Wednesday, May 21, 2008

Hope for Homeowners Act of 2008

I have reviewed portions of the Committee Print of the proposed GSE bill (the “Bill”) that came out of The U.S. Senate Committee on Banking, Housing, and Urban Affairs (the “Senate Banking Committee”)as announced by the Senate Banking Committee on May 19, 2008. In particular, I have read Secs. 401-403 of the Bill titled “Hope For Homeowners Act of 2008.” I believe this Bill is a recipe for disaster and likely the next big target of fraud against taxpayers. First, I will attempt to summarize how this plan works, and then I will comment on it based on my interpretations and opinions.

How it works (if passed as is):
This plan authorizes FHA to provide guarantees for mortgages up to an aggregate of $300 billion. These mortgages get packaged and sold through the Government National Mortgage Association, or GNMA, and the securities sold by GNMA are backed by the full faith and credit of the United States (and that means the taxpayers).

Who can borrow under the plan:
These loans will only be made to borrowers who “provide a certification to the Secretary [of FHA] that the mortgagor has not intentionally defaulted on the eligible mortgage” and the current borrower debt to income ratio must be GREATER THAN 31 percent! So, we are talking about people who cannot pay their mortgages because they have too much mortgage debt relative to their income (I note that the Bill states “mortgage debt to income” as the ratio, but I am assuming it means to say “mortgage debt service to income” as a total mortgage debt to income ratio of 31% would make no sense in this context). Bill Sec. 402(e) The penalty for falsely stating that you did not intentionally default on your mortgage can be steep, including fines and prison time (how one proves this and what it means is beyond me – if one intentionally buys food instead of paying the mortgage is this an intentional default?)

How is this a bailout for investors?
Once a borrower is qualified, they can borrow up to 90% of the appraised value of the home to refinance their existing mortgage, assuming the mortgage holders (including the holders of the first mortgage and all subordinate loans) agree(s) to a full satisfaction of all of the borrowers obligations from the proceeds of the new loan. So if this is a better deal for the mortgage investor than foreclosing on the property and realizing larger losses, the investor should buy into the refinance. That’s where the bailout comes in – investors would be liquidating their positions at favorable recoveries based on taxpayer guarantees. In order to protect taxpayers, the Bill provides that the appraisal must not be influenced by an interested party (curiously there are no stated penalties for a breach of this requirement and no absolute limitation on using related parties). There is also an insurance fund to back these loans before taxpayers would be on the hook.

The insurance is provided through a new insurance fund, the Home Ownership Preservation Entity Fund, to be used by FHA to carry out its mission that states, in part, “to allow homeowners to avoid foreclosure by reducing the principal balance outstanding, and interest rate charged, on their mortgages…” Bill Sec. 402(b)(2) The fund is funded through an initial payment of 3% of each loan amount, paid from the proceeds of the loan, plus an annual premium of 1.5% of the remaining principal balance of each loan. Bill Sec. 402(i) Now I admit that I am not a mathematician and have not constructed a detailed quantitative model to figure out the risk that this fund will be insufficient to cover losses. I do, however, have serious doubts that this fund will support losses from these loans and I believe it is likely taxpayers will eventually be on the hook.

I wonder how the premium rate of 3% plus an annual 1.5% of non-defaulted loans plus a share of a share of future equity appreciation compares to default rates on refinanced defaulted loans? I don’t think the data exists to make this calculation, but I could be wrong about that. Even if they do, however, I wonder how any assumptions regarding default rates hold up when this plan is full of incentives for abuse by almost everyone involved:

1) FHA - FHA wants to show results and will actively try to guaranty a lot of loans. Unfortunately, as discussed in this Congressional testimony, there is already serious concern about FHA’s ability to manage its existing portfolio, let alone a huge new program like this one. That means quantity over quality – a recipe for trouble in any lending business. One other point I would like to mention is that back in December I wrote about a plan to reform the FHA. In that piece I linked to the website of the Senate Banking Committee for a copy of congressional testimony by Basil Petrou from Federal Financial Analytics that discussed many weaknesses of the plan and the FHA. That link has been taken down, and I have had to replace it with a link to the Federal Financial Analytics website. Curious. If you are interested you can now find that testimony here.

2) INVESTORS - Existing lenders want out of their bad loans and that provides incentive to push borrowers into this program thereby limiting their losses. Again we have the quantity over quality problem.

3) APPRAISERS – Appraisers are under pressure from their clients, lenders, because they appraised so many properties for too high a value. These appraisers have a strong incentive to help the lenders exit these loans at the highest possible recovery, and that means highest appraisal.

4) HOMEOWNERS - Homeowners love this even if they don’t plan to stay in the house. If you are a homeowner with two mortgages, default notices, foreclosure threats, and all of your other personal assets at risk because you are under water, would you love to get one of these loans and make all of those problems go away? The trade-off for making it all go away is being obligated for one loan that’s guaranteed by the taxpayers. Sounds like a nice value proposition for the homeowner to me. In furtherance of this perverted incentive structure, the Bill provides that any equity in the home that is realized through a later refinance or sale is shared between the homeowner and the FHA (a portion of which, if applicable, is for distribution to any subordinated mortgage holder who took a loss). If the home is sold or refinanced in the first year any appreciation goes to FHA, in the second year 90%, third year 80%, and so on to 50% after five years and forever thereafter. So, refinance with FHA at no cost or very little cost, get all of the lenders off your back, then walk away from one loan guaranteed by the taxpayers leaving them with the problem.

Lets review. What the Bill proposes is to find mortgage borrowers who cannot afford their mortgage payments and are in default. Then, an appraisal is secured through an appraiser (the same group that got values completely wrong the last time around and are likely conflicted because of their relationships with lenders). The FHA then guarantees a loan to refinance the existing mortgages up to 90% of the appraised value. All parties have incentives to do these transactions that are unrelated to the resulting credit quality. In fact, the worse the credit quality is the greater the incentive for the investor/appraiser and the homeowner to participate. Then, once the FHA is on the hook, the homeowner is given the disincentive to remain in the house because under the best of circumstances they will realize only 50% of any future equity appreciation in the home. Under these circumstances is 3% plus a share of a share of future appreciation plus 1.5% per year (on loans that do not default) enough to cover the losses on this impending portfolio? I, for one, am not convinced that it is. Of course I could be wrong and this plan could turn out to be a great idea, but I see too many conflicts and perverse incentives in the current draft to believe this plan will actually work to the benefit of taxpayers. Instead, I see too much opportunity and incentive for quick transfers of bad loans from investors to taxpayers under the inadequate supervision of FHA and, as a taxpayer, that concerns me.

[There are other issues with the Bill that, for the most part, are left to FHA to figure out. For example, does a home improvement add to the homeowner’s equity or is the value added by improvements shared as future equity? The Bill also describes future equity in a very strange way: “any equity created as a direct result of such sale or refinance”. I suppose you can consider a sale the creation of equity although that is arguable. I certainly do not see how equity is “created” through a refinance. Another issue is that the Bill provides for refinancing up to an amount not exceeding 132 percent of the old conforming loan amount – in other words jumbo loans.]

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Wednesday, May 14, 2008

Understanding the Inflation Report

The Bureau of Labor Statistics (BLS) reported today that inflation was contained in April, with prices rising only .2% (this would be about 2.4% on an annualized basis). This was welcome news for the equity markets that responded positively to the report. Sounds good, except we have the usual adjustments and assumptions built into how this number is calculated. The biggest standout in this report is Transportation, which is down by .7 percent in April. Lets take a look at this category to try and understand how these numbers work.

Here is the report’s discussion of why Transportation prices fell by .7% in April:

The transportation index declined 0.7 percent in April, reflecting a 2.0 percent decrease in the index for gasoline. The index for new vehicles declined 0.2 percent and was 1.3 percent lower than in April 2007. The index for used cars and trucks declined 0.3 percent in April, but was 1.8 percent higher than a year ago. The index for public transportation declined 0.4 percent in April, reflecting a 0.5 percent decrease in the index for airline fares. (Prior to seasonal adjustment, airline fares rose 0.9 percent and were 10.1 percent higher than a year ago.) (Gasoline prices rose 5.6 percent in April. Compared to a year ago, these prices were up 20.9 percent. Gasoline prices increase seasonally during the first five months of the year, with the largest increases occurring in March and April and decline seasonally for the remainder of the year).

Taking a closer look at this part of the report, it states that the gasoline price index is down 2 percent in April. This would probably surprise most drivers. In fact, gasoline prices were up 5.6 percent in the month, so how can they be down 2 percent? Well, the government expects gasoline prices to go up 7 percent in April as people drive more, and then go down later in the year as people drive less. Because prices only rose 5 percent, the seasonally adjusted price index fell 2 percent. This assumes that gas prices will, as the report states, decline seasonally from June through December. We know, however, that oil prices have risen for future delivery and gasoline prices are expected to go up, not down. Based on the seasonal adjustment figures, prices should go up about 3.5 percent in May, then drop for the rest of the year. So should the gasoline number be seasonally adjusted downward by 5.7 % even though oil futures are up? I suppose what that means is that future inflation numbers will be worse.

The next subcategory is new vehicles. According to the report new car prices fell .2 percent (the seasonal adjustment for this category is .22 percent, so prices must have fallen by approximately .4 percent). This is interesting, especially when Toyota just announced price increases for their new vehicles in the U.S. These increases will reportedly become effective later in May, so this price decline will likely also reverse next month or in June. That’s bad news because based on the seasonal adjustments, car prices are supposed to go down .32 percent in May and .33 percent in June, so once adjusted this category could look even worse.

The drop in the price of used cars and trucks is not surprising given that we are in the midst of a shift to more fuel efficient vehicles. Used vehicles, which would tend to be high fuel consumption vehicles, are declining in value. If a person goes to buy a new car, don’t they usually trade in the old one? So if the value of the old one declined, the actual cost of a new car, on a net basis, has not declined by .2 percent because the buyer will get less credit for the trade-in. So this is good news for used car buyers but not as good for people who buy new cars.

Finally, airline fares declined! That’s news to me. Before seasonal adjustments they were up .9 percent. So if the reported number fell .4 percent, we know the expected seasonal rise must have been 1.3 percent (there are rounding issues – the actual adjustment is 1.44 percent). Because they rose only .9 percent, on a seasonally adjusted basis they were down .4 percent! What about the fact that the Easter holiday was in March this year but April last year? The seasonal adjustment is down a bit from last year, from 1.95 percent to 1.44 percent, but so is the March adjustment, from 1.23 percent to 0.97 percent. These changes do not reflect adjustment for this point as far as I can tell. Airline prices may reflect this increasing a seasonally adjusted 3% in March and decreasing a seasonally adjusted .4 percent in April.

Seasonal adjustments do make sense to me on a normal ongoing basis, but when we have better information (such as futures prices for oil) perhaps we should take that information into account. Then again, there is a lot to be said for consistency, so making adjustments to adjustments may not be such a great idea. Finding the real story, however, requires work.

In the unlikely event that you would like to look at other categories in this way you can find a lot of information at the BLS. The way to do it is look at the seasonal adjustment table for 2008. The expected change is the percentage change in any given category from one month to the next. If you get a 1 percent increase, then an actual increase of 1% will be reported as a zero percent increase. If you are a statistician and want to get into the calculation of the seasonal adjustments you can start with this report.

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Saturday, May 3, 2008

Subprime and the Bush Administration

What did the Bush Administration have to do with the credit crisis? I keep hearing people say that a president does not have very much influence on the economy and they are given too much of the credit or blame when the economy fluctuates. I disagree for two reasons. The first is that fiscal policies can have a rather dramatic and immediate impact on economic activity as the President is making clear today by touting the fiscal stimulus plan. Tax cuts and government spending certainly impact the economy in a direct and timely way. The other reason is the general regulatory oversight that each administration is responsible for. For example, who heads the SEC and what are the priorities given it by the administration? What about the Treasury Department? I believe these policies have a direct impact on economic activity and are responsible for a lot of the fluctuation in the economy as well as income distribution from one administration to another. Here is an example.

As hedge fund investor David Einhorn laid out in his recent remarks, ”Private Profits and Socialized Risk” the SEC, under the Bush Administration, altered the capital requirements for broker-dealers. Einhorn concludes that the result was a lower capital requirement leading to higher leverage. The higher leverage, as we know, leads to higher risk and that higher risk culminated with the failure of Bear Stearns. So, is this why we have the credit crisis? Wait, there’s more.

The SEC regulations applied to the broker-dealer world. What about the commercial banks? What have they got to do with all of this? Well, as I wrote about last October, the rules regarding commercial bank capital requirements were also altered back in 2004 through rules promulgated by the Federal Reserve and Treasury as regulators of the commercial banking system. In effect, these rules said to banks they could move loans and other assets from their balance sheets to off-balance sheet conduits and reduce their capital requirements. Banks love this because it allows them to – guess what – leverage! They set up something called a conduit that purchases assets from the bank and/or a bank customer. The conduit gets the money for the purchase by issuing securities, like commercial paper. The rating agencies rate the commercial paper based, in part, on the fact that the bank typically provides a line of credit to the conduit so that if the commercial paper market dries up the conduit can borrow to repay maturing commercial paper. This is a very general description and these structures can get very complex, but this is the basic idea. So how does this increase leverage? The rules promulgated in 2004 established that under this structure banks could provide these credit lines to back these conduits but hold only 10% of the risk based capital they would hold against the same assets if they were on the bank’s balance sheet. You can find the announcement of the rules here. So, using this structure, banks can leverage their capital in multiples. Eureka – a way to get around the sound banking principals established by the regulatory framework over the past 90 years! The regulators behind these rules included the Office of the Comptroller of the Currency (Treasury), The Federal Reserve System, The Office of Thrift Supervision (Treasury), and The Federal Deposit Insurance Corporation.

Lets review. According to Mr. Einhorn, in 2004 the SEC relaxed capital rules for broker dealers, placing more of the regulatory requirements in the hands of the banks and allowing them to use more leverage than before. In the very same year the Federal Reserve and Treasury codified the rules that permitted commercial banks to leverage through off-balance sheet entities. (In case you were wondering, Congress had hearings on many of these issues as well.) All of this turned out to be extremely profitable for the banks, brokers, and rating agencies.

Suddenly, there is an incredible credit bubble that begins with loans and ends up as securities in the portfolios of, among others, the investment banks, banks, and off-balance sheet bank sponsored conduits. I wonder if there is a link between these events? Now, to be fair, the credit bubble began a little before these regulatory changes. But these changes must have accommodated a huge demand that was unsustainable. The graph accompanying this post illustrates the credit bubble I am referring to.

What really caps all of this off is the cries from many of these agency heads now about what should be done to fix this mess. For example, Sheila Bair, head of The Federal Deposit Insurance Corporation, has been calling for months for a bailout of subprime borrowers. First, back in October, she called for a freeze on interest rates for those who had adjustable rate subprime mortgages. She is now lobbying for loan modifications to reduce principal for those subprime borrowers whose mortgages exceed their property values. From her recent comments before Congress

Permanently forgiving part of the principal amount can provide a better financial result for investors than foreclosure by creating long-term, sustainable solutions that will allow borrowers to stay in their homes. This approach also has the added benefit of limiting the overall adverse affect of declining property values on communities.
In closing, Ms. Bair states
Congress, the SEC, the Treasury Department, as well as federal bank regulators have expended considerable time and effort to assure that the industry has authority under tax and accounting rules to modify loans proactively. The industry needs to demonstrate greater commitment to using those authorities.
They should be expending all the time they possibly can and they should never mention it because these agencies are collectively, in my opinion, among the most culpable groups in this entire debacle.

To be fair to Ms. Bair, she was appointed to head the FDIC in 2006, after these regulatory changes. She was, however, on the FDIC’s Advisory Committee on Banking Policy. Donald Powell was FDIC Chairman in 2004, John Snow was Secretary of the Treasury, William Donaldson was Chairman of the SEC, and our old friend Alan Greenspan was Chairman of the Board of Governors of the Federal Reserve System. Who appointed these people?

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