by Calculated Risk on 5/01/2008 01:53:00 PM

The BEA released the supplemental tables to the GDP report this morning. One of the interesting details is real spending on home improvement.

Almost exactly one year ago, I wrote that home improvement investment was holding up pretty well (see What Home Improvement Investment Slump?) - and I didn't expect that to continue.

Click on graph for larger image.

The BEA reports that real spending on home improvement fell 2% in Q1 2008 (from Q4 2007), and has fallen about 4% in real terms from the peak. This is probably just the beginning of the home improvement slump; if this housing bust is similar to the early '80s or '90s, real home improvement investment will slump 15% to 20%.

Note: This graph shows real home improvement investment (2000 dollars) since 1959. Recessions are in light blue with the current recession "probable". (source: BEA)

by Anonymous on 5/01/2008 11:55:00 AM

I think the British term "scheme" might apply, however.

And what, you ask, is HOP? It is the brainchild of the only Federal Deposit Insurance Corporation you happen to have, that's what. Formally, it is the Home Ownership Preservation Loan:

This proposal is designed to result in no cost to the government:

* Borrowers must repay their restructured mortgage and the HOP loan.
* To enter the program, mortgage investors pay Treasury's financing costs and agree to concessions on the underlying mortgage to achieve an affordable payment.
* Treasury would have a super-priority interest -- superior to mortgage investors' interest -- to guarantee repayment. If the borrower defaulted, refinanced or sold the property, Treasury would have a priority recovery for the amount of its loan from any proceeds.
* The government has no continued obligation and the loans are repaid in full.

Mortgage Restructuring:

* Eligible, unaffordable mortgages would be paid down by up to 20 percent and restructured into fully-amortized, fixed rate loans for the balance of the original loan term at the lower balance. New interest rate capped at Freddie Mac 30-year fixed rate.
* Restructured mortgages cannot exceed a debt-to-income ratio for all housing-related expenses greater than 35 percent of the borrower's verified current gross income ('front-end DTI').
* Prepayment penalties, deferred interest, or negative amortization are barred.
* Mortgage investors would pay the first five years of interest due to Treasury on the HOP loans when they enter the program. After 5 years, borrowers would begin repaying the HOP loan at fixed Treasury rates.
* Servicers would agree to periodic special audits by a federal banking agency.

Process:

* Mortgage investors would apply to Treasury for funds and would be responsible for complying with the terms for the HOP loans, restructuring mortgages, and subordinating their interest to Treasury.
* Administratively simple. Eligibility is determined by origination documentation and restructuring is based on verified current income and restructured mortgage payments.

Funding:

* A Treasury public debt offering of $50 billion would be sufficient to fund modifications of approximately 1 million loans that were "unsustainable at origination." Principal and interest costs are fully repaid.

Eligible Mortgages:

Applies only to mortgages for owner-occupied residences that are:

* Unaffordable – defined by front-end DTIs exceeding 40 percent at origination.
* Below the FHA conforming loan limit.
* Originated between January 1, 2003 and June 30, 2007.

The FDIC helpfully gives us an example of a $200,000 2/28 loan with 28 years remaining to maturity at a fully-indexed rate of 8.00%. Using the payment provided for the HOP loan of $235 ($40,000 repaid over 23 years, as the first five years require no payment from the borrower), the assumed interest rate is 4.6% or roughly the yield on the 30-year Treasury bond.

So all the investor would have to do is apply for $40,000 in Treasury funds. I have to assume that the first five years of interest to the Treasury is prepaid by the investor, meaning the actual funding would be $30,800 (4.6% interest for five years of $9,200 subtracted from the funding amount). For a securitized mortgage, this would be an immediate charge to the deal's credit enhancement (presumably a write-down to the overcollateralization or most subordinate bond, possibly a partial claim against a mortgage insurance policy). I find it hard to believe that the Treasury would contemplate having mortgage-backed securities remitting monthly interest to the Treasury for five years. But then, I find a lot hard to believe these days, and the FDIC website doesn't really say.

The interest rate on the loan would be reduced to 5.88% for the remaining 28 years. The difference between the fully-indexed rate of 8% and the modified rate of 5.88%, adjusted for whatever anybody happens to think is a plausible average prepayment speed for a loan like this, would be a reduction to the "excess spread" or overcollateralization of the security.

The servicer would execute a modification of mortgage which would adjust the terms accordingly, and record that modification in a junior position to the mortgage given to the Treasury. So, assuming the value of the property was $200,000 at the time, instead of an "80/20" deal this would be a "20/80" deal. In the case of subsequent sale of the home (or default), the Treasury's $40,000 loan would be satisfied first, before any funds were available to the holder of the $160,000 "second lien." (Presumably, if there were a sale or default within the first five years, a portion of the prepaid interest could be deducted from the payoff of the Treasury's lien.)

If, on the other hand, the loan performed for five years and then the borrower sold the property for, say, $220,000, the Treasury would get $40,000, the investor would be paid the outstanding balance on the $160,000 loan (about $147,000), and the borrower would receive the rest of the proceeds. I don't see any provision for the lender to recover the interest it paid on the Treasury loan ($9,200) at this point. As far as I can tell there is no "equity sharing" arrangement on these loans.

What happens if there is lender-paid or borrower-paid MI on the loan? I have no idea. Possibly the mortgage insurer might agree to pay a partial claim when the loan is modified (to cover the investor's loss of the prepaid interest on the Treasury loan), and then the policy would be modified so that the new insured amount is equal to the reduced loan balance (in exchange for a reduced premium). That would reduce the MI's absolute loss exposure in dollar terms. (Suppose the MI coverage on the loan is 35%; the MI's dollar exposure would be $70,000 on $200,000 but only $56,000 on $160,000.) I really have no idea, although I'm sure that insured loans are a small fraction of the loans the FDIC has in mind here.

More likely they have outstanding second liens, and apparently what's supposed to happen here is that the second lien lender just writes off its entire loan amount and goes away quietly. There is only one rather stark sentence regarding second liens: "Under the proposal, the underlying loan is modified within the mortgage pool and does not worsen the position of subordinate lien holders." I gather that means that the second lien lenders are expected to subordinate their liens behind the old first-lien lender's new second lien, making the second a third. (To release the second lien entirely would surely have to be understood to "worsen" the second lienholder's position here.) There is no discussion of the possibility of using the Treasury loan to pay off or pay down the second lien, only to pay down the first lien. HOP may not worsen the second lienholder's position, but it doesn't improve it any.

In the FDIC example loan, the borrower's housing payment-to-income ratio goes from 50% at the time of modification to 35% for five years, and then increases to 39% for the remainder of the loan. These numbers already have a 1.5% annual income increase built into them. If the borrowers have no other debt, that's certainly affordable. Is it affordable enough that the reduced frequency of default in the next five years or so makes up for the increased severity of loss given default to the investor? A borrower whose HTI was 50% and whose DTI was 60% will be going to an HTI of 35% and a DTI of 45%. With the distinct possibility of further declines in home values, that's still a pretty high-risk loan. I'm guessing we will be able to judge whether investors think so by the extent to which they all line right up to participate in this voluntary program. Of course, servicers will be looking at the total debt-to-income ratio, not just the housing payment.

Bottom line: although it's silly to claim this program will have no cost to the government, it is true that the government's exposure is minimal (administrative expenses; either the Treasury services its own loan or the servicer is being asked to do so for free), assuming that I am correct that the first five years' interest will be prepaid. The losses are taken by the lenders and the borrower pays back the full loan amount, albeit at a reduced interest rate. As far as I can tell, the only party who really gets a "bailout" here is the mortgage insurers. That's the real beauty of this plan, and why I cannot for a moment imagine it's going to work.

If you made the assumption that borrowers are entirely insensitive to their equity position--that it is only a question of making the monthly payment affordable--then you could assume that borrowers would like this program and that it would substantially prevent defaults. If you do assume that equity position matters as well as affordability, then this program doesn't do much, since it doesn't change the total indebtedness--even if second lienholders are charging off their loans, if they aren't releasing their liens that money can still be collected from future sale proceeds. Having those liens still out there is likely to make voluntary sale of the property unlikely for some time to come, given the house price outlook.

And the key is a real reduction in the likelihood of default, since it's clear that in the event of default the lender is worse off under the HOP scheme than it would otherwise have been. We can certainly applaud the FDIC for coming up with a plan that protects the taxpayers' contribution in any scenario, but I'm not sure that MBS servicers (or even portfolio lenders) will see this as a sufficient improvement to the risk of default on these loans to take the bait.

by Calculated Risk on 5/01/2008 09:59:00 AM

Spending declined in March for residential, but increased to for non-residential private construction. The increase in March - to a new record high for non-residential spending - followed three straight months of spending declines.

From the Census Bureau: March 2008 Construction Spending at $1,123.5 Billion Annual Rate

Spending on private construction was at a seasonally adjusted annual rate of $827.4 billion,1.7 percent below the revised February estimate of $842.0 billion.

Residential construction was at a seasonally adjusted annual rate of $445.0 billion in March, 4.6 percent below the revised February estimate of $466.7 billion.

Nonresidential construction was at a seasonally adjusted annual rate of $382.3 billion in March, 1.9 percent above the revised February estimate of $375.3 billion.

Click on graph for larger image.

The graph shows private residential and nonresidential construction spending since 1993.

Over the last couple of years, as residential spending has declined, nonresidential has been very strong. It appeared - over the last three months - that the expected slowdown in non-residential spending had arrived.

However, non-residential spending in March set a new nominal record (seasonally adjusted annual rate). This is a little surprising given tighter lending standards and reduced capital spending plans - and perhaps the numbers for March will be revised downwards in the next release.

by Calculated Risk on 5/01/2008 09:43:00 AM

Press Release: The Home Depot Updates Square Footage Growth Plans

The Company has determined that it will no longer pursue the opening of approximately 50 U.S. stores that have been in its new store pipeline ...

Aggregate new store capital spending will be reduced by approximately $1 billion over the next three years ...

The Company reiterated that its total capital spending for the current fiscal year is projected to be approximately $2.3 billion, down from $3.6 billion last year.

The Company also announced that [it] will close 15 underperforming U.S. stores that do not meet the Company's targeted returns.

Of course Home Depot is being hit hard by the slump in home improvement spending, but this is another company significantly reducing capital spending.

by Calculated Risk on 4/30/2008 07:02:00 PM

CNN Video via Yahoo: Angry owners vandalizing foreclosed homes in Las Vegas

Update: And here is a video from the O.C. Register of Riding with a sheriff’s deputy on eviction day.

by Calculated Risk on 4/30/2008 06:42:00 PM

From the WSJ: Starbucks to Cut U.S. Store Growth But Plans to Accelerate Overseas

Starbucks Corp. plans to drastically reduce the number of stores it builds in the U.S. over the next three years ...

Starbucks said Wednesday that this year, it plans to open 1,020 locations in the U.S., down from the 1,175 that it had planned for as of January. But over the next three years, Starbucks plans to cut that number by more than half, opening less than 400 net new locations per year in the U.S.

This is another company cutting investment plans related to non-residential structures.

by Calculated Risk on 4/30/2008 02:21:00 PM

Update: The Fed's "Pause" signal:

If you compare the current FOMC statement to the March 18th statement (previous meeting), it appears the Fed is signaling a pause.

On March 18th, from the FOMC statement (emphasis added):

"Today’s policy action, combined with those taken earlier, including measures to foster market liquidity, should help to promote moderate growth over time and to mitigate the risks to economic activity. However, downside risks to growth remain. The Committee will act in a timely manner as needed to promote sustainable economic growth and price stability."

The same paragraph of the statement today:

"The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time and to mitigate risks to economic activity. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability."

It appears the Fed believes the downside risks to growth have diminished and the inflation concerns remain about the same.

FOMC statement:

The Federal Open Market Committee decided today to lower its target for the federal funds rate 25 basis points to 2 percent.

Recent information indicates that economic activity remains weak. Household and business spending has been subdued and labor markets have softened further. Financial markets remain under considerable stress, and tight credit conditions and the deepening housing contraction are likely to weigh on economic growth over the next few quarters.

Although readings on core inflation have improved somewhat, energy and other commodity prices have increased, and some indicators of inflation expectations have risen in recent months. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook remains high. It will be necessary to continue to monitor inflation developments carefully.

The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time and to mitigate risks to economic activity. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; Gary H. Stern; and Kevin M. Warsh. Voting against were Richard W. Fisher and Charles I. Plosser, who preferred no change in the target for the federal funds rate at this meeting.

by Calculated Risk on 4/30/2008 11:41:00 AM

After the Q4 GDP report was released, I wrote: Non-Residential Investment: The Key?

The good economic news in the Q4 GDP report was that non-residential investment was still positive. Investment in non-residential structures increased at a very robust 15.8% annualized real rate. And investment in equipment and software increased at a more modest 3.8% annualized real rate. This non-residential investment is probably the key (along with consumer spending) on how weak the economy will be in 2008.

As I highlighted this morning, the non-residential investment news has turned negative in Q1 2008. Investment in non-residential structures was off 6.2% at an annualized rate, and investment in equipment and software investment declined 0.7%.

This is the normal historical pattern: residential investment leads non-residential investment, and all signs point to a sharp investment slump in 2008, especially in non-residential structures.

This graph shows the YoY change in Residential Investment and investment in Non-residential Structures.

Note that residential investment (RI) is shifted 5 quarters into the future. The typical lag between RI and non-RI structures is 4 to 8 quarters.

Although the year-over-year change is still positive, this will probably turn negative in Q2 or Q3.

Since non-residential investment is highly correlated with recessions, this is a strong indicator that the U.S. economy is now in or near recession.

by Calculated Risk on 4/30/2008 08:51:00 AM

The Bureau of Economic Analysis reports that the U.S. economy grew at a 0.6% annual real rate in Q1 2006, mostly because of a buildup in inventories. Without the unwanted buildup in inventory, GDP would have been negative, suggesting the economy is in recession.

Consumer spending was up 1.0% at an annual rate, with services up 3.4% (the two month method predicted 1% PCE growth in Q1), and investment spending was off in all categories: residential investment off -26.7%, non-residential structures off -6.2%, and equipment and software investment off -0.7%.

Click on graph for larger image.

This graph shows residential investment (RI) as a percent of GDP since 1960. RI as a percent of GDP is now at 3.8%, still well above the investment lows in 1982 (3.15%) and 1991 (3.3%). RI will probably decline further over the next few quarters.

Perhaps more important for the economy is that investment in equipment and software, and investment in non-residential structures, both turned negative in Q1. This is important because business investment slumps are highly correlated with the beginning of a recession.

The second graph shows non-residential investment in structures as a percent of GDP since 1960.

Non-RI structure investment has finally turned negative, and will probably decline sharply during 2008. See CRE Bust: How Deep, How Fast?

More on investment later.

by Calculated Risk on 4/29/2008 10:07:00 PM

The WSJ reports: HBOS Sets $8 Billion Rights Issue

HBOS PLC announced a £4 billion, or roughly $8 billion, rights issue designed to bolster the bank against a worsening market and repair the lender's capital base following write-downs.

... The price is 45% below Monday's closing share price of 496 pence.

Ouch. A 45% discount!

And from MarketWatch: Citigroup to raise $3 billion selling new stock

Citigroup Inc. said late Tuesday that it is raising $3 billion selling new shares as the financial-services giant tries to rebuild capital after huge losses from the credit crunch

.