Wednesday, February 11, 2009
Mortgage resets and expected defaults: This is what they are afraid of
In case you were wondering why the Obama administration is using the "politics of fear" on the economy, it is because they are afraid. Here is one estimate of looming mortgage rate resets. Not all will go bad by any means, but if the economy is in the tank when these hit many of them will.
CWCID: Paul Kedrosky.
26 Comments:
By 
Charlottesvillain, at
Wed Feb 11, 08:26:00 AM:
No end in sight to the fall in housing prices. Pay option arms are the next wave. Minimum payment loans, often underwritten without documentation, that allow payments below the interest rate with negative amortization. 80% of these borrowers (more than $500 billion in debt) are paying the minimum payment, increasing their loan balance in the face of a declining housing market. The loans eventually recast, and shift to a fully amortizing payment schedule, resulting in large increases in payments. Delinquencies on this cohort are already above 8% and we've only just entered the recasting period!
Putting aside the issue of who is holding this dreck, anyone who thinks housing will bottom in 2009 is going to be wrong. A new wave of foreclosures is coming.
By Mike, at
Wed Feb 11, 09:44:00 AM:
The real issue here is not declining housing prices, but debtor propensity to pay.
The market puffed up because everyone assumed that prices could not decline and therefore, the borrower's character did not matter (technically, low FICO scores or unverified financial claims were acceptable). We've now realized prices can move in either direction.
How much do we need to burn through before we hit the first resets on the poor underwriting cohorts (January 2007?)?
By 
, at
Wed Feb 11, 11:00:00 AM:
At a finacial seminar the other day a speaker stated that if the CDO's and CDS's along with MBS's are levered at 40:1, the amount stated on this chart (and at risk) might well be 70 trillion or so.
Channeling the late Senator Everitt Dirksen of Illinois, " 70 trillion here, and 70 trillion there, and after a while you're talking about REAL money...."
By , at
Wed Feb 11, 11:23:00 AM:
I have a hard time understanding this. We're told that subprime and other badly underwritten mortgage loans are the source of the problem. But they only total something like $500 billion. When you add up all the recent actions taken by the government they're now totaling several trillion dollars. But I see figures that the total mortgage debt in the US is only something like $10 trillion. Most of us have mortgages that were well underwritten -- we won't default if we don't lose our jobs.
So why does the commitment to the bank bailout need to be so large?
I understand that things like CDOs have magnified the loss, but I don't understand exactly how and why so much. I also suspect that losses on these instruments may be zero sum. If so, shouldn't some of the losses cancel out? If zero sum, who's the "winner" on the other side? Is this where the money is going ... to cover trillions in bad derivatives?
Link
By Christopher Chambers, at
Wed Feb 11, 12:06:00 PM:
I was going to address the figures above, but I'm travel weary and...
...early this morning my wife and I were at National (out-flying), and as we sipped are coffee b4 going through security, bankers and their retinue (some carrying bundles of rods and axes) along asshat lawyers were rolling off USAIR flights/shuttles from Charlotte, NYC etc. (they made it a point to arrive on "commerical airlines and Amtrak" this time reports NBC News to avoid the PR slaughter from the last time they appeared at the Russell or Ryaburn Buildings LOL). Smug, unrepentent...the sight pissed me off so much that I, in earshot of a Washington Post reporter, shouted "Nice work...can I see what car you bought with my money!" and "Get a job!" My normally taciturn, reasonable wife (as TH can attest) joined in "Yeah!" The girl behind the counter at the coffee bar near USAIR gates grinned and clapped. Some these of clowns rolling out of the their newly decorated offices are my age or no more than 10 years older; I recall either the same people or folk like them--90% white male--back when all were thinner, more hair in the go-go 80s and 90s disparaging regular people, poor people, homeless people, brown people...even the Joe the Plumber people who usually carry their water. Well, now they know how it feels.
Screw the graphs and charts. This is the currency of many, many chickens coming home to roost, period. And all the best brightest wealthier and supposedly so much smarter, more industrious, "risk takers" folk who brought this on us should eat crow and get down in the mud with the rest of us and dig and pray.
By Viking Kaj, at
Wed Feb 11, 12:11:00 PM:
In response to Link, as far as I understand things it is the securitization of the mortgage debt that causes the problem. There is a big ratchet on those securities. So if the default rate goes from say 5% of the portfolio to 10 % you would expect the value of the security to drop by 5%, right? But what actually happens is the value of the security will fall from for example .86 cents to .02 cents because it no longer meets its return threshold. It's a little like a bond issue not being able to meet its coupon. This is what has the banks so scared. And because these things are securitized, ie. sold as a package, it is not easy to pick the bad apples out of the barrel. You can't tell in advance who is going to loose their job and default. The result is that even though 90% of the mortgages in the barrel are still good, the security instrument still loses a majority of its value.
That is why shoring up the balance sheets of the banks is not going to solve the problem. They will keep the additional reserves to meet future wire downs in the value of the mortgage based securities. If they don't, they will fail, which is an even bigger problem. But because they are not lending, and consumers are no longer borrowing and spending, the money is not ending up in circulation. And when spending falls, people loose their jobs and the default rate goes up.
Things are going to get a lot worse before they get better. Housing prices are still pretty high compared to 1998 levels, so we still haven't seen a real correction. Since we had housing going up at 30-40 % a year while real incomes were only going up at 3-4% the correction is inevitable.
But the government spending bill is nothing but Chicago style pork that will end up lining cronies and political constituents pockets.
And the markets reaction to Geithner's pronouncements earlier this week show that nobody in government has a clue how to fix this thing. They are still whistling in the dark, doing the things that Democrats usually do.
Borrowing and spending at this rate, when we are this far in debt, is likely to be highly inflationary on the currency.
From where I am sitting the congressional-military-industrial complex that Eisenhower warned against is spending the democracy into the gutter. The founders warned against this, republics seldom survive 60 years of sustained warfare, and we will be no exception.
By Viking Kaj, at
Wed Feb 11, 12:36:00 PM:
As far as the zero sum goes, let's say that real value of all the real estate in our previous theoretical portfolio is .60 cents when all the dust settles. There will be money to be made by liquidating the security, paying off the holders, and rebundling and selling the assets. The government realizes this and is trying to sell the banks on this aspect, as Geithner's comments show. But so far the banks realize that things are going to get a lot worse before they start to get better, as TH's curve shows, so they are not biting. There is money to be made on this thing, but it will be on the other side of the mess when we start to emerge in 3-4 years not 3-4 quarters like the government economists are trying to sell. Until then there are accounting rules and federal regulators to worry about and so far banks are realizing that government is not necessarily their friend when it comes to all this stuff. This is going to be interesting because the Long Island Liberals on Wall Street were a major source of campaign finance for the big "O". Putting a crimp in their compensation, while popular and populist, will not incentivize anyone to take the risks turn this thing around, especially when a uninvited visit from the US Attorney for the SDNY is also a possibility.
By Viking Kaj, at
Wed Feb 11, 12:40:00 PM:
Finally, on a gut level, I agree with Chris Chambers. The arrogance of these people is amazing given their level of incompetence.
By , at
Wed Feb 11, 01:06:00 PM:
To Christopher Chambers ... I've had the Barney Frank hearings on in the background. From what I've heard so far, Barney & Co haven't hit the bank executives as hard as some of them deserve. They're not all equal in this. Lloyd Blankfein at Goldman has made hundreds of millions, but his firm was a big driver of the problems. Goldman would be broke if former Goldman CEO Paulson didn't give Goldman the money he denied to Lehman. Stan O'Neal -- former Merrill CEO -- should be in the dock. In 2006 - 2007 he fired executives who told him he was running Merrill over a cliff, and cashed out a hundred million in options. All of these guys are arrogant pricks. Wall Street runs a lot like the Mob ... each guy at a rung expects the guys below him to kick up a share of profit. In the old days, these places were partnerships, so the discipline was that the house money you bet was yours. For years now, it's all been bets made with other people's money.
Appreciate the response Viking Raj,
I share your concerns about the stimulus bill, future inflation, etc. We have a big problem with both parties continuing to buy key blocks of voters using money from the rest of us. Obama just raised the ante with his stimulus bill.
I can't tell which is the bigger swindle ... the stimulus bill, or TARP. The dirty secret here I think is that the TARP money is just filling a really big hole. Wouldn't we better off putting money in other banks, not the big Wall Street banks ... if we wanted to get a multiplier going? Who benefits from the big bad banks being propped up? Are they just so big and so levered, that we can't allow a failure?
I still don't understand the effect of securitization. In theory, couldn't you buy it all back in, unwind the securitizations and just have $500 billion in bad mortgages to deal with? Even with a decline in home values, the total loss on US mortgages shouldn't be more than $1 trillion, $2 trillion tops, right? Is the problem that some kinds of securitization have the effect of multiplying loss. Greenspan liked securitization because he thought it was diversifying risk. Or is it that the added complexity has compounded risk?
One trend is clear from the hearings ... practices at the big banks will get politicized. Jacking credit rates for example. It suggests that the big banks will just become arms of government, that only make politically correct loans with politically correct pricing. This is very third world.
Link
By MartyH, at
Wed Feb 11, 01:16:00 PM:
If the problem is ARM resets exploding, then change the terms of the loans that are reissued for those who can't qualify or pay for a traditional loan.
For example, a hundred year loan at 2% interest requires a payment of less than $20 per $10,000 borrowed. That means a payment of $482 per month on a $250K loan-36% of the payment of a 5% 30 year fixed.
Interest deductibility can be eliminated or phased out depending on how much more of a sweetener you need (and I think this is already pretty darn sweet.)
This turns these people into defacto renters, since no one lives a hundred years; all that most people would make is interest payments.
Maybe I have the term too long and interest rate too low, and the program is too expensive for the government.
Maybe no one would take a loan that would last longer than their lifetime.
But this solution takes a huge problem compressed into five years and maybe turns it into a manageable problem over forty or fifty years.
Assuming normal inflation, most houses should be above water by the time the noteholder dies, leaving the heirs with a small asset.
Caveat: I'm an engineer. I have no insight into the housing or finance industry. Feel free to deride if it's an idiotic idea.
By , at
Wed Feb 11, 01:20:00 PM:
Okay, you guys seem to understand the problem. Tell us what to do with our individual remaining assets so that we can continue to eat and will be able to survive after this mess passes.
By Viking Kaj, at
Wed Feb 11, 02:11:00 PM:
As I understand it, the valuation problem with the mortgage backed securities is on at least two counts, the default level and house prices.
On the first count you have a problem with the default level. You can predict in the aggregate generally how high the default level is going to be in the aggregate even if you can't pick out the individual defaulters. The default level is based upon certain assumptions about the economy in general. This is where the "brains" on Wall Street got it wrong. Financial models generally assume that the economy is going to perform in accord with some historical norms, ie. the last five years, the last ten years, etc. Since the Fed has been pumping cheap money into the economy since the last real recession, 1993, there hasn't really been a good baseline for the models. So the assumption was that some of these "high risk" mortgages wouldn't have a greater default rate than normal historical defaults. By the way, this is the same assumption about Junk Bonds that led to all the problems in the 1980's. Ph.D.'s in economics from Harvard, Yale and Princeton working for Citibank and Merill made the same basic assumption as the investors in the Dutch Tulip crash of the 1600's, ie. since the market had gone up for some period (in this case 15 years) that it would continue to perform that way. Right now we are trying to figure out how bad the default level will get (5%, 10% or more?), which is one problem with evaluation.
The second problem with evaluation for these securities is falling housing prices. As more houses come on the market due to defaults, and prices fall, the value of the assets in the mortgage based security continue to decrease. Right now, nobody can predict how much prices are going to fall. From what I have read, many people who have purchased homes in the last five years may be under water on their mortgages, ie. they owe more on their homes than the houses are worth. Will we rollback eight years, ten years?
It is at least these two uncertainties that have the market in such turmoil. Bankers are traditionally pretty risk adverse, they don't like to get into deals unless it is pretty certain that they will make money. But since we have gone so long without a correction, there is a lack of certainty (ie. historical data) for the financial models regarding what the default level will be, and how much prices for housing will fall. That's why you hear the words unprecedented and unpredictable bandied about so much these days. The guys in the executive suite are hammering the geeks in the basement for an answer, and the answer is there is no answer.
The government is projecting a best case scenario saying that a large infusion of cash will prime the pump and get consumers spending again. What has driven the economy for the last ten years is consumer spending based upon increased personal debt. Government is assuming that they can get this carousel going again quickly, and prop up housing prices in the interim with low interest rates.
Given the curve that TH posted, which jives with a lot of the other data I have seen, I am not as convinced that this will be a 3-4 quarter thing. I think consumers are going to be very careful about taking on increased debt, and that the government stimulus package will not work as well as targeted tax cuts. And on the whole, I think the long term policy of the government should be to decrease our reliance on personal and public debt, but then what do I know? Maybe you can have your guns and butter too as long as the Chinese and Japanese keep lending you the money,
By Coach Morgan, at
Wed Feb 11, 02:29:00 PM:
What about the Senate Republican (Mitch McConnell) proposal to have the Feds underwrite a reissue of all/nearly all mortgages at 4% fixed?
That would completely eliminate reset risk. The Feds would have a positive carry at current financing rates and could easily sell off the mortgages as bundled securities with a 6% yield for about a 15% discount from par.
So $10T of mortgages could be completely refinanced to 4% and sold off for $8.5T to yield 6%. Total cost, $1.5T. (30 year mortgages bundled into securities will trade with a duration of about 10 years - ask TH to explain bond durations - and a 4% coupon 10 year bond has a yield to maturity of 6% at a price of 85%).
$1.5T, of course, is the upper bound - a complete refinancing of the US mortgage market. And I like the idea of removing mortgage interest deductibility for the 4%s
By , at
Wed Feb 11, 02:43:00 PM:
Morgan,
I think your proposal illustrates what I'm struggling with. If in theory you could refinance the entire US mortgage market for less than $1.5 trillion ... so that even someone like me -- who bought my house 12 years ago, and did two interest-lowering refis since then -- could get a lower monthly rate ... why isn't this at most a $1 trillion problem.
Now $1 trillion is big, but we could take that hit. Add up everything done and being talked about, and we're at multiples of that.
Link
By Viking Kaj, at
Wed Feb 11, 03:11:00 PM:
Even if you have the government refi everything at 4% and securitize it how does this solve:
1) questions about the default level and valuation of the underlying assets?
2) who is going to buy the securities? the chinese have stopped buying secondary securities and are are only buying t-bills?
3) what if people don't want to refinance?
4) don't you substitute the government for the whole mortgage industry? what happens to their profits?
By SR, at
Wed Feb 11, 03:12:00 PM:
Morgan and Link,
Of course your solution would be the sensible and easy way, and possibly the cheapest. However, a lot of rich people have mortgages too, and the Chambers Democrats would never think of bailing them out.
No, they are just using the opportunity to pay off their political supporters (Soros is getting ready to short the dollar just like he did the pound making his second fortune). The country be damned (no wait, Rev. Wright is under the bus).
By , at
Wed Feb 11, 03:29:00 PM:
What do you all think of this thesis. As we continue into the recession some of the exotic holdings of our big banks will become even more worthless ... so much so that the capital of some of our big banks will get wiped out. Citigroup is probably very exposed. JP Morgan less so. Bank of America bought their way into trouble with Merrill. Who knows about Goldman.
It's worth noting that Bank of America's market cap ($38B) is now less than the announcement value of what they agreed to pay for Merrill ( $40 some odd billion) just a few months ago. This is why Merrill's paying out year-end 2008 bonuses is shocking. You have to admire how the Goldman dynamic duo of Paulson-Thain stuck it to country-boy Ken Lewis.
Big bank failures can have serious knock-on effects for the broader economy. But in this environment, there are no private sector buyers or investors. So the US has to step in.
If we're not careful in their resolution, however, we'll just create a few big zombie banks that will continue to suck in resources. The business model of the large Wall Street banks is largely broken. We have to figure out how to break up these firms, so the profitable units can get on with life. Many of the big banks don't know how to make money any more .... government involvement will only make it worse. In that regard, these banks are no different than General Motors. It's hard to make cars without being a big business, but there are plenty of small banks and other lenders who can step up.
By extension, we shouldn't make policy decisions to prop up real estate prices for an indefinite future. That will only make things worse in the long run.
If there's a theme I'm seeing it's that most of America is OK, at least for the moment, but that a few big institutions and a small number of stupid borrowers -- small in percentage, not in aggregate -- have created some big problems. The solution should reflect this. I'm very angry that the solution that's being developed will stick me ... and more so my children ... with the bill.
My nightmare is a dollar collapse. I don't think it will happen -- because the rest of the world sucks more -- but we've put ourselves on thin ice. Soros is salivating.
Link
As I understand it, this
By , at
Wed Feb 11, 04:05:00 PM:
Follow-up
I've had the Barney Frank hearings on in background. Around 4 pm bank CEOs were emphatic in their denials that they have solvency issues. E.g, Citi's capital ratio is at 12%. But then why do many of these banks trade so low -- some are way below book value -- and why is Guenther saying he made need a couple of trillion?
By , at
Wed Feb 11, 05:07:00 PM:
The Obama administration is only vaguely aware of the economic issues: they see everything in political terms. Demogoguery is the order of the day because they are afraid they are losing politically. Why? One reason for the invective might be that for the first time in the Rasmussen "generic" poll they are tied with the GOP.
Michael Barone of US News says that the generic ballot typically understates GOP election performance, translating to a big win for the Republicans in off-year Congressional races. Rasmussen says this is the lowest level of support for Congressional Democrats in the history of the poll. Sadly, those races are two years away, and lots can obviously change between now and then, but the President seems to have blown his initial political capital on this porkulus bill he is jamming through Congress. Independents are now solidly GOP, as are voters describing themselves as investors.
Hard to believe- the guy worked so hard to get elected, and it turns out his most impressive act might well be to pay off ACORN and buying electric golf carts.
By , at
Wed Feb 11, 05:12:00 PM:
I got spooked from hearing second-hand that Guenther wanted as much as $2 trillion more. After monitoring today's hearings, I came out guardely optimistic that the big banks won't go bust, and that core credit markets are starting to work. If so, it'll be bad, but it's not the end of days.
Link
By MartyH, at
Wed Feb 11, 06:04:00 PM:
Viking-
I think the problem posed here is limited to refi only, not new home purchases. Borrowers are looking at ARM resets where their payments go up dramatically; they cannot refinance due to poor credit or the house being underwater.
Right now, many of these borrowers will default. The idea is to give them an option that allows them to stay in their homes without foreclosing. This prevents a wave of foreclosures, killing any recovery.
1) questions about the default level and valuation of the underlying assets?
The valuation of the underlying asset doesn't matter-this is a dollar for dollar loan swap, with the borrower getting better terms than he has now. He does not have to participate in this program. If he does, hopefully it will be better for both him and the noteholder.
2) who is going to buy the securities? the chinese have stopped buying secondary securities and are are only buying t-bills?
The government buys the loans initially (or backs "Bad Bank", who is formed to buy the loans.) Bad Bank is legally obligated to hold onto them to maturity. They cannot be securitized, collateralized, borrowed against, or otherwise leveraged. Bad Bank is not meant to make money; it is only supposed to return the original principal to the government.
As long as the government can borrow money, this program can be funded.
3) what if people don't want to refinance?
It's their choice. Again, though, we are trying to avoid the ARM resets that are a gun pointing at many of these borrowers and lenders. In many cases, this will be the only option to foreclosure. Make the payment low enough, and people will stay put, even if they are paying the rest of their lives.
4) don't you substitute the government for the whole mortgage industry? what happens to their profits?
Only the refi portion of it (which probably isn't very active with the borrowers we're talking about anyway.) Bad Bank can be mandated to only refi loans initiated prior to 2008, and the window for Bad Bank issuing new loans closes at the end of 2012, when we are past the knee in the curve in the chart above. This means that purchases of toxic assets stop in 2012.
If interest is not deductible, high earners will be less inclined to take this program, leaving them to refi in the private market.
Also, this program is only available for primary residences.
Hopefully this will avoid another rash of foreclosures, and any derivatives based on the original loans will now be secure.
Purchases go to zero after 2012. The interest payments should cover expenses of tracking these loans. I proposed a 100 year loan earlier. In essence, the principal would be repaid when the borrower died and the house sold or refi'd through traditional means. I don't expect this to be a money making venture, but it could roughly break even.
Default if the biggest risk. The assumption is that people want to stay in their homes and hang onto their good credit.
Anyway, it's an idea.
By , at
Wed Feb 11, 08:38:00 PM:
Holy sh*t! I've been hearing about this next wave of resets but until I saw it in the graph above, I had little understanding of the magnitude.
By Viking Kaj, at
Thu Feb 12, 04:07:00 AM:
Marty, I hear what you are saying about the dollar for dollar loan swap but it still makes various assumptions.
One assumption is that the default level will not continue to increase as unemployment increases. If we hit 10-12% a lot of the people who are in those ARM instruments are vulnerable.
And since they are vulnerable, the value of those underlying assets does matter. If the value of your house is less than the mortgage value then it makes no sense to refinance. Think of this as the reverse ATM.
Your assumption is that people want to stay in their homes and hang on to their credit, which I agree with and believe is true. But as this thing continues to snowball, that may matter less to a certain group of debtors. Thanks to years of government policies and aggressive marketing by financial institutions there are many people out there who live from payment to payment.
The problem for both government and the banks is that nobody knows how bad all of this is going to get. The calculations above make certain assumptions, but the real defaults and price drops could mean that the losses on bad loans go to $ 2-3 trillion or more.
I guess I also still don't see how this solves the problem with the mortgage backed securities. These things were set up in semi-boiler room operations without regard to the type of borrower or asset that was being bundled. So it is impossible to predict which security is relatively good and which is rotten. And since this is all bundled, and the valuation is based on an aggregate, you can't selectively pull the bad ones out. Also, yeild calculations on those securities were based in part on the ARM rates, which means that refinancing leads to further problems with evaluation.
By , at
Thu Feb 12, 10:30:00 AM:
Maybe I missed it somewhere, but it sounds like you all are assuming it is necessarily bad when an ARM resets. I was thrilled several years ago when my ARM reset because then my monthly payment dropped considerably. Of course, "teaser rates" are another matter, and I'm not sure what percentage they make up of the total.
By , at
Thu Feb 12, 01:01:00 PM:
Squealer ... I think the answer is that the reset rate will be higher than it is presently. And if there are loans that require any kind of revalidation of the value of the underlying asset, the loan holder is most likely toast.
There are many markets that are only slightly impacted by this implosion in housing, but it's the big epicenters that are sinking the ship (Phoenix, Vegas, Florida, virtually all of CA, etc.)
I think until the loan defaults, the bank doesn't classify it as toxic ... even if it's foreseeable and probable.
In some instances ... houses are 1/3 or less than the peak. If you lost 67%, AND were underwater by big money, it'd be really tough to keep making that payment ...
By MartyH, at
Thu Feb 12, 01:09:00 PM:
Viking-
I totally missed the derivative angle in my "solution". Don't know how to address it without udnerstanding how holds how much of what. Again, my field is engineering, not finance.
In any event, it's clear that regardless of what happens, lots of people are going to lose lots of money. I'd rather focus on solutions that allow people to stay in their homes. The "sophisticated" investors who bought and sold these securities should bear more of the burden for their failure. I'd try to protect the banks and keep people in homes, but everyone else-hedge funds, pension funds, mutual funds-can take a beating.
