by Calculated Risk on 10/21/2009 01:30:00 PM

Yesterday both former Fed Chairman Paul Volcker and BofE Governor Mervyn King argued to break up the big banks. Fed Governor Tarullo disagrees.

From Fed Governor Daniel Tarullo: Confronting Too Big to Fail

One approach suggested by a number of commentators is to reverse the 30-year trend that allowed progressively more financial activities within commercial banks and more affiliations with non-bank financial firms. The idea is presumably to insulate insured depository institutions from trading or other capital market activities that are thought riskier than traditional lending functions. There are, however, at least two reasons why this strategy seems unlikely to limit the too-big-to-fail problem to a significant degree. One is that, historically at least, some very large institutions got themselves into a good deal of trouble through risky lending alone. Moreover, as we have already seen in the experience with Bear Stearns and Lehman, firms without commercial banking operations can now also pose a too-big-to-fail threat.

Another approach would be to attack the bigness problem head-on by limiting the size or interconnectedness of financial institutions. Some observers have even suggested that existing large firms should be split up into smaller, not-too-big-to-fail entities, in a manner a bit reminiscent of the break-up of AT&T in the early 1980s. Of course, the conceptual and practical challenges in breaking up the nation’s largest financial institutions would be considerably more daunting than those faced by Judge Greene in creating four regional operating companies and a long distance carrier out of the old AT&T. Indeed, to my knowledge, no one has offered anything like standards for undertaking this task, much less a blueprint for how it would be accomplished. This is, in other words, more a provocative idea than a proposal. Like many a provocative idea, though, even in an unelaborated form it can focus attention on the relative effectiveness of alternative policy proposals.

The fact that the largest financial firms will account for a significantly larger share of total industry assets after the crisis than they did before can only add to the uneasiness of those worried about the too-big-to-fail phenomenon. It is notable that current law provides very little in the way of structural means to limit systemic risk and the too-big-to-fail problem. The statutory prohibition on interstate acquisitions that would result in a commercial bank and its affiliates holding more than 10 percent of insured deposits nationwide is the closest thing to such an instrument. Policymakers and policy commentators alike might usefully attempt to develop similarly discrete mechanisms that could be beneficial in containing the too-big-to-fail problem. As must be apparent from my remarks today, my strong suspicion is that an effective response to the problem will likely require multiple, mutually reinforcing instruments.
emphasis added

Tarullo suggests:

A regulatory response for the too-big-to-fail problem would enhance the safety and soundness of large financial institutions and thereby reduce the likelihood of severe financial distress that could raise the prospect of systemic effects. Such a response consists of three elements.

First, the shortcomings of the regulations that failed to protect the stability of the firms and the financial system need to be rectified. Regulatory capital requirements can balance the incentive to excessive risk-taking that may arise when there is believed to be government support for a firm, or at least some of its liabilities. There is little doubt that capital levels prior to the crisis were insufficient to serve their functions as an adequate constraint on leverage and a buffer against loss. The Federal Reserve has worked with other U.S. and foreign supervisors to strengthen capital, liquidity, and risk-management requirements for banking organizations. In particular, higher capital requirements for trading activities and securitization exposures have already been agreed. Work continues on improving the quality of capital and counteracting the procyclical tendencies of important areas of financial regulation, such as capital and accounting standards.

These regulatory changes are surely a necessary part of a response to the too-big-to-fail problem, but there is good reason to doubt that they are sufficient. Generally applicable capital and other regulatory requirements do not take account of the specifically systemic consequences of the failure of a large institution. It is for this reason that many have proposed a second kind of regulatory response--a special charge, possibly a special capital requirement, based on the systemic importance of a firm. Ideally, this requirement would be calibrated so as to begin to bite gradually as a firm’s systemic importance increased, so as to avoid the need for identifying which firms are considered too-big-to-fail and, thereby, perhaps increasing moral hazard.
...
A third regulatory change is in some respects the most obvious and straightforward: Any firm whose failure could have serious systemic consequences ought to be subject to regulatory requirements such as those I have just described.

by Calculated Risk on 10/21/2009 11:47:00 AM

From the BLS: Regional and State Employment and Unemployment Summary

Twenty-three states and the District of Columbia recorded over-the-month unemployment rate increases, 19 states registered rate decreases, and 8 states had no rate change, the U.S. Bureau of Labor Statistics reported today. Over the year, jobless rates increased in all 50 states and the District of Columbia.
...
In September, nonfarm payroll employment decreased in 43 states and the District of Columbia and increased in 7 states.
...
Michigan again recorded the highest unemployment rate among the states, 15.3 percent, in September. The states with the next highest rates were Nevada, 13.3 percent; Rhode Island, 13.0 percent; and California, 12.2 percent. The rates in Nevada and Rhode Island set new series highs. Florida, at 11.0 percent, also posted a series high.
emphasis added

Click on graph for larger image in new window.

This graph shows the high and low unemployment rates for each state (and D.C.) since 1976. The red bar is the current unemployment rate (sorted by the current unemployment rate).

Fourteen states and D.C. now have double digit unemployment rates.

New Jersey, Indiana, and Missouri are all close.

Three states are at record unemployment rates: Rhode Island, Nevada, and Florida. Several others - like California, Delaware, North Carolina and Georgia - are close.

by Calculated Risk on 10/21/2009 09:11:00 AM

From Reuters: U.S. architecture billings up in September-AIA

... The Architecture Billings Index was up 1.4 points at 43.1, matching July's level, according to the American Institute of Architects.

The index has remained below 50, indicating contraction in demand for design services, since January 2008.
...
A measure of inquiries for new projects, however, rose to 59.1, its highest in two years -- "an encouraging sign," said AIA Chief Economist Kermit Baker.

"Some larger stimulus-funded building activity should be coming online over the next several months, partially offsetting the steep decline in private commercial construction," Baker said.

Click on graph for larger image in new window.

This graph shows the Architecture Billings Index since 1996. The index has remained below 50, indicating falling demand, since January 2008.

Note: Nonresidential construction includes commercial and industrial facilities like hotels and office buildings, as well as schools, hospitals and other institutions.

Historically there is an "approximate nine to twelve month lag time between architecture billings and construction spending" on commercial real estate (CRE). This suggests further dramatic declines in CRE investment through most of 2010, if not longer.

by Calculated Risk on 10/21/2009 08:56:00 AM

The MBA reports: Mortgage Applications Decrease

The Market Composite Index, a measure of mortgage loan application volume, decreased 13.7 percent on a seasonally adjusted basis from one week earlier. ...

The Refinance Index, also adjusted for the holiday, decreased 16.8 percent from the previous week and the seasonally adjusted Purchase Index decreased 7.6 percent from one week earlier.
...
The average contract interest rate for 30-year fixed-rate mortgages increased to 5.07 percent from 5.02 percent, with points increasing to 1.13 from 1.11 (including the origination fee) for 80 percent loan-to-value (LTV) ratio loans.

Click on graph for larger image in new window.

This graph shows the MBA Purchase Index and four week moving average since 2002.

The Purchase index declined to 268.8, and the 4-week moving average declined to 284.

Note: The increase in 2007 was due to the method used to construct the index: a combination of lender failures, and borrowers filing multiple applications pushed up the index in 2007, even though activity was actually declining.

by Calculated Risk on 10/20/2009 10:18:00 PM

A couple of interesting articles and a daily summary ...

From MarketWatch: Treasury to introduce program to help small banks

The ABA and other bank lobby groups for small banks are seeking to have Treasury develop a program to provide TARP funds to small stressed banks -- those with less than $5 billion in assets -- on the cusp of a default that haven't received TARP funds.

And I thought everyone agreed that the FDIC closing small failing banks - albeit slowly - was an example of how bank problems should be resolved. Now we have "Too small to fail"?

Philly Fed Chairman Charles Plosser, in a speech tonight, questioned the effectiveness of many of the recent Fed actions: Sound Monetary Policy for Good Times and Bad

As the crisis unfolded and problems arose in different parts of the financial system, the Fed responded by trying to increase liquidity in several markets through special lending programs. These programs may have had some stabilizing effects on markets and may have lowered some spreads. Yet, without defining in advance a systematic and consistent approach to such lending, these programs also raised uncertainty — in this case, about who would or would not have access to the various facilities. This was illustrated when the Term Asset-Backed Securities Loan Facility (or TALF) was announced. Many market participants lobbied for expanding the categories of securities eligible for the program. Did these multiple lending programs keep lenders on the sidelines waiting to see which asset classes the Fed would support and which it would not? Did this delay the healing of the financial markets?

Bank of England Governor Mervyn King criticized the lack of reform and 'too big to fail'. Here is the text of King's speech. Or see The Telegraph and The Times for excerpts.

Housing Starts were flat in September. And I also posted a short comment on why the focus should be on housing starts (and new home sales), and not existing home sales - and why (briefly) I think a V-shaped recovery is not going to happen: Housing and the Economy

I posted some HAMP Modification Documents and some discussion of a trial modification. Note: Reposted documents with all personal information removed.

There was much more discussion of the first-time home buyer tax credit today. The White House expects to announce a decision in the next couple of weeks.

DataQuick reported that California Mortgage Defaults Trended Down in Q3 . This will be a record year for default notices, and DataQuick also noted that defaults are moving up into higher priced areas.

Note: I recently changed the page layout. It now has the last 5 posts, and then short excerpts and links to previous posts.

by Calculated Risk on 10/20/2009 07:16:00 PM

A quote from Bank of England Governor Mervyn King in the Telegraph: Mervyn King: bank bail-outs created 'biggest moral hazard in history' (ht Jonathan)

"It is in our collective interest to reduce the dependence of so many households and businesses on so few institutions that engage in so many risky activities. The case for a serious review of how the banking industry is structured and regulated is strong. ... The belief that appropriate regulation can ensure that speculative activities do not result in failures is a delusion. ... It is hard to see how the existence of institutions that are 'too important to fail' is consistent with their being in the private sector."

More from The Times: Mervyn King calls for banks to split as public finances take record hit

“What does seem impractical, however, are the current arrangements. Anyone who proposed giving government guarantees to retail depositors and other creditors, and then suggested that such funding could be used to finance highly risky and speculative activities, would be thought rather unworldly. But that is where we now are.

“It is important that banks in receipt of public support are not encouraged to try to earn their way out of that support by resuming the very activities that got them into trouble in the first place.”
...
“To paraphrase a great wartime leader, never in the field of financial endeavour has so much money been owed by so few to so many. And, one might add, so far with little real reform.”

by Calculated Risk on 10/20/2009 05:12:00 PM

From Reuters: White House skeptical on renewing home buyers credit

[Housing and Urban Development Secretary Shaun] Donovan told the Senate Banking Committee that while he was aware the program was popular with lawmakers, "At the same time, I am mindful that these proposals can be very expensive, especially at a time of significant budget deficits."
...
Under questioning, Donovan said the administration would make a decision in the coming weeks after it sees more government data on the cost of the tax credit.
...
"I do not believe that a catastrophic decline would be the result of the end of the credit," Donovan said.
emphasis added

And more from Reuters on the widespread fraud: IRS warned again of U.S. homebuyer credit fraud

The internal watchdog for the U.S. Internal Revenue Service is expected to warn the agency for the fourth time about fraud in the multibillion dollar homebuyer tax credit program ... The inspector general found at least 70,000 tax credit claims, totaling $489 million, were granted to individuals who do not appear to qualify for it. ... The agency has opened 107,000 civil cases related to the credit and identified 167 criminal schemes

From Diana Olick at CNBC: HUD Hints on Home Buyer Tax Credit . Olick reviews Donovan's testimony and writes:

[T]hat sounded more like a "No" to me than a "Yes."

And Rex Nutting at MarketWatch reviews many of the arguments against the tax credit: Kill the wasteful home-buyer tax credit

There are other reasons to oppose the tax credit (other than it is expensive and poorly targeted). An extension of the tax credit will increase the apartment vacancy rate, push down rents, and lead to more defaults for CMBS (with falling rents), see Housing Wire: Rating Agencies See More Pain Ahead for Commercial MBS

[S]ervicers of commercial mortgage-backed securities (CMBS) are ... requiring more time to resolve delinquent loans, according to Fitch Ratings.

The delay for servicers, combined with continued market value declines, indicates loss severities are likely to increase “markedly” for US CMBS well into 2010, according to an annual study by the rating agency.

Multifamily loans in particular, which represent an average cumulative loss severity of 38.6% in 2008, will see a significant increase in loss severity as many markets suffer rising unemployment and oversupply.

And that means more losses for small and regional banks.

And, for fun, from housing economist Tom Lawler (no link, a joke):

Michigan politicians, meanwhile, are arguing that Senator Isakson [sponsor of tax credit] is “almost right” in that housing needs a big boost, but so does the auto industry. As such, legislators from the Wolverine State are working behind the scenes to craft a “bipartisan” bill that would eliminate a home buyer tax credit, but instead would give all home buyers next year an American-made compact car valued up to $15,000 – at, of course, the MSRP, and paid for by the US government. Purportedly one staffer said, “hey, this proposal is no dumber than Isakson’s, and in fact it helps kill two birds with one stone, so to speak!”

This was a joke, but it really is no dumber than the Isakson proposal.

by Calculated Risk on 10/20/2009 04:12:00 PM

For those interested, here are some Wells Fargo (America's Servicing Corporation) HAMP documentation (pdf) (ht Dave).

A few notes:

The borrower is delinquent and hasn't made a payment in about one year.

The trial modification plan (three months) calls for three payments of $1170.82 per month (includes an escrow account for taxes and insurance). This is about $1000.00 less than the borrower's previous monthly payment.

The borrower owes approximately $330,000 (including missed payments). Wells Fargo is waiving the late fees if the borrower completes the trial modification plan.

A similar house has recently sold for $150,000 (distressed sale), so the borrower is probably $150,000 to $180,000 underwater.

Comparable houses rent for close to $1,500 per month. So the borrower is paying less than the going rent on the modified loan.

by Calculated Risk on 10/20/2009 01:30:00 PM

There is a lot of interesting data in the DataQuick report. A few key points:

2009 will be another record year for NODs.

Lenders have change policies and are trying to modify more mortgages.

2006 was a toxic lending year (probably because that was when house prices peaked or were starting to fall).

Defaults are movin' on up into the mid and high priced areas.

Click on graph for larger image in new window.

This graph shows the Notices of Default (NOD) by year through 2009¹ in California from DataQuick.

¹ 2009 estimated as total NODs to date, plus Q3 NODs (as estimate for Q4).

Clearly 2009 is on pace to break the record of 2008. I'd expect something close to 500 thousand NODs for the entire year.

From DataQuick: California Mortgage Defaults Trend Down Again

The number of mortgage default notices filed against California homeowners fell last quarter compared with the prior three-month period, the result of lenders' evolving foreclosure policies, an uncertain legislative environment and an uptick in the number of mortgages being renegotiated, a real estate information service reported.

A total of 111,689 default notices were sent out during the July-through-September period. That was down 10.3 percent from 124,562 for the prior quarter, and up 18.5 percent from 94,240 in third quarter 2008, according to San Diego-based MDA DataQuick.

The number of recorded default notices peaked in the first quarter of this year at 135,431, although that number was inflated by deferred activity from the prior four months.

"It may well be that lenders have intentionally slowed down the pace of formal foreclosure proceedings. If so, it's not out of the goodness of their hearts. It's because they've concluded that flooding the market with cheap foreclosures in this economic environment may not be in their best financial interest. Trying to keep motivated, employed homeowners in their homes might be the most cost-efficient way to stem losses," said John Walsh, DataQuick president.
...
While most foreclosure activity was still concentrated in affordable inland communities, the foreclosure problem continued to slowly migrate into more expensive areas. The state's most affordable sub-markets, which represent 25 percent of the state's housing stock, accounted for 52.2 percent of all default activity a year ago. In third-quarter 2009 it fell to 42.9 percent.
...
Although 111,689 default notices were filed last quarter, they involved 108,372 homes because some borrowers were in default on multiple loans (e.g. a primary mortgage and a line of credit). Multiple default recordings on the same home are trending down, DataQuick reported.
...
Trustees Deeds recorded, or the actual loss of a home to foreclosure, totaled 50,013 during the third quarter. That was up 9.5 percent from 45,667 for the prior quarter, and down 37.1 percent from 79,511 for third-quarter 2008, which was the all-time peak.

In the last real estate cycle, Trustees Deeds peaked at 15,418 in third-quarter 1996. The state's all-time low was 637 in the second quarter of 2005, MDA DataQuick reported.
emphasis added

by Calculated Risk on 10/20/2009 12:08:00 PM

Emile Brinkmann, MBA Chief Economist, testified today before the Senate Committee on Banking, Housing and Urban Affairs at a hearing titled, "The State of the Nation's Housing Market." Here are some excerpts:

"... Whenever I am asked when the housing market will recover, I explain that the economy and the housing market are inextricably linked. The number of people receiving paychecks will drive the demand for houses and apartments and the recovery will begin when unemployment stops rising. ...

Edit: this is correct in terms of housing units, but it is important to note that housing investment leads the economy both into and out of a recession, and, in recent recessions, employment lags. I'd argue the recovery in housing investment has already started, but it will be a very sluggish recovery.

... Prior to the onset of this recession, the housing market was already weakened due in part to the heavy use of loans like pay option ARMs and stated income loans by borrowers for whom these loans were not designed. Together with rampant fraud by some borrowers buying multiple properties and speculating on continued price increases, this led to very high levels of construction to meet that increased demand, demand that turned out to be unsustainable. When that demand disappeared, a large number of houses were stranded without potential buyers. The resulting imbalance in supply and demand drove prices down, particularly in the most overbuilt markets like California, Florida, Arizona, and Nevada - markets that had previously seen some of the nation's largest price increases.
emphasis added

Unfortunately the MBA didn't take the lead in trying to halt the spread of these products (Option ARMs and Stated Income loans).

Thus the nature of the problem has shifted. A year ago, subprime ARM loans accounted for 36 percent of foreclosures started, the largest share of any loan type despite being only 6 percent of the loans outstanding. Now prime fixed-rate loans represent the largest share of foreclosures initiated.

We're all subprime now!

Unfortunately, the consensus is that unemployment will continue to get worse through the middle of next year before it slowly begins to improve. While we have seen certain good signs like a stabilization of home prices and millions of borrowers refinancing into lower rates, we still face major challenges.

The most immediate challenge is what will happen to interest rates when the Federal Reserve terminates its program for purchasing Fannie Mae and Freddie Mac mortgage-backed securities in March. The Federal Reserve has purchased the vast majority of MBS issued by these two companies this year and in September purchased more than 100% of the Fannie and Freddie MBS issued that month. The benefit has been that mortgage rates have been held lower than what they otherwise would have been without the purchase program, but there is growing concern over where rates may go once the Federal Reserve stops buying and what this will mean for borrowers. While the most benign estimates are for increases in the range of 20 to 30 basis points, some estimates of the potential increase in rates are several times those amounts.

My estimate is an increase of 35 bps for mortgage rates (relative to the Ten Year Treasury yield).

The extension of the Fed's MBS purchase program to March gives the Obama administration time to announce its interim and, perhaps, long-term recommendations for Fannie and Freddie in February's budget release.

All of this, however, points to the need to begin replacing Fannie Mae and Freddie Mac with a long-term solution. MBA has been working on this problem for over a year now and recently released its plan for rebuilding the secondary market for mortgages.

MBA's plan envisions a system composed of private, non-government credit guarantor entities that would insure mortgage loans against default and securitize those mortgages for sale to investors. These entities would be well-capitalized and regulated, and would be restricted to insuring only a core set of the safest types of mortgages, and would only be allowed to hold de minimus portfolios. The resulting securities would, in turn, have a federal guarantee that would allow them to trade similar to the way Ginnie Mae securities trade today. The guarantee would not be free. The entities would pay a risk-based fee for the guarantee, with the fees building up an insurance fund that would operate similar to the bank deposit insurance fund. Any credit losses would be borne first by private equity in the entities and any risk-sharing arrangements put in place with lenders and private mortgage insurance companies. In the event one of these entities failed, the insurance fund would cover the losses. Only if the insurance fund were exhausted, would the government need to intervene.

One of the concerns is privatizing profits and socializing losses - exactly what happened with Fannie and Freddie. This proposal has some positive features - especially restricting insurance to "the safest types of mortgages". That would be prime fixed and ARM loans only, with no risk layering. Subprime would be excluded. Alt-A should disappear.

It appears - although it isn't explicitly stated - that no other entities could securtize mortgages. That would be a key.