October 3, 2022

Archives for September 2008

What has Bernanke learned?

The Wall Street Journal reports on the lessons that Chairman Bernanke,  a student of the last depression, learned from his textbooks and  studies in school.   According to the Chairman, “The experience of the Depression helped forge a consensus that the government bears the important responsibility of trying to stabilize the economy and the financial system, as well as of assisting people affected by economic downturns”.

This theory no doubt has been the impetus behind the efforts to provide massive amounts of liquidity and loans not only to the banking industry but also to scores of non banking related entities as well.  These operations have been criticized for their apparent ineffectiveness so far but I have no doubt that eventually,  the Federal Reserve will succeed in “stabilizing” the banks and the economy by providing oceans of credit in such great quantity  that only the most ridiculously inept companies won’t survive.  If you have an inquisitive mind, however, and analyze why we are in a financial crisis, one might conclude that it was brought forth by excessive credit creation and leverage on a scale never seen before by the same government entity now attempting to save us.  The great credit bubble did not start overnight- it began in the 1980’s and has grown exponentially ever since, propelled in large part by the Federal Reserve, which reacted to every mini crisis of the past two decades by simply providing more credit at lower rates.  Every event that might have caused a ripple in the economy was papered over with more credit instead of letting the creative destruction forces  of a capitalist system purge itself of poorly run,  financially reckless companies.  A recession, which is the mechanism by which excesses are cured and capital allocated more wisely next time, was viewed with horror and an end of the world event.

So here we are today, again, apparently left with no options to save the system, except by increasing the leverage again.   Will it work one last time or will our lust to borrow in excess once again this time be tempered by the reluctance of our foreign creditors?  My vote is that since we cannot apply fiscal discipline on ourselves, let us hope that China, Japan and the rest of the future bag-men for our treasury paper will limit our attempts at financial self destruction.

IOU’S Pile Up – Taxpayers Refuse to Pay

Forbes Magazine had a great article by William Baldwin explaining the addiction to debt by everyone from the Federal Government on down to Joe Sixpack. Politicians get elected by handing out entitlements that the “future generation” has to pay for, therefore, no new taxes need be imposed and the voters are kept happy; Joe Sixpack can buy his house with no money down and instead of saving for a downpayment can buy the new plasma TV and jet off to Cancun for the weekend; the ultra rich hedge fund operators and bankers can leverage up 40 to 1 and exponentially increase their net worth. Up until now this has worked like magic and no one, except for a few fiscal conservatives, worried about the mountains of debt building up at every level of society. As is the case with most trends that go to unimaginable extremes, all of a sudden it does matter in a very big way. Properly enough, the ones who incurred the most debt are now suddenly suffering the most from hedge fund managers facing liquidations requests and job loss to Joe Sixpack receiving his default notice to towns, cities and states suddenly facing massive deficits as the great credit machine implodes.

Debt to GDP

Here’s where it gets really interesting as the bills come due and the debts can’t be rolled over. Governments cannot cut back due to the nature of democracy; no will vote for someone who tells us what we need to hear – that the bills are due and we now have two options – drastically cut government services or dramatically raise taxes to pay for our past purchases. The option previously used on every occasion was to simply borrow more to pay the bills but, as we saw today, when you can’t borrow more it gets very ugly, very quickly.

Ironically, a few pages after the article by William Baldwin on out of control debt levels, we have the “Taxed to the Max” comment about a ballot initiative that will be voted on in Massachusetts which would eliminate the state income, wage and capital gain taxes which currently brings in the State of Mass over $12 billion a year. After a decade of stagnant wages, increased cost of living and maxed out credit cards it is going to be political suicide to convince the taxpayer that he needs to start paying on the mountains of debt that have piled up. How this problem is ultimately resolved will profoundly affect all of us for many years and there is no easy way out. How many people will accept a much lower standard of living and higher taxes to bring our debts in line with our ability to repay? I fear that as usual, the politicians will take the easy way out and try to continue to borrow until they can’t. The real big question is, short of simply printing the money, do we still have the ability to borrow and roll over our debts?

Taxed to the Max
Massachusetts is often referred to as “Taxachusetts” because the state’s taxes are so high. Now the Committee for Small Government wants to change that image by pushing legislation called the Small Government Act, which Bay Staters will vote on in November. The legislation repeals the state income, wage and capital gains taxes. That’s a $12.5 billion state revenue cut–with no other revenue to replace it. That reduction would force state legislators to seriously rethink their financial priorities. But it would also leave that money in the hands of families, where it will surely be better spent. Bostonians were once brave enough to tell England–and the world–that taxes were too high. Now let’s see if they have the courage to tell their own legislators.
–Merrill Matthews, Institute for Policy Innovation

Unsound Lending Policy

Where have these guys been?

This email came across my desk last week from a mortgage lender looking for business.

“More bad news yesterday from the agencies with reduced LTV’s and increased fico’s for cash-out. How can you avoid this latest problem? With a Dream House “combo loan”!

85% cltv with a 650 fico (won’t get there now without a 700!)

No MI required!
DTI to 55%

AVOID LOAN LIMITS and get easier approval with lower LTV 1st mortgage

Call me today for more details!”

Please note that this lender is allowing a debt to income (DTI) ratio of up to 55%. This means that they are offering to lend mortgage money to someone who ultimately will never be able to make the payments on his mortgage, for the following reasons. Calculation of debt to income ratios are a routine part of the underwriting process in determining loan approval, along with credit and collateral review. The front end DTI is the ratio of an applicant’s monthly payment of principal and interest on the mortgage, plus the monthly amount due for property taxes and home owners insurance divided by his gross monthly income. Thus, if the PITI (principal, interest, taxes, and insurance) is $2,000 per month and the applicants gross income (before taxes) is $5,000 per month, the front end DTI will be 40%. The back end debt to income ratio includes the PITI and all other recurring payments for installment and revolving debt, such as credit cards, car loans, personal loans, etc. If the PITI is $2,000 per month and other debt payments total $750 per month, and gross income is $5,000 per month, the total back end debt ratio would be 55%.

If a loan applicant accurately reports his income and has a debt ratio of 55%, he faces almost a certain future of defaulting on the mortgage.

Debt ratios are computed using “gross” income before any deductions for payroll taxes, etc. In this example, the borrower with a gross income of $5,000 will be lucky to take home $4,000 of spendable income after deductions for social security, Medicare and federal income tax deductions. This would leave him with only $1,250 per month for everything else in life such as food, dining, gas, car repairs, home repairs, tuition, medical expenses, life insurance premiums, gifts, clothing, entertainment, etc. etc., you get the idea. If the borrower has no savings, as is frequently the case, one large home or car repair could easily result in a missed mortgage payment. Typically, one missed mortgage payment will easily lead to another until the borrower is in default.

Question???? Why would anyone make a mortgage loan to a borrower with such a high debt ratio? The time tested banking limits on the back end DTI of 32-35% were used for a reason – it prevented the borrower from overextending himself and falling into default. Theoretically, lenders should be able to lend to whomever they wish to using whatever underwriting standards they chose to use. In addition, some borrowers have additional income that they cannot provide documentation for and thus are not able to use this type of income when applying for a mortgage. Therefore, they may have debt ratios that are in reality better than what appears in the formal debt calculation.

The only problem with this rationale is that allowing very high debt ratios is what has led us as a nation into a financial crisis based on easy lending to borrowers who really never had a realistic chance (absent eternal home price appreciation) of paying back the money that they were approved to borrow. Also, it was not a great leap, once you allowed high debt ratios, to also allow approvals of mortgages by applicants with low credit scores and minimal down payments, which totally guaranteed foreclosures for this type of borrower profile.

Given the the large number of mortgage defaults that we already have, I believe that lenders should be constrained in their enthusiasm to make aggressive loans to borrowers who may not fully realize their financial limitations.  In fact, in many ways, lending to a borrower with a verified high debt ratio is worse behavior than the approvals previously given to subprime and altA stated income borrowers since in those cases, at least the lender could look with two blind eyes at the income the borrower stated that they made and say, “ok approved”.  However, approving a loan where you have verified the income and know that the borrower’s income is insufficient is simply irresponsible .

What Does This Man Do All Day???

What's an economy?

The Wall Street Journal reports today that the President expressed surprise that the bailout bill did not pass. Earlier in the day, White House spokesman Tony Fratto had predicted that the vote would pass. One has to wonder what kind of indifferent involvement there was by the White House if they had no idea how many members of their own party were not going to go along with the President’s plea to pass the bail out bill.

Someone not familiar with the structure of our government and reading the financial press for the past year, could easily be pardoned for assuming that our country was being ruled by Ben Bernanke and Henry Paulson, whose decision making powers seem to be unlimited yet still have had no ability to forestall the deepening loss of confidence and the rapidly escalating meltdown of the world financial system. Is it possible that the President did not want to get engaged, believing that his Treasury Secretary and the Federal Reserve would solve all our financial problems in short time? I think the more likely answer is that President Bush never had and still has no comprehension of the magnitude and dangers of the financial crisis that has been unfolding in ever more frightening ways over the past two years. Apparently aroused from his slumber a week ago by dire forecasts of an imminent meltdown, he gave a national speech that was so dumbed down and ineffective, you have to wonder what audience he thought he was speaking to. Obviously, the President wasn’t even able to convince members of his own party, that the bailout made sense and could never overcome the popular notion that the bailout was simply another handout to Wall Street.

My own perception is that even if the bailout is passed, it will not accomplish what the powers to be were expecting. Confidence worldwide has been shattered by huge losses on virtually every asset class. The perception that loss avoidance is better than taking any risk for a gain will remain with us for some time, especially with the daily collapse of large institutions. Few saw this collapse coming and none know how it will ultimately end.