Surmountable mortgage mess

I’ve been watching the housing and mortgage markets with great interest for years.

When working for my former employer (2002-2005), I watched (but didn’t follow) as he doubled- and tripled-down on investments associated with the housing market.  As his employee, I worked hard, struggling to understand the individual investments, but never fully got my arms around them.  I knew enough to be very cautious, but that was all. 

Now, after watching the boom and bust over the last decade, I believe I have a much better understanding of how the housing, mortgage and financial markets work (or don’t work) together.  I’ve watched, researched, studied, invested and blogged on the subject over the last six years (my blogs from the spring, summer and fall of 2007 are particularly revealing of my concerns). 

So, it was with great interest that I read an article in the Wall Street Journal today, The Mortgage Hangover.  I highly recommend it to anyone who sincerely wants to understand the boom and bust of the housing and mortgage markets over the last decade (and not just looking for evidence to confirm one’s conclusions beforehand).  The article is not perfect, but it does a great job of highlighting many of the important details.

Specifically, it describes how the mortgage market was distorted over the last decade in the Bronx.  You may think that Bronx real estate has nothing to do with Florida, Nevada, California or Colorado real estate, but it does.  In fact, I believe it represents a microcosm of all U.S. real estate.

The problem started with well-meaning politicians who wanted everyone to have a home.  That problem was exploited by real estate and finance workers who were heavily incentivized to take things to the brink (which was the inevitable result of bad policy).  When those problems led to collapse, the same well-meaning politicians tried to prevent the resultant suffering.  Once again, those efforts are creating new problems instead of solutions.

The good news is that the mortgage and housing problems can be fixed.  It requires that housing and mortgage markets be allowed to reach clearing prices (where free buyers and sellers agree to exchange without any distorting incentives from politicians).  When that happens, housing and mortgage markets can begin growth afresh. 

I’m not saying the process will be pretty, but it will happen.  The destination will be the same no matter how well-meaning those who disagree.  The only question, now, is how quickly or slowly we get there.  Policy can impact the duration of the pain, not its intensity.

The bad news is that politicians and voters are unlikely to take the fast approach.  This is unfortunate, because U.S. economic and employment growth are unlikely to recover until the housing market recovers.  The longer we put off clearing prices in the housing and mortgage markets, the longer until employment and our economy truly improves. 

Mortgage and housing markets need not wallow in freakish misery.  Recovery, both for those markets and the U.S. economy, could start soon.  But, with continued meddling in housing and mortgages, recovery will take much longer and be much less robust.  It’s time to face the inevitable, hold our noses, and take our medicine.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Surmountable mortgage mess

Moral Hazard

Today, the Federal Reserve and President of the United States offered a life raft to the mortgage market.

It sounds like this will come in the form of additional liquidity for lenders from the Federal Reserve, and loan guarantees and loan restructuring for borrowers through various government departments.

Although this may seem like much needed help for “victims” of the market, to me it looks like a dangerous incentive to take more risk–also known as moral hazard.

You see, borrowers who shouldn’t have gotten money were lent money. Many were speculators hoping home prices would keep going up. Others were ignorant of the loans they signed because they didn’t bother to read the paperwork.

Should borrowers be bailed out who shouldn’t have borrowed? Suppose I go out and buy a large screen TV with my credit card. Suppose I can’t make the payments because I didn’t realize the interest rate I would pay. Should taxpayers bail me out because I’m ignorant of the contract I signed? If they do, what would I learn? Not to take the risk?

Even worse, lenders knew about their borrower’s credit histories and ability to pay. Lenders also knew they would pass such loans off to Wall Street investment banks who would sell such bad loans to ignorant investors.

Should the mortgage originators, Wall Street banks and lazy investors be bailed out for making bad loans? Suppose I lend someone money at a 20% rate because they can’t get a loan elsewhere. Suppose they can’t make payments at some point. Should the taxpayer bail me out for making a bad loan? What would I learn? Not to make loans to people who can’t pay?

The Fed and President are offering to bail out borrowers and lenders with other people’s money. Those other people are U.S. taxpayers. You will pay in the form of inflation due to the Fed printing money and higher tax rates or higher government debt due to the executive branch bailing out “victims” of bad lending.

The real problem with this scheme, as any study of history will tell you, is moral hazard. If someone learns they can take risk at another’s expense, then they’re incentivized to take that risk over and over again.

If you let a teenager borrow your car and they get in an accident, what do they learn if you prevent them from living with the consequences? Why would that be any different with adult borrowers and lenders in the U.S. economy?

Just look at the people rebuilding their huge houses in Alabama that were wiped out by hurricane Katrina. They know they don’t have to pay for insurance because the government will bail them out, so they are quite happy to rebuild because they know they won’t bear the expense of the risk they’re taking.

So, when you see spiking inflation over the next several years and higher tax rates or increased federal debt to pay for all the bailouts the government is offering, keep in mind that you’re getting to bail out speculators in real estate, people with bad credit histories, banks who pass their loans off to Wall Street, Wall Street investment banks that don’t need the help, and investors who don’t bother researching what exactly they are buying.

And, when such teenagers take this risk over and over again, and you get to bail them out each time, remember that there is a name for this phenomenon–moral hazard.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

What will happen if the credit market’s other shoe drops?

Recent bond and stock market turmoil has turned full attention to credit markets. What has surprised me is that conditions for credit markets aren’t that bad. Am I mad, you may be thinking?

Here’s my line of reasoning. There are three things that can really beat up the consumer credit market: availability of credit, interest rates and employment.

The fireworks seen so far are almost purely due to the availability of credit. Market participants have been scared by recent credit defaults and delinquencies, and so they are refusing to grant such markets more credit.

But, interest rates and employment are just as important, and they are doing great right now. Both look as good as they have since the 1950’s and 1960’s, with long term interest rates at 4-5% and unemployment down around 4-5%.

What would happen if this were to change, and why doesn’t anybody seem to be discussing this?

I guaranty that if interest rates increase and employment starts to fall, you will see many more defaults and delinquencies. In other words, what we are witnessing in credit markets could just be the tip of the iceberg.

With Congress threatening 27.5% tariffs on Chinese goods and China threatening to sell the huge amount of US Government Treasury bonds they hold in response, the threat of higher interest rates is real. With credit market troubles in the US forcing the Fed to intervene and the dollar falling, higher interest rates are even more of a threat.

With the housing market supplying so many jobs since the 2001 recession and the housing market crashing, employment problems could just be surfacing. With recent retail sales so poor, additional employment problems could be rearing their ugly head, too.

I don’t know how this will play out, but I’m watching it carefully. If the economy continues to be strong, then interest rates and employment will not be big concerns.

But, if the economy continues to slow, the dollar continues to fall, retails sales continue to look punk, the housing market continues to decline, or protectionist sentiment in Congress gains momentum, look out below!

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Graham and Dodd on guaranteed real-estate mortgages and mortgage bonds

I recently re-read–with pleasure–chapter XVII of the 1934 Edition of Security Analysis by Benjamin Graham and David Dodd. The chapter addresses guaranteed real-estate mortgages and mortgage bonds.

I re-read the section because I think it highlights the problems of mortgage insurance companies and other insurance companies that enter the business of guaranteeing the payment of mortgages and mortgage securities (such as surety businesses like bond insurers).

You see, the real estate boom of the 1920’s led to a terrible real estate crash in the 1930’s. It basically wiped out the mortgage insurance industry and many of the surety companies that ended up guaranteeing mortgage bonds. The history is illustrative for what can happen and what may be happening today.

I quote liberally from the text below (starting on page 184).

“The idea of underlying real-estate mortgage guarantees is evidently that of insurance.”

“It is within the province of sound insurance practice to afford this protection in return for an adequate premium, provided of course, that all phases of the business are prudently handled. Such an arrangement will have the best chance of success if:
1. The mortgage loans are conservatively made in the first instance.
2. The guaranty or surety company is large, well managed, independent of the agency selling the mortgages, and has a diversification of business in fields other than real estate.
3. Economic conditions are not undergoing fluctuations of abnormal intensity.
The collapse in real-estate values after 1929 was so extreme as to contravene the third of these conditions.”

“In the first place a striking contrast may be drawn between the way in which the business of guaranteeing mortgages had been conducted prior to about 1924 and the lax methods which developed there-after, during the very time that this part of the financial field was attaining its greatest importance.”

“The amount of each mortgage was limited to not more than 60% of the value, carefully determined; large mortgages were avoided; and a fair diversification of risk…was attained.” [loan to value ratios run very high today: 80%, 90% and even 95%]

“It is true also that the general practice of guaranteeing mortgages due only three to five years after their issuance contained the possibility, later realized, of a flood of maturing obligations at a most inconvenient time.”

“The building boom which developed during the new era was marked by an enormous growth of the real-estate-mortgage business and of the practice of guaranteeing obligations of this kind.”

“Great emphasis was laid upon the long record of success in the past, and the public was duly impressed….”

“The weakness of the mortgages themselves applied equally to the guarantees which were frequently attached thereto for an extra consideration.”

“The rise of the newer and more aggressive real-estate-bond organizations had a most unfortunate effect upon the policies of the older concerns. By force of competition they were led to relax their standards of making loans.”

“…the face amount of the mortgages guaranteed rose to so high a multiple of the capital of the guarantor companies that it should have been obvious that the guaranty would afford only the flimsiest of protection in the event of a general decline in values.”

“When the real-estate market broke in 1931, the first consequence was the utter collapse of virtually every one of the newer real-estate-bond companies and their subsidiary guarantor concerns. As the depression continued, the older institutions gave way also.”

“During the 1924-1930 period several of the independent surety and fidelity companies extended their operations to include the guaranteeing of real-estate mortgages for a fee or premium.”

“…surety companies began the practice of guaranteeing real-estate-mortgage bonds only a short time prior to their debacle….”

“In most cases the resultant losses to the suretor were greater than it could stand; several companies were forced into receivership, and holders of bonds with such guarantees failed to obtain full protection.”

Perhaps the real estate boom of the early 2000’s was similar to that of the 1920’s. If that is the case, and I believe it is to some degree, then Graham and Dodd’s historical lesson served as a potent warning for investors in mortgage and bond insurance companies. Maybe that is why they have sold at such seemingly cheap prices over the years….

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Continued ripple effects

It’s been interesting to watch how the fallout in credit markets has rippled across other markets.

The initial indication of credit market stress showed up as subprime problems during late winter and early spring of this year. At the time, many market commentators were saying it was isolated and contained.

Then, as expected, credit tightening continued to ripple across other markets as it became more difficult to raise high yield debt. This, too, was described as a short term and isolated situation.

Now, it sounds like prime home equity loans are having trouble as are auto loans. The ripples keep showing up in more and more places. And, the market commentators continue to declare that it’s contained and short term.

Is this unusual? Not at all. This is exactly the type of thing that happens every time credit markets get too loose. As the credit market gets further and further away from its most recent problems, lower quality borrowers are loaned more and more money, or money is lent to borrowers at a rates not high enough to compensate for the risk involved.

At some point in time (forecasting if it will happen is easy, forecasting when is extraordinarily difficult), credit markets tighten again as lenders realize they have made bad loans.

This usually takes several years to unfold and almost always includes a large and “unexpected” crisis such as Long Term Capital Management in 1998, the Saving and Loan Crisis in the late 80’s and early 90’s, or the corporate credit squeeze in 2002.

I expect greater difficulties for banks (especially mortgage banks) that made bad loans, bond insurers that insured AAA tranches that were much more risky than they assumed, and mortgage insurers who looked only at recent data when pricing their insurance premiums.

At a later point in time, the market will become so disgusted that great buying opportunities will occur. I don’t think that time is here, yet, but I also assume that smart investors will start buying long before the bottom is reached. I just may be in that group, too.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Bill Gross’s Investment Outlook

Bill Gross is a legend in the investing industry. He doesn’t work, though, in the more glamorous equity side of investing. Instead, he is a bond market investor, and has one of the best long term records in the business.

Gross also happens to be an outstanding writer. I envy his ability to say a lot with few words, and to explain complex financial concepts with amusing analogies.

For these reasons, his monthly Investment Outlook is a must read for me. As usual, his Investment Outlook for this month didn’t disappoint.

Gross takes to task the mortgage market, how it has performed and will perform in the future. His conclusion is that the fallout is not over, and that we’re just looking at the tip of the mortgage iceberg.

He believes this is the case because many adjustable rate loans made over the last several years have yet to reset, and when they do, many more homeowners will punt their houses back to the market.

He also indicates that these problems will be felt in the Mortgage Backed Security (MBS) and Collaterlized Debt Obligation (CDO) markets. This, along with legislative action, will tighten credit and limit the number of people who can get new loans.

His conclusion is that the housing market will takes years to work through it’s problems (tougher credit, high inventories of homes for sale, anchoring by home sellers), and that the Federal Reserve may soon cut rates in an attempt to limit such problems now that inflation is looking less threatening (according to their narrow metrics).

Am I planning on acting on this advice? I can’t say I am. Unlike a bond market guru with institutional clients who demand short term performance, I don’t need to forecast interest rates or try to guess what the housing market will do. But, I find his thinking very provocative, and it reinforces my desire to stay far away from companies that deal intimately with the housing or mortgage market.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Interest rates

For those of you not paying attention, the bond market has had an amazing month and a half!

If you are thinking to yourself, “What does the bond market have to do with anything, I buy stocks,” hold on to your hat.

Bonds are frequently used as the discount rate or the base rate from which discount rates on stocks are computed. This is most prevalently seen in the Fed Model, but is also the way almost every finance textbook used in business school starts.

If bonds drop in price, and their yields go up (as has happened lately), then stock prices should go down (all things being equal, and they never are). By how much? I’ll get to that below.

Back on May 2nd, the 10 year yield on US Treasury bonds was 4.64% and the 3 month yield on US Treasury bills was 4.87% (according to Value Line’s May 11 Selection and Opinion). Today, according to PIMCO’s website, the 10 year is yielding 5.30% and the 3 month is yielding 4.72%.

This is a massive change! The 10 year’s yield jumped 0.66% and the 3 month’s yield dove 0.15%. Because the bond market has such a huge impact on all discount rates in the market, this is a huge change!

For those of you thinking the stock market’s recent sell off has taken account of such a discount rate change, think again. The DJIA was at $13,211.88 on May 2nd and closed at $13,295.01 today, a 0.63% increase. All things being equal (assuming estimates on company earnings haven’t changed), the DJIA should be at $11,566.60–down 12.45%! Instead, it’s at $13,295.01, implying that earnings estimates for the DJIA have increased by 14.95% in the past month? I doubt that.

I’m NOT suggesting the Fed Model is correct or that stock prices should move precisely with bond yields, but I am suggesting that the stock market, and perhaps other markets, have not taken full account of recent bond price and yield movements.

Also, how do you think bond price moves will impact mortgage and housing markets? A 30 year mortgage on a $300,000 house should go up around 7% per month (or $130) based on this bond price change. Does it seem like that’s been figured into market prices for home builders and mortgage companies? It doesn’t seem like it to me.

As usual, I’m making no assumptions about what will happen in the market and when, but I do find recent bond market moves disturbing.

Perhaps bond prices and yields will go back to where they were, vindicating recent stock market moves. Perhaps fundamentals are improving just as quickly as bond prices are dropping and this justifies no move in prices.

I can’t predict what will happen much better than the next guy, but I am scratching my head and wondering what other people in the market are thinking.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.