A simple solution to the subprime crisis: loan officers’ pay

Put them on salary rather than commission:

As he drives through the Slavic Village neighborhood (of suburban Cleveland), passing homes stripped of aluminum siding, copper pipes and other remnants, Marc A. Stefanski says, “There are still S.& L.’s and banks that lend with a conscience, but, man, you got to find them.”

Mr. Stefanski should know: as the chief executive of Third Federal Savings and Loan, a Cleveland thrift that his parents founded in 1938, he has an unusual perspective on the mortgage mess. Unlike most of his competitors, Mr. Stefanski resisted the urge to cash in on the subprime lending boom.

His bank never offered no-money-down loans, piggyback mortgages, exploding adjustable-rate mortgages or the other financial exotica that ultimately tripped up the Sweets and millions like them. Third Federal pays its loan officers salaries, rather than commissions, so there is no incentive to go for volume. Even more remarkable is that Third Federal holds onto a sizable portion of its mortgages and keeps them on the books, rather than selling them to Wall Street to be sliced and diced into asset-backed securities owned by investors on the other side of the globe.

The result is that unlike many other mortgage lenders, Third Federal has a vested interest in making sure its loans do not go bad, so foreclosure is a last resort.

And, Third Federal practices what it preaches in selling more risky loans, when it does:

Third Federal has created a program for more risky borrowers like the Sweets, with required classes so that mortgage holders understand exactly how their loans work and what they will owe.

If the majority of American lenders were like Third Federal, we would never have had the problems we do.

There's more: "A simple solution to the subprime crisis: loan officers’ pay" >>

Cleveland foreclosures hit post-Depression high

How can you not think this will likely lead to a recession that Fed chief Bernanke won’t be able to stop, when you read about this:

In the first seven months of this year, there were 13,600 foreclosures in Cleveland and Cuyahoga County alone, compared to just 7,000 for the whole of 2006, and 3,400 in 1995, said county treasurer Jim Rokakis.

To date, at least 30 percent of the subprime mortgages in Cleveland have gone bad, Rokakis said, while nationally, some estimates place the current foreclosure rate at one out of every 130 homes.

In this area, there have not been so many sheriff's sales since America's Great Depression in the 1930s.

Rokakis said there are projections the crisis will surpass one trillion dollars, dwarfing the 300 billion dollars losses in the Saving and Loan crises of the last decade.

Those of us old enough to remember the S&L crisis know this is a pretty dire situation, if it’s going to be worse than that.

What’s next will not be a clamor for Bernanke to cut the Fed’s funds rate, but for Treasury Secretary Henry Paulson to arrange a bailout of Countrywide and other mortgage brokers. Amazing how capitalism can be a one-way street, isn’t it?

There's more: "Cleveland foreclosures hit post-Depression high" >>

A final, post-subprime bust kick in the crotch from the IRS

If your house gets repoed because you can’t keep up on a mortgage, the IRS
wants to tax the amount of the debt you had eliminated.

Foreclosure is one way that beleaguered homeowners can fall into this tax trap. The other is when homeowners are forced to sell their homes for less than the value of the mortgage. If the lender forgives that difference, they are liable for income taxes on that amount.

The 1099 shortfall, as it is called, stems from an Internal Revenue Service policy that treats forgiven debt of all types as income even if the taxpayer has nothing tangible to show for it, unless the debt is canceled through bankruptcy.

The Center for Responsible Lending expects that 20 percent of the home loans made in 2005 and 2006 to people with weak credit, commonly called subprime loans, will end in foreclosure. Because so little money was required as a down payment during the boom, the value of many of these houses may be less than what is owed.

Some people in this predicament are fighting the I.R.S. and winning. Sometimes, lower payments can be negotiated with the I.R.S., tax experts say.

In other cases, bankruptcy or a claim of insolvency can eliminate the tax burden.

Even though you may have some legal recourse, in general, this is ridiculous and non-sensical. And, it’s punitive, as well as being stupid.

It will also contribute to more of an economic downturn, taking more money to buy things out of peoples’ pockets.

There's more: "A final, post-subprime bust kick in the crotch from the IRS" >>

Edwards’ subprime talk isn’t convincing

Especially since he was first informed that his former employer and still invested private equity firm, Fortress Capital, owned not just one but two subprime lenders, back in May. And claiming there’s a difference between subprime loans and predatory ones is laughable.

Update: Let me specify that I agree with David, in comments, that not all subprimes are predatory. But, Edwards could arguably be seen as claiming none of them are, and that's just not true. Subprimes being extended to people like Katrina victims who may not even know yet how much their insurer is going to pay on a 60-year-old house seems pretty predatory to me.

There's more: "Edwards’ subprime talk isn’t convincing" >>

Financial analysts should have seen the subprime bomb ticking

In fact, some did:

“All of the old-timers knew that subprime mortgages were what we called neutron loans — they killed the people and left the houses,” said Louis S. Barnes, 58, a partner at Boulder West, a mortgage banking firm in Lafayette, Colo. “The deals made in 2005 and 2006 were going to run into trouble because the credit pendulum at the time was stuck at easy.”

“I’m one guy in a research department, but many people in our mortgage team have been suggesting that there was froth within the market,” said Jack Malvey, the chief global fixed income strategist for Lehman Brothers. “This has really been progressing for quite some time.” …

“We’ve contended for a while that there was an issue in subprime debt,” said Neal Shear, global head of trading at Morgan Stanley. “A year ago, we were aware that delinquencies were going to rise.”

Meanwhile, since everybody who has followed this issue knows that the incestuous action of ratings agencies like Moody’s, touting subprime derivatives on which they stood to profit, is a fair part of the problem, the European Union is planning to investigate possible conflicts of interest. Where’s the SEC, on our side of the pond?

And, the anti-Cassandras also bear blame for being in denial still, primarily through their claim that this is a just a problem with subprime mortgages.

No, it also has affected a number of Alt-A mortgages, the next class above subprimes. Therefore, it has affected more collateralized debt obligations. It’s also caused other classes of mortgage to hike their interest rates.

And, with the peak in number of adjustable rate mortgages due to reset nearly a year off, we’re still not at the bottom of this.

There's more: "Financial analysts should have seen the subprime bomb ticking" >>

Money markets latest to catch the subprime bug

Even though money market accounts are supposed to be “safe” investments, it looks like at least one got tempted to dip its hand into the subprime cookie jar:

Sentinel Management Group asked the Commodity Futures Trading Commission to help it stop Sentinel's investors from withdrawing their money, according to CNBC. Sentinel doesn't manage money funds for retail investors. Rather, it helps commodity trading firms and hedge funds invest the cash they accumulate in short-term, interest-bearing vehicles, according to The Wall Street Journal.

Money funds, similarly, invest in short-term, high-quality obligations called commercial paper. But in an effort to gain a competitive edge, some companies that run the funds stretch a little further out on the risk spectrum. Though it's not clear yet what securities Sentinel holds, there has been speculation in the market in recent days that some money funds owned short-term paper — including mortgage-backed securities — issued by banks with exposure to problems in the subprime-mortgage market.

The problem is twofold. One, Sentinel doesn’t have the type of liquid capital to pay off many investors. Two, the commodities commission said it has no power to do what Sentinel wants.

And, the problem has its own shockwaves

Sentinel is not a mutual fund company, and should not be confused with Sentinel Funds of Vermont, which today posted at its website that it is “in no way affiliated with the Sentinel Management Group (of Illinois).” …

Spokesmen for Fidelity Investments, Vanguard Group and T. Rowe Price said their firms have no significant exposure to commercial paper backed by subprime mortgages.

If other money-market funds are exposed, watch out. Calls on money could become stampedes, which will only further tighten business liquidity and cut the availability of business credit.

Cross-posted at Socratic Gadfly.

There's more: "Money markets latest to catch the subprime bug" >>

California home mortgage foreclosures at record pace

And the subhead in the Los Angeles Times’ online version of the story even uses the word “recession” in describing the problem:

Foreclosures soared to 17,408 for the three months ended June 30, an increase of 799 percent from the same period last year. The current rate handily exceeds the previous foreclosure peak set in 1996, when the state was in the final throes of a six-year slump.

“The economy will bend further under the weight of the mounting
housing and mortgage problems, but it will not break,” said Mark
Zandi, chief economist at Moody’s Economy.com.

That’s what passes for optimism these days. Others are more downbeat.

“All the artificial stimulus housing gave the economy is going to go away,” said Rich Toscano, a financial advisor with Pacific Capital Associates in San Diego who runs the popular Piggington.com real estate website. “There will be individual pain for people who made the wrong decisions. We all may end up in a recession.”

The good news, as seen by Toscano: “I don’t envision a ‘Grapes of Wrath’ scenario where we all have to pile in the family car and look for harvesting work.” ...

Most analysts say the housing market won't stabilize until 2008 or 2009. The so-called soft landing that was much talked about last year is rarely mentioned anymore.

The rising foreclosure rate is tied to stricter lending standards and weakening home values. With housing prices flat or falling, lenders are less willing to refinance loans — especially to borrowers with shaky credit who are most likely to miss payments. ...

One reason foreclosures are rising faster than defaults is that strapped owners are having a harder time saving themselves.

As recently as a year ago, most homeowners who had slipped behind in their payments found a way to get current again. Nearly 9 out of 10 defaulting borrowers got out of trouble by selling their house or refinancing, according to DataQuick.

Fewer than 6 out of 10 are able to do so now. “People have stretched their finances to the breaking point,” said DataQuick analyst John Karevoll.

There’s already a year’s supply of houses on the market in San Bernardino and Riverside counties, up from a three-week supply at the height of the boom, said Ron Barnard, owner of Home Center Realty in Norco. Many are foreclosures that banks are trying to unload.

Will this be an “as California goes, so goes the nation,” scenario? As I’ve posted in the past about this issue, even states like Texas which look good on paper aren’t so solid.

In the sense of not liking or wanting a recession, it gives me little comfort to have my analysis confirmed by a major seven-day daily newspaper. But, in the sense of confirming that I’m not Chicken Little, it shows indeed that I’m on the right analytical track.

Cross-posted at Socratic Gadfly.

There's more: "California home mortgage foreclosures at record pace" >>

Subprime crisis moves right into prime-market loans

Countrywide Financial has prime-level mortgages at least 30 days late increase more than 250 percent:

Shares of Countrywide Financial Corp. tumbled today after the nation's biggest mortgage lender signaled that rising defaults and delinquencies are spreading beyond the troubled sub-prime market to higher-quality "prime" loans.

The Calabasas-based company reported a 33 percent drop in its second-quarter profit and slashed its outlook for the rest of the year, citing an “increasingly challenging” housing market. ...

Countrywide said payments were at least 30 days late at the end of second quarter on 4.56 percent of prime home-equity loans serviced by the company, up from 1.77 percent a year earlier.

Payments were late on 23.71 percent of sub-prime mortgage loans, up from 15.33 percent at the end of the same period in 2006, the company said.

What does this have to do with “watching those we choose”?

Bill Clinton said, 15 years ago: “It’s the economy, stupid.”

I give you 1-3 odds we’re in a recession in 12 months. It will be the economy, again, as well as Iraq, on the presidential and congressional campaign trails.

I increase those odds to 1-2 by Jan. 20, 2009, especially if Bloomberg’s is right about $100/bbl oil. Whoever is elected president will have to deal with this.

Update: DuPont was among slumping stocks today, with profit projections tumbling due to a decline in housing starts, home remodeling and related business affecting demand for countertops.

Cross-posted at Socratic Gadfly. (Both the subprime crisis/housing bubble and Peak Oil are blogged extensively at my blog.)

There's more: "Subprime crisis moves right into prime-market loans" >>

Why hasn’t Wall Street reacted to the subprime crisis the way it “should”?

Because the Street has a lot to protect. Note the words “contained,” “suppressed” and “protected” in the Bill Fleckenstein analysis quoted below:

The problems have taken a long time to play out, largely because of what we've recently come to discover but probably could or should have known all along: that the building blocks of the housing ATM — more accurately referred to as structured credit — were created in such a way that these securities were rarely marked to market. Rather, they were allowed to be marked to a model, based on a variety of assumptions. Essentially, therefore, one's assets were impaired only when the ratings companies downgraded them. ...

Fast-forward to last February and March, which saw the implosion of a couple of dozen subprime lenders. Wall Street reacted by proclaiming the problem “contained.” Though I essentially laughed at that sanguine response, now I understand what it meant: Those in the know understood that nothing was going to be marked to market, so the subprime-loan-originator implosion didn't matter.

Next, we saw the blowup of Bear Stearns’ High-Grade Structured Credit Strategies Enhanced Leverage Fund. That happened, in part, because manager Ralph Cioffi had tried to hedge some of its weaker credits with an ABX index that did get marked to market. Thus the fund lost money and was hit with redemptions.

At the time, I said that redemptions were going to force price discovery into the market — although, as Jim Grant so eloquently put it in a recent issue of Grant's Interest Rate Observer — Bear Stearns had a totally different opinion: “Price discovery could wait until the return of blue skies and normal pulse rates. The first order of business was price suppression.”

This price suppression was the outcome folks had hoped for. After all, according to a July 11 article in Bloomberg, Wall Street took in about $27 billion in revenue from underwriting and trading asset-backed securities last year alone. It’s a mighty profitable business that they are protecting.

In other words, until the Street gets as “rational” about sunk costs as classical economists believe people are supposed to be, it’s not going to own up to the size of this problem.

There's more: "Why hasn’t Wall Street reacted to the subprime crisis the way it “should”?" >>

How much of a worry should subprime mortgages and collateralized debt obligations be?

Maybe even more than I’ve written before.

First, according to Counterpunch, financial derivatives have 10 times the float of all publicly traded stocks combined. That’s a lot of dinero, and no matter how much the Dow is up, ultimately, the broader investment market just can’t run from that:

Noriel Roubini puts meat to these bones. In his June 27th blog, Roubini wrote:

“The fallout of this CDO mess is likely to end up into $100 billion plus of losses for banks, financial institutions, hedge funds and investors once these CDOs and subprime mortgage backed securities are marked-to-market rather than being marked-to-a-delusional — misrated-model. Thus, the Bear disaster is only the tip of the iceberg of a much bigger financial mess that will unravel in the next few months: the pile of rising subprime and nearprime delinquencies will take a toll on the toxic waste of mortgage backed securities that a rating ‘voodoo magic’ pretended to turn below-junk securities into A-rated ones.”

Meanwhile, the Bank of International Settlements is worried about how the Fed has first mishandled this situation, then hedge funds. (Are hedge funds being used to “vent” the subprime crisis just like Greenspan used housing to ‘vent” he dot-com bubble?)

Here’s just how bad the problem is:

The BIS referred to the toxic effect of the $470 billion in collateralized debt obligations (CDO), and a further $524 billion in “synthetic” CDOs which have spread through hedge funds industry. These CDOs are the loans (many sub primes) which were bundled off to Wall Street and turned into securities which are highly leveraged in hedge funds for maximum profitability. As Bear Stearns is discovering, these CDOs are like roadside bombs. …

Banks doubled the amount of CDOs outstanding in the past two years to $2.6 trillion, including a record $769 billion sold last year, according to J.P. Morgan.

And, just because Wall Street is doing fine, that doesn’t mean the economy is so great, in case you’re wondering how it can be looking at 14,000 in the face of all that debt:

The current rise in stock prices does not indicate a healthy economy. It simply proves that the market is awash in cheap credit resulting from the Fed's increases in the money supply. Consumer spending is a better indicator of the real state of the economy than stocks. When consumer spending drops off; it is a sign of overcapacity, which is deflationary.

Here’s the bottom line:

The underlying problem is not simply the Fed's reckless increases to the money supply, but the growing “wealth gap” which is undermining solid economic growth. If wages don't keep pace with productivity; the middle class loses its ability to buy consumer items and the economy slows.

The reason that hasn’t happened yet in the US is because of the extraordinary opportunities to expand personal debt. The Fed's low interest rates have created a culture of borrowing which has convinced many people that debt equals wealth. It's not.

On mortgage refinancing, the purchasing of second homes as investments, etc., that confusion of wealth and debt is now coming home to roost.

And, if that’s not enough to wake you up:

The rise in housing prices has created the illusion of prosperity but, in truth, we are only selling houses to each other and are not making anything that the rest of the world wants. The $11 trillion dollars that was pumped into the real estate market is probably the greatest waste of capital investment in the nations' history.

Harsh words, but at least a fair-sized grain of truth behind them. This reminds me of Paul Kennedy’s book “The Rise and Fall of the Great Powers.” Somewhat for the Netherlands, and definitely for Great Britain, Kennedy states the move from manufacturing and industry to a focus on financial services was a key part of the decline of these great powers.

Caveat emptor.

Cross-posted at Socratic Gadfly.

There's more: "How much of a worry should subprime mortgages and collateralized debt obligations be?" >>

Subprime crisis a reflection of larger debt-investment problems; possibly comparable to Enron derivatives

Jim Jubak explains the incestuous relationship between credit-rating agencies and banks, and how the subprime crisis has left a lot of emperors’ new clothes exposed:

It's important to understand that bond professionals don't want to think badly of the job done by the credit-rating agencies. The bankers pay the rating agencies' fees. (Bet you didn't know that. Yep, the issuers of debt are the ones who pay the bills.) The bankers literally sit across the table from the rating agencies. The banks poach anybody on the other side of the table that they think has the talent to work for them. And the banks rely on the credibility of the rating agencies to sell their debt offerings. It's a pretty cozy club.

But the subprime debacle has been big enough to disrupt the club. Buyers of packages of subprime mortgages and derivatives based on these packages that have been burnt by rising defaults on these mortgages and falling prices for the debt they hold have angrily wondered if banks issuing the debt disclosed all the risk. And the banks have passed the buck, saying, that they relied on the ratings from the three agencies.

As a result, Jubak said, this is part of why not just the ratings agencies in particular, but Wall Street in general, hasn’t reacted faster to the subprime crisis and its possible larger economic effects, specifically the problems with mortgage-based securities.

Several issues here.

First, where is a Democratic Congress, in failing to push for new regs out of either the SEC or FDIC to eliminate this incestuousness?

Probably waiting for “new Democrat” financial donors, which it has often been since the Clinton days.

This would be like Ford or GM paying Consumer Reports for their car ratings. It’s ridiculous.

It’s ridiculous it took the subprime crisis to expose this, if “expose” is the right word for something still generally flying well beneath the Big Media radar.

Beyond that, there’s the fact that these particular securities, known as collateralized debt obligations, are big turkeys in their financial performance. And, to the degree small investors have gotten talked into them, they could take a bit of a bath.

And, these are very complex debt-based securities. Jubak says many people, not small-time buyers, but even bigger pros, can’t analyze them well. He even draws Enron-type comparisons.

It’s ridiculous nothing has yet been done.

Cross-posted at Socratic Gadfly.

There's more: "Subprime crisis a reflection of larger debt-investment problems; possibly comparable to Enron derivatives" >>

Housing market continues to slide; foreclosures jump 90 percent

Could a recession be looming? If so, or potentially so, can Democrats handle this and Iraq as well?

The story reports two additional concerns beyond the headlines stat.

First, the foreclosure rate jumped 19 percent from April.

Second, we aren’t about to turn the corner.

A jump in foreclosures at a time of year that traditionally is the busiest for home sales means the slide in prices probably isn't over, said James Saccacio, chief executive officer of RealtyTrac. Typically, more than half of all home sales occur in the April to June period, according to Freddie Mac, the No. 2 mortgage buyer.

“Such strong activity in the midst of the typical spring buying season could foreshadow even higher foreclosure levels later in the year,” Saccacio said in the report. That will add “to the downward pressure on home prices in many areas.”

I’ve been blogging about this for months; I totally agree. Unfortunately, Wall Street and the Federal Reserve refuse to face the music.

Just go to my blog and click either the “subprime mortgages” and “housing bubble” labels.

I’ll give you 50-50 odds the country faces at least a “mini-recession” 12 months from now. If Congressional Democrats can’t get their act together better on Iraq and aren’t prepared for something like this, the 2008 election season will be far short of a cakewalk. Remember what Big Bill and Cajun Carville said back in 1992 about the economy?

Cross-posted at Socratic Gadfly.

There's more: "Housing market continues to slide; foreclosures jump 90 percent" >>