by Calculated Risk on 7/24/2007 07:41:00 PM

From the WSJ: Fed Official Sees No Signs Of Subprime Woes Spreading

A Fed policy maker said rising delinquencies on prime mortgages would be one reason to worry that problems in subprime mortgages are affecting the broader economy, but there's no sign of that yet.

"If I started to see some of the spillovers occur in some of the prime mortgages, I'd get more nervous," Federal Reserve Bank of Philadelphia president Charles Plosser said in an interview with The Wall Street Journal Tuesday. Worrisome signals, he said, would be "things like serious, substantial falls in consumer spending, or employment really begin to tail off" or signs that the negative impact on consumer wealth of falling housing prices is "showing up in consumption in one form or another, or employment. And we don't see that much."

I guess Plosser will be "more nervous" tonight when he reads the CFC press release and the summary of their conference call.

by Calculated Risk on 7/24/2007 05:03:00 PM

Later this week I'll post an update on my 2007 housing forecast. I've been waiting for the foreclosure data for Q2, and the existing and new home sales data for June, scheduled to be released tomorrow and Thursday respectively.

On Friday I pulled out the old Supply and Demand drawings to compare the housing market to an efficient market. In this post I'd like to discuss two recent shifts in demand for housing, and how I expect them to unwind.

First, here are the new and existing home sales, since 1969, normalized by the number of owner occupied units (OOU).

Click on graph for larger image.

For the recent housing boom (in sales, not price), I marked three periods on the graph. There may be some disagreement on the dates and the causes of the boom for each period, but a simply explanation is:

Period 1: This was mostly due to fundamentals of real wage growth, employment growth and demographics.

Period 2: This was primarily due to an interest rate shock (lower rates) that moved renters to home ownership.

Period 3: This was primarily due to speculation, especially home buyers using excessive leverage for speculation.

NOTE: The following models of demand shifts assume an efficient market and no shifts in supply.

Period 2: Interest Rate Shock

This diagram depicts how I'd expect an interest rate shock to impact housing demand. After interest rates decrease sharply, there would be a temporary increase in demand - perhaps for a couple of years - as renters migrate to home ownership.

According to the Census Bureau, the number of American households renting decreased by 1.4 million from 2001 to early 2004. These households probably migrated to home ownership because the "rent or buy" decision favored buying due to lower interest rates.

This increase in demand was temporary, and according to the Census Bureau, the migration from renting to buying ended by early 2004.

Looking at a Supply and Demand diagram, the interest rate shock temporarily shifted demand from D0 to D1.

This moved the quantity demanded from Q0 to Q1, and the price from P0 to P1.

When the demand shifts back (above model of temporary demand shift), the quantity demanded falls back to Q0 - but housing suffers from sticky prices, so price only declines slowly to P0.

However, we can look at the graph of actual sales (first graph), and we can see that sales didn't decline in 2004 and 2005; instead sales increased.

Period 3: Excessive Leverage as Speculation

Speculation frequently chases appreciation, and the earlier price increases, based at least somewhat on fundamentals and an interest rate shock, probably spurred many buyers to only considered their monthly costs when buying a home (during period 3). Many of these buyers used excessive leverage, speculating that the price would continue to increase into the future.

This type of leveraged activity pulls demand from future periods as shown in this diagram. The rampant speculation (with innovative mortgage products) pushed demand from D1 to D2, with associated increases in price and the quantity demanded. However, when the speculation ends, demand will eventually fall back to D3; below the level of demand (D1) when the speculation started.

These models are just a guide, and are intended for efficient markets. But this suggests to me that sales, especially of existing homes, will eventually decline to below the levels of 1998 to 2001.

Flippers and Supply Shifts

Some people may be thinking about the impact of investors (or flippers) on the demand curve. Note: This type of speculation was probably only rampant in the coastal regions. Instead of viewing investor activity as a demand shift, it might be better way to view this type of speculation is as storage - or a supply shift; when the investor buys, they remove the asset from the supply. This means that investor speculation shifted the supply curve (not shown) to the left during the period of speculative activity. When the speculator sells, the supply curve shifts to the right, as the stored units come back on the market. So the news is bad for housing: not only is the demand curve shifting left, but the supply curve is shifting right (especially in some coastal regions).

Credit: template for diagram was from Wikipedia.

by Calculated Risk on 7/24/2007 01:15:00 PM

From Bill Gross at PIMCO: Enough is Enough

Over the past few weeks much ... has changed. The mistrust of rating service ratings, the constipation of the new issue market and the liquidity to hedge the obvious in CDX markets has led to current high yield CDX spreads of 400 basis points or more and bank loan spreads of nearly 300. The market in the U.S. seems to be looking towards this week’s large and significant placing/pricing of the Chrysler Finance and Chrysler auto deals to determine what the new level for debt should be. In the U.K., a similarly large deal for BOOTS promises to be the bell cow for European buyers. But the tide appears to be going out for levered equity financiers and in for the passive owl money managers of the debt market. And because it has been a Nova Scotia tide, rising in increments of ten in a matter of hours, it promises to have severe ramifications for those caught in its wake. No longer will double-digit LBO returns be supported by cheap financing and shameless covenants. No longer therefore will stocks be supported so effortlessly by the double-barreled impact of LBOs and company buybacks. The U.S. economy in turn will not benefit from this tidal shift and increasing cost of financing. The Fed tightens credit by raising short-term rates but rarely, if ever, have they raised yields by 150 basis points in a month and a half’s time as has occurred in the high yield market. Those that assert that this is merely an isolated subprime crisis should observe very closely the price and terms that lenders are willing to accept with Chrysler finance this week. That more than anything else may wake them, shake them, and tell them that their world has suddenly changed.
emphasis added

The Chrysler deal will be interesting, and Chrysler finance is probably the best part of the deal (and most easily financed). Back in '89, the failure of the UAL LBO marked the peak of the LBO cycle, however that deal was very different from today since UAL was contingent on obtaining debt financing (if I remember correctly). Now very few deals have contingencies, and we are seeing more and more bridge loans become "pier loans" that end up on the investment banks' balance sheets. See Citi May Be Stuck With Bridge Loans and JPMorgan Marks Down "Hung" Bridge Loan. This probably means the consequences of a failed major deal could be much uglier than in '89.

by Calculated Risk on 7/24/2007 11:34:00 AM

From Mathew Padilla at the O.C. Register reporting on DataQuick numbers:

There were 17,408 foreclosures in the Golden State in the second quarter — that’s the highest quarterly total since DataQuick began tracking them in 1988. It surpassed the previous high point of 15,418 foreclosures in the third quarter of 1996.
...
Notices of default, the first stage of foreclosure, totaled 53,943 in the second quarter, the highest since late 1996.

DataQuick reported 46,670 Notice of Defaults (NODs) in Q1.

Click on graph for larger image.

This graph shows the NODs filed in California since 1988. For 2007, the number is estimated at twice the NODs for the first half of 2007. This estimate is probably low, since the housing market appears to be deteriorating rapidly in California.

UPDATE: Here is the DataQuick press release: California Foreclosure Activity Continues to Rise

by Tanta on 7/24/2007 08:28:00 AM

This ought to calm the markets:

Management anticipates that the second half of 2007 will be increasingly challenging for the industry and Countrywide. Absent a reduction in mortgage interest rates, production volumes are expected to fall and competitive pricing pressures are expected to increase. In addition, volatility in the secondary markets has increased significantly early in the third quarter and liquidity for mortgage securities has been reduced as a result. These conditions are expected to adversely impact secondary market execution and further pressure gain on sale margins. Furthermore, additional deterioration in the housing market may further impact credit costs.

Management has taken, and is continuing to take, a number of actions in response to changing market conditions. These include tightening of credit guidelines, particularly related to subprime and prime home equity loans; further curtailment of subprime product offerings, including the recent elimination of certain adjustable-rate products; risk-based pricing adjustments; use of mortgage insurance for credit enhancement; and expense reduction initiatives. . . .

Credit-related costs in the second quarter included:

-- Impairment on credit-sensitive retained interests. Impairment charges of $417 million were taken during the quarter on the Company's investments in credit-sensitive retained interests. This included $388 million, or approximately $0.40 in earnings per diluted share based on a normalized tax rate, of impairment on residual securities collateralized by prime home equity loans. The impairment charges on these residuals were attributable to accelerated increases in delinquency levels and increases in the estimates of future defaults and loss severities on the underlying loans.

-- Held-for-investment (HFI) portfolio. The provision for losses on HFI loans incurred in the second quarter was $293 million, driven primarily by a loan loss provision of $181 million on prime home equity HFI loans in the Banking segment.

Guidance hereby reduced to $2.70 to $3.30/diluted EPS from April's $3.50 to $4.30.

I could be snarky about this, but since it's the first thing I've read today that didn't blame the rating agencies for all the problems, I'm giving extra credit.

by Tanta on 7/24/2007 08:11:00 AM

Continuing today's utter childishness:

Headline: "Basis Hires Blackstone to Limit Losses on Hedge Funds"

Funny Money Quote:

``The fallout from subprime is likely to impact most asset classes and investment strategies over the next couple of years because the ratings agencies completely goofed up,'' said Peter Douglas, the principal and founder of Singapore-based hedge fund research firm GFIA Pte. ``Basis Capital is viewed as a bellwether.''

Maybe Blackstone will help out by explaining what "basis risk" is.

by Tanta on 7/24/2007 07:35:00 AM

CR has been drawing our attention to what happens when "bridge loans" become "pier loans." There's another kind of what is supposed to be temporary financing on the Street known as "warehouse" lending. Mortgage bankers use warehouse lines of credit to fund loans as they are originated, carrying them in the warehouse until they can be sold to a whole-loan investor or securitized. What happens if the bottom falls out of the whole-loan or security market and nothing moves out of the warehouse? Long walk. Short pier.

CDO issuers also use warehouse funding to buy tranches of ABS and other securities to create the CDOs with. There are many different kinds of warehousing agreements, but I will note that one kind is known as a "gestational" facility. A better term might be "day care" facility, since the idea, like the bridge loan, is that somebody's going to show up at 5:30 and take the grubby little ankle-biters off your hands.

That's all in aid of extracting the utmost enjoyment out of the following, from Bloomberg, which I must say carries a headline we could only have dreamed of last year, "KKR, Homeowners Face Funding Drain as CDO Machine Shuts Down":

July 24 (Bloomberg) -- The Wall Street money-machine known as collateralized debt obligations is grinding to a halt, imperiling $8.6 billion in annual underwriting fees and reducing credit for everyone from buyout king Henry Kravis to homeowners.

Sales of the securities -- used to pool bonds, loans and their derivatives into new debt -- dwindled to $3.7 billion in the U.S. this month from $42 billion in June, analysts at New York-based JPMorgan Chase & Co. said yesterday. The market is ``virtually shut,'' the bank said in a July 13 report. . . .

``We're walking on thin ice,'' said Alexander Baskov, a fund manager who helps oversee $25 billion of high-yield debt for Pictet Asset Management SA in Geneva. ``People are trying to find value and the right price and right now nobody knows what it is. Pretty much everyone is in the dark.'' [Insert Patsy Cline chorus here] . . .

The shakeout is leading firms from Maxim Capital Management in New York to Paris-based Axa Investment Managers to delay or scrap planned CDO sales.

Maxim began buying mortgage bonds for a new CDO after completing its second deal in March. Chief Investment Officer Doug Jones in New York said he slowed the purchases, having acquired only a third of the assets planned, partly because the bank underwriting the deal grew concerned it could lose money as volatility increased. He declined to name the underwriter.

``We don't want to get too far along and create something that's not sellable,'' said Jones, who manages $4 billion of CDOs.

Banks are becoming more skittish about providing credit lines, called warehouse financing, managers use to buy assets that go into CDOs in the months before the securities are issued, said James Finkel, chief executive officer of Dynamic Credit Partners. The New York-based company manages $7 billion in 10 CDOs and a hedge fund.

``There are just very few, if any, bankers opening new warehouses,'' said Finkel.

"We don't want to get too far along." Uh huh. Today you're a little bit pregnant, tomorrow you're loading up the cart with Pampers.

by Calculated Risk on 7/23/2007 08:18:00 PM

From the WSJ: GM's Allison Hits a Financing Snag

Wall Street firms postponed a sale of $3.1 billion in loans that would pay for the leveraged buyout of General Motor Corp.'s Allison Transmission unit ...

The snag reflects difficult conditions in the market for risky corporate debt and raises questions over the prospects of other buyout-related debt financings that need to be completed this summer ...

GM ... agreed to sell Allison Transmission ... to private equity firms Carlyle Group LP and Onex Corp. for $5.6 billion. ...

Underwriters, including Citigroup, Lehman Brothers and Merrill Lynch, were planning to sell, or syndicate, $3.1 billion of the loans to investors. ...

The buyout is still on track to be completed in the third quarter. If the debt hasn't been distributed by then, the deal will be financed directly by the underwriters ...

Another possible "pier" loan for the underwriters.

Note: A bridge loan is short term financing provided by the underwriters until they can syndicate the debt. If the underwriters can't syndicate the debt, and they have to keep the loan (the short term financing becomes long term financing), it's frequently called a "pier loan"; i.e. a bridge to nowhere.

by Calculated Risk on 7/23/2007 07:19:00 PM

Is it Friday? The downgrades are coming every day now! (hat tip Cal)

From Reuters: Moody's cuts CSFB Home Equity tranches

Moody's Investors Service cut 22 CSFB Home Equity Asset Trust securities on Monday while placing 32 other classes under review for downgrade, citing an increasing rate of delinquent loans.

Also from Reuters: S&P may cut $1.76 bln in ABS CDOs backed by subprime

Standard & Poor's on Monday said it may cut $1.76 billion in collateralized debt obligations backed by asset backed debt, citing exposure to residential mortgages that have undergone downgrades.

And the details from Standard & Poor's: Various Ratings On 8 Cash Flow, Hybrid CDOs Put On Watch Neg; $1.76 Billion In Notes Affected

by Calculated Risk on 7/23/2007 04:32:00 PM

From Reuters: Wells Fargo pulls popular subprime loan from mix.

Wells Fargo & Co. ... on Monday said it stopped offering a popular subprime mortgage product in response to market and regulatory pressure.

The company in an e-mail said it ended on Friday retail offerings of so-called 2/28 loans, which at 65 percent of all subprime mortgages last year are the staple of the industry. ...

Decisions were partly driven by the $583 billion market for subprime mortgage bonds, where sales rely on opinions of rating companies such as Moody's Investors Service, Wells Fargo said. Rating companies in the past two weeks have unleashed a flood of downgrades on subprime bonds in response to rising delinquencies and increased their assumptions of losses that new loans will produce.

"These changes are being made to align our practices with industry guidance, as well as appropriately respond to recent downgrades by key ratings agencies regarding subprime bonds," the San Francisco-based bank said in a statement. ...

Other big lenders including Countrywide Financial Corp., Washington Mutual Inc., Merrill Lynch & Co.'s First Franklin and H&R Block Inc.'s Option One Mortgage have also said they would stop making 2/28s.