Tuesday, August 25, 2009

Some Feedback and Tuesday's Links

Before I get into today’s links, I wanted to share some feedback I have gotten from my article on the potential supply imbalance in the housing market. Two different people (Mark Hanson and Jeff Bernstein) whose opinions I respect thought that I was onto something when I suggested that we have way too many houses that were built for an income range or available financing range that many people have dropped out of. The concern is that these prices will have to fall dramatically so that people who cannot currently afford them based on the lack of available exotic mortgage products or sufficient income will eventually be able to buy them.

Here is the response from Mark Hanson (whose insight inspired the original article):

During 2002-2007 a married couple that worked at McDonalds for 2 years with 5% to zero down could reach into whatever band they wanted up to approx $750k using stated income or a pay option arm as long as they had decent credit scores. This forced the good guy that was putting 20% down and buying a property full doc on a 30 year fixed to be pushed out of his price bands and so on. Right now, in CA for example you have no supply at $300k and below with bidding wars for houses, normal supply from 300k to 500k, and years of supply over that. That is because in reality a very small percentage of the population really make enough money and have enough down to afford it. During the bubble inventory and demand was spread out much more evenly. Most that can already own homes in the mid to upper bands that they can’t sell because of negative equity or for enough for the down payment on the new place. They can’t rent it because rents are tumbling. Builders would suit themselves well building shelter houses 2k sq ft and under for 300k and under in CA for the time being. But there are hundreds of thousands of props in the foreclosure pipelines that when they finally make it out the other side will hit the low to low-mid bands again. Over the next few years what you will get is massive house price compression from the upper to the low ending up where a $1 million house is the home of a real millionaire. Everything else will be in the middle. We have a long way to go.

I argued in my piece that the under $300K housing market that Mark discusses above could see an increase in demand because so many people have dropped into that affordability range. Mark confirmed that in his assertion that there currently are bidding wars for these houses. However, what I hadn’t thought of is that many of the forthcoming foreclosures will be in that price range and the subsequent excess supply will likely prevent these houses from increasing in value despite the existing strong demand. Hard to see a major turnaround in prices with all of these headwinds.

Also, after I sent my response to his post on the BB&T and Colonial deal, Karl Denninger pointed out something I hadn’t thought of. In its presentation on the deal, BB&T included a chart that compared the marks it took on the Colonial book to those that other banks had taken in other FDIC assisted deals. I had argued that the 37% haircut that BB&T placed on Colonial’s assets might not reflect true fair value based on a number of factors. However, what Karl highlighted is that the majority of the prior deals that had significantly smaller marks associated with them occurred before the FASB relaxed the rules on fair value accounting. The implication, from Karl’s point of view, is that the rule change allowed Colonial to mask the true value its assets and when BB&T had to mark them at fair value it required a much bigger discount than it would have if the rules had not been changed. Of course, if true, this potentially allowed Colonial to operate longer than was probably justified and forced the FDIC to make the eventual deal more BB&T friendly.

My only response to that has to do with the fact that the BB&T/Colonial deal included a loss sharing agreement and most of the others listed did not. With the FDIC on the hook for future losses BB&T may have had extra incentive to make the situation look dire and thus force the FDIC to accept a lower threshold in which it would assume 95% of the losses. The only other deal that had anywhere near as large a haircut taken was the US Bancorp/Downey Financial/PFF Bancorp sale, which also happens to include a loss sharing agreement. But this sale occurred in November 2008, well before the FASB changed the rules. So I would argue that there could be something about the loss sharing agreement that motivates the buyer to take more extreme marks and therefore the discount may not be indicative of true fair value.

Now onto the links:

Mark Hanson with his usual great insight: With all the discussion regarding the need to modify mortgages so people can stay in their houses, I automatically assumed that the process was beneficial and that it was the greedy banks and servicers that weren’t allowing it to play out. But, in a recent piece Mark Hanson explains how in actuality mods are not necessarily good for borrowers either as they are turned into zombie owners:

I always say that mortgage mods make homeowners “underwater, over-levered renters for life, unable to sell, re-buy, refi, shop or save”. In part this is because mortgage mods qualify borrowers at the maximum debt-to-income ratio allowed to ensure that they are paying out every disposable red cent they earn each month to debt. It is also in part because once they accept a loan mod they are dead to new creditors because their credit rating is severely impacted. Remember, we are still in a credit crisis — perhaps the new normal – in which only great borrowers can get credit and those that really need it can’t.

The moral of the story? Always try to identify the unintended consequences of ostensibly positive proposals and plans. The way that Mark explains it makes it hard to see how mods help borrowers in the long run. In fact, some may be better of letting the bank foreclosure and moving into cheaper rental properties.


More bad news about mortgage defaults: Hat tip to Karl Denninger for finding this article. If you are at all interested in the housing market and the ultimate impact of the recent wealth destruction on consumers, I suggest you read the following excerpt VERY carefully.

Delinquency cure rates refer to the percentage of delinquent loans returning to a current payment status each month. Cure rates have declined from an average of 45% during 2000-2006 to the currently level of 6.6%.

In addition to prime cure rates dropping to 6.6%, Alt-A cure rates have dropped to 4.3%, from an average of 30.2%, and subprime is down to 5.3% from an average of 19.4%. 'Whereas prime had previously been distinct for its relatively high level of delinquency recoveries, by this measure prime is no longer significantly outperforming other sectors,' said Slump.

In other words, cure rates represent the percentage of loans that go back to being current (meaning the borrower paid off the balance after becoming delinquent) each month. From 2002-2006 a little less than half of all delinquent prime borrowers were able to recover after becoming delinquent. NOW THAT RATE IS DOWN TO 6.6%!!!! Translation: once people become delinquent foreclosure is basically assured without some kind of intervention. For obvious reasons, the numbers are even worse for Alt-A and subprime loans. The combination of the housing bust and high unemployment is a knock-out punch for borrowers. I don’t know what to do about this, but the fact is that while economists are glowingly talking about green shoots real people are getting crushed by the weight of the recession.


All the economists are wrong: Hat tip to Simoleon Sense for finding this post on Naked Capitalism. In it, the author asserts that the major schools of economists are wrong about the state of the US economy: both the supply-siders and the Keynesians. Specifically, he believes that both schools of thought are too idealistic and their models translate very poorly to the real world.

The greatest flaw in the many studies that come from each of the schools to prove their point is the brutal way in which they flatten the reality of the markets and make assumptions to allow their equations and analysis to 'work.' They spend most of their energy showing while the 'other school' is a group of ignorant fools, doomed to ignominious failure, in an atmosphere reminiscent of a university departmental meeting.

I am not an economist so I can’t really speak to the ability of their models to actually predict or reflect human behavior. What I do know is that very few saw this crisis coming in the slightest so it is a bit hard to know whether to trust them not or not. This author says we absolutely should not and states his own thoughts about the US economy:

The condition of the American economy is strikingly similar to the Soviet state economy of the last two decades of the 20th century. People are trying to sustain a system "as is" that is based on bad assumptions, unworkable constructions, conflicting objectives, and a flagging empire laced heavily with elitist fraud and corruption. The primary difference is that the US has a bigger gun and its hand is in more people's pockets with the dollar as the world's reserve currency. But the comparison seems to indicate that the economy must indeed fail first, before genuine change can begin, because the familiar ideology and practices must clearly fail before they can recede sufficiently to make room for new ways and reforms.

A new school of Economics will rise out of the ashes of the failure of the American economy as happened after the Great Depression. Let us hope that it is better than what we have today.

However outlandish, I can’t say that elements of his argument are not compelling. We seem to be trying to get back to the status quo of the boom years and continuing to allow the financial and business oligarchs to have undue influence on just about all of our policies. I don’t like the idea that a cataclysmic failure of the economy has to occur in order to precipitate needed change. Accordingly, I hope we can find a better way out through smart legislation and prudential regulation.


(Picture courtesy of Zillow.com)