Mortgage Banking
November 2007
The mortgage meltdown is deepening, and prolonging the housing recession. A weak housing sector has ripple effects for the rest of the U.S. economy. Financial markets remain vulnerable to renewed turmoil from hidden exposures to subprime mortgages and related derivatives.
By Robert Stowe England
After having several teeth pulled out in the most painful way, the mortgage industry awoke the next morning to discover there is no Tooth Fairy. More to the point, surviving players in the mortgage industry now realize they were living in a fairy tale before last summer, when they expected a soft landing for the housing market. In fact, now everyone knows there is no soft landing in store for the housing sector-and possibly none for the economy, either.
The question now is how much damage the mortgage meltdown will have on the housing sector and whether or not it will pull the whole economy into recession.
Most economists see the potential for a recession, but differ on the odds of it occurring. "I think the effect of the [mortgage] credit crisis is to vastly increase the odds of a recession in the first half of next year," says David M. Jones, chairman of Investor security Trust Co., Fort Myers, Florida, and president and chief executive officer of DNJ Advisors LLC, Denver.
For some market watchers, the negative effect of the mortgage meltdown has already been clearly demonstrated. "Late last year, it looked as though single-family home sales were stabilizing. That led to the view expressed by me and others that perhaps the end to [the] housing decline was not too far off," says Lyle Gramley, former Fed governor and senior economic adviser at the Stanford Group, Washington, D.C.
"Then we had a meltdown of the subprime market, and single-family home sales then fell another 10 percent," Gramley adds. "Since mid-July, we've had a generalization of the problems in subprime to all other sectors of the mortgage market as well, affecting different segments of the mortgage market to varying degrees. And those other sectors comprise [the remaining] 80 percent of the total market [outside subprime]," he explains, referring to lending by any party. The subprime fallout effect is seen in portfolio and securitized lending, he says. It even affects conforming, conventional loans-not so much on pricing, which has remained close to where it was before the crisis, but in "a tightening of nonprice terms," such as the amount of down payment required, the allowed debt-to-income ratios, required FICO® scores and so forth, Gramley says.
"The problems outside subprime have not been as acute, but there is simply no doubt that it is going to have a significant negative effect on the housing industry [going forward]. I think we face a situation in which the decline in housing [as measured by new-housing starts] may turn out to be the worst in the post-war period," Gramley says.
Mortgage woes
The mortgage market is facing supply constraints in the wake of the collapse of the private-label residential mortgagebacked securities (RMBS) market. While slackening demand is a factor, the lower availability of mortgage financing, along with sharply higher rates for many mortgages, is a key reason that existing-home sales fell 4.3 percent in August to a seasonally adjusted rate of 5.5 million units. That was down from the 5.75 million level in July and 12.8 percent below the 6.31 million-unit pace of August 2006, according to the National Association of Realtors® (NAR), Chicago. (September data were slated to come out too late to be included in this story.)
Lawrence Yun, senior economist at NAR, cited the turmoil in the mortgage market as the chief reason for the fall in home sales. "The unusual disruptions in the mortgage market, including a significant rise in jumbo loan rates, resulted in a fairly high number of postponed or cancelled sales, with many buyers having to search for other financing when loan commitments fell through," he says. "Lower sales contributed to a buildup of unsold inventory," he adds.
The "disruptions" in the mortgage market include, of course, the complete collapse of the private-label RMBS market, which had represented a majority of total RMBS originated in 2006.
The high-powered Wall Street engine that drove the housing boom and captured as much as 57 percent of the RMBS market in the second quarter of 2006, according to Inside Mortgage Finance, was dead, at least temporarily, with no clear idea when it would be revived.
In the aftermath of the summer breakdown in the privatelabel market, the mortgage origination landscape is radically changed.
Explains Doug Duncan, chief economist at the Mortgage Bankers Association (MBA): "Anything that's not Fannie [Mae], Freddie [Mac] or Ginnie [Mae], or [is a mortgage] somebody isn't willing to hold in portfolio, is not being done. Anything that's in the jumbo, alt-A or subprime space is only being done to the extent that a bank will put it in portfolio," he says.
Some portfolio lenders are moving to fill the gap, Duncan adds. "At the biggest banks that have well-established logos, the volume of business is way up. Even so, even the big banks have a number of limitations that restrict their ability to take on mortgage loans," according to Duncan.
Portfolio lenders face three restrictions that limit their ability to take on portfolio loans, he says. First, "Capital is limited, and every whole loan you put on your balance sheet requires more capital, for example, than an MBS," Duncan says. Portfolio lenders, then, are constrained by the amount of capital they want absorbed by whole loans. "secondly, in the portfolio, they typically will hold [mortgages] in the category called 'loans held for sale,' and the accounting treatment of'loans held for sale' is that they have to be marked to market continually," he adds. "If a sale takes place in the securities market shortly after they've booked it, and the valuation is lower than what they booked, they have to mark to market and take a hit to earnings," Duncan says. "Thirdly, they always have some diversification objective, and it's possible that the earnings on [mortgages held in portfolio] would alter their diversification strategy-because [even though] the payoff would be there, diversification is an issue for them to consider."
When asked how voluntary portfolio-lending limits might be imposed from diversification considerations, Duncan explained: "Banks in their portfolios hold many different kinds of assets. Some of my peers at banks will manage the asset-liability selection committee or be the chief risk officer of the company for portfolio risk," he says.
"Different assets have different levels of correlation with one another in terms of performance. So, for example, homeequity loans' performance is going to be highly correlated to first mortgages, but much less correlated to the performance of, for example, working capital loans to small business. And so, when you start to grow one section of your portfolio relative to the others, it changes the overall correlated risks in your portfolio," Duncan adds.
Is the goal to avoid having everything correlate? Not exactly, he says. "You want to understand the correlations. Sufficient compensation for the risk will lead you to change the composition of the portfolio, but you have always to be cognizant of the correlation," Duncan says.
"If you dramatically grow one portion of the portfolio, which is highly correlated to two or three others, you are not just increasing the risk held in that portfolio, but the risk in your overall portfolio or several portions of your portfolio. You may be willing to do that because the returns from taking on that risk are substantial. That's a fundamental tenet of portfolio management," he says.
"The net result of all [three constraints on lending by portfolio lenders] is that the interest rates on nonconforming [loans] have risen substantially. Risk spreads in that part of the market have widened out," Duncan says. The suddenly higher rates lenders are charging for jumbo mortgages have raised some questions from borrowers and the press, he notes. "I've had some reporters calling and asking, 'Why are you abusing jumbo borrowers?' And the answer is, 'We're not.' There are rational economic reasons why institutions are managing their risks by that pricing."
Looking for a bottom
Not surprisingly, economists differ on their estimates for when the housing market will hit bottom, as measured first by reaching a peak in inventory and, finally, by a bottom in the decline in housing prices.
Mark Zandi, chief economist at West Chester, Pennsylvania-based Moody's Economy.com, sees house prices falling more than others. This is partly because he believes the impact from the turmoil in the mortgage markets will be stronger than some others are suggesting. "I think it's a significant blow to the housing market. It's resulted in the effective shutdown of what was last year half the origination market," says Zandi.
"Subprime and alt-A lending [have] been frozen, and jumbo lending has been severely disrupted," says Zandi. "That means less housing demand, because there will be fewer home sales, and it also means more mortgage defaults and foreclosures and thus more supply thrown back on the market. Given the already mountainous level of unsold inventory, it's going to cause construction and house prices to fall sharply, particularly in California, Florida, Arizona, Nevada and parts of the Northeast corridor," he says.
Zandi predicts that national home prices, on average, will fall more than 10 percent from the peak of the housing cycle in the fourth quarter of 2005 to the bottom in the fourth quarter of 2008. So far, he estimates, average prices across the nation are down 4 percent. The average home price across the nation could fall another 7 percent to 8 percent overall, Zandi says. The price declines will be greater in the markets that were the most heated during the boom. In those markets, Zandi forecasts, home prices will decline 10 percent to 30 percent.
"The most severe declines will be in Florida and in the central valley of California," he says. Declines in Florida will be steepest in Fort Myers, Naples and Miami, as well as in communities north of Palm Beach, including Port St. Lucie and Palm Bay. Zandi also predicts home real estate markets will fall hard around much of California, Nevada and Arizona, along with the Washington, D.C, area, coastal New Jersey and Long Island, New York.
"This is where the housing markets were the most frenzied, where speculation was the most rampant and lenders were most aggressive. This is also where there was a fair amount of fraud. That's also contributed to the current downturn," Zandi says.
Was overbuilding a key factor in the housing bust? "Overbuilding is a significant part of it," says Zandi. "If I were going to rank-order the problems. It would be [as follows]: the aggressive lending first, the
speculation second, and it would be the overbuilding third."
Zandi estimates that in the "juiced-up markets," that onethird to one-half of the purchases in 2006 were speculative. "Some were to short-term investors. Others were to longerterm investors [and baby] boomers looking for a second vacation home. But a fair amount of it was short-term investment. The condominium market is obviously the market most at risk, particularly in Florida," he says.
One mitigating factor that could limit the expected carnage in the markets that were once sizzling is demand for housing by foreigners in key markets, such as New York, Miami, parts of the Washington, D.C, area, San Francisco and the Bay Area, and, to a lesser extent, Chicago and Boston. "The strong global demand is one of the reasons the neighborhoods close in to D.C, Miami and the [San Francisco] Bay Area have held up better than you would expect," Zandi says.
When will inventory peak? Zandi predicts it will peak as soon as the fourth quarter of 2007 and perhaps the first quarter of 2008. "I think we'll see some sharp declines in construction as we make our way to the first part of 2008. And I do expect sellers to cut price to revive demand in early 2008."
Some major builders have held auctions and have done mass one-time price cuts and sell-offs of inventory. That, however, may not be enough to be bring inventory in line, according to Zandi. "They need to cut prices consistently across the board," he says. "More importantly, we need to see existing home sellers-where most of the unsold inventory is located-to start cutting price more aggressively," he adds.
Meanwhile, Zandi says, builders need to reduce new construction, which fell to 1.33 million housing starts annualized in August. "They need to pull that down to 1.1 million and keep it there for a while-six to 12 months," he says.
Worst decline since the Depression
If average housing prices across the nation actually decline 10 percent from peak to trough in the current housing bust, it will be "the worst decline since the Depression, when prices declined by one-third," Zandi says.
He predicts new-housing starts are likely to fall to their lowest level since the recession of 1990-1991, when new-housing starts fell below 900,000 units.
"The only way it will get lower than that is if the economy goes into recession." Zandi's forecast on home prices and new-housing starts is based on the assumption that while the broader economy weakens, it does not fall into recession.
"There are some fundamental strengths in the economy, but the principal reason [the economy will stay out of recession] is that the policy-makers are aggressively trying to shore up the economy," he says.
Fed's actions improve outlook
The actions of Federal Reserve Chairman Ben Bernanke have been perhaps the single biggest factor in reducing the odds of a general recession, according to most economists. On Sept. 18, the Fed cut the discount rate 50 basis points from 5.75 percent to 5.25 percent, and cut the Federal Funds Rate 50 basis points from 5.25 percent to 4.75 percent.
Absent those actions, would the economy be headed into a recession? "Yes, very much so," Zandi says. "I think the most important result of that action was to buoy confidence in the financial system, and ultimately among consumers and businesses." Zandi also notes that both Congress and the Bush administration "are now engaged and acting" to limit the damage from the mortgage turmoil and the housing recession.
"So far, the steps have been small-but I think they'll get bigger," he suggests, noting President Bush's announcement of the FHASecure program and the decision to allow the government-sponsored enterprises (GSEs)-Fannie Mae and Freddie Mac-"to expand their portfolio[s] a bit more quickly."
Zandi thinks Congress will pass legislation backed by the administration to allow the loan-limit caps to rise temporarily to allow for lending in high-priced markets such as California and Florida.
Robert Shiller, professor of economics at Yale University, New Haven, Connecticut, is another economist who foresees significant further declines in house prices. So far, there has been a 4.5 percent decline in the 20-city S&P/case-Shiller® Indexes of home prices over a period of 20 months, ending in July 2007. (The CSI are market-specific indicators of homeprice changes based on the repeat-sales methodology.) That's a decline of 6.5 percent in real terms, when one adjusts the prices for inflation, Shiller says.
The futures markets for the CSI, which are traded on the Chicago Mercantile Exchange, "are predicting substantial declines, notably in Miami [and] Las Vegas," Shiller says, where the futures markets are pricing in another 10 percent decline. The futures market is predicting a decline of 5 percent to 10 percent in other cities, Shiller adds. The CSI is traded individually for the 10 largest metropolitan areas and as a composite. "They've been consistently in degradation," Shiller says of the prices in the futures market.
"If you take those forecasts of a 10 percent further decline on $20 trillion housing values, that's a loss of a couple of trillion dollars," he says. "We've already lost over $1 trillion since the peak. And we stand to lose another couple trillion, if markets are right," Shiller says.
That fundamental change will show up on a lot of balance sheets. It means the value of the collateral backing a lot of mortgages will fall significantly. "It's a big thing," he says. It can potentially promote "a downward spiral on prices" and foster a curtailment of mortgage credit, Shiller suggests.
When will the housing market come back? "I'm not optimistic it will come back soon, given the continuing decline in collateral value," Shiller says.
However, he adds, in some areas of the nation, the real estate markets may already be on the mend. "Prices in the Northeast have risen," he says. He notes that the index for Boston is up 2 percent since February. "That's quite remarkable. That's why I temper my enthusiasm for talking about [future] declines," he says. Shiller also cites Denver as a newly strong market, where prices have been rising since March.
However, Shiller believes residential real estate in California could suffer a prolonged downturn that could be worse than the long and deep housing recession it suffered in the 1990s. By Shiller's calculation, Los Angeles prices dropped 40 percent in real terms (adjusted for inflation) between 1989 and 1997.
"Los Angeles again is a very troubled city," he adds, with a 4.8 percent decline in July over the previous July. Shiller also sees trouble ahead for Miami, which he noted was not affected much by the 1980s boom, but has been a key player in the housing boom in this decade. "The turnaround in Miami has been spectacular. The Miami index is now dropping at an annual rate of 20 percent," he says.
Shiller also says the Washington, D.C, area is falling "at a good clip"-7.2 percent year-over-year in July. "New York [City], especially Manhattan, appears stronger than the city as a whole," he says, while the whole New York metropolitan area is weak, with a 3.8 percent decline year-over-year in July. Troubled Midwestern cities, where unemployment is high, continue to slump. Detroit, for example, was down 9.7 percent from a year ago in July.
Despite worries over these troubled markets, not all is doom-and-gloom. The National Association of Realtors found a silver lining in the August rise in the median price of a home, which rose 0.2 percent from July to $224,500. In August 2006, the median was $224,000.
Overall home sales, however, declined in August to an annual pace of 5.5 million from 5.75 million in July, representing a decline of 12.8 percent below the 6.31-million-unit pace of August 2006. Total housing inventory rose 0.4 percent at the end of August to 4.58 million existing homes available for sale, representing a 10-month supply at the current sales pace. That rose from a 9.5-month supply in July.
NAR's Yun found some cause for hope in the numbers for the Northeast region, where the median home price was $282,300, up 3.6 percent from August 2006, even as sales fell 5.7 percent to an annual pace of 1 million.
"The Northeast was the first region to go into a slump," Yun says, tracing the beginning of the slump in the Northeast to the fall of 2005, when sales turned negative. Median prices turned negative in the Northeast in August 2006. The Northeast registered its first median price increase in May 2007, Yun says.
"In recent months, the Northeast has been outperforming the rest of the nation," beginning with its first median price gain in May 2007, he says. August was the fourth straight month the median price in the Northeast had been up, with the average for the last three months at 3.7 percent-"a fairly decent price gain," Yun says.
The NAR data reveal that the West is the most troubled region, with a 9.8 percent drop in existing-home sales to an annual level of 1.01 million, 21.7 percent below August 2006. The median price in August was $332,300, 3.8 percent below the level of a year ago.
Impact on the economy
Yun predicts that the slump in the housing sector will hold economic growth to a 2 percent level for all of 2007. It will not tip the economy into recession, he says, because "business spending is solid and export growth is solid." He predicts that in 2008 home sales will be higher than this year and median prices will also rise, followed by an even better 2009.
Shiller calculates the probability of an economic recession at greater than 50 percent, due mainly to the effect of declining home values on the pace of consumer spending. "When asset prices go down, people are likely to spend less," he says.
Shiller notes that most economic models used to make forecasts do not include a measure of the impact from a collapse of a large portion of the mortgage market on the economy. A lot of blows have hit the economy, and it keeps on chugging, Shiller says, citing the end of the speculative boom in housing, higher oil prices and hits to financial infrastructure. "We've survived that, [but at the same time] it makes people a little bit more edgy," Shiller says. "If we see a lot of foreclosures, it could be interpreted negatively for the economy," he adds.
Shiller notes that the last time foreclosures rose dramatically, during the 1930s, "it had a powerful impact on confidence and led to a powerful regulatory response" in Washington. "I suspect we will see that. Congress is not going to sit idly by with houses in foreclosure. They won't sit idly by while millions of people lose their homes," he says.
People are edgy-not just about the economy, but about systemic risks, particularly to financial institutions, Shiller says. He suggests that one thing Congress should do to address public confidence is to raise the ceiling on Federal Deposit Insurance Corporation (FDIC) deposit insurance.
"It has been fixed at $100,000 since 1980," he says. "If you take that as a ratio to income, it has lost 85 percent of its value, because incomes have grown in real and inflationary terms." A $100,000 account is not such a big account anymore, he adds.
"The risks are the same as those that faced Northern Rock. That could happen here," claims Shiller.
A run on Northern Rock pic, Newcastle upon Tyne, England, began on Sept. 13 and depleted the bank of $4 billion in deposits in a matter of days, according to a Sept. 16 BBC report. Northern Rock's chief executive officer, Adam Applegarth, declined to give a figure-or confirm or deny the BBC report, according to USA Today. Customers were lined up around the block to take out their deposits at branches all across Britain. The run was halted Sept. 19 only after The Bank of England took the extraordinary step of guaranteeing all the deposits in the bank as of that day. Northern Rock is one of Britain's largest mortgage lenders.
Shiller notes that the Federal Housing Administration (FHA) was created during the last big housing crisis in 1934, and it served as the subprime lender in this country. "It did not do lending. It made possible subprime lending. It has lost its share of that market," he says. He thinks that the current housing bust will lead Congress to expand the roles of both the FHA and the Department of Veterans Affairs (VA), which guarantees home loans made to veterans.
More rate cuts on the way?
Some economists and Wall Street observers believe the Fed will need to lower the Fed Funds Rate further to prevent the economy from falling into recession. The sudden reversal in tone at the Fed on Aug. 9, when it announced the first 50-basispoint cut in the discount rate, signaled a change of heart by Chairman Bernanke and the Federal Open Market Committee (FOMC), which had only a few days earlier signaled they were still predominantly concerned about inflation.
"Bernanke's calculations were completely wrong when he said earlier in the year that damage would be confined to the subprime sector," says Investor security Trust Co.'s Jones. After Bernanke's reassurances in late spring that the subprime fallout was contained, the subprime contagion knocked out two hedge funds at New York-based Bear Stearns Co. Inc. It then spread around the globe hitting financial institutions with any connection to U.S. subprime and others, eventually knocking down two funds at Paris-based BNP Paribas on Aug. 9. Problems at two funds at BNP Paribas, in turn, helped prompt a big global sell-off in stocks.
"The biggest shock of all is that [ BNP Paribas] couldn't determine the net value of those accounts," says Jones.
On Aug. 10, Bernanke indicated the Fed would supply emergency liquidity, and a week later it cut the discount rate by 50 basis points. What is important, Jones says, is that the Fed also announced it would accept mortgage-backed securities as collateral for banks that wanted to borrow at the discount indow. This dealt directly with the "total breakdown" of the private-label RMBS market, says Jones.
"In all my whole career, I never remember a market like this," Jones adds. In the months since then, people are still unable to determine the value of existing private-label mortgage securities, he says. "No one will buy them," so there's no way to determine their market value-and holders of the securities are then stuck with the mark-to-model method, which is wholly inadequate in determining the value of the shares in the current market, Jones says.
Beyond the mortgage market, panic led to the negative fallout in asset-backed commercial paper and high-yield corporate bonds in the United States and abroad. "We're in the process of a major repricing and deleveraging of risk" around the globe, Jones says-and the process is not over yet.
Systemic risks
The markets and financial institutions remain susceptible to further fallout from the ongoing credit and liquidity crisis, Jones says. However, he adds, this time the situation is different from the credit and liquidity crises that erupted in 1998, which led to the bailout of Long-Term Capital Management by banks in a coordinated effort led by the New York Fed.
The situation today does not have the structural risk that was present in 1998, partly because there are more complex structures surrounding mortgage securities, which have spread the risk widely around the globe, he says.
Uncertainties and fears due to a lack of market transparency about where the risks reside can become so great that, at times, "lender confidence is so shattered, banks are unwilling to lend to one another," Jones adds. The Fed's efforts to pump emergency liquidity into the system allowed banks to use collateral-such as MBS-they could not otherwise use to borrow from the Fed. This effort restored liquidity to the banking system, he says.
Jones, speaking from his office in Denver the day the Fed lowered the Federal Funds Rate 50 basis points, said he believes the Federal Funds Rate needs to fall another 50 basis points to 4.25 percent to fully restore lender confidence. "This will help maintain liquidity in the banks, and it will also steepen the yield curve," Jones said, "which will improve the profitability of depository institutions [because they] will have a lower cost of funds at the same time they can lend out at higher rates," he says.
Shiller also suggests that the Fed rate cuts taken so far have been based on worries about systemic risk. "I think they are worried about system effects, and they want to nip that in the bud. That's why [the step to make two 50-basis-point cuts on Sept. 18] was perceived as such a dramatic response," he says.
"I didn't think that was a big cut," Shiller says. He notes, "It was hardly bigger than the decline in inflation, and in fact, it was only keeping the rate the same," when adjusting for lower inflation. Shiller also believes the market now expects the Fed to make more rate cuts. "The Fed tried hard not to encourage that expectation, and that's why their statement was ambiguous," he says. One can see the expectation by investors of future rate declines in the Federal Funds futures market, he adds.
Zandi, too, sees some element of continued systemic risk. "Is there any systemic risk out there? Could we have another round of problems? Yes, we could," he says. "Because I do think there is a significant amount of the credit risk in the mortgage market that has not yet been fully priced or recognized. I think the place where it's most likely to show up next is in the banking system. And we've seen problems among lenders and borrowers and investors, but really nothing from banks. And now the banks are very highly exposed to what's going on," he says. The banks "are the financial backstops to the financial markets, and they're being stressed," he says.
"All this commercial paper that's rolling over and not being purchased is ending up on bank balance sheets as conduits use their bank lines. And if you look at banks' holdings of mortgage securities and even whole loans, and consider their construction and land-development portfolios that finance home building, they've got a very, very significant exposure to the housing mortgage market-and we've not heard a thing from them," Zandi says. "I suspect if there's another shoe to fall, it's in the banking system."
Cutbacks in home sales and mortgage lending are already adding to the downward pressure on economic growth rates, according to Zandi.
"One reason the broader economy will be weakened is because layoffs in the housing-related industries will continue," he says. Over the next 12 to 24 months, the level of layoffs will be significant. During the boom, between early 2003 and early 2006, there were 1.3 million jobs created in housing-related industries, Zandi says. "Since early 2006, we've lost 300,000 jobs," he says.
Meanwhile, home sales and housing starts are already below their 2003 levels and falling. "That would suggest we have a lot more layoffs to come," he says.
Risk premiums and aggregate wages
Gramley suggests watching two key indicators in terms of anticipating the potential fallout from the housing recession and the turmoil in the mortgage markets: the risk premiums or spreads between non-agency mortgage rates and other rates; and the aggregate level of wages and salaries, which in turn is tied to overall employment levels. If one looks at the spreads, it would appear that "demands for risky assets are rising," says Gramley. This is a sign of the beginning of a recovery.
For example, the spread for jumbo mortgages over agency mortgages was 106 basis points on Aug. 28, according to bankrate.com. By Oct. 15, the spread was down to 64 basis points, but still well above the 20- to 30-basis-point spread that prevailed before the breakdown of the private-label securities market. Gramley attributes these gains to the Fed's leadership in cutting rates. "When the Fed shows that kind of leadership, one can reasonably argue that [in time] things will settle down," he says.
Gramley also thinks the rate cuts will have a positive effect on consumer spending, which, in turn, can be positive for the economic outlook.
"It depends on how much spillover there is into consumer spending. At the moment, consumer spending numbers look reasonably good," he says. An increase of 110,000 jobs in September boosted the outlook for employment after a 4,000-jobs decline was initially reported for August. The figure for August was revised upward to an 89,000-jobs gain when the September estimates were released by the Department of Labor.
If the aggregate wage income of workers declines, Gramley says, it would add to the impact of declining house prices on consumer spending.
"Will it push us over the edge of the cliff into recession? That's possible. I would say, however, the chances are better that we'll sneak by without a recession," he says. Like several other economists, Gramley believes the United States would now be moving into recession without the Fed's rate cuts in September. He rates the odds of a recession at about 40 percent."We've got support from the trade side. Our exports are doing very well. Financial conditions, aside from the credit crunch, are reasonably accommodating," he says. "Interest rates are relatively low by historical standards. We've had a good run-up in the stock market [over] the past several years. The dollar has been declining since February of 2002. Those things are likely to keep us away from recession. But we could skate very close to the edge," says Gramley.
The declining dollar, which can be inflationary, may also put a brake on what the Fed might be able to do. This puts the Fed "in a pickle," according to Bill Gross, managing director of Pacific Investment Management Co., Newport Beach, California. Gross, writing in his company's monthly Web site column for October, stated that if interest rates do not fall fast enough, it could exacerbate the housing crisis. However, if Bernanke chooses faster declines in interest rates, "he risks igniting speculative equity-market behavior" and a run on the dollar, Gross wrote.
In his column, Gross predicted that falling home prices will dominate policy at the Federal Reserve for several years, and he predicted the Fed will cut the Federal Funds Rate to 3.75 percent in the next six to 12 months.
Gross warned that the Fed has yet to come to terms with the "brazen new world" of supercharged private money in shadow banking, derivatives and an alphabet soup of CDOs that does not necessarily respond to Fed policy.
Private-label comeback?
The timing of a comeback for the private-label MBS market remains uncertain. Observers are more confident about the resurrection of the private-label jumbo MBS market than they are of alt-A, while they are less optimistic about the recovery of the subprime market.
What needs to happen for the private-label market to be resurrected? "I think investors have to lose their fears and the panicky ways [in which] they were behaving. That takes time," Gramley says. He does not expect much improvement before the spring of 2008.
MBA's Duncan suggests it will take the leadership of a respected major investor to be willing to come back into the private-label new-issuance market to get the market going again. "You'd have to see someone or some institution who is viewed as a sophisticated party with good private information, that enters the market and establishes a floor," Duncan says.
"Typically in these types of market interruptions, that happens. Someone who has a strong reputation as a savvy investor comes in, in a significant way, from which the market proceeds to build," he says. "This may occur when an investor thinks house prices are close to a bottom, and they see an opportunity to make a good return on an investment," he adds.
The last interruption to the private-label MBS market occurred in 1998, Duncan notes. "It didn't take this long for the market to re-emerge," he says, referring to the time now passed since the private-label MBS market cratered in late July of this year.
The issue in 1998 was not the housing market, but a broader credit-market concern that grew out of the Russian bond default and weakness in Asian currencies, according to Duncan. Back then, the private-label mortgage market recovered as soon as the Fed found private parties to rescue Long-Term Capital Management. Back then, too, "risk spreads stayed wide for the better part of a year," Duncan recalls. "Don't expect the risk spread to narrow [significantly] anytime soon," he adds.
A private investor and former sell-side mortgage finance analyst, Mike McMahon of San Francisco, thinks it will take two to four quarters before investors regain confidence in private-label mortgage bonds.
"Investors will have to wait and watch the performance of the various securities before they wade back in," he says. "Selectively, right now there are entities forming funds to invest in mortgage securities that have been beaten down, perhaps more than they deserve to be," McMahon says. "Others are reacting now-very smart, sophisticated folks-in trying to take advantage of mispriced assets," he says.
"But before pension funds and banks and foreigners resume buying [private-label] mortgage securities, they are going to have to get comfortable that they're all not going to zero," he says. "As far as I know, what we've seen so far, we've seen soaring delinquencies and foreclosures statistics. We haven't seen the losses yet. While everyone expects losses to increase, it is not clear how bad the losses will be and how widespread they will be across mortgage types, prime and subprime," he explains.
In particular, it is unclear whether investors in investmentgrade private-label MBS are going to suffer losses, too, McMahon adds.
"Unfortunately, mortgage-backed securities have become so complicated .. . [that] tranches of mortgage-backed securities are being securitized into additional securities, [and] tranches of those securities are being securitized into a third security," McMahon says. "It becomes extremely difficult to really gauge the expected performance of those securities," he says.
Market observers will continue to watch for potential investor losses in private-label securities. Any recovery in the private-label market will depend on the level of losses that surface during the rest of the year and throughout 2008, as many mortgages originated in 2006 reset.
McMahon says it's possible, if not probable, that there will be another wave of selling to hit private-label RMBS close to the end of the year as funds make an effort to remove troublesome assets from their balance sheets. While earlier in the year there was a big discount sale of AAA-rated bonds by some holders, such as the sale of $22 billion in investment-grade mortgage securities at a loss of $1.1 billion by Santa Fe, New Mexico-based Thornburg Mortgage Inc., McMahon says. The next wave may be a sell-off of the riskier pieces that could not be sold earlier, he adds.
There are investment companies and real estate investment trusts (REITs) that invest in distressed assets that have the capital and balance sheet to purchase such assets, he adds, naming Redwood Trust Inc., a Mill Valley, California-based REIT, as an example. A number of major financial companies are already taking big write-downs on mortgage assets in the third quarter, and more will do so in the fourth quarter, McMahon predicts. This paves the way for managers at these firms to sell the assets later and get them off the books, he adds. "The last shoe to drop will be when they start selling those assets," he says.
Finally, McMahon predicts a comeback for the subprime lending business led by small entrepreneurial firms. "Financial history is filled with instances where everybody runs from one side of the boat to the other," McMahon contends. "For the last three or four years, everyone ran to the subprime side of the boat, competition grew intense, underwriting standards weakened and rationality disappeared, resulting in substantial losses," he says. "Now everyone is running to the other side of the boat, saying, 'We're not going to do subprime.'"
The growing negative investor and lender sentiment and behavior "will create opportunities for some smart people to come in and underwrite [subprime mortgage loans] rationally," according to McMahon. From a small base of entrepreneurs, the subprime market will be reborn, he predicts.
Gramley thinks the rate cuts will have a positive effect on consumer spending, which, in turn, can be positive for the economic outlook.
END
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