Showing posts with label ARM. Show all posts
Showing posts with label ARM. Show all posts

Tuesday, March 13, 2007

Move Over Sub-Prime

With all the news lately concerning the sub-prime meltdown and its considerable effects on commercial (private and public) lending institutions it’s easy to forget that nearly 50% of all mortgage debt is held by the two main government sponsored enterprises (GSEs) Fannie Mae and Freddie Mac.

These two organizations, though purportedly operating both to the benefit of the public and within certain constraints not required by commercial lenders are not immune from the very same risks that commercial lenders face when managing a large portfolio of debt.

To the contrary, it appears quite possible that because of the GSEs special status and federal entanglement, they may actually be presenting a greater risk of failure, and the possible systemic fallout that could follow, than any of the larger commercial lenders.

Although the GSEs don’t technically write sub-prime or alt-A loans and restrict their lending activities exclusively to conforming loans, they have not been immune from the current culture of excessive lending.

It’s important to note that nearly 6% of GSE debt is composed of ARM loans.

Additionally, at least 3% of GSE fixed and adjustable rate loans have “interest only” options.

Furthermore, the OFHEO limit for conforming single family loan soared to a lofty $417,000 during the historic housing boom.

In a speech given last week, Federal Reserve Chairman Bernanke suggested that the GSEs have taken on more risk than typical commercial lending institutions, function with far less “market force” scrutiny than comparable commercial lenders and don’t even fulfill the public objectives set out for them by the federal government.

“The regulatory framework under which the GSEs operate has two principal objectives: first, to support the GSEs’ mission of promoting homeownership, especially access to affordable housing; and second, to ensure that these two companies operate in a financially prudent manner.”

“This line of business [the GSEs] has raised public concern because its fundamental source of profitability is the widespread perception by investors that the U.S. government would not allow a GSE to fail, notwithstanding the fact that--as numerous government officials have asserted--the government has given no such guarantees.”

“Consequently, the GSEs’ ability to borrow at a preferential rate provides them with strong incentives both to expand the range of assets that they acquire and to increase the size of their portfolios to the greatest extent possible.”

“… they [GSE Portfolios] are not only large but also potentially subject to significant volatility and financial risk (including credit risk, interest-rate risk, and prepayment risk) and operational risk. Many observers, including the Federal Reserve Board, have expressed concern about the potential danger that these portfolios may pose to the broader financial system; that is, the GSE portfolios may be a source of systemic risk. … with possibly serious implications for the performance of the broader economy.”

“Unlike other private firms, however, the GSEs face little or no market discipline from their senior debt holders because of the belief among market participants that the U.S. government will back these institutions under almost any circumstances.”

“… because of both regulatory requirements and the force of market discipline, banks hold much more capital than GSEs hold. The very largest bank holding companies generally hold equity capital equal to 6 percent or more of assets, and the largest regional banks generally have capital ratios of about 8 percent. (As I am sure you are keenly aware, community banks often have a capital-to-assets ratio exceeding 10 percent.) In comparison, the GSEs hold capital equal to roughly 3.5 percent of assets. The justification for the low capital holdings of GSEs relative to banks is unclear.”

“However, evidence that Fannie and Freddie have had beneficial effects on the supply of affordable housing (over and above the benefits of their securitization activities for the mortgage market as a whole) has been difficult to find. After conducting several studies of the effects of GSEs on the mortgage market and establishing the GSEs’ disappointing results”

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Thursday, March 08, 2007

Coming Home to Roost

With the sub-prime meltdown now in full swing, federal regulators seem to be working feverishly to crank shut the recklessly spewing spigot of easy lending.

A little late to the party maybe but at least its confirmation that something other than useless lip-service regarding “toxic” loans and “rate shock” needed to be paid to the situation.

Of course, we did see the initial signs of official concern back in June of 2005 when former Federal Reserve Chairman Alan Greenspan suggested that “the apparent froth in the housing markets may have spilled over into the mortgage markets” while raising concern about “exotic” mortgage products during his testimony to the Joint Economic committee.

This was later followed by the drafting and subsequent finalization in September 2006 of the Federal Reserve’s “Interagency Guidance on Nontraditional Mortgage Product Risks”, a series of new regulatory guidelines that clearly had the effect of creating concern among some of the most aggressive lenders.

About that same time, Congress expressed some interest in the issue, hosting a Senate Banking Committee hearing entitled “Calculated Risk: Assessing Non-Traditional Mortgage Products” in which many government and industry experts spilled their guts on the topic.

Unfortunately, these efforts, although sound an necessary, were essentially all in vain as the real damage had already been inflicted over an unrestrained period years that saw Americans go on a home-buying-investing-building-rehabbing-flipping binge of epic proportions.

While lenders hit new lows of standards and ethics the nations housing markets surged to highs not seen before in history.

Well now the “chickens have come home to roost” so to speak leaving federal regulators in the position of playing catch-up for the years of negligent regulatory oversight.

To that end, late yesterday afternoon the FDIC issued an “Order to Cease and Desist” to Fremont Investment and Loan of California, asserting that Fremont and it’s affiliates Fremont General Credit Corporation and Fremont General Corporation have been practicing “unsafe or unsound banking practices and violations of law and/or regulation”.

Certainly, this effort is to be expected in this new found era of regulatory risk management but what’s most interesting about this initiative is that many of the corrective actions that FDIC is requiring of the company could easily be applied to countless other lending institutions including those not know to be primarily sub-prime lenders.

This is, in fact, the key take-away from this action.

Fremont may have been primarily a sub-prime lender but it is being “spanked” for committing the very same “unsafe” practices that were exceptionally common during the housing run-up.

Most, if not all of the nations lenders, including the largest institutions, have engaged in either direct sub-prime lending or some form of “pseudo-prime” lending, turning a blind eye to both risk and ethics.

Foolishly though, many on Wall Street are refusing to see the writing on the wall, instead favoring a point of view that seeks to recognize the sub-prime fiasco as merely isolated circumstances, contained only to those participants at the lowest end of the economic spectrum and with the poorest credit quality.

One only needs to recount some of the circumstances we have all observed over the last five to ten years and contrast that to prior eras to see the insanity that has become commonplace in the home lending market.

Zero-down, low-doc no-doc, hybrid-piggyback-blended loans, ARMs, rate-shock, interest only, reverse amortization, teaser rates, cash-out refinance, cash-back at closing, 40-50 year terms, the list goes on and on.

There is simply no doubt that, although the melt-down has begun in the sub-prime market it will end, and in a significantly more ugly fashion, in the pseudo-prime market.

The following is the list of actions that the FDIC is requiring of Fremont but could be applied to nearly every lender sub-prime or not:

  • Bank’s analysis of a borrower’s debt-to-income ratio include an assessment of the borrower’s ability to meet his or her overall level of indebtedness and common housing expenses, including, but not limited to, real estate taxes, hazard insurance, homeowners’ association dues, and private mortgage insurance.
  • In any case in which a loan would result in a debt-to-income ratio greater than 50 percent, the Bank’s policy should set forth specific mitigating factors (e.g., higher credit scores, significant liquid assets, mortgage insurance) that will permit the Bank to determine that the borrower possesses the demonstrated ability to repay the loan.
  • Bank must verify the borrower’s income, assets, and liabilities, including the use of recent W-2 statements, pay stubs, tax returns, or similarly reliable documentation, and verify that the borrower remains employed.
  • Provisions which require that when the Bank uses risk-layered features, such as reduced documentation loans or simultaneous-second lien mortgages, the Bank shall demonstrate the existence of effective mitigating factors that support the underwriting decision and the borrower’s repayment capacity, which mitigating factors cannot solely be based on a higher interest rate.
  • Bank shall develop, adopt, and implement a policy governing communications with consumers t0 ensure that the borrowers are provided with sufficient information to enable them to understand all material terms, costs, and risks of loan products at a time that will help the consumer select products and choose among payment options.
  • All communications with consumers, including advertisements, oral statements, and promotional materials, provide clear and balanced information about the relative benefits and risks of the products, and that such communications shall be provided in a timely manner to assist consumers in the product selection process, not just upon submission of an application or at the consummation of the loan.

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Wednesday, February 28, 2007

Fueling the Fire

Today, the Bureau of Economic Analysis (BEA) released their second installment of the Q4 2006 GDP report showing a series of significant downward revisions to the preliminary estimates released last month.

Remember that last months preliminary report showed GDP growing at an annualized rate of 3.5% giving many Wall Street bulls optimism that the 2.0% growth seen in Q3 2006 could have represented a temporary anomaly.

But today’s release revises down the preliminary estimate 1.3% to an annualized rate of 2.2% with significant revisions to, amongst other things, non-durable goods and net imports (as I had suggested last month might occur) as well as durable goods.

Additionally, residential investment is showing a continued and dramatic fall-off registering a decline of 19.1% shaving 1.16% from overall GDP.

Furthermore, the decline to non-residential investment that first showed up in last months report as a meager 0.4% was today revised to a far more substantial decline of 2.4%.

Taken together, the declines to both residential and non-residential fixed investment are now depressing GDP by a stunning 1.43%.

As with last months estimate, today’s release is still showing unusually large increases to non-durable goods, net exports of services, and defense spending as well as an unusually large decrease to net imports, all working to boost overall GDP figure.

Be on the lookout for these values to be revised in next months final Q4 2006 GDP report possibly depressing GDP further still.

The following chart shows real residential fixed investment and nonresidential fixed investment versus overall GDP since Q1 2003 (click for larger version).


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