Professor Cole's Finance Blog

A couple of days ago, the Wall Street Journal published an article detailing a major and still-unresolved problem in the "Hope for Homeowners"--the Department of Housing and Urban Development's program designed (supposedly) to help homeowners who are "upside down" or "underwater" on their mortgages, i.e., who owe more on their mortgage(s) than the current value of the mortgaged property. According to the WSJ, only 95--yes--95 mortgages have been refinanced under this program. Hope for Homeowners was originally implemented under the Bush administration but has been repeatedly reworked under the Obama administration in hopes of providing some relief to the troubled U.S. housing market, so it is truly a "bipartisan" disaster.

Moody's economy.com estimates that as many as 16 million mortgage-holders--about one in three of the approximately 50 million households with a first mortgage--are currently underwater. These borrowers are often ineligible for $75 billion from the TARP that the Obama administation "diverted" to the Home Affordable Mortgage Program, another part of the administration's Making Homes Affordable program, which was announced back in March 2009 and has seen approximately 360,000 trial loan modifications started and more than 100,000 loans modified under the program. (Keep in mind that approximately 250,000 homes have been going into foreclosure EACH MONTH during 2009 to get an idea about how "successful" even this program is, although it is a home run when compared to Hope for Homeowners.)

The big problem explored in the WSJ article, and previously discussed on this blog, is the program's failure to address the problem of second liens--typically home equity lines of credit used to finance loan amounts above the typical 80% loan-to-value of conforming mortgages that can be securitized by Fannie and Freddie. Market participants estimate that more than half of all underwater first mortgages are collateralized by properties encumbered by second liens. The market value of these second liens is virtually zero, except for the fact that the second-lien holders can "hold up" refinancing of the first lien by demanding full repayment (to which they are contractually entitled). Hope for Homeowners requires that second liens be "extinguished" before the first mortgage can be refinanced, but second-lien holders want to be compensated for their claim, and Hope for Homeowners, until now, has not provided for such compensation. (Currently, there is a plan to offer some minimal compensation to second-lien holders, but unlikely to be enough to ge their cooperation.)

The vast majority, estimated at eight in ten, of these second liens are held by the financial institution that originated the first mortgage, and most of these are held by the Big Four of commercial banking--Bank of America (which bought Countrywide), Chase (which bought WaMu), Wells Fargo (which bought Wachovia) and Citi (which originated enough crap on its own and didn't have to go out and buy trouble)--each of which received at least $10 billion in TARP funds, although all have repaid, or are planning to repay, those funds.

In aggregate, commercial banks hold more than $600 billion in home equity loan balances outstanding, and most of these are held by the Big Four banks. Because these loans are designated as "held to maturity," they are recorded at book value and do not have to be "marked-to-market." This is the crux of the problem because recent transactions indicate that these loans are worth in the range of ten cents on the dollar, or about $60 billion--implying that there are about $540 billion in imbedded losses that these banks have yet to recognize, and cannot afford to recognize. Think of this as "ground-hog day" for the banking industry, taking them back to September 2008, should they be forced to write down these loans. Each of the Big Four would be insolvent and require yet another massive bailout by Uncle Sam, but, worse than that, probably would bring about another financial panic where no financial institution would trust or lend to another financial institution. This is what happened after the Lehman Brothers failure last September, and could happen again any day this September (or October or December.) It's going to happen--but just a matter of when . . . .

Posted by m1rac01 at 03:09 PM | Permalink

10. The Automobile Industry: In spite of the government's $50 billion bailout of GM and Chrysler, as well as the $3 billion "cars for clunkers" program,  the U.S. automobile industry continues to spiral downward, taking with it future consumption and employment.

9. Interest Rates: The Fed cut interest rates to less than 1 percent in order to fight the recession, but this situation cannot continue long-term. The Fed will be forced to raise rates by 500 basis points or more during the coming year, which will force up mortgage rates and consumer rates, strangling the housing market and consumption.

8. Deficits: The administration has ballooned the budget deficit for 2009 to more than $2 trillion, with annual deficits over the next decade expected to top $1 trillion per year. Hyper-inflation, anyone? 

7. Securitization: During the past decade, securitized debt replaced the bank debt as the ultimate source of credit for mortgage and consumer debt financing. In September 2008, Wall Street's securitization machinery ground to a halt, and, even today, it remains in gridlock. Virtually no residential or commercial mortgages have been securitized without government guarantees during 2009. Without securitization, Wall Street as we knew it in 2007 is dead and the consumers aree without their primary source of financing.

6. Commercial Real Estate: This industry is facing its darkest hour since the early 1990s. Default rates on CMBS have tripled since last year and are forecast to double from current levels during the coming year. Properties are selling at 50% discounts to their values only a couple of years back. Look for defaults on properties with mortgages worth hundreds of billions of dollars during the coming year. These defaults will drag down with them a large segment of the commercial banking industry.

5. Bank Failures: Thus far during 2009, 94 banks have failed, the largest number since 1991, which was the last year of the last major banking crisis. During that crisis, more than 2,000 banks (including thrifts) failed. This crisis, like the last crisis, is largely attributable to losses on loans to finance commercial real estate, especially construction-and-development loans. Look for several hundred additional banks to fail during the rest of 2009 and through the end of 2010, costing the FDIC another $100 billion, or even much more should one of the 19 "too-big-to-fail" banks fail the "ultimate stress test."

4. Unemployment: The unemployment rate rose to 9.7 percent in August 2009, the highest since 1981. Among men, the rate rose to 10.1 percent. Almost 4 in 5 lost jobs during the recent downturn have fallen to men, but no one has questioned whether employers are discriminating. Are they? I don't know; it would take a very sophisticated statistical analysis that someone should undertake. What I do know it that men are more likely to head households and men are disproportionately bearing the brunt of job loss in the current recession.

3. Residential Real Estate: The combined delinquency/foreclosure rate on residential real estate has more than doubled in the last year, to more than 13 percent of outstanding mortgages as of August 2009, or more than one in eight of every mortgage in the U.S. In August, this rate rose to a new record, indicating that the market has not yet hit bottom; things continue to get worse. During the next two years, more than $1 trillion in option ARMs will reprice, primarily due to negative amortization; look for about half of this amount to end up in foreclosure.

2. Small Businesses: Small businesses account for roughly 4 out of 5 new jobs, according to the U.S. SBA. Because of top-ten items 5, 4 and 3, small businesses are failing at record rates and cannot hire new workers. Small businesses cannot get new bank loans to fund new investment; rising unemployment reduces demand for the output of small businesses; and small businesses can no longer rely upon rising home equity as a source of investable capital. 

1. The Debt-Burdened American Consumer: Consumption accounts for roughly 70% of Gross Domestic Product (GDP), and consumer, over the past two decades, have "borrowed" against their homes to finance excessive spending they could not otherwise afford. Now, that source of credit has dried up. Consequently, consumers will now have to forego future consumption in order to deleverage, and this process will starve GDP of its most important input. Compounding this is the demographic fact that Baby Boomers, the most numerous age cohort, are leaving peak consumption years and heading towards retirement. In years past, home equity was a large portion of retirement assets, but this generation of retirees has already borrowed against and spent its home equity. As consumption falls in response to these factors, so does GDP, making recession more likely than recovery during 2010. And beyond . . . .

Posted by m1rac01 at 03:36 PM | Permalink

As we debate the costs and benefits of the various "health insurance" reform plans, let us agree on several issues:

First, let us agree that "health care" is freely available to all Americans, at great cost to those of us who pay taxes and pay for health insurance. No American can be refused treatment from an emergency room at a U.S. hospital. In fact, no one can be refused emergency room treatment, U.S. citizen or not. Consequently, only about one in twelve emergency room patients actually pays his or her bill. We pick up the cost for the other eleven. Beyond the direct monetary costs we bear, we also suffer because of horribly overcrowded emergency rooms, where waiting times for initial treatment routinely reach four hours or more. 

Second, let us agree that this is an incredibly inefficient and expensive way to handle health care for the uninsured. Surely, there are more efficient options. By covering the uninsured with a government subsidized plan or routing them to ambulatory care centers instead of emergency rooms, we can significantly reduce both the costs of emergency room treatments and the ridiculous waiting times for emergency-room treatment.

Third, let us agree that "rationing" currently, and always, willl take place. Under our existing system, bureaucrats at insurance companies are responsible for rationing decisions; under a single-payer system, government bureaucrats would be responsible for rationing decisions. In every possible scenario, someone will be responsible for deciding what drugs and treatments will be paid for by insurance and what will be the financial responsibility of the insured. No country is wealthy enough to provide gratis the most expensive and experimental medical treatments available to all of it citizens. Somone must make the tough calls, but who?

Fourth, let us recognize that our current system, where we rely upon our employers to provide health insurance, is the result of unintended consequences from earlier government regulation. Back during WWII, the U.S. government imposed wage-price controls. In response, employers looking for workers offered free health insurance as non-wage compensation. It worked, but led us to a system post-war where U.S. employees increasingly obtained health insurance from their employers. No other developed country followed this model. Unintended consequences of government regulation are insidious and long-term, so we must be careful with any major overhaul of the current system.

Fifth, let us recognize that true "portability" of health insurance will never be available so long as employer-provided health insurance is the norm. If your employer provides your health insurance, your employer is choosing your plan and you are not. Should you decide to change employers, you will not be able to continue your old plan; you will be forced to choose a new plan chosen by your new employer. This is simply a fact and will not change under current proposed changes, unless we go to a "single-payer" government plan. In that case, everyone will have the same government plan and we will have true portability, but we will not have any "choice." Whatever is offered by the single payer is what we will have. Look to Canada for what this will look like. Canadians routinely come to the U.S. to obtain care they cannot obtain under the single-payer Canadian plan; this will not be an option for U.S. citizens unless they want to fly to Costa Rica, Singapore, or some other country for treatment.

Posted by m1rac01 at 12:44 PM | Permalink

As pointed out in today's NY Times column by Gretchen Morgenson, the recent financial crisis has refocused attention on the failure of the board of directors at publicly traded U.S. corporations, especially at financial institutions such as Countrywide, Fannie Mae/Freddie Mac, Lehman Brothers, and Washington Mutual.

In our system of corporate governance, the board of directors is supposed to represent the interests of shareholders, hiring, firing, monitoring and setting compensation for the top management team of its corporation. The recent crisis has demonstrated the abject failure of boards to fulfill their responsibilities to shareholders.

Why has this happened? There are a number of reasons, which together have wrested control of the board of directors from shareholders and handed it to CEOs.

Dispersed ownership: in contrast to corporations elsewhere in the world, ownership of U.S. corporations is dispersed. This means there are few large block holders to ensure that the board of directors represents shareholder interests.

Dominance of inside directors: at most corporations, inside directors (meaning members of the management team or their flunkies) hold a majority of the positions so that they can vote the interests of management over the interests of shareholders.

Multiple roles for the CEO: The CEO is often also the Chairman of the Board of Directors. As such, he controls the agenda for the annual shareholders' meeting and chairs that meeting. He also chairs all meetings of the board. Few outside directors want to challenge a CEO who also holds the Chairman's seat. In yet another role, the CEO also often is head of the board's nominating committee, which nominates new directors. As such, he is in position to select "compliant" directors, even when they are allegedly "independent."

Voting of "unvoted shares" by brokers: Existing rules allow for your stock broker to vote your shares in the event you choose not to vote them (or forget to vote them). On average, about 20 percent of all shares are voted in this manner, and surveys indicate that brokers overwhelmingly vote for the existing management team. This means that management starts with two-fifths of the 51 percent share it needs to retain control of the board. Alternatively, it means that someone challenging management has to win five-eights (more than 60 percent) of the remaining 80 percent of the shares in order to defeat incumbent management. Fortunately, this outrageous practice will end next year.

Anti-takeover provisions: Such provisions are too numerous to enumerate here, but, in sum, they make it all but impossible for dissident shareholders to throw out an incumbent management team by replacing its lapdog board of directors.

In the absence of an effective board, what are shareholders to do? Well, they can vote with their feet and sell their shares. Unfortunately, in an age of index mutual funds and EFTs, we all end up owning shares in these companies run by bad managers. In such an environment, it may fall to government regulators the role of disciplining management. When viewed through these glasses, the Fed's recently announced plan to oversee compensation policies for bankers looks less like over-reach and more like much-needed oversight. Proposals to provide shareholders with a "say on pay" also deserve our attention and support.

Posted by m1rac01 at 10:39 AM | Permalink

Yesterday, the FDIC closed two more bank, bringing the total for 2009 to 94, and surpassing every year since 1991, which was the tail-end of the last major banking crisis. More than 2,000 banks and thrifts were closed during that crisis. How many will fail during the present crisis? No one knows, but the number is unlikely to rise anywhere near 2,000.

Even so, the costs of bank failures this time around have been larger, as the FDIC has been forced to tackle several large banks that imposed losses of more than $1 billion on the Deposit Insurance Fund ("DIF"), which replaced the Bank Insurance Fund ("BIF") and Savings Association Insurance Fund ("SAIF") a year ago. At the end of the second quarter, the DIF reserves stood at only $10.4 billion, far below the statutory requirement, which is 1% of the more than $4 trillion in insured deposits, or more than $40 billion.

Are your funds safe? Well, that depends . . . . 

Most likely they are, so long as you have less than $250,000 in any one account at one bank. This amount was raised from $100,000 last year during the financial crisis.

So, for most of us, this issue doesn't affect us directly. Indirectly, however, it affects us all.

The FDIC has a $500 billion line of credit with the U.S. Treasury (read U.S. taxpayer), and is almost certainly going to have to access that line of credit later this year. This borrowing potentially puts us taxpayers on the hook for bailing out the banking industry yet again, over and above the TARP funds appropriated last year.

(See yesterday's blog for information on yet another back-door bailout of the banking industry.)

Posted by m1rac01 at 11:16 AM | Permalink

Today, the Wall Street Journal published an article Uncle Sam Bet the House on Mortgages, which documents how yet another back-door bail-out of the Big Banks (Bank of America, Chase and Wells Fargo) is taking place at taxpayer expense, but largely behind the curtains of public scrutiny.

The scam works like this: "Big Bank" (BofA, Chase or Wells) makes mortgages that it would never carry on its own balance sheet because the loan doesn't pay enough interest to cover the loan's risk. (The article quotes the CEO of Wells Fargo: "We're not putting on 30-year [fixed-rate] mortgages at these rates.")

Big Bank then uses the FHA to guarantee repayment of the loan and GNMA to securitize the loan, which is then sold to . . . get this . . . the FED!!! 

According to the article, the three big banks made more than HALF of all mortgages in the U.S. during the first half of 2009, the FHA or another Treasury-backed entity such as Fannie or Freddie insured 85% of all mortgages made during this period, and then the Fed BOUGHT 80% of the securities into which these mortgages were packaged.

What was in it for the banks? More than $14 BILLION in fee income on mortgage servicing during the first half of 2009.

Who bears the risk on these loans? The FHA.

In another article today entitled The Bailout Bill Comes Due, Vexing Agencies, the NY Times reports that the FHA's cash reserves has fallen below 2% for the first time, as the percentage of FHA mortgages that are now delinquent has risen above 14%, more than double the 6.4% rate for prime agency mortgages. Why? Because the FHA has become the new Countrywide--that is--the FHA is now the primary source for "subprime" mortgages. Unlike other lenders, the FHA requires only 3.5% down payment and lends to borrowers with bad credit scores. As a result, the FHA's share of the mortgage market has skyrocketed from less than 5% to more than 40%. Americans know a sucker, er, bargain when they see one!

But now the day of reckoning is at hand. The FHA now faces the strong likelihood of needing a government bailout at a time when the American taxpayer is fed up with bailouts. How big the pricetag for this bailout will be is open to speculation, but one thing is for certain:

The pricetag is rising each and every day.

Posted by m1rac01 at 11:03 AM | Permalink

This morning at 8:30 a.m. EDT, just as it does on each first friday of a new month, the Bureau of Labor Statistics released its monthly employment report entitled "The Employment Situation," for the previous month, in this case, for August 2009.

The report summarizes the findings of two separate monthly employment surveys, one of establishments and one of households. The establishment survey is larger and hence has a smaller forecast error, but it only captures employment at larger, established non-farm establishments. It misses the self-employed, as well as employees of smaller and newer establishments that don't participate in the survey. The second is the household survey, which is smaller and hence has a larger forecast error, but is able to provide information on unemployment, which is not available for obvious reasons, from a survey of employers. It also captures information on self-employed workers and workers at smaller and newer establishments.

The headline jobs number comes from the establishment survey while the headline unemployment rate comes from the household survey. For August, these numbers were -216,00 and 9.7%, respectively. The employment number has been trending upward from peak job loss of more than 700,000 in January. The unemployment rate has been trending upward since April 2008, with the exceptions of June and July 2009; August 2009 re-establishes that upward trend.

If we delve deeper into the numbers we find the following: Employment as measured by the household survey fell by almost double the number in the establishment survey, 392,000 lost jobs verus 216,000 lost jobs. While this may be statistical noise, it also may reflect the disproportionate effects of the recession on small businesses and the self-employed, which are not captured in the establishment survey. Also of note is the decline in labor force participation, which fell by 143,000 in August and by 637,000 in July. Had these workers remained in the labor force without jobs, the unemployment rate would now be 10.1% instead of 9.7%. (In order to be unemployed, one has to report having actively looked for work during the previous four weeks; if not, then one is "not in the labor force.")

There also is wide variation by age, gender, race and ethnicity. Among teenagers, unemployment is up to 25.5%. Among adult men, unemployment is up to 10.1% as compared to only 7.6% for adult women; this recession discriminates against men. Among African-Americans, unemployment is up to 15.1% and, among Hispanics, up to 13.0%.

The BLS also reports broader measures of unemployment in Table A-12 of its report. U-6 is the broadest of these measures, including officially unemployed plus discouraged workers, plus those employed part time for economic reasons, plus marginally attached workers, and this measure rose to 16.8% in August, up from 16.3% in July and 10.9% in August 2008.

Finally, we note that the BLS "revised" its jobs numbers for June and July. Both months were revised downward, June by 20,000 and July by 29,000. This strongly suggests that we will see the August jobs number adjusted downward next month, once the BLS has had the chance to review data from late-filing respondents.

Only Vice President Joe Biden could find green shoots amidst this dire economic news. Yesterday, Biden reported that the administration's $787 billion Stimulus program, of which less than 20% has been spent to date, has already "created or saved between 500,000-750,000 jobs." How he measures a "saved" job is anybody's guess, but I'm sure the 15 million - 26 million unemployed (depending upon the narrow or broad definition of unemployment) workers are glad to  hear that Joe is looking out for them.

Posted by m1rac01 at 11:07 AM | Permalink

Today, the WSJ reported that the Obama administration plans to add another 2,000 workers to the 1,100 already toiling away on the paperwork for the 'Cash-for-Clunkers' program, which ended back on August 24. I kid you not.

In a previous post (see August 24th), I noted how the administration had been forced to more-than-triple the number of workers processing 'clunker' paperwork, from 300 to 1,100. Now, ten days after the program ends, we learn that they need to AGAIN triple the number of workers from 1,100 to more than 3,000. In other words, the administration underestimated the number of workers needed for this program not by a factor of THREE but by a factor of TEN! That's right: off by one full order of magnitude.

Meanwhile, dealers continue to complain about the program, with many fearing that they will not receive the promised rebates because their "paperwork is not in order."

Sounds more and more like something out of the 1980s era Soviet Union, for those of us who remember that country.

Posted by m1rac01 at 03:18 PM | Permalink

Today, the Wall Street Journal published an article on the dismal failure of the Obama administration's Home Affordable Refinance Program.  The administration’s response to the housing crisis has been to trot out a set of ill-conceived programs formulated by advocates rather than practitioners or scholars. Now, four months have passed, during which more than 500,000 homeowners have fallen delinquent on their mortgages IN EACH MONTH, including 564,000 during July (Source: Lender Processing Services). The percentage of mortgages either delinquent or in foreclosure has risen from 10.4% in March to 11.56% in July. Why has the administration’s housing relief program failed so miserably?

The answer lies in the poorly conceived programs put out by the administration. The policy wonks who devised these programs appear to have been blissfully unaware of how the mortgage market works and how bad the housing situation had deteriorated.

These wonks failed to address the fact that the majority of troubled borrowers couldn’t put down a 20% down payment and, therefore, took out second mortgages equal to 20% or more of the primary loan balance. When the borrower attempts to refinance the first mortgage, she must either refinance the second mortgage or get the holder of the second lien to “subordinate” its claim to that of the new first-lien holder. Most of these second liens are practically worthless on a market- value basis, so the second-lien holders view this as an opportunity to force repayment of their claim, and refuse subordination.

The wonks also appear to have been unaware of complications posed by insurance purchased by some lenders to deal with requirements of Fannie and Freddie on high LTV mortgages. By refinancing these mortgages, the original lenders would lose the protection afforded by the insurance for which they had already paid.

The wonks originally targeted the HARP program at borrowers who owed between 80% and 105% of their home’s current appraised value. This knocked out millions of borrowers who were and/or are now underwater by more than 5%, for better or for worse. (Refinancing these loans without principal reduction is a recipe for future delinquencies.)

Adding to the comedy of errors was the administration’s failure to harmonize this program with the Fed’s program to temporarily push down mortgage rates, which was quite successful during April and May, but more recently has faltered in the face of the administration’s massive and rising deficits.

Home equity is the seed capital for small businesses and small businesses are responsible for the vast majority of new jobs (source: SBA). There is a vicious feedback effect where rising unemployment leads to deterioration in the housing market, which, in turn, contributes to rising unemployment. Until this feedback cycle is broken, unemployment will continue to rise, housing values will continue to fall and budget deficits at both the state and federal levels will continue to balloon. 

For an alternative plan, see my Housing Asset Relief Program, which I first posted to SSRN in early February and circulated to policymakers shortly thereafter. An abbreviated version of this program was published as an Op-Ed in the Financial Times on April 21, 2009.

Posted by m1rac01 at 12:13 PM | Permalink