Monday, March 19, 2007

Signs of the Economic Apocalypse, 3-19-07

From Signs of the Times:

Gold closed at 653.90 dollars an ounce Friday, up 0.6% from $650.10 at the close of the previous Friday. The dollar closed at 0.7509 euros Friday, down 1.5% from 0.7625 at the previous week’s close. That put the euro at 1.3318 dollars compared to 1.3115 at the end of the week before. Gold in euros would be 490.99 euros an ounce, down 1.0% from 495.69 for the week. Oil closed at 57.11 dollars a barrel, down 5.1% from $60.05 at the end of the week before. Oil in euros would be 42.88 euros a barrel, down 6.8% from 45.79 for the week. The gold/oil ratio closed at 11.45, up 5.7% from 10.83 at the close of the previous Friday. In U.S. stocks, the Dow Jones Industrial Average closed at 12,110.41, down 1.4% from 12,276.32 for the week. The NASDAQ closed at 2,372.66, down 0.6% from 2,387.55 at the close of the previous Friday. In U.S. interest rates, the yield on the ten-year U.S. Treasury note closed at 4.54%, down four basis points from 4.58 for the week.

Fears of a serious recession sparked by the bursting of the housing bubble drove down the dollar, oil and stocks last week. The problems of the sub-prime mortgage market were all over the news. For oil prices to drop so sharply, over 5% last week, in the face of extreme instability in the Middle East, it must mean that the housing problem in the United States is even worse then they are letting on.
Foreclosures May Hit 1.5 Million in U.S. Housing Bust

By Bob Ivry

March 12 (Bloomberg) -- Hold on to your assets. The deepest housing decline in 16 years is about to get worse.

As many as 1.5 million more Americans may lose their homes, another 100,000 people in housing-related industries could be fired, and an estimated 100 additional subprime mortgage companies that lend money to people with bad or limited credit may go under, according to realtors, economists, analysts and a Federal Reserve governor. Financial stocks also could extend their declines over mortgage default worries.

The spring buying season, when more than half of all U.S. home sales are made, has been so disappointing that the National Association of Home Builders in Washington now expects purchases to fall for the sixth consecutive quarter after it predicted a gain just last month.

“The correction will last another year,” said Mark Zandi, chief economist for Moody's in West Chester, Pennsylvania. “Fewer people qualifying for mortgages means there will be less borrowers, and that will weigh on demand.”

A five-year housing boom that ended in 2006 expanded home- ownership to a record number of U.S. households. Now it has given way to mounting defaults, failing subprime mortgage companies and an increasing number of unsold homes.

Last Housing Slump

If this slump follows the same pattern as the last one, in 1991, it will persist for at least another year and may fuel a recession. New-home sales declined 45 percent from July 1989 to January 1991 and about 1 percent of all U.S. jobs, or 1.1 million, were lost in that recession, said Robert Kleinhenz, deputy chief economist of the California Association of Realtors.

This time around, new-home sales have declined 28 percent since September 2005, hitting a low in January, the last month for which data is available. And though the national jobless rate is near a five-year low this month, mortgage-related jobs fell by almost 2,000 in January alone. At least two dozen of the more than 8,000 mortgage lenders have been forced to close or sell operations since the start of 2006.

Subprime lenders Ameriquest Mortgage Co. in Irvine, California; Ownit Mortgage Solutions LLC and WMC Mortgage Corp., a subsidiary of General Electric Co., in Woodland Hills, California; Mortgage Lenders Network USA Inc. in Middletown, Connecticut and Fremont General Corp. together have fired more than 5,600 workers in the past year.

New Century

New Century Financial Corp., the second-largest subprime lender, said today it ran out of cash to pay back creditors who are demanding their money now. The Irvine, California-based company has lost 90 percent of its market value this year and stopped making new subprime loans, prompting speculation it will seek bankruptcy protection. New Century already has cut 300 jobs and its 7,000 remaining employees are waiting to see if the company will survive.

Fremont General, the Brea, California-based lender that is trying to sell its residential-mortgage unit, was ordered to stop making subprime loans by the U.S. Federal Deposit Insurance Corp. last week. Fremont was marketing and extending loans “in a way that substantially increased the likelihood of borrower default or other loss to the bank,” the FDIC said last week.

Doug Duncan, chief economist of the Washington-based Mortgage Bankers Association, predicted in January that more than 100 home lenders may fail this year.

The subprime crisis “has taken the fuel out of the real estate market,” said Edward Leamer, director of the UCLA Anderson Forecast in Los Angeles. “The market needs new money in order to appreciate, and all of that money is gone for a very long time. The regulators are not going to allow it to happen again.”

Higher Rates

Subprime mortgages are given to people who wouldn't qualify for standard home loans and typically have rates at least 2 or 3 percentage points above safer prime loans. The portion of subprime loans that financed new mortgages rose to 20 percent last year from 5 percent in 2001, according to the Mortgage Bankers Association.

Subprime loans contributed to a home-ownership rate that reached a record 69.3 percent of U.S. households in the second quarter of 2004, up 5.4 percentage points from the same period in 1991, according to the U.S. Census Bureau.

“Probably the gain in home ownership over the last four, five years, is almost entirely due to looser lending standards,” said James Fielding, a homebuilding credit analyst at Standard & Poor's in New York.

Refinancing Option

As home prices steadily gained from 2001 to 2006, homeowners who fell behind on mortgage payments could sell their homes and pay off their loans or get better refinancing terms based on the higher value of their property. Now that home values are declining, many borrowers won't be able to refinance because they would have to come up with the difference between their new mortgage and what their home is now worth.

Defaults may dump more than 500,000 homes on a housing market already saturated with leftover inventory built during boom times, New York-based bond research firm CreditSights Inc. said in a March 1 report.

Mortgage defaults may climb to $225 billion over the next two years, compared with about $40 billion annually in 2005 and 2006, according to debt strategists at Lehman Brothers Holdings Inc.

Seven-Year High

The portion of subprime loans more than 60 days delinquent or in foreclosure rose to 10 percent as of Dec. 31, from 5.4 percent in May 2005, the highest in seven years, according to data compiled by Friedman Billings Ramsey Group Inc. of Arlington, Virginia.

Many of the delinquencies came from loans where borrowers didn't have to provide tax returns or other evidence of income, or where they financed 100 percent or more of the home's value, CreditSights analyst David Hendler wrote in a March 5 report. Other defaults came on adjustable-rate mortgages with artificially low introductory “teaser” rates, sometimes with “option” payment plans that allowed borrowers to defer interest.

Banks ought to be concerned about such loans and are likely to see more missed payments and foreclosures as consumers with weak credit histories begin to face higher monthly mortgage payments, Federal Reserve Governor Susan Bies said last week.

“What we're seeing in this narrow segment is the beginning of the wave,” Bies said. “This is not the end, this is the beginning.”

About 1.5 million U.S. homeowners out of a total of 80 million will lose their homes through foreclosure, University of California-Berkeley economist Ken Rosen said last week.

“The subprime borrowers paid too much for their homes, and all of a sudden, they'll see their house value drop by 10 to 15 percent,” Rosen said.

Borrowers at Risk

The Center for Responsible Lending in Durham, North Carolina, said in a December study that as many as 2.2 million borrowers are at risk of losing their homes, at a potential cost of $164 billion, from subprime mortgages originated from 1998 through 2006.

The number of U.S. foreclosures rose 42 percent to 1.2 million last year from 2005, according to Irvine, California-based RealtyTrac, while delinquencies in the last three months of 2006 rose to the highest level in four years, the Federal Reserve said.

Housing and related industries, which account for about 23 percent of the U.S. economy -- including makers of everything from copper pipes to kitchen cabinets -- fired about 100,000 workers last year. The total will be higher this year, according to Amal Bendimerad of the Joint Center for Housing Studies at Harvard University in Cambridge, Massachusetts.

Job Cuts

By the end of this year, job cuts at companies including Benton Harbor, Michigan-based Whirlpool Corp., Masco Corp. of Taylor, Michigan, and St. Louis-based Emerson Electric Co. may exceed the fallout from the 1991 housing slump, said Paul Puryear, managing director at St. Petersburg, Florida-based Raymond James & Associates. The Bureau of Labor Statistics doesn't give data for housing-related job losses.

“The fallout in the early 1990s was much worse than what we've seen so far, but this downturn is not over,” Puryear said. “The full impact hasn't hit yet.”

U.S. House Financial Services Committee Chairman Barney Frank, a Massachusetts Democrat, said he may propose legislation to reign in “inappropriate” lending, and a House subcommittee is scheduled to consider subprime lending and foreclosures March 27.

“The standards got loosened so much, and there's always the pressure to make money that there was pressure to maybe make the questionable loans that shouldn't have been made,” said Ohio Representative Paul Gillmor, the subcommittee's top Republican, in a March 9 interview. “The major problem has been the overall deterioration in credit standards by lenders that's exacerbated by those who are unscrupulous.”

Fraud ‘Pervasive and Growing'

The Federal Bureau of Investigation says mortgage fraud is “pervasive and growing” and the incidence of such fraud has almost doubled in the past three years.

“There has been an increase in unscrupulous individuals in the market,” said Arthur Prieston, chairman of the Prieston Group, a San Francisco-based company that investigates mortgage fraud. “There's an unfair assumption of a connection between subprime failure and fraud. But there is a connection between early default and fraud.”

Mortgage fraud is committed when a borrower misrepresents himself or his finances to a lender. Some of that fraud involved speculators. They drove up prices during the boom by ordering new homes with the intent of selling them immediately after taking possession.

That “flipping” inflated demand and put the speculators in competition with the homebuilders, propelling the median U.S. home price to $276,000 last June from $177,000 in February 2001.

Housing Bubble

“A lot of the housing bubble was speculation,” said Mike Inselmann of the Houston-based research firm Metrostudy.

When home prices got so high that speculators could no longer turn a profit, they canceled their contracts and walked away from their down payments.

Cancellation rates for new homes have surged to almost 40 percent of home contracts, Margaret Whelan, a New York-based analyst at UBS AG, said in a report on March 2.

That forced the top five U.S. homebuilders -- D.R. Horton Inc., Pulte Homes Inc., Lennar Corp., Centex Corp. and Toll Brothers Inc. -- to write off a combined $1.47 billion on abandoned land in the fourth quarter of 2006.

On top of that, new home sales plunged 17 percent last year from 2005, the biggest decline since 1990, according to the Chicago-based National Association of Home Builders. Existing home sales fell 8.4 percent in 2006 from a record in 2005, according to the National Association of Realtors…

The problem is so important, yet more than a little complicated, so it’s worth reading different attempts to explain it, even though it’s ground we have covered extensively. Most people can understand mortgages and risky mortgages. But bring in securitized mortage pools and then derivatives and it becomes increasingly hard for the layperson to keep up. The following is one of the better explanations of derivatives:

"Well, What Do You Want It To Be?"

Thursday, March 15, 2007

Today I will follow a debt trail, from loan origination all the way to its ultimate existence as part of a credit derivative product. I will use a sup-prime mortgage loan as an example, but any debt obligation will do. Keep the question of the title in mind, it will make sense in the end.

Let's start two years ago with Ron and Ronda White, a couple in their early 30's with a combined income of $60.000 who have their eyes set on a $300.000 house to call home. They have saved only $5.000 to put down, which barely covers the closing costs. Their mortgage broker talks them into a $250.000 first mortgage ARM with an initial 2-year teaser rate of 2% rising to prime+1% thereafter and a $50.000 second, 30-year fixed at a whopping 10.5%. Despite the obvious problems apparent right from the start, such loans were made to hundreds of thousands of people. But no matter...

The two loans were immediately sold to investment bank XYZ who pooled them with other loans (creating Residential Mortgage Backed Security, or RMBS) and placed them inside a CDO. Using recent default data, the financial engineer employed by XYZ took 90% of the White's outstanding mortgage amount and placed it in CDO Tranch A, the supposedly safest portion rated AAA and paying 0.10% more than other AAA straight corporate bonds. The rest was apportioned 7% to Tranch B rated BBB, paying 1.5% more than equivalent bonds and the remaining 3% to Tranche C, also known as the "equity" tranche, which was unrated and paying 10% above Treasury bonds. In case of default, Tranche C gets hit first until it is exhausted, then Tranche B and, finally, Tranche A. This is a "cascade" or "waterfall" pattern, common to all such collateralized products.

Notice how 100% of a loan package that could be described as CCC has been turned into 90% AAA, 7% BBB and 3% NR. In plain terms, the "engineer" is betting that no more than ~3% of the total principal and interest will be lost, including recoveries from selling foreclosed real estate.

Call this the First Derivative - depending on conditions, the market prices of the CDO Tranches will vary significantly more than straight corporate or government bonds.Those CDO Tranches are then sold as follows, typically:

· Tranche A to a pension fund attracted by the slight yield premium on a AAA bond.

· Tranche B to a fixed income mutual fund.

· Tranche C to a hedge fund attracted by the high yield - or is retained by XYZ.

So far this has been a plain vanilla process, the only question mark being how high or low the "engineer" places the assumptions for defaults and recoveries.

The next step in debt "derivativization" is the issuance and trading of Credit Default Swaps on the first two Tranches of the CDO. It can be done by XYZ, another bank, a hedge fund or all of them - there is no limit. These swaps guarantee payment in case of default events by the CDO, itself a conduit for Mr. and Mrs. Smith's mortgages. These CDS's require an up front payment and subsequent semi-annual ones, usually for up to five years. One can think of them as tradeable insurance policies. Naturally, Tranche A carries a much smaller insurance premium than Tranche B, given the respective AAA and BBB ratings.

Call this the Second Derivative - the prices of CDS's will certainly vary more than the prices of the underlying Tranches and much more than straight bonds.These CDS's generate income to the seller, who assumes the risk of making the buyer whole if the CDO Tranches experiences payment shortages. Who sells this insurance?

· CDS on Tranche A may generate 0.15% annually and is typically sold by a bank or a pension fund attracted by the income generated by insuring a AAA credit.

· CDS on Tranche B may generate 1.30% annually, commonly sold by hedge funds.

Who buys the stuff? It would seem pointless for the CDO owner to buy protection for the bonds he already owns, but it does happen for portfolio hedging purposes or even as a way to "trade" the underlying CDO's without actually selling or buying the actual bonds.

But there are more buyers than just hedgers, as we shall see below.

Another investment bank, it could even be XYZ itself, buys a bunch of such CDS's and creates another CDO, also with tranches, ratings, etc. Remember, all you need for a CDO is a stream of regular payments to slice and dice into tranches.

We have now reached the Third Derivative stage: the potential volatility of such a product can be orders of magnitude greater than a simple bond. This is a CDO made up of CDS on another CDO made up of RMBS's - the alphabet soup is thickening fast. The credit leverage, i.e. what happens to the price of this type of product for a given rise in loan defaults in the, by now very distant, mortgage is very, very high.

Should an "investor" actually provide cash to purchase the above Third Derivative CDO we have what is known as a "funded" CDO. But this is becoming increasingly uncommon, because there is yet another derivation that can be performed on Mr. and Mrs. White's nortgage.

Another investment bank (or the original XYZ) can construct an "unfunded" CDO from the CDS's in step three, an instrument that just pays out or demands payment from its owners on a quarterly basis, depending on the shrinking or widening of the CDS spreads. This "synthetic" CDO owns nothing - not even the CDS; it just uses them to mark to market the said CDS spreads and to thus calculate the quarterly payments.

We are up to the Fourth Derivative. Sorry, but I have run out of superlatives to describe the leverage, volatility and credit risk sensitivity of these constructs. And yet, les apprentices sorciers who cook them up think it "innovative financial engineering". Like any fourth derivation, the price of such instruments is completely unrecognizable versus the original mortgage.

Thus the title of today's post, explained best by an anecdote:

Bank XYZ is looking for a dealer for its derivatives desk. Candidate A walks in the door and the desk manager asks, "What is 2 and 2?" --- "Four, sir" answers the job candidate. "Next", says the manager.

Candidate B is asked the same question: "Depends on if you mean 2 plus 2, or 2 minus 2", answers B ..."Next"...

Candidate C comes in and before he answers the question he looks at the manager and asks: "I just want to be absolutely sure - the job is for the credit derivatives desk, right?"

"Certainly", answers the desk manager.

"In that case, 2 and 2 is whatever YOU want it to be", says C.

"Hired, when can you start?"

P.S. Now, let's say that Mr. and Mrs. White default on their loan and, along with them, another 6% of the mortgages default, too - way above what the "engineer" had assumed. What will happen to the prices of the above RMBS, CDO, CDS, Synthetic CDO's? Aren't we lucky we have trader C to tell us - or aren't we?

P.P.S. If it was not made clear, unlimited CDS's can be written on a particular debt obligation, including the CDO in step one. Say a "first derivative" CDO has $100 million outstanding. The CDS's issued against, however, may amount to many times that - as I said, there is no limit. Therefore, there is no limit to the third or fourth derivative CDO's that may be issued, themselves backed by those multiple CDS's. This situation can easily create a viral contagion negative effect, as one "sick" original CDO can infect many others through the CDS market. Ouch.

Here’s this from the Washington Post (no longer is it just crazy bloggers writing about this stuff!)
'No Money Down' Falls Flat

By Steven Pearlstein
Wednesday, March 14, 2007

Today's pop quiz involves some potentially exciting new products that mortgage bankers have come up with to make homeownership a reality for cash-strapped first-time buyers.

Here goes: Which of these products do you think makes sense?

(a) The "balloon mortgage," in which the borrower pays only interest for 10 years before a big lump-sum payment is due.
(b) The "liar loan," in which the borrower is asked merely to state his annual income, without presenting any documentation.
(c) The "option ARM" loan, in which the borrower can pay less than the agreed-upon interest and principal payment, simply by adding to the outstanding balance of the loan.
(d) The "piggyback loan," in which a combination of a first and second mortgage eliminates the need for any down payment.
(e) The "teaser loan," which qualifies a borrower for a loan based on an artificially low initial interest rate, even though he or she doesn't have sufficient income to make the monthly payments when the interest rate is reset in two years.
(f) The "stretch loan," in which the borrower has to commit more than 50 percent of gross income to make the monthly payments.
(g) All of the above.

If you answered (g), congratulations! Not only do you qualify for a job as a mortgage banker, but you may also have a future as a Wall Street investment banker and a bank regulator.

No, folks, I'm not making this up. Not only has the industry embraced these "innovations," but it has also begun to combine various features into a single loan and offer it to high-risk borrowers. One cheeky lender went so far as to advertise what it dubbed its "NINJA" loan -- NINJA standing for "No Income, No Job and No Assets."

In fact, these innovative products are now so commonplace, they have been the driving force in the boom in the housing industry at least since 2005. They are a big reason why homeownership has increased from 65 percent of households to a record 69 percent. They help explain why outstanding mortgage debt has increased by $9.5 trillion in the past four years. And they are, unquestionably, a big factor behind the incredible run-up in home prices.

Now they are also a major reason the subprime mortgage market is melting down, why 1.5 million Americans may lose their homes to foreclosure and why hundreds of thousands of homes could be dumped on an already glutted market. They also represent a huge cloud hanging over Wall Street investment houses, which packaged and sold these mortgages to investors around the world.

How did we get to this point?

It began years ago when Lewis Ranieri, an investment banker at the old Salomon Brothers, dreamed up the idea of buying mortgages from bank lenders, bundling them and issuing bonds with the bundles as collateral. The monthly payments from homeowners were used to pay interest on the bonds, and principal was repaid once all the mortgages had been paid down or refinanced.

Thanks to Ranieri and his successors, almost anyone can originate a mortgage loan -- not just banks and big mortgage lenders, but any mortgage broker with a Web site and a phone. Some banks still keep the mortgages they write. But most other originators sell them to investment banks that package and "securitize" them. And because the originators make their money from fees and from selling the loans, they don't have much at risk if borrowers can't keep up with their payments.

And therein lies the problem: an incentive structure that encourages originators to write risky loans, collect the big fees and let someone else suffer the consequences.

This "moral hazard," as economists call it, has been magnified by another innovation in the capital markets. Instead of packaging entire mortgages, Wall Street came up with the idea of dividing them into "tranches." The safest tranche, which offers investors a relatively low interest rate, will be the first to be paid off if too many borrowers default and their houses are sold at foreclosure auction. The owners of the riskiest tranche, in contrast, will be the last to be paid, and thus have the biggest risk if too many houses are auctioned for less than the value of their loans. In return for this risk, their bonds offer the highest yield.

It was this ability to chop packages of mortgages into different risk tranches that really enabled the mortgage industry to rush headlong into all those new products and new markets -- in particular, the subprime market for borrowers with sketchy credit histories. Selling the safe tranches was easy, while the riskiest tranches appealed to the booming hedge-fund industry and other investors like pension funds desperate for anything offering a higher yield. So eager were global investors for these securities that when the housing market began to slow, they practically invited the mortgage bankers to keep generating new loans even if it meant they were riskier. The mortgage bankers were only too happy to oblige.

By the spring of 2005, the deterioration of lending standards was pretty clear. They were the subject of numerous eye-popping articles in The Post by my colleague Kirstin Downey. Regulators began to warn publicly of the problem, among them Fed Chairman Alan Greenspan. Several members of Congress called for a clampdown. Mortgage insurers and numerous independent analysts warned of a gathering crisis.

But it wasn't until December 2005 that the four bank regulatory agencies were able to hash out their differences and offer for public comment some "guidance" for what they politely called "nontraditional mortgages." Months ensued as the mortgage bankers fought the proposed rules with all the usual bogus arguments, accusing the agencies of "regulatory overreach," "stifling innovation" and substituting the judgment of bureaucrats for the collective wisdom of thousands of experienced lenders and millions of sophisticated investors. And they warned that any tightening of standards would trigger a credit crunch and burst the housing bubble that their loosey-goosey lending had helped spawn.

The industry campaign didn't sway the regulators, but it did delay final implementation of the guidance until September 2006, both by federal and many state regulators. And even now, with the market for subprime mortgages collapsing around them, the mortgage bankers and their highly paid enablers on Wall Street continue to deny there is a serious problem, or that they have any responsibility for it. In substance and tone, they sound almost exactly like the accounting firms and investment banks back when Enron and WorldCom were crashing around them.

What we have here is a failure of common sense. With occasional exceptions, bankers shouldn't make -- or be allowed to make -- mortgage loans that require no money down and no documentation of income to people who won't be able to afford the monthly payments if interest rates rise, house prices fall or the roof springs a leak. It's not a whole lot more complicated than that.

Although the mainstream media is now covering the issue, rarely have they pointed out one obvious fact. The reason they had to extend credit to such poor risks is that there was no other way to keep the market afloat while they were, in effect, cutting the pay of the vast majority of people in the United States. The results are completely predictable and have been predicted for years, so that can only mean that the whole cycle, from bubble creation to bubble popping, has been intentional, has been part of a long process of funneling the wealth up to a small elite. Those in the know could make out like bandits as long as they know when to pull out. When the crash happens, we may go from being debt- and wage-slaves to real slaves.

Another thing the mainstream media ignores in all of this talk about the housing market is how this crash coincides with disastrous foreign-policy mistaked by the United States. That is the elephant in the room. Many financial journalists are comparing this housing bust with the one in 1990-91. The difference here couldn’t be clearer. In 1991, the United States was a triumpant winner of both the Cold War and the Gulf War. In 2007, the United States is in the process of losing everything.


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