Matrix Blog

As I lamented in yesterday’s post Banking On Profits, Not Risks, the lending industry and investors have had short attention spans when it comes to understanding risk. As the housing market continues to either cool or stabilize, depending on what local market is being discussed, a new focal point is arising…lending.

With the housing bubble as a media topic nearly worn out, or even with a few kicks left in it, subprime has taken the torch as one of the next hot (er…sorry) topic. Today alone, the Wall Street Journal had seven stories on subprime lending. And here is an endless supply of other sources on the topic as well.

Institutions looked at subprime as a growth sector in an otherwise highly competitive mortgage landscape. Large fees, higher margins were some of the attractions of the lenders like HSBC, Novastar, New Century Financial and Citigroup. Now its all about damage control.

In today’s Heard on the Street column Subprime Game’s Reckoning Day [WSJ]:

If these so-called subprime borrowers continue to have problems paying their debts, the lenders that target them likely will have to boost how much money they set aside for bad loans, cutting into their bottom lines. That could mean even lower stock prices.

There also is a concern that if the real-estate market remains cool, some borrowers with better credit histories might also begin struggling to make payments on certain popular, but unorthodox, mortgages. These types of loans allow borrowers to skip monthly payments, carry low short-term teaser rates or don’t require detailed financial documentation. If that happens, companies such as BankUnited Financial Corp. and Countrywide Financial Corp. could suffer.

And today, Freddie Mac announced that it will toughen subprime lending standards [Reuters]. Here’s Freddie’s press release. Ever notice how these things are announced AFTER its a problem? After all this is a quasi-government corporation that sets standards for secondary market investors. Seems like there was a lack of foresight on this issue.

Here’s a great primer on the topic by Jouhn Makin called Risk and Return in Subprime Mortgages [AIE].

Tags: Sub-Prime, Freddie Mac

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Weakness in the national housing market hasn’t really hit the banking sector results yet, or so it would appear to be the case. Here are a few thoughts:

Banking Profits/Credit Quality
On Friday the Federal Deposit Insurance Corp (FDIC) announced that banks and thrifts reported record earnings in 2006, the sixth yearly increase in a row. The FDIC is an independent agency of the federal government created to maintain public confidence in the banking system.

However, credit quality of mortgage loans has fallen as evidenced by the increase in mortgages that are more than 90 days delinquent and the increase in charge-offs.

Residential mortgage loans that were noncurrent (90 days or more past due or in nonaccrual status) increased by $3.1 billion (15.6 percent) during the fourth quarter. This increase followed a $974 million (5.2 percent) increase in the third quarter. Net charge-offs of residential mortgage loans totaled $888 million in the fourth quarter, a three-year high.

Exotic Mortgages
Even negative amortization adjustable rate mortgage (NegAm ARM) delinquencies, the universally loathed and blamed mortgage product of all that is bad with mortgage lending these days (excluding subprime) has remained relatively low so far. The risk of their delinquencies may rise as housing prices fall, especially since these products were more popular in markets that saw the largest levels of appreciation. Its a little premature to attribute the lack of significant problems with these types of loan products as a sign that they really weren’t a big problem to begin with.

Foreclosures
According to RealtyTrac, foreclosures are clearly on the rise. January 2007 versus 2006 saw an increase of 25%. A scary number but percentages can be a little misleading since the hard numbers are not presented as a percentage of the total mortgages outstanding. According to the Mortgage Bankers Association, the December 2006 total delinquency rate was 4.67%, which is not high by historical standards. The largest portion came from subprime loans. However, delinquency is a broader definition than foreclosure, but for argument’s sake, its getting worse.

Click here for full sized graphic.

Risk Assessment
One of the problems with mortgage underwriting during the housing boom was the lack of understanding of risk. Automation and detachment from the collateral itself allowed lending institutions to marginalize the risk, perhaps by pushing it off onto theoretically unaware secondary market investors.

One of my favorite, go-go 1980’s books was Liars’ Poker by Michael Lewis (along with Barbarians at the Gate: The Fall of RJR Nabisco and Den of Thieves).

One of the stars of Liar’s Poker was Lewis Ranieri who helped invent the mortgage backed securities concept – selling bonds tied to mortgages was part of an excellent James Hagerty piece in the WSJ on Saturday called [Mortgage-Bond Pioneer Dislikes What He Sees [WSJ]](http://online.wsj.com/article/SB117227957162518036-search.html?KEYWORDS=ranieri&COLLECTION=wsjie/6month).

Ranieri and his colleagues in the late 1980’s (thoughts of my Liar’s Poker readings included them bragging about having more powerboats than polyester suits and how they ate onion cheeseburgers for breakfast) combined

regular mortgages into giant pools of loans that could be divided up and resold as bonds to pension funds and other institutional investors. These bonds come with a variety of credit ratings and are repackaged in endless permutations to meet investors’ varying appetites for risk.

Ranieri’s current assessment of the problem is that today’s investors don’t understand the risk because the expansion of offerings has changed dramatically in recent years and they don’t have the historical perspective.

The problem, he says, is that in the past few years the business has changed so much that if the U.S. housing market takes another lurch downward, no one will know where all the bodies are buried. “I don’t know how to understand the ripple effects through the system today,”

One of the reasons, has been the meteoric rise in collateralized debt obligations, or CDO’s which are sort of like mutual funds for mortgage securities investors who want to spread their risk. The problem is that he says that buyers of the debt don’t understand the risk like secondary market investors do because they don’t have access to the same level of information.

Take away:
Its ok to work hard for profits, and banks have every right to do that. In fact its their responsibility. However, its also their responsibility to understand the risks that are out there. Mortgage lending played a significant role in the housing boom. I am not confident that the banking industry can remain impervious to the by-product of the aggressive lending we’ve seen in recent years, characterized by the don’t ask, don’t tell mentality. I am surprised that more attention hasn’t been placed on the risks in the mortgage collateral pool (note: faulty valuation of assets).

There hasn’t been enough time for the housing slow down to affect banking’s bottom line yet. We are starting to see signs of weakness in terms of rising foreclosures and noncurrent loans. However, I wonder if there is greater long term risk associated with the lack of understanding of the risks themselves, or simply greater demand for a good polyster suit with cheeseburger grease stains.

Tags: Fannie Mae, FDIC, Sub-Prime

2 Comments

A few years ago, I was amazed at how profitable sub-prime lending was and how national banks were flocking to buy them. The first danger sign for me was when Citibank ran into problems when they purchased [The Associates](http://www.consumeraffairs.com/news02/citi_settles.html) and subsequently assumed their legal woes and eventually settled. But it didn’t end there. In addition to large national retail lenders, International banks got into the game, including HSBC.

Daniel gross wrote a witty piece on HSBC called [Hey Sucker Banking Corporation: How a British bank blew it in America [Slate]](http://www.slate.com/id/2159371/):

HSBC’s woes are the most highly visible evidence that the real estate-credit orgy of recent years is coming to an unhappy end.

[Other names for the acronym HSBC](http://bigpicture.typepad.com/comments/2007/02/mortgage_tart_w.html) other than its actual Hong Kong Shanghai Banking Corporation have been proposed but HSBC has become the posterchild for all that is wrong with subprime lending.

Don’t get me wrong, subprime serves a need. However, the search for quick profits and lapses in ethical standards associated with subprime lending has begun to take its toll on the lending sector of the economy. [Sub-prime lending comprises 20% of all mortgages [MW]](http://www.marketwatch.com/news/story/predatory-lending-creating-crisis-homeowners/story.aspx?guid=%7BE25C4567-28AA-4C80-91F8-5CBF65FEB190%7D) so its not an insignificant sector. It doesn’t mean that all sub-prime is predatory but its significant.

In a recent staff report by the New York Fed called [Defining and Detecting Predatory Lending](http://www.newyorkfed.org/research/staff_reports/sr273.html) explores this topic:

We define predatory lending as a welfare-reducing provision of credit. Using a textbook model, we show that lenders profit if they can tempt households into “debt traps,” that is, overborrowing and delinquency.

This is all scary since those that borrow in this sector are the least likely to afford outside advice.

Tags: Dan Gross, Citibank, Sub-Prime

Comments Off on Banking Acronyms And Predatory Lending

Before we get all excited and hope for some sort of near term national housing rebound, please take a look at Daniel Gross’ [A Phantom Rebound in the Housing Market [NYT]](http://www.nytimes.com/2007/01/07/business/yourmoney/07view.html). His [MoneyBlog](http://www.danielgross.net/) is a daily read for me.

Housing market hopefuls were uplifted by the Commerce Department’s 3.4% increase in purchases of new one-family homes. In fact, I grew annoyed because [new home sale stats are very misleading](http://matrix.millersamuel.com/?p=1012) and to place hopes on a housing rebound based such a flawed statistic, is a waste of energy.

The [FOMC](http://www.federalreserve.gov/FOMC/) piled on to the optimism by saying:

“Sales of new and existing homes showed tentative signs of stabilizing, although at levels well below their mid-2005 peaks,” the Federal Reserve’s Open Market Committee said at its December meeting.

Dan’s article points out something that makes the Commerce Department look even more statistically challenged.

If a contract to buy a home, signed in November, is canceled in December, the Census Bureau does not subtract the failed transaction from the number of sales, or add the house back to its inventory total. In the last year, as the housing market has cooled, the volume of cancellations has risen to epidemic proportions.

In fact [NAHB](http://www.nahb.org/) estimated that in November 2006, cancellations constituted 38 percent of gross sales, compared with 26 percent in November 2005 and about 18 percent in the first half of 2005. This means that 150k to 200k homes are being counted that never got built.

In their nearly always pessimistic outlook, but very insightful market commentary by Commstock Partners this week [Don’t Believe the Hype on Housing](http://www.comstockfunds.com/index.cfm?act=Newsletter.cfm&CFID=12464329&CFTOKEN=98986847&category=Market%20Commentary&newsletterid=1284&menugroup=Home), they define the generally inferred housing bottom as a

…a triumph of hope over reality.  Almost everything we see indicates that housing is still in a decline that has further to go.

• Builders continue to report steep declines in new orders
  
• Housing prices do not include non-price incentives and concellations
  
• Underwrtiting standards are tightening (I have to laugh about that – if they increased 5-fold, standards would be much more lax than 5-10 years ago.
  
• State and federal guidances have been issued about non-traditional mortgages
  
• Subprime lenders are going bust.
  

It seems that as far as new home sales go, demand may be less than it seems. Of course before we write off the housing rebound completely, new home sales only accounted for 14.4% of all housing sales (annualized) in November.

Tags: Dan Gross, Commerce Dept, NAHB, Census, Sub-Prime

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Source: Wachovia

According to the recent press release by the Mortgage Bankers Association [Some Delinquency Measures Tick Upwards in Latest MBA National Delinquency Survey](http://www.mortgagebankers.org/NewsandMedia/PressCenter/44582.htm):

2Q 06 delinquency rates fell 2 basis points to 4.39% from 1Q 06 and were up 5 basis points from 2Q 05. The decline from the prior quarter was attributed to the surge in delinquency after Hurricane Katrina.

“In previous quarters we indicated a number of factors including the aging of the loan portfolio, increasing short-term interest rates, and high energy prices have been putting upward pressure on delinquency rates. To this point, generally healthy economic growth and labor markets have kept delinquency rates from rising. However, we are seeing increases in delinquency rates for subprime loans, particularly for subprime ARMs. It is not surprising that subprime borrowers are more susceptible to these changes.”

Foreclosure rates, the next stage of the delinquency process were 0.99% in 2Q 06 up from 0.98% in the prior quarter. The RealtyTrac foreclosure rates that are released each month [infer much higher foreclosure levels](http://matrix.millersamuel.com/?p=852) which I discussed in an earlier post. Overall foreclosure rates are still considered low but a weakening economy is bringing additional concerns.

Source: Wachovia

[A Wachovia Corporation Economics Group report [pdf]](http://mediaserver.fxstreet.com/Reports/df0150b8-eddf-4233-8d92-3c0995725393/4aa167ab-6aaa-4d72-a334-6ddd55ae9638.pdf) (via [FXstreet](http://www.fxstreet.com/fundamental/economic-indicators/us-mortgage-delinquencies-low-but-trouble-lurking/2006-09-18.html)) suggests that the delinquencies are concentrated in a few states yet the projected income growth in these states is above the national average. The article suggests that the growth in income will temper some of the problems as mortgage rates reset over the next 12-18 months. Since the delinquencies seem to correlate in markets known for investor and flipping purposes, the numbers don’t show a national problem, yet.

In David Berson’s weekly commentary post, he wonders [Mortgage Delinquencies remain low, but will they stay that way? [FNMA]](http://www.fanniemae.com/media/berson/weekly/index.jhtml)

First of all, the behavior of home prices is an important determinant of serious delinquency rates. If a household has enough equity in a home it could either sell the home or extract some equity, so a delinquency resulting from a negative shock to a household (e.g., job loss, serious illness, etc.) should not lead to a foreclosure. The rapid home price growth seen over the past few years in much of the country should mitigate the risk of foreclosure. However, we expect national home price appreciation to slow this year and next, and some areas of the country could see declines. In those areas, a decline in home prices could leave some households with a mortgage balance significantly in excess of the value of the home. Increases in interest rates that would cause payments on adjustable-rate mortgages (ARMs) to rise sharply relative to incomes could also lead to increases in the serious delinquency rate. While only about 30 percent of prime conventional mortgage originations last year were ARMs, the ARM share was significantly higher in the subprime market. Many of these subprime ARMs have short fixed-rate periods and will be adjusting in the next year, which could lead to rising serious delinquency rates.

[Note: Berson’s link lasts one week. After 9/24/06, go here and search for his 9/18/06 post.](http://www.fanniemae.com/media/berson/weekly/archive/index.jhtml;jsessionid=GQATCTK1I5SX1J2FQSHSFGI?p=Media)

I think the overall problems related to the mortgage delinquency rate will be strongly influenced by how quickly mortgage rates move upward. Right now mortgage rates are projected to be stable as the economy continues to weaken and inflation is held in check. However, mortgage rates are already higher than when many adjustable rate mortgages (approximately 30% of the all mortgages) were issued.

Rising personal incomes may serve to contain the problem since the areas with the highest real estate investor concentrations are located in areas with the largest personal income upside. I wonder if good job prospects in these areas helped fuel the speculative characteristics of local markets.

Tags: Hurricane, Hurricane Katrina, Sub-Prime

1 Comment

This week, there was no hot air in the Zeppelin commentary. In fact it was so heavy, I don’t think it got off the ground. Here’s a sample:

• It’s interesting reading everyone talk about the inpact of interest rates on the slowing real estate market. “Rates when up .24356, that’s why real estate is slowing” etc. That is nothing! I live in Florida. I paid $3500 for my home owners policy last year. I thought that was too high. I just got my renewal notice. My new premium is $12,500! That’s an increase of $700 per month! Florida and the coastal areas of the US are in a free fall in property values as it is. This new wave of insurance hikes will be a disaster for coastal property values!

• Are you allowed to say “in a gentrifying area”?

• I have come to belive all news is presented in the most negative light possible, especially news about the economy. I have also come to believe that most people who post comments to blogs or news stories want the sky to be falling (I don’t know why – but it appears to be the case). I expect that you will be bashed for trying to “keep it in perspective”. [as I suspected, Matrix readers didn’t do that – Jonathan]

• We can strip away all the information overload and focus in to what real estate pricing is all about which is simply supply and demand.

• You definitely pinpointed the limited usefulness of the RealtyTrac report in that the comparison should be to the national housing stock that has mortgages. That’s exactly what the Mortgage Bankers Association did in a survey out today, which puts the foreclosure rate for the second quarter at .99 percent — up 1 basis point from last quarter, but down 1 basis point from the same quarter last year. If you have a lot more people taking out loans, as they did in the boom years, the (raw) number of foreclosures is naturally going to go up, even if people are just continuing to default at the same old rate. The real question is what’s the number of homes in foreclosure as a percentage of all loans. The MBA survey did show a pretty good bump in the number of delinquencies on subprime and FHA loans, however (and even prime ARMs), but chief economist Doug Duncan said he doesn’t expect “order of magnitude” increase in delinquencies next year. Companies like RealtyTrac are in the business of selling info about foreclosed properties to investors, and maybe the raw numbers mean something to that crowd — like more opportunities to cash in on others’ misfortunes. Which doesn’t mean their numbers aren’t true. They just, as you say, lack perspective.

• Here in Southern California, foreclosures (Notice of Defaults, actually) are sky-rocketing. In the first year of this housing market down cycle, the monthly number of NODs is already nearing the worst monthly levels of the 1990’s housing market down cycle. Yes, this is perspective. This is going to get very ugly before the sun starts to rise again.

• Now that you mention it, Lereah has been MIA for the NAR — hadn’t noticed that. Stevens tenure is about to end, so we soon won’t have him to kick around any more. But let’s give it one more shot. The Washington Post carried a piece last Saturday about (essentially) NAR President Stevens getting caught in the market … um … correction. “his old house in Great Falls has now been on the market for a year at the price of $1.45 million.”What I should have done,” confessed the senior vice president of NRT Inc., parent of Coldwell Banker Residential Brokerage, “was listened to my agent and cut the price by $50,000 to $100,000 early on, and the property would have sold last October.” Or, even better, he said, “I should have listed it a month earlier,” when the market was only just beginning to lose air.” [And on, and on he goes.](http://www.washingtonpost.com/wp-dyn/content/article/2006/09/08/AR2006090800760.html) I don’t know what average days on the market is in the DC area, but I bet it is less than 365. And Stevens hasn’t sold yet…

• I was under the impression that prior to the impending bonuses of 2006, 2005 was also a record year. However, it didn’t seem to do all that much for housing – maybe in the luxury/ultra luxury area, but not overall. We still had a lousy spring. So I can’t see why that would change this year, with inventory so much higher. Besides, don’t all those rich guys own by now?

• New York’s economy is strong, and people are pouring in. In the short run, therefore, any price decrease would be the result of prices being too high relative to income to being with, and nothing else. I think that may happen. Next year, however, it may also be that weakness in the housing market elsewhere causes weakness in the economy elsewhere and weakness in the stock market, working its way back to NYC. Bonuses will be at record levels this year, but Crains reported on Monday Wall Street’s three-year bull-run is losing steam. “After a terrific first half, earnings are expected to fall 40% in the second half…The slowdown is hitting virtually every trade plied on Wall Street. Stock and bond underwriting volume plunged nearly 50% in the summer quarter compared with a year earlier. The hugely lucrative businesses of advising on corporate mergers and taking companies public are also slumping.” Perhaps, with a slowdown coming, those high flying finanical geniuses won’t blow their bonuses this time around. Naaaah.

• But you DON’T have perspective until you can answer the question, “What is the impact of NODs (or foreclosures) on the market?” Are they affecting inventory? By how much? What other pressures are there on inventory? The RealtyTrac survey reports 12,506 California homes entered into foreclosure in August — up 25 percent from July and 160 percent from the year before. That sounds pretty serious, right? Well, maybe not if foreclosures were at historic lows. Maybe not if some 500,000 homes change hands in the state every year. Which is not to say that the market’s not soft, especially in particular areas. Inventory in the state is up — CAR puts it at 7.5 months in July, versus 2.9 months same time last year. But what is causing inventory to rise? Is it because more homes are going into foreclosure, or because houses are just sitting on the market because they are overpriced? The bottom line is that the raw number of foreclosures, by itself, doesn’t tell you that much about supply and demand.

Tags: FHA, Wall Street Bonus, David Duncan, Sub-Prime

Comments Off on [Matrix Zeppelin Series] Coastal, Gentrifying, Negative Light, Overload, Raw Numbers, Get Ugly, Lereah Is MIA, Bonuses, Slowdown Coming, Going Into Foreclosure

To their credit, the FDIC writes in a good summary on the economy and some possible concerns for a recession in [FYI: An Update on Emerging Issues in Banking: Scenarios for the Next U.S. Recession [FDIC]](http://www.fdic.gov/bank/analytical/fyi/2006/032306fyi.html)

Its a surprisingly good narrative on banking as it relates to housing as these industries go hand-in-hand in estimating when we may see the next recession.

Housing

The risk of a housing slowdown is another area of concern going forward. The recent housing boom has been unprecedented in modern U.S. history.2 It has been suggested by many analysts that the housing boom has been a significant contributor to gains in consumer spending in recent years. Indeed, a number of the FDIC roundtable panelists pointed to the apparent connection between rising real estate wealth during the past four years and the sustained strength in consumer spending during that period. Because consumer spending accounts for over two-thirds of U.S. economic activity, any shock to consumer spending, such as that which might be caused by a housing slowdown, is a concern to overall economic growth.

Housing analysts are in disagreement as to whether or not recent signs point to a moderation in housing activity or the beginning of a more significant correction. Currently, inventories of unsold homes and sales volumes are among the indicators pointing to a housing slowdown. Inventories of unsold existing homes rose from under four months of supply at current sales volume in early 2005 to 5.3 months of supply as of January 2006. Meanwhile, the pace of existing home sales has been trending lower since last summer. A clear trend in the direction of home sales and prices may not be evident until the completion of the peak spring and summer selling season later this year.

Many analysts argue that home prices in the hottest coastal markets, especially in the Northeast and California, could be poised to decline in the near future. For example, PMI Mortgage Insurance Company analysts place essentially even odds that home prices will decline during the next two years in a dozen cities in California and the Northeast.4 Should home prices either stop rising or begin to fall in these areas, local banks and thrifts would need to look to non-residential loans to support revenue growth.

Banking

There are concerns, however, that changes in the structure of mortgage lending could pose new risks to housing. These changes are most evident in the rising popularity of interest-only and payment-option mortgages, which allow borrowers to afford more expensive homes relative to their income, but which also increase variability in borrower payments and loan balances.

Credit

10 percent of U.S. households may be at heightened risk of credit problems in the current environment. This group mainly includes households that gained access to mortgage credit for the first time during the recent expansion of subprime and innovative mortgage loan programs.

Tags: Pending Home Sale Index, FDIC, Sub-Prime, PHSI, NAR, National Association of Realtors

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If there is one thing that mortgage servicers learned from the last downturn in the housing cycle (1989-1995) was that foreclosure were expensive and had the potential to be a public relations nightmare. In the today’s market, Ken Harney’s article [Mortgage Servicers Help Avoid Foreclosures [Washington Post]](http://www.washingtonpost.com/wp-dyn/content/article/2005/12/23/AR2005122300849.html) discusses how mortgage servicers do everything they can to avoid foreclosures.

In the 1990-91 market downturn, lenders had to maintain large in-house departments to manage inventory as well as manage vendors that were needed in the process such as lawyers, brokers and appraisers. As an appraiser, I stood with many a broker and locksmith in the early 1990’s, getting into a foreclosed apartment, only to find the interior was picked clean.

Daniel Gross, in his article [Didn’t Pay Your Mortgage? Don’t Worry. Why banks are so afraid to foreclose on you [Slate]](http://www.slate.com/id/2132094/) he discusses why this is happening. Lightening up on those who fell victim to the hurricanes is understandable and would be a public relations disaster. But what about everyone else?

In the process of [raising the percentage of home ownership [Census]](http://www.census.gov/hhes/www/housing/hvs/historic/histt14.html), the lending industry is trying to avoid the expense of foreclosure. [The delinquency rate as of the 2nd quarter, according to the MBA was 4.34%, but less than half of those are in excess fo 90 days. [MBA]](http://www.mortgagebankers.org/marketdata/index.cfm?STRING=http://www.mortgagebankers.org/news/2005/pr0915.html)

Gross notes that the delinquincy rates of ARM mortgages is 10.04% and subprime loans is 9.06%, which means that the rate for conventional loans is barely on the radar, clearly a pattern related to the pressure to expand the base of customers to those who are a higher risk.

He concludes that when borrowers get behind in their payments, lenders prefer to do workouts and these often can come into the form of another refinance, with the homeowner getting deeper in debt. They have in effect, like lenders 20 years ago, become too big to fail.

Tags: Hurricane, Dan Gross, Commerce Dept, Census, Sub-Prime

Comments Off on Home Owners: Too Big To Fail

According to a [study by the Federal Reserve [PDF]](http://www.federalreserve.gov/pubs/bulletin/2005/3-05hmda.pdf) blacks are 3 times more likely to borrow through sub-prime lenders than whites. Sub-prime mortgages are typically 2% above prime rates.

[[New York Times] Blacks Hit Hardest by Costlier Mortgages](http://www.nytimes.com/2005/09/14/business/14lend.html?pagewanted=print)

The new report, based on data collected from 8,853 lenders, is the Fed’s first attempt to look for evidence of racial and ethnic discrimination in the booming business in exotic mortgages and subprime lending.

Tags: Sub-Prime

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