by Calculated Risk on 4/13/2009 10:51:00 PM

From the WSJ: General Growth Bondholders Ask Trustee to Sue (ht bearly)

A group of bondholders have ratcheted up the pressure on General Growth Properties Inc. by asking their trustee to sue the debt-laden mall owner for payment of their past-due bonds.
...
The bondholders' action pushes General Growth closer to a bankruptcy filing but doesn't mean that one is imminent.

Here is the story from Reuters: General Growth bondholders seek to sue company--WSJ

by Calculated Risk on 4/13/2009 08:54:00 PM

A number of forecasters have mentioned Unemployment Claims as an important indicator of the end of a recession. Professor Hamilton mentioned this last week: Initial unemployment claims and the end of recessions. Historically this is a useful indicator.

Back on March 28th, the WSJ quoted Robert J. Gordon, an economist at Northwestern University and a member of the National Bureau of Economic Research committee:

[Gordon] points to one indicator in particular with a remarkable track record: the number of Americans filing new claims for unemployment benefits. In past recessions, it has hit its peak about four weeks before the economy hit a trough and began to grow again. As of right now, the four-week average of new claims hit its peak of 650,000 in the week ended March 14. Based on the model, "if there's no further rise, we're looking at a trough coming in April or May," he said, which is far earlier than most forecasts currently anticipate.

Since then, the four-week average has risen further (now at 657,250). So much for a trough in April ...

Click on graph for larger image in new window.

This graph shows the four-week average of initial unemployment claims and recessions.

Typically the four-week average peaks near the end of a recession.

Also important - in the last two recessions, initial unemployment claims peaked just before the end of the recession, but then stayed elevated for a long period following the recession - a "jobless recovery". There is a good chance this recovery will be very sluggish too, and we will see claims elevated for some time (although below the peak).

We need to see a significant decline in the four-week average before we start talking about the peak. In a note today, Goldman Sachs economist Seamus Smyth estimated a significant decline as:

Roughly speaking, a 20,000 decline in the 4-week moving average corresponds to a 50% probability that the peak has already been reached, and a 40,000 improvement to a 90% probability.

So we need to see the four-week average decline by 20,000 to 40,000 or more. Don't hold your breathe ...

by Calculated Risk on 4/13/2009 06:29:00 PM

Here is the 2nd part of the VoiceofSanDiego article: A Staggering Swindle: How It Could Happen in 2008

In 2008, when the loans were made to McConville's buyers, some of the only companies still willing to buy these bundles of mortgages were Fannie Mae and Freddie Mac, even though the mortgage mess had affected them, too.

At the tail end of McConville's deals, last September, the federal government took over Fannie and Freddie, assuming more direct control of the companies' day-to-day operation and pumped in funding to absorb their losses. Now the taxpayers own 79.9 percent of Fannie Mae and Freddie Mac.

"You and I are getting stuck with these inflated loans, via Fannie and Freddie," [Real estate appraiser Todd Lackner] said.

There is a way out, as long as the smaller lenders who made the loans to McConville's buyers still exist. On any loans Fannie and Freddie bought, if they discover fraud or faults in underwriting in the loans, they'll send them down the chain, requiring the investor that sold the loans to the giants to buy them back. Ultimately, the original lenders might face those buybacks, said Michael Lea, a former chief economist for Freddie Mac.

But the small lenders who made these mortgages might not be in business anymore -- like Nazari's All American Finance.

Ask Wall Street what happens when they push back loans to the small lenders - they just close up shop.

Here was Part I: Rented Identities, Extravagant Prices and Foreclosure: A Post-Boom Real Estate Scam

And a related article: Mafia-Esque Charges Brought Against Alleged Mortgage Fraud Ring

by Calculated Risk on 4/13/2009 04:29:00 PM

From MarketWatch: Goldman Sachs swings to profit, plans $5 billion offering

Goldman Sachs Group Inc. said Monday it swung to a profit in the first-quarter, and announced it has commenced a public offering of $5 billion of its common stock. Goldman Sachs said net earnings for the period ended in March were $1.8 billion ... compared to a loss of $2.1 billion ... in the same period a year earlier.

The $5 billion will be used to repay the TARP money Goldman received last year.

by Calculated Risk on 4/13/2009 04:09:00 PM

From Oregon.gov (ht Justin):

This graph is from Oregon’s Employment Situation: March 2009 and shows the Oregon unemployment rate since Jan 2000.

The unemployment rate is at the peak level of the 1982 recession - the highest since record keeping started in 1947. The unemployment rate is increasing rapidly, and the rate of increase appears to be accelerating.

Oregon’s seasonally adjusted unemployment rate rose to 12.1 percent in March from 10.7 percent (as revised) in February. The state’s unemployment rate has risen rapidly and substantially over the past nine months, from a rate of 5.9 percent in June 2008.
...
Manufacturing shed 2,100 jobs in March, during a time of year when a flat employment pattern is typical. Employment stood at 171,600 in March, which was by far the lowest employment level since comparable records began in 1990.
...
Construction losses steepened, dropping 1,700 jobs at a time of year when a gain of 700 was the expected normal seasonal movement. The rate of seasonally adjusted losses in construction has quickened, as the industry is down 12,600 jobs or 13.6 percent over the past six months.

Seasonally adjusted construction employment, at 80,000, is now below its level of approximately 83,000 jobs seen during much of 1997 through 2000. Despite a drop of more than 25,000 jobs since reaching its peak in 2007, construction is still slightly above its low point over the past dozen years—75,500, which was reached in June 2003.
...
Oregon’s seasonally adjusted unemployment rate rose to 12.1 percent from 10.7 percent in February. This tied Oregon’s unemployment rate in November 1982, the highpoint of the early 1980s recession. While historical records prior to 1976 are not exactly comparable, it appears clear that the 12.1 percent level is Oregon’s highest since 1947, when the Employment Department first started publishing unemployment rates.

by Calculated Risk on 4/13/2009 03:00:00 PM

From Bloomberg: Manhattan Apartment Rents Fall as Unemployment Rises

Manhattan apartment rents fell as much as 5.9 percent in March from a year earlier as rising unemployment damped demand, Citi-Habitats Inc. said.
...
Rents for studios dropped 2.1 percent to an average of $1,812, while those for one-bedroom apartment fell 5.9 percent to $2,595. The cost of renting two-bedroom homes declined 2.2 percent to $3,631 and three-bedrooms fell 1.6 percent to an average of $4,670.

The average declines for March don’t reflect concessions offered by landlords, such as a free month’s rent, that lower the overall cost, [Gary Malin, president of Citi-Habitats] said.

“There is a greater degree of price decline than those numbers show,” he said.

Some asking prices are falling even faster. From Amanda Fung at Crain's on New York: Big landlord takes hit on falling apt. rents

Since February alone, Equity Residential has lowered its Manhattan asking rents by an average of 13%, said Michael Levy, an analyst at Macquarie. That reduction came on top of a 15% cut over the previous year.

by Calculated Risk on 4/13/2009 01:49:00 PM

Here is another story from VoiceofSanDiego: Mafia-Esque Charges Brought Against Alleged Mortgage Fraud Ring

Federal prosecutors on Tuesday announced unprecedented charges against individuals involved in an alleged mortgage fraud ring involving 220 properties in San Diego County, with total purchase prices topping $100 million.

The 24 defendants were all charged with participating in a "corrupt enterprise" under a federal law created by the Racketeer Influenced and Corrupt Organizations (RICO) Act...

... defendants include several real estate professionals ... a public notary ... a licensed real estate agent ... a licensed real estate appraiser ... a CPA; and ... registered tax preparers.
...
Prosecutors also name several straw buyers as participants in the corrupt enterprise ...

This is a different case than the previous story, but notice that the straw buyers are facing charges too. "Lend" out your good credit, sign false documents - and face prosecution and jail time.

by Calculated Risk on 4/13/2009 11:24:00 AM

Kelly Bennett and Will Carless at the VoiceofSanDiego investigate: Rented Identities, Extravagant Prices and Foreclosure: A Post-Boom Real Estate Scam

Over the course of several months last year, [James D. McConville] picked up at least 81 condo conversions from distressed developers and orchestrated their sale to more than 20 buyers who'd rented him their identities ...

By arranging purchase prices well above market value, McConville was able to pay off the developers and capture what the developers' records state as more than $12.5 million. Now, 74 of the 81 homes involved in the deals in Sommerset Villas and Sommerset Woods in Escondido and Westlake Ranch in San Marcos are in the first stage of foreclosure.

McConville bought distressed condos from developers in bulk, and then sold them to straw buyers (individuals with solid credit records who agreed to sign for the loans for a fee). McConville pocketed the difference between the straw buyer price and the bulk price - approximately $12.5 million.

McConville promised to rent the properties, and pay the mortgages from the rental income.

The individuals had pristine credit, and one mortgage lender said:

"Everything was just absolutely perfect -- some of the cleanest loans we'd seen."

Of course the relationship with McConville was apparently never disclosed.

This was happening in 2008. Lenders were supposed to be back to the three C's: creditworthiness, capacity, and collateral. These straw buyers - who apparently were willing to falsely sign that they were the actual buyers - satisfied the creditworthiness and capacity criteria. But this raises serious questions about the appraisals.

Also McConville timed the multiple applications perfectly so the lender wouldn't see the other loans apps when they performed a credit check - that is pretty amazing.

Part II will be out today tonight ...

by Calculated Risk on 4/13/2009 09:08:00 AM

Professor Roubini writes: Stress Testing the Stress Test Scenarios: Actual Macro Data Are Already Worse than the More Adverse Scenario for 2009 in the Stress Tests. So the Stress Tests Fail the Basic Criterion of Reality Check Even Before They Are Concluded

[I]f you look at the actual data today macro data for Q1 on the three variables used in the stress tests – growth rate, unemployment rate, and home price depreciation – are already worse than those in FDIC baseline scenario for 2009 AND even worse than those for the more adverse stressed scenario for 2009. Thus, the stress test results are meaningless as actual data are already running worse than the worst case scenario.

I've noted before that the baseline case is no longer useful, and that the more adverse case is the new baseline. Roubini is taking this a step further and saying the more adverse case is also meaningless. I think this is premature - although I agree with Roubini that there is no real stress test.

First, Roubini is working from the annual stress test forecasts. The following table shows the quarterly data being used by the banks.

Click on graph for larger image in new window.

This table shows the quarterly GDP growth rate (annualized), unemployment rate, and house prices being used for the stress test scenarios.

House prices are based on the Case-Shiller Composite 10 Index with Dec 2008 = 100.

Unemployment

For the unemployment rate, Roubini is correct. The unemployment rate was 8.1% in Q1 - above both the baseline (7.8%) and more adverse (7.9%) scenario rates.

[B]ased on current and likely trends the unemployment rate will be – at best over 10% by year end – and more likely closer to 11% by year end (and average 9.8% for the year) 2009 data are already worse than the adverse scenario and will for sure be worse than the adverse scenario. But more importantly by year end 2009 the actual unemployment rate – even with a growth recovery in H2 – will be higher at 10.5% - than the average unemployment rate assumed by the FDIC in the adverse scenario for 2010, not 2009!

In a recent note, S&P mentioned their stress test "assumes that an economic recovery does not begin until at least late 2010" and that "the unemployment rate rises to the mid-teens". That is a real stress test!

From Bloomberg: Wall Street in Wells Fargo Moment as Euphoria Meets Stress Test

“The bottom line is if the unemployment rate peaks at 10 percent these banks can make it through,” [Paul Miller, an analyst at FBR Capital Markets] said. “But if it peaks closer to 12 percent, nobody makes it. Or very few people make it.”

So far the baseline case is meaningless, and for unemployment, the economy is tracking worse than the more adverse scenario.

GDP Growth Rate

Roubini writes:

A similar analysis suggests that the FDIC assumptions for GDP growth and home prices are already worse than the adverse scenario – let alone the baseline scenario – for Q1 of 2009. A first estimate of Q1 2009 GDP growth will be out only at the end of April 2009 but the current consensus is that the figure will be around -5% for the SAAR figure in Q1. ... the current consensus forecast for 2009 GDP growth is – at 3.2% - practically identical to the adverse scenario GDP growth for 2009; and most reputable research institutions are forecasting for 2009 a figure that is actually worse than the consensus scenario. Also, while the current consensus forecast for 2010 growth (2.0%) is practically identical to the baseline scenario for 20010 GDP growth (2.1%) a number of more accurate than consensus source are predicting a much weaker scenario for 2010: for example Goldman Sachs has a current forecast of 1.2% for 2010 GDP growth as opposed to the baseline scenario figure of 2.0%. So, in all likelihood even the current consensus forecasts is close – or worse – than the more adverse scenario while the baseline scenario is already out of the window both for Q1 and the year overall.

Once again, Roubini is working off the annual stress test forecasts. The above table shows that a 5% annualized decline in real GDP is the baseline case.

Earlier I compared the quarterly stress test forecasts with forecasts from Paul Kasriel at Northern Trust, and from Goldman Sachs (no link). See: Stress Test, Quarterly Forecasts for Unemployment and GDP

This graph compares the stress test forecasts for changes in real GDP with recent forecasts. Note: Kasriel has announced he is revising his Q1 GDP forecast upwards.

An interesting note: the stress test scenario is using the advanced GDP release estimate for Q4 2008 of -3.8%, as opposed to the revised estimate of -6.2%.

These bearish private forecasts are tracking slightly better than the more adverse scenario.

House Prices

Roubini:

[H]ome prices have been falling in recent months at a rate that is much higher than the 14% assumed in the FDIC baseline for 2009. They are also running currently at an annual rate that is higher than the 22% in the more adverse scenario of the FDIC; and even considering actual figures for the last few months – that show an accelerated rate of fall in homes prices between the spring of 2008 and the most recent data – home prices have been falling in the last few months at rates – average of y-o-y and m-o-m figures – of about 20% with an upward trend in the data. So the actual and trend figures are well above the baseline figure of 14% and closer to the 22% of more adverse scenario.

As Roubini notes, we only have one month of data since the stress tests scenarios were released. The Case-Shiller index is released with almost a two month lag (January data was released near the end of March). Also, we have to be careful because there is a strong seasonal component to house prices.

This graph compares the Case-Shiller Composite 10 index with the Stress Test scenarios from the Treasury (stress test data is estimated from quarterly forecasts).

This is the first month and it is difficult to see the track on the graph. Here are the numbers:

Case-Shiller Composite 10 Index, January: 158.04

Stress Test Baseline Scenario, January: 159.69

Stress Test More Adverse Scenario, January: 158.07

It is only one month, but prices tracked the more adverse scenario in January.

Roubini concludes in bold:

Conclusion: Actual macro data for 2009 are already worse than the more adverse scenario in the stress tests. These are not stress tests but rather fudge tests

I agree there is no real stress test, and the more adverse scenario is the real baseline. But I think it is premature to say that the more adverse scenario is meaningless.

by Calculated Risk on 4/13/2009 12:39:00 AM

From the NY Times: ‘Surgical’ Bankruptcy Possible for G.M.

The Treasury Department is directing General Motors to lay the groundwork for a bankruptcy filing by a June 1 deadline... The goal is to prepare for a fast “surgical” bankruptcy, the people who had been briefed on the plans said.
...
One plan under consideration would create a new company that would buy the “good” assets of G.M. almost immediately after the carmaker files for bankruptcy.
...
Treasury officials are examining one potential outcome in which the “good G.M.” enters and exits bankruptcy protection in as little as two weeks ...

For discussion:

Bloomberg Futures.

CBOT mini-sized Dow

CME Globex Flash Quotes

Futures from barchart.com

by Calculated Risk on 4/12/2009 09:36:00 PM

A couple of photos from the "A New Way Forward" protest at the San Francisco Fed yesterday. Photo credit: Darin Greyerbiehl, 4/11/2009. More photos here.

Click on photo for larger image in new window.

by Calculated Risk on 4/12/2009 06:55:00 PM

Zach Fox at the North County Times brings us another house "Deal of the Week": Sans stability in San Marcos

San Marcos is in north county San Diego.

Here is the price history for the featured 3 bedroom, 2 bath, 2 car garage home:

May 1992: $115,500

April 2003: $275,000

April 2006: $440,000

March 2009: $135,000 (REO)

The March 2009 price was a distressed sale, and is half off the 2003 price. Once again, I wonder what buyers (and lenders) were thinking in 2006?

by Calculated Risk on 4/12/2009 10:19:00 AM

"Everybody is building these big buildings, and they're empty. It is sad. I live in a ghost town."
Robert Siegel, an advisory neighborhood commissioner

From the WaPo article on the stalled commercial construction projects at the Capitol Riverfront Business Improvement District: At Nationals Park, District of Dreams Hits a Slump (ht mort_fin)

A few excerpts:

At [Nationals owner Theodore N. Lerner]'s 10-story office building at 20 M St., the lobby doors are sometimes locked much of the afternoon. The only tenant is a bank.

A few blocks away, at 2nd and M streets SE, sits a parking lot where developer Chris Smith had planned to build a 10-story office building without a tenant signed in advance. Now he says he needs to have the building about 70 percent leased to even try for financing.

Closer to the Anacostia River, Florida Rock owns land where a cement plant still operates. It hopes to begin construction on office, retail, hotel and residential buildings in the fall of 2010 -- if it can get financing and find a major office tenant.

Nearby, Cleveland-based Forest City stopped construction on a loft building at its project, the Yards, because it couldn't get a loan. It is trying to get financing through a city housing program to restart construction. In the meantime, brown paper and plywood cover the windows.

At developer JPI's apartment project, called Capitol Yards, about half of the nearly 700 apartments are leased. For the past four months, the developer offered two to three months of free rent on the units, which start at roughly $1,600 for a one-bedroom.

Here is a map of the D.C. neighborhood. And a Google map of the area:


View Larger Map

And I had heard that D.C. was immune ...

by Calculated Risk on 4/12/2009 12:34:00 AM

These photos are of a CRE project in San Diego.

Click on photo for larger image in new window.

Photo credit: Michael C.

Michael writes:

Who knew that i-beams create a perfect home for cottontails!

... this was suppose to be 12 buildings and three parking garages.

Now it is one building and a field of steel.



Michael estimates the delivered steel takes up a football field!

At least the rabbits have found a place to hide.

by Calculated Risk on 4/11/2009 10:00:00 PM

Here is an interview with Paul Krugman earlier this week ...

"We have some real real problems. They are not going to go away through self-fulfilling optimism. One of the little things that has been reported is that the IMF now - International Monetary Fund - has upped its estimate of losses on bad loans to $4 trillion. Not so long ago $1 trillion was considered an exorbitant estimate."
Paul Krugman, April 7, 2009

On delaying the release of the stress test results (actually the original release date was the end of April):

I think we can say pretty clearly that if the stress tests were saying that every thing was fine, they probably wouldn't be eager to postpone the release of that. This is a problem. One of the versions that we're hearing is that they'll release some generic information, but not information on particular banks. Boy would that be a downer. What everyone is worried about is what we talk about Japan in the '90s - keeping the zombie banks still shambling forward. There is a lot of feeling that American zombie banks now on the march. This news was not good. It made that scenario look a little bit more likely.

by Calculated Risk on 4/11/2009 06:56:00 PM

From The Oregonian: Construction of downtown Portland high-rise is halted by tight credit (ht Shawn, Justin, Neil)

Tom Moyer, one of Portland's most successful real estate developers, will halt work Monday on his 32-floor tower now under construction in downtown Portland.

Moyer's decision to pull 350 workers off the Park Avenue West is a stunning sign that no city, no person and no block is spared from this recession.

... The building, originally scheduled to open in 2011, already was more than half leased by a law firm and a Nike store.
...
At the job site Friday, the concrete, mechanical and iron workers left the site about 3 p.m. with the building 15 percent finished. It remains just a parking garage, frozen for now about three floors below ground.
...
[Vanessa Sturgeon, president of TMT Development] said she expects construction to remain stopped until they can find financing in early 2010. They'll use the time to redesign the building and lop off the top 10 stories that were to be "ultra-luxury" condos.
...
Carpenter Steve Callopy said he has no safety net beyond unemployment compensation and doesn't see any fresh work on the horizon. Commercial construction, in particular, seems to have fallen apart.

"Do you see any commercial stuff going on?" he said. "I see a lot of commercial 'For Lease' signs."

This article makes several key points:

Even the best financed CRE developers are halting work. This building was already half leased!

The most financing the developer could find was 45% LTV.

Even when construction restarts, the developer is "lopping off" the top 10 stories of luxury condos. That condo market will dead for years.

There will be many more construction jobs lost this year as CRE projects are completed or halted.

by Calculated Risk on 4/11/2009 01:56:00 PM

National Credit Union Administration (NCUA) released an update on the two corporate credit unions seized three weeks ago. (ht August)

First, on the size of the two seized corporate credit unions:

U.S. Central has approximately $34 billion in assets and 26 retail corporate credit union members. WesCorp has $23 billion in assets and approximately 1,100 retail credit union members.

These "corporate credit unions" don't serve the general public, and all "natural person" credit union money held at these corporate credit unions was guaranteed earlier this year.

From NCUA Chairman Fryzel in yesterday's Media Advisory:

The outline released today of the portfolios of WesCorp and U.S. Central, and NCUA’s associated summary analysis, provides a concise synopsis of the respective portfolios and enables informed parties to appreciate the scope and severity of the stress on these investments. Though virtually all of the securities purchased by these two corporate credit unions were AAA or AA rated at the time of purchase, the summary clearly demonstrates how the nature of the securities and the deterioration in the economy have resulted in significant expected credit losses.

Here is the corporate stabilization program.

And the following is from the analysis of the portfolios held at WesCorp and U.S. United.

The securities purchased by corporate credit unions ... were all permissible under NCUA’s Rules and Regulations. Almost all had very high ratings (AAA and AA) as assigned by the nationally recognized statistical rating organizations (NRSROs). NRSRO ratings were the norm in the financial markets for determining the quality of a security. However, NRSROs relied primarily on historical data of the performance of a security’s underlying assets in making rating determinations. No reliable historical data existed relating to the performance of the sub-prime and other types of loans that were originated in a period of rapid home price increases and relaxed underwriting criteria. As such, NRSRO ratings did not prove to be a reliable means of determining the quality of these securities. Since late-2007, analysis of these securities has been based on actual performance of the underlying assets and projected future performance. This has led to very significant downgrades in the NRSRO ratings of many of the securities held by corporate credit unions. The downgrades had the most severe impact on the portfolios of WesCorp and U.S. Central.
emphasis added

And the following table shows the ratings at the time of purchase and the most recent ratings.

Click on graph for larger image in new window.

There is much more in the document on these portfolios. As an example, WesCorp bought a significant amount of AAA rated mezzanine securities back by Alt-A and Option ARMs - and those securities have taken substantial losses since they absorb losses before more senior securities.

Sadly most of the problem securities were bought in 2006 and 2007 - after the housing bust had already started.

by Calculated Risk on 4/11/2009 08:59:00 AM

From Bloomberg: China Loans, Money Supply Jump to Records on Stimulus

China’s new lending surged more than sixfold from a year earlier to a record 1.89 trillion yuan ($277 billion) in March ...

President Hu Jintao said April 1 that China’s 4 trillion yuan stimulus plan was taking effect, after urban fixed-asset investment surged 26.5 percent in the first two months. ...

The explosion in credit since the central bank dropped lending restrictions in November prompted the nation’s banking regulator to warn this month that lenders face a “severe” challenge in managing their risks.
...
A concentration of loans in infrastructure projects is a potential hazard for banks, China Banking Regulatory Commission Vice Chairman Jiang Dingzhi wrote in the April 1 edition of China Finance, a magazine affiliated with the central bank....

“The biggest dangers to China’s economy and financial system come from within, not from outside,” Jiang Zhenghua, former vice chairman of China’s parliamentary standing committee, said at a financial conference in Beijing today. “The biggest of these hidden dangers is the degree of bad loans in China.”

Doesn't China already have too much capacity?

by Calculated Risk on 4/10/2009 09:32:00 PM

From the FDIC: FDIC Creates a Deposit Insurance National Bank to Facilitate the Resolution of New Frontier Bank, Greeley, Colorado

New Frontier Bank, Greeley, Colorado, was closed today by the State Bank Commissioner, by Order of the Banking Board of the Colorado Division of Banking, which then appointed the Federal Deposit Insurance Corporation (FDIC) as receiver. To protect the depositors, the FDIC created the Deposit Insurance National Bank of Greeley (DINB), which will remain open for approximately 30 days to allow depositors time to open accounts at other insured institutions. ...

All insured depositors of New Frontier are encouraged to transfer their insured funds to other banks. ...

As of March 24, 2009, New Frontier had total assets of $2.0 billion and total deposits of about $1.5 billion. At the time of closing, there were approximately $150 million in insured deposits and $4 million in deposits that potentially exceeded the insurance limits. ...

The cost to the FDIC's Deposit Insurance Fund is estimated to be $670 million. New Frontier is the twenty-third bank to fail this year and the second in Colorado. The last bank to be closed in the state was Colorado National Bank, Colorado Springs, on March 20, 2009.

Ouch. No one wanted this one!

by Calculated Risk on 4/10/2009 08:16:00 PM

This is an interesting paper by Christopher Foote, Kristopher Gerardi, Lorenz Goette, and Paul Willen: Reducing Foreclosures

The authors make two key points:

DTI (debt to income) at origination is not a strong predictor of default.

What really matters in the default decision is the mortgage payment relative to the borrower’s income in the present and future, not the borrower’s income in the past. Consequently, the high degree of volatility in individual incomes means that mortgages that start out with low DTIs can end in default if housing prices are falling.

Evidence suggests loan servicers are unwilling to turn high-DTI mortgages into low-DTI mortgages.

The evidence that a foreclosure loses money for the lender seems compelling. The servicer typically resells a foreclosed house for much less than the outstanding balance on the mortgage ... This would seem to imply that the ultimate owners of a securitized mortgage, the investors, lose money when a foreclosure occurs. Estimates of the total gains to investors from modifying rather than foreclosing can run to $180 billion, more than 1 percent of GDP. It is natural to wonder why investors are leaving so many $500 bills on the sidewalk. While contract frictions are one possible explanation, another is that the gains from loan modifications are in reality much smaller or even nonexistent from the investor’s point of view.

We provide evidence in favor of the latter explanation. First, the typical calculation purporting to show that an investor loses money when a foreclosure occurs does not capture all relevant aspects of the problem. Investors also lose money when they modify mortgages for borrowers who would have repaid anyway, especially if modifications are done en masse, as proponents insist they should be. Moreover, the calculation ignores the possibility that borrowers with modified loans will default again later, usually for the same reason they defaulted in the first place. These two problems are empirically meaningful and can easily explain why servicers eschew modification in favor of foreclosure.
emphasis added

This analysis suggests mortgage modifications - without principal reduction - will have limited success. The authors suggest that loan or grants to homeowners with lost income might be more effective than mortgage modifications.

The authors also makes several other important points:

On "walking away" or "ruthless default" (when the borrower walks away because they refuse to make payments on an underwater house).

If there is no hope that the price of the house will ever recover to exceed the outstanding balance on the mortgage, the borrower may engage in “ruthless default” and simply walk away from the home. Kau, Keenan, and Kim (1994) show that optimal ruthless default takes place at a negative-equity threshold that is well below zero, due to the option value of waiting to see whether the house price recovers.

But the authors conclude that ruthless defaults are only a small part of the current foreclosure problem:

To sum up, falling house prices are no doubt causing some people to ruthlessly default. But the data indicate that ruthless defaults are not the biggest part of the foreclosure problem. For the nation as a whole, less than 40 percent of homeowners who had their first 90-day delinquency in 2008 stopped making payments abruptly. Because this figure is an upper bound on the fraction of ruthless defaults, it suggests ruthless default is not the main reason why falling house prices have caused so many foreclosures.

Negative equity is key to defaults (Falling house prices!)

The empirical evidence on the role of negative equity in causing foreclosures is overwhelming and incontrovertible. Household-level studies show that the foreclosure hazard for homeowners with positive equity is extremely small but rises rapidly as equity approaches and falls below zero.

Faced with loss of income, homeowners with enough positive equity sell. Homeowners with negative equity default.

Resets are of only limited importance.

Many commentators have put the resets at the heart of the crisis, but the simulations illustrate that it is difficult to support this claim. The payment escalation story is relevant if we assume that there is no income risk and that the initial DTI is also the threshold for ex post DTI. Then loans with resets become unaffordable 100 percent of the time and loans without resets never become unaffordable. But adding income risk essentially ruins this story. If the initial DTI is also the threshold for ex post DTI, then, with income risk, about 70 percent of the loans will become unaffordable even without the reset. The reset only raises that figure to about 80 percent. If, on the other hand, we set the ex post affordability threshold well above the initial DTI, then the resets are not large enough to cause ex post affordability problems.

These are all key points.

I think it is important to understand that loans with high DTI were an enabler for speculation during the housing bubble, and this speculation pushed up house prices. So, although the authors argue high initial DTI loans are not a good predictor of defaults, the prevalence of high DTI loans was evidence of a bubble - and a good predictor of a housing bust.