What’s Ahead for the U.S. Economy?

Wharton, the University famed for its finance programs, has an online offshoot called Knowledge@Wharton where various articles often penned by its professors about business and the economy can be found.  On November 14, 2007, five well-known professors weighed in about their respective insights about what’s ahead for the U.S. Economy. 

 

The professors were asked to make sense of a market in tumult, sometimes looking good (GDP growth, full employment) and sometimes looking bad (stock market and dollar falling, real estate and mortgage market decay).  In this posting, I summarize the pearls of their wisdom, the luster of which can more fully be appreciated in this article.

 

Jeremy Siegel.  He expects the U.S. economy to slow down by summer, but marks the chance of recession of only 25% over the next year.  “I am more worried about gasoline spiking up to $4 a gallon and beyond than I am about the subprime crisis.”

 

Richard J. Herring.  There’s a balance between the falling dollar making some vital goods more expensive for Americans, like fuel, and the boon it is to the balance of payments from a trade perspective.  The dollar is unlikely to fall much further due to China dumping it, as this would reduce the value of China’s dollar holdings and reduce their exports to the U.S.   The real worry is consumer spending, the key to the economy, so look to what happens in retail come December.

 

Gregory Nini.  This former Fed economist has fewer concerns now than last summer, as back then corporations had difficulty borrowing to help fuel their growth, a situation that is better now.  “The big question now is how the job market will play out, and in particular, how it feeds into consumer spending.”  Although he recognizes that concern about the dollar influences the Fed, he thinks that financial markets don’t view inflation as a threat and recognizes, like Herring, that if China dumped dollars, it would be punishing to China itself.

 

Richard Marston.  He’s more pessimistic and believes that recession is a threat given that the subprime mortgage impact is hard to gauge.  Echoing the sentiments of Nini, he says if businesses can not reasonably borrowing money, the economy could seriously weaken.  “Whether we hit a recession depends on one of two things happening. Either the banks get into enough trouble that they engineer a credit crunch on regular bank lending, which hits the medium and small firms in this country, or the consumer starts to blink. We are weak enough now that either thing could push us into recession.”

 

Marshall E. Blume.  The collapse in the subprime markets “was a wakeup call that things were priced too high across the whole spectrum.”  High-yield corporate bonds carried yields too close to those of investment-grade bonds suggesting that investors were underestimating the risk.  More Wall Street firms will have losses, and when combined with tight credit, this can weaken the economy… “I think we’re basically coming from a bubble economy to a more realistic economy. And whenever you do that, things are painful.”

 

Again, to get the full flavor of the article I summarize, read it here.

How to Know When Residential Real Estate Will Rebound?

Whether or not you’re a subprime borrower, prime borrower, or own your home outright, there’s a good chance you’re wondering about its value. Some people have been facing a steady decline in home value. If their mortgage is now equal to the home’s current value, or it has become too expensive (the mortgage rate adjusted upward), they may have no other option than to hand the keys to the bank. But even if you have plenty of home equity and/or income cushion, you may have that foreboding feeling that a large part of your wealth – home equity — is being impacted by declining values.

 

And then there’s the real estate investor. This person has been leaning in from the sidelines calculating when to pounce once his assessment of the economics is perceived to be in his favor. But how does he, or anyone else, know when the bottom’s been reached?  If lucky or smart enough to perceive the bottom,  is there enough time to pull the investment trigger before bounce has occurred, assuming that it’s not a dead cat bounce.

 

Robert Campbell, publisher of the Campbell Real Estate Timing Letter, thinks that he’s got five predicative indicators that can accurately tell when prices are ready to rebound, and here they are:

 

Existing Home Sales. What is needed here is a moving average from month to month which takes seasonality into effect.

Building Home Permits. Local home builders know their market and respond accordingly.

Mortgage Defaults. Defaults often lead to foreclosures, and if the number of foreclosure filings is rising, prices are usually going to decline.

Foreclosure Sales. This is how many foreclosures have actually occurred, which is the number of filings less the number of owners that have pulled out of default status by getting current on their debt service.

Mortgage Rates. Campbell says that this isn’t as much as a predictor as an accelerator because normally rising rates slow down the housing market, whereas falling rates propels it.

 

For more information, check out Lew Sichelman’s San Francisco Chronicle article. And remember that all real estate is local, so these indicators must be relative to the area of interest.

 

Oh, one more thing particularly tuned to real estate investors – few are smart enough to call the bottom, so rather than be paralyzed on the sidelined looking for it, find the deal that can carry itself. If rents can pay the mortgage and other expenses, and you expect to be able to keep it leased, then you’ll be fine even if, in retrospect, you paid a bit more than you could have if that foresight, now seen in hindsight, was 20/20.

Countrywide Takes the Lead

Countrywide Financial Corporation, the largest mortgage lender in the U.S. took the lead today in announcing that it will seek to refinance and/or modify about $16 billion in loans that are about to reset to a higher interest rate.

 

Though this is unprecedented for Countrywide, or any other mortgage lender, the company has been active in refinancing its loans.  So far, Countrywide has modified 20,000 loans, or 5% of its mortgage portfolio.

 

“Unprecedented times call for unprecedented remedies,” Countrywide President and Chief Operating Officer David Sambol said in a statement. “We are determined to assist borrowers who have the willingness and wherewithal to remain in their homes, but need a little help to do it.”  If other banks see this as good business, expect more to follow.

Behind the Curtain of the Credit Crunch

So, the bulls were cautious as they bid the Dow up 101 points today, the second straight day that investors sought to regain some of the multi-hundred point drop earlier this week. It’s been an up and down ride lately. Uncertainty rules.

Yahoo Finance today exclaims:

Bulls Tread Cautiously on Earnings Data: “Stocks advanced Thursday after Wall Street received some solid readings on corporate earnings and the job market, but remained nervous that a tighter credit market could impede U.S. growth.”

Yes, after the free-for-all of several years of making home loans to whomever could fog a mirror, the pendulum is swinging back, and investors just don’t know how far it will adjust and who will be knocked down.

Delinquencies are up. Countrywide, one of the biggest subprime lenders has a delinquency rate of about 24%, which is actually better than some. In the past, most delinquencies would “cure” (property sale or refinancing), but today’s spike in foreclosures suggests the obvious – borrowers are having a problem selling or refinancing.

That makes sense. After all, many of the subprime borrowers never had any equity to begin with in their home and could only afford the first few years of their mortgage payments – before they “adjusted” upward. Now, facing unaffordable mortgages on homes that, in areas of devaluation, are no longer worth the outstanding balance of the mortgages, borrowers are placing the keys on the door mats and heading for greener pastures.

The impact to financial institutions and the stock market can happen well before foreclosures spike. Consider all the slicing and dicing that our brilliant financial engineers do to eek out another product to sell. Many billions of dollars of Credit Enhanced Securities (“CES”) and Collateralized Debt Obligations (“CDO”) have been produced and sold world-wide. Often, institutions that have purchased and now hold these securities can demand more collateral from the originator which doesn’t exist, particularly if the collateral pool is subject to a write-down. This is what just happened to American Home Mortgage, now heading for bankruptcy.

But for those originators who hold the loans in a portfolio rather than warehousing them and then selling them as whole loans (subject to performance covenants that if not met can trigger repurchases – the originator get back non-performing loans), or for those S&Ls that are dependent on deposits to fund loans rather than institutions, things aren’t so bad, or perhaps not bad at all.

Capital Alliance (my company) is an example of the originator who underwrites the loans and keeps them in a portfolio – they are not sold. In this case, no outside entity can create instability, because there is no investor with rights to demand more collateral or a repurchase. In effect, the herd instinct can not impact the portfolio that Capital Alliance manages. Thus, the potential problems that could beset such a portfolio of mortgages (trust deeds) stem from the actual quality of portfolio, not its perceived quality. If loans were consistently made to borrowers with the verifiable ability to pay debt service in conjunction with enough equity in the collateral to keep the keys in their pockets, exogenous market conditions would have less impact.

Apparently, It’s All About Trust

Wharton and State Street Global Advisors recently published a special report, “Bridging the Trust Divide: The Financial Advisor-Client Relationship”, an insightful look into issues surrounding trust and fees, which is here summarized.

Over the last 15 years, the financial advice business has experienced a (commonly called) paradigm shift from pushing investment products with opaque, hidden and/or complex fees to offering consultative services with straightforward fee structures.  This report examines how advisors can:

1. Strengthen relationships by engendering trust.
2. Best communicate their value to clients.
3. Successfully discuss fees with clients.

TRUST

It’s all about trust.  The foundation of the advisor-client relationship, the report explores trust at three levels:

1. Technical competence/know how
2. Ethical conduct and character.
3. Trust in empathic skills and maturity.

This might not be a Eureka moment for many advisors, but what the surveys in this report uncover is that there’s a substantial disconnect in these three levels of trust between the client’s and the advisor’s perceptions.  For instance, there’s a sizable gap between the value clients place on expertise and the value advisors place on it, and a similar disconnect between how well clients think their advisors are doing as compared to the advisors’ much higher opinion of their performance.

Getting on the same perceptional page with your clients is a given, but what might not be so clear is Richard Marston’s bottom line advice.  Marston, a professor of finance at Wharton, believes that, increasingly, the value of financial advice has more to do with the “softer” advisory elements (personal counseling and instruction) than managing the money: “The advisor has to understand the logic behind the advice and work the argument through with the client so that client really understands it.”

And what has the most damaging effect on trust and the advisors effectiveness with clients?  An unsupportive staff.  Only 15 to 20% of the average client’s time is spent with the financial advisor – the rest is with the advisor’s assistant and support staff.  These people have a big impact, for better or worse.

Next up in the report is the sensitive topic of fees.

FEES

Fees are often fuzzy.  The fuzzier they remain, the more the potential damage to trust.  Though advisors often skirt the issue of fees, the evidence suggests that most clients aren’t as concerned about the absolute levels of the fees, but their clarity and transparency.  People want to know what’s going on. 

The lack of fee transparency has made advisors more vulnerable than they realize, says Mitch Anthony, a consultant to the industry.  He says, “No matter how much you think you realize the level of distrust over fees, we underestimate it.”

The winners, says Marston, the Wharton professor, are either advisors who offer custom service or cheaper, almost automated solutions.  The losers are those who haven’t adapted to a world divided between providers of higher-fee, custom-tailored service and inexpensive solutions geared for the mass market.

The shift to a fee-only model has its challenges when it comes to articulating the value proposition.  Investors are becoming wiser and they know that the pitch that you’ll choose better asset managers has little value when it’s known that the majority of actively-managed funds under perform the index.

The better approach, Marston insists, is to incorporate two services into the value proposition. The first is to understand and communicate to clients that the advisor creates substantial value by getting clients into a portfolio and keeping them invested through different market cycles, thus keeping them from reflexively reacting to shifts in the market on a behavioral basis.  The second is to alert clients of the potential mistakes they may be making within self-directed portions of their portfolios, where most do not rebalance their portfolios relative to shifts in the market, or risk tolerance related to age.

And along the way, to recognize that what the client really needs, and appreciates is to incorporate the personal with the financial.

Read the entire Special Report here.

Where O’ Where Did MY FICO Go?

“FICO”, appropriately, is an acronym for Fair Issac Credit Organization because Fair Issac developed this credit-scoring system that lenders use to evaluate the credit-worthiness of their borrowers.  As such, a borrower’s FICO score is supposed to predict the default risk of a loan.  The problem of late is that it isn’t working very well.

 

Historically, credit scores have worked so well that lenders rely on them as the most basic arbiter of credit-worthiness.  But as lenders have added more layers of risk to a loan, such as adjustable-rates, stated income loans, interest-only loans and the like, the borrower’s FICO score has steadily become less predictive.

 

In Kathleen Pender’s May 20^th column in the San Francisco Chronicle, she cites the Fitch Ratings (of mortgage-backed securities) which says that for borrowers taking “common sense” mortgages in 2003, those that who became 90 or more days delinquent had an average FICO score of 589, 31 points below the average of 620.  In 2006, however, that margin narrowed to 10 points: 615 vs. the average score of 625.  Glen Costello, a Fitch managing director says, “The loans that are defaulting now have higher FICO scores”.

 

So now Fair Issac seeks to make their FICO more predictive by a calculus that divides the population into 12 segments – eight for good credit people and four for bad credit people. Fair Isaac spokesman, Craig Watts, says that the new FICO will deliver better results for those in the lower end of the credit spectrum. 

Whether or not it does, I think the Federal Reserve study frequently cited in this blog got it right when it concludes that the primary predictor of default is the equity in the property.  Give a high FICO scorer a 100% loan-to-value loan (no equity) and if things get tough, he’ll get out and leave the keys for the lender.

Bernanke: No Subprime Woes

Yesterday, Fed Chairman Ben Bernanke was widely quoted about his views of the current and future impact of the subprime loan defaults.  A CNNMoney.com article quotes him as saying that the Fed has “seen signs of self-correction” through more stringent underwriting standards, which generally support his assessment that markets do a better job of allocating credit than does government.  He appropriately laid much of the blame of the subprime debacle on loose lending practices, but feels that there will be a minimal impact felt in the general economy.

 

Lenders with “nonconforming” mortgage products (think special circumstance and quick funding requirements) who stayed away from subprime lending are finding more funding opportunities happening now that many subprime lenders – who also offered nonconforming products – are no longer in business.

Q&A About Subprime Mortgages

You can’t pick up a newspaper or watch the TV news these days without reading/seeing a story about troubles in the land of subprime mortgages, which is, by the way, a very big place.  Big not only because of the significant portion of all real estate mortgages that are considered subprime loans, but because if the level of foreclosures and bankruptcies that some pundits anticipate actually happens, it could have a domino effect that touches, sometimes painfully, nearly everything that people care about.

I’d like to reference two good background articles about subprime mortgages. Chronicle reporter, Kathellen Pender’s March 15 article takes an informative FAQ approach that addresses questions such as these:

-What is a subprime loan?

-How big is the market?

-What went wrong?

Whereas Harry Domash in his Chronicle spot called Online Investing chooses a question and answer format that speaks to questions such as:

-Can I profit from the subprime lending fiasco…?

-Will the REIT I hold be hurt…?

One overlooked issue in the subprime mess that Kenneth Harney writes about in his Nation’s Housing article (April 1 Chronicle) is how the paucity of escrows for insurance, taxes and such will likely mean that these obligations will be unpaid by the financially overstress subprime borrowers who face them.  The result here could be liens by government entities against the properties that could ultimately result in losses for the lender.  This is an under-reported story that you can read in Mr. Harney’s article here.

Opportunities in the Subprime Implosion

Freddie Mac says that it will no longer buy high risk mortgages vulnerable to foreclosure. While there are many kinds of loans that can be deemed “high risk”, what Freddie is really referring to is “subprime loans”. Freddie Mac is developing new standards for subprime loans; in fact, half of the loans they currently own will no longer comply.

The mortgage leviathan is reacting to surging home-mortgage delinquencies and foreclosures in the subprime market. Write-offs of mortgage loans by banks have reached a three-year high in the fourth quarter last year, according to Federal Deposit Insurance Corporation (FDIC), while at the same time several large subprime lenders have been bleeding – stock shares have plummeted in price, some are teetering on bankruptcy, and others have shut their doors.

Joining noteworthy industry lions such as HSBC, Countrywide and Saxon, New Century reported earlier this week that it too has troubles which are particularly egregious. New Century admits that it’s technically in default with several lenders and is under investigation by federal regulators. Analysts caution that this company – the second largest in the subprime industry – may implode if most of its warehouse lenders do not issue waivers to New Century for being out of compliance with debt covenants.

Companies like New Century rely on warehouse lenders to help finance their operations. These lenders require that the loans they invest in perform to clearly defined standards. If they don’t, the warehouse investor can put it back to the loan’s originator (New Century). Consequently, originators are getting saddled with the non-performing loans they aggressively originated.

How did this happen?

Peter Coy in his BusinessWeek.com article “Why Subprime Lenders Are In Trouble” gives an accurate and succinct description of what went wrong.

He reports that the quality of mortgages underwritten by the industry has dramatically changed in recent years, particularly as recently as 2006. At that time there was a shift in lenders’ loan strategy. Rather than competing with one another based on price (lowering rates), the game became to compete based on easy terms (lowering lending standards). Reducing the standards enabled the most aggressive to keep volume up, and now loans that should never have been made are becoming delinquent and going into foreclosure.

When Countrywide recently announced that 19% of their subprime portfolio is in default (last year it was about 2.5%!), I asked Bill Aubrey, the Chief Investment Officer of Capital Alliance to give me his take on what’s happening to the industry. (Disclosure: I work for Capital Alliance.) Bill Aubrey:

“Despite all the recent blood letting in this industry, there’s nothing wrong with writing subprime/nonprime/non-conforming or whatever the street folks want to call it as long as it’s done correctly. That is to say, don’t let a “restaurant engineer” who also happens to be a 1^st time homebuyer with $7,000 per month income stated on his unexamined loan application borrow 100% of the appraised value.

Or for that matter, lend to the quintessential sales guy who states he makes $25,000 per month, but examination of his bank statements shows he made this income 12 months ago! Since then he ran into a small glitch in paying his bills on time because he had to pay all the medical bills for his sick Mother who is 76 years old. Like the lady did not have Medicare.

Or better yet, the guy who wants to borrow $200,000 (at a 100% loan-to-value) for “investment purposes”. Great investment when the borrower is paying 12.5% for the dough!

All three of these scenarios have come across my desk in the last 6 to 8 months and everyone of those so called “deals” were purchased by the big boys on the street! Now the whole industry is getting a black eye because of this stupidity.”

My take is that despite the “black eye”, those left standing will have opportunities to underwrite more quality loans because the “big boys” will be hurting so badly that they’ll make a substantial retreat from funding non-conforming loans. Companies like Capital Alliance — which follow a strict underwriting guidelines that require substantial borrower equity in the collateral, a minimum credit rating, and affirms stated income and appraisals — may find that they have more quality business knocking at their doors than they can answer.

Those with discipline often win in the end, and in this situation, those that followed conservative underwriting policies will look better than ever relative to the subprime industry as defaults and foreclosures soar for the undisciplined.

Piggyback Fall-off + Uncle Sam Spikes Mortgage Insurance

Over the last few years with easy credit and soaring housing values, many mortgage borrowers by passed mortgage insurance in favor of so-called piggyback loans.

Mortgage insurance pays the lender should its borrower default on a loan.  Lenders like this and typically require borrowers to purchase this insurance if the borrower’s down payment is less than 20% of the purchase price.  The cost of this insurance averages between 0.6 and 0.8% of the loan and, until recently, has not been tax deductible.

So, given that Uncle Sam wouldn’t help pay for it and that fewer borrowers could afford a 20% down payment, the market was ripe for piggybacks which let home buyers avoid mortgage insurance by tying a second or third mortgage to the first.  These can be called 80-20 or 80-10-10 loans where the second and third mortgages come with a higher rate than the first.  All this is tax deductible.

When rates were low, the second and third mortgages were cheaper than mortgage insurance, especially with the deductibility angle.  The mortgage insurance business contracted as the mortgage business exploded.

But now Uncle Sam has aided the insurers by making their product tax deductible about at the same time that the downturn in the real estate market has made piggybacks more costly.

 Read about the details here.