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Why I don’t think regulators should suspend mark to market accounting

Tuesday, March 24th, 2009 | Economics | Permalink | 6 Comments |

Here’s my simplistic, probably naive take on mark market accounting. In recent years some of these banks loaned $500,000 to buy California houses that in today’s market are only worth $250,000. Mark to market accounting would require them to value the asset (the mortgage) at $250,000 (the market price) rather than the nominal price the asset is carrying on their books (the original $500,000, minus any payments on the principal of the loan).

Banks don’t want that to happen, because it makes their books look bad. Banks have capital requirement ratios they have to maintain and that becomes difficult when the underlying value of their assets is shrinking. Hence the calls from banks to Washington to suspend or modify mark to market accounting.

Here’s an example that demonstrates why I don’t think we should suspend mark to market. Let’s say the bank has two $500,000 mortgages exactly like the example above on two identical houses next door to each other in the same subdivision. One homeowner is still making the mortgage payment. The other one stops making payments and the bank forecloses, eventually selling the house for $250,000.

The bank wants to pretend that the first house is still worth $500,000 even though the second, identical house only brought $250,000 on the open market. That’s what a suspension of mark to market accounting would accomplish.

If you really want to see how absurd that is, let’s swap positions with the bank. I’ll go to California and tell the bank I want a loan to buy that foreclosed house for $250,000. But I don’t want a $250,000 loan. I want a $500,000 loan. After all, that’s the amount of the original mortgage from a few years ago. As a comp I’ll use the first, identical house that the bank is valuing at $500,000 on its books.

Naturally, no bank in their right mind would let me claim a house is worth $500,000 in loan collateral when the market says it’s worth half that. Yet if regulators suspend mark to market rules on mortgages the banks will be doing exactly the same thing because it benefits them.

One reason this example is somewhat simplistic is that if the second homeowner is making payments the asset is generating revenue for the bank. One argument in favor of ignoring mark to market accounting, or not giving it full weight, is that some assets, like mortgages, have both an asset value and a revenue-generating value that needs to be taken into consideration.

Comments and criticism appreciated.

Some other peoples’ thoughts on mark to market here and here. You might also read the relevant part of the Wikipedia entry.

Tags: banks, mortgages

NY Times Joe Nocera: no bailouts for homeowners

Tuesday, March 17th, 2009 | Economics | Permalink | No Comments |

There’s a teensy-weensie little twist at the end.

Tags: bailout, mortgages

FICO CEO says “worst is yet to come” for mortgage problems

Monday, March 16th, 2009 | Economics | Permalink | No Comments |

FICO CEO Michael Porter on CNBC, via Calculated Risk: “Before we do the credit cards, we are actually not done with the mortgage [crisis] - the worst of that is yet to come in fact. The thing about mortgages is you can predict when they are going to reset and you can sort of see what is coming. We easily have another 12 to 18 months of pretty ugly times in terms of mortgage resetting. … Credit cards are next.”

Tags: mortgages

Adjusted for inflation, prime interest rates were negative from 2002 to 2005

Friday, March 13th, 2009 | Economics | Permalink | No Comments |

Lots of people, me included, think that the main cause of the real estate bubble and credit bubble were the interest rates set by the Federal Reserve under former Chairman Alan Greenspan. Those interest rates were kept too low for too long. It turns out that the interest rates were so low that once you factored in inflation the interest rates were negative. The Federal Reserve under Greenspan was paying banks to borrow money.

Greenspan recently surfaced to defend his record and distance his decisions from the current mortgage mess and collapse. For his trouble he’s getting attacked further, just as he deserves.

Greenspan lays out his case that the Fed’s easy money policies can’t possibly be to blame for “the U.S. housing bubble that is at the core of today’s financial mess.” It is long-term interest rates that determine “the prices of long-lived assets,” such as housing, he writes. And those rates, which stayed low as a result of a “global savings glut,” are out of the Fed’s control.

Control, yes. Influence, no.

“Why not try raising short rates if long rates are too low?” asks Paul Kasriel, chief economist at the Northern Trust Corp. in Chicago. “The recession was over in 2001. Why did he take so long to start to raise the funds rate?”

Greenspan is selective in arguing his case. By any measure, the overnight fed funds rate was too low earlier in the decade. The real funds rate, which is the nominal rate adjusted for inflation, was negative for three years, from October 2002 to October 2005, a longer stretch than in the mid-1970s. And we know how well that turned out.

Now we have additional evidence of the effect of negative real rates. When financial institutions are being paid to borrow, borrow they will.

The history of the mortgage crisis is not going to be kind to Alan Greenspan.

Tags: greenspan, inflation, mortgages, the fed

An analogy for the real estate crash

Thursday, March 12th, 2009 | Economics | Permalink | No Comments |

Heidi the bar owner decides to extend her customers easy credit terms so they can drink now and pay later:

Taking advantage of her customers’ freedom from immediate payment constraints, Heidi increases her prices for wine and beer, the most-consumed beverages. Her sales volume increases massively.

A young and dynamic customer service consultant at the local bank recognizes these customer debts as valuable future assets and increases Heidi’s borrowing limit. He sees no reason for undue concern since he has the debts of the alcoholics as collateral.

At the bank’s corporate headquarters, expert bankers transform these customer assets into DRINKBONDS, ALKBONDS and PUKEBONDS. These securities are then traded on markets worldwide. No one really understands what these abbreviations mean and how the securities are guaranteed. Nevertheless, as their prices continuously climb, the securities become top-selling items.

You’d think a story about excess alcohol consumption, immediate gratification, and unlimited credit would end well, but no.

(And needless to say spend now pay later has been the U.S. government’s policy for decades, and the rate at which we’re outspending our income is accelerating dramatically right now.)

Tags: banks, mortgages

Who got us into this mortgage mess

Thursday, February 26th, 2009 | Economics | Permalink | 2 Comments |

Over at SayUncle’s tgirsch talks about who and what was responsible for the mortgage industry problems that are shaking the finance industry apart. In particular, he says that the Community Reinvestment Act was not the cause. Here’s my comment from over there.

I haven’t seen any evidence that CRA was a major contributor.

However, Fannie and Freddie were major contributors, particularly in taking no-doc loans. See Congressional testimony here:

Freddie Mac’s senior executives ignored similar warnings. Donald J. Bisenius, a senior vice president, wrote in April 2004 to a colleague that “we did no-doc lending before, took inordinate losses and generated significant fraud cases.”

“I’m not sure what makes us think we’re so much smarter this time around,” he wrote.

Housing analysts say that the former heads of Fannie Mae and Freddie Mac increased their nonprime business because they felt pressure from the government and advocacy groups to meet goals for affordable housing as well as pressure to compete with Wall Street. But Mr. Pinto said one in five Alt-A loans in recent years were made to investors, not to first-time home buyers.

Other big factors:

Securitized mortgages. Some lenders wrote shite loans and pawned them off as investments.
Moody’s and S&P then somehow rated those investments as high quality.
Banks were massively over-leveraged relative to deposits and investments.
The market was wildly inflated in many areas, with some areas (like California) much worse than others.
Federal Reserve interest rates that stayed too low too long encouraged those crazy prices. Lowering the interest rate a couple of points makes an enormous difference in how much house people can afford, which drives up rates.
Lending institutions went nuts, with things like 100% loan to value ratios (as opposed to the traditional 80%) and options ARMs, which are insane.
There were some instances of intentional mortgage fraud, though that was relatively rate.
There were also cases of people buying more house than they could afford, but the banks should have simply told them no.

Overall, I rank the failings greatest at the government level, then at the banking level, and least at the individual level of honest buyers.

The government - particularly the Federal Reserve under Greenspan - tried to prop up the economy with too-easy credit for too long. Greenspan in 2004 said that fears of a speculative housing bubble were exaggerated, and that more Americans should use adjustable rate mortgages.

Banks and other lending insitutions betrayed their depositors and investors by glossing over risk and ignoring long-standing rules like the 80% loan to value ratio and the 3 to 1 annual income to mortgage ratio. Many buyers who went in seeking loans beyond their means should have been denied loans. That would have prevented many of the problems we’re seeing today.

The next day Doctor Housing Bubble had a graphic showing who was responsible for the current mess, with the most responsible at the top. I’m in general agreement with this:

The Federal Reserve kept interest rates too low for too long and actively encouraged borrowing even as the housing market was overheating. Greenspan and Bernanke were terrified of letting the economy cool off, which in retrospect it definitely needed to do years ago. It would have been better to have a small recession and let people sober up instead of having an entire economy that was drunk on its belief in ever-appreciating real estate prices.

The banks and the investment firms who made these loans and who bought securitized debt were responsible because they were supposed to be the caretakers of their depositor’s money and investor’s money. Instead they got greedy and made their lending standards impossibly low. Now in many cases they’ll never get all of the principal back.

The rating agencies enabled much of this by giving top ratings to securitized debt, much of which is now recognized as toxic waste on the balance sheet.

One level not shown in the pyramid is Fannie Mac and Freddie Mac. As the testimony above and this internal email show, they were involved in incredibly reckless lending practices in order to maintain their growth, though certainly part of that was due to political pressure.

Tags: fannie mae, freddie mac, mortgages

Good explanation of Obama’s refinancing plan

Wednesday, February 25th, 2009 | Economics | Permalink | No Comments |

I haven’t said much about the housing plan because I haven’t had time to study it, but this seems like a pretty good explanation. The plan has two notable restrictions on the types of loans that qualify:

The loan must have been held or securitized by Fannie Mae or Freddie Mac. So no jumbo loans and no crazy option ARMs, because Fannie and Freddie didn’t do those. Beyond that, there are just lots of loans that didn’t go through those agencies and therefore don’t qualify.
The loan to value ratio can’t exceed 105%. You can be a little upside down, but not massively upside down. This won’t help people who bought a $500,000 house that’s now only worth $300,000. (Nor should it, in my opinion. That would be using taxpayer money for a spin of the roulette wheel. Sad as it is, a person in that situation is wiped out and needs to leave the table. Their losses shouldn’t be covered by taxpayers who didn’t overspend on houses or who couldn’t afford a house in the first place. Likewise, their bank’s losses shouldn’t be covered.)

Tags: bailout, banks, mortgages

Will lower interest rates help adjustable rate mortgage holders?

Saturday, December 20th, 2008 | Economics | Permalink | 5 Comments |

Will lower interest rates help adjustable rate mortgage holders? Answer: It depends on the type of adjustable rate mortgage (ARM).

There are ARMs and then there are option ARMs. Some of the option ARMs had crazy terms. Unlike a regular ARM, option ARMs don’t just change the interest rate over time. They also delay principal or interest payments for years so that when the loans recast the price increase can be astronomical.

Dr. Housing Bubble - Option ARMs for Dummies: Why 4.5 Percent Mortgages Rates will do Absolutely Nothing for these Toxic Assets.:

It usually helps to look at a real world example. In a lawsuit filed by the State of California against Countrywide, examples of some real world option ARM mortgages show us how absurd these loan products really are. Let us look at the details first:

I know at a quick glance, you are probably shaking your head at the absurdity of the terms above. We are looking at an option ARM with a 1% teaser rate offered by Countrywide. The margin on this mortgage is 2.9%. That is why you saw people spending like A-list celebrities because with the initial one year payment of $1,479 a month, they had money to spend even though the mortgage itself was negatively amortizing. Little by little the payment went up until it hit the 5th year and explodes to $3,747.83.

Previously:

Tags: mortgages

Inflation-adjusted U.S. house prices 1975-2008

Tuesday, November 25th, 2008 | Economics | Permalink | 24 Comments |

Source. The graph shows the bubble taking off in 1998 and the market peaking in 2005-06. That latter date is generally considered the market peak by many sources.

Note that this graph completely contradicts the chirpy real estate agent advice that “home values always go up!” Home values tend to hold their value relative to inflation, which is no small feat. Your home also gives you a place to keep your stuff dry, which is something you can’t say about T-bills and mutual funds. However, significant appreciation relative to inflation was seen almost entirely in the housing bubble era.

We’re now in an era in which home prices are depreciating. Based on the graph above prices may have to decline an additional inflation-adjusted 15-25% to be back within historical norms.

LATER: Here’s a longer-term graph from the same source: