by Tanta on 3/22/2007 06:04:00 PM

New testimony of Roger T. Cole, Director of the Division of Banking Supervision and Regulation for the Federal Reserve, given to the Senate Banking Committee, is now available on the web here.

Most of it is quite familiar to CR readers and will hold few surprises—we’ve been on top of this story for a long time. I see nothing particularly dramatic in it; if you need to catch up on the whole context of banks, subprime lending, and new regulation, though, it’s worth a read. I found two parts of it worthy of note.

First, the message from the Fed seems to be that lenders are not going to be punished in examinations for trying to work out as much as is prudent with borrowers.

Although a rising number of borrowers are having difficulty meeting their obligations, regulated institutions do not face additional supervisory scrutiny if they pursue reasonable workout arrangements with these borrowers. Existing regulatory guidance does not require institutions to immediately foreclose on the underlying collateral when a borrower exhibits repayment difficulties. Working constructively with borrowers is typically in the long-term best interests of both financial institutions and the borrowers. Capital markets investors in securitizations have the same motivation as direct lenders in maximizing recoveries on defaulted loans. Thus, mortgage servicers will have an important role to play in working with delinquent borrowers. Established and well-rated loan servicers are usually given a range of options by investors in workout situations. These options could include modification of interest rates, payment restructuring, and extension of maturities. Working together, the federal regulatory agencies will continue to use their supervisory authority to ensure that regulated institutions have policies and procedures designed to treat borrowers fairly, both when seeking new credit and when working through financial difficulties.

I see no Fedspeak hint here of any bailout assistance to anyone; if there’s anything remarkable it is that the Fed is suggesting that depositories may not use the fear of regulatory punishment to deny reasonable workouts to borrowers, and that the Fed considers reasonable workouts to be consistent with safety and soundness. I don’t know to what extent this might be the Fed implying that banks made their beds and now have to lie in them; it’s not exactly inconsistent with the idea of potential bailouts. As stated, though, it suggests to me that banks had better give some serious thought to mitigating their losses—by taking the hit on some mods or forbearance agreements, if necessary—before they go expecting the Fed to vote for bailout relief.

The second thing I want to point out is the one place in this document where I think the Fed has really drunk a little of the Kool Aid:

Homebuyers have also benefited in this environment of financial innovation and market liquidity. More lenders are actively competing in the mortgage market, product offerings have expanded greatly, the underwriting process has
become more streamlined, borrowing spreads have decreased, and obtaining a mortgage loan has become easier. In short, securitization has helped to expand homeownership, which recently reached a record 69 percent. Not surprisingly, there have also been significant gains in homeownership for low- and moderate-income individuals. The development of the subprime mortgage market has been an integral factor in creating these homeownership opportunities for previously underserved borrowers.

It is not my purpose today to question the wisdom of uncontrolled increases in homeownership, although that’s an important debate. I am simply irritated in the extreme by the inclusion, without qualification, of “streamlined underwriting processes” and “easier” obtaining of loans under the heading of benefit to homebuyers. First, as we’ve already noted here at CR, all this streamlining and easing has often made potential homebuyers prey of unscrupulous lenders and sellers, as well as having made lenders and sellers prey of unscrupulous homebuyers. But I want us to take this a little further. What I see here is the Fed falling for advertising slogans and confusing it with public policy. Like Queen Victoria, I am not amused.

Come on. How streamlined and easy does the mortgage lending process really have to be? Look, I like innovations in grocery shopping, like scanners, self-scan aisles, express lanes, debit card readers, and so on, because I have to shop for groceries a lot, and it’s drudgery. But how often do you buy a home or refinance your mortgage? Is it really such a terrible burden to you to get your documents out of your desk drawer, drive down to the local bank, and plop yourself down in a chair across the desk from Louise Loan Officer for an hour? Is saving that kind of time and effort ultimately important enough to you that you are willing to accept the risks to all of us, to our economy, of unsafe and unsound lending by federally-insured depositories that is the effect of these “benefits”? I’m not at all sure I am.

The issue of access, specifically, is certainly important. If you live in Podunk, you might not be able to drive to the office of a national lender with a really good interest rate. If you live in certain urban neighborhoods, you might not have easy access to the suburban jewel-box banks on every corner. So having kinds of telephone, internet, or brokered access to credit from depositories, with the “alternative documentation” processes they often require, may be an important part of keeping access fair.

But that’s not at all the same thing as saying that “speed” and “ease” are always true benefits to borrowers.They’re benefits to lenders. The story is that lenders pass on the efficiency savings to borrowers, in the form of lower rates and fees. Forgive me for shooting some Kool Aid out of my nose here, but I think I see these “savings” going mostly to executive bonuses, originator commissions, and investment in overcapacity, which just begs for more loose loan writing to keep the mortgage mills busy. If you agree with me on that, and you want to let your regulators know how you feel, you might want to mention to them that you don’t care to have benefits to lenders confused with benefits to borrowers, or that you’d be willing to have to use up another hour of your time and a gallon or so of your gas if it meant saner lending policy.

At some point we’ll have to let them know that marketing slogans are just marketing slogans. We don’t all secretly crave drive-up McBanks offering Happy Loans, even if the lenders’ marketing departments seem to think we do, or seem to want to convince us that we do. At least, we don't crave this so much we're willing to bet a couple hundred billion taxpayer dollars on it working out OK in the end.

Besides that, how much is Health and Human Services spending on this "war on obesity" business? Do we need to insure the risk of borrowers who are too damned lazy to dig up the W-2s? Somehow I don't think so.

by Calculated Risk on 3/22/2007 09:17:00 AM

"We entered 2007 with a backlog substantially lower than the year-earlier level and consequently delivered fewer homes in the first quarter than in the same period of 2006. ... profit margins ... were constricted due to the persistent imbalance in housing supply and demand that is fueling intense competition and pricing pressure among homebuilders and other participants in the new home and resale markets. We believe these conditions will likely continue for at least the remainder of 2007, reducing our quarterly and full-year revenues and earnings compared to 2006 results."
Jeffrey Mezger, president and chief executive officer. KB Home, March 22, 2007

From KB Home Reports First Quarter 2007 Results

by Calculated Risk on 3/22/2007 09:00:00 AM

From the Department of Labor:

In the week ending March 17, the advance figure for seasonally adjusted initial claims was 316,000, a decrease of 4,000 from the previous week's revised figure of 320,000. The 4-week moving average was 326,000, a decrease of 3,750 from the previous week's revised average of 329,750.

Click on graph for larger image.

This graph shows the four moving average weekly unemployment claims since 1968. Although the four week moving average has recently been trending upwards, the level is still low and not much of a concern.

by Tanta on 3/21/2007 02:59:00 PM

PMI is insurance against mortgage default; it insures the lender, not the borrower. I use the abbreviation “MI” instead of “PMI” because there is a company called PMI that offers insurance with which I do not want to become confused; you may, however, encounter other sources using “PMI” in the generic sense. Fair warning. The “private” part of the term means we are not talking about government-insured loans such as FHA. Such government-sponsored insurance works similarly, but not identically, to private MI.

We often use the term “first loss” position when talking about MI, and I am going to use that term, because that’s how the industry does it. But we should always bear in mind that the true first loss position on any mortgage loan is the borrower’s, whenever there is borrower equity. Here’s how it works.

In exchange for a premium, the mortgage insurer reduces the lender’s exposure to risk. The amount of the premium is determined by the coverage level, loan type, and credit quality of the loan. There are lots of different coverage levels available; most lenders use the ones required by Fannie Mae and Freddie Mac. For instance, the standard coverage level on a 30-year loan with a 95% LTV is 30%. That means that the insurer will cover losses in the event of default up to 30% of the insured loan balance. Another way of putting that is that the lender’s original exposure is reduced to 67% LTV (95% times 70%). Standard coverage for 30-year loans in the 90.01-95% range is 30%; in the 85.01-90% range is 25%; in the 85% and under range is 12%. Less coverage (25%, 12%, and 6%, respectively) is required for loans with a 20-year or less term. Coverage for very high LTV loans (greater than 95%) is not really standard; the GSEs will require a specific coverage level for different loans they might buy in that category. You can generally assume a minimum of 35%. Here is a link to MGIC’s actual rate cards, which show how premiums are priced for different loan types, terms, and features. I expect the terminology will be gobbledygook for a lot of you, but we can get that far into the weeds later if you insist.

Specifically, in the event of default the mortgage insurer pays the lower of 1) the coverage percent (say, 30%) of the unpaid principal balance of the loan plus accrued interest and liquidation expenses or 2) the actual net loss. The MI policy generally gives the insurer the right, but not the obligation, to pay 100% of the unpaid principal balance (and any accrued interest) and take title to the property itself, if it wishes to handle the actual liquidation. It might want to do that if it believes it can recover more than the mortgage servicer can, which might well be the case with a small servicer without expertise in handling REO. What you should bear in mind is that the longer it takes to foreclose and market the REO, the more interest accrues, and the more expenses rack up, resulting in higher net losses and thus higher claims paid by the insurer. The insurer has a vested interest in making sure that the process is both timely and efficient. It controls its exposure by reserving rights to approve and regulate parts of the collections/foreclosure/ REO management processes, by having the option to bid at the foreclosure sale, and by challenging any claims that it considers excessive.

CR UPDATE: Try this link for spreadsheet.

This spreadsheet shows a simple comparison of a lender’s potential losses in the case of a 95% LTV loan with MI, and an 80% LTV loan without MI. The loan term is 30 years in all cases. Three base scenarios are presented: a fully-amortizing loan, an interest-only loan, and a negatively-amortizing loan. For each scenario, it is assumed that the loan defaults 18 months after origination; the columns show the result with no change in the property value, 10% depreciation, and 20% depreciation. The net loss is calculated assuming that it takes 6 months from default for the lender to foreclose, and 6 months from foreclosure for the REO to be sold. Total expenses (foreclosure costs, repair and maintenance of the property, force-placed hazard insurance, RE broker commission, closing costs on the final sale, etc.) are simply assumed to be 15% of the sales price in any scenario. If you’ve been wondering why the coverage level is lower on loans with a shorter term, notice how amortization of the loan balance affects the loss severity. The shorter the loan term, the faster the borrower pays down principal, and so those loans require less MI coverage. You can also see here how interest-only and neg am can get ugly, as well as how the age of a defaulted loan affects severity.

Of course, the actual net loss for any loan is dependent not just on the sales price of the REO, but also on the efficiency of the servicer (how quickly and inexpensively the servicer handles the FC and REO), the property state (which affects the FC time frame, whether FC is judicial or nonjudicial, etc.), the costs of hazard insurance and any property taxes that come due while the lender holds the REO, and so on. You may adjust the spreadsheet with your own assumptions; for many markets and properties, 15% may be a very sunny assumption.

A mortgage insurer is considered in “first loss” position, and so the spreadsheet shows loss to the lender (second-loss position) only after payment of the maximum MI claim amount. The MI’s exposure to loss is limited: it covers only the contractual percent of the loan balance plus accrued interest and expenses. The lender’s potential exposure has no contractual limit: it is solely a matter of how far the property value can depreciate and how expensive it can get to foreclose or liquidate REO. In a real doomsday scenario, the lender’s loss could be 100% net of the MI claim proceeds. You can build your own “doomsday” scenarios on the spreadsheet just by slashing the REO liquidation value to 50% or less of the original sales price, or increasing the default-to-liquidation period of interest accrual, or increasing expenses, or all of it at once. If you wish to play subprime lender, just up the interest rate on the loan (the spreadsheet uses 6.50%).

You will notice, of course, that the 80% LTV loan almost always results in a loss to the lender in foreclosure. Remember, though, that this spreadsheet shows loss severity. It does not address the issue of loss frequency. All other things being equal, the borrower with substantial equity will default less frequently than the borrower with minimal or no equity—the borrower, remember, is in true “first loss” position. The lower default frequency of the 80% LTV loan compensates for its higher loss severity, compared to a high-LTV insured loan. If, of course, the 80% LTV loan is really an 80/15, say, then the default frequency of the 95% MI loan is likely to be comparable to the 95% CLTV loan (which is why sane lenders—both of them—charge a higher interest rate on the first mortgage when the CLTV is that high). In the latter case, the second lien holder is in first loss position. Notice that the spreadsheet shows only one scenario in which there are any proceeds available to a theoretical second lien holder. Obviously, in most cases of foreclosure a second lien is a total charge-off. Therefore, the profitability of second-lien lending is only as good as the underwriting and pricing of the second liens, just as the profitability of insuring first mortgages is only as good as the underwriting and pricing of the premiums. (Note that a second lien holder has accrued interest and expenses, too, at least in the early months of default when it is attempting to collect on the loan. As a rule, second lien holders give up collection efforts and write off loans very quickly, compared to first lien holders, because expenses are rarely recovered.)

Our next installment of Private Mortgage Insurance for UberNerds will discuss the various ways premiums are calculated and remitted, and will explore the differences between primary, bulk, and pool insurance, which bond investors particularly will care about. Go ahead and ask all your questions in the comments anyway; you might as well let me know what you want to know in future installments (a brief explanation of why you care is optional, depending on how much of your inner Nerd you wish to reveal in the intimate setting of the internet). In the meantime, play with the spreadsheet and try not to let the suspense get too much for your blessed little hearts to bear.

by Calculated Risk on 3/21/2007 02:32:00 PM

Comparing the FOMC statement from today with January:

Economy:

Today:

"Recent indicators have been mixed and the adjustment in the housing sector is ongoing."

January:

"Recent indicators have suggested somewhat firmer economic growth, and some tentative signs of stabilization have appeared in the housing market."

Inflation:

Today:

"Recent readings on core inflation have been somewhat elevated."

January:

"Readings on core inflation have improved modestly in recent months ..."

Bias (slight change with different wording):

Today:

"... the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected."

January:

"The Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth ..."

Weaker economy with more inflation.

by Tanta on 3/21/2007 12:52:00 PM

Look who just got the keys to Calculated Risk, The Blog.

And we'll have fun, fun, fun 'til the Daddy takes the Blogger password away . . .

Note: From here on out, you must actually read the name under "posted by" at the end of a post, if simple common sense does not allow you to distinguish between some long sprawling wonkery by Tanta (deputy assistant co-blogger) and a trenchant, crisp observation by CalculatedRisk (founder and CBO) accompanied by the usual beautiful charts.

The comments to this post are open to anyone who thinks he or she can discern the topic (and thus figure out a way to take them off-topic immediately). I believe Those Other Blogs call it an "open thread." This is your big chance to get as snotty as you want to with me, since this is my very first Blogger post and I haven't yet discovered how to edit your comments. In fact, I see that CR hasn't given me that ability. The man is clever.

by Calculated Risk on 3/21/2007 12:49:00 PM

"Housing has always sort of been the canary in the coal mine for the economy — it tends to turn down before the rest of the economy. If you were just looking at this indicator, you would say recession is here, but I think there's enough offsets and optimism to keep the economy out of recession,"
Dirk Van Dijk, director of research at Chicago-based Zacks Equity Research.

This LA Times article lays out the more optimistic view that the housing slump will not take the general economy into recession. A few excerpts from Molly Hennessy-Fiske at the LA Times: Home equity could buoy economy

Analysts say the U.S. economy won't completely crash ... as a result of the sub-prime mortgage meltdown, thanks in part to homeowners ... home equity built up during the boom ... that could support consumer spending and the housing market.

Click on chart for larger image from the LA Times.

Many ... sub-prime borrowers ... are expected to lose their homes, unable to make mortgage payments. But they are not a big enough part of the overall housing market to harm the entire sector, experts say.

So although failing sub-prime mortgages are likely to slow consumer spending and overall economic growth, they aren't expected to provoke a broader credit crunch or tip the economy into recession — barring severe disruptions, many analysts say.
...
One of the biggest concerns is that the sub-prime meltdown will result in a surge of foreclosures that in turn will sink home prices and trigger a housing-led recession.

But sub-prime foreclosures will be only a small percentage of total foreclosures and thus "will not break the national economy or the mortgage lending industry as a whole," said Christopher Cagan, director of research at First America CoreLogic, a Santa Ana-based real estate analysis firm.

I'll look at the First American report later this week.

by Calculated Risk on 3/21/2007 12:24:00 PM

The Mortgage Bankers Association (MBA) reports: Mortgage Applications Decrease in Latest MBA Survey

The Market Composite Index, a measure of mortgage loan application volume, was 672.1, a decrease of 2.7 percent on a seasonally adjusted basis from 690.5 one week earlier. On an unadjusted basis, the Index decreased 2.5 percent compared with the previous week and was up 18 percent compared with the same week one year earlier.

The Refinance Index decreased 4.5 percent to 2208.6 from 2312.2 the previous week and the seasonally adjusted Purchase Index decreased 0.9 percent to 410.6 from 414.3 one week earlier.

Mortgage rates increased slightly:

The average contract interest rate for 30-year fixed-rate mortgages increased to 6.06 percent from 6.03 percent ...

The average contract interest rate for one-year ARMs increased to 5.88 from 5.86 percent ...

Click on graph for larger image.

This graph shows the Purchase Index and the 4 and 12 week moving averages since January 2002. The four week moving average is up 1.8 percent to 407.9 from 400.6 for the Purchase Index.

The refinance share of mortgage activity decreased to 45.3 percent of total applications from 46.2 percent the previous week. The adjustable-rate mortgage (ARM) share of activity decreased to 20.9 from 21.9 percent of total applications from the previous week.

by Calculated Risk on 3/20/2007 06:44:00 PM

Bill Fleckenstein recently received this email:

"Our business is a large hardwood sawmill (sawing oak, maple, cherry, ash, etc., for the furniture (read: HOUSING) industry. We usually enter recession five to six months ahead of the rest of the economy. IT'S HERE! Prices for green and finished lumber are falling at a faster rate than at any time since 1974."
Posted with permission.

Typically lumber and housing move together, so it is not surprising that those in the lumber industry would feel they "enter recession five to six months ahead of the rest of the economy".

Click on graph for larger image.

This graph shows New Home Sales vs. Recessions for the last 35 years. New Home sales were falling prior to every recession, with the exception of the business investment led recession of 2001.

Lumber, along with New Home sales, and starts and completions all tell us basically the same thing; the housing market is in a deep recession - and we should be concerned about the general economy.

by Calculated Risk on 3/20/2007 02:32:00 PM

Tiffany Kary at Bloomberg reports: People's Choice Home Loan Files for Bankruptcy

People's Choice Home Loan Inc., ... filed for bankruptcy protection.

The Chapter 11 filing today in U.S. Bankruptcy Court in Santa Ana, California, comes as delinquency rates on so-called subprime home mortgages hit a four-year high. ...

People's Choice, based in Irvine, California, is the fourth subprime lender to file for bankruptcy since December, joining Ownit Mortgage Solutions LLC, Mortgage Lenders Network USA Inc. and ResMae Mortgage Corp.
...
Filing the same day as People's Choice Home Loan was People's Choice Funding Inc. The companies are subsidiaries of People's Choice Financial Corp., a real estate investment trust.

And apparently LoanCity is finished (hat tip Anthony):

LoanCity is closed for business. Today March 20, 2007 is the last day we will be funding loans.

LoanCity closed seven branches in February, so this must be the remaining five branches.

Mortgage lender LoanCity closed seven branches recently, leaving it with five nationally, BankNet360 has learned.

The San Jose, Calif.-based lender closed offices due to a “softer market and improved technology, which allows for better load balancing among branches,” according to a company spokesman.

LoanCity originated about $5 billion of loans last year, which includes prime, alt-A and jumbo mortgages.

The Mortgage Lender Implode-O-Meter is going to be busy.