by Calculated Risk on 1/31/2007 08:33:00 PM

Note from CR: A friend sent me an excerpt from Fleckenstein's newsletter yesterday and I forwarded it to Tanta. First, from Fleck:

Turning to the subprime industry, once again I heard from my friend who has been staggeringly accurate. He continues to feel that things are about to really get worse. In an email to me, he wrote: "Scratch and dent loans are killing everybody. Bids that were 92 or 93 are now low to mid-80s. It is a bloodbath, and is pressuring even strong companies to buckle. NO ONE is making any money in the market right now. We are at a point of no return for many. The next two weeks will be wild."

I've been in the investment business over 25 years, and again, I have rarely seen someone so accurately call a turn in the market as he has done. Remember, we are just now witnessing a change in lending standards, and these will ripple all through the lending food chain, though thus far only small changes have occurred.

And the following are Tanta's comments:

Thanks for the tidbits--a former colleague of mine used to get Fleck’s newsletter and you could frequently hear some serious snickers from that cubicle—we’d all have to go over and hear what Fleck said this time. Mortgage punks—the Secondary Marketing ones, at least--aren’t, in my experience, mostly permabears, but they’re cynical as the day is long. It comes from constant exposure to the underbelly of the credit monster.

“Scratch and Dent” is a real industry term. The approximate meaning is “loan with incurable defect.” “Curable” is a real industry term and indicates something like a loan that closed with too little MI coverage (a kind of “bad stuff that happens”): you can “cure” that by buying more coverage. If you can’t get the customer to pay for it, though (usually because you didn’t disclose the correct MI on the regulatory docs, and so if you start charging the borrower more MI, you then provide yourself lawsuit or pissy regulator material), the loan has a serious long-term yield problem and qualifies for a “scratch & dent” pool. A loan that once had a 30-day late but then made the last six payments is just “seasoned,” unless the late was EPD (Early Payment Default), in which case the loan, assuming it’s performing again, is S&D. (You can’t “cure” an EPD. It’s the mortgage equivalent of the unforgivable sin.) The stuff the rating agencies call “reperforming” is S&D. 99% of performing loans that are repurchased from an investor are sold by the repurchaser as “S&D.”

The actual industry term for seriously nonperforming loans (in BK, 90 days, nonaccrual, in FC, etc.) is “nuclear waste.”

I suppose you could get someone to take a loan with certain kinds of “misrepresentation” evidenced as S&D or NW—the ones, say, where income has been proven to be “exaggerated” but there is no other evidence of fraud that could mean a payable claim for the property seller or some other party. The ones with incurable title problems? No exit. If nobody can convey title, you can’t foreclose. Your only possible recovery comes from criminal prosecution, if you’re lucky enough not to be an unindicted co-conspirator yourself and therefore have standing in the courts. That will, of course, take longer than a lot of these folks can stay solvent.

Fleck’s informant is saying that scratch & dent is getting nuclear waste bids. This implies that nuclear waste is probably heading for “no bid.” In any case, one is generally made to repurchase a loan at par (you might have to give back any actual premium paid if it’s an EPD, depends on the contract). So passing it off to a junk dealer, in turn, at a bid in the 80s is a painful thing. Hanging on to it, if you’re as thinly capitalized as your average subprime mortgage banker, is out of the question. Hence the “bloodbath.”

If it hits an outfit like Fremont—which is an FDIC-insured thrift and can therefore hang onto this stuff a lot longer than a mortgage banker can—we’ll be out of “thinning the herd” and into “decimation.” One reason it’s so hard to tell at the moment how bad this might get is that it’s hard to tell how many more “pending” repurchases we have out there. The EPD garbage is just the first wave. Every NOD in that big pile you see reported has been most thoroughly examined for other potential rep and warranty “issues” if the investor is any kind of awake, and they seem to be waking up. There used to be this idea that you didn’t push so hard on your correspondents and brokers that you broke their backs—you need a counterparty to keep having a business model. That’s a “normal” downturn idea. The current one seems to be more like “close the gates of mercy, shoot the wounded, and sink the lifeboats.” That does imply—as JPMorgan also implies—that the Big Dogs have more cooties on the balance sheet than they’re prepared to tolerate. Looks like total war to me.

by Calculated Risk on 1/31/2007 04:11:00 PM

This graph shows Residential Investment as a percent of GDP.

Click on graph for larger image.

Residential investment (RI) has now fallen to 5.3% of GDP from the peak of 6.3% in the second half of 2005.

If RI falls back to the median level of the last 35 years (4.5% of GDP), then the RI declines are just over half over. If RI falls to the '80s and '90s bust lows (below 3.5% of GDP), then the RI bust has just started.

by Calculated Risk on 1/31/2007 10:28:00 AM

From MarketWatch: GDP surges at 3.5% rate in fourth quarter

Fed by robust consumer spending, a drop in energy prices and big turnaround in the trade balance, the economy notched its highest growth in a year, offsetting the drag of the weak housing and auto sectors.

The 3.5% growth rate was much stronger than the 2% recorded in the third quarter, and handily beat the 3% expected by economists surveyed by MarketWatch.

Consumer prices fell 0.8% annualized in the quarter, the first quarterly decline in 45 years and the biggest drop in 52 years.

As predicted, PCE inflation was negative in Q4, for the first time in 45 years. And PCE was everything in this report. Residential investment fell 19.2% annualized. Nonresidential investment fell 0.4%, the biggest drop in nearly four years.

UPDATE: On Investment.

Click on graph for larger image.

This graph shows the YoY change in residential investment vs. nonresidential investment. In general, residential investment leads nonresidential investment. There are periods when this observation doesn't hold - like '95 when residential investment fell and the growth of nonresidential investment remained strong.

Another interesting period was 2001 when nonresidential investment fell significantly more than residential investment. Obviously the fall in nonresidential investment was related to the bursting of the stock market bubble. But typically changes in residential investment lead changes in nonresidential investment, and GDP, by three to five quarters. Something to watch.

by Calculated Risk on 1/31/2007 09:59:00 AM

The Mortgage Bankers Association (MBA) reports: Refinance and Purchase Applications Both Increase

Click on graph for larger image.

The Market Composite Index, a measure of mortgage loan application volume, was 631.3, an increase of 3.2 percent on a seasonally adjusted basis from 611.3 one week earlier. On an unadjusted basis, the Index increased 5.9 percent compared with the previous week and was up 0.7 percent compared with the same week one year earlier.

The Refinance Index increased by 4.9 percent to 1940.2 from 1848.8 the previous week and the seasonally adjusted Purchase Index increased by 1.3 percent to 408.0 from 402.7 one week earlier.

Mortgage rates were mixed:

The average contract interest rate for 30-year fixed-rate mortgages increased to 6.29 from 6.22 percent ...

The average contract interest rate for one-year ARMs decreased to 5.86 percent from 5.91 ...

The second graph shows the Purchase Index and the 4 and 12 week moving averages since January 2002. The four week moving average is up 0.1 percent to 430.8 from 430.5 for the Purchase Index.

The refinance share of mortgage activity decreased slightly to 47.4 percent of total applications from 47.8 percent the previous week. The adjustable-rate mortgage (ARM) share of activity increased to 21.4 from 20.3 percent of total applications from the previous week.

by Calculated Risk on 1/31/2007 01:38:00 AM

Jim Clash interviews Sasha (part II)

Part I was here.

by Calculated Risk on 1/30/2007 06:43:00 PM

From MarketWatch: Dimon sees a sign of recession

Rising defaults in some of the riskiest home loans offered by J.P. Morgan Chase & Co. signal a recession may be looming, Jamie Dimon, the bank's chief executive said Tuesday.

Dimon, speaking at Citigroup's annual financial services conference, said high-risk loans - as measured by credit scores and loan-to-value ratios of 90% or more -- make up 2% of the bank's home equity portfolio, Dimon said according to a live webcast.

He also said defaults are rising at J.P. Morgan "a little bit," adding, "home equity is subject to deterioration" from a recession, but that the bank is well positioned to sustain a downturn in the economy. The bank has largely exited the subprime lending area.

Did someone just say "credit crunch"?

by Calculated Risk on 1/30/2007 04:28:00 PM

"We've never had a decline in housing prices on a nationwide basis. What I think is more likely is that house prices will slow, maybe stabilize ... I don't think it's going to drive the economy too far from its full-employment path, though."
Dr. Bernanke, July 29, 2005

From the AP: Thumbs Up for Bernanke on First Year

The economy tested Federal Reserve Chairman Ben Bernanke during his first year on the job. A sinking housing market and a troubled auto industry threatened to short-circuit economic activity. Gyrating energy prices threatened as well.

By most accounts, the Fed chairman passed.

Although I've disagreed with Bernanke at times, I think he deserves credit so far. I included the above quote as a point of disagreement - I expect we will see housing prices decline on a nationwide basis in 2007.

I'd also argue that Bernanke hasn't been tested yet. From Stephen Roach in late 2005:

"Alan Greenspan faced a stock-market crash two months after he took over in August 1987. Paul Volcker had to cope with a rout in the bond market three months after he became chairman in August 1979. G. William Miller was challenged immediately by a dollar crisis in the spring of 1978. For Arthur Burns, it was the inflation bogie in the early 1970s."

So far Bernanke hasn't faced anything like the challenges of his predecessors, but I do feel a little vindicated for supporting his nomination.

by Calculated Risk on 1/29/2007 05:02:00 PM

The Census Bureau reports the Homeowner Vacancy Rate was a record 2.7% in Q4 2006.

Click on graph for larger image.

This graph shows the recent surge in the homeowner vacancy rate. This is further evidence of the significant supply overhang in the housing market.

Fannie Mae economist David Berson has estimated the overhang at 600K units. This data from the Census Bureau suggests the overhang may be closer to my estimate of 1.1 to 1.4 million units.

Update: For a 50 year chart see: Empty homes everywhere

by Calculated Risk on 1/28/2007 06:24:00 PM

From the OC Register: Subprime's grip slips

Many of Orange County's boldest lenders are struggling to stay in the black – and in some cases to stay in business – as their customers miss mortgage payments in record numbers.
...
Sluggish home prices, rising interest rates and lax underwriting spurred defaults on subprime loans made just last year to the highest level in six years. Perhaps most troubling, loans made by Orange County companies in 2006 were among the quickest to see defaults, data show.

And many of those subprime companies – which tend to cluster here in Orange County – are in trouble.
...
UBS Investment Bank ... found subprime loans made in 2006 are on track to be the worst-performing loans ever issued.
...
So what went wrong, exactly?

Lenders made two mistakes, according to UBS and other analysts. They didn't scrutinize borrowers' incomes, and they allowed subprime borrowers, who by definition have had past problems with their credit, to take on lots of risk.
...
Borrowers gambled on rising home prices to bail them out of trouble, analysts said. Consumers thought home prices would keep climbing, which would enable them to sell or refinance if they got into a jam, analysts said.

The article has this great quote:

"[Borrowers] lost the motivation or incentive to send in the checks."
David Liu, director of UBS' mortgage strategy group, Jan 28, 2007

This sounds like a quote from "Office Space":

PETER: I, uh, I don't like my job. I don't think I'm gonna go anymore.

JOANNA: You're just not gonna go?

PETER: Yeah.

JOANNA: Won't you get fired?

PETER: I don't know. But I really don't like it so I'm not gonna go.

JOANNA (LAUGHS) SO YOU'RE GONNA QUIT?

PETER: No, no, not really. I'm just gonna stop going.

JOANNA: When did you decide all that?

PETER: About a week ago.

JOANNA: Really?

PETER: Oh, yeah.

JOANNA: Ok. So, so you're gonna get another job?

PETER: I don't think I 'd like another job.

JOANNA (LAUGHS): SO WHAT ARE YOU GOING TO DO ABOUT MONEY AND BILLS?

PETER: Y'know, I never really liked paying bills. I don't think I'll do that either.

by Calculated Risk on 1/27/2007 12:24:00 PM

This is my first post with the new blogger. I'd like to take this moment to offer some thoughts on my blogging experience:

I started blogging just to share a few thoughts with my friends. To my surprise, more and more people have been reading this blog - and happily I've made several new internet friends. That was unexpected and has been very rewarding for me.

The downside to more readers is I'm not able to answer all the questions in the comments or sent to me in emails. I appreciate all the emails and information I receive, and please accept my apology if I miss your question or I'm slow to respond to your email. I also receive many other inquiries or requests: interviews, link exchanges, offers for sponsorship, etc.

Given all these requests, I'd like to make this clear: this is a personal blog, I've made no effort to market this blog, I haven't accepted advertising or sponsorships, and I'm not looking for any publicity for myself or for this blog. I have no current plans to change my approach.

Perhaps readers have a sense of my personalty from this blog. One of the highlights for me was Don Luskin complaining I was "too polite"! I'm also happy to correct any mistakes I make, and point out when I've been wrong. These traits have served me well in real life.

I believe the one major misperception is that I'm all doom and gloom. Readers have frequently expressed surprise, in the comments, and occasionally via email, at my positive long term outlook. This reaction is probably understandable since most of my posts have a bearish economic tone.

At the time I started writing this blog, I was becoming increasingly concerned about the apparent excessive speculation in the housing market. I was also concerned that the inevitable housing correction might have a negative impact on the U.S. economy. Add in my very negative views of the current U.S. administration, and naturally my posts have had a cautious tone.

I've discovered there is quite an industry of publications catering to people's fears. My negative posts have led to several offers to write for these doom and gloom websites and magazines. That isn't me, and I've declined all these offers. I'm looking forward to being positive in my posts - maybe I'll get offers from Wall Street then!

That is all for now. My best to everyone, and hopefully the new blogger will work well.