Experienced loan officers know that one of the best predictors of a loan default is a prior loan default. Therefore, the news that mortgage modifications have a very high rate, approaching 60 percent, of new defaults is not surprising.
Since defaulting on a mortgage is the requirement for qualifying for a mortgage loan modification, a high rate of new defaults after modification is normal. Tweaks to the government and the banks' loan modification programs will not decrease the rate of defaults unless mortgage modification programs allow people who did not default to qualify for a modification.
Saturday, February 28, 2009
Monday, February 23, 2009
Determinates Of Home Prices
House prices are composed of two primary components. The total value of a house is the combined value of the land that the structure sits on and the value of the physical structure. While there are regional differences in the cost of lumber and other materials primarily due to differences in transportation and storage costs and in the regional costs of labor, these do not account for the significant difference in regional prices of comparably built homes. The land's value is the primary cause of regional difference in comparably built homes. Over time, it is the value of a home's raw materials, labor, land and depreciation that determine a home's value.
The house structure as opposed to the land, depreciates over time due to the wear and tear of its components. For example, roofs will need replacement. The exterior will need repainting or need siding repair or replacement. Plumbing wears out and leaks. Weathering damage occurs to the structure, and many other parts of the house will need maintenance, repair or replacement. Any one who has ever seen an abandoned house recognizes that it will deteriorate over time without maintenance and repair.
A home's value will decline yearly due to this depreciation unless there is enough appreciation to compensate for the natural decline in a home's value or unless a potential buyer can assume that the current homeowner added back to the home's value the cost of the depreciation through repair and maintenance. In a robust economy, one can assume that the current owner is making the necessary repairs and maintenance and that the value of the replacement is equal to the depreciation value.
Assuming a 20-year average life for the combined house structure (it is just a reasonable guess to use as an example and not an actually computed value), the value of a home's structure will decline in value by 5 percent per year. Assuming that the land a house sits on is worth about 20 percent to the total house price (again just a reasonable guess for an average with the understanding that in some areas such as DC, San Francisco, NYC, etc it will be higher), the value of a home will decline by 4 percent per year (80 percent of 5 percent). A four percent increase in the total value of a home will be just enough to compensate for the loss due to depreciation and hold constant the total value of a home. To say that a home increases in value by the CPI is in effect to say its value increased by CPI plus 4 percent or that it increased by CPI and the homeowner added back to the home the 4 percent value of the depreciation. In recessionary times, homeowners will defer maintenance and repairs. Home prices will decline by their depreciation amount since the homeowner is not adding back the depreciation value, where in better times home prices will remain stable. Therefore, a 2-3 percent CPI increase in home prices will not be enough to compensate for the depreciation loss and lead to a 1-2 percent decline in home values. Currently, we are facing a deflationary price period and many of the raw materials needed for repairs have declined in price. For example, lumber prices are at a five year low. Due to the slow down in residential construction, labor costs are also low. Any repairs made by owners (if made) will cost less than anticipated and not compensate for the decline in a home's value due to depreciation. Plus, there is the increased likelihood that maintenance and repairs will be deferred.
Land value is set by supply and demand, which is determined by the desirability of an area and the availability of approved (or potentially approvable) buildable land in the area. Local government regulation determines if available land is approved for building a home. The availability of employment and the salaries paid for the jobs is a determinate of an area's desirability. The other is leisure, including retirement. When an area's total employment declines, the value of the residential land in that area will also decline causing a decline in a home's value. Likewise, in poor national economic times the value of leisure plus a delay in retirement decreases the value of land in leisure and retirement areas.
Therefore, home values will continue to decline due to two factors. Poor regional economies will cause a decline in land values in regional areas. The national downturn will cause a decline in retirement and leisure land areas. The decline in raw materials and labor for houses will also cause a decline in the replacement value of a home.
Home prices will not stabilize until regional employment stabilizes, until retirement and leisure return to normal levels and until raw material and labor prices recover to a level to compensate for the loss in value due to depreciation and homeowners add back the replacement cost of depreciation.
The house structure as opposed to the land, depreciates over time due to the wear and tear of its components. For example, roofs will need replacement. The exterior will need repainting or need siding repair or replacement. Plumbing wears out and leaks. Weathering damage occurs to the structure, and many other parts of the house will need maintenance, repair or replacement. Any one who has ever seen an abandoned house recognizes that it will deteriorate over time without maintenance and repair.
A home's value will decline yearly due to this depreciation unless there is enough appreciation to compensate for the natural decline in a home's value or unless a potential buyer can assume that the current homeowner added back to the home's value the cost of the depreciation through repair and maintenance. In a robust economy, one can assume that the current owner is making the necessary repairs and maintenance and that the value of the replacement is equal to the depreciation value.
Assuming a 20-year average life for the combined house structure (it is just a reasonable guess to use as an example and not an actually computed value), the value of a home's structure will decline in value by 5 percent per year. Assuming that the land a house sits on is worth about 20 percent to the total house price (again just a reasonable guess for an average with the understanding that in some areas such as DC, San Francisco, NYC, etc it will be higher), the value of a home will decline by 4 percent per year (80 percent of 5 percent). A four percent increase in the total value of a home will be just enough to compensate for the loss due to depreciation and hold constant the total value of a home. To say that a home increases in value by the CPI is in effect to say its value increased by CPI plus 4 percent or that it increased by CPI and the homeowner added back to the home the 4 percent value of the depreciation. In recessionary times, homeowners will defer maintenance and repairs. Home prices will decline by their depreciation amount since the homeowner is not adding back the depreciation value, where in better times home prices will remain stable. Therefore, a 2-3 percent CPI increase in home prices will not be enough to compensate for the depreciation loss and lead to a 1-2 percent decline in home values. Currently, we are facing a deflationary price period and many of the raw materials needed for repairs have declined in price. For example, lumber prices are at a five year low. Due to the slow down in residential construction, labor costs are also low. Any repairs made by owners (if made) will cost less than anticipated and not compensate for the decline in a home's value due to depreciation. Plus, there is the increased likelihood that maintenance and repairs will be deferred.
Land value is set by supply and demand, which is determined by the desirability of an area and the availability of approved (or potentially approvable) buildable land in the area. Local government regulation determines if available land is approved for building a home. The availability of employment and the salaries paid for the jobs is a determinate of an area's desirability. The other is leisure, including retirement. When an area's total employment declines, the value of the residential land in that area will also decline causing a decline in a home's value. Likewise, in poor national economic times the value of leisure plus a delay in retirement decreases the value of land in leisure and retirement areas.
Therefore, home values will continue to decline due to two factors. Poor regional economies will cause a decline in land values in regional areas. The national downturn will cause a decline in retirement and leisure land areas. The decline in raw materials and labor for houses will also cause a decline in the replacement value of a home.
Home prices will not stabilize until regional employment stabilizes, until retirement and leisure return to normal levels and until raw material and labor prices recover to a level to compensate for the loss in value due to depreciation and homeowners add back the replacement cost of depreciation.
Thursday, February 19, 2009
FDIC Procrastination Is The Way Around Pricing The Toxic Assets
The large banks, such as Citi, are not cash flow insolvent and are still in a position to lend. Some are likely book value insolvent or at least capital insufficient if the assets are repriced to market value, but on a cash flow basis, they can continue to operate and lend and honor normal deposit withdrawals.
Deposits are stable. Many of the toxic assets are receiving payments and are cash flow positive. Plus, these banks have liquid securities, such as Treasury securities, that can be converted to cash to further increase lending.
As long as these banks are not seeing a run on its deposits and as long as they can continue to lend, there is no functional need for the FDIC to step in and takeover Citi or the other large banks.
Buying or moving the toxic assets requires a repricing of the assets to a current market value and destroying much, if not all, of these banks' capital base. However, as long as the banks are receiving payments on the toxic assets, despite accounting rules, they can avoid writing down these assets until they default arguing that the assets are more like loans than securities. They may face some future shareholder and SEC lawsuits, but that potential liability will be small in comparison to a FDIC takeover.
Assuming that not all the assets will default at the same time and that Citi and the other banks will have positive earnings from the rest of their lending and investment portfolios, they can survive and come out of this crisis (although bruised) over the next few years. They will write down over the next few years its toxic assets (as they are already currently doing) as they default in their payments and these write downs will be offset by earnings from the remainder of the banks.
30 years ago, the large banks faced a crisis over sovereign debt until the Baker Plan and were technically insolvent, but were not required to write down those assets to a market value. Similarly, 20 years ago, there was a commercial real estate crisis and the banks took loan losses but not market value write-downs.
The current banking crisis with toxic assets is not like the S&L crisis. With S&L's there was a moral hazard because large shareholders controlled the bank and use the delay to take on very high risk as the only hopes of salvaging their wealth and many in effect bet the bank and lost. But many also survived.
Sometimes, banks have to wear the emperor's new clothes. Over time, the toxic assets will disappear through repayments and write-downs. Quick fixes are not always the best solutions. In the case of the large banks, procrastination is possibly the best answer.
Deposits are stable. Many of the toxic assets are receiving payments and are cash flow positive. Plus, these banks have liquid securities, such as Treasury securities, that can be converted to cash to further increase lending.
As long as these banks are not seeing a run on its deposits and as long as they can continue to lend, there is no functional need for the FDIC to step in and takeover Citi or the other large banks.
Buying or moving the toxic assets requires a repricing of the assets to a current market value and destroying much, if not all, of these banks' capital base. However, as long as the banks are receiving payments on the toxic assets, despite accounting rules, they can avoid writing down these assets until they default arguing that the assets are more like loans than securities. They may face some future shareholder and SEC lawsuits, but that potential liability will be small in comparison to a FDIC takeover.
Assuming that not all the assets will default at the same time and that Citi and the other banks will have positive earnings from the rest of their lending and investment portfolios, they can survive and come out of this crisis (although bruised) over the next few years. They will write down over the next few years its toxic assets (as they are already currently doing) as they default in their payments and these write downs will be offset by earnings from the remainder of the banks.
30 years ago, the large banks faced a crisis over sovereign debt until the Baker Plan and were technically insolvent, but were not required to write down those assets to a market value. Similarly, 20 years ago, there was a commercial real estate crisis and the banks took loan losses but not market value write-downs.
The current banking crisis with toxic assets is not like the S&L crisis. With S&L's there was a moral hazard because large shareholders controlled the bank and use the delay to take on very high risk as the only hopes of salvaging their wealth and many in effect bet the bank and lost. But many also survived.
Sometimes, banks have to wear the emperor's new clothes. Over time, the toxic assets will disappear through repayments and write-downs. Quick fixes are not always the best solutions. In the case of the large banks, procrastination is possibly the best answer.
Monday, February 16, 2009
Forget About Bank Recapitalization Or Nationalization
The US Treasury is worrying about the wrong problem.
The US is not any better off or richer if the government places its own stock in banks for the banks' toxic assets. It just moves the toxic asset problem from the right hand pocket of a potential FDIC liability to the left hand pocket of a potential US Treasury (or Federal Reserve) liability. In either pocket, US citizens still owned the potential liability and will have to make up any future shortfall through paying taxes. Furthermore, the capital base of the banks will be the same through a recapitalization as through a delay in writing down the toxic assets. Therefore, the total lending by these banks will be the same and the US economy will not be getting any economic benefit after the government's investment in these banks. Insolvency does not affect a bank's ability to be a lender, but does call into question its ability to survive as a corporate entity.
A recapitalization of the large banks is an optical trick that allows the US government to say it will not close these banks down. Unless the government reorganizes the bank and wipes out the private investors with the chance that the government becomes the sole investor, a recapitalization protects the banks' current shareholders and bondholders.
Insolvent banks pose a threat to debt holders and shareholders who face a complete loss of their investments. Insolvent banks, also, pose a threat to depositors only if the bank's income and positive cash flow are insufficient to continue paying deposit interest, deposit withdrawals and fund new lending. The large banks that the government is thinking about salvaging have sufficient positive cash flows to continue to operate. Many of the toxic assets continue to have a positive payment stream. These banks also have many cash equivalent assets such as US Treasuries, which can be converted to cash to fund lending without increasing the banks' leverage ratios and without increasing the banks' need for further capital to make loans.
Write downs of toxic assets decrease capital and accounting income, but do not decrease cash flow and sometimes actually increase cash flow because of the reduction in taxes. Capital amounts due to regulatory minimum capital requirements do impact the ability to lend. Simply allowing banks to delay writing down toxic assets (or allowing them to amortize the loss over a long time period such as on a asset cash flow matching basis), would obviate any need for the government to recapitalize these banks. It would allow banks with positive cash flows to remain sufficiently capitalized to continue to lend.
Banks were once, until about 40-50 years ago, the primary source of lending and deposit gathering in the US. With the advent of greater direct access by corporations to capital markets, private equity, hedge funds, insurance companies, non-financial lenders and with mortgage and loan securitization, bank lending has declined from 40 percent in 1980 to about 22 percent in 2008. The downward trend will continue, as banks no longer hold the monopoly on lending and are not the most efficient or knowledgeable source about borrowers.
Similarly, these days a much greater share of corporations and consumers place their funds in alternatives to FDIC insured bank deposit accounts, such as money market funds, muni and corporate bond funds, direct investment into US Treasuries, corporate bonds, municipal bonds and stocks. Like lending, banks have lost their monopoly as funds gatherers. In fact, without FDIC insurance, these large banks probably would not have been able to continue to gather and keep their deposits as the banks increased the riskiness of their assets. Either the deposits would have left these banks or demanded an interest rate higher than the return on the banks' assets.
Whatever the government decides to do with the large banks, it will not change the total bank lending in the US, but it can meaninglessly transfer potential liability from the FDIC to the US Treasury. The US government should just allow the importance of these banks to the US economy to continue to diminish. The government and the Federal Reserve should continue to focus on reinvigorating the non-bank lending and securitization in the US, which are now, as have been for a while, the primary sources for loans to the US economy. The government should just give the banks the OK not to write the down the toxic assets and then focus on the real economic problem in the US of the lack of non-bank lending and securitization. Over time, the large banks will continue to lose their importance to the US economy and whatever is done to them at a later date will no longer be a major concern.
The US is not any better off or richer if the government places its own stock in banks for the banks' toxic assets. It just moves the toxic asset problem from the right hand pocket of a potential FDIC liability to the left hand pocket of a potential US Treasury (or Federal Reserve) liability. In either pocket, US citizens still owned the potential liability and will have to make up any future shortfall through paying taxes. Furthermore, the capital base of the banks will be the same through a recapitalization as through a delay in writing down the toxic assets. Therefore, the total lending by these banks will be the same and the US economy will not be getting any economic benefit after the government's investment in these banks. Insolvency does not affect a bank's ability to be a lender, but does call into question its ability to survive as a corporate entity.
A recapitalization of the large banks is an optical trick that allows the US government to say it will not close these banks down. Unless the government reorganizes the bank and wipes out the private investors with the chance that the government becomes the sole investor, a recapitalization protects the banks' current shareholders and bondholders.
Insolvent banks pose a threat to debt holders and shareholders who face a complete loss of their investments. Insolvent banks, also, pose a threat to depositors only if the bank's income and positive cash flow are insufficient to continue paying deposit interest, deposit withdrawals and fund new lending. The large banks that the government is thinking about salvaging have sufficient positive cash flows to continue to operate. Many of the toxic assets continue to have a positive payment stream. These banks also have many cash equivalent assets such as US Treasuries, which can be converted to cash to fund lending without increasing the banks' leverage ratios and without increasing the banks' need for further capital to make loans.
Write downs of toxic assets decrease capital and accounting income, but do not decrease cash flow and sometimes actually increase cash flow because of the reduction in taxes. Capital amounts due to regulatory minimum capital requirements do impact the ability to lend. Simply allowing banks to delay writing down toxic assets (or allowing them to amortize the loss over a long time period such as on a asset cash flow matching basis), would obviate any need for the government to recapitalize these banks. It would allow banks with positive cash flows to remain sufficiently capitalized to continue to lend.
Banks were once, until about 40-50 years ago, the primary source of lending and deposit gathering in the US. With the advent of greater direct access by corporations to capital markets, private equity, hedge funds, insurance companies, non-financial lenders and with mortgage and loan securitization, bank lending has declined from 40 percent in 1980 to about 22 percent in 2008. The downward trend will continue, as banks no longer hold the monopoly on lending and are not the most efficient or knowledgeable source about borrowers.
Similarly, these days a much greater share of corporations and consumers place their funds in alternatives to FDIC insured bank deposit accounts, such as money market funds, muni and corporate bond funds, direct investment into US Treasuries, corporate bonds, municipal bonds and stocks. Like lending, banks have lost their monopoly as funds gatherers. In fact, without FDIC insurance, these large banks probably would not have been able to continue to gather and keep their deposits as the banks increased the riskiness of their assets. Either the deposits would have left these banks or demanded an interest rate higher than the return on the banks' assets.
Whatever the government decides to do with the large banks, it will not change the total bank lending in the US, but it can meaninglessly transfer potential liability from the FDIC to the US Treasury. The US government should just allow the importance of these banks to the US economy to continue to diminish. The government and the Federal Reserve should continue to focus on reinvigorating the non-bank lending and securitization in the US, which are now, as have been for a while, the primary sources for loans to the US economy. The government should just give the banks the OK not to write the down the toxic assets and then focus on the real economic problem in the US of the lack of non-bank lending and securitization. Over time, the large banks will continue to lose their importance to the US economy and whatever is done to them at a later date will no longer be a major concern.
Tuesday, February 3, 2009
Job Cut Announcements Overstate Job Losses
Losing ones job is horrible, but in previous periods of announced job cuts, the announced cuts at public companies significantly exceed the actual numbers that lose their jobs at those companies. Publicly traded companies often believe it is good for their stock price to announce a cost cutting effort, particularly when profits are low.
Companies will often include in announcements: (1) personnel included in a sale of a business unit or subsidiary who retain their jobs under the new owners; (2) people retained by the company and moved to a different job in the company when their old position is abolished; (3) abolishing a higher paying senior position to only rehire at a lower paying junior position; (4) normal job attrition due to retirement, quitting, taking a job at another company, etc., and (5) failure to follow through and actually lay-off the announced number of people for numerous business reasons.
Also, companies are often vague about the time frame in which the reductions will occur. The reductions at some companies are not immediate and they can take place over several years.
Companies will often include in announcements: (1) personnel included in a sale of a business unit or subsidiary who retain their jobs under the new owners; (2) people retained by the company and moved to a different job in the company when their old position is abolished; (3) abolishing a higher paying senior position to only rehire at a lower paying junior position; (4) normal job attrition due to retirement, quitting, taking a job at another company, etc., and (5) failure to follow through and actually lay-off the announced number of people for numerous business reasons.
Also, companies are often vague about the time frame in which the reductions will occur. The reductions at some companies are not immediate and they can take place over several years.
A Bank Toxic Assets Solution
A simple solution for dealing with the toxic assets on banks' books that goes to the core issue is to have the regulators use their inherent powers to create a new asset category on the banks' books. The new regulatory asset category will be for performing assets with a disputed market price that need not be written down to market price as long as the loan asset is substantially performing and current in its predicted and scheduled payments. The regulators can call these assets Disputed Market Price Performing Assets.
As long as these assets are receiving their scheduled payments or are fully paid off, the banks will receive over time their booked value of these assets plus interest and no write-downs due to mark to market will be necessary. If these assets go into arrears on their payments, the regulators can require, as they do for non-performing loans, that these assets be put into a non-performing category on the banks' balance sheets. If within a reasonable time, such as 120 days, these assets do not become current in their payments, then the bank will need to write down the value of the asset to a more realistic value based on the lower amount of payments that it is receiving. Banks and regulators are well versed in dealing with and valuing loan assets that are not performing as predicted and scheduled.
Having this additional asset category solves many problems. It allows banks to disagree with the current market price without immediately needing to write the asset down to current market value. The asset will be written down and lose value on the banks' books only when it stops receiving the scheduled payments. It avoids the difficult problem of valuing hard to value assets. It decreases the number assets that are potentially toxic on the banks balance sheet to those assets that actually go into default. It spreads the write-downs of the bad assets over their lifetime of many years.
If the banks and the administration are right, that these assets are incorrectly valued currently by the market, then no write-downs by the banks will occur. If these assets do need to be written down, it will be over time as they show their true diminished value through defaults in payments. Time will give banks opportunity to reserve against these losses and preserve their capital base.
As long as these assets are receiving their scheduled payments or are fully paid off, the banks will receive over time their booked value of these assets plus interest and no write-downs due to mark to market will be necessary. If these assets go into arrears on their payments, the regulators can require, as they do for non-performing loans, that these assets be put into a non-performing category on the banks' balance sheets. If within a reasonable time, such as 120 days, these assets do not become current in their payments, then the bank will need to write down the value of the asset to a more realistic value based on the lower amount of payments that it is receiving. Banks and regulators are well versed in dealing with and valuing loan assets that are not performing as predicted and scheduled.
Having this additional asset category solves many problems. It allows banks to disagree with the current market price without immediately needing to write the asset down to current market value. The asset will be written down and lose value on the banks' books only when it stops receiving the scheduled payments. It avoids the difficult problem of valuing hard to value assets. It decreases the number assets that are potentially toxic on the banks balance sheet to those assets that actually go into default. It spreads the write-downs of the bad assets over their lifetime of many years.
If the banks and the administration are right, that these assets are incorrectly valued currently by the market, then no write-downs by the banks will occur. If these assets do need to be written down, it will be over time as they show their true diminished value through defaults in payments. Time will give banks opportunity to reserve against these losses and preserve their capital base.
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