by Calculated Risk on 1/15/2007 01:53:00 PM

About 15 years ago I was working for a decently-sized regional bank in Secondary Marketing (the bitch with the rate sheet), and one fine day this unspeakably cheerful young person from Primary Marketing (the ditz with the Sunday Ad Section) sashayed into my cubicle with the request that I, as a “subject matter expert” (corporate-speak for “nearest available victim”) review this brochure being produced for mortgage applicants and other innocent bystanders. It took the form of a glossary of terms—how original—and it had actually occurred to Marketing that perhaps it should be reviewed for accuracy. Being a sucker for that sort of thing—accuracy, and light bulbs going on over in Marketing, I mean, not extra work—I held out my hand. I will never forget the definition provided for the term “points”: “A fee paid at closing to increase the lender’s yield on the loan.”

Now, that definition is, in fact, perfectly accurate (and copied directly from The Handbook of Mortgage-Backed Securities, second edition, I believe). For a mortgage portfolio investor, it’s a good thing to know, too: you may have a low-rate loan to invest in, but luckily Verne and Mary Sue coughed up some points at closing that you get to amortize over the expected life of the loan to bring that yield up to market. Oh, wait, that definition doesn’t actually tell you that. Not to worry, you’re just an investor with great gobs of money at risk, you don’t need details.

If, on the other hand, you are Verne and Mary Sue, and you have just been confronted with a loan officer telling you to bring a four-figure check to closing to pay for this thing called “points,” and you don’t know what they are, and you check out the handy Glossary of Terms provided by your trusty bank, and it says that points are things you pay just to make the lender richer—there is no other way to construe that sentence if you don’t already know what points are—you will of course happily whip out the checkbook instead of running across the street to some other bank. Happens all the time.

So I got out the red pen and re-wrote the definition of points to indicate that they are an optional fee that you may pay if you want a lower interest rate, and that there are loans that do not charge points, but the interest rate on those loans is higher. After I turned in my marked-up copy, the Marketing Ditz did mention that some of my revisions might get edited a bit for length. Not surprising, I thought; Tanta does blather on.

The final printed version contained the following definition of points: “A fee paid at closing to increase the lender’s yield on the loan.”

I’d like to say we lost customers over it, but I doubt that’s true. I’m sure that net-net—losing all the literate and at least marginally sane borrowers, gaining the ones who cannot be stopped by information of any sort, true or not, keeping everyone with the good sense to refuse to accept a brochure offered by a stranger—we came out even. It used to make me so proud when I went to conventions and met colleagues from other, bigger banks: “You might have more customers than I do, but mine are still more ignorant than yours.”

My point is that there is, in fact, no party to any transaction—borrowers, lenders, investors, regulators, those menacing sorts who squeegee your windshield at busy city intersections, my Aunt Harriet’s cats—for whom this definition is more useful than an acid flashback. If you do not already know something, it either doesn’t tell you enough or tells you the wrong thing. If you already know something, it doesn’t exactly advance you toward the goalposts. It’s a classic example of a statement that is literally true and perfectly worthless. Yet my employer saw fit to use it because it came from a real published textbook, whereas the suggested revision came from that coffee-torqued bitch on the third floor, and besides, it fit into the margins of a tri-fold better. Those of you who know anything about the writing of annual CRA reports will know what we included among our “community outreach” efforts for the year, of course. The regulators were glad to see us make such nice educational commitments, too; I think we got an “Outstanding” rating that year. And people call me cynical.

I have often wondered over the years what happened to the Marketing Ditz, but I wonder no more: looks like she got a job with the Washington Post. Consider, if you can bear to, ”Mortgage-Trapped”:

At 64, and looking toward his retirement next year, Willie Lee Howard agreed to refinance his duplex in Northeast Washington, thinking that a fixed-rate loan would help stabilize his finances.

What Howard got instead was a mortgage he did not understand. Baffled by the loan documents he was mailed after the closing, he consulted an AARP lawyer and learned that he now had an interest-only loan, a new and controversial kind of mortgage. Howard was told that under its terms, his mortgage balance will rise instead of fall and that he will need to refinance in 10 years, when he may be too old to work.

"This is a bunch of junk they done to me," said Howard, a construction worker.

Howard's chagrin at his mortgage's complex provisions illustrates the confusion felt by many borrowers struggling to adapt to a radically transformed home lending market. . . .

Howard said he was persuaded to refinance his house by a "very friendly" loan officer who called once a week for a year, telling him the time was right to stabilize his finances.

After deciding to take out the loan, he said he told the lender he would need help reading the paperwork at the closing. He said he still doesn't understand exactly what kind of mortgage he signed.

Howard's mortgage contains several of these new features, said Sugarman, who has reviewed the documents. It is an interest-only loan, which is one of the nontraditional mortgages designed to help wealthy people manage their cash flow, and for people whose incomes are likely to rise -- not for those whose incomes, such as Howard's, are likely to fall as they retire on Social Security. The rate is fixed, but only for 10 years. Sugarman said Howard appears to have qualified for it with a "NINA" loan, a "no-income, no assets" loan that required minimal income documentation.

"It's a very exotic mortgage, and he had no idea he was getting that," Sugarman said. "He thought he was doing something smart."

That’s it, kids. That’s all the information provided in the article on Howard’s loan—read the whole thing if you don’t believe me. Read the whole thing anway: you really need to absorb the vicarious-outrage-on-behalf-of-the-uninformed tone of the whole worthless thing in order truly to savor the irony:

• Howard was told that an interest-only loan would result in a rising balance. This is of course false, a confusion of interest-only with negative amortization. The reporter does not correct this misinformation. Possibly the AARP lawyer is an illiterate moron. Possibly the AARP lawyer was misquoted by the reporter. Possibly a rather condescending article on how borrowers don’t often understand loan terms has gotten off to a rocky start in the second paragraph.

• Later in the article, we are given to understand that a “no-income, no assets” loan requires “minimal” income documentation. There are some misleading terms used by the mortgage industry, but in the case of a NINA, “no” actually means “no.” Not “some.” Loans with “minimal” income documentation are usually called “Reduced Doc” or “Streamlined Doc” or “Alternate Doc.” Have you ever heard the cliché “the blind leading the blind”? Just askin’.

• Howard was told that “he will need to refinance in ten years.” Why? Is the loan a ten-year balloon, which remains, in literal fact, the only kind of loan that really does require you to refinance in ten years? Tanta suspects—but can’t prove—that the loan is not a balloon but a 10/1 ARM. It is possible that Howard might want to refinance it in ten years. It is possible that Howard might not be able to afford the payments after the first rate adjustment. It is possible that Howard can’t afford the payments today. If you do not already know something about how mortgage loans work, what does “he will need to refinance in ten years” mean to you? If the Post thinks these loans are so dangerous to uninformed consumers, what would be the argument against actually letting us know what they’re called? That’s what I thought.

• Howard qualified for the loan with no—or possibly some but not much—income or asset documentation. What, precisely, is the problem with that? Do you know? Did you know before you read the Post? Do you still know after you read the Post? Would it have wrecked the layout of the entire newspaper to add one little sentence pointing out that this was a problem because Howard would not have qualified for the loan if he had provided verifications, or would have gotten a more affordable interest rate if he had provided verifications, or thought that he had provided verifications when in reality the lender threw them away, or perhaps is less an innocent victim than he would like us to think, or whatever the bloody problem actually is? Is it time for a drink yet?

• Howard, the story goes, refinanced his existing loan. He thought, the story goes, that “a fixed-rate loan would help stabilize his finances.” Um, did Howard start out with an ARM? Did he start out with a really high-rate loan? Did he need to take cash out? Other facts aside—and Dog knows we aren’t getting any anyway—if Howard already has a high-rate adjusting ARM, how, exactly, did he get screwed by being put into a 10/1 IO ARM? How did he fail to recognize another ARM? Is Howard illiterate? Would better-written disclosures have helped him in that case? Does the reporter actually believe that an IO loan legally prevents you from making the equivalent of an amortizing payment if you want to? If not, would it be worth providing that advice to people who have one? Could it be that Howard couldn’t have afforded a fixed rate amortizing loan if one had been offered? Does the reporter understand that amortizing fixed rate loans require higher payments and carry higher interest rates than IO ARMs do? Does Howard have faulty expectations as well as missing information? Does Howard have a very serious problem—he cannot afford his home with any available mortgage type—that cannot, actually, be solved merely by the provision of more information by a more honest loan officer? Would it be worth sacrificing the lack-of-lender-disclosure-screws-borrower-who-always-wants-the-right-thing-but-doesn’t-get-it boilerplate narrative in order to examine the question of what the real problem is? Could we, like, advance the ball?

There’s a definition of “news” that involves providing relevant information that readers don’t already have—true information, even—and there’s a definition of “serious reporting” that involves not providing unintentional comedy by parading one’s ignorance about mortgages in an article full of high-minded tut-tutting over ignorance about mortgages. There is. Really. Maybe we should send out a press release.

by Calculated Risk on 1/15/2007 01:05:00 AM

Bill Fleckenstein writes at MSN Money: Home-loan house of cards ready to fall

... a former top executive at a subprime lender (whose chronicling of the unwind has been amazingly accurate and timely), told me that serious issues are developing, and that large companies like New Century Financial (NEW, news, msgs), Accredited Home Lenders (LEND, news, msgs) and NovaStar Financial (NFI, news, msgs) will, in his words, "hit the wall" very soon.

This is a rumor, Fleck has been bearish for some time, and he is short New Century Financial. But it is still interesting.

by Calculated Risk on 1/14/2007 11:55:00 PM

Professor Mankiw reads Greg Ip at the WSJ: Fed Chairman May Face Heat At Hearings

When Federal Reserve Chairman Ben Bernanke testifies on monetary policy next month, he is likely to get far more scrutiny than usual.

By law, the Fed chairman must testify twice a year to Congress: in February and July. Ordinarily, each installment lasts two days, one before the Senate Banking Committee, the other before the House Financial Services Committee. There are no other witnesses.

In a break with that tradition, Barney Frank, the Massachusetts Democrat who took over the House panel this month, said he plans to hold an additional day of hearings in which witnesses, such as economists and labor experts, will give their views on what Mr. Bernanke said.

Mankiw asks:

"After reading a story like this, one might worry that more Congressional scrutiny will translate into less Fed independence and ... worse macroeconomic outcomes."

Mankiw's concern about Fed independence is a false worry. The hearings may provide more heat than light, but, as Fed President William Poole wrote in 2004: FOMC Transparency

It is natural to ask why central banks need to be transparent. One answer is that central banks are governmental agencies and as such are accountable to the public for their actions.

This is called oversight. But Poole also argues that transparency leads to better results:

The roots of central bank transparency are found not only in the principles of democratic accountability but also in economic theory.
...
Transparency should help markets to make the best possible adjustments over time and minimize uncertainty flowing from monetary policy itself.

Better transparency usually leads to better results, not worse.

Oversight. Transparency. Perhaps these extended hearings will not be especially productive in terms of oversight or transparency, but then they are at worst neutral in terms of macroeconomic outcomes. And these hearings are definitely not an assault on Fed independence.

by Calculated Risk on 1/14/2007 11:27:00 AM

Excerpt from Jon Lansner at the OC Register: Insider Q&A with local lender

Lansner: What are your home-buying clients thinking? What's the popular financing for this crowd?

Aaron [local lender]: The buyers that I have consulted with lately are first time homebuyers. They are feeling a bit of a pinch, but are able to qualify using strategic financing. We structure the deal using a seller financed buy-down of the interest rate. The beauty of this is that the buyer receives a below market interest rate to help them ease into the home. Additionally, the tax write-off afforded through the pre-paid interest on the purchase loan is given to the buyer in the year the purchase closes. It doesn't matter that the seller paid for the buy-down.

"Strategic financing".

Seller "buy-down" of interest rate.

Help the buyer "ease into the home".

File under phrases no one really wants to hear (at least no one associated with the housing market).

by Calculated Risk on 1/13/2007 01:10:00 AM

This bears repeating:

"The worst is not over. The worst is in front of us."
Dr. Christopher Thornberg of Beacon Economics, Jan 12, 2007

We can debate whether or not the housing bust will significantly impact the economy, but there is no question the "worst is in front of us."

More from the Press Enterprise:

[Thornberg] warned that the housing slowdown has appeared slower and less daunting than it really is, because it takes a while for home prices to drop.

"This isn't going to hit bottom in 2007. This is going to be a mess for quite a while," he said. As a result Thornberg said construction-related jobs should feel a bigger pinch ...

by Calculated Risk on 1/12/2007 02:32:00 PM

UPDATE: I had the title backwards. Trend real GDP is probably around 3.2% and nominal GDP is probably in the 5% to 6% depending on inflation. Since real GDP equals nominal GDP less inflation, it is unusual for real GDP (or real PCE) to be greater than their respective nominal values - unless the PCE and GDP price deflators decline.

Original Post: It is possible in Q4 that real PCE (and maybe real GDP) will be greater than the nominal value. If so, this hasn't happened since the early '50s. This is another way of saying reported inflation was negative for the quarter (I don't want to use the term "deflation").

Click on graph for larger image.

This graph shows Real PCE minus nominal PCE quarterly since 1947 (also GDP).

Looking at the monthly PCE price index, it appears the PCE price index will decline in Q4. This means that real PCE (and probably real GDP) will be higher than expected.

Is this drop in inflation because of "one-time" changes, and inflation is actually higher, and GDP lower, than what will be reported? That seems to be the view of Fed Vice Chairman Kohn this week:

"Core inflation is still higher than it was just a year ago, and, as I noted, some of the very recent decline may result from one-time changes in relative prices rather than an easing in underlying inflation pressures."

If Kohn is correct about inflation being higher than reported due to "one-time" changes, then the same argument can be made about GDP (lower than reported).

by Calculated Risk on 1/12/2007 01:37:00 PM

From the National Retail Federation (NRF): Warmer Weather and Soft Housing Market Lead to Subdued Holiday Gains

... retail industry sales for December (which exclude automobiles, gas stations, and restaurants) rose 3.9 percent unadjusted over last year and increased 0.4 percent seasonally adjusted from November. November industry sales were revised down from 6.3 percent unadjusted to 5.1 percent unadjusted.

December retail sales released today by the U.S. Commerce Department show that total retail sales (which include non-general merchandise categories such as autos, gasoline stations and restaurants) rose 0.9 percent seasonally adjusted from November and increased 3.6 percent unadjusted year-over-year.

“Unseasonably warmer weather and the slower housing market had a clear impact on consumer spending,” said NRF Chief Economist Rosalind Wells. “NRF expects these subdued gains to continue into the first half of 2007.”

After the Government report, this is a little surprising.

by Calculated Risk on 1/12/2007 09:21:00 AM

The Census Bureau reports:

The U.S. Census Bureau announced today that advance estimates of U.S. retail and food services sales for December, adjusted for seasonal variation and holiday and trading-day differences, but not for price changes, were $369.9 billion, an increase of 0.9 percent from the previous month and up 5.4 percent from December 2005.

After a weak start in Q4, it looks like retail sales finished reasonably strong.

by Calculated Risk on 1/11/2007 12:18:00 PM

In the comments, and occasionally via email, people have expressed surprise at my positive long term outlook. This reaction is probably understandable since most of my posts have a bearish economic tone.

In my view, both history and logic suggest that the economic future will be brighter. Economic growth has been the norm, and in the long term, the markets almost always reward the bullish investor.

It's human nature to be concerned about specific events, but historically the economy has recovered quickly from trauma. Concerned about the bird flu? Look at the 1918 flu pandemic that was followed by the Roaring '20s. Concerned about an economic Depression? The Great Depression was the worst economic event in recent times, and the economy was fine after WWII.

These are serious, but relatively short term events for the general economy.

Logically this makes sense. Economic growth is dependent on innovation and population growth. And innovation will almost certainly continue. In fact, the only real threats to the long term economy are massively destructive events (like a major meteor strike) and impediments to innovation.

It's not worth worrying about very low probability events like super volcanoes or meteor strikes. However higher probability events, like the potential impact from global warming, is probably a concern. But once again, even with global warming, innovation will most likely (hopefully) save the day.

I'll discuss possible impediments to innovation in a future post.

So why are my posts generally bearish? Simple - because I am writing about the short term. And in the short term I'm concerned about the impact of the housing bust on the general economy. And a short term aberration (a recession) to the long term trend is interesting and worth discussing. Clearly I'm bearish in the short term, and I feel the "odds of a recession" in 2007 "are at least a coin flip".

But we have to guard against always being short term bearish and long term bullish. That doesn't work from an investment perspective, since we will always be cautious in each successive short term - and the sum of many short terms is the long term. Intelligent people can always make a strong short term bearish argument, so a pattern of always being short term bearish is a serious risk - just something to consider.

Luckily, as I've been noting for some time, we will probably know by mid-2007 if the housing bust is going to significantly impact the general economy. I believe it will, so the next few months should be interesting.

Best to all.

by Calculated Risk on 1/11/2007 11:24:00 AM

Fed Governor Susan Schmidt Bies spoke today on Enterprise Risk Management and Mortgage Lending. On mortgage lending risks:

Effectively managing the risk associated with mortgage lending involves much more than prudent underwriting. Experienced risk managers understand the need to carefully consider the risks should the housing market slow, interest rates change, or unemployment rise. These include the risks that borrowers will not have sufficient income in the future to manage substantial payment increases and that continued home price appreciation may not provide a sufficient equity cushion to minimize losses in foreclosure. In addition, an accumulation of portfolio concentrations could leave an institution exposed in a downturn. Lenders specializing in subprime loans, for example, have endured a string of bad news recently, including increasing loan delinquency and foreclosure rates and the shutdown of some lenders that could not operate profitably in a slower origination environment.

Then Bies reviewed the nontraditional mortgage guidance (see speech), and commented on subprime mortgage lending:

The agencies' guidance on nontraditional mortgage products did not specifically address mortgage lending to subprime borrowers--although, as noted, nontraditional mortgage products are sometimes offered to subprime borrowers. ...

While overall mortgage delinquency rates remain low by historical standards, they have been increasing in recent months, especially in the subprime sector. Performance deterioration is most notable in the more recent vintages. Many industry observers believe the poor performance of more recently originated subprime loans is due primarily to looser underwriting standards, including limited or no verification of borrower income and high loan-to-value transactions. ...

Subprime mortgages typically carry higher interest rates than prime loans. It is not uncommon to find margins of 600 basis points or more on adjustable rate subprime loans after the expiration of a teaser rate. Not surprisingly, some borrowers are unable to keep up with their mortgage payments once these payments fully adjust. In some cases, if alternative financing cannot be found, borrowers may be forced to sell their home or enter foreclosure. And given prepayment penalties, home price appreciation slowing significantly and capital market investors becoming more conservative, some borrowers may be having more difficultly in refinancing to avoid foreclosure.

And from the Financial Times: High-risk loans revealing shaky foundations

In the closing days of last year, something came un-stuck in a small but important corner of the US mortgage market, causing pain for investors and resulting in several mortgage lenders shutting their doors.
...
In the last few weeks of 2006, the poor credit quality of the 2006 vintage subprime mortgage origination came home to roost.

Delinquencies and foreclosures among high-risk borrowers increased at a dramatic rate, weakening the performance of the mortgage pools.

In one security backed by subprime mortgages issued last March, foreclosure rates were already 6.09 per cent by December, while 5.52 per cent of borrowers were late on their payments by more than 30 days.

Lenders also began shutting their doors, sending shock waves through the high-risk mortgage markets.