in fact, agree to a set of underwriting guidelines when you bought loans or invested in a pool of loans. If you agreed to guidelines which are harmful to borrowers, then this capital you are pouring into the mortgage market is not helping borrowers. The essential confusion here is between failure to follow responsible guidelines and faithful following of irresponsible guidelines. My sad news for the investment community: a whole lot of what you are suffering from is the latter, not the former.

How can anyone possibly require more proof of that? Starting in 2007, investors rapidly pulled out of the 2/28 ARM subprime product. They just announced they wouldn't buy it any longer. And it went away. You do not have a bunch of mortgage brokers still selling 2/28s to borrowers, or correspondent lenders still throwing 2/28s into new securitizations. As you might have noticed, you don't have new securitizations. You always had the power to click your heels together three times and return to the land of just not buying the paper, but I guess you didn't know that until the pink witch showed up.

And you will note that what immediately happened after you all stopped agreeing to those goofball underwriting guidelines was that a bunch of marginal originators immediately went belly-up. That's all the business they could get: writing junk paper for foolish investors. You put them out of business. You should not be sorry about that, except for the part about how you did business with them for so long that now you might have a bunch of worthless contractual warranties. This is called learning by doing. The solution to it is not to go back to buying any old dumb loan that you can get someone to offer a warranty on.

The solution is for investors to refuse to get within 20 feet of a mortgage-backed security that is backed by dumb loans. If you do not know what a dumb loan is, you might want to consider investing in a different kind of instrument. If the guidelines are not dumb, then by all means hold those originators to every last dotted i and crossed t in their contracts, because it is true that the quality of the process is what the originators control. But if you tell them it's OK for them to make loans without seeing docs, without requiring down payments, without worrying about ability to repay, then that is what you get and what we all get.