Track the Stimulus

President Obama announced stringent new requirements for GM and Chrysler to receive more aid from the government.  As a result of the auto task force analysis of the viability plans put together by the two automakers, the administration came to the conclusion that GM could be viable if significant steps to reduce its cost structure, reorganization and introduction of new vehicles were taken, and that Chrysler was not viable as an independent company, and that to receive government help it needed to not only lower its cost structure, but find a partner – preferably Fiat with which it has already been in talks.  While many are crying wolf that the President is being too lenient on Wall Street, and too punitive on Detroit, I believe comparing the two approaches is like comparing apples to oranges.  

The auto task force provided a well thought out critique of the automakers' plans, and the rationale behind the actions the government is now forcing them to take.  Detroit's problems have been festering for a very long time; GM has been destroying shareholder value for the better part of  three decades, and during that period has seen its market position deteriorate steadily year after year.  While it may appear inconsistent to force Detroit to take drastic actions, and seemingly not requiring the same for Wall Street, they are different beasts, and how they impact the economy is also different. 

Both have structural problems, but they are not the same.  For GM and Chrysler (and Ford as well for that matter), viability is predicated on building vehicles that customers want to buy at a price that they can afford - the current cost structures of these firms make this very difficult, if not impossible, and therefore not viable.  Addressing these issues, and an overburdened capital structure is key.  In the near term the risk of a collapse of the automotive is the heavy burden it will place on the economy in the form of higher unemployment and lower spending.

For Wall Street the issue is risk management, and the existence of financial conglomerates that are "too big to fail" - making sure that those managing the financial system continue their role providing liquidity to the private sector while not betting the farm using other people's money will be the most important aspect of the new regulatory framework.  In the near term, securing the health of the banking system is fundamental to any recovery as most individuals and companies do not have money “under their mattresses”, but rather use the banking system and the capital markets to access the liquidity they need to operate and grow.

Unlike Detroit, Wall Street is viable even when paying what some consider outrageous amounts of money to its employees.  Requiring them to take a lower paycheck while they are on the government's dole, may satisfy some sense of fairness for the rest of us, but it will not solve the structural problems of the financial system (though the skewed, short-term compensation schemes of the Street have much to do with the appetite for risk on the part of traders and management). 

Furthermore, unlike GM whose board left its CEOs at the helm even as its stock nosedived over 90%, a large number of the Wall Street CEOs that caused the debacle did loose their jobs (ok, collecting huge pay-days that for the most part they did not deserve, but I suspect Rick Wagoner will not be relinquishing his bonuses either).

We will be anxiously awaiting the result of the government's stress tests on the banks, and the actions that are taken by the administration on banks that fail their tests.  In the meantime, while one may disagree on some of the details in the administration plans, they have by in large been pretty logical and grounded on reality, we have to hope they do work.



4:41 PM GMT  |  Read comments(0)

February 28

Who Will the Housing Plan Benefit? Will it Work? (Part 3)

Now we get to the hard part, the “homeowner stability initiative”.  The $75 billion plan to benefit 3 to 4 million homeowners who are either delinquent on their loans, or have very high debt to income ratios that makes them likely to default on their mortgages soon.  The plan calls for banks to reduce the monthly cost of the mortgages by either lowering their interests payments or providing principal reductions.  All in all at the midpoint, taxpayers will be giving away $21,429 over 5 years (~$360/month) to every homeowner that falls under this category.  The government looks to identify “responsible” homeowners – assuming the rules when published on March 4th take the “responsible” part seriously, people who lied in their applications (or whose broker lied for them) in particular with regards to their income levels should be excluded.  The plan directly disqualifies speculators (defined as people that bought homes without intending to live there), and “house-flippers” (not sure yet, how they will identify them, other than perhaps looking for people who kept buying homes, selling them and moving again).  Although we will not know until the rules are specified on March 4th, the wording of the plan suggests that only first mortgages would be included, no equity lines of credit (by the end of 2007 there were approximately $200 billion of them outstanding, the estimates are computed using AHS 2007 figures).  So, these 3 to 4 million people are likely to be individuals/families that knowingly or unknowingly took on subprime mortgages that had provisions that after an introductory period charged very high interest rates.  It would also include prime borrowers who have fallen in dire-straits.  Given the much lower home prices there is no way these people can sell their properties at a price that will cover their mortgages.

It is worth reading a couple of dated, but good articles published by the Wall Street Journal back in late 2007, “The United States of Subprime”, published on October 11, 2007  and “Subprime Debacle Traps Even Very Credit-Worthy”, published December 3, 2007.  The former examines the explosion in subprime lending across the nation from 2004 to 2006, and concludes that unlike the general belief that subprime mortgages were given only to low-income, minorities and people living in the inner cities, subprime was prevalent across all the nation, neighborhoods and income levels.  From 2004 to 2006 subprime loans went from 16% of the total number of loans to 28%.  Moreover, the average value of a subprime mortgage increased from $112,500 in 2004 (a 34% discount over the average loan at the time) to $158,300 in 2006 (only a 16% discount over the the average loan).  So, not only did subprime loans become more popular, but they had become much more spread out across the income spectrum, and become almost as accepted as prime mortgages.  The second article presents an analysis that shows that most people taking subprime mortgages could have qualified for a prime mortgage; furthermore, it presents anecdotal evidence that ties incentives in mortgage brokers’ pay to subprime mortgages being pushed to people that could have qualified for better loans, and the fact that loan documentation was for many people difficult to understand.  Of course many people were quite aware of what they were doing when they took out loans with very little payments upfront in either principal or interest, but that had very high interests once the introductory period ends – these individuals hoped that increases in home prices will allow them to easily refinance later before the high payments kicked in.

The discussion in the paragraph above is relevant to the extent that it shows that there was more to the subprime story than just a bunch of irresponsible individuals at the lower end of the income spectrum that got themselves into big problems and should be let to face the consequences.  Moreover, it may explain the fact that even at these stage of the recession, 84% of subprime mortgages are still current on their payments (according to the HOPE NOW Coalition).  The fact is even more startling if one considers that at the height of the bubble 13% of subprime mortgages were given to speculators, which are more likely to walk away from their underwater mortgages. 

According to HOPE NOW, there are 6.5 million subprime loans outstanding, of which over 1 million are delinquent.  If we assume that approximately 10% are in the hands of speculators, then 5.9 million are potentially eligible; if we further assume that of these over half could have been converted into prime loans because the homebuyers would have qualified at the time they contracted them, then approximately 2.5 million of these loans would be eligible, and would be given to people that for the most part played by the rules – continued making payments until their interest exploded on them, or are still current in their payments.  The remaining people that would qualify are prime borrowers that because of changes in their status (e.g. loss of income, divorce, etc.) can no longer support the full amount of their prime mortgage.  Currently of the more than 47 million prime loans more than 1.5 million are delinquent.

So, perhaps the government has a case for helping these people.  By providing a floor to the value of these houses it may prevent others to fall further in value, and it will also help the banking system start dealing with the root cause of its problems. 

Could an alternative to this be to disburse the $75 billion to potential buyers?  The problem with that proposal will be that while it may generate some demand for housing, it is unclear whether it will come soon enough to help housing stabilize; after all it will not stop foreclosures, it may just help reduce the current inventory.  Furthermore, while a government incentive helps, the fear of further drops in prices will still serve as a deterrent for people to purchase; after all there is already a $8,000 incentive for first-time buyers to purchase.  Finally, like in sales, in the short term it is easier to deal with current customers rather than look for new ones to do business with.

Let’s give the administration the benefit of the doubt.  The plan does provide some clear benefits to the economy, and while in some respects it may seem unfair, it is a fair attempt to start resolving the root cause of the housing problem.  Unless somebody comes up with a much better workable solution, let’s just work with it.

6:16 PM GMT  |  Read comments(0)

Who Will the Housing Plan Benefit? Will It Work? (Part 2)

The first component of the housing plan provides assistance to those that while keeping their payments current, and having bought their houses with a down payment (and/or insurance) that allowed them to qualify to receive a “conforming loan” can not refinance their mortgages at lower rates because the fall in home prices has caused the value of the equity on their homes to fall below 20% (or the value of their mortgage is in excess of 80% of the value of house).  For homeowners that are in this predicament and whose mortgage value does not exceed 105% of the value of their properties, the government is offering the possibility to refinance their mortgages through Fannie Mae and Freddie Mac at the current low rates (~5% or so). 

Based on the S&P Case-Shiller Home Price index, the price of the average home today is the same as it was in late 2003, and 27% below its peak value in July 2006 (this is directionally in line with the estimates from the National Association of Realtors which announced its depressing January home-sales numbers on Wednesday).  What this means is that on the average, if you bought a home in 2004, 2005, 2006, 2007 or 2008, you are likely underwater (you paid more than what your house is worth today).  During this period 35.7 million homes were sold – based on the National Association of Realtors number for existing home sales and US Census new-home sales figures).  Now, say you paid cash for your home, the fact that the price fell makes the thought painful, but you are probably ok otherwise.  However, if you like most people took a mortgage on the house, and your down-payment was less than 20%, there is a pretty good chance that you owe more for your home that your home is worth, in particular if you bought in 2005, 2006 and most of 2007 when prices where at their highest levels (22.3 million homes were sold during those 3 years).  Of course, real-estate is local and while areas like Dallas, TX, or Charlotte, NC have not seen major price decreases (and in the case of Dallas they didn’t have much in the way of extreme price increases either), areas like Miami, Las Vegas, Phoenix, San Francisco, San Diego and others have had price decreases from the top of over 30%.  So, where you bought certainly matters. 

Well, but who are these people who are in trouble?  Based on results from the U.S. Census’ American Housing Survey (AHS), in 2007 approximately 42% of home buyers are first-time buyers, this is similar to the AHS results in 2005, which were 43%.  So, there were approximately 9.5 million first-time home buyers in the 2005 to 2007 period.  According to an analysis of the AHS data performed by the National Association of Home Builders (Characteristics of First-Time Home Buyers, 01/2008), over 54% of first-time home buyers had mortgages of 80% or more of the value of their homes.  This means that 5.2 million of these first-time home buyers are likely to owe more on their mortgages than what their homes are worth.  Approximately 3.7 million of existing home-owners look to be in the same predicament. 

The average age of a first-time homebuyer is 33 years old (again according to the NAHB analysis), with 66% of them under 35, and 86% under 45.  Quite likely the younger group also makes up the majority of those with little, no or negative equity in their homes.  We could blame them for not being smart and buying at the peak of the market; for drinking too much of the “ownership” society kool-aid, or for buying into the “houses always go up in price” mentality prevalent at the time, but thinking of these folks as just a bunch of “loosers” because they were buying a piece of the “American dream” seems a bit hard, doesn’t it?  

How many of the above people should qualify for low-cost refinancing?  In the case of first-time home buyers if we eliminate those that had took mortgages with less than 5% down payment (which we’ll assume were subprime mortgages, and could not have qualified to purchase a conforming loan), then about 2.7 million first-time home buyers will be eligible, and 1.9 million people with existing homes will too, for a total of 4.6 million.  The approximate number of people that fall in this predicament is within the range (close to the midpoint) of the 4-5 million that the Treasury gave in its housing plan – I am sure that their estimates are more precise taking into account regional factors, exact nature of the loans, job loss estimates, etc., but it is always good to see that some simple back of the envelope numbers confirm their figures.

Providing access to low cost refinancing to this group, assuming they kept up with their mortgage payments shouldn’t make us feel too bad, while the case for people who were “upgrading” to ones the could afford but that now have wiped out their equity is harder to make – they have been responsible, and beyond being bad investors, a break on their mortgage interest to what others that out of wits or plain luck could get, should help the economy.  The extra money in their pockets could be spent in the economy, so helping in the recovery, and if they run into difficulties it should lower the risk that they would go on default, thus helping the housing market as a whole.  The cost is the implicit increased risk in the investments made by Fannie Mae and Freddie Mac when they buy those refinanced mortgages, as their higher risk of default is not captured in the mortgage rate.  The government is assuming that benefits and costs cancel out and the net cost to the taxpayer for these section of the housing plan is effectively zero.

On the third installment I’ll cover the most controversial part of the housing plan, “The Homeowner Stability Initiative.”

6:14 PM GMT  |  Read comments(0)

Who Will the Housing Plan Benefit? Will It Work? (Part 1)

Ever since President Obama introduced the Housing Affordability and Stability Plan there has been a chorus of commentators blasting the plan for what they perceive is a bailout of individuals that either gamed the system or were simply irresponsible and did not know what they were doing.  Those bailing them out will be the rest of us that have been responsible and did not over-extend ourselves.  In effect, why should those that play by the rules and are doing well subsidize a large group of loosers?  Haven’t we already subsidized bad behavior enough?  Shouldn’t we rather be funneling those funds to those that do not need to be bailout, and want to buy a home of their own?  Shouldn’t interest rates be lowered to everyone not just those that failed?  Thanks to the White House, CNBC’s Rick Santelli has become the most well known opponent of the housing plan as can be seen in his now famous rant.  In this article I want to take a look at just who these “truants” are and whether helping them will in fact help the overall economy and the rest of us by default.

Of the three components of the housing plan, perhaps the least controversial is the government’s intention to continue using Fannie Mae and Freddie Mac (and behind them the Fed and the Treasury) to continue pumping liquidity into the housing market and keeping mortgage rates low (and support the other two elements of the plan that will talk about in a minute).  To this effect it will inject $200 billion into these two entities to expand their ability to continue buying mortgages from lenders.  This part of the plan benefits everyone that has a “conforming loan” (loans below $417,000 in most parts of the country, or $625,500 in high cost areas) – so far people looking to refinance their mortgages seem to have taken the most advantage of this plan, but if you are buying a home (as long as the your mortgage stays within the bounds of conforming loans), this also helps you.  Keeping rates low not only helps people afford the purchase of a home, thus helping to eventually put an end to the malaise in that sector, but also provides an indirect stimulus to the economy, as those refinancing their mortgages at lower rates will have extra cash in their pockets that can be used for additional spending. 

Those left out are people that have “jumbo” mortgages – those with balances larger than what a conforming loan would call for.  We assume the underlying assumption is that if you can afford that big an investment, you should not need any assistance from the government and banks should be able to provide adequate liquidity for that market.  For some areas on the coasts the assumption breaks down - in Manhattan, New York City, the average 2 bedroom goes for over $1 million, and owning one does not make you “rich”.  Nevertheless, it is hard to envision many people around the country feeling sorry for those in the “jumbo market”.  It needs to be pointed out though that they are the same people whose taxes help everybody else keeps their rates lower.

Next we’ll tackle the part of the housing plan that provides “Access to Low-Cost Refinancing”.

6:10 PM GMT  |  Read comments(2)