by Gary North
by Gary North
The worst is not behind us. The worst is yet to come. I have this on the highest authority — from the man who has openly admitted that his organization has no solutions to offer except month-old data on the extent of the housing crisis.
When the public at last figures this out, there will be financial blood in the streets.
When I first read Ben Bernanke's March 4 speech, I was amazed at how gloomy he was in full public view. He concealed this gloominess with academic bloviation, which is his version of Greenspan's FedSpeak. But if you pay attention to what he says, you can find out much of what he is thinking. This was not true with Greenspan.
Bernanke spoke on the need for banks to reduce interest rates for busted home owners. This indicates just how scared he is. To argue for a rewriting of millions of contracts to favor debtors is one more example of the asymmetric nature of mortgages. Lenders lose; debtors win.
His long, tedious, and thoroughly academic speech revealed an academic economist whose career has not yet hit the inevitable brick wall: the unforgiving realities of capital markets, contracts, and an economic crisis. He may still believe that footnotes will save his reputation. They won't.
He is presiding over a stock market decline that threatens to turn into a collapse. Yet he pretends that being a boring professor in public will somehow calm international stock markets. It won't.
Greenspan was incoherent. Bernanke is boring. His rhetorical strategy in his speeches is to drone on and on about what is now obvious to all of his listeners. He thereby avoids concentrating on looming disasters that are not yet obvious to his listeners. But, unlike Greenspan, he eventually does hint at what is not yet obvious. I slog through his speeches in search of those hints.
Bernanke's public strategy for the last six months has been to offer a series of detailed analyses of how the horses got out of the barn. He has no clue as to how to get them back in.
REDUCING PREVENTABLE MORTGAGE FORECLOSURES
The mortgage market, as we all know, is the heart of the current problem. It is a gigantic carry trade market, and it always has been. Mortgage lenders are borrowed short and lent long, which is the essence of the carry trade. Now this trade has been disrupted because what should have been obvious in 2005: the inability of subprime borrowers to pay off their loans. This has become public knowledge. The mortgage lenders cannot raise the short-term capital necessary for the game to go on as before. Here is what is obvious to most investors at this point.
Over the past year and a half, mortgage delinquencies have increased sharply, especially among riskier loans. This development has triggered a substantial and broad-based reassessment of risk in financial markets, and it has exacerbated the contraction in the housing sector. In my remarks today, I will discuss the causes of the distress in the mortgage sector and then turn to the key question of what can be done in this environment to reduce preventable foreclosures.
This newly reassessed risk is based on a discovery, namely, that Greenspan's ludicrously loose monetary policies, 2000—2003, have led to a housing bubble crisis. But Bernanke will never admit this in public.
He is now in search of new suppliers of pools of capital who are willing to rush in and bail out the mortgage-lending market. Who wants to be first? Nobody. But the crisis will get much worse if lenders don't enter this market to provide loans for visible deadbeat borrowers. This must be done very soon.
If the deadbeats walk away from their homes, and if new lenders are not found to fund replacement owners, America will experience hundreds of billions of dollars of property equity decline by the end of 2009. He will not say this directly, but this is the problem. Squatters and the weather will take over occupancy.
Who, then, should rush in where angels fear to tread? Local banks, says Bernanke. They did not create the crisis, but they must solve it.
Although I am aware, as you are, that community banks originated few subprime mortgages, community bankers are keenly interested in these issues; foreclosures not only create personal and financial distress for individual homeowners but also can significantly hurt neighborhoods where foreclosures cluster. Efforts by both government and private-sector entities to reduce unnecessary foreclosures are helping, but more can, and should, be done. Community bankers are well positioned to contribute to these efforts, given the strong relationships you have built with your customers and your communities.
Local banks got out of the mortgage market two decades ago, after the savings & loan debacle took its toll. Government-guaranteed mortgage lenders entered, pooling trillions of dollars of mortgages based on a broad geographical base of loans from around the country. This was done in the name of asset diversification. It also cut costs of local monitoring. The statisticians assessed the risk, and nobody was hired locally to monitor the loans and collect monthly payments. So, local banks took commissions for originating loans locally and then passed the loans on to Fannie Mae and Freddie Mac.
Local banks went into commercial real estate instead. Their banks are now at risk. The Comptroller of the Currency, John Dugan, on January 31 gave a speech to the Florida Bankers Association. He made this unsettling observation.
Over a third of the nation's community banks have commercial real estate concentrations exceeding 300 percent of their capital, and almost 30 percent have construction and development loans exceeding 100 percent of capital.
Here in Florida, as in other states where housing is so important to local economic growth, the concentration levels are more pronounced. Over 60 percent of Florida banks have CRE loans exceeding 300 percent of capital, and more than half have C&D loans exceeding 100 percent of capital.
When the commercial real estate market begins to fall in the recession, as it will, local banks will have their hands full. Where will they get the capital to head off foreclosures in the residential estate market?
So, no one is available locally to monitor the empty houses or screen replacement home owners. The cost of monitoring is rising. The number of people locally to do the job has declined.
Bernanke now thinks that local banks are ready, willing, and able to take over their old tasks. But how? No one has been trained to do this for 20 years. The people with these skills have retired. The local banks got cut out of the mortgage market except as loan originators, which economic idiots could do, and did.
Why would any local bank step in now? Not to get rich, surely. Only to keep from getting poorer in a national banking crisis. Here is Bernanke's message: "Heads, you lost; tails, you will lose even more. Step right up! This way to the guillotine!"
Then he went into his now-famous "Let me give you a history of the foul-up instead of offering a solution" routine. Or, as I have often described it, blah, blah, blah.
MORTGAGE DELINQUENCIES AND FORECLOSURES
Here is what we all know. So, he calls it to our attention.
Mortgage delinquencies began to rise in mid-2005 after several years at remarkably low levels. The worst payment problems have been among subprime adjustable-rate mortgages (subprime ARMs); more than one-fifth of the 3.6 million loans outstanding were seriously delinquent at the end of 2007. Delinquency rates have also risen for other types of mortgages, reaching 8 percent for subprime fixed-rate loans and 6 percent on adjustable-rate loans securitized in alt-A pools. . . .
Boring. Useless. Irrelevant. In other words, a Ph.D. academic economist's career strategy. "Bore them into submission." It won't work.
It's going to get worse, he says. Yes, he says this in a boring way. Pay attention anyway. Watch for key phrases, such as this one: "some further declines in house prices are likely." They surely are!
Delinquencies and foreclosures likely will continue to rise for a while longer, for several reasons. First, supply-demand imbalances in many housing markets suggest that some further declines in house prices are likely, implying additional reductions in borrowers' equity. Second, many subprime borrowers are facing imminent resets of the interest rates on their mortgages.
Ed McMahon used to ask Johnny Carson, "How bad is it?" Bernanke plays the role of Carson, but without the humor.
In 2008, about 1-1/2 million loans, representing more than 40 percent of the outstanding stock of subprime ARMs, are scheduled to reset. We estimate that the interest rate on a typical subprime ARM scheduled to reset in the current quarter will increase from just above 8 percent to about 9-1/4 percent, raising the monthly payment by more than 10 percent, to $1,500 on average. Declines in short-term interest rates and initiatives involving rate freezes will reduce the impact somewhat, but interest rate resets will nevertheless impose stress on many households.
In other words, we have not yet begun to see the carnage in the subprime market. The problem is refinancing. No one wants to lend strapped, stressed debtors any more money.
In the past, subprime borrowers were often able to avoid resets by refinancing, but currently that avenue is largely closed. Borrowers are hampered not only by their lack of equity but also by the tighter credit conditions in mortgage markets. New securitizations of nonprime mortgages have virtually halted, and commercial banks have tightened their standards, especially for riskier mortgages. Indeed, the available evidence suggests that private lenders are originating few nonprime loans at any terms.
This situation calls for a vigorous response.
Ah, yes, the ever-popular "vigorous response." And what has the FED's response been? To deflate. The financial press has not yet caught on. The FED has not inflated. It has deflated.
What additional vigorous response does Bernanke have in mind? Administered how? How fast? With who in charge? Using what for money? At whose expense?
Here comes neighborhood blight, like a thief in the night. Here comes the collapse of collateral for millions of bonehead loans.
At the level of the individual community, increases in foreclosed-upon and vacant properties tend to reduce house prices in the local area, affecting other homeowners and municipal tax bases. At the national level, the rise in expected foreclosures could add significantly to the inventory of vacant unsold homes — already at more than 2 million units at the end of 2007 — putting further pressure on house prices and housing construction.
He said steps are underway to solve this problem. He gives no proof of how these steps can work or if they are working now. He said: "Policymakers and stakeholders have been working to find effective responses to the increases in delinquencies and foreclosures." Oh, yeah? So what?
There is a big and growing problem. This problem was created by loose money policies under Greenspan and by national mortgage lending agencies (GSE's). But the economic hit will be taken locally. "Troubled borrowers will always require individual attention, and the most immediate impacts of foreclosures are on local communities. Thus, the support of counselors, lenders, and organizations with local ties is critical." But where are these local agencies? What incentives do they have to step in?
In short, forget about the busted borrowers. What about the troubled lenders? Busted and troubled lenders? Who is going to finance borrowers who have no credit, no extra money, and no jobs in a recession?
"O course, care must be taken in designing solutions." Spoken like a true academic. What care? Administered by whom? "Solutions should also be prudent and consistent with the safety and soundness of the lender." Like what, for instance?
Bernanke then droned on and on about the Federal Housing Administration's plans, as if the FHA had money to solve the problem, as if the FHA were involved in this massive pile of bad mortgage loans. The FHA is a peripheral player, yet this is the main government agency in the housing loan market. So, he talked about the toothless FHA. This indicates that the government has no tools or plans to intervene. But what else could he have done? He dared not admit that the government has insufficient money and leverage to solve this crisis.
He then called for a vague "loss-mitigation arrangements." Like what? Administered by whom locally? At whose expense? With losses to be borne by whom?
In cases where refinancing is not possible, the next-best solution may often be some type of loss-mitigation arrangement between the lender and the distressed borrower. Indeed, the Federal Reserve and other regulators have issued guidance urging lenders and servicers to pursue such arrangements as an alternative to foreclosure when feasible and prudent.
Guidelines? That was what the mortgage industry needed ten years ago.
The response system is running out of time, yet foreclosure costs are high — thousands of dollars per home — and the courts are jammed. Meanwhile, an empty house falls in value within weeks, as crackheads or weather take their toll.
You want to know what is coming? This: gigantic equity losses. Yes, Bernanke is boring. Read him anyway. The financial media are not reporting on this.
Loss mitigation is made more attractive by the fact that foreclosure costs are often substantial. Historically, the foreclosure process has usually taken from a few months up to a year and a half, depending on state law and whether the borrower files for bankruptcy. The losses to the lender include the missed mortgage payments during that period, taxes, legal and administrative fees, real estate owned (REO) sales commissions, and maintenance expenses. Additional losses arise from the reduction in value associated with repossessed properties, particularly if they are unoccupied for some period.
He was talking about abandoned homes and equity losses. This is happening already. This is not a maybe. This is a sure thing. The loss of equity will undermine the loans. Look at his estimate: 50% of principal balance.
A recent estimate based on subprime mortgages foreclosed in the fourth quarter of 2007 indicated that total losses exceeded 50 percent of the principal balance, with legal, sales, and maintenance expenses alone amounting to more than 10 percent of principal. With the time period between the last mortgage payment and REO liquidation lengthening in recent months, this loss rate will likely grow even larger. Moreover, as the time to liquidation increases, the uncertainty about the losses increases as well.
Who is going to write new loans at anything like today's home prices? Nobody who is not already stuck with the bad loan. But these lenders are running short of capital.
I love the man's use of language. Consider the words "limited" and "considerable." He seeks to convey calm. The reality of what he is describing does not point to calm in the mortgage markets anytime soon.
The low prices offered for subprime-related securities in secondary markets support the impression that the potential for recovery through foreclosure is limited. The magnitude of, and uncertainty about, expected losses in a foreclosure suggest considerable scope for negotiating a mutually beneficial outcome if the borrower wants to stay in the home.
Can any of this actually work? He used the phrase "less likely." I agree entirely.
Unfortunately, even though workouts may often be the best economic alternative, mortgage securitization and the constraints faced by servicers may make such workouts less likely.
So, how bad is it? Very bad and getting worse. The default rate is rising.
Despite this progress, delinquency and default rates have risen quickly, and servicers report that they are struggling to keep up with the increased volumes. Of course, not all delinquent subprime loans can be successfully worked out; for example, borrowers who purchased homes as speculative investments may not be interested in retaining the home, and some borrowers may not be able to sustain even a reduced stream of payments. Nevertheless, scope remains to prevent unnecessary foreclosures.
Scope remains. I see. Scope. When I hear "scope," I think of a mouthwash that covers bad breath.
He made it plain: borrowers will be allowed to escape their debts. Once again, the asymmetry of the mortgage market becomes visible. Borrowers win. Lenders lose.
Lenders and servicers historically have relied on repayment plans as their preferred loss-mitigation technique. Under these plans, borrowers typically repay the mortgage arrears over a few months in addition to making their regularly scheduled mortgage payments. . . .
Loan modifications, which involve any permanent change to the terms of the mortgage contract, may be preferred when the borrower cannot cope with the higher payments associated with a repayment plan.
Lenders are balking at writing down principal. Surprise! Surprise! If they write it down, they have to record this in their books as a loss. They don't want to do this. They prefer to conceal the loss with negotiated rates.
Lenders tell us that they are reluctant to write down principal. They say that if they were to write down the principal and house prices were to fall further, they could feel pressured to write down principal again. Moreover, were house prices instead to rise subsequently, the lender would not share in the gains.
Then what can be done? Fannie Mae and Freddie Mac must come to the rescue. But with what? They are under siege. Their credit ratings are held up in the same way Wile E. Coyote was held up when he overshot the ledge of a cliff. He has looked down, but he is still hanging in mid-air. We await the inevitable fall.
The government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, likewise could do a great deal to address the current problems in housing and the mortgage market. New capital-raising by the GSEs, together with congressional action to strengthen the supervision of these companies, would allow Fannie and Freddie to expand significantly the number of new mortgages that they securitize. With few alternative mortgage channels available today, such action would be highly beneficial to the economy. I urge the Congress and the GSEs to take the steps necessary to allow more potential homebuyers access to mortgage credit at reasonable terms.
The man droned on for another four pages of text. All of it boiled down to this: the FED has no solution. All that the FED can do is share data. As a professor, Bernanke believes in data. As the head of the FED, he has no answers, but he has lots and lots of data to share.
I would like to comment briefly on Federal Reserve System efforts to reduce preventable foreclosures and their costs on borrowers and communities. The Federal Reserve can help by leveraging three important strengths: our analytical and data resources; our national presence; and our history of working closely with lenders, community groups, and other local stakeholders. A major thrust of our efforts is sharing relevant and timely data analysis of mortgage delinquencies with community groups and policymakers to efficiently target resources to areas most in need.
If you think the FED can solve the mortgage crisis, it's time to re-think your understanding of the FED. Bernanke has confirmed Franklin Sanders' aphorism: "The Federal Reserve has only two policy tools: inflation and blarney."
Bernanke is running low on blarney.
March 8, 2008
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