by Calculated Risk on 4/17/2008 09:56:00 AM

From Fed Vice Chairman Donald L. Kohn: The Changing Business of Banking: Implications for Financial Stability and Lessons from Recent Market Turmoil

Setting aside the 100 largest banks, the share of commercial real estate loans in bank loan portfolios nearly doubled over the past 10 years and is approaching 50 percent. The portfolio share at these banks of residential mortgage and other consumer loans, which are more readily securitized, fell by 20 percentage points over the same period.

This is a key point that we've discussed before - the small to mid-sized institutions were not overexposed to the housing bubble because those loans were mostly securitized. Therefore the housing bust led directly to only a few small bank failures over the last couple of years.

However, these same banks have a heavy concentration in commercial real estate (CRE) loans, and also in construction & development (C&D) loans. Now that CRE is weakening - and the C&D loans are coming due - there will probably be a sharp increase in bank failures over the next couple of years.

Concentration risk is another familiar risk that is appearing in a new form. Banks have always had to worry about lending too much to one borrower, one industry, or one geographic region. But as smaller banks hold more of their balance sheet in types of loans that are difficult to securitize, concentration risks can develop. Concentrations of commercial real estate exposures are currently quite high at some smaller banks. This has the potential to make the banking sector much more sensitive to a downturn in the commercial real estate market.

by Calculated Risk on 4/17/2008 09:25:00 AM

From the WSJ: Merrill Lynch Swings to a Loss, Plans to Cut Another 4,000 Jobs

Merrill Lynch & Co. posted ... $6.6 billion in write-downs related to mortgages, complex securities called collateralized debt obligations, and loans made to junk-rated companies. Merrill wrote down another $3.1 billion in mortgage-related securities held at its U.S. banks...

Merrill CEO John Thain, speaking on a conference call with analysts, said the period was "as difficult a quarter as I've seen in my 30 years on Wall Street" and said the next half-year will continue to be difficult.

Merrill makes another visit to the confessional.

by Calculated Risk on 4/16/2008 09:02:00 PM

From MarketWatch: J.C. Penney scales back growth plans

Pointing to a tough economic environment that is clouding its outlook for the year, J. C. Penney Co. said it will open and renovate fewer stores ...

Penney plans to open 36 new stores this year, compared with 50 last year, a reduction that'll save $200 million in capital spending this year ... Total capital spending will drop by about a fifth to $1 billion this year from $1.24 billion...

"I've been in business in 39 years," [Chief Executive Mike Ullman] said. "I don't think I've seen anything as unpredictable. Our entire business is soft because of lack of traffic. We can't give much guidance because there's no visibility."

Company after company has announced scaled back capital spending plans. This will lead to more layoffs - especially in non-residential construction - and further weaken the economy. This is the typical pattern as the economy enters recession.

by Calculated Risk on 4/16/2008 07:19:00 PM

From The Times: Bank close to agreeing plan to end drought in funding for mortgages

It is understood that the Treasury is close to finalising a scheme under which the Bank would allow lenders to swap their mortgage-backed assets for government bonds rather than cash. Lenders would be able to use the gilts as collateral for loans from other banks. It is hoped that the move will ease the seizure in the credit markets and lead to a drop in mortgage rates for homeowners.

by Calculated Risk on 4/16/2008 02:05:00 PM

From the Fed's Beige Book:

Consumer spending was characterized as softening across most of the country, with some Districts reporting year-over-year declines in retail and/or auto sales.
...
Reports on real estate and construction were generally anemic for the residential sector; activity in the commercial sector has slowed.

On Real Estate and Construction:

Housing markets and home construction remained sluggish throughout most of the nation, though there were few signs of any quickening in the pace of deterioration. Ongoing weakness in housing markets, in general, was reported in almost all Districts. ... New residential construction was reported to have remained at depressed levels, and none of the Districts reported any pickup since the last report.

Declines or downward pressures in selling prices were specifically reported in the Boston, New York, Philadelphia, Richmond, Atlanta, Chicago, Minneapolis, Kansas City, and San Francisco Districts. In particular, New York and San Francisco noted some incipient price declines in areas that had previously shown resilience ...

Commercial real estate markets were generally reported to be steady or softening in most areas. ... sales of commercial properties were generally indicated to be sluggish, while prices were said to be under downward pressure. The Boston, Philadelphia, Minneapolis, Kansas City, Dallas, and San Francisco Districts all reported weakness in commercial real estate sales and prices.

Consumer spending and commercial real estate were two of the key areas that helped keep the U.S. economy out of recession for most of 2007. Now that these areas are weakening, this is more evidence that the U.S. economy is now in recession.

by Calculated Risk on 4/16/2008 12:53:00 PM

From the Q&A: (hat tip Brian)

No stabilization in home equity portfolio:

Analyst Question: Just a question on whether you're seeing anything that would give you some signs of stabilization of the loss and delinquency rates in the home equity portfolio?

JPM: No, it's exactly what we saw, higher, more houses are going negative equity, roll rates are high, home prices we expect to still go down. We have not seen it.

And on the deteriorating prime mortgage portfolio:

Analyst: You talked a little bit about prime mortgage and that it's definitely getting worse. But I look at a 48 basis point charge-off ratio on and say that's pretty bad. From that as a base, how much worse do you envision it getting or could it get?

JPM: You know, first of all, the risk factors in prime mortgage are exactly the same as in elsewhere, which is negative home prices, high LTV, things like that, and you know, I think it will probably get a little bit worse and we probably owe you a better answer on that. We did not -- but it's hard in almost all these mortgage areas to say exactly what's going to happen to behavior. You can guess as well as we can what's going to happen to home prices. We expect it will go down another 7, 8, 9% in '08.

And on Credit Card losses:

“Outlook, 4.5 to 5% full year losses trending higher as we get through the rest of the year and probably a little bit of an effect of slowing card spend which is what we've seen in the past couple of weeks.”
all emphasis added

How many companies - from GE to JPM - have said they saw a slowdown in March?

by Calculated Risk on 4/16/2008 11:50:00 AM

San Francisco Fed President Janet Yellen repeated an earlier speech today: The Economy: Where Are We and What Will Happen Next?.

This section is worth repeating:

[R]esearch ... reveals that the single best predictor of subprime delinquency rates is the pace of house price changes. ...

The link between house prices and delinquency rates is not surprising. When house prices have been stagnant or declining, a borrower with a recent mortgage secured with a very small or no down payment has little, if any, equity in the house and, therefore, can’t rely on it to help weather income and wealth stresses like job loss, illness, or divorce. Moreover, though some borrowers may be able to afford their loans, they may decide just to walk away, if, for example, their house is worth less than their mortgage.

I should also note that, while default rates for prime loans are lower than for subprime loans, delinquency rates among all categories are highly correlated with house price declines across the country, whether borrowers are prime or nonprime, or whether loans have fixed or variable rates.
emphasis added

Now that house prices are falling rapidly in many areas, delinquency rates can be expected to increase sharply for all loan categories; prime or subprime, fixed or variable.

by Calculated Risk on 4/16/2008 11:00:00 AM

There is an article this morning in the WSJ suggesting that the LIBOR rate might be too low, possibly because banks don't want to reveal their actual borrowing costs. See: Bankers Cast Doubt On Key Rate Amid Crisis

Here is a description of the LIBOR from the BBA:

Libor stands for the London Interbank Offered Rate and is the rate of interest at which banks borrow funds from each other, in marketable size, in the London interbank market.

The WSJ article suggests that banks are actually borrowing at a slightly higher rate (one estimate is 0.3% higher), but reporting a lower rate to the BBA. This doesn't make much sense to me, since understating their borrowing costs would reduce the banks net interest margin.

The article offers two possible explanations for a manipulated rate: reputation to the bank (banks reporting higher borrowing costs might see a bank run), and banks might be earning more profits from derivatives transactions. Neither seems convincing, but it is possible.

Other measures of the liquidity crisis are definitely showing the third wave is not over.

The TED Spread from Bloomberg: The TED spread has increased to 1.62%.

Note: the TED spread is the difference between the three month T-bill and the LIBOR interest rate. Usually the TED spread is less than 0.5%. The higher the spread, the greater the perceived credit risks (compared to "risk free" treasuries).

by Calculated Risk on 4/16/2008 08:44:00 AM

The Census Bureau reports on housing Permits, Starts and Completions.

Some key points:

Housing permits in March fell sharply to 927 thousand at a seasonally adjusted annual rate (SAAR). This is the lowest since 1991.

Single family housing starts were at 680 thousand SAAR. This is also the lowest since Jan 1991.

Completions are still very high. Privately-owned housing completions in March were at 1.216 million (SAAR). Completions will probably fall to the level of starts - and this will impact construction employment.

Click on graph for larger image.

Here is a long term graph of starts and completions. Completions follow starts by about 6 to 7 months.

Privately-owned housing starts in March were at a seasonally adjusted annual rate of 947,000. This is 11.9 percent below
the revised February estimate of 1,075,000 and is 36.5 percent below the revised March 2007 rate of 1,491,000.

Single-family housing starts in March were at a rate of 680,000; this is 5.7 percent below the February figure of 721,000.

The second graph shows Single family housing starts vs. New Home sales. Single family starts also include homes built directly by owners, in addition to homes built for sale (and some other minor differences).

This graph indicates the difference between single family starts and new home sales has narrowed recently, possibly indicating: 1) that fewer homes are being built by owners, and 2) that single family starts are now low enough to begin to reduce the inventory of new homes for sales.

Another very weak report.

by Anonymous on 4/16/2008 07:44:00 AM

Kind reader AK (bless you) sent me the link to this awful Slate piece on "walking away." It's a fact-free rehashing of the increasingly popular "walkaways are the new subprime" meme, worthwhile only as a kind of crystallization of everything that is wrong with this "story." Its burden of wisdom is the simple assumption that while those subprimers couldn't afford their mortgages, the Option ARM borrowers just don't want to be underwater after their loans recast and, um, they either can or can't afford their mortgages depending on how you do or do not look at it.

What kind of logic do you expect from an essay that begins:

California is to mortgage lending what Chicago is to pork bellies.

California (the whole state) has a famous exchange on which future prices of mortgage lending are determined? Well, no:

For years, that meant it was a place with soaring house values; today, the foreclosure rate across the state is twice the national average and going up fast.

"That meant"? Home prices in California bubbled and then busted because homes were traded like commodities futures? We're two sentences into the piece here and the wheels have already come off the logical wagon. The tone is set for the lede:

California should be the poster child for a mortgage-loan bailout. In few other places have so many taken on such onerous debts with so little equity. Unfortunately, the crisis in California is going to get much worse, and there is no bailout that will solve it. Why? Because if the first stage of the foreclosure crisis was about people who could not afford their mortgages, the next stage will be about people who have every reason not even to try to pay their mortgages.

As usual, I'm amazed at how short memories are, since the "subprime crisis" was only just last year. And why just last year, when we had been originating large volumes of subprime loans for years prior to that? Well, 2007 was when those people who couldn't afford their mortgage payments suddenly lost the ability to refinance or to sell the home ahead of foreclosure. And why was that? Because home values were sliding in high-subprime-concentration markets. So maybe the price declines as of a year ago were "only" single-digits, as opposed to the "40%-50%" our intrepid Slate reporter forecasts for California. So? Underwater is underwater: if you cannot or do not wish to bring cash to the closing in order to sell your home, and you cannot maintain the payments, you end up in foreclosure, whether you're 5% under or 50% under.

Insofar as there's any sort of point here, it seems to be the unsurprising one that so-called "prime" borrowers last longer in an RE bust than subprime borrowers do. By the time prime borrowers get to the end of their ability to handle crushing mortgage payments, RE values have dropped further than they had for subprime borrowers. What else are we to make of this:

The most common subprime loans were known as "2/28" in the industry: 30 years, including a two-year teaser rate before the interest rate rose. Now these loans have reset, and we're seeing the fallout.

But prime borrowers, too, got loans that started out with low payments; if you bought or refinanced your house in the last few years, it's not unlikely that you have one. With an "option ARM" loan you have the "option" (which most borrowers happily take) of paying less than the interest; the magic of "negative amortization." The loan grows until you hit a specified point—the exact point varies with the lender; with Countrywide, it'll come after about four and a half years—when the payment resets to close to twice where it was on Day 1. . . .

The really amazing thing is that the meltdown in California is already happening and virtually none of these loans have yet reset.

Option ARM loans were heavily marketed to upper-tier home buyers in California. It's hard to know how bad the option ARM crisis will be before it actually happens, but Moe Bedard, an advocate in Southern California who advises homeowners on foreclosure and blogs about the crisis at Loansafe.org says that the difference in the time until the rate rises is the main reason that upper-middle-class Orange County (now facing foreclosures at a rate merely twice the national average) hasn't yet been hit as badly as places like Riverside.

The 2/28 "subprime" foreclosure crisis also started well before most of those loans had reset, as the failed flippers and borrowers with crushingly high DTIs even before reset were trapped by even modest drops in value. It shouldn't be surprising that Option ARM failures are beginning to occur before the payment recast.

But, as with the CBOT analogy, what's the point here? That well-heeled Orange County OA borrowers will not be able to afford doubled mortgage payments when their OAs reset, and that by then they will be underwater by 40%? This makes them "walkaways," whereas the subprime borrowers were just plain old "foreclosures"? The way I see it, we have two choices here. We can take the perspective that "we're all subprime now," or we can insist that in fact "we" aren't subprime, "we" are walkaways, and that's different.

Such "rebranding" leads inexorably to this sort of fantasy:

Consider, too, that, yes, going through a foreclosure kills your credit rating and makes it a lot harder to buy a new house—but as more and more prime borrowers go into foreclosure, it's perfectly possible that buying a new home a year later will in the near future be as routine and unsurprising as the once inconceivable idea that you can get a whole batch of new credit cards two years after a bankruptcy.

What a foreclosure and a "killing" of your credit rating does to you is make you "subprime." "Prime" is not a birthright; it is not an immutable characteristic like having blue eyes. The confident assertion that credit will be easily and quickly available to these borrowers formerly known as prime rests on a hidden assumption that they are unlike any other "subprime" borrower, and therefore will get preferential treatment in a year or two.

Mystification aside, this is a prediction that the subprime mortgage lending industry--and the investors therein--will have recovered sufficiently in just a year that this new large crop of subprime borrowers with a year-old FC on their records will be deluged with mortgage offers. Perhaps that will happen, but what makes anyone think it will happen just because these were once "prime" borrowers? Most subprime borrowers were once prime. With the exception of borrowers who have never had any credit, which is a fairly small group, subprime borrowers once had prime credit, and did not manage it well, and therefore now have cruddy credit records and FICOs. How, exactly, will these "walkaways" be any different from any other subprime borrower?

The whole thing is so nonsensical that I am forced to the conclusion that for this (and many other writers), "subprime" is code for "poor people" and "prime" is code for "middle and upper class people," hence the need for distinguishing terms for loan failure: "foreclosure" for the poor, "walkaway" for the non-poor. Foreclosure is something that happens to you against your will; "walkaway" is something you do to the bank as an exercise of control over your finances. If we can maintain these illusory distinctions, we can maintain "our" distance from "them."

In the realm of rhetoric, that is. I for one suspect that the economics of mortgage lending in a year or two will be somewhat less fantasy-driven than that.