This is Housing Doom’s unauthorized, unannotated transcript of the American Enterprise Institute seminar on the subprime mortgage crisis that was held on March 28, 2007. For context and a guide to the seminar and Doom’s annotated transcript, and to comment on this effort, please refer to the post "AEI March 28th Subprime Seminar - Guide to Doom Transcripts" (July 23, 2007).
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Alex Pollock [0:00:00]: We’ll begin. Welcome to our discussion of "Mortgage Credit and Subprime Lending: Implications of a Deflating Bubble". The conference is cosponsored by the American Enterprise Institute and the Professional Risk Managers International Association, and on behalf of both, let me say how pleased we are to have you all here today. I’m Alex Pollock, a Resident Fellow of AEI, and we have an excellent panel, whom I will introduce in a moment.
Briefly to set some context, we had a big housing boom with unprecedented increases in real house prices facilitated by a mortgage lending boom and, notably, a subprime mortgage lending boom. As we all know, the subprime boom is over and the bust is here. Former enthusiasm has been replaced by large financial losses, the bankruptcy or closing of numerous subprime lenders, layoffs, accelerating defaults and foreclosures — what Moody’s has just referred to as a stunning erosion in mortgage credit quality, a liquidity squeeze, and of course escalating political recriminations. What was not so long ago praised as creative or innovative expansion of homeowership is now described as an irresponsible and culpable activity.
How much more bust will we have? Is this problem confined to the subprime sector, as a whole panel of regulators told the Congress yesterday? Or will problems spread to other parts of the mortgage market. What are the implications for house prices, that is, the market value of the most important asset for households by far? What are the implications for the market for mortgage related securities and the housing industry? And are there wider implications for monetary policy and the overall economy?
Of course, and needless to say, booms and busts are hardly new. As they recur in financial history, they differ in detail, but they display the same general patterns. You would think that we would learn, but we don’t.
I personally can never think about this subject without recalling the marvelous Victorian prose of Walter Bagehot in Lombard Street published in 1873. Some of you who know me have heard this before. And you should enjoy it again as I quote:
"… The mercantile community will have been unusually fortunate if during the period of rising prices it has not made great mistakes. Such a period naturally excites the sanguine and the ardent; they fancy the prosperity they see will last always, that it is only the beginning of a still greater prosperity. They altogether over-estimate the demand for the article they deal in or the work they do. They all in their degree, and the ablest and cleverist the most, … trade far above their means. Every great crisis reveals the excessive speculations of many houses no one before suspected. …"
Bagehot continues …
"… The good times of too-high price almost always engender much fraud. All people are most credulous when they are most happy; and when much money has just been made, when some people really are making it, and when most people think they are making it, there is a happy opportunity for ingenious mendacity. Almost everything will be believed for a little while, …"
Alas, how true in 1873, and in 2007.
We have a distinguished panel to discuss the implications of the deflation of our most recent bubble. Their detailed biographies are in you conference material. We’ll hear first from Desmond Lachman, who’s a Resident Fellow at AEI, having previously been a Wall Street economic stategist. His research includes global currencies and emerging market economies, multilateral lending institutions, and lately the housing bubble. Desmond and I have been reinforcing each others’ bearish outlook on this for some time now.
Next will be Nouriel Roubini, who’s next to me here, who is Professor of Economics at the New York University Stern School of Business, and is Chairman of Roubini Global Economics. He’s also served as the Senior Economist for International Affairs at the White House Council of Economic Advisors among many other assignments, and written provocatively on today’s topic.
Our third speaker will be Chris Whalen, who is over next to Desmond, who is Senior Vice President and Managing Director of Institutional Risk Analytics, to which he brings experience as an investment banker research analyst and a journalist, including working in both equities and fixed income, as well as risk management, and Chris has been my excellent partner in organizing this conference and thank-you again, Chris.
Tom Zimmerman will be our last speaker, bringing us first hand securties market perspective. Tom is a Managing Director at UBS Investment Bank, where he manages the firm’s mortgage credit and Asset Backed Securities research. His research has appeared in numerous fixed income reference works, and he’s a member of the UBS team voted first in the latest institutional investor survey of fixed income analysts.
Each member of the panel will speak for from 12 to 15 minutes, after which we’ll give the panel a chance to respond to each other or make comments. We’ll then open the floor to your questions, with adjournment scheduled for 4 o’clock.
And now the panel. Desmond, you have the floor.
Desmond Lachman: [Desmond Lachman's slide deck (PDF)] [slide 1] Thank-you very much, Alex. Thank-you for inviting me and before I make my remarks, I should just commend Alex for the timing of this seminar. When we discussed this sometime in December, most people hadn’t heard about subprime mortgages. And Alex’s timing was so great that even this morning he managed to orchestrate Ben Bernanke to give testimony before Congress indicating that subprime mortgages might be a bigger problem than the Feds originally thought. [slide 2]
What I want to do is put the subprime mortgage mess, as I would call it, into some kind of context. I’m wanting to talk about other things going on in the housing market, and I do this not because I think that the subprime mortgage problem is a minor problem, that after all it had, what something like 20 percent of all loan originations in 2006, and we have a mere 1.3 trillion dollars of subprime mortgages outstanding, which looks rather dubious. To put that into perspective that’s some 10 percent of United States GDP. But the reason that I put it in context is that we’ll see that there’s a whole bunch of adverse factors operating in the housing market, and when you connect the dots it’s very difficult to buy the sell-side line that has been given on Wall Street and elsewhere that the worst of this crisis is behind us.
My view is that we’re … I’m not even sure that we’re in the first innings of a long drawn out process in which we’ll see housing prices drop by a considerable amount before this is all over, and we’ll see this as being a big drag on the United States economy.
Before one prognosticates, it’s always good to know where one’s coming from. So the way in which I’m going to organize my remarks is first asking where have we come from? Next — where are we? and then finally, where are we going?
Now I think that what best encapsulates where we’re coming from is this chart [slide 3] by Robert Schiller, looking at housing prices over the last hundred years in constant terms. And what is really very striking is what we see between 2000 and 2006 is something that’s got absolutely no historic precedent in the United States. It’s that we see house prices increasing by something like 80 percent in constant dollar terms.
If we look at just the post-War period, since World War II, house prices generally oscillate in a very narrow range and don’t really move much in constant terms. As I say, until you get to 2006. What this does is it’s really pushed housing affordability way beyond the reach of most, and the point that I would emphasize is that here we’ve got a boom of incredible proportions. So I’m not too sure that previous busts are that great a guide. I think that we are in new territory — that this is a bust that’s going to be of greater magnitude and I think that therefore you should be expecting the fallout [0:10:00] to be all the greater.
The second chart [slide 4], which captures somewhat of a mirror image of the first, which encapsulates what has been going on, is that homeownership, which used to hover around about 64 percent, the rate of homeownership in the United States for much of the period between the 60s and the mid-90s suddenly moves up to pretty close to 70 percent. So essentially what’s occurred is a whole lot of people have been brought into the market, driving the prices to very high levels.
I would submit that though demographic factors or fundamental factors of that sort can’t explain the tremendous boom in house prices of the last 6 or 7 years. Instead of which one really has to look towards financial factors. And I think that there’s a confluence of, in my view, around about four factors that contributed to this [slide 5]. And I don’t think that the Federal Reserve Board comes out very well in this procedure. In their wisdom in not looking at asset prices, allowing that to influence their thinking too much. I think that they were pretty much asleep at the wheel as this was all occurring.
The first factor driving the house prices was the easing of monetary policy in the wake of the dot com bust in 2001. Interest rates were reduced to 1 percent by something like 2003 they were kept at very low levels. They kept at 1 percent for a long while and then they moved to neutral policy — was very gradual. So we had a bunch of liquidity created by the Fed that, I think, started the problem. But then what occurs at the same time is that I’m not quite sure what the regulators were thinking or what the regulators were doing when this was going on, but you get an explosion of subprime lending [slide 6], lending to people who really aren’t credit-worthy, so that by the time we get to 2005 / 2006, subprime lending is something like $600 billion. If you add Alt-A lending, which isn’t a whole lot better, you’ve got something like a trillion dollars each year has been lent, and this is something like 35 percent of the market.
So I just don’t see this as just a niche problem, I think that this is really a very big, has been a very big driving force. The other two factors were, that I would mention, were the exotic instruments, whether they were adjustable rate mortgages, whether they were interest only loans, whether they were negative amortization mortgages, and these in fact go beyond the subprime universe, that about a third of all loans now are adjustable rate mortgages and it might have something to do with a little later on.
The final factor I would like to emphasize, because I don’t think it gets sufficient attention in all of this, people look at subprime and look at the liquidity, is … There’s a certain amount of speculation in the market. I think that that might be an understatement. If I look at these numbers by the National Association of Realtors, they are suggesting that investment purchases of houses has been something like 25 percent [slide 7]. To put that into perspective, historically the figure has been something closer to 12 percent. So we’ve got a lot of froth, and what bothers me about that is not simply that this will dry up going forward, but you’ll get unwinding of positions that can really [complicate] matters [going] forth.
Just to round out where we’ve come from, the legacy of all this is that the households in the United States are now stuck with a lot of obligations [slide 8], and Alex is very fond of telling me that one of the things he learned as a banker was that liabilities generally don’t shrink. It’s the assets that shrink, and that people are going to be stuck with these obligations.
The other thing from a macro point of view of course, that is, dramatic, is that the boom in the housing prices coupled with mortgage equity withdrawal and all the like has induced American households to reduce their saving rates, which used to be something like 7 percent of disposable income — we’ve now got negative rates of savings [slide 9]. So we’ve really had one hell of a party going on — I don’t want to get into external imbalances and the like, because I think the story is depressing enough as it is.
Where are we now? [slide 10] In a word, I would say that we are in a situation of oversupply. Whatever indicator you wanted to look at, there’s too much supply, and that is causing prices to begin to weaken. If you’ve got an overhang of inventory, what you expect is for prices to weaken. So what if you want to look at — I think that vacancy rates might be the thing to look at [slide 11]. These are houses that are just sitting vacant, nobody’s renting them, nobody’s owning them. This used to run at something like 1.5 percent. It’s suddenly gone up 50 percent and it’s now 2.7 percent. So it’s telling you that there’s too many houses on the market. If you don’t like that indicator you can look at housing inventory as supply of sales, which now have gone up to something like 7 months [slide 12]. Sales — and we’re back to the levels we were at in 1995, and I don’t think that that is all over.
Another side is housing completions still run at a high rate [slide 13] – more than the fundamental demand, which could weigh on prices. And finally that I realize that there are very many different indicators of prices — whether you smooth them out or not — but they all seem to be telling the same story, that house prices that were increasing towards the end of 2005 at 15 percent annual rate are now actually declining [slide 14].
That brings me to — where might we be going? [slide 15] So, I don’t know, I took Economics 101, and the idea there was that if there was more supply than demand, generally prices fell. I’ve already mentioned that we are in a situation of excess supply, so the question you’ve got to ask yourself is — what is going to happen to demand and supply. Is demand going to operate in a way that’s going to reduce that excess supply, or are we going to get supply being reduced? And the answer that I come to is — no — that’s really what’s going to be occurring is that as the factors that drove this process go into reverse, we’re going to get demand shrinking, and what we’re going to get is because of foreclosures and because unwinding speculative positions we’re going to get supply increasing.
So I find it difficult to see how this isn’t going to get worse. So the factors that go into reverse is, firstly, the Fed has brought interest rates back into a more normal level; so affordability issues are going down [slide 16] — that would be the first factor. The whole mess in the subprime issue — reflected in rising default levels [slide 17], it just means that what you’re going to get is you are either going to get a credit crunches developing the incentive of people making these subprime loans is drying up. We’ve already have something like 30 of these subprime lenders going out of business, many more down the track. And just to put it into perspective, if subprime and Alt-A is something like 35 percent of all originations in 2006, it doesn’t take much of a decline in that segment of the market to produce sales dropping by perhaps 10 percent just from that factor.
Then there is the issue of the bank credit standards generally are tightening [slide 18]. The regulators suddenly realized what they were supposed to be doing. In a typical fashion they’re operating in a pro-cyclical kind of manner, so the last time that we need lending standards to be tightened, this is the time. So it’s just making sure that the demand goes down [slide 19]. I’ve mentioned that we’ve got adjustable rate mortgages that are going to be resetting because — something like 400 billion dollars of this, that resets at 2 percentage points higher, so that’s another factor restricting demand. And then finally I would just say the speculative side really does that in.
Let me just conclude by just giving my two cents worth on the macro-economic impact of where this goes [slide 20]. I’m not talking about other problems that we’ve got — high oil prices, or dollar weakness, or stuff like that — just looking at the housing side. The way I would see it is that you’ve [0:20:00] got to distinguish between a direct impact of the housing market — meaning that if you’ve got lower construction that means that you are going to have less jobs in that industry, and we’ve just taken a look at housing is something like 6 percent of GDP [slide 21] – so if you’ve got a 30 percent decline in housing activity in 2007, that’s a mere 1 1/2 percent shaved off GDP right away. I think, though, that the more important factors are going to be the indirect impact, and I think that that is a little bit more difficult to quantify because there is a lot of psychology involved. American households, as I mentioned, ran down their savings from six / seven percent of disposable income to zero, because housing prices were rising at 10 or 15 percent. The question you have to now ask is — isn’t that going to operate in reverse when households figure out that their houses aren’t appreciating, but in fact are declining.
Isn’t that going to freak them out, that they don’t really have savings, somehow they’ve got to restore the savings, and then the various wealth effects, 5 cents on the dollar sort of thing, would tell you that if we’re shifting from 15 percent increase in house prices to a 15 percent decline, we could easily be talking about 1 1/2 to 2 percent further shaving off. So when Greenspan’s talking about a 25 percent probability of recession, I think that’s — he might be being a little bit modest. But then I’m no Greenspan fan. I think that most of this problem really lies at his door.
So just finally I should say that the other indirect impact that I find very difficult to quantify is that when I look at financial markets risk is not priced anywhere. And I’ve got no way of quantifying that when we get losses floating all over the show, how many dead bodies are going to be floating on Wall Street. And what are the ramifications of credit derivatives and all the like are. But I don’t really need that in my case just to say that we are in for a pretty rough ride, and I’d be as bold as to say that I think that this issue is going to be the issue in the 2008 election campaign.
Alex Pollock: Thank-you Desmond. I thought issues were floated on Wall Street, not bodies. Ah, Nouriel.
Nouriel Roubini: Thanks. Like Desmond I’d like to actually discuss how the fallout of the subprime meltdown is going to have some implication for the economy. I think that’s one of the crucial things because right now there is this debate ongoing between the consensus that says that the economy is going to experience a soft landing and the alternative view that it might actually experience a hard landing in the form of either a growth recession or actual recession. I’m certainly of the latter view.
I’m a little bit curious that we’re talking only about subprime mortgages because if you think about it, we are literally in a subprime economy, and I’m not talking about it just metaphorically, but think of it, we have dozens of millions of, for example, subprime credit cards, and even before you default on your subprime mortgage you’re going to default on your credit cards, there are dozens of millions of subprime auto loans. And today there was a report on Bloomberg that S&P says that autoloans, subprime auto loans are sharply increasing in terms of default rates. And there was another piece today, I actually thought it was interesting that suggested, you know, that twenty percent plus of all the loans that financed the purchase of a Harley-Davidson’s hogs are also subprime and the default rate for today, the delinquencies has gone, since last year, from two and a half percent to five percent today.
So the point is we’re talking about subprime mortgages, but it’s auto loans, it’s credit cards, it’s all sorts of other things. There’s a whole economy that is subprime, and as I’ll point out also, it’s not just subprime, the spillovers are going to all other parts of the mortgage market and all other parts of consumer credit, and also to corporate creditors.
I think that, you know, the consensus view again, I think has been that somehow felt since last summer, because a bunch of people were worried about the housing recession and its deepening, about the subprime mortgages and the trouble coming of it, and the risk of a hard landing … The consensus was wrong then, then they discovered there was a subprime problem, and now what they’re telling you is that it’s just a niche problem and there’s no contagion from housing for the rest of the economy and no contagion from subprime to [???] mortgages and so on, so I’d like to address some of these consensus views and make some points on why they were wrong then and they’re going to be wrong again now.
First point. Consensus tells us since last fall that the housing recession is bottoming out. I have a long paper that was distributed around … I’m not going to be able to go into details of it. Essentially it says that we’re nowhere near close to the bottom of the housing recession. In the typical housing recession housing starts fall by fifty percent approximately. And in some of the deeper ones over sixty percent. We’re down only thirty percent. There’s a long way to go. And any indicator you have right now from the housing market, whether it is building permits, whether it is the housing starts, whether it’s construction, whether it’s completions, where is the demand for new homes, it’s just heading south. The glut of existing and new homes is becoming worse by any standard — unprecedented. The price pressure is downwards.
The official numbers are not showing it all to you. The Case-Shiller number came out yesterday, now showing falling prices, but a lot of it is actually seller side incentives that are not measured. You know when you get a forty thousand dollar free swimming pool when you buy a four hundred thousand dollar home, that’s a ten percent price cut that doesn’t show up in any one of the official numbers. So home prices are already falling today. At the rate it’s closer to ten percent, even if the official number is telling you otherwise.
So if you look at any indicator of the housing market, before we even talk about subprime or mortgages, it’s a disaster. This is going to be the worst housing recession we’re going to have since 1960. That’s my view of it. And I cannot flesh out the details of it right now.
Second point. The consensus now says — OK, yeah now we are in a subprime problem — now everybody just, whenever they say the words "subprime" they attach to it the term "meltdown" or "carnage." It’s just become almost automatic, when three months ago they were not even talking about the problem, but now the consensus is that it’s just a niche problem, it’s only subprime, it’s not the rest of the mortgages. But think about the reckless lending practices that were essentially being used for the last four or five years. You have zero downpayments, no documentation of assets or income, what people refer to as "liar loans." Interest only mortgages. Teaser rates. Negative amortization. Option ARMs. Was it only subprime? Look at the numbers — was subprime, was Alt-A, was piggyback loans, was home equity, was also a good chunk of the option ARMs. Subprime, near-prime, prime. If you look carefully, the numbers, I would argue that about fifty percent if not more of all originational mortgages for the last couple of years would be things I would consider as reckless — as just toxic waste.
So that’s what’s happening. Of course the rate at which Alt-A and other stuff is going to start defaulting and get in trouble is going to be later. It’s going to start with subprime and going to go to all the other stuff. But the idea that this is just a niche, that subprime is only ten percent of the stock of mortgages and therefore it’s not a problem is just nonsense. OK.
Additional point. Now people are recognizing, where there’s a total mess in subprime, there’s also a credit crunch in subprime (guess what, about thirty of the lenders have already gone bankrupt in the last three months), but again the problem they say is only a niche problem, it’s going to be a mini credit crunch only for the subprime section, and so on.
The reality is otherwise. When you look at the whole series of indicators and the chart that Desmond showed about … now loan officers are getting more worried by tightening stardards. They’re not tightening standards only for subprime. They’re doing it across the board.
The borrowers now are facing a credit crunch, regulators are now, they were asleep at the wheel for six years, under the ideology they should not regulate markets … they let this thing fester and grow. So now they’re cranking on the other side. We’ve seen it every time before. Where we’ve seen all this sort of boom and then bust. And then there was a nasty credit crunch, and we got a recession in 1990.
This time around it’s going to spread — it’s going to spread from subprime to other mortgages, it’s going to spread to consumer credit, first subprime, and it [most problem??] among consumer credit, and to the rest of the economy.
Fourth point. People say, you know, the residential mortgage backed security market is still kind of OK. So, as long as it’s OK, then there’s going to be financing and all the rest. I think there’s already evidence that actually, that there have been massive losses in the CDO market, and in a recent study by Rosner and Mason show that if you’re going to have a significant interruption in the CDO market then the whole financing base for the residential MBS market is, figure about 1.33 trillion dollars of issues of new residential mortgage based securities last year, is going to essentially falter. So that’s the kind of thing we’re facing.
Securitization helped the growth of this credit boom and bubble, and this squeeze now on the other side is going to create a mess on the other side around.
Additional point. People say there is no contagion to corporate credit risk. You know, those spreads are still relatively low. We’ve seen actually ripple effects and guess what, in a matter of two weeks the CDS speads for firms such as Goldman Sacks, Merrill Lynch, Morgan Stanley, went from triple-A to near junk rate. You have effects on CDX spreads, on Itracks, [0:30:00] on CMBX [??], the commercial mortgage backed securities, and so on. If you look at the numbers, and there is a study that has been done by my colleague at Stern, Ed Altman, who is the world leading expert of corporate defaults, based on firms and economic fundamental default rates for corporates today should be around two and a half percent, historically they are around two and a half percent. Last year they were only around point six percent — twenty percent of what they should be given current fundamentals. Why? Well there’s just a massive amount of liquidity coming from Private Equity, levered institution, lots of firms that are under distress are being refinanced out of court, they don’t go through Chapter 11, but under serious distress there is tons of junk that is being issued right now.
Once the party is over, and I would say the party is going to be over soon, corporate profitability will be shrinking, all these problems are going to be coming to the surface. You’re going to be seeing massive increases in corporate defaults (back to normal and worse) and then the spreads are going to go through the roof. You’re going to see the contagion is going to take a few months.
Additional observation. Until now, people said, this is just a housing recession. It’s not effecting the rest of the economy. That’s actually incorrect. We don’t have just a housing recession, it’s getting worse. we have an auto sector recession, we have a manufacturing recession, we have every single component of investment that has been falling since Q4. Residential investment was falling twenty percent, but in Q4 investment in equipment and software by corporations has been falling, and given the numbers on capital goods order, last month the ones that came out this morning, it’s getting worse in Q1. People said, yes maybe the construction / residential sector’s doing terrible, but the non-residential construction’s doing great. Yeah, it was growing twenty percent in Q2. Then it went from twenty percent in Q2 annualized growth rate to fourteen percent in Q3, and it became negative in Q4. And now it’s getting even worse. So the idea of there being a decoupling between real estate, residential and the rest of the construction sector was also nonsense.
You know Janet Yellen, President of the Federal Reserve Bank of San Francisco said that whole bunch of ghost towns out in the West. So if you have a bunch of ghost towns in the West, why would you want to build shopping centers, offices there. Obviously, with a delay of a quarter or two, there is going to be a link between a collapse of residential and the rest of the construction sector, always happens, so why would there be a decoupling this time around.
Now so we have a housing recession, we have an auto recession, we have a manufacturing recession, we have every single component of investment — residential, non-residential, equipment, inventory is collapsing — and people said, we’re not going to have a hard landing until the consumer is faltering, and consumption is seventy percent of GDP, and the consumer is resilient. Trouble is that consumption depends on four things:
- it depends on job generation / income generation,
- depends on interest rates,
- depends on wealth, and
- depends on debt servicing ratios.
We are already seeing massive losses of jobs, is going to accelerate in housing, in manufacturing, that’s going to slow down job and income generation. There’s right now interest rates on official mortgages don’t mean anything, you have now a credit crunch, and once there is a credit crunch there is adverse selection … so the price doesn’t go up, what cuts is the quantity, so you don’t see it on the price, it’s on the quantity of credit shrinking, so what houses are facing right now — a credit crunch.
Until now the households were consuming more than their income, negative savings, because they were using their homes as their ATM machine. As long as home prices were going up, you could keep up with this party. Right now home prices are falling, and home equity withdrawl was at a 700 billion dollar annual rate in 2005, Q4 it is down to 270. In the meanwhile debt servicing ratio is going up. This year alone you are going to have one trillion of ARMs that are coming to maturity and being reset at much higher interest rates.
So the issue is the consumer is on the ropes, is being squeezed, and now we have two consecutive months of retail sales that is pretty much flat. So that’s what we are facing right now.
So the point is that this argument that it is just a small housing recession, mostly a small subprime problem, doesn’t have any basis. What we’re facing right now is a serious situation which the economy is spinning into a recession; a good chunk of the economy is already in recession, the rest of it is going to enter it by next quarter. And the Fed is telling us, like the consensus, we’re going to have two and a half percent growth, this quarter and next (first half of the year) and three percent in the second half of the year. We went from a growth of 5.6 in Q1 last year to 2.6 to 2 percent to 2.2 in the fourth quarter. Now the consensus has it this quarter has at least two and a half percent, but how could it be? I mean, that 2.2 percent number for Q4 was before the subprime collapse, before we had the lousy number of consumption, before we had the collapse of capital spending and investment by firms. How could the consensus tell you that the growth rate this quarter is going to be better than last quarter? It just doesn’t add up in no way or form.
Now will the Fed come to the rescue? In spite of what they say? They’ll try to come to the rescue. Is it going to make a difference? No difference at all. Once you have a glut of capital goods, what the Fed does doesn’t make any difference. In 2000 the Fed was behind the curve — they worried until November of 2000 about inflation rather than growth, like today there was a tightening bias, then from November to December they went from tightening to easing and two weeks later on January 3rd when they announced that open after New Year had collapsed, and they cut rates in between meetings. And they slashed rates very aggressively.
Did they avoid the recession? No, they put a floor under it. And the simple reason why is that, you know, the Fed rate went from six and a half to one, long rates fell six hundred basis points. And real investment fell by four percentage points, as share of GDP, between 2001 and 2004, why? once you have a glut of capital goods and tech goods, this time around housing and consumer goods, what the Fed does doesn’t make any difference. It puts a floor, of course, on the recession, but the idea that you could just stimulate the economy that way doesn’t make sense. You know, once until you work out this glut and it’s going to take years to work out the glut of housing, the same way it took five years to work out the glut of tech, we’re not going to see a recovery. So the Fed is going to cut rate … are we going to avoid a hard landing? My answer is no. So, I think that’s the problem we’re facing today.
Alex Pollock: Thank-you, Nouriel, I think thank-you, uh, for that incisive outlook. The co-author of the paper you cited, Josh Rosner is with us today, Josh, thanks for coming. Good to have you. Let’s go on to Chris. [Chris Whalen's slides] [slide 1]
Chris Whelan: Thank-you Alex, and especially on behalf of Professional Risk Managers I want to thank AEI for putting on this event with us.
I’d like to spend a few minutes talking specifically about where we’ve been, where we are, and where I think we’re going to be with respect to US financial institutions. I want to really, in essence, cover a lot of the same ground that you’ve already heard, but by looking at a couple of bank business models and making some observations on their default experience, which is also referred to as charge-offs, but essentially what the bank’s losses have been in a given period. And then make some comments about where I see both the asset quality of US banks and the major sources of revenue that they’ve enjoyed over the last couple of years because of the boom in mortgage — where I see those factors going.
First off, how far is down [slide 2], in terms of banks, which is what my firm spends a lot of its time on — benchmarking bank financial performance and credit quality. The real trough for the surrogate I like to use was in 1991, and I like to use the lead banks, the major money centers, particularly Citibank NA [slide 3], the lead of the Citigroup organization.
What’s interesting is that even half a decade into the rate tightening by the Fed, default rates still remained very low. In fact charge-offs in 2006 may have been the trough for the last 10 years. So they’re clearly a lagging indicator, but they’re also a very interesting one because of what they tell you about different bank business models.
Now as I mentioned, Citibank’s one of my favorite surrogates. They peaked at 330 basis points of default in 1991. That’s 3.3 percent of total loans and leases. That was a pretty big hit, as you can recall if you’re as old as I am. That was the time when people were worried about the solvency of the major banks, there were rumors of rescues by the Fed, you had events like Bank of New England and other de facto rescues by the regulators.
What’s interesting though is the near term peak in 2002. It’s only about 2 1/2 percent losses or charge-offs on total loans and leases. And again, I’m going to show you in the next slide, that was bad, but it certainly wasn’t as bad as your early 90s.
Now this chart you see up here [slide 4]. This is Citibank NA versus its large bank peers going back 18 years to 1989. What I would have you notice is that it kind of looks the way you would expect — in other words if you were looking at a GDP chart, or a chart about interest rates it would follow basically the same form in terms of the time line. You have an early 1990s very high default rates, by Citi, as you can see well above peer, which is typical for them. They generally have a more subprime, or more high risk profile in terms of their lending compared with, say, JP Morgan or particularly Bank of America.
And then we have this period in the 90s. Very quiet. Especially Citibank, when they get down below a hundred basis points of default, or 1 percent default in a given year, that’s actually extremely good for them, then you can see again, 2001 2002 period, pretty serious spike, but notice how long it lingered. There were actually 4 years there where Citi’s default rate was just above or just below 200 basis points, which is, I think, a [0:40:00] fairly telling observation.
Now the difference, of course, in the next bank examples we’re going to look at, is the mortgage sector. Since the early 1990s, defaults in mortgage product generally have collapsed [slide 5]. I mean they have been so low for so long that most of the mortgage bankers I know, the ones who are my age, haven’t even bothered to update their default studies, internally. They just haven’t had enough events to put into the work. So why bother, you just buy the vendor default calculator and everything’s fine.
As I’m going to show you in the next slide [slide 6], some of the bigger, more pure business models like World Savings, which is the lead bank of Golden West, was acquired by Wachovia last year, actually reported zero or negative defaults for consecutive quarters. They had so much money coming back in that they couldn’t report a positive default rate.
Well, again, this is the same data, this is the portfolio data from the FDIC. And what you have is, the dark line is Washington Mutual, the pink line is World Savings, as you can see sort of crawling along the bottom of the chart there — and then the peer average — obviously institutions with higher loss rates a little more volatile too — but that’s a very big peer group. This is about 70 members of the mortgage specialization peer group which the FDIC maintains. And what I would ask you to notice is just look at the way the defaults have fallen off in that period basically from the period from the mid-1990s onward.
This is absolutely extraordinary, and going back to some of the earlier comments …
Alex Pollock: Chris … your vertical scale is basis points there …
Chris Whalen: That’s correct …
Alex Pollock: just to make it clear for everybody.
Chris Whalen: … that’s correct. So what you would have here — 21.2 percent 200 basis points at the very top would be 2 percent. Defaults here very low, you’re talking about, for Washington Mutual for example, they were reporting 10, 15 basis points of default on their mortgage portfolio. It was very low.
Now, the couple of observations about subprime [slide 7]. I totally agree with what Nouriel was saying. There’s many different kinds of subprime. The way we find them in our work is we look at a couple of things. We’ll look at the yield on the loan portfolio. If the yield is above 10 percent, or even mid-teens, that’s a subprime portfolio. At least in my opinion. If you see high loss rates you’re talking over 300 400 basis points, or 3 or 4 percent loss rate in a given year, a very high Loss Given Default, that’s a Basel II term, that’s basically how good are you at recovery after you have a default. What’s your loss rate after default.
Most credit card banks, most subprime lenders, they’ll be in the 90 percent range. If you default on the loan, they just take it and sell it to a collection agency or a hedge fund for a couple of cents on the dollar.
So those are the kind of indicators we look for to identify a subprime lender, because other than the HUD list, which is very useful, they’re really aren’t too many ways of segregating out these assets, other than the way that they’re priced, and the way that they throw off defaults.
There was a great piece in The Journal a couple of weeks ago talking about a guy who buys homes from banks at a foreclosure, and there was a very interesting business model, a good benchmark for you if you’re following this. He would pay 8, 10 thousand dollars for a house out of foreclosure, mark it up to 30 or 35 thousand, put it out there on the market. It was very minimal mortgage payment. He would typically hold onto title for at least a year before he gave the title to the buyer, just to see how they did. And then he still had a 30 / 35 percent default rate over a couple of years period on those transactions he was putting together.
That’s a tough business. That’s a business where you’re going to have, if you’re a bank, at least 15, 20 percent capital of total assets to see you through the tough times, because you know that portfolio is going to throw off 10, 15, sometimes 20 percent defaults in a given year.
Now one of the interesting things, just a quick observation about the HUD lenders [slide 8]. If you look at the different lists they have available on their web site, they have 6 years of lists of subprime and Alt-A lenders. Early on, these are a bunch of Thrifts, small banks, but none of the big guys really. This was basically a private sector business with a couple of regulated financial institutions involved. But you didn’t see the big guys. Today you do. Today when you look at the list you see [Wachovia?], you see Citigroup, you see Wells Fargo, you see a number of other Thrifts and large bank holding companies who’ve all got into what used to be, as I say, a private cash business. This was a tough business to finance. Not any more. You have hedge funds who want to get into this business now.
Now this is a chart of a very interesting non-bank [slide 9]. This is GE MoneyBank. This is one of GE’s credit card subsidiaries down in, I believe in Atlanta. And what I’d have you notice about this series is — notice how it doesn’t look like that original series for Citibank, which kind of had some rough correlation to the economic cycle, to the interest rate cycles. This you just see default experience ranging between 5 and 10 percent a year, and then this big anomaly. Now that anomaly is all GE MoneyBank, there’s only about 10 banks in this peer group. And I left it in for a reason, which is to say that the difference between subprime lending and your normal prime, kind of plain vanilla mortgage lending with high [sic] loan-to-value ratios, very conservative terms, is that there tend to be a lot more idiosyncratic events with subprime lenders. If you go through them as a group [slide 10] and look at each one, almost every single one has an event like this which has nothing to do with interest rates or credit quality. They screwed up. They had to essentially write off 25 percent of their portfolio in a single year. That’s pretty tough, but that describes what kind of business this is. When you talk about subprime you’re really talking about something that’s a triple-C double-C bond equivalent rating.
Now, I think we’ve covered pretty much all of this. Let me just move on. I guess the thing that I would have you take away from these examples is that — the thing that scares me the most as an analyst is that mortgage chart. If I could just go back [back to slide slide 6]. This really frightens me. Because when you see a group of financial institutions essentially telling you that there’s no risk on their portfolio for years at a time, that should put up little red flags everywhere. And it did, I can tell you, among the supervisory community, because they’ve been out doing stuff, trying to head this off for the last couple of years; pulling people out of retirement, and placing them as consultants with financial institutions. There’s a couple of proposals that have come out through FBO.gov in the last couple of months that all have a very clear supervisory focus. In fact we’re probably going to hear the final release within a month or so of the revisions to shared national credits. That’s again going to be focus on things like CDOs, syndicated risk enhancement, even hedge fund reporting.
You may see some credit ratings aggregated for hedge funds if they’re a significant part of a bank’s risk. But all of it is trying to get their hands around the risk that this chart shows you, which is essentially that the risk isn’t priced. As Desmond was saying before, when you were doing these deals a year and two years ago in the CDO market, they were going to hedge funds and saying, "heh, we’ll pay you a point and a half," or two points per year, to guarantee a portfolio that in normal times should have thrown off 10 percent defaults a year. You know — what’s wrong with this picture?
This is what scares the regulators, it’s not that the banks have kept a lot of this risk, it’s that they’ve sold it to somebody else [laughs] and now the zillion dollar question in Washington is "where is all of this risk?" that has been packaged and sold by the sell side to buy-side investors, whether you’re a homeowner, whether you’re a hedge fund that owns CDOs you have basically the same problem right now. It’s a shame we can’t get them together sufficiently.
So just to conclude [slide 11], I think that the performance of the mortgage industry — if you look at the default rates of the banks we were just looking at — it’s a pretty good surrogate for the marketplace generally. And especially for the things like bond market spreads and credit derivatives swaps.
My personal view is that 2006 was probably the low [slide 12], in terms of bank default experience, and it’s going to be up from here. I think that, for a number of reasons, but we’re several standard deviations from the mean — even today. So if the Fed starts easing interest rates later this year or early 2008, I’m still not sure that we won’t see defaults rise [slide 13] for quite a number of years just because of what’s baked into the pie.
I think it has sort of been mentioned about home prices, and I totally agree with that — I live in the New York area, I have a lot of family in the Real Estate business and — things are quiet. The great fiction that they’re trying to maintain up in New York is that the New York City market is OK. But that’s not true. The flow in New York City has dribbled to just about nothing. And the classic that I’ve heard a couple of times now are sales that have failed because people in the business have lost jobs.
That to me is not good. I don’t like hearing that stuff on weekends from, you know, two family members who make their living in the real estate market in New York City. But it’s getting to be an increasingly common problem.
And really I think that — the last issue I would leave you with is that — too often when people react to subprime stories they make the mistake, I think, it’s just about mortgages — but I think the scope of the problem that’s embedded in our financial system right now is almost unknowable at this point [slide 14]. Why?
Imagine I’m a trader in a hedge fund. I own a bunch of CDOs that I’ve been buying for the last three years from our prime broker and from other brokers who service us. I get my valuations for these products [0:50:00] from those dealers. There are no public prices for these securities. I could call two dealers, and I’ll get two different prices. They’ll be widely disparate in many cases. But what I’m saying to you is that there is absolutely no way for an auditor or a manager of a bank or a mutual fund or a hedge fund to verify the value of these securities until you try to get a bid for them.
When you go back to the broker-dealer and you say, "Oh, Al, you know you said 115 over for that tranche 2 you sold us, what’s your bid in 5 or 10?" You’re going to find out that it’s probably 200 over — or 250. Because this stuff is totally illiquid, and if you think of it from the broker-dealers perspective, what’s he going to do with it once he buys it from you. It’s just going to become dead inventory on his book.
So I think the issue of liquidity is the issue I would want to leave you with today, because it really affects this entire market — from the homeowner on through to the end investor in the asset. [slide 15]
Alex Pollock: Thank-you Chris, if you’ll remember Chris’ question — if the banks sold all this risk to somebody else, where did it go? We’re hoping someone in the audience will tell us the answer to that. [laughter] And we ended up on liquidity, which sounds a lot like the securities markets, so Tom, you get the last word here. Zimmerman slide deck [slide "0," title slide]
Tom Zimmerman: Well, there’s always problems going last. Most of your thunder has been stolen one way or the other, including Alex’s first comments, because that’s what I was going to start out with, you know, bull markets are bull markets, you always know what’s going to happen at the end, and it’s not good. A lot of people love them when they are going up, and then when they come down we don’t like them. And in the subprime world there’s going to be a lot of victims. It’s not just the homeowners, there’s going to be a lot of guys who lose their jobs in these subprime originators. There’re all going out of business, they’re not going to be around. You’re going to see Wall Street operations shrink in size, the subprime market will be probably be half, going forward, half of what it was in the past few years, so we don’t need so many bankers or research people. Oh yeah, a lot of people are going to get hurt in this thing.
And it’s not just the homeowner. So it’s a classic, classic, you know, bull market enthusiasm and classic bear market pain, so that’s where we’re at.
In terms of this topic of contagion - that’s kind of a funny word - in my view, and I’ll show you some slides about this, for the last two or three years, when I appeared on mortgage panels around the country, I’ve always been way over there on the bearish side. And as the years went by I sort of got to the middle. And now I come to this group and I’m on the other side. It’s like I just [laughter] … so I agree with a lot of the comments made here today. I mean, I really think this is a big big problem, and I’ve been saying that for some time.
I don’t know if it is quite as big as it’s been exagger- … said here. When you talk about some of the numbers. But clearly this is not a small issue, it’s a big issue. And I think, what I would like to do is spend a little bit of time with my slides and go in and drill down into the details of this subprime world itself and tell you sort of the way I see what happened here … and then maybe talk about extrapolations from that. And so most of my presentation is sort of focussed right on the subprime market sort of describing how I saw it unfold and what sort of happened here.
Now here’s a slide [slide 1] that I had, that I gave, the first slide at a seminar I was at and we talked about what’s happening in the subprime market. So if you read those questions you’d say, "yes, there’s obviously something going on here." Investors are asking these questions, they’re not naive. There’s an issue here, right?
Is this growth unsustainable, aren’t these standards dropping, aren’t these new loan types going to break, etc. etc. etc. So this was done, this was January 2005, right? [slide 2] So this is not a new story, this story has been out there for quite some time. We knew it was coming, we knew it was a problem, it was going to happen. This is September ‘05. OK, here’s my forecast [slide 3] what’s going to happen when the market slows down. Subprime losses, which, let’s say, these scenarios are like our average subprime world of the last seven or eight years. Not the last two or three years, but the previous seven or eight years. Housing appreciation five to seven percent, total losses over the life of these loans four percent.
In the never-never world of the last couple of years, these losses — I mean you’re talking low default rates — man there was nothing, nothing — you were golden in mortgage-land the last few years. And those cummulative losses dropped dramatically. And now of course when the housing market slows down, here’s what we thought was going to happen. We did this, you know, a couple of years ago. These numbers are going to go up by factors of two or three. You know, no question about that. This is subprime.
These next couple of charts [slides 4&5] go beyond subprime and take a took at Alt-A, subprime and prime, and these next three charts [slides 6,7,8] show — these are default rates. and they’re linked to HPA. The higher the HPA, the lower the defaults, right across the board, bam-bam-bam. Loss severities, same thing. Loss severity is dramatically linked to HPA. That’s almost a no-brainer, right?
Alex Pollock: You’re telling us that HPA is …
Tom Zimmerman: Oh, I’m sorry, Housing Price Appreciation, sorry … I’m coming out of a world where that’s … it’s … Three years ago, or four years ago that question would have been asked at the mortgage panels, but lately everybody knows that. OK, ah [laughter] … so — loss severities … same thing. And now you put them together … you take how many times people default times loss severity, you’ve got actual losses and here they are. So … If people think this is just a subprime problem, obviously it’s not, because, you know, this is the data, this is what’s been happening across the country in the last five or six years, and if you slow the housing market down, losses are going to go up. That’s almost physics and not economics.
So we knew it was going to happen. Now … and take a look at this subprime number roughly — and this is historical data — at zero to five percent HPA we’re looking like, you know, eight percent kind of losses. [slide 6 - bottom rightmost bar]. That’s an ugly number to a lot of CDO investors. That’s a bad number. That’s not good. The old numbers were three and four percent. So if the market slows down, if the housing market slows down — a flat market, forget going negative, then there’s a lot of problems. So … this is what we’ve been talking about for the last couple of years.
Now this is longer history, this is, like, the cumulative defaults in the subprime market for the last ten years, [slides 7&8] and the real bad years were 2000 - 2001, really ugly stuff, and the last couple of years looks really great, which it was — ‘03 ‘04 really great.
You take these curves and you can standardize them, normalize them. What percentage of these losses occur when. You take a look, over here in the first year, into the second year — maybe you’ve got 15 percent of the losses have occurred, OK? So now, if you back up — and we knew this train wreck was coming some time, right? — so we figured, OK, not here, a year or two years from now we’re going to see lots and lots of problems. That’s always what happens, right?
Well, we got surprised, right? [slide 9] We got surprised like everyone else did. A thing called "Early Pay Defaults." Out of the blue, no one expected them to be coming, I didn’t, nobody that I know in the industry did — a few journalists thought they knew, because they criticized some comments I made and said, "ah, everybody knew it was coming," right? No one knew [laughter] no one knew this was coming.
We were out talking with some subprime guys early in ‘06 and they were saying, "you know, one thing we’re worried about is EPDs are really creeping up fast — we don’t understand what it is." An Early Pay Default is when a person takes out a loan, and then doesn’t make the first payment. Or maybe the second or third payment.
This used to be a small niggling little problem, like less than one percent of the loans. This thing soared to six or seven or eight percent by the middle of ‘06. And that’s what knocked the subprime business out, it wasn’t these defaults that were going to happen down here — it wasn’t just normal default curve — it was the EPDs, that’s what knocked them out. It was not the regular default statistics we talk about, that’s what killed them. What happened, when these people originate these loans, typically they’ll sell half of them to The Street, keep half of them, securitize them, the ones they sell to The Street, they sell them with Reps and Warranties. And it says typically — when I sell this loan to you, if within the first two or three months, there is an Early Pay Default, guess what? You can put that loan back to me.
And that’s what took down all these shops. They were selling loans to Wall Street, Wall Street took a look at them and said, "Heh! These guys … these are EPDs, take them back, guys!" …"But wait a minute, we don’t have the money to take them back! We have a cash flow system going here with securitized loans. We sell them — we don’t take them back!" OK, now you’re taking them back. So a lot of the smaller capitalized shops Ownit, First … a lot of these small guys … they’re gone, they just went out like that.
These EPDs really hammered the big guys, whether it was New Century or Fremont or … even WaMu and CountryWide … all got hit with this stuff. But the bigger guys could survive it. They’ve got a lot of capital, they can handle it. The smaller guys, they’re gone.
So what’s interesting to me — and we still don’t know — is what caused it exactly, and who these people are. Now we know part of what went on was this underwriting standards — we talk about how loose underwriting gets in this industry? These are the statistics for the subprime world for the last five or six years. [slide 10] You can take a look at a couple of things which really look pretty ugly … like the second liens — they went higher and that’s really bad … this I/O and 40 percent — these are affordability loans — they were zero they came to 30 or 40 percent of the market. Take a look at debt to income, it’s increasing.
What’s really bad is these purchased … uh not purchased, the full doc loans, which went from 73 percent down to 56 percent. And on the far right are these [1:00:00] seconds associated with the 80 percent firsts. So these were the 20 percent seconds. So by the end of, by ‘06, like 25 percent of these loans out there — these 80/20s where you were actually giving these people a loan with no money down.
So this is what, this is what created this perfect storm that we’re now seeing the fruits of. [slide 11] Now, here’s the breakdown of how many 2/28s and 3/27s were in the subprime product. And it’s like 60 percent is 2/28s and 12 percent are 3/27s. Now what is a 2/28? A 2/28 is a hybrid ARM. The first two years are fixed, usually at some rate linked off of two year swap rates. It runs maybe 200 basis points above a 30 year fixed rate loan. After the two year period, it will automatically reset to an ARM. And that ARM is six month LIBOR plus 6 percent. That’s now about 11 percent.
So these 2/28s that were being created for this industry probably was the wrong product for a subprime borrower who was on the margin anyway in terms of income. Now you’ve got him into a 2/28, and now you’re going to give him an 80/20. These 80/20s are these 80 percent firsts / 20 percent seconds / no money down. And now you’re going to give him a low-doc loan where he doesn’t have to identify who he is or what his income is, it’s just what he says. So this product, by the end of ‘05 — early ‘06, was really, really, really a very scary product waiting to blow up. It’s not surprising it blew up, but I still say it’s surprising it blew up so fast.
And here is this trap these guys are sort of getting themselves into. This is a good chart [slide 12] because it shows what these 2/28 individuals are faced with. The blue line, the most volatile line, is 6 month LIBOR plus 6 percent. The orange, no, the pink line is the actual loan rate for that two year part of the 2/28. That’s the loan rate these guys were paying for the first two years. And that’s the pink line. And the yellow line is just the pink line moved forward two years. So if you take a look at the yellow line, it tells you where you’re at today, so for instance in January uh March of ‘07, we’re at about seven and a half percent. That means our loans, we’re getting ready for a two year reset — I’ve got a seven, I’ve had a seven and a half loan for the last two years … and now my choice is to reset into this current pink line, which is up about nine percent, or go to eleven percent. That’s the refinance choice these people have. [aside] — I get this backwards all the time —
Now, in addition to that lousy underwriting we just talked about, of course you know what happened. The housing market slowed down. These are just the data showing the housing market slowing down. [slides 13,14,15] We all know that took place. The question is, who were these people? [slide 16] These six percent of these billion dollar loan packages, really six percent people who took out a loan — and then a month later or two months later didn’t make the first payment. I don’t know. No one knows exactly.
My guess is some of them were speculators, who for the last several years have been taking a zero percent down loan and going out and speculating on houses? And all of a sudden, they took the loan out, they tried it one more time … "Wait a minute! The market is not going in my direction, I’ll just walk out of here."
I don’t know. It could be one of these serial re-fi people. If you were back in here, look, if you were in ‘02 ‘03 ‘04, and you had a subprime loan, and you were on that yellow line, [back to slide 12] heh, you can re-fi out. Go down to that pink line, lower you loan rate by 200 basis points, and by the way take cash out, because the market is going up 20 percent a year. That was a great trade for all of those poor people we’re now worried about. They had a pretty good time for a couple of years, by the way.
Uh, they were doing very well. They were rolling out of those loans into lower rate loans and taking cash out of their houses. It was, as we say, it was a win-win-win for everybody during that period.
So, I think some of those people got caught. They just re-fi’d one too many times. And who knows, you know, if you don’t charge anyone a down payment, maybe some young person just decided to take out a loan to live in a house for a year and then walk away. I don’t know, I don’t know who these people are. But there’s a lot of them, and that’s what put the industry down. It’s wasn’t this default rate we’re going to expect to see in the coming years.
Now, the other thing that hurt the industry of course, was that already this gross profitability that they’d had the past four or five years had already disappeared. [slide 17] When LIBOR dropped dramatically back in ‘01 ‘02, and their loan rate, which is this 2/28 WAC rate on the top — that light blue line, that net margin they have just exploded during this period of ‘02 ‘03 and ‘04. There were companies like Ameriquest that were taking a billion dollars a year out of this market. They just took just took a billion out and went home. It was like boom boom boom boom.
So there was enormous amounts of money being made in this industry during that period. Then of course LIBOR rises, their rates rise a little bit, but not nearly as fast, and it’s just you go back to a normal environment, or close to a break-even kind of a situation.
And now what happened, these early pay defaults, it really pushes them over the edge. [slide 18] So by early ‘06, their margins, which were enormous, had shrunk to a pretty small amount — and these are like, rough numbers — but we see these early pay defaults are always there, but they come in at a very low number. Now you go to, by early ‘07 or late ‘06, you calculate what those early pay defaults are 8 percent of you packages — you’re gone. This is … so it’s not a profitable industry — it’s time out.
So the originators, they have all these early pay defaults going on from their prime product. [slide 19] So how do you get rid of your early pay defaults. They’re sinking you. You’ve got to reduce what you’re doing. You’ve got to shrink it. But one of these large companies reduced their production by 25 percent, and their early pay defaults went from 6 to 3 percent. They’re still getting killed. So you have to really, really change the product that you’re producing to get rid of these early pay defaults. And when you do it, you shrink your volume dramatically.
The problem is in the last five years you’ve built overhead dramatically. So now you’ve got a really lose-lose situation. And that’s where they are right now. That’s why these guys are going down. So the early pay defaults were the mechanism that just triggered it. But it was the larger problem of having underwritten these really lousy loans and having a profit margin already squeezed.
So you put them together and you’ve got massive defaults across this industry. What’s going to happen? The industry is going to create a new product. They have to. It’s going to be a new product. It’s not going to be a 2/28, it’s going to be a … what? a 5/1, it’s going to be a 15 year fixed rate loan — I don’t have a clue what it is, but they’re right now trying to figure it out.
We’re in the middle of this transition. No one knows what it’s going to be, but it ain’t going to be a 2/28 80/20 low-doc. We know that. It’s not working.
The industry, you know, is in a shambles. The only people who will survive are the very large companies who are part of a major commercial bank or investment bank. The rest of them will be gone. That’s basically it.
Here’s a list [slide 20] – I’m not going to go through it. But all the problem childs and what’s happened to them. They’re now … the government steps in — right? [slide 21] So the government was onto this, right? early December ‘05 came out with the new rules … not regulations … new rules about how you should underwrite certain types of loans. And there was a big discussion. Do we include language that says: "every loan you write must be written, must be to a fully amortizing –" you must fully qualify the person at a fully amortized fully indexed rate.
There was some sort of logic to that. If you’re going to qualify a person for a loan — I don’t know about anything else, but at least you should take a look at this loan — what are the features of it are? But once you fully index it, and you fully amortize it, they should be able to carry that loan.
So that language didn’t get in. That language did not get into the first set of rules that went out in October. The first set of rules that went out only said — if it’s an I/O, or an option ARM do those rules apply. So the subprime industry thought … we’re off the hook … right? They didn’t get us.
But a month later — comments, you started seeing it in the press, etc. etc. that guess what, some people think that maybe a 2/28 is also a pretty risky loan — it is inappropriate — now we know what’s going to happen, within a month the new rules will be out, and the 2/28s and 3/27s will now have to be qualified at a fully indexed fully amortized number, for which that’s 11 percent now, and as one executive from WMC said at a recent conference, "that is 75 percent of my business."
So it’s a whole new world, it’s a whole new ball game, it’s not like it used to be, and the borrowers who are out there now — going forward in six months — we’re going to have a new industry. Right? half the volume or sixty percent of the volume. The new loan — same players — damaged a little bit, beaten up a little bit, but they’ll still be there. CountryWide will be there, WaMu will be there, other banks will still be there. But the problem are these guys. [slide 22] These are the guys that took out the loans in the last two or three years. And this goes back to some questions and comments made earlier. These are the guys we’re concerned about and who Congress is concerned about.
These are the people who took out these 2/28s, and now what’s going to happen is — the capital markets can’t originate them because nobody wants them, these loans. The bank raters won’t let them do it. So what’s going to happen is these guys in the ‘04 ‘05 ‘06 vintages, mostly ‘05 and ‘06, when it comes time for them to refinance in two years, there’s no where to go. There’s none of those nice 2/28s left, teaser 2/28s sitting out there. There’s going to be something else, there’s going to be a very, very different world. There’s going to be a higher loan rate, by far, 100 200 basis points, I don’t know what the number is, but it’s going to be big. It will be a lot more than these old 2/28s. And, you’ve got to put some money down. [1:10:00]
No more of this zero financing. That’s gone, that’s history. So, they may be able to deal with this higher loan rate, but they’re not going to be able to deal with this … 10 percent down? I don’t know what the number is … whatever it is. It’s going to be created in the open market. They can’t deal with it. Which brings us back to Congressional legislation, the question is — do we have a bailout for these subprime guys — I don’t know. I have no idea how this will go, how you’re going to deal with … and how you are going to figure out whether or not the person who you bail out is the people you who see on the front page of the Wall Street Journal and the New York Times — and there’s clearly a lot of agony about this stuff — or those 6 percent EPDs who decided to take a flyer on the housing market and decided to jump out.
Now are you going to save them all together, or how do you decide which ones you’re going to save and you don’t save … or where the money comes from to do the saving, I don’t know? So that’s beyond me.
Nouriel Roubini: You could exclude all those EPDs, right? If you exclude the EPDs from the bailout you’re going to throw them over the wall, essentially right out of the system.
Tom Zimmerman: yeah, yeah, that’s one way, you could do that. But an EPD could be — I don’t know, maybe you could have had an accident. I don’t know, maybe he got sick. I don’t know either. There are other ways to do it, right? So that’s the trap that these … the trap that the government is in right now … trying to deal with, and it’s not easy to figure out how to solve this particular problem, but it is a big problem.
How much time do I have?
Alex Pollack: Your time is up, but it’s been so good, I’ve been letting you go. We ought to wrap up.
Tom Zimmerman: OK, we’ll wrap up, OK. Ah, numbers, [slide 23,24,25] this is just some data that showed what percentage of the market was subprime. 12 Percent by this measure, 13 and some percent by the MBA’s numbers of loans, but they really underestimate it because you’re only covering like 60 percent of the subprime market, so they’re numbers are something like 17 or 18 percent. Let’s say it’s 15 percent of the world is subprime markets. Let’s say that the old numbers were 15 or 20 percent default and the other 25 or 30, say it’s 20 percent or so default, 3 percent of the loans are going to go bad, so 3 percent of the loans in the country go bad, something like that — 3 percent is the number.
That’s why some people say it’s not a great big problem, because we’re talking about 3 percent of the mortgages out there. There are 10 million mortgages, 17 billion [note: probably meant "trillion"] dollars worth of assets, so not everybody has a mortgage, right? So it’s less that 3 percent of the homes in America are effected by this. 2 or 3 percent are effected by this. So, by that measure, yeah, it’s going to hurt those people in certain sections of the country, but it’s not a great big deal from that point of view. I agree that — well, here’s another point. This is the delinquencies, [slide 26] subprime delinquencies are going up, right? Look at the prime numbers, they’re going up just as fast. All these prime, Alt-A, everything, everything’s going up.
It’s just that subprime — look at the Y scale over here — these are big numbers. You know, in the subprime world, you have delinquencies and default rates that are, like, 4 or 5 or 10 times what they are in the prime world. So that’s why the numbers are so difficult to deal with. It’s not that the rate of increase of defaults are worse, it’s just that they’re starting, it’s just such a big number.
And finally I think I agree here with some of the comments that were made earlier. Even though only 3 percent of the houses might be at risk of a default from this process we’re talking about in subprime world, in the last 3 or 4 years it accounts for 40 percent — between Alt-A and subprime — between 40 percent of the market. [slide 27]
You take that out of the housing market and that’s a big vacuum. That’s really going to hurt the new home sales, the new home sales and the whole housing market, so I agree with that, it’s really, we’ve really just begun to see the pain from this part of it. It’s not really the subprime default rates that are going to kill us, it’s going to be the lack of subprime funding that’s going to go out there to fund those loans — and it’s been going out there the last 2 or 3 years.
What that number is and how that impacts the overall economy. You’re a better judge of that, I don’t have a good idea what [inaudible] One last comment. In terms of the impact on two other groups of people. The impact on the banks is marginal. The only big banks who are involved in it, it’s just a small part of their business. Even HSBC, it doesn’t bother them. It’s too small. The independent investment banks claim that it’s like 3 percent, right? Goldman 3, Bear 3 Lehman 3, something. The most, you know, 2 or 3 percent of their revenue is coming from this business. You shrink it in half, it’s not going to be a big deal.
So Wall Street is going to take some hits here and there — trading desks will get hit, but it’s not going to be a serious systemic problem.
Who owns this stuff? The subprime … first of all, 75 percent of the subprime securitized product in subprime, 75 percent is triple-A. You’re home free, not a problem. I can stress these numbers as much as I want and that triple-A guy is not going to get hit. His spreads might widen out a bit but he isn’t going to lose a dollar or principal.
That’s good, because Freddie and Fannie owns about half of that. So they’ve got about half of that risk. It’s triple-A, it’s not going to go anywhere. So 75 percent of the subprime market is not a problem.
The lower rated tranches triple-B minus, those guys, they’ve got problems — they’ll get hit. Some of them will go down, half of them will go down. People who own the equity pieces will down, but that’s spread all around the world. It’s spread out into private money coming out of Central America, it’s State money coming out of China, it’s Hedge Fund money coming out of Europe and America, it’s all over the place.
So the guys who are going to get hit with this in the capital markets from losses in here and losses in the CDO market, are all around the world. It’s really spread out, and this is back to your question about who’s got the risk, it’s just all over, so in a way that’s good, not bad, right? It’s not concentrated it’s all over the place. So I don’t see that as a systemic problem. Whether or not the corporate side starts to get the same things, then you realize that the corporate risk is of a different magnitude.
If it all happened together, yes that would be a different issue. Just the subprime world itself, and its Alt-A cousin, together is not going to be the kind of numbers which would create this systemic financial kind of crisis. It’s going to weigh heavily on the housing market in the next few years.
Alex Pollock: Maybe on that relatively hopeful note we’ll end, Tom, Thanks very much. And thanks very much to the panel for excellent presentations. Let me give the members of the panel a minute, if you want, to make any further comments that occur to your mind, or responses to other speakers. Anybody? Desmond?
Desmond Lachman: Yeh, I was just a little bit surprised why Thomas [Zimmerman], after making a presentation like that, describes himself as being relatively optimistic. [laughter] I thought that what he’s telling us is that there is going to be a lot of defaults, that’s there’s going to be a lot of foreclosures, that more of these houses are going to be turning onto a saturated market, that prices are going to decline and that his HPA ratios are going to go into the wrong direction, and we’re just going to have more defaults. So I would have thought, if I’d looked that closely at those numbers, I would have been a lot more worried about a vicious cycle and that more downward pressure on house prices going forward. But then I’ve got an optimistic view of the world.
Peter Wallison: Other comments? Nouriel.
Nouriel Roubini: My other comment that follows up the one by Desmond is that — if the [??] thing about the general equilibrium effects about these things. As we said, may not be just subprime, might be spreading to other parts of the economy. I think that crucially what’s going to happen to home prices is essential, because you can get into a vicious circle there. If prices are falling, home equity — values are falling the withdrawal is falling and then you have a vicious circle. And then from that point of view you have — that the crucial thing is that if you look at what’s going to happen to the excess supply or glut of inventory of new and existing homes, it’s going to just get worse.
It’s true that housing starts have fallen, but in the last few months new home sales have fallen even more, so when you look at the measure about absolutes, share of current sales, debt ratio, unsold homes, is going up. Secondly, deadwood is going to get worse. There is a government study, that suggested actually that the effect just alone of subprime, the shrinkage of that market, might reduce new home sales by 200,000 this year alone. They are already down to 844 [1,000s] last month from a peak of something like 1.4 [1,000,000s] so if you get another 200,000, falling demand, that’s an excess supply of new homes on the market. And that’s only one channel — you’ve got three other ones on existing homes. You’re going to have all those guys who go into foreclosure — and then the bank owns the thing and six months down the line they’re going to dump it on the market. That’s an excess supply of existing homes. You’re going to have the people … the speculative stuff, and now you’re seeing their home equity is shrinking, and therefore they have to sell as fast as they can before they get a loss. So that’s an excess supply over there. [1:19:11]
And you’re going to have also lots of people that have these resetting ARMs, and they have to decide — What do I do? If I can afford it, I try to sell the home and try to have a distress sale or short or whatever not. So if you think about the channels through which you’re going to have an increase in the supply of homes, both existing and new ones on the market, I think that the situation is that the excess supply that we see today is going to get worse. If that’s going to happen, home prices fall even more, and you get all that vicious circle effects of that on values of home, home wealth, home equity withdrawal, on consumption, on demand, on supply, and so on. So that’s the things from a general equilibrium point of view you have to worry about.
Alex Pollock: Any other comment before we open it up? OK, let’s — We’re going to open the floor to questions. If I could remind you all how this will work [1:20:00] … Dan Geary, who is here with a microphone — first of all please wait for Dan to get to you with the microphone and — I’m sorry —
Dan Geary: We have another microphone on the other side.
Alex Pollock: Oh, there’s another microphone over here, OK, thank-you. First of all wait for the microphone to get to you. Secondly, if you would then tell us your name and your affiliation. And then your question. … And let’s open the floor. [laughs] I see a hand here.
Bert Ely: Bert Ely, banking consultant. You know an interesting question here is what are the underlying causes of this mess, and in particular what role does securitization play in it. And I’d like to just read to the panel this … what I thought was an interesting comment that the moderator made yesterday in a Congressional hearing and get your reaction to him. He said, "securitization typically breaks the link between the originator of the mortgage loan and and who actually bears the credit risk. This usually results in riskier and less careful lending. The financing engine of the subprime mortgage boom was securitization. This structure has greatly suffered, as is now clear. From just this break in credit decisions, from credit risk breaking / risk bearing. The subprime mortgage financing system is very far from this ideal of linking credit risk to the lender."
What are your thoughts about that and, in particular as we look ahead, both in terms of what will happen in the marketplace and from a public policy standpoint, what does this say about the fate of mortgage securitization particularly in the subprime area.
Alex Pollock: Outside of the fact that the comments were brilliant, we’ll see if the other panelists want to react. … to the question, the question is, the breaking of the credit decision from the credit riskbearing.
Tom Zimmerman: Right, but all these financial innovations, I know, I come out of a commodity background and a lot of people were really concerned about all the speculators in the corn markets several years ago, you know. You get a lot of financial innovation, and a lot of risk gets passed around to different people — is that good or bad? I don’t … that’s been debated for the last hundred years I guess. And securitization is just one more of those advances that allows … you know there was one time when we had a mortgage market that was, you know, done mainly out of the thrift industry. And now was it good to get away from those local decisions where every banker knew his customer? I mean, maybe that was the best way, maybe we should go back to a thrift industry where the thrift would actually know, ‘Mr. Jones, I know you and your family and we’ll take care of you.’ Yeah, things are different, we’ve moved ahead, but I’m not arguing that’s not part of the problem, I’m just saying I doubt if we’re going to go back. It’s a proven mechanism for transferring risk, moving, you know, moving risk around, owning what part of this risk you want, whether you want to be a servicer, you want to own the risk of the loan, you want to own the servicing, none of the above … I agree that there in all these markets there is this dislocation between, often in the …
Here’s a great story, a friend of mine went to Japan a year ago, was talking with one accountant, and he was talking about investing in some subprime securities, and the accountant said, ‘no, no, no, I don’t want any subprime securities, I want a CDO.’ [laughter] So, you know, that’s, yeah, there’s an issue, but I …
Alex Pollock: Thanks Tom, Chris?
Chris Whelan: Yeah, Bert’s absolutely right, I think, if I understand the implication, the union between the Wall Street sales machine and the origination of the loans is why we have this issue. When the Street figured out that they could buy production from everybody and anybody, and package it up and sell it, and make more money on that than on almost any other product in the house except for over-the-counter derivatives, which are about the same magnitude, that was the boom, and if you just look at banks, if you exclude the independent broker-dealers, what else were they going to do to make this kind of money.
I mean I was telling people at lunch today … I have friends in the banking business in North Jersey who had clerks who were filling out loan applications who made hundreds of thousands of dollars in a single year, just on commissions from their production. That’s another red flag, by the way. But I think ultimately you’ve got to remember that the deals that are rated investment grade oftentimes are rated that way because a rating agency gave them that blessing based on the collatoral and the enhancement, and there’s probably a hedge fund or somebody else who’s provided a credit derivative enhancement to that structure, and they may have to be called upon to perform. And if we see default rates go back and achieve the same levels we saw in the early 1990s or higher, which is what some of the data you’ve seen today suggests is possible, then we’re definitely going to stress those assumptions. And I think you’re going to see not only rating agencies, but a lot of hedge funds who have been writing default insurance below economic rates really get into a lot of trouble.
You know, go back to what I was saying before. People were being paid a point or two points a year in a premium on a credit derivative contract to insure a portfolio that’s going to throw off ten or fifteen percent a year defaults. You know, what’s wrong with this picture? And that to me is the underlying issue, really, with Bert’s question is, you know, these securitizations are seen as good sales. But maybe they won’t be, but we’ll leave that up to the trial lawyers.
Alex Pollock: Let’s have another question … yes here Dan.
Elliot Levy: I would like to ask the panel …
Alex Pollock: Could you identify yourself please, first?
Elliot Levy: Elliot Levy, I’m with the Department of Commerce. I would like to ask the panel — what are their feelings about the manufacturing side of construction like the timber cutters, like Boise Cascade and Weyerhaeuser, Georgia Pacific, and the builders of construction machinery like Caterpillar, Kohler — plumbing pieces — plumbing from Kohler, tools from Dewalt, …
Alex Pollock: Nouriel, this gets into your general equilibrium issues I think.
Nouriel Roubini: I think that’s a valid point, but again when I think about general equilibrium when you talk about housing the usual argument was made was you cannot get a recession out of housing because it’s only 6 percent of GDP. The same thing was said of the tech sector. They said it was only 4 percent of GDP. There was a bust, you won’t get a recession. It’s because you are forgetting the linkages of the economy.
I’ve looked at these numbers. About 1/3 of all employment creation in the last six years is directly or indirectly related to housing. I want to talk about employment. There’s also construction and the other industries are related. When you think of it, you don’t just have construction workers. You have also all those mortgage brokers, millions of them. You get the real estate agents. You have all the mortgage financing industry, you have all the manufacturing industry related to housing from building materials to all the home appliances and all the rest. Once you look at the chain of links, a third of all the demand for pick-up SUVs is just coming from contractors that need them for building homes. It’s not just people buying them for recreational stuff. So if you think of the entire kind of linkages between the economy, the idea that this is only 6 percent of the economy and the rest is not going to be effected does not make any sense and we’re seeing it right now. It’s no surprise that now after a housing recession we have an auto sector recession and we’re having a manufacturing recession. And it’s spreading now to investment firms having excess capacity, they’re cutting investment. So it’s spreading to other parts of the economy.
Alex Pollock: Desmond, further?
Desmond Lachman: Yeah, I would just add, I wouldn’t disagree with what Nouriel said, but I would say that’s it’s not really just affecting 6 percent of the economy, it’s rather affecting 70 percent of the economy in the sense that housing is the main component of most people’s wealth. And if we do get, if we move from a situation where we had prices, house prices increasing by 10 percent, in other words people’s wealth increasing to one where the wealth is actually declining, then we’re not just talking about 6 percent, we’re talking about how this is going to be affecting people’s consumption behavior in general. So I think that the problem just goes way beyond the housing sector, the construction sector narrowly defined.
Alex Pollock: … OK, thank-you. I’m going to … I’m going to get this question here, and then we’ll come back here. Yes, here.
Gary Berman: Hi. Gary Berman, Tricon Capital. It’s amazing to me how the statistics tell two stories. Desmond, if you actually look at your Shiller chart, you actually figured out what the tager(?) is from 1890 to 2006. It’s actually 70 basis points. So that’s the annual growth in house prices, constant house prices. It’s kind of interesting to look at it. And that leads me to my question, which is — statistics are often trailing indicators. The media is often late to the party. Does anyone on this panel think that the actual mess that we are in are already baked into the numbers? So for example if we look at housing sales, new home sales, they’re 850,000 as you said Nouriel. That’s way below what they had been. Is that maybe the new benchmark where we’re at? Or if we look at vacancy rates, they’re 2 1/2 percent, way higher than what they are. Are these statistics already reflecting the problems [1:30:00] that you’re seeing in the market, the anecdotal information you’re talking about?
Alex Pollock: Somebody want to take that?
Desmond Lachman: I would think that they are only reflecting the beginning of a process that is going on. You know that we are just at the start — that the bubble has burst. You’ve had this huge boom, that if you just look historically at previous busts we’re nowhere nearly towards the end. I think that in many senses, a lot of this is baked in the cake. That if you look at housing starts, the fact that housing starts have dropped by something like a third, we know that housing construction / completions take 2 or 3 quarters later, so what’s already occurred on the starts is telling you where the rest of the economy’s going. But I would look at it rather more broadly, that this is a dynamic process in the same way as you have dynamics driving the cycle up, we’re now at the stage where the dynamics is driving the cycle down and in my view it’s pretty much baked in the cake — what happens after the next couple of years. Now the only issue is how aggressively does the Fed try to resist this, to put a floor, as Nouriel says.
Alex Pollock: Chris? …
Chris Whalen: The one interesting observation I would like to make listening to Desmond is that on The Street, if you talk to risk analysts, especially the younger ones, there’s a tendency to only look back 5 or 10 years for your benchmarks on credit quality. So many of them are looking at 2001 / 2002 as their reference point, saying that’s as bad as it can get. And the observation I would make is that the head-fake we all may be the victim of is maybe we go to "ex" that. Maybe we exceed the early 90s because of the house price appreciation. When you see collateral move that much in value, and you notice the way that this has distorted investor behavior, the question comes, do we now spend time on the other side of the mean, and rebalance. Because otherwise we just throw the rulebook away, right? [laughs] We don’t need bank capital, we don’t need anything. People never default. And I’m just — having traded through two serious recessions — I have a feeling that we’re going to test the lows in the early 90s in terms of the economic losses to banks. Now the question is, will that appear in bank financial statements? Or will that be buried privately on the books of some mutual fund. As I like to point out to people, you’ll notice there’s been no litigation over the Amaranth failure, but I can tell you as soon as some big public pension fund takes as loss in Ohio or California, they’re going to start coming after some of these brokers for these transactions. You know, this is how you get to be Governor. You’re Attorney General of a state, even if you’re a Republican, you become a public sector trial lawyer. In fact you let them do all the work for you. But that’s … I see that coming and I’ve had some conversations with a number of people who took losses in that failure, and they’re all pretty annoyed, but if you work in the business they don’t like to go aft