Green shoots and leaves? Or a false spring?

July 14, 2009 at 6:09 pm | Posted in economics, recession, saving | Leave a comment
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The economy is in recession partly because the consumer is fearful.  The consumer is afraid of the high level of debt as well as of falling networth (retirement, real / investment asset prices) and also afraid of job loss. The correct private response to these fears is to cut back spending to deleverage, boost assets/networth by fresh savings / investment and to build a short term savings buffer as unemployment self-insurance. The means of doing this is by cutting back on discretionary spending to generate or increase a cash flow surplus, and put that to work to achieve these private objectives. However, given that private debt is such a large part of income, it will take a long time to realign.

Suppose someone wants to build an additional savings buffer of 6-months of must-spend expenses… pretty reasonable, I’d say, and not something that would fundamentally improve their balance sheet, so they really need to do more… Take an average family with $50k household income. Given that they are probably taking home about 80% of their pay ($40k) after taxes, and spending about 95%+ of their take home, and assume that 75% of their expenses are non-discretionary ($30k), they would need to save $15k to achieve that 6-month goal. Since only 20-25% of their spending is discretionary, even if they cut that to zero (highly unrealistic) it would take 18 months to achieve this objective. Clearly, then, spending alone is not enough. But right now, raising incomes to meet this goal is just as unrealistic, on average!

This $15k savings goal for an average family translates to $1.7 trillion for all US households – $1.7 trillion of reduced consumer spending. I think the true savings goal to restore private fiscal health is way greater than this.  So the stimulus is not enough. No way. Not even close.

The public impact of the collective private actions is this: Everyone is cutting back, and is willing to work longer hours / grow productivity just to keep their job. People are even willing to take pay cuts to avoid layoffs ( you kept the job, but your nominal debt is the same, real debt has increased because nominal and real wages went down). As a collective, that sucks because the economy needs to deleverage even more with a lower income base to do it – debt to income just went up a notch. That means demand for discretionary goods and services is way down, will stay down for a long time, and, when it begins to recover, the incremental demand will be met for a long time from existing employment, so this will be a jobless recovery when it recovers. In the meantime, note that the growth in unemployment is only about 5-6% points so far i.e. unemployment has not risen fast enough to account for higher productivity and the lower demand that has occurred and will continue to impact the economy. This means there is a lot of “dry powder” left in productivity gains for when the recovery does happen.

The economy is 65% consumer, and the rest is enterprise spending to create capacity to meet consumer demand. A lot of export markets are in worse shape than the US.

I think this is a false spring. We may not drop back into the depths of winter, but the real spring lies on the other side of a few bad cold spells – enough to wither the green shoots.

Stay cautious. Stay pessimistic.

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Summarizing my three year old thesis

March 13, 2009 at 12:54 pm | Posted in economics, Housing | Leave a comment
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I’m back after a long break from writing. I’ve been thinking about how psychology plays into the recession – in fact, most of my direst predictions of the past three years have played out, often worse than I expected, mostly because I think I got consumer actions right.

My thesis can be summarized as follows: The US economy is 70% consumer spending. Much of business spending is in anticipation of future consumer spending ( or anticipation of other businesses anticipating consumer spending). With the savings rate near 0% and housing slowing down, there was no wealth effect or accumulated assets to drive spending, so any correction in house prices must necessarily slow down consumer spending and thus the economy as consumer’s try and fix their balance sheets and their income statements (expenses and savings % equivalent to net income margin for business). Businesses would respond accordingly, and, while exports could help, a lot of global income – especially emerging markets like China, is dependent directly or indirectly on US consumer demand. The bottom had to fall out of the market, and the banking system was going to be part of that because of housing and consumer exposure (Credit cards are yet another shoe waiting to drop). Oil prices didn’t help but were not central to the argument.

My proposal for the rescue

October 3, 2008 at 2:23 am | Posted in credit, economics, Housing, regulations | Leave a comment
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I’ve said all this before, but I’m collecting all my thoughts in one place with the following article.

The housing crisis has caused a series of writedowns, leaving the financial sector seriously undercapitalized and averse to further lending – even if their balance sheets permitted much lending. The resulting unwillingness or inability to lend money is threatening the entire economic system, as otherwise sound businesses find themselves unable to raise or refinance debt.

While a number of ad hoc actions have already been taken, with a major bailout plan proposed, they have tended to focus on supporting financial institutions while not tackling the real housing problem or the value of the actual mortgages underlying the mortgage backed securities and various related derivatives. However, as mortgage defaults increase, the value of these securities falls, often precipitously for some MBS tranches and for some derivatives.

I would like to propose an alternative workout that could simultaneously support the institutions while also providing some relief to Main Street.

I propose creating an agency empowered to buy near-foreclosure mortgages from the banks / debt holders, at a modest 3-5% discount to the outstanding principal balance, provided the homeowner agrees to a) transfer over the title of the property to the agency without a foreclosure and, b) continues to reside in the property as a tenant for at least a two year period at a reduced rental rate.

This would serve two purposes – First, by taking distressed mortgages off banks’ balance sheets at or near par value, this recapitalizes the banks and restores equity – basically by overpaying for the mortgages at taxpayer expense. You could prop up the prices of all mortgages, and thus restore the health of all balance sheets, as opposed to current policy of letting the value of mortgages slide, and then rescuing banks piecemeal, as they fail, without supporting underlying mortgage prices. Second, by keeping the erstwhile homeowner in the property, it reduces the supply of vacant homes -and the attendant security / vandalism problems for the neighborhood and unsold / auctioned / bank-owned home inventory, which eases the downward pressure on home prices, hopefully keeping more people in their homes.

How would this be structured, and how much would it cost? Here’s a back of the envelope calculation with some simplifications: Let’s say home ownership declines from near two-thirds of all households down to a 64% historical average level, which would translate into 3 million fewer home owners, with an average of $300,000 in outstanding debt (above the $203,100 median home price, to be conservative, as defaults are more likely in urban and suburban areas). At about a 5% discount, these mortgages could be purchased for $850 billion in capital ($900 billion face value). This money could support home prices and help keep other homeowners in their homes.

The homeowner must commit to a two-year rental on the property to be eligible for this scheme, with the rent set at a level that can recover the cost of capital for the agency. I assume a 4% cost of capital, the average tenant with a $300,000 loan would pay $12,000 a year towards capital cost. Assuming a $4000 annual property tax, the monthly rent could be set at just over $1300 for this average property – almost certainly more affordable than their current payment. If the tenant can make payments for two years, they avoid a foreclosure on their credit record. This brings the agency $36 billion in annual cash inflow, after paying $12 billion in property taxes (thus bolstering the local communities as well).

Some tenants will still be unable to make these rent payments on time, and will fall behind – Let us assume 20% of them fall behind, on average halfway through the two-year rental period. This would create a $10 billion shortfall in rental cash inflows over the two years. While these places can be rented to another tenant, let us assume they are sold at 25% below the debt value. Since the properties were bought at a 5% discount, the actual loss to the agency would average $60,000 per home, or $36 billion in capital.

Finally, if the remaining properties were sold after twoyears at a 15% loss to the debt value (10% loss to purchase price), the agency would lose a further $72 billion. In addition, the agency would incur various legal, administrative and property management expenses. Let us assume the annual cost to manage the entire process is 15% of the annual rent, above conventional propoerty management fees, considering the complicated transactions and higher default risk. This totals to about $10 billion. The total cost comes to $128 billion, or ~$56,000 per acquired house. Private sectors investors could be attracted to this scheme either in place of a federal agency, or in competition with it, by offering a $43,000 (14%) taxpayer-paid subsidy per average house, and acquiring it a 5% discount to outstanding principal. In fact, the government could auction the subsidy, granting the contracts to bidders who require the lowest percentage subsidy.

The government would need to create the legal framework, structure and guidelines to ease acquiring mortgages as well as to create a new “tenancy” alternative to foreclosure.

With a capital outlay of $850 billion, and a conservatively estimated cost of $128 billion to the taxpayer, this scheme can help homeowners in trouble, support housing prices and ease excess inventory, and support the mortgage backed securities’ and derivatives’ prices, restoring bank balance sheets. Hopefully, this could restore liquidity and some return to normalcy for the credit markets and the broader economy as well.

Analyzing the cost of a tenancy workout for the credit crisis.

September 25, 2008 at 5:35 am | Posted in credit, Housing, regulations | 3 Comments
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Maybe we can have an agency or a fund that buys off foreclosed properties from banks, and allows the erstwhile owner to continue to occupy the place as a tenant (I’ve written about this here) . This would take the toxic mortgage off the bank’s balance sheet, and, by buying the mortgage at face value, or at a slight discount to face value, it would basically rescue the bank’s capital by overpaying for the debt. This, in turn, may support the mortgage market and the derivatives on these mortgages.

Knowing that the bad mortgages – those approaching foreclosure- can be sold at near-par (I suggest a 3-5% discount) would support prices of all mortgages.

In the meantime, the agency could convert the foreclosure process into a tenancy process – Ownership transfers to the agency, the previous owner now pays rent (at a rate somewhat lower than the mortgage payment, but one which covers the capital cost of the money the agency used to acquire the place), and, if s/he makes the rent payment regularly for a certain period of time (say two years – after all, plenty of renters lock themselves into a two year lease), they can then exit without a foreclosure on their credit record.

How much will this cost?

Lets try some round numbers to estimate this.

Two-thirds of about 110 million households own their homes, while the historical rate has been about 64%. The difference is about 3 million households, or about 4% of current homeowners. While the cycle could take homeownership even lower, I think rescuing homeowners would support the market to the point that perhaps prices and, more importantly, home ownership does not dip too far below this level.

The median home price in August 2008 was $203100, down from $224,400 in August 2007. However, we can assume that the median foreclosure may be above this amount for a couple of reasons – 1. Foreclosures are more likely in higher priced areas, and urban / suburban areas, and 2. The slowdown is worse in higher priced areas such as Southern California. Foreclosures started off in below-median-income households, but I think they are moving up the income ladder.

So lets assume the average mortgage on a foreclosed home is $300,000. This translates into about $850 billion in capital to purchase these foreclosed homes, at a 5% discount. Putting this money to work may help support pricing and keep other homeowners in their homes despite a decline in house prices.

I have previously estimated that the fall in home values could leave aggregate mortgage debt about $1.8 trillion above home values, so a real estate (RE) fund that buys up to $850 billion in property and converts them into rentals could make a serious dent in the problem. I wouldn’t worry too much about the derivatives market if we can bring some stability to the underlying real estate market – the derivative losses may be limited somewhat by the underlying stabilization, and anyway, I would rather use taxpayer money to support both Wall Street and Main Street, not just Wall Street.

Assuming a 4% cost of capital for the RE fund, and a $4000 median property tax, the median rental on these properties would be ~$1350 per month. We would have some people falling behind on the rent as well, so there would be losses on that as well, but I’m guessing that by stabilizing the market, and by charging rent that is probably considerably below what the tenant was previously paying in monthly installments, we might make it easier for the tenant to make these reduced payments.

So this fund would need $850B in capital, hopefully be able to largely produce returns that meet its cost of capital, and have assets that would eventually be sold to recover a fair amount of the principal, with a holding period of 2-5 years. Administratively, this would be a tough challenge to manage, but one could contract with property management agents to take care of some of these issues.

The ultimate cost to the tax payer may be a relatively small portion of the real estate fund. If we assume that about 20% of tenants fall behind on their payments (a conservatively high figure) during the two-year lease period (at a median of 1 year into the lease), that is just a $10 billion shortfall in lease collections. Lets say these 20% of properties are then sold (instead of being rented out to someone else) at a 20% loss. That is a 4% loss to the fund = $35 billion. Finally, assume the rest of the properties are eventually sold at a 10% loss. That would be $70 billion.

By my estimates, the total cost of a tenancy workout would be $115 billion, spread over several years. This is assuming the taxpayer-funded RE fund would actually purchase 3 million homes. But why not bring in private players who would get government backstop funding, based on these assumptions? Let them buy the properties at a 4% cost of capital, manage the process and the landlord -tenant relationship, and participate in the gain / loss relative to these back of the envelope calculations?

I would love to see a plan built around some such framework, and I would support the use of taxpayer money for this purpose.

Wall Street bailout: Not enough, and, without equity, too much of a giveaway?

September 25, 2008 at 3:57 am | Posted in credit, Housing, regulations | Leave a comment
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Bush appeals to Americans to support the $700 billion rescue effort.

I’m afraid, though, that this rescue will not be last of it. As I have examined elsewhere, a 25% drop in prices, which is not improbable, would leave home values $1.8 trillion below mortgage debt. The finance sector is undercapitalized, and is in no position to absorb these losses, or the losses on the derivative positions on these mortgages.

In any case, I oppose overpaying for mortgage assets without the government taking equity stakes in the businesses it rescues. That way, some of the overpayment may eventually be recovered. If it isn’t, at least the taxpayer won’t be worse off. Equity is basically the call option on the underlying health of the economy and financial system – If, as the government insists, the fundamentals are better than current panic conditions suggest (but bad, nonetheless), there is no reason why the government would not want equity as a call option on the bet that they are right.

Unless the rescue includes a workout to keep people in homes (I’ve explored this idea here), home values will keep falling, and the inventory of unsold and bank-owned homes will continue to rise. Not that this wouldn’t happen with a owner-to-tenant transition, but the price trough and the inventory peak may be muted somewhat by taking the urgency out of the foreclosure sale.

One likely consequence could be rental prices would fall as well, hurting landlords, but benefiting tenants, saving them money which they can use elsewhere. Which might be a good thing for broad sections of the economy.

$700B real estate fund!

September 21, 2008 at 6:02 pm | Posted in credit, Housing | Leave a comment
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In round numbers, total residential mortgages outstanding are about $11 trillion (See the time series on OFHEO’s website here).

Roughly, 65% of Americans live in owned housing, of which a third own the property free and clear. About 45% of about 108 million households have mortgage debt. Thanks to easy credit and the record low interest rates in 2003-2004, a majority of properties were recently refinanced, so the average age of mortgages are 3-5 years, with relatively few loans of pre-2001 vintage.

So basically, the government wants the authority to buy up about 6.3% of all outstanding mortgages, by initial value.

The government won’t buy a sample of mortgages – they will buy the worst of the lot, so we can expect that a very large number of the mortgages in the taxpayer’s portfolio will go delinquent at some point – in fact, many may already be delinquent by the time the government acquires them. With home prices sinking and very little equity to start with, in these toxic mortgages, the homeowners (I use the word loosely, its more like occupants) are basically upside down – They owe more in the mortgage than the house is worth, so many of them will walk away and go through foreclosure, unless the government also works out some kind of foreclosure avoidance package.

Otherwise, the US government is about to become the world’s largest residential real estate owner.

Own-to-rent?

September 21, 2008 at 5:30 pm | Posted in credit, Housing, regulations | 2 Comments
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Here’s an idea. How about, the government acquire toxic mortgages and modify the foreclosure process. Maybe the title transfers over to the government. The government then transfers it over into what is, essentially, an apartment REIT, and appoints a property manager to manage its rental portfolio.

The erstwhile homeowner is now a tenant of the property. They’ve lost equity – if they ever had any- but not the roof over their head. They now owe rent instead of the monthly mortgage payment, and perhaps the rent can be modified to the interest payment on the outstanding balance at a reasonable interest rate (Perhaps the current average 30-year fixed rate), rather than either a low teaser rate or a too-high post-reset ARM rate.

The tenant is basically locked in to a 2-year lease, so they have to pay rent for two years. If they fail to do so, they have a foreclosure on their credit report; if they do make the payments, they walk away with no equity, but also no dings to their credit. The foreclosed home stays occupied, so there isn’t a flood of bank-owned real estate boosting supply and depressing prices. The neighborhood doesn’t start emptying out, and foreclosed homes don’t drag down values – or boost crime in vacant homes.

Perhaps the government could in turn sell these rental REITs to investors – They buy into the rental cash flows + the value of the property. We know that the government will lose on this – The REIT cannot be valued at what the government paid for the assets in the REIT, but at least this will provide liquidity to both the financial markets as well as support the real estate market, helping borrowers in trouble.

I think this might be a workable idea, although it needs developing further.

Moral hazard for main street

September 21, 2008 at 5:15 pm | Posted in Housing | Leave a comment
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Let me see – These guys are finding it difficult to make the payments, and they owe more than the house is worth, and many of these are 2006 /07 vintages – i.e., They are still on the original ARM terms, they cannot claim to be in trouble because the interest rate reset to some unaffordable level.

How, exactly, would the government help them? Do we artificially lower the interest rate they have to pay? Do we forgive a part of their debt and lower the principal balance? Do we give them a longer repayment term?

And why does someone who took a mortgage they couldn’t afford, and is delinquent, deserve rescue? I could have taken a larger mortgage – I could have cashed out, or be living in a larger house – I didn’t. I’ve made all my payments on time. Do I have to continue to owe the full principal at whatever my rate is, while this guy misses a few payments, has 20% shaved off his balance, and the interest rate lowered by 2%?

Maybe I should consider skipping a few payments too.

Crisis of risk aversion

September 20, 2008 at 6:55 pm | Posted in credit, economics, Housing | Leave a comment
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I think, and some people wiser than me think, that this whole crisis was created, not by too much risk taking, but by too little. Investors had money to invest, and tons of potential investments. They could invest in startups, or corporate debt, or in biotech R&D ventures, or in retail – They had the option of investing in just about any area of our economy.

But they invested disproportionately in two areas – First, in treasuries – safe paper. The other area they invested in was also supposed to be just as safe, but could let them eke out a few extra points of interest – mortgage securities of all stripes. They were very complex, and a single security contained as many as tens of thousands of underlying mortgages. This was too much data to handle, in terms of the quality of each underlying mortgage, and the derivatives on this became ever more complex. The investors did not have the time, the data or the ability to understand them fully.

But the credit rating agencies said that they had studied these mortgages, and their models predicted that the losses in the portfolio would be modest, so the investors piled in. The problem was, the models were wrong. The models assumed that house prices would always keep going up, and thus, that refinancing would never be a problem. Wrong on both counts.

All it takes is a close look at the economy – where have all the record profits of the past 5 years gone? Where is the big spending? Where is the corporate expansion? Where is the massive R&D? The investments?

It all got crowded out by the least risky option – Not by someone swinging for the fences with their investments, but by someone hoping to approximate the safety of a treasury with 27 extra basis points of return.

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