June 23, 2024

Archives for January 2009

Congress Proposes Cram-Downs As New Mortgage Solution

The plight of homeowners delinquent on their mortgages has been the focus of much debate lately.  There have generally been two major lines of thinking:

-The best course is to let free market principles apply.  If homeowners cannot afford the mortgage payment, the old fashioned remedy of foreclose should take place, turning an overburdened homeowner into a renter.

-Those more inclined to assess the loss of a home in terms of human suffering rather than as an economic equation have sought to provide relief to struggling homeowners by modifying the terms of the original mortgage.

As the number of mortgages in default grew, the situation attracted the attention of politicians.  Their viewpoint seemed to focus on helping the homeowner stay in the home, regardless of cost.

The governments’ efforts to encourage the banking industry to cure the foreclosure problem through voluntary participation in loan modifications was a failure.   For a variety of reasons the loan mods were not working.   Data from the Comptroller of the Currency shows that over 50% of modified loans re-defaulted within 6 months.  With many loan mods, payments went up for the borrowers and principal was hardly ever reduced.  The loan mods actually left many borrowers in a worse position than when they started.  In addition, most of them had negative equity before and after the loan mod.  The negative equity position locked them into the house, unable to sell or refinance.

Today, from Washington, a new solution – giving bankruptcy courts the power to alter the terms of the original mortgage.

Lawmakers Set New Mortgage Bankruptcy Bill

WASHINGTON (Reuters) – Legislation designed to stem foreclosures by allowing bankruptcy judges to erase some mortgage debt will be introduced by Congressional Democrats on Tuesday, and hopes are high that it will pass after a similar plan failed last year.

“Economic conditions have only worsened since we last debated this plan,” said Rep. Brad Miller, a member of the House Financial Services Committee who plans to introduce a bankruptcy reform bill on Tuesday. “Until we stop the slide in foreclosures and falling home prices, the economy will get worse still.”

The legislation would change allow bankruptcy judges to modify home loans in the same way that they currently may modify other unsettled obligations, such as credit card debt.

The lending industry has said that allowing bankruptcy judges to modify mortgage obligations would change how they weigh risk. Currently a lender knows that it has recourse to foreclosure if a borrower fails to meet mortgage payments, but the lender does not have to factor in the possibility that the payments it receives could be decreased by a judge.

What will be the impact of allowing bankruptcy judges to discharge (cram-down) mortgage debts?  Some of the issues and questions to be considered include the following.

1.  Interest rates are correlated to risk – that’s the way things work in a free market.   If a mortgage loan is made with the risk of principal impairment by bankruptcy, this risk has to be priced into the loan rate.  Reducing mortgage principal by legislative fiat may bring unintended adverse consequences.

According to The Mortgage Bankers Association “It is our position that if this proposal were to become law, mortgage rates would increase by at least one and a half points. In addition, lenders will be forced to require higher down payments and charge higher costs at closing. All these increased costs would be necessary to account for the new risks that lenders will face when judges decide to change how much borrowers owe on their mortgages.”

2.  Since total mortgage delinquencies are less than 10% and not all of these cases will wind up in bankruptcy,  cram downs might help less than 5% of mortgaged homeowners.   If the MBA is correct and mortgage rates rise significantly due to cram downs, expect a significant backlash from the other 95% of mortgaged homeowners who will wind up paying for the losses through higher interest rates.

3.  According to The Housing Wire, 50% of Americans oppose bailing out troubled homeowners. “These findings indicate that there are significant political barriers to proposals now being drafted in Congress”

The bankruptcy discharge of a mortgage balance will be viewed by many as the ultimate bailout.  The final compromised bill may result in contorted regulations that ultimately benefit few homeowners.

4.  The free market has a solution for “troubled homeowners” which is known as foreclosure.  Does the free market solution lose all merit merely because the number of foreclosures increased dramatically due to imprudent borrowing and lending?

5.  According to Rep. Brad Miller, “Until we stop the slide in foreclosures and falling home prices, the economy will get worse still.”   Rep. Miller is confusing a symptom of the disease as the cause.  Falling home prices did not cause our economy to weaken.    The housing asset bubble that burst was due to reckless lending, fueled by a government providing easy credit and obsessed with making everyone a homeowner. Political interference in economic matters usually delays a solution by impeding the free market forces that will ultimately prevail anyways.

6.  If the mortgage cram down bill is passed, it will drive many homeowners to bankruptcy, lured by the promise of wiping out mortgage debt.   The loan modification program allowed the banks to pretend that the amount they were owed would still be repaid over time.  When the loan gets reduced in bankruptcy, this illusion will be gone.  More write offs by the banks could lead to a self defeating cycle of tighter credit, stricter mortgage underwriting, weaker housing prices and further bailouts.

7.  How many homeowners that are incapable of handling the burden of home ownership will be allowed to remain in their homes, only to face foreclosure again at a later date?

8.  Continued massive government support of the mortgage market will be necessary since investor demand for mortgage securities is likely to remain low due to collapsing housing prices and the risk of mortgage debt being discharged by bankruptcy. How does an investor properly price a mortgage security where the asset value underlying the security is declining and also face the risk that the principal investment may be impaired by court decree?

9.  The Fed is now expected to absorb virtually all of the new mortgage backed securities this year.   With the Fed extending its purchases into virtually every asset class, a question comes to mind.  As the Fed assumes the losses of all failing economic entities in the country, at what point does the US Government begin to share the credit quality of those being bailed out?

Job Losses Continue – “Unprecedented Economic Conditions”

Job losses continue to dominate the headlines in 2009.

Logitech To Slash 15% Of Work Force

ZURICH (Reuters) — Logitech International SA, the world’s largest computer-mouse maker, said it plans to cut 15% of its workforce and withdrew its fiscal 2009 financial targets, citing deepening global recession.

“During the December quarter, the retail environment deteriorated significantly,” Chief Executive Gerald Quindlen said in a statement on Tuesday, adding that the company expects the economic environment to worsen in coming months.

Cigna To Cut 1,100 Jobs

LOS ANGELES (Reuters) — Health insurer Cigna Corp. said Monday it will cut 1,100 jobs, or about 4% of its workforce, and consolidate certain operations as it copes with the economic downturn.

“Given the unprecedented economic situation we and our customers are facing, these actions are essential to ensure we can meet their needs for high-value, cost-effective products and services,” Chairman and Chief Executive H. Edward Hanway said in a statement.

The Cigna news follows a similar announcement last month from No. 3 health insurer Aetna, which said it would cut 1,000 jobs, or about 3% of its workforce, by the end of 2008.

UnitedHealth Group Inc., the largest U.S. health insurer by market value, said in July it was cutting some 4,000 jobs, or about 5% of its workforce, over the course of a year.

Alcoa to Cut 15% of Work Force, Unload Assets

Alcoa Inc. announced the elimination of about 15,000 jobs, more plant closures, plans to sell assets and a 50% cut in capital expenditures to contend with the sustained recession.

“Many of these things are painful and many of these things are drastic,” Alcoa Chief Executive Klaus Kleinfeld said in an interview Tuesday. “We will continue to monitor the dynamic market situation to ensure that we adjust capacity to meet any future changes in demand and seize new opportunities.”

Alcoa lost much of its luster in the recent commodity boom, failing to match the profit rise of other mining and metals companies, including rivals Rio Tinto Aluminum and UC Rusal. Both of those companies have also announced major cuts, shutting operations and selling businesses such as operations in China.

About 15% of the company’s employees and contractors will lose their jobs. Alcoa also is freezing salaries and hiring.

One day’s results – 3 companies cut over 17,000 jobs resulting in hard times and unemployment for many families.  Job losses have been an ongoing event and promise only to get worse as the job losses ripple throughout the economy.

The common theme in many of the layoffs is the eye popping size of the job cuts and company statements that conditions deteriorated significantly.  The size of the cuts do not suggest a typical slowdown but rather a “falling off the cliff” economy.

The only possible positive view one can take here is that when the news is this bad, it has to get better.

Fed’s Asset Purchases Continue To Expand

The $8 Trillion Dollar Bailout

NEW YORK (CNNMoney.com) — Sitting down? It’s time to tally up the federal government’s bailout tab.

There was $29 billion for Bear Stearns, $345 billion for Citigroup. The Federal Reserve put up $600 billion to guarantee money market deposits and has aggressively driven down interest rates to essentially zero.

The list goes on and on. All told, Congress, the Treasury Department, the Federal Reserve and other agencies have taken dozens of steps to prop up the economy.

Total price tag so far: $7.2 trillion in investment and loans. That puts a lot of taxpayer money at risk. Now comes President-elect Barack Obama’s economic stimulus plan, some details of which were made public on Monday. The tally is getting awfully close to $8 trillion.

The amount of $8 trillion is incomprehensible to most people, including myself.   But there is an interesting way to contemplate the amount of $8 trillion dollars.  The total amount of home mortgage debt outstanding in 2008 amounted to only $10.6 trillion (see Mortgage Holiday).  If the government had simply used the $8 trillion to directly payoff consumers’ mortgage debt, all of us could have seen an 80% reduction in our mortgage payments!  Go figure.

Stop the Bankruptcy Cram Down

As Congress debates legislation to empower the Treasury to purchase troubled mortgage-related assets, some are trying to weigh the bill down with ancillary, unnecessary provisions. The one which concerns us the most is a provision that would allow bankruptcy judges to unilaterally change the terms of many mortgage loans, including the loan balance, as part of Chapter 13 bankruptcy proceedings. By granting judges this power, this bill would throw into question the value of the collateral that backs every mortgage made in this country — the home.

The fact remains that the lending community remains united against this idea. It is our position that if this proposal were to become law, mortgage rates would increase by at least one and a half points. In addition, lenders will be forced to require higher down payments and charge higher costs at closing. All these increased costs would be necessary to account for the new risks that lenders will face when judges decide to change how much borrowers owe on their mortgages.

Interest rates are correlated to risk – that’s the way things work in a free market.   If a mortgage loan is made with the risk of principal mark downs in bankruptcy, this risk has to be priced into the loan rate.

During the bailout vote, Democratic Senator Dick Durbin of Illinois argued for the right to give bankruptcy judges the ability to change the terms of a mortgage.  With the change of power in Washington, the odds of mortgage cram down legislation passing is very high.

Since total mortgage delinquencies are less than 10% and not all of these cases will wind up in bankruptcy,  cram downs might help less than 5% of mortgaged homeowners.   If the MBA is correct and mortgage rates rise significantly due to cram downs, expect a significant backlash from the other 95% of mortgaged homeowners who will wind up paying for the losses through higher interest rates.

Mortgage/Treasury Spreads Reflect Risk

Bloomberg) — Federal Reserve officials are focused on driving down the spreads between U.S. Treasury yields and consumer and corporate loans, after cutting the main interest rate to almost zero failed to revive lending.

Credit costs for households and businesses haven’t followed yields on government debt lower. Fifteen-year fixed-rate mortgages were at 5.06 percent last week, 2.59 percentage points above 10-year Treasury yields; the spread averaged 0.88 point in 2003, when the Fed slashed rates to 1 percent.

Chairman Ben S. Bernanke sees the thawing of frozen credit markets as critical to a recovery, and is determined to try to prevent a second wave of credit distress as the U.S. weathers bad economic news over the next two quarters. The Fed is now looking at ways to revive lending by using its balance sheet to hold loans and bonds that investors don’t want.

“Investors in general don’t want to take on the risk,” said Richard Schlanger, who helps manage $15 billion in fixed income securities at Pioneer Investments in Boston. “It is going to reach the point where the Fed will intervene again.”

If spreads between treasuries and mortgages followed the historical norm, mortgage rates on both the 15 and 30 year mortgage would be at least 1.5% points lower.   The question that is not addressed, of course, is how much higher would mortgage rates be without government price support?  Since private buyers see a poor risk/reward ratio in owning mortgages, does the government establish a permanent presence as mortgage lender of last resort?

In addition to providing price support to mortgages, we now have a Federal Reserve pledging to bring down consumer and corporate lending rates as well.   The announcement that the Fed would be buying mortgage backed securities brought down mortgage rates.  Can the Fed do the same in other debt markets by purchasing securities that free market investors view as too risky to own?

With the Fed extending its purchases into virtually every asset class, a question comes to mind.  As the Fed assumes the losses of all the failing economic entities in the country, at what point does the US Government begin to share the credit quality of those they are bailing out?

Home Ownership Turns Into Nightmare For Many

The government’s obsession with making everyone a homeowner, regardless of qualification, has resulted in misery for millions and trillions in financial losses.  Here’s another example of our failed social experiment.

Housing Push For Hispanics Spawns Wave of Foreclosures-WSJ

California Rep. Joe Baca has long pushed legislation he said would “open the doors to the American Dream” for first-time home buyers in his largely Hispanic district. For many of them, those doors have slammed shut, quickly and painfully.

Mortgage lenders flooded Mr. Baca’s San Bernardino, Calif., district with loans that often didn’t require down payments, solid credit ratings or documentation of employment. Now, many of the Hispanics who became homeowners find themselves mired in the national housing mess. Nearly 9,200 families in his district have lost their homes to foreclosure.

For years, immigrants to the U.S. have viewed buying a home as the ultimate benchmark of success. Between 2000 and 2007, as the Hispanic population increased, Hispanic homeownership grew even faster, increasing by 47%, to 6.1 million from 4.1 million, according to the U.S. Census Bureau. Over that same period, homeownership nationally grew by 8%. In 2005 alone, mortgages to Hispanics jumped by 29%, with expensive nonprime mortgages soaring 169%, according to the Federal Financial Institutions Examination Council.

An examination of that borrowing spree by The Wall Street Journal reveals that it wasn’t simply the mortgage market at work. It was fueled by a campaign by low-income housing groups, Hispanic lawmakers, a congressional Hispanic housing initiative, mortgage lenders and brokers, who all were pushing to increase homeownership among Latinos.

The full article is well worth reading as it details how reckless lending and borrowing by numerous players, some corrupt and others simply stupid, helped to cause the greatest housing crash in history.

The country has now learned the hard way that home ownership is not the best option for many people.   See Long Term Housing Stability Based On Strong Borrowers.

If sound underwriting guidelines had not been abandoned over the past 10 years, the rate of home ownership would have been marginally lower and we never would have had a housing boom or a housing bust.  We would have all been better off without either.

Stay Long SSO & DIA

My initial assessment on December 3rd that the world had run of sellers has been a win so far – see Breathless Hysteria Overdone?

I am maintaining my long positions in SSO and DIA.

Although not quite as bullish as I was a month ago, my thoughts remain the same:

Markets discount bad news and this market has discounted everything except the end of civilization.  The talking head predictions of doom dominate the headlines.   Today is probably psychologically equivalent  to when oil was peaking at $150 and predictions of $300 dominated the headlines.

Without bothering to consider what the future will bring, at this point there is money to be made on the long side.   The market is extremely oversold.  Nothing goes in a straight line.  High quality Dow stocks have 5-7% dividends.  The Fed’s zero interest rate policy will force money into higher risk investments.  There is optimism building about a new Administration.

Returns on SSO and DIA from December 3, 2008 closing to January 2, 2009 closing.

It is interesting to note that the DIA, an ETF structured to provide investment results that, before expenses, match the price and yield of the Dow Jones Industrial Average returned 4.8% vs 5.1% for the DJIA.

The SSO, an ETF designed to return twice the performance of the S&P 500, returned 12.3% vs a gain of 7.0% on the S&P500.

Generally speaking, the ETF’s worked as they were theoretically supposed to.

Under my theory of selective contrarian investing, which has served me well, this may be the time to start moving into selective issues in the oil and gas industries and to start selling positions in long treasuries.   Given the vast over performance of treasuries last year and the dismal results in oil and gas, the odds favor this investment reallocation on a long term basis.

I will be buying DIG this week and adding to positions on weakness.

Let’s all have a prosperous New Year!

Charts courtesy of Yahoo Finance

The Risk Of Higher Mortgage Rates

Mortgage rates again ticked higher Friday as the treasury market continued its sell off.  Most of the good news may already be priced into the treasury market that mortgage rates are based on.

Reasons why mortgage rates may increase:

1.  As the Fed’s efforts to stabilize the credit markets succeed, frightened money is moving out on the risk curve, selling treasuries and purchasing much higher yields on corporate debt, preferred and common stock and municipals.  To the extent that the Fed is calming the credit markets, their actions are  counterproductive to lower mortgage rates.

2.  The Fed’s announcement in late November of their intention to buy half a trillion dollars of mortgage backed securities is what kicked the mortgage rate decline into high gear.  Most of this may now be fully discounted.  The actual announcement of the purchase schedule of the MBS’s did nothing to lower rates.

3.  Without the backing of conventional mortgages by the government, mortgage rates would be much higher.   This can be seen from pricing in the jumbo fixed rate mortgage market where rates are as much as 2 to 3% higher since Fannie and Freddie do not purchase or guarantee these mortgages.  Many banks effectively do not offer jumbo mortgages since there is no secondary market for them.

4.  Continued massive government support of the mortgage market will be necessary since investor demand for mortgage securities is likely to remain low due to collapsing housing prices and the risk of mortgage debt being discharged by bankruptcy and loan modifications. How can an investor properly price a mortgage security where the asset value underlying the security is declining and also face the risk that the principal investment may be impaired by court decree?

5.  The question of how much financial support the government is able to continue to provide to subsidize mortgage rates becomes important, especially as bailout demands escalate.  There are reports today that the State governors are seeking $1 trillion in bailout support as their deficits grow.  Unless the funding ability of the US Treasury is infinite, price support for mortgages may be reduced.  The Fed is now expected to absorb virtually all of the new mortgage backed securities this year.  Meanwhile, the debt of the US Government continues to explode, possibly beyond the point where the debt can ever be repaid.  This scenario implies higher rates on all government backed debt.

Many investors expect the eventual outcome of the Fed’s quantitative easing campaign to result in much higher inflation.  Some very astute investment managers, who had correctly predicted the financial meltdown now view the treasury market as overpriced.

  • Jeremy Grantham of GMO describes the 30 year treasury bond as “ridiculously” overpriced and effectively forecasting only a 1% annual rate for the next three decades.  Mr Grantham sees the scenario where there could easily be a large surge in inflation.
  • Bob Rodriquez who runs the FPA New Income Fund and was up on the year in 2008 also sees a “massive bubble in treasurys”.  He is not buying treasurys since “We will not lend long term money to a borrower that capriciously erodes its balance sheet.”
  • Peter Schiff of EuroPacific Capital also sees a substantial risk of massive inflation and sharply higher interest rates at some point.   Eventually foreign investors will refuse to buy US Government debt based on concerns about the US ability to repay its debts.

The above scenarios may not be imminent but they do become more probable as the US Government depletes the Treasury with endless bailouts, guarantees and borrowing.

The Good News About Retail Sales

Business Week reports bad news that is actually good news.


The Economy That Stole Christmas

It was just as bad as experts had feared—and maybe even worse. Retail sales for the Nov. 1-Dec. 24 season sagged between 5.5% and 8% from 2007, according to MasterCard (MA) SpendingPulse, which tracks credit-card, cash, and check outlays. Wintry weather on the weekend before Christmas added insult to injury. E-commerce suffered least, down only 2.3%, boosted by healthy sales at Amazon’s (AMZN), Apple’s (AAPL), and Wal-Mart’s (WMT) sites. Now, get set for the fallout: The International Council of Shopping Centers projects 73,000 stores will shut their doors in the next six months. On Dec. 28th, Parent Co. (KIDS), a baby products company, filed for Chapter 11.

Reasons Why The Bad News Is Good News: Consumers Become Frugal

The American consumer may finally be starting to spend less than he earns.

The easy credit that made many of us big spenders and big debtors is over.

The savings rate is starting to increase as less is spent and more is saved.

The realization that our financial security will not rest on eternally appreciating stock and home values.

The downside of excessive leverage and debt can be devastating.

The ridiculous fact that many of our purchases wind up in our closets unused.

The American consumer is adjusting to reality by spending less, being frugal and saving more for an uncertain future.  Now if only our government would follow our example, everything would work out fine.

Promises That Cannot Be Kept

Did Bernard Madoff run the biggest Ponzi scheme of all time, or does this honor actually belong to the US Government?

Is Social Security A Ponzi Scheme?

In the aftermath of the Madoff implosion, quite a few people have pointed out the parallels between a Ponzi scheme and Social Security. Arnold Kling, whom I respect, has written:

I’ve been thinking that Madoff is a perfect analogy for the public sector. The government gives people money, which it expects to obtain by taking the money from people in the future. Even the Center on Budget Policy and Priorities, not known as a right-wing organization, sees the U.S. fiscal stance as unsustainable (pointer from Ezra Klein via Tyler Cowen)—in other words, a Ponzi scheme.

Other people have gone farther. Paul Mulshine of the New Jersey Star Ledger wrote a column entitled “The Ponzi scheme that Baby Boomers are waiting to cash in on.” And Jim Cramer has called Social Security the biggest Ponzi scheme in history.

The article above discussed only social security and not the other two financial time bombs – medicare and medicaid.  The net present value future cost of these three programs is estimated at $52 trillion, a burden that we have thrown on future generations who may be unwilling or unable to pay.

Wages have been stagnant for a decade.  Politicians are afraid to raise taxes and voters don’t want to pay so the easy solution is to borrow the money and add more debt, a self defeating cycle.   Promises and free lunches are great ways to get elected but governments only redistribute wealth.   Without the ability to tax the productive capacity of its country’s labor force, a government would have no fiscal capacity.

Debts do matter, of course, it’s just common sense.  Merely because a governmental entity has taken on the debt in the name of the taxpayer does not mean we can get a free lunch.  Ultimately we fool ourselves to believe that debt obligations are not a problem –  the world learned this in 2008.   The government can promise all of us everything and we can keep electing the fools who say what we want to hear, but ultimately someone has to pay for the promises or they will not be kept.

The Terminal Debt Trap

US Could Be Facing Debt “Time Bomb” This Year

WASHINGTON – With President-elect Barack Obama and congressional Democrats considering a massive spending package aimed at pulling the nation out of recession, the national debt is projected to jump by as much as $2 trillion this year, an unprecedented increase that could test the world’s appetite for financing U.S. government spending.

Despite those actions, the economic outlook has continued to darken. Now, Obama and congressional Democrats are debating as much as $850 billion in new federal spending and tax cuts to create or preserve jobs and slow the grim, upward march of unemployment, which stood in November at 6.7 percent.

Congress is not planning to raise taxes or cut spending to cover the cost of those programs, because economists say doing so would further slow economic activity. That means the government has to borrow the money.

Economists from across the political spectrum have endorsed the idea of going deeper into debt to combat what many call the most dangerous economic conditions since the Great Depression.

“When you accumulate this amount of debt that we’re moving into, it’s not a given that our foreign friends are going to continue on the path they’ve been on,” said G. William Hoagland, a longtime Republican budget analyst who now serves as vice president for public policy at the health insurer Cigna. “There’s going to come a time when we can’t even pay the interest on the money we’ve borrowed. That’s default.”

The unanimous conclusion of the politicians and economists seems to be that we can borrow our way to prosperity via fiscal stimulus conducted with borrowed funds or printed money.

It is, of course, delusional to think that we can spend and borrow our way out of a financial crisis caused by over spending and over borrowing.   The reason we are in a financial crisis is due to excess leverage and credit at every level of our economy.  The attempt to subvert free market solutions by socializing every loss will only expand and prolong our economic mess.

Foolish politicians promising easy and painless solutions are pandering at best.   Quantitative easing, fiscal stimulus, bailouts and guarantees are no solution.   We have a crisis because we spent our future.  The solution of hard work and a lower standard of living will eventually be forced upon us.   Massive new spending and borrowing at this point only brings us closer to a terminal debt trap where we have neither the capacity to repay nor the ability to borrow.