Housing Prices Plunge in December

The Case-Shiller index showed accelerating price declines in December. Every city experienced declines. Denver and Dallas held up the best declining approximately 4% in value from sales of existing homes in December of 2007. Sun Belt cities continued to post the worst declines with Las Vegas and Phoenix sliding 33% and 34%, respectively. San Francisco posted the worst monthly drop ever, a 31% decline. The rest of California fared no better with San Diego and Los Angeles both falling 25% and 25%, respectively.

The S&P/Case-Shiller home-price index is a closely watched gauge of U.S. home prices in 20 major metropolitan areas. The housing market will continue to deteriorate at least through the summer and probably through the rest of the year.

Deteriorating housing prices cause buyers to sit on the sidelines thus causing housing prices to fall further. This is a deflationary spiral that is hurting the economy. Consumer confidence dropped to an all time low of 25 in February. This is the lowest reading since the index's inception in 1967. This new reading shows consumers do not expect economic conditions (i.e. employment and business conditions) to improve in the next six months. In fact, 40% of respondents said they expect economic conditions to instead worsen. Under these conditions, few consumers are willing to buy a new home especially if they expect the housing market and economy to worsen. So the spiral continues …..

The only glimmer on the horizon is the new Obama housing stimulus plan. It is an elegant plan but it may not be enough. The plan is expected to help 9 million families refinance their mortgages to avoid foreclosure by using incentives and subsidies. Unfortunately, the plan is structured to offer the least help to homeowners in markets that have receded the most (the Sun Belt States, California, Florida and Michigan). It is a start and will help shore the housing market up in some parts of the country but it will not completely bolster the collapsing housing market.

Interactive Housing Market Graph Link

It is not likely that the economy will turn around in 2009.

How Did a Few Bad Mortgages Humble Wall Street?

That was the topic this morning of a persentation I gave to a retired group of seniors interested in investments. Their name is the $ums in Retirement. A great group of guys in Walnut Creek that are retired but actively involved in improving and maintaining their financial health. I really enjoyed talking to them. I promised to post this slide which was orignally a full page article in the New York Times. It shows how mortgages were packaged and sold. If you read this and then my previous posting on Shadow banking you will have better understanding of how a few bad loans could humble Wall Street. To clearly read this graphic just click on it and it will appear full size in a seperate window. Pay careful attention how the BBB rated mortgages in step 3 are miraculously turned into AAA rated securities in step 4. Happy reading!

Mortgage-Backed Securities and the Housing Market

Most mortgages are not held by the lender who made them to you. They are pooled with others and sold to investors such as insurance companies, mutual funds, foreign banks and pension funds. A different company processes your loan payments. Yet another company represents the investors as the trustee.

The very innovation that made mortgages so easily available, an assembly line process known on Wall Street as securitization, has caused our current problems.

The idea of pooling loans and selling them to investors dates back to 1970, but the practice has exploded in recent years. At the end of last year, $6.5 trillion of securitized mortgage debt was outstanding. In the last few years, securitization led to this explosion of bad loans because the agents writing the loans didn’t care if they would ever be paid back. They made a fee by originating the loan and then sold the mortgage (passed on the risk) to another middleman who then passed it on to some anonymous investor. The incentive was to originate loans and to heck with proper underwriting (screening the borrowers to see if they qualified).
The process begins with the entity that originates the loan, either a mortgage broker or lender. The loan is assigned to a company that will service it (collecting borrowers’ payments and distributing them to investors). A Wall Street firm then pools thousands of loans to be sold to investors who want a steady stream of cash from loan payments. The underwriters separate them into segments based on risk called tranches.

Once a pool of mortgages (trust) is sold, a trustee bank oversees its operations on behalf of investors. The trustee makes sure that the terms of the pooling and servicing agreement are met; this document determines what a servicer can do to help distressed borrowers.
By its nature, the complex design of mortgage securities creates unwanted difficulties, which are written to ensure that the middlemen make their profit with little to no risk. Almost nothing in this process is done in favor of the borrowers’ interests. In fact, the agreements require that any modifications to loans in or near default should be “in the best interests” of those who hold the securities. Loan modifications are restricted which explains why many borrowers are having difficulty renegotiating their loans.

Fifteen years ago, the last time the housing market ran into stiff trouble, government-sponsored enterprises like Fannie Mae did most of the work pooling and selling mortgage securities. These enterprises readily agreed to loan modifications, but not so this time. In fact, it is in many cases impossible to determine who really is holding the title.

This is a mess, and many more home owners will lose their homes, keeping the housing market depressed until well into 2009. Why has the implosion of mortgage-backed securities been so destructive to the financial markets? The failure of mortgage-backed bonds has rippled through the markets, hurting financial institutions and the newer non-traditional banking system. This unregulated shadow banking system is comprised of a plethora of opaque institutions and vehicles that have sprung up in American and European markets over the last decade. They have come to play an important role in providing credit across the financial system. In the next few days I'll post more information about this sahdow banking system as well as credit swaps, SIVs and more.

How Bad is the Housing Market? Pretty Bad

The pizza guy delivers a pizza to your door. He wants to be paid in cash right now. He doesn’t care how much equity you have built up in your house. You look in your wallet and it is empty. This scene is playing out for many home owners. They can’t make their mortgage payments and the bank is knocking on their door demanding payment. These resetting mortgages payments have ballooned to a level that borrowers aren’t able to pay.
Why did the banks and secondary lending institutions make these loans to people they knew would never be able to repay? Greed! Wall Street was clamoring for these riskier mortgages because they were looking for bonds that generated a higher yield (higher interest rates) and to heck with the risk. In particular, hedge funds had an insatiable appetite for these riskier asset-backed consumer loans. Here is the bad news: the worst is yet to come. The most egregious of these risky loans (with high escalating payments at reset) were 2 year Adjustable Rate Mortgages made in 2006 and early 2007. As the above graph shows there is a massive wave of these loans that will reset in 2008. The default rate will be significant. This is like watching a train wreck in slow motion.
Unfortunately, when excesses end, things don’t just return to normal. The pendulum frequently swings far in the other direction. This quick swing sparked a liquidity crisis on Wall Street. The mortgage defaults triggered an extreme lack of interest in holding consumer-backed debt, and an inclination on the part of most institutions not to lend to each other. This cascaded into broader risk avoidance on the part of investors, hedge funds, and other financial market players who have played an important role in expanding the amount of available credit. This was greatly exacerbated by large amounts of leverage (debt) held by many of the non-bank credit providers (e.g., hedge funds). The result was that credit, which as noted is crucial to the economy, was sharply restricted for a few weeks during the quarter.
With the Fed’s decisive action in September to cut the federal funds rate by 50 basis points, things have settled down, but they have not returned to normal. Capital will no longer be available to certain groups of borrowers and it will be costlier to other groups. This is somewhat good because excess liquidity was leading many investors to make imprudent investment decisions. On the flip side, the seizing up of the credit markets in a credit-dependent economy has a ripple effect which will hurt consumer spending.

With consumers unable to use their homes as an ATM machine (consumers extracting capital from their homes largely shut down and housing prices have fallen) and home sales severely slumping, the economy is faced with the possibility of a material cutback in consumer spending. The primary driver of economic growth is consumer spending, which accounts for approximately two thirds of the US economy. Some industries are already slumping since consumers have less cash available to spend on their homes and lifestyle. For instance, the furniture, home improvement and auto industries are already feeling the pain. The homebuilders and mortgage lending industries have also begun to retrench. All this has a negative multiplier effect on the economy. It seems highly probable that the economy will, at the very least, experience slower growth.

Federal Reserve Leaves Interest Rate Unchanged

The Federal Reserve held tight leaving its key overnight interest rate at 5.25%. The Fed gave no hint whether it would be changing interest rates anytime soon. Many economists expected the Fed to allude when it might start cutting rates. Instead, the Fed held open the possibility that it might increase rates if inflation does not moderate. It also expressed concern regarding the slowing housing market. The Fed described the housing slowdown as "substantial". This is stronger language than the Fed has used before.

The Fed is talking tough to keep a lid on inflation in hopes that it will not have to act tough and raise rates again. The stock market pulled back today (Tuesday December 12th), finishing slightly lower as investors grappled with the Fed's economic assessment and worries about accelerating inflation.

Friday’s release of November’s consumer price data will give us an indication of the Fed’s success at taming inflation. The Bloomberg poll predicts a 0.2 % increase, after food and energy items are removed. The increase for October was 0.1 %.