June 23, 2024

Archives for May 2009

Sanity Returns to Mortgage Lending – After Trillions In Losses

Liar Loans To Become Illegal

Case Closed on Liar Loans

Case Closed on Liar Loans

New legislation passed by the House will outlaw “stated income”  mortgage loans (commonly called liar loans).

WASHINGTON — The House voted Thursday to outlaw “liar loans,” ballooning mortgage payments and other bank practices that lawmakers say preyed on consumers who couldn’t afford their homes.

The proposal, by North Carolina Democratic Reps Brad Miller and Melvin Watt, is one of several that Democrats are pushing to tighten controls on an industry that critics say undermined the economy by underwriting risky loans, then passing them off to investors.

The bill passed 300-114, with many Republicans contending it would limit consumers’ options and restrict credit.

Democrats said it would ban only the most egregious lending practices and wouldn’t keep most people from getting a mortgage they can afford.

Under the bill, banks offering other than traditional fixed-rate mortgages would have to verify a person’s credit history and income and make a “reasonable and good faith determination” that a loan can be repaid. This provision is aimed at eliminating high-risk credit lines that became known as “liar loans” because they required little or no documentation.

Banks also would have to make sure the loan provides a “net tangible benefit” for the consumer.

What Congress is saying is that banks should not lend in a situation where the borrower cannot provide proof of income or has a poor credit history.  Inadequate income and poor credit have always been two factors that imply high risk of  loan default.  In other words, the banks need legislative action to outlaw practices that they should never have  engaged in to begin with.

Niche Lending Gone Astray

Lending to borrowers who cannot provide proof of income and have poor credit has been going on for decades, first by small private “hard equity” lenders and later by (the now defunct) sub prime mortgage lenders such as Countrywide (now part of Bank of America).  Typically, such loans were made at high rates and at low loan to values, reflecting the very high risk of loan default.   Lenders knew the risk and priced accordingly – borrowers knew that not paying back the loan would likely mean the loss of their home which was the collateral for the loan.

Various situations made this type of lending sensible on occasion for both borrowers and lenders.  For example, a homeowner facing a sudden financial emergency could borrow against his home and hope that his situation would improve.  Borrowers who for various legitimate reasons could not verify income, were allowed access to credit.  Small business owners wanting to expand or open a new business could access risk capital that would otherwise not be available.

Unfortunately, Wall Street and the Banking Industry combined forces to turn a small segment of the mortgage industry into a colossal part of their lending operations – greed overrode sound lending and the sowed the seeds for the biggest housing and banking bust in US history.   The legislation to outlaw liar loans should have happened  five years earlier if regulators had been doing their jobs properly.

Some Thoughts on the New Legislation

It is not clear if the legislation outlaws stated income loans only by lending institutions regulated by state or federal agencies.  If private lenders wish to risk their capital without regard to income or credit criteria they should be allowed to do so with informed borrowers.

Banking institutions whose deposits are protected by the FDIC and whose losses are ultimately paid for by the taxpayer should not be allowed to engage in unsound, high risk lending practices.  The very nature of lending without regard to credit or income implies a very high risk loan that should not be backed up by taxpayer funds.

The requirement that there be a “net tangible benefit” to the borrower when engaging in a mortgage transaction is also another sound rule meant to eliminate abuses.  In the past, there were situations in which a borrower could pay closing costs that far exceeded any benefit of cash out or payment reduction.  Does it really make sense to charge a borrower $15,000 in closing costs while the borrower walks away with maybe $5,000 cash and a higher monthly payment?   This type of law is not a restriction on free enterprise – it merely protects the foolish or desperate borrower and prevents some of the egregious lending abuses that have occurred in the past.

Had it not been for the outrageously reckless lending policies engaged in by the banking industry, this new law would not have been necessary.   Although I believe that less  government regulation is usually better, this is one case where it should be welcomed.  Since the lending industry could not properly institute sound lending policies, it is only appropriate that the government  establish guidelines.

A Law That Should Have Never Been Necessary

Consider the message that the House is sending to the banking industry –  loans should not be made to borrowers who cannot afford the loan payment!  The fact that Congress had to pass this type of legislation is an indictment of the banking industry’s judgment and conduct and a reminder of how ongoing absurd situations can be viewed as normal – until the house of cards collapses.

Insiders Lose Taste For Chipotle

Insiders on Selling Rampage

Led by Chief Executive Steve Ells, Chipotle Mexican Grill (CMG) insiders sold over 230,000 shares in April.   This large number of sales by insiders has investors wondering if they should follow the lead from those who know the company best.

Chipotle Grill was one of Wall Street’s most successful initial public offerings, soaring from the IPO price of $22 in early 2006 to $150 at year end 2007.   The stock sold off to a low of $36.86 during the 2008 market crash but has subsequently soared back to $81 per share.

CMG

CMG

Courtesy: yahoo.com

Why Diversify Now?

CMG has a very strong balance sheet, the latest quarter shows revenue growth of almost 20% and the stock price is rebounding.  Why, with such good news, would insiders have sold almost as many shares in April 2009 as they have sold in total since the company went public?    The company’s spin on the reason for the huge sale of shares came right out of the standard public relations manual.   A Chipotle spokesman said that the reason for the stock sales was due to a desire by company insiders to “diversify” their holdings.

The big unanswered question, of course, is why the sudden urge to diversify at this point in time?  Many of the shares sold were from recently exercised stock options, so the standard diversification reason may have some merit.   As an investor, however, it is better to watch what the owners of a company do, rather than what they say.  No matter how strong the urge to “diversify”,  no one sells large amounts of stock if he thinks the stock price is heading higher.   Insider behavior here suggests that CMG may see weaker earnings and a lower stock price in the near future.

Shorts Bet Big On Chipotle

Another indicator that someone is betting big on a decline in CMG is shown in the latest short interest figures reported as of April 15, 2009.  Although the total short interest declined by 7.5% to 6.9 million shares, CMG is ranked number 31 on the NYSE list of companies having the largest short interest ratio.  The shorts are aggressive in CMG and are obviously looking to cover at lower prices.   Eat the tacos – avoid the stock.

New Twist On Stimulating Economies – Work Less

Desperation Produces Silly Suggestion yen

Governments worldwide are obsessed with pushing consumers to spend more.  From Japan we now have a new twist on how to stimulate spending.   Government bureaucrats (with obviously too much time on their hands) are mulling the stimulus  impact on Japan’s economy if workers were forced to take more vacation time.    Consider the logic as described in Businessweek:

Some 92% of Japanese workers don’t use up their vacation time, a recent global survey by travel site Expedia found. On average, they use 7 of an allotted 15 days each year. Prime Minister Taro Aso’s administration says the vacation law could spur $121 billion in spending and generate 1.5 million jobs. Critics say it may hurt struggling companies—and fail to loosen up outlays for leisure. Many Japanese “live to work,” says Toshihiro Nagahama, senior economist at Dai-ichi Life Research Institute, “and wouldn’t know how to enjoy more vacations.

Whether the Japanese are workaholics or simply like to spend time away from home is up for debate.  The issue not up for debate is whether this silly proposal will create new jobs.  Companies do not conduct new hiring to make up for employee vacations, and economies produce less wealth when there are fewer people productively employed.   The Japanese government simply seems to be out of intelligent options after attempting to stimulate the hell out of Japan for the past two decades with little success.

Big Picture

The Japanese bureaucrats are missing the big picture.  The Japanese worker (as in many other countries) does not need more vacation time to spend money they don’t have; they simply need more income.   The Japanese saving rate as a percentage of income has been high by necessity.  With real estate and stocks prices lower than they were 20 years ago, the Japanese cannot rely on asset inflation to increase their net worth.  Savings can only come from incomes which have been stagnant for decades and now dropping sharply due to the recession in Japan.

Bloomberg — Japan’s wages dropped at the steepest pace in more than six years in March as manufacturers slashed overtime pay to cope with a collapse in exports.

Monthly wages, including overtime and bonuses, dropped 3.7 percent from a year earlier, the most since July 2002, the Labor Ministry said today in Tokyo.

Overtime payments slid an unprecedented 20.8 percent as manufacturers cut extra working hours by a record 49.5 percent, the report showed. The government has been tracking the figures since 1990.

Governments Shooting At The Wrong Target

Governments world wide are obsessed with pushing customers to borrow and spend.  They are all shooting at the wrong target.  The borrowing and spending will come naturally to most people if they are confident in their job security and confident of increases in real wages.  Right now their is scant confidence for either outcome with job losses in the millions and widespread salary reductions or freezes.

Making matters even worse for the thrifty Japanese is that the interest earned on their savings is virtually zero at the short end and a paltry coupon of 1.3% on 10 year Japanese government bonds.   Savers like to see their savings increase every year and the only way to accomplish this is to save more and spend less.  Bringing rates to virtually zero to help the over leveraged has ironically resulted in punishing the savers who theoretically provide capital to borrowers.

Japan’s economic mess will not improve  without addressing the lack of real growth in incomes and jobs and the low return on savings.  Fix these problems and the rest will take care of itself.

FHA 203k Program – Financing Uninhabitable Homes

Good Intentions Gone Astray?

Vacant - Please Destroy

Vacant - Please Destroy

The Federal Housing Administration (FHA) currently provides over one third of all mortgage financing.  One unique mortgage program the FHA offers is the “Rehabilitation Loan Program (203k)”.

The benefits and features of the 203k program according to the FHA are as follows:

Funds for Handyman-Specials and Fixer-Uppers

The purchase of a house that needs repair is often a catch-22 situation, because the bank won’t lend the money to buy the house until the repairs are complete, and the repairs can’t be done until the house has been purchased.

HUD’s 203(k) program can help you overcome this obstacle by enabling you to purchase or refinance a property plus the cost of making the repairs and improvements in one mortgage.

A potential homebuyer locates a fixer-upper and executes a sales contract after doing a feasibility analysis of the property with his/her real estate professional. The contract should state that the buyer is seeking a 203(k) loan and that the contract is contingent on loan approval based on additional required repairs by the FHA or the lender.

If the borrower passes the lender’s credit-worthiness test, the loan closes for an amount that will cover the purchase or refinance cost of the property, the remodeling costs and the allowable closing costs.

An iron clad rule that I have observed is that government programs once enacted never end even after they serve no useful purpose. In a different time, the 203k program made a lot of sense by revitalizing a community. It also allowed a home buyer the opportunity to acquire a property at a low price and through “sweat equity” rehabilitate the property and increase the value of the home.

Does The 203k Program Still Make Sense?

The collapse in home values and the wave of foreclosures require a reassessment of the FHA 203k program due to the huge number of vacant homes in the country.

(Bloomberg) — A record 19 million U.S. homes stood empty at the end of 2008 and homeownership fell to an eight-year low as banks seized homes faster than they could sell them.

The U.S. had 130.8 million housing units in the fourth quarter, including 2.23 million empty homes that were for sale, the Census report said. The vacancy rate was 3.5 percent in urban areas and 2.6 percent in suburbs, the report said.

U.S. banks owned $11.5 billion of homes they seized from delinquent borrowers at the end of the third quarter, according to the Federal Deposit Insurance Corp. in Washington. That’s up from $5.4 billion a year ago.

Many of the vacant homes that the FHA is lending on through the 203k program are currently empty due to the fact that they are uninhabitable (no utilities, gutted interiors, major damage, etc)  and being sold for little more than the value of the land they sit on.   Do we as a nation really need to allocate more of our limited resources to housing when we already have millions of existing vacant homes?  Would it not be more cost effective to tear down the gutted houses and put potential homeowners into a vacant home that needs minimal repairs?

Of course, once the vacant home is rehabilitated via the 203k, there is more than a 1 in 10 chance of the borrower defaulting on the new FHA loan and the home potentially becoming vacant again (See FHA – Ready To Join Fannie and Freddie.)

Low Rate Credit Cards That Make Sense

Good Deal

Good Deal

Make Your Credit Card Work For You

Many consumers with impeccable credit have seen huge rate and fee increases imposed on them recently by the major credit card companies – see Pay Back Time For Credit Card Companies.

There are many well run, lesser known card issuers who lent responsibly and do not have to charge exorbitant rates to cover large credit losses.   Many of these card issuers have tougher underwriting standards but their rates reflect the lower credit risk of customers that they approve.    Many of these card issuers also offer substantial benefits to their customers in the form of cash rebates or travel miles.

If you have great credit and are annoyed by the manner in which your current card issuer has treated you, it is certainly worth the effort to see what the competition is offering.  The new credit card legislation restricts some of the more obnoxious tactics employed by many large card issuers but does not do much to restrict the interest rate or fees  charged to A+ customers who deserve better treatment.

The Credit Card Good Guys

Many smaller banks and credit unions are offering some of the better deals in the credit card industry.  Since credit cards are a basic necessity for most of us, it’s worth shopping around for the best deals.  Here’s a sampling, courtesy of Kiplinger.

Credit Cards You’ll Love

Pentagon Federal Credit Union’s Visa Platinum Rewards card. There is no annual fee, and you get a 5% rebate on gas, 2% on groceries and 1.25% on everything else.

Visa Classic card from Pulaski Bank & Trust (soon to be known as Iberia Bank), in Little Rock, Ark. The 0% balance-transfer offer is good for six billing cycles, and there is no transfer fee.

The BP Visa gas card earns a 5% rebate on gas, 2% on travel and dining, and 1% on everything else. Plus, you get double rebates for the first 60 days. We also like the Simmons First Visa Platinum Travel Reward card. You earn one point for each dollar spent; it takes 22,000 points for a plane ticket anywhere in the 48 contiguous states.

Despite a $35 annual fee, for a low rate it’s tough to beat Iberia’s Visa Classic cards, with a purchase rate fixed at 6.5%, compared with a national average of about 13%. Farm Bureau Bank’s no-fee Platinum MasterCard currently carries a low, 5.24% variable rate.

For each $2,500 you charge on your Wells Fargo Home Rebate card, the bank applies 1% of that amount to the principal of your Wells Fargo mortgage. Fidelity Retirement Rewards American Express card gives Fidelity account holders a 2% rebate that can be deposited in any Fidelity-managed individual retirement account. The Schwab Bank Invest First Visa card sweeps a 2% rebate into your Schwab IRA or brokerage account.

The new Upromise World MasterCard deposits a 1% rebate on all purchases in your Upromise college-savings account, then adds another 10% rebate on spendng at drugstores and groceries.  Fidelity’s 529 College Rewards American Express card earns a 2% rebate that can go into any Fidelity-managed 529 account.

Pay Back Time For Credit Card Companies

Card Company Practices Draw Heat                                                                                   Credit Cards

The credit card industry has drawn considerable attention in Washington.  It’s the kind of attention that the card industry did not want but probably deserves.   In an effort to reduce mounting credit losses, the credit card industry has increased interest rates and fees and reduced credit lines.   The backlash by consumers has resulted in the  House of Representatives passing the “Credit Card Holders’ Bill of Rights”, which will prohibit some of the more dubious  practices employed by credit card companies.

The new legislation will prohibit retroactive rate increases and the infamous double cycle billing, require 45 days advance notice of rate increases and require that a borrower be at least 18 years of age.

Prior to passage of the new legislation, lobbyists for the card industry were warning of the adverse impact that new legislation would have.

Congressional action may make credit-card debt less attractive to investors, said the American Bankers Association, the American Securitization Forum, the Financial Services Roundtable, the U.S. Chamber of Commerce and others, in a March 30 letter.

House legislation will “have a negative effect on lenders’ ability to offer reasonably priced credit,” said Kenneth Clayton, senior vice president for card policy at the Washington-based ABA, in a statement.

Card lending is unsecured, meaning the bank doesn’t have any collateral to claim when loans go bad. “The industry is taking massive losses on consumer credit across the board,” Kenneth Lewis, CEO of Bank of America, said on April 8. “Banks in the industry are just trying to protect those assets.”

Weak arguments such as these obviously did little to prevent the new legislation.  My advice to the card companies is – make your debt attractive to investors by restricting lending to people who have the ability to pay back their debts.  Sub prime lending of unsecured money to deadbeat customers regardless of rate will guarantee losses.  Responsible lending will allow you to offer “reasonably priced credit”.

Card Companies Victims of Their Own Tactics

The credit card companies have created their own disaster through reckless lending.  For years I have observed credit card companies extending ridiculously large credit lines to borrowers with minimal ability to service their debts.   It was common to see fixed income retirees or low income wage earners with credit card balances far in excess of their yearly income.   Many borrowers, living on the edge, cannot be blamed for accepting the “no questions asked” easy credit and payment terms pushed by the card companies.   The lenders are the ones responsible for ensuring sound lending.

The logical question is why would anyone lend money to people who in the end cannot pay you back?  The answer is that for decades the scheme worked and resulted in huge profits, as noted in Bloomberg.

Citigroup, Bank of America Corp. and the rest of the top seven U.S. card issuers together raked in more than $27 billion in operating profit from credit cards in 2007, according to Bloomberg data. Now they’re mostly earning customer outrage.

It became routine for borrowers to max out credit card debt and then pay it off through a mortgage refinance (using stated income of course) and then repeat the cycle.   This routine produced large profits for the credit card industry until housing went bust.   No surprise that suddenly maxed out and over leveraged customers started defaulting en mass on their credit cards.  Needless to say, the huge losses were quickly transferred onto the backs of taxpayers  via the magic of the TARP program.  Logically reckless borrowers walk away from their debts and reckless lenders get reimbursed for losses – does anyone see a problem here?

As delinquencies spiraled out of control, the card companies implemented new harsh policies to cut their losses. The problem that the card companies face  is that there is no way for them to accurately forecast who will default and who will pay, since they had previously approved cards without bothering to thoroughly verify the borrower’s financial profile – see Capital One’s Losing Strategy. Not knowing the card holder’s income or asset situation and facing huge losses, the credit card industry had no choice but to raise rates and fees for everyone.

The problem with this new “strategy” is that the borrowers willing to pay 18 to 25% interest rates are probably those most likely to default.  No one who has sufficient income and  spends prudently would be willing to owe card balances at ridiculously high interest rates.   Given these circumstances, the customers owing balances on their cards tend to be the highest risk borrowers, which necessitates  higher rates to offset higher losses.  Maybe the credit card guys should rethink their basic lending strategy?

Disclosure: No positions in companies mentioned