by Calculated Risk on 1/22/2008 08:05:00 AM

From the WSJ: Bank of America Reports Sharp Drop in Earnings

Bank of America Corp.'s fourth-quarter net income fell 95% as the company recorded a higher-than-expected $5.28 billion in collateralized debt obligation write-downs and said credit costs soared.

by Calculated Risk on 1/21/2008 11:59:00 PM

From MoneyControl.com: Mkts hit lower circuit; trading stopped for an hour

Sensex and Nifty both opened with over 10% cut and hit the lower circuit and the trading got halted for one hour only fourth time in Indian history. Sensex opened down 9.75% or 1716.41 points at 15888.94 and Nifty was down 12.10% or 630.45 points at 4578.35. Sensex so far was down 25% and Nifty 28% from its all time high.

Meanwhile in Japan the Nikkei is down 651.01 or 5.5%. It is the same story throughout Asia.

by Calculated Risk on 1/21/2008 09:55:00 PM

When a bank makes a bridge loan, and then can't syndicate the debt, it is known as a "pier loan"; a bridge that goes nowhere. With all the discussion of real estate debt, it is easy to forget that Wall Street is still saddled with pier loans from the LBO frenzy of 2007.

From the WSJ: New Year, Old Problem: Buyout Debt

The banks now sit on $158 billion in leveraged loans in the U.S., which are credits with a high default risk, according to Standard & Poor's Corp. That pool includes private-equity deals valued at $88.25 billion that have been funded by the banks but not fully syndicated, according to data tracker Dealogic.

The investment banks are trying to sell the debt:

The market will get another test as a group of underwriters led by Deutsche Bank AG and Bank of America Corp. begin unloading $7.25 billion in loans related to the buyout of casino operator Harrah's Entertainment Inc. by Apollo Management LP and TPG. Last week, the banks began marketing the bonds at a discount of 96.5 cents on the dollar, for a deal widely seen as one of the most desirable credits created during the 2006 buyout boom.

It will be interesting to see if this "most desirable" of buyout debt gets sold, and at what price. Imagine the haircuts for the less desirable debt. And these pier loans also contributes to the credit crunch by limiting the amount the banks can loan to other companies.

by Calculated Risk on 1/21/2008 07:13:00 PM

Update: From Mike in Long Island here is a live DOW future (at the CBOT):

Here are a couple of places to track the futures market.

Bloomberg Futures.

Futures at 7:10 PM ET:

INDEX	VALUE	CHANGE
DJIA INDEX	11,657.00	-449.00
S&P 500	1,271.50	-53.80
NASDAQ 100	1,779.25	-70.25

Barchart.com Indices

Note: make sure you read the ones that are open. Some people sent me the Bloomberg site before they opened! At the barchart.com site, look at the time. If it shows a date, then that future is closed.

by Calculated Risk on 1/21/2008 03:45:00 PM

The O.C. Register's Jon Lansner shares an email from Pimco's Paul McCulley:

“Sometimes when you are ill, you make an appointment with your doctor; other times, you go straight to the emergency room. Now is an other time. ... Time is of the essence. What needs to be done needs to be done. Now."

Wow. Some people are really scared.

by Calculated Risk on 1/21/2008 12:48:00 PM

UPDATE: Same graph for DOW added back to Great Depression.

Here is a look back at previous recessions and bear markets.

The following graph shows the change from the three year daily high and the monthly close. Not all market declines are associated with recessions. As an example, there was a sharp market decline in 1987 and also in 1998 (the Asian financial crisis).

When looking at this graph, monthly closes within 5% of so of the three year high usually indicates the market was setting new three year highs.

Click on graph for larger image.

Note: the probable 2007/2008 recession is shown starting in December 2007.

Using the monthly close doesn't capture the entire down move - but it does capture most of it (the change is from the daily high) - but my graphics package won't handle any more data!

Here is a table of the recession related down moves:

Recession Year	Market Correction
1953	-12.5%
1957	-19.4%
1960	-12.1%
1970	-33.5%
1974	-47.8%
1980	-15.8%
1982	-24.6%
1990	-17.8%
2000	-47.4%
2008	-15.9% (through last friday)
Median (previous 9 recessions)	-19.4%
Average	-25.6%

All recessions are different, but based on the S&P futures, it appears the current decline will be close to the median decline tomorrow.


Here is the same chart for the DOW (I used four year max to capture entire Depression decline). I'd ignore the WWII period.

by Calculated Risk on 1/21/2008 10:26:00 AM

From the WSJ: Bank of China May Report Subprime-Related Write-Down

Analysts estimate that state-owned Bank of China ... may have to write off a fourth of the nearly $8 billion it holds in securities backed by U.S. subprime mortgages ...

More containment.

It looks like the stock market are in for more fun too: U.S. stock futures point to major decline on re-open

by Calculated Risk on 1/20/2008 12:45:00 PM

On Thursday, the Census Bureau reported housing starts were at the lowest level since the 1991 recession. Here are some more thoughts on starts:

Click on graph for larger image.

This graph shows total and one unit structure starts since 1968. Yes, I've marked the current probable recession on the graph!

Some people might argue that the graph isn't normalized by population or the number of households. That is correct, and it would appear with increasing population that the number of starts is pretty low right now. However, there is more to demographics than population growth; changes in household size can have a significant impact on the demand for housing. In fact, a majority of the demand in the '70s was driven by declining household size. (see this demographics and housing demand).

Here is a table from the above post that shows the number of housing units added due to population growth, and the number added due to changes in household size. In the '70s, there were more housing units added due to smaller households, than growth in the population. Conversely demand in the '90s was almost exclusively due to population growth, as household sizes stabilized.

Housing Added due to Population Growth and changes in Household Size
Decade	Due to Population Growth	Due to Change in Household Size	Total Housing Units Added
1940s	5.84 Million	2.86 Million	8.70 Million
1950s	9.11	3.08	12.19
1960s	8.10	2.27	10.37
1970s	9.05	10.65	19.70
1980s	9.13	4.77	13.90
1990s	13.47	0.13	13.60
2000s (through July '06)	7.63	2.04	9.67

Predicting population growth and changes in household size are both important in predicting the need for new housing units. With the high cost of homeownership, I wouldn't be surprised to see household sizes increase slightly over the next couple of years - lowering the demand for new housing units - at least until prices fall significantly.

Another driver for housing starts is the current housing supply. I've discussed this here: Housing Inventory and Rental Units. Currently there are about 1.6 to 1.7 million housing units in the U.S. above the normal level of inventory.

If housing units were transportable, and each unit was a perfect substitute for another, starts could fall to zero in 2008 and there would still be some excess inventory at the beginning of 2009!

Starts won't fall to zero in 2008 - units are not transportable, and they are not perfect substitutes - so we need to look at starts from a different angle to estimate how far starts will actually decline.


This graph breaks down housing starts by type and intent since 1974. This data is available quarterly at the Census Bureau. Note: this is the annual rate, not seasonally adjusted, Q4 2007 is estimated using monthly data.

We could use this data to make some estimates for 2008. First single family units built for sale is clearly dropping sharply. This was at about 550K annual rate in Q4, and has been as low as 400K in 1982 (300K quarterly). An estimate in the 400K range is probably reasonable for 2008.

Homes built for owners has been running over 300K per year for some time, although the level has fallen recently. A recession will probably cause a dip in owner built homes, however this is a housing area with favorable demographics (people in their 50s like to build their "dream home"). Perhaps 250K homes will be built for owners in 2008.

The next category is built for rent. This has been running just over 200K per year, and I expect the number to be at least that high in 2008.

The final category is condos. Condo starts are starting to decline too, but there is a fair amount of momentum in the larger projects, so a decline to 50K to 100K is probably reasonable.

This means something like 400K Built for Sale, 250K Owner built, 200K rental units, and 75K condo units will probably be started in 2008. That puts starts at 925K - higher than many other estimates.

If starts came in at 925K, this would actually be good news for the economy since residential investment wouldn't fall as far as some are forecasting, but this would mean very little of the excess inventory would be worked off in 2008 keeping pressure on housing prices and the homebuilders in 2009 and 2010.

A more pessimistic view would take starts to 800K in 2008: 350K built for sale, 200K owner built, 200K rental, 50K condos.

by Calculated Risk on 1/20/2008 12:44:00 PM

For those that participate in the comments: The blog has been loading slow, or stalling after the first post. This appears to be due to problems with Haloscan. I'm trying a few things with Haloscan, but to resolve this issue, I might have to change comment vendors.

I'm considering switching to js-kit comments. Mish is using js-kit if you'd like to check it out. Comments and suggestions are appreciated.

Best to all.

by Tanta on 1/19/2008 10:00:00 AM

We get a lot of questions about accounting issues these days. People are concerned about accrual accounting, particularly as it relates to Option ARMs or negative amortization and the income treatment of accrued but unpaid interest. This issue always butts up against the question of how mortgage holders reserve against losses on loans, or determine the extent to which capitalized interest is or is not ultimately collectable. We've also posted some news stories regarding the uproar over SFAS 114 treatment of modified mortgages, which really get down into the weeds in terms of mortgage accounting and which are, therefore, hard to follow without a basic understanding of general mortgage asset accounting. Finally, a number of people have been asking, as we keep seeing more and more reports of write-downs at banks and investment banks, how long this writing-down is going to go on, and how it is really calculated.

Some of you--bless your lovely hearts--may be entirely innocent of any background in accounting. You may be struggling to follow the conversation in part because you make the common civilian error of forgetting that bank accounting is "backwards." To you, a loan is a liability and a deposit account is an asset. To the bank, the loan is an asset and the deposit account is a liability. It does get more complicated than that, but it never makes any sense at all until you do get past that point.

Some of you, I know, come from the "real economy," or "widget-accounting," and you are stuggling with accounting concepts that make sense to you in terms of widget makers (or retailers), like inventory and receivables and warehouses, but become puzzling when they are applied to financial accounting. Some of you may be small business owners who work on a cash basis, not an accrual basis, so you may find financial accounting even more impenetrable.

I, who was never allowed into the accounting department unescorted am not an accountant, quite often struggle to make these things clear. Fortunately, our regular commenter Lama, who is a real accountant, has offered us a splendid GuestNerd post which walks us through the basics of accrual accounting, reserves, income, and asset valuation. I have added a few comments of my own, strictly from a banking perspective. Another of our regulars, the mighty bacon dreamz, has contributed illustrations to support Lama's text. I think you will find them enlightening.

Lama On Accrual Accounting and Reserves:

To understand how "other amortization" works, I guess you first need to know how accrual accounting works. Most individuals calculate their taxes based on cash basis accounting. You recognize income when you receive the cash (or check); you recognize expenses when you pay cash. Companies with simple cash transactions and not much equipment or inventory do not vary much if they use cash or accrual accounting (think newsstands, maybe a small consulting company).

Accrual accounting means you recognize revenue when earned, expenses when incurred. A gas station would not incur an expense when they purchase gas for resale. That station would incur the expense at the time the gas was sold. That’s because the gas’ cost was a cost to produce the sale. In the time between the purchase and subsequent sale, the company holds the gas as inventory as an asset on its balance sheet.

Another concept to keep in mind is that every asset on a balance sheet has a base and a reserve. The base asset value is the easy part. If someone borrows $100,000, you have a schedule with the $100,000 on it. The loan cost you $100,000 to make. If someone owes you the $100,000 and $5,000 accrued (unpaid) interest, now your schedule will have $105,000 as a current loan value.

Making a loan on the accrual basis means the lender is earning income based on what he is owed, not based on how much cash he receives, but how much the borrower owes. If there’s a $100,000 loan at 5%, the borrower owes $5,000 after one year. If the borrower pays $6,000, the loan balance is $99,000 with $5,000 paying interest and $1,000 paying principal. If the borrower pays $4,000, the loan balance is now $101,000, with $5,000 paying interest and $1,000 increasing the amount of the loan. That’s all there is to calculating the base asset. This is in keeping with every related principle of accrual accounting and has been done the same way since The Mortgage Pig wore short pants.

Now the reserve or fuzzy area. A reserve is the amount by which you will devalue the amount you record as the base asset. There are 3 basic ways to calculate a reserve. It’s possible to use any combination of 1, 2 or 3 within a portfolio. On debt instruments a company intends to hold (until maturity or involuntary termination), the reserve will be based on both Net Present Value of cash flows and collectability. The most accurate method is to specifically identify impaired assets. If you only think you’ll collect $90,000 NPV, the value is $90,000. Repeat the same for each loan. One might have a value of $0. [Tanta: this involves a credit analyst reviewing each loan at each reporting period, generally quarterly, to determine whether or to what extent it is impaired. You will find this method used on commercial portfolios, where there are fewer units of much larger loans which may not be homogenous or easily comparable to each other.]

The second method is a percent reduction of loan values based on historical experience. Say, if instruments of a certain type typically devalue by 5%, you’d apply that to the assets in the classification. Split the classified loans into as much detail as you think appropriate (there’s some detail in this area we don’t need today). [Tanta: this is the method typically used for loans classified as residential 1-4 family mortgages. In any but the tiniest portfolios, there are too many units to examine individually, and the guidelines and underlying collateral for residential 1-4 family are (supposed to be) homogenous enough that classification or grouping of loans for analytical purposes is considered sound practice as well as obviously efficient practice.]

The third type of reserve is called a general reserve. It is simply an educated guess applied to the entire portfolio. A manager might apply this on top of the other two types. This is also known as wetting your thumb and checking which way the wind is blowing. Years ago, the chairman of the SEC decried general reserves as “Cookie Jar” reserves and “Rainy Day Funds” and their use substantially diminished. Oh, in case you do some research on your own, Reserves = Allowances. [Tanta: in the context of banking, you will find loan reserves referred to as Allowances for Loan and Lease Losses or ALLL.]

The loan balance you see on the balance sheet or support schedule is the net of the base less reserves.

So, how does this affect Income? In accounting, everything is a transaction. Hence the Debits and Credits, which are just names. Your credit card company says “we’ll credit your account.” That means they are posting a credit to their Assets account “Loans." Assets are Debit accounts, so increases in Assets are Debits, decreases are Credits. Revenue is a Credit account, so increases in Revenue are Credits, decreases are Debits.

Reserves for Loans Losses is a Contra-Asset account. Contra-assets are credit accounts that piggyback off Asset accounts. That is to say, an increase to the Reserve is a decrease (credit) to the net Asset. The sister account to Loan Reserves on the Income Statement is the expense called "Provision for Credit/Loan Losses." To balance the journal entry, you post a debit to the expense, increasing it. So, in our example loan above, the base Asset is still $100,000 and the Contra-asset is $10,000, net $90,000. Expenses in the Income Statement will take the other side of the journal entry and increase (debit) for $10,000. In theory, there could be income from a reduction of the allowance account. I don’t see that happening these days. [Tanta: that would be the “cookie jar” problem: the temptation to over-reserve in very good times, which reduces current income to just “good,” in order to reduce those unnecessary reserves in future bad quarters, which would increase income in those quarters from bad to “good” (or just “acceptable,”) and therefore make the income over time appear more stable, which makes Wall Street analysts happy. It is not likely that anyone intentionally over-reserves in bad times, since it’s hard to withstand the effect that has on current income, whatever it might do for future quarters. I certainly do not believe that banks and thrifts were over-reserving during the boom, and as each quarter’s reports come out we see they are steadily increasing ALLL. This does not look like “smoothing” income to me.]

Something very likely to happen is that, in addition to principal, jingle mail senders will not be paying interest. If the bank can foresee a future default on our loan’s interest payments of $2,000, then they record a liability for $2,000 (not a reserve to an asset) and record a debit to Interest Income for $2,000 in the current year, reducing revenue.

Now, our total Net Income is reduced by $10,000 + $2,000, $12,000. Unless and until Cash is loaned or received, there is no effect on Cash.

It’s clear that there is some estimating and guessing done within the reserve calculations and bank managers are going to do all in their power to avoid restatements as none of them ever could have known (enter specific affecting crisis here). So if you want some moral outrage, don’t vent it on the accrual method, vent it against the reserves (more specifically, the people who estimate them). [Tanta: this is why I keep saying that the accounting treatment we are seeing for OAs is not "accounting games." The issue isn't the accounting rules for non-cash income; the issue is what assumptions went into estimating how much of that deferred interest is ultimately collectable.]

Lama On Asset Valuation:

First of all, most assets are required to be valued at the lower of cost or market (assuming a market exists). Usually, the more liquid an asset, the closer the market value will be to cost. Cash is the logical extreme as cost always equals market. Then you have Accounts Receivable which is usually proximate. Next, Inventory can closely trace the actual cost. That is, it should, but companies buy things they can’t sell, they redesign products they make, causing component inventory to be worth little to the company. Even items that have value to someone else might be valued at very little because there’s too much cost involved in finding a buyer and transportation. I once audited a company that had hundreds of thousands of titanium pipes valued at cost. Well, they had no use and no customer for them. The best offer they got was from the original vendor, 15% of cost. That was my number. So it goes onto Capital/Fixed Assets. Here, market value is usually not important. Heavy equipment that might make lots of money frequently has a low resale value and huge transportation costs if it was sold.

Our debt instruments are, by their nature, very liquid. If the holder is interested in selling, they should be valued at market. If you don’t like the current market price, then the instruments are not for sale . . . ok, you don’t mark them to market, you mark them to discounted cash flows. This is where the “mark to make believe” has been and is happening.

[Tanta: banks and thrifts in the mortgage business have two categories of mortgage assets: HFS (held for sale) and HTM (held to maturity). The former is “inventory” and the latter is “portfolio investment.” HFS is marked to market. As Lama says, if you aren’t marking to a market price, then apparently you aren’t really trying to sell anything here (home sellers, take notes on this part). Eventually, if you cannot (or will not) sell your HFS pipeline, you will need to transfer it to HTM (if you have the capital necessary to hold loans to maturity), and at that point you record the loan at the lower of cost or market. In this case there is an original “write-down” of the asset if current market value is less than cost. After that, further write-downs will be necessary at each reporting period, as Lama indicates above, if the assets become impaired (or more impaired than they were when you originally put them on the books). So what we are reading in the news about write-downs of mortgages and mortgage-related assets these days involve a combination of mark-to-market adjustments (for anything in “inventory” or being taken out of HFS to HTM) and impairments of assets that have deteriorated since the asset value was originally recorded. No one is allowed to take a “once and for all” write-down of a mortgage asset; ALLL is based on your best projections of realized losses in the next 12 months (adjusted each quarter). Theoretically, every loan you own is subject to further write-down each quarter if in fact your estimate of collectability continues to deteriorate.]