by Calculated Risk on 7/23/2007 11:33:00 AM

"Our recent conversations with builders around the country find that housing demand has continued to wilt in the summer heat, with conditions sequentially worsening in the past four to six weeks,"
Deutsche Bank analysts Nishu Sood, Lou Taylor and Rob Hansen in a research note.

From MarketWatch: Deutsche Bank analysts say spring weakness carrying over into summer

by Tanta on 7/23/2007 08:46:00 AM

Captain Obvious! Please report to the Marketing Department!

Now, I have no idea what marketing people do when Captain Obvious is temporarily off the premises, but I have always believed that it involved "networking" and "teambuilding" with occasional bouts of "work" such as calling a very busy person in Secondary Marketing at market open on quarter-end during a blizzard resulting in severe short-handedness to ask whether a pricing special from two months ago was for all the "Super Expanded" loans or just the "DeLuxe ARM Super Expanded" loans. But I may be jaded by my own sad personal baggage.

It appears that at Countrywide they do really empirical scientific methodologically-rigorous stuff like asking complete strangers whether they would prefer to choose from a list of options or just get handed the same thing everyone else gets. Sit down, folks: this being early 21st century America, not the Politburo under Stalin, a majority of respondents picked "choice"! I am like so totally stunned and surprised. Who'd of thunk?

CALABASAS, Calif., July 23, 2007 /PRNewswire via COMTEX/ -- Countrywide Home Loans today unveiled a broad national initiative designed to educate mortgage consumers about the fact that they have many options available to them regarding how certain costs are paid when refinancing or obtaining a home loan, no matter which mortgage lender they choose. Countrywide is arming its more than 9,000 loan officers and mortgage sales force with new and improved tools, such as specialized mortgage cost calculators, that will allow them to thoroughly and transparently show customers cost-effective choices for structuring their home loan packages.

To understand how strongly consumers feel about the issue of choice versus a one-size-fits-all mortgage, Countrywide commissioned a national survey of more than 2,280 homeowners. The results show that the majority of respondents (76%) strongly agreed that they wanted to be informed by mortgage lenders about as many closing cost choices as possible in order to arrive at a decision best suited to their individual circumstances.

"Specialized mortgage cost calculators." What will they think of next? Fax machines?

I don't know exactly how many hours (days, weeks, months) my own personal butt has spent parked in a conference room listening to some front-end mortgage software vendor go through the dog and pony show on the "specialized mortgage cost calculators" that are included in the package and that allow the loan originator to run something between six and eleventy-jillion "scenarios" for a customer since the mid-90s, but it's a lot. I will say that back in '97 probably only the bigger shops had this cool technology, but then only the bigger shops in those days had fax machines that didn't use thermal paper rolls. If there is one mortgage originator out there today doing more than $25,000 a month in volume that does not use a multi-scenario pre-qual module, I want to know who it is.

You see, this isn't just a rant about stupid marketing strategies. This is about whether we did or did not just spend the last six years or so inventing endless new products, new fee schedules, and new underwriting "guidelines" such that every consumer had a giant Chinese menu to choose from. Word on the street is that a large percentage of these folks chose the one with the smallest monthly payment and the smallest cash-outlay at closing, since they really didn't have any other choice. Word in the back room, which is trickling out into the street, is that a very large portion of those folks are doomed.

But by all means, let's keep encouraging people to think that "I'm only going to be in the house for two years" is something other than the wallpaper on the corridor to Hell. The diaper aisles are full of people who were only going to have two children. The universities are full of 24-year-olds who were only going to take 4 years to get a degree. The county jails are full of penitents who were only going to have one more drink. The bankruptcy courts are getting a tad crowded with REITs who were only going to buy back less than 1% of their mortgage loans. You think there are some folks who bought in mid-2005 with no-down low monthly payments whose plans are under adjustment right about now?

When Countrywide has to drag out a marketing campaign that was stale before the invention of the internet and is putrefying since then, you know we're getting a little desperate to keep clinging to the illusions. What a bunch of tools.

by Calculated Risk on 7/22/2007 10:01:00 PM

Click on graph for larger image.
Last week, Chairman Bernanke presented this chart to Congress. At the time, Greg Ip at the WSJ noted:

Despite fears in the markets and press that subprime problems would trigger broader contagion, the Federal Reserve has repeatedly predicted that what started in subprime would stay in subprime. ...

A key reason for that confidence is this chart ... showing that the sharp rise in delinquencies has been confined to one class of loan: subprime variable-rate mortgages.

Here is the referenced report: Monetary Policy Report to the Congress My reaction was that Bernanke's chart was flawed, and that we already know that "what started in subprime" has not stayed in "subprime".

This chart is from the WSJ today: States Aim to Stem Tide Of Home Foreclosures With Funds for Refinancing

The two charts present different pictures of homeowner distress. Bernanke's chart shows loans that are 90 days delinquent (as of April and May); the WSJ's chart shows loans already in foreclosure. The WSJ chart clearly shows what we already know: the mortgage problems have spread to Alt-A.

Note: I'd just ignore these state programs. They are very small, and appear to be designed to show politicians are "doing something". The fact that the programs bailout lenders, more than borrowers, is probably lost on most constituents.

by Tanta on 7/22/2007 11:10:00 AM

Honestly, I don't know if this is an UberNerd post or an UnterNerd post. I am not an expert in CDOs or financial "gearing," and I'm happy to be educated by people who know more than I do about high finance. I'm writing this just because our discussions of The Big News Story of the last few weeks are mystifying a lot of folks who are not familiar with the leverage issue. The following is both lengthy and, inevitably, over-simplified in spots, which is such a weird combination. (You'd think for that many words you could get Definitive Answers to Really Complex Questions.) I can only observe that this is why what you read in the papers is, nearly exclusively, so worthless or misleading on this subject. It takes three or four times the length of your average feature article just to clear up the basics, let alone get to the hot new developments in the story.

Given that, if you're still puzzled about how, exactly, all this leverage and marking to market and downgrading of securities can come together to wipe out entire large hedge funds, here's an attempt to explain the basic mechanisms. Those of you who are well beyond basic mechanisms should go play outside today.

Let us imagine a hedge fund operating on a maximum 20% margin, or 4x leverage. That means that for every $100 invested, $20 is equity (investor funds) and $80 is borrowed (from the "prime broker"). The exact mechanism of that borrowing can be more or less complicated (like the dreaded "collateralized repo facility"), but underneath it all it's a margin loan.

That $100 investment is subject to periodic marking to market. What that means, in simple terms, is that the fund must establish what the current observable market price is for the assets in question, and "mark" its holdings accordingly. With frequently-traded things like shares of (and options on) stock and vanilla bonds (Treasuries, GSE MBS), one simply checks the Big Board (or the Bloomberg terminal), finds the closing price for the period in question, and there's your mark. With things that are not frequently traded, like a lot of low-rated tranches of certain complex private-issue ABS (Where the Wild Subprimes Are), it can be a challenge to find an observable market price.

That's what causes this "mark-to-model" phenomenon: the marked price is a construct, a kind of theoretical rather than observed price, based on some assumptions, some adjustments for differences in quality or yield between recently-traded issues and the ones you happen to hold, and so on. Mainstream reporters, for reasons best known to themselves, seem to think such a process is either unheard-of or necessarily Enronified accounting. In reality, just about everyone over the age of 12 has heard of a residential appraisal for a refinance transaction, which is a classic example of "mark to model." The appraised value of your home is not derived from going to the MLS and finding an observed price of your house. The appraiser collects several "comps" and then adjusts them for different quality of the house, age of the last sale, the current cost of financing, and so on. Problems crop up when models are opaque, when assumptions are faulty, and when data is corrupt, in appraisals and elsewhere. But these innocents who just discovered model-based pricing or infrequently-traded assets as if they were A Recent Invention of the Devil are unclear on the concept in a bad way.

However one arrives at a mark, it is meant to be the price the fund would take if it had to liquidate the asset or unwind a position today. It is not a net present value calculation of an asset that is intended to be held to maturity. It is a snapshot in time, and I need hardly mention that it can result in gains as well as losses. It's simply that mark-to-market gains don't tend to cause problems with leverage. We all used to love our appraisals when they were generating the "wealth effect."

What happens if our example investment gets a 5% mark-to-market loss? We now have a $95 investment of which $15 is equity and $80 is borrowed, or leverage of 5.3x. This results in a "margin call" from the lender, who demands that the 20%/4x relationship be reestablished. (Here's where margin lending is very different from mortgage lending, because mortgages are not callable. You live by the original loan terms, you die by the original loan terms. That's why we used to be accused of being so conservative.)

Therefore, the fund sells $20 in assets and pays the lender with the proceeds. That results in a $75 investment ($95 minus $20), $15 of which is equity and $60 of which is borrowed, bringing the leverage back to 4x. What is important here is that the original mark-to-market loss on the investment does not, in and of itself, trigger the sale of fund assets. An unleveraged fund can still hold the assets to maturity, if it chooses and its prospectus allows, waiting patiently and hopefully for the day that market prices recover, the assets can be marked to a gain, and the sea gives up its dead. A mark-to-market loss requires liquidation of assets when there is a lender involved who demands that leverage stay at an agreed-upon limit. You see here how leverage magnifies losses on the downside: a 5% drop in value of the investment results in a 20% 25% drop in the equity value of the fund.

That's how it works in the textbook case. However, a couple of things tend to complicate these "forced unwinds." One is that selling off assets to meet margin calls in an environment when the price is already dropping (that's why we got the mark-to-market adjustment in the first place) creates even more downward pressure on asset prices, forcing another mark, another call, another sale, etc.

Another is that lenders who get spooked enough can raise the margin requirement. Imagine the scenario above--the $95 mark of the investment--with the lender raising the margin limit to 25% or 3x leverage. The fund would have to sell $35 in assets instead of $20, to achieve 3x leverage ($60 investment, $15 equity, $45 loan). Having to sell that much more of the fund's investment creates even more downward price pressure, triggering yet another unwind. We call this a "credit crunch."

Furthermore, investor redemptions can have the same effect, which is why we've seen some funds "halting" redemptions (not allowing investors to liquidate their holdings in the funds) lately. This is what is known as the "rush to the exits" problem: more people can get crushed in the stampede than get burnt by the original fire. By halting redemptions, fund managers are attempting to keep people in their seats while the fire is extinguished. Campers become unhappy.

Finally, a major problem in talking about leverage ratios with hedge funds is that this basic example is just the "financial leverage." Because hedge funds invest in instruments that are themselves leveraged, such as credit default swaps, synthetic or debt-funded CDOs, leveraged loans, and so on, their actual or "effective" leverage can be much, much larger than 4x. When you hear people talk about some high-roller funds being levered at 10x or 20x, they're talking about "effective leverage," not just simple financial leverage.

You should bear in mind that hedge funds being hedge funds--largely unregulated and opaque to the rest of us--public discussions of a fund's leverage are estimates and assumptions, informed or not. Nobody exactly knows except the fund managers themselves, and we have our doubts at times about them. (I for one am ready to be confident that fund managers can fairly accurately calculate their financial leverage; whether the calculations of effective leverage are anything to which the term "accurate" could be applied is less certain. That gets us back to our "mark to model" problem.)

For our purposes, it's important to keep in mind that leverage is the key to understanding how things that look like modest declines turn into major losses. Start with a handful of homeowners who bought a house with 100% financing. A drop in home values of just a few percent puts these borrowers underwater and removes a lot of the incentive to keep making mortgage payments. The lender forecloses and takes, at this point, a fairly modest loss to the asset-backed securities that own these loans. But the credit enhancement of the ABS is fairly thin, and so the lowest-rated tranches of the securities get downgraded. The lower rating means a lower bid price on resale of the securities. That forces a mark-to-market (or "mark-to-model") loss to the holder of them. A CDO of ABS may well issue AAA-rated tranches, but that means that the AAA-piece of the CDO is no more than a senior lien on the payments generated by a large portfolio of BBB-to-B rated tranches of underlying ABS. (You could call that "ratings leverage.")

Perhaps we need to look at a picture again. Here's a chart from Pershing Capital Management:

A CDO of ABS can own 100 BB, BBB, and BBB- tranches from any number of ABS deals. The top tranche of the CDO gets its AAA rating not because any of the ABS it owns are necessarily AAA-rated, but because it does what structured finance instruments do: it carves up the cash-flow and payment priority of the underlying assets, and so provides "credit enhancement" to the top tranches.

Think of it this way: the originator of the mortgage loans we started with "levers" its investment by selling bonds worth 96% of the face value of the loans (leaving it 4% equity, as in the chart above). The CDO buys up tranches of this (and other) securities, and then "levers" its investment by selling bonds worth 95% of the face value of the ABS tranches it owns. By the time you get to the equity portion of the CDO, you have very high yield (the highest-yielding tranche of a CDO composed of high-yielding tranches of ABS), and also enormous risk, since there is no credit enhancement below the equity: it takes all losses first.

But what happens if the BBB- tranches of the ABS start taking major write-downs? The collateral of the CDO can simply disappear at an alarming rate. In the example above, if the original ABS took a 5.5% write-down, that would reduce the face value of the BBB- tranche by half (it would eliminate 100% of the 4% equity, 100% of the 1% BB tranche, and 50% of the 1% BBB- tranche). If a quarter of the bonds in the CDO were BBB- tranches and 10% were BB tranches that all took that kind of loss, then the collateral value of the CDO would drop by 22.5% (25% times 50% plus 10% times 100%). That would take write-downs all the way into the CDO's AAA tranche, which in our example "breaks" at >20%. If the AAA tranche of the CDO is held by a hedge fund using 4x financial leverage, you get a nasty, nasty unwind problem.

I need to stress that CDOs, on the whole, are a lot more complex than this example might make you think. They have short positions as well as long positions, and a lot of credit default swaps and other derivative holdings and bond insurance as well as--one hopes--a fair amount of diversification both within the mortgage category and within the larger category of ABS, which includes other kinds of debt besides mortgages. (Whether that "diversification" is helping any, insofar as some of it involves commercial RE and LBO notes and other perfectly "uncorrelated" risk-free no-brainers, is another question. But we are, at least for purposes of illustration, following the received wisdom that this is all about subprime mortages and nothing else.) It does no one any good to think of "CDOs" as all alike, or as just another kind of CMO or ABS. The fact that the mainstream business press is encouraging you to think that CDOs are just another kind of mortgage-backed security is why we get so pissy with them here at Chez Risk.

I'm not, therefore, trying to suggest that the Bear Stearns hedge funds or anyone else lost their money in this exact way. My point is that it is perfectly plausible that some funds holding CDOs of ABS took huge hits to A-rated tranches even when the underlying ABS collateral has, so far, only taken hits to B-rated tranches. That's the "effective leverage" problem.

We should be aware that downgrades of the lowest-rated underlying collateral tranches can, at least in judicious doses, be a good thing for the holders of the highest-rated tranches. Why? Because downgrades of the lowest tranches will prevent the deals from "stepping down," or redirecting the cash-flow of principal to the lowest-rated tranches. By keeping the principal payments directed to the topmost tiers, those AAA and AA classes prepay while the prepayin' is good.

Another reason that the mainstream press reports mislead everyone about this is that they continue to think of structured securities as "chopping up loans" instead of structuring cash flows from loans. These cash-flow structures mean that the top tranches have 1) first dibs on money coming in from the underlying loans and therefore 2) much shorter durations than the supporting tranches. They're set up with certain "triggers" such that, if and when it starts to look like there won't be enough money for everybody--that's basically what a downgrade means--the flow of cash goes primarily or even exclusively to the top tranches until they're retired (amortized or paid off completely), and only then do the subordinated tranches get any leftovers. Depending on how a given deal is structured (if they were all the same, remember, we wouldn't have such "mark to model" problems), a ratings downgrade to the lower tranches can seriously boost the cash flow up above.

(To those of you who keep asking in the comments why the rating agencies aren't downgrading the A-rated parts of these deals much: remember that downgrading the subs can, in and of itself, improve the loss probability for the senior notes by accelerating their payoff, and some of them in the older deals have already amortized so much that time is very much on their side. The senior notes are a lot less likely to get crushed in a rush to the exit if they're already half-way out the door.)

Remember all the outrage over loan modifications in these securities? If you're holding one of those subordinate tranches, modifications will prevent (in better case) or delay (in worse case) actual realized losses, which is good for you, at least in the near term. However, if you're holding one of those "super seniors," modifications can extend the duration of your investment by slowing prepayments (a modified loan stays in the security, while a refinanced or foreclosed loan is a liquidation or prepayment) and by helping the deal pass the step-down triggers that allow some cash to be shared with the lower-rated tranches.

My own view of the matter is that a lot of this anger and contempt and disgust and general ill-feeling with the rating agencies coming from certain quarters of the investment community is not really a matter of holders of the toxic tranches complaining that their BBBs are "really" BBB-. (This, you might say, is the part we're not "surprised" about.) It's coming from AAA holders who want to see the subordinate tranches downgraded as fast as possible so that the AAAs pay off as fast as possible: from this angle, the problem is not the downgrades but the timing of them. (This is the "why did you wait until there were actual losses?" part.) Class warfare is an ugly thing, and the rating agencies (and mortgage servicers dealing with modification problems) are in a tough position if they think they can make everyone happy. As they are in a tough position which they happily participated in creating, you can as far as I'm concerned leave your lace hankies in your lingerie drawer. This isn't about sympathy; it's about recognizing complexity.

If you require a moral to your story, I'll suggest this one: we just spent the last several years being told that securitization of mortgage debt was a reliable way of minimizing (in some quarters, downright "eliminating") the risk of making very high-risk mortgage loans, by moving the risk off the books of the lenders and onto the books of sophisticated investors who knew how to hedge it. Evidently some sophisticated investors are now telling their lawyers that nobody actually knew what this stuff was or how it was supposed to be hedged or that those juicy returns were being generated by incredible amounts of leverage. To these folks, it was so credible that investing in subprime mortgage loans could easily throw off 20% annual returns forever that they had every reason to believe that their fund managers knew how to do this without losing any of their principal ever, cross our hearts and hope to shout.

So the great innovation of securitizing mortgage financing in support of a wild housing boom involves a chain that starts with a sucker on one end who overleverages a real estate investment with a pseudo-callable loan (i.e., an ARM that reprices to market) and ends with a sucker on the other end who overleverages a hedge fund investment with an explicitly callable loan. In the middle are a bunch of bright lights who kept it all going long enough to extract a lot of fees and bonuses. On the sidelines are a lot of people who leveraged conservatively but who get the same mark-to-market adjustment everyone else does. To judge from the whining from certain parts of the hedge fund world, those "qualified investors" were just part of the great "unqualified buyer auction" that so sadly played out in the housing market, bidding up the value of these CDOs and ABS until it seemed that no amount of leverage was too much and no position would ever have to unwind badly. Scratch the surface of the complaints over "mark to model" adjustments, and you get to the question of which model everybody used to establish the original price of these securities from which perspective the current mark is looking ugly.

Unless, of course, these "qualified investors" were in fact perfectly qualified buyers in the auction, in which case the appropriate response to the Great Bear Stearns Pile On would be something along the lines of "tough breaks." In any case, this is where acid flashbacks to the bad trip of "investor liability" for predatory loans comes in. Mercy, we have been told, how unfair that is, because investors can't be expected to actually investigate whether Bear is preying on Bubba before investing the big bucks. Yeah, well, that's so last week. This week's theme is how Bear preyed on Buffy, and that's serious, dude.

by Calculated Risk on 7/21/2007 07:38:00 PM

From the North County Times: Report: Job growth stalls in San Diego County

Job growth has nearly ground to a halt in San Diego County, raising the risk of a recession later this year, two economists who track the local business climate said Friday.

The latest monthly employment report shows that woes in real estate and construction have spilled over into the local economy, said the economists, Kelly Cunningham of the San Diego Institute for Policy Research and Alan Gin of the University of San Diego.
...
Gin, who compiles a monthly index of leading economic indicators, said last month that his numbers indicated a recession was possible. His index has been fallen in 13 of the last 14 months, signaling a steady deterioration in San Diego's economy.

The chance of a recession is "getting higher," Gin said. "I wouldn't say over 50 percent, but it's not infinitesimal.

"The culprit is real estate," Gin said....

Cunningham said that nonresidential real estate construction has also begun to slacken.

"The commercial side of it is starting to see slowing down," Cunningham said. "So both of those things together seem to reflect a slowing economy and perhaps pulling us into recession."

A couple of key points: the problems in housing have "spilled over into the local economy" and nonresidential real estate construction has "begun to slacken".

San Diego is probably still a good leading indicator for housing and any spillover effects. As David Streitfeld noted in the LA Times almost exactly one year ago:

San Diego had the wildest run-up among major California cities, with prices tripling since the mid-1990s. ... The market also began to fade first in San Diego. ...

Whatever happens here, optimists and pessimists agree, will happen later in the rest of the state.

Of course there are problems in all of California, from the LA Times: State's job growth hits the brakes and in Florida too, from Bloomberg: Miami Condo Glut Pushes Florida's Economy to Brink of Recession

by Tanta on 7/21/2007 10:34:00 AM

As you all know, earnings season is upon us, wherein we shareholders of financial and real estate sectors will be treated to some cheerful news. I say we celebrate with one of the great rock classics.

by Tanta on 7/20/2007 09:19:00 PM

Fitch has affirmed ($2.383 billion) and downgraded/placed on watch negative ($32.2 million) a handful of classes of seven SASCO/Lehman RMBS. The two biggest problems are:

Structured Asset Securities Corp., Lehman Mortgage Trust (LMT), Series 2006-3
--Class A affirmed at 'AAA';
--Class M affirmed at 'AA+';
--Class B1 affirmed at 'AA';
--Class B2 affirmed at 'A';
--Class B3 downgraded to 'BB+' from 'BBB';
--Class B4 downgraded to 'BB' from 'BBB-';
--Class B5 downgraded to 'B' from 'BB';
--Class B6 downgraded to 'CCC/DR2' Distressed Recovery (DR) from 'B'.

For LMT 2006-3, the loans in 90+ delinquency at twelve months seasoning as a percentage of the current pool balance is 3.13%. The CE of the B3, B4, B5 and B6 classes are 1.39%, 1.21%, 0.80% and 0.39% respectively.

Structured Asset Securities Corp., Lehman Mortgage Trust (LMT), Series 2006-7
--Class A affirmed at 'AAA';
--Class M affirmed at 'AA+';
--Class B1 affirmed at 'AA';
--Class B2 affirmed at 'A';
--Class B3 affirmed at 'A-';
--Class B4 affirmed at 'BBB';
--Class B5 rated 'BBB-' placed on Rating Watch Negative;
--Class B6 downgraded to 'BB-' from 'BB';
--Class B7 downgraded to 'CCC/DR1' from 'B'

For LMT 2006-7, the loans in 90+ delinquency at eight months seasoning as a percentage of the current pool balance is 1.70%. The CE of the B5, B6 and B7 classes are 1.19%, 0.81% and 0.38% respectively.

LMT 2006-7 is Alt-A with some scratch & dent mixed in. LMT 2006-3 is Alt-A originated exclusively by Countrywide.

Then there was this:

Fitch Ratings-New York-20 July 2007: Fitch Ratings has taken various rating actions on the following Luminent Mortgage Loan Trust issue:
Series 2006-3:
--Class A affirmed at 'AAA';
--Class II-B-1 affirmed at 'AA';
--Class II-B-2 affirmed at 'A';
--Class II-B-3 affirmed at 'BBB';
--Class II-B-4 downgraded to 'B+' from 'BB';
--Class II-B-5 downgraded to 'CCC' from 'B' and assigned a Distressed Recovery (DR) rating of 'DR2'.

The collateral for subgroup II consists of 1,135 adjustable rate mortgage loans totaling $313,511,042, as of the cut-off date (April 1, 2006). The mortgage pool demonstrated an approximate weighted-average loan-to-value ratio (OLTV) of 76.51%. The weighted average FICO credit score was approximately 712. . . .

The downgraded classes reflect the deterioration in the relationship of CE to future loss expectations and affect approximately $3 million of outstanding certificates. Although the trust has experienced little loss thus far (0.01%), approximately 5.56% (as a percentage of the current pool balance) of loans are 60+ days delinquent at this time. This includes bankruptcy, foreclosures and real estate owned (REO) of 0.15%, 2.62% and 0.71%, respectively. The CE for the II-B-3, II-B-4 and II-B-5 classes is 1.9%, 1.14% and 0.5%, respectively.

The LUM deal is half neg am; 90% of the other half is IO.

Let me point out that so far we're talking about a few classes of a few securities at a modest total dollar amount on these Alt-A downgrades.

That tends to be how things start.

I'm just trying to make sure that if the day comes when the Alt-A downgrades come in a torrent, we are stunned but not surprised.

by Calculated Risk on 7/20/2007 04:20:00 PM

This is a preliminary update to my 2007 housing forecast (see bottom of post for graphs on inventory).

Let's review the basics of supply and demand.

This diagram shows a normal Supply and Demand relationship. When the supply curve shifts (dark blue to light blue) then the price falls from P0 to P1.

And when the demand curve shifts, perhaps due to the changes in lending standards (from dark red to light red), the price falls again, this time from P1 to P2.

So, given a normal market, with the given shifts in supply and demand, we would expect prices to fall, keeping the quantity demanded in balance with the quantity supplied.

The above diagram works well for commodities, like corn, and these facts - shifts in supply and demand - would lead to falling prices, bringing the quantity demanded and the quantity supplied back into equilibrium. But, for housing, prices are sticky because sellers tend to want a price close to recent sales in their neighborhood, and buyers, sensing prices are declining, will wait for even lower prices.

With perfect information, sellers would reduce their prices to P2, and the markets would clear. However, with imperfect information and sticky prices, we usually see a precipitous decline in the quantity demanded instead.

Look at the diagram and imagine that the price stays at P0. What happens? The quantity demanded is where the light red line and P0 cross. Meanwhile the quantity supplied is determined by where the light blue line would cross P0 (imagine the P0 line extends to the light blue line). This implies transaction volumes would decline and inventory levels would rise - exactly what is happening right now.

The Supply and Demand Curves shifts

This post would get very long if I tried to explain why and when the demand and supply curves shifted. Obviously the demand curve has shifted to the left recently due to the tightening of lending standards. But the first shift in the demand curve actually occurred towards the end of 2005 - because so many buyers were "speculating" with leverage and pulling demand forward during the boom. (Not to be confused with speculators buying investment homes).

As a reminder of the buying frenzy back in April, 2005, in an LA Times article "They're In — but Not Home Free", the writer described a woman that was "able to afford, barely, her first home". She had taken out "an adjustable-rate mortgage that won't require her to pay any principal for three years". She was already strapped, working overtime to pay her bills, and didn't know what she would do in early 2008. She was gambling that either her income would increase or that the value of her home would rise enough to sell at a profit. From the article:

Californians are adopting a "buy now, pay later" strategy on a massive scale. The boom in interest-only loans — nearly half the state's home buyers used them last year, up from virtually none in 2001— is the engine behind California's surging home prices.

This type of leveraged activity pulled demand from future periods (i.e. now) shifting the demand curve to the right during the boom, and has shifted the demand curve to the left during the bust.

The supply curve was shifted to the right during the bust for at least two reasons: 1) investors were buying homes in record numbers to flip during the boom. This can be described as "storage", reducing supply during the boom, and increasing supply during the bust as investors try to unload their properties, and 2) rising foreclosures also increases the supply during the bust.

I'll update the 2007 housing forecast next week, after the June New and Existing home sales reports are released. Meanwhile, here is a look at inventories through May:

Inventories are at record levels and rising.

This graph shows the year end total houses for sale since 1982 (2007 inventory is for May). Existing home inventories are currently at a record 4.431 million units, and new home inventories of 0.536 million units are near the record.

And the situation appears to be getting worse. Based on ZipRealty data, existing home inventories were probably over 4.5 million units in June. And since cancellations for new home builders are increasing - for examples, see here and here - the number of new homes for sale is probably understated (note: see Caroline Baum on how cancellations impact new home inventory levels).

In the second graph, inventory levels are normalized by the number of owner occupied units (OOU). Normalizing by OOU isn't perfect, since it doesn't account for changes in 2nd home ownership, but it does show that inventories are at record levels even compared to the growth in homeownership.

The third graph uses the "months of supply" metric for both new and existing homes. The "months of supply" metric is now above the level of the previous housing slump in the early '90s, but still below the peak levels of the housing bust in the early '80s.

The "months of supply" is calculated by dividing the total inventory by the seasonally adjusted annual rate (SAAR) of sales, and multiplying by 12. Currently inventory is 4.431 million, SAAR sales are 5.99 million giving 8.9 months of supply.

Both the numerator and the denominator are moving in the wrong direction. Not only is inventory at record levels and increasing, but sales are falling ...

Demand is falling.

It is difficult to graph "demand", but we should be aware of the incredible increase in turnover of existing homes during the recent housing boom (due to excessive leverage as described above). This graph shows existing and new home sales normalized by the number of owner occupied units. Existing home sales reached 9.5% of owner occupied units in 2005, far above the median level of 6.0% for the last 35 years.

Some of the sales were for investment and second homes, but normalizing by owner occupied units probably provides a good estimate of normal turnover. If existing home sales fell back to 6% that would be about 4.6 million units. If sales fell back to the level of 1998 to 2001 (7.3% of total owner occupied units sold) that would be about 5.6 million units in 2007.

This graph also shows that new home sales, as a percent of owner occupied units, has already fallen back to the median level of the last 35 years. However existing homes are a competing product for new homes, and the record inventory of existing homes for sale will probably continue to put downward pressure on new home sales.

And finally a word on prices: Sticky doesn't mean stuck. Prices are now falling by most measures, and will probably continue to fall slowly over the next several years. While we wait for prices to fall to P2, it is easy to predict that transaction volumes will decrease, but it is difficult to predict by how much. The housing market moves in slow motion, so I think my sales prediction of between 5.6 and 5.8 million existing homes in 2007 still looks pretty good. Sorry for the long post!

by Calculated Risk on 7/20/2007 12:10:00 PM

On Wednesday, it was JPMorgan expressing concern about "hung" bridge loans. Today it is Citigroup.

From the WSJ: Citi May Be Stuck With Bridge Loans

Citigroup Inc. is bracing for the possibility that it will get stuck holding more leveraged loans for corporate buyouts ... On four deals in the second quarter, Citigroup was unable to sell debt to investors, leaving the world's biggest bank and its peers holding so-called bridge loans on their balance sheets, said CFO Gary Crittenden. ...

In the third quarter, Citigroup is likely to find itself in similar situations with other deals, which likely "will impact our revenue," Mr. Crittenden said in an interview. ...
...
Asked in the interview whether the Chrysler loan could get stuck on banks' balance sheets, Mr. Crittenden said he wouldn't comment on specific transactions. "But it's a question of pricing and terms generally...but we have the capacity along with many other syndicate partners to have that be on the balance sheet if that's the right decision at the time the deal needs to get done," he said.

by Calculated Risk on 7/20/2007 11:22:00 AM

St. Louis Fed President William Poole spoke this morning: Reputation and the Non-Prime Mortgage Market.

... the non-prime mortgage market—with 2006 originations of about one trillion dollars —clearly is large enough to affect aggregate homebuilding activity and consumer spending.
...
Most of the news, and most of the problems, relate to the highest risk part of the non-prime mortgage market—the subprime market. There have also been some problems in the so-called “Alt-A” market, which lies between prime and subprime. What I am calling the non-prime market covers subprime and Alt A.

The discussion has now expanded beyond subprime to include Alt-A.