Letís do some housing math.  Last fall there were about one million delinquent mortgages.  Let us presume the current figure is now fifty percent worse ñ i.e. one point five million homes.

Assume that the average delinquent loan has a face value of about $180,000, and that a typical mortgage would have a term of from 15 to 30 years to maturity.  Under normal circumstances the borrower would be required to pay about $10,800 per year in interest and principal to amortize the loan.  Because of the variable rate mortgages this cost would be about $20000 per year per loan.

We are told that the housing crises is the cause of the current financial problems of the banking industry and  that fixing the housing crises is a critical first step in restoring financial stability to the economy. On a worst case basis presume that all delinquent mortgages are in default, which is not true because some of the borrowers could make partial payments or could pay if the terms of the mortgages were renegotiated.

The annual cost of the delinquent payments would be $30 billion.  Are we to believe that for a cost of less than $2.5 billion per month all of the defaults of all of the banks on all of the sub prime mortgages could be resolved?

Why then are we talking about payments to banks and financial institutions of more than a trillion dollars? Is there no one in Washington that does the math? Wait, you say, the problem is more difficult. You are right, other complications must be considered.

If the Federal government, on a temporary basis, guaranteed the monthly payments of the mortgages that are delinquent, the banks would have no reason to presume, as they do, that the outstanding balance of the loan is in default.  When banks make this presumption they deduct the total value of the loan from their reserves.  They declare this amount to be a loss which impacts their capital account. The formal declaration of loan default triggers a secondary default of derivative securities for which the sub prime mortgages are collateral. This in turn activates the credit default swaps obligations.

Housing market foreclosure proceedings and the subsequent sale of assets by public auction creates an environment of pure opportunism in which there is no floor price.  The structure of the market encourages instability and low pricing.  This procedure obviously has a negative affect on the whole real estate market.

With respect to renegotiation of troubled mortgages the method of evaluation of property is important.  In a stable, unemotional market the value of a home would be the replacement cost plus the value of the land.  Both factors can be reasonably determined by skilled evaluation. In some instances the land could, in fact, have only nominal value.  In any normal market the value thus determined should represent the minimum basic price at which a house would be sold and also the value for mortgage purposes.

Let us take a typical sub prime home with a 10 year variable rate loan, now at 11%, in the amount of $200,000 which is now under water by $50,000.  The ownerís monthly cost is $2507 per month.   If the calculated assessed value determined by the procedure proposed above is $170,000, a new 30 year fixed rate mortgage at 6% would cost $1049 per month.  The bank would now have a non toxic asset on its books equal to 85% of the original loan value. It is only the remaining 15% that is toxic.

What would be the cost of settling all 1500000 delinquent mortgages, using the same assumptions?   The total amount owing would be $255 billion which would convert into $217 billion of credit worthy loans and toxic assets of $38.25 billion.  Even in a worst case analysis this is the cost of stopping the housing slump, refinancing the banking system and restoring the credit markets to normality.  In total it represents only a few days of normal Federal Government spending.

A matter of great complexity would be the renegotiation of the terms of outstanding credit obligations so that the principal would be secure but the rates of return would be reduced. It took Canada many months to negotiate an arrangement to prevent the default of collateralized debt obligations.

So, maybe my calculations are a bit off.  Suppose the number of homes to be refinanced is double the amount calculated.  Suppose other uncertainties of equal magnitude exist. Nothing adds up to the trillions of dollars spent and proposed to be spent. The magnitude of these expenditures must inevitably lead to the deterioration of the US dollar as a currency.  And, if a significant portion of leveraged debt can be saved, AIG might not need more bail out money.

At this time, with unemployment of 8%, most wage earners are better off than they were a year ago  Oil and gas prices are down, clothing prices are at sale levels.  Cars are being sold at much reduced prices (5 years at 0% interest), housing prices will never again be as low as they are. It would cost only $100 billion per year to double unemployment benefits for the unemployed. Investors, and particularly retirees, have suffered greatly.  With stock prices at enticing fifteen year lows there is hope of some recovery but perhaps something should be done for them as well.

Would someone please kindly explain to me how my calculations can be so wrong! CNN has suggested that the cost of the recovery program proposed to date will be in excess of $2,4 trillion. Is there no one in Washington that can do simple math or is there some rule that rounds off any calculation to the nearest eleven zero figure.

John E. Conner

John Conner is a former Royal Canadian Air Force pilot, an economist and he’s founded and headed a company or two. He’s now retired and free to pour a shot at the Whiskey Bar now and then.

Math of Subprime Mortgage Default was originally featured on Whiskey and Gunpowder

The first strike against the theory is the global recession. It now looks like the global economy will grow a lot less fast in 2009, if it grows at all. Investors are busy re-pricing commodity stocks for a world where resource demand drops along with consumption in the developed economies.

But a cyclical recession in resource stocks is a manageable event. The bigger challenge to the inflation argument is, well, deflation. The argument here is that there was simply much more leverage in the system than even we expected. As that leverage disappears-hedge funds selling assets to meet redemptions, for example-all assets fall in value.

So far, it looks like the deleveraging of the global financial system is destroying wealth faster than central banks can create new credit to replace it. Europe organized US$1.7 trillion in guarantees on bank loans last week. And in the States, it won’t be long before every institution and every debt is guaranteed by the full faith and credit of the American government. This should lead to the first trillion dollar fiscal deficit in American history. Heck, it might even be two trillion.

South Korea guaranteed $100 billion in bank debt this weekend, and provided banks $30 billion in loans. The Dutch government “injected” $19.6 billion into ING this weekend. Yet as large as these government guarantees and capital injections are, they might not be large enough.

These amounts are small compared to the amount of value already destroyed in the residential real estate market and in the share market. $20 trillion has already been wiped off global shares. Real estate markets in the U.K. and the U.S. are imploding.

What we may have underestimated is how quickly this deleveraging and value destruction would spread to the commodity markets, which we thought would provide relative safety with the backing of tangible value. Resource stocks did not hold up for long at all. Why not?

On the one hand, it now looks like a lot of investors were long commodities with borrowed money. Those investments have been sold to raise cash and pay back loans. Secondly, when it’s a bear market in stocks, there aren’t too many stocks that do well, full stop.

But isn’t inflation in tangible assets just a matter of time as the global money supply grows to re-flate credit markets? And what about all the new government loan guarantees and capital injections? Don’t they have to be inflationary?

Well, if governments borrow to finance these various programs, they’ll issue new bonds. Bonds soak up the available pool of global savings. To that extent, the borrowing crowds out other ventures, which might put the savings to a productive use. But financing the scheme with bonds is not, at least, right away, inflationary.

However, if governments can’t find takers for the bonds they issue to finance the scheme, they will have to either raise taxes (not likely in a recession), or simply print the money. And here’s a hint. That’s what they always do, from Argentina to Zimbabwe. That is why we maintain the preferred response to huge debt levels is outright money-printing.

Besides, simply making credit more available by lowering interest rates stops working after awhile (like when you can’t lower rates any further…zero bound.) How do get available credit out of bank computers and into consumer wallets? It’s not easy. Bankers are suddenly quite shy where they were once promiscuous.

Then you have to get people to spend the money instead of stuffing in mattresses. The banks have been stuffing their money in mattresses (overnight accounts with Central Banks). So now, governments are simply taking over the banks. Let the new loans begin!

This government nationalization of the banks solves another problem with run-of-the-mill credit creation. You can make the credit flow, but you can’t always determine where it goes. But in these unusual times, the government is in the position of deciding where it wants the money to go. Right now, it’s simply shoring up bank balance sheets with more capital.

But to really “get things going again” and “fight the recession” the money will have to get back into the real economy. This is where see the inflation coming. Not in asset prices for houses or shares. But in real goods. Why? If the government engages in massive public works projects as a way of stimulating demand in the economy and keeping up growth, it’s going to be resource intensive.

In a way, this is just another kind of phony boom, but with the free-market varnish stripped off to reveal it as an uber-lending program by some kind of pan-governmental agreement. We already had one simultaneous global credit bubble. Now we’re getting the mother of all government debt bubbles. Only this one will not simply be a collection of various national bubbles.

Instead, it looks like we’re going to get a kind of Global New Deal. Leaders from world’s nations are already suggesting a system where the world’s top thirty banks will operate under the supervision of a government panel of some sort. You’ll see more “super banks” and greater control of the levers of global banking and a concerted program to flood the world with new fiat.

How this prevents future bubbles or leads people away from their addiction to debt, we’re not sure. But we’re pretty sure it’s not a promising development on either score. And inflation? It’s coming…

Regards,
Dan Denning
October 23, 2008

Inflation on Its Way was originally featured on Whiskey and Gunpowder

To answer this, we need to consider two closely linked topics. First, what is an inflation hedge? Second, what makes a good inflation hedge? The first answer is simple. An inflation hedge is an asset that loses little value in periods of rising prices. Thus, it holds its value and purchasing power during inflation. This also applies to hyperinflation. An investor expecting inflation will buy this asset to hedge against inflation.

The answer to the second question requires understanding of the two basic types of assets: real assets and financial assets. Real assets have intrinsic value. They have value of their own. People value them for their direct or indirect usefulness. Examples include books, TVs, cars, wheat, gold, real estate, land, etc.

Financial assets, on the other hand, are a claim on the income or wealth of a firm, family or the government. Their typical form is a certificate or a receipt. Examples include paper money, stocks, bonds, mortgages and exchange traded funds. All money market and capital market instruments serve as examples.

In general, real assets hedge better than paper assets. By definition, real assets have a value of their own. Inflation does not erode their value. Thus, any real asset can be an inflation hedge. It follows that real estate is also a hedge, but it’s not the best.

Good hedges have a few key properties. We mention here only four. One key property of a hedge is that it holds its value. It should lose little value over time. Cars and eggs lose value over time. Land, silver and wine do not.

Another key property is marketability. This means that it is easy to sell. Other people will easily take it for payment. Hence, it is good for barter. Chairs and clothes do not sell. Corn and gold do.

A third key property is divisibility. This means that the asset splits into smaller parts without a loss of value. Houses, cars and cows are not divisible. Rice, wine, gas and gold are.

The last key property is financing. It is vital. Experts prefer to fully ignore it. Investors buy assets with either cash or credit. Cash-based hedges are good. Credit-based hedges are bad. History repeatedly shows that assets bought on credit are prone to speculation and bubbles. The hedge might be already overvalued. In this case, investors should avoid it. Credit clearly drives real estate. Moreover, real estate recently went through a wild bubble. It is grossly expensive, so a poor hedge.

The verdict is clear. Real estate is a hedge, but a poor one. It fails all of the above four tests. On the other hand, gold is a far superior hedge. Gold aces all the tests of a good hedge. That is why it is the ultimate inflation hedge. Better yet, now gold is cheap, while real estate is dear. Thus, as a hedge, gold handily beats real estate.

Real estate bought with cash, free and clear of any debt, might be a poor hedge, but it is nevertheless a hedge. It will protect the value of your money. It is not as good a hedge as gold, but it will do the job. However, we emphasize that real estate bought on credit (with a mortgage) creates substantial new risks to the investor. It’s possible to hedge one risk by assuming another, but not recommended.

So what are the risks, or traps, associated with leveraged real estate? We mention here four. First, we could be wrong! What if prices actually fall — or you have what people commonly call a deflation? Deflation kills those who borrowed to hedge with real estate, because it makes those debts more difficult to pay. Even worse, deflation triggers recession, unemployment and falling income. Similarly to what happened during the Great Depression and to Japan during the 1990s, deflation results in massive foreclosures and business failures.

Another trap for leveraged real estate is that the possibility of another credit crunch might spook the market. We saw this in February; we saw it again in August. Real estate was no place to hide then.

The third trap concerns how investors finance real estate. An ARM, or adjustable rate mortgage, can be a risky way to finance. Rising prices drive interest rates higher. Mortgage rates may rise from a modest 3-4% to 12-15%. This actually happened during the 1970s. Thus, monthly payments could easily triple. Obvious, yet millions of Americans fell for it once again in the early 2000s. Sure, they fell driven by greed. Still, many hedgers are oblivious to this.

The last trap is by far the most insidious, for it is the hardest to see. Inflation overwhelms the borrower; it eats him alive. Before long, food prices double, gas doubles, electricity doubles; prices of all the basic needs double in short order. Yet salaries do not; they lag far behind prices. Oftentimes, as in the 1970s, salaries lag many years behind. Similarly, prices of basic goods, such as food and energy, have more than doubled since 2002. Eventually, there comes the time that after paying for your basic needs, there’s not enough left to pay the mortgage. Let’s further clarify this point with an example.

Say the borrower makes $2,000 — $1,000 goes to pay the mortgage; the other $1,000 goes to pay the bills. Rising food and gasoline prices squeeze the borrower. To pay the bills, he cuts down on consumption, but the bills overwhelm him — they cost him now $1,600. He got a raise and his salary is now $2,300, but he must still borrow some more, maybe on his credit cards, to pay the bills and keep up with the mortgage. He falls deeper and deeper into debt. The higher interest on the credit drains more and more of his income, leaving less for living expenses and the mortgage. Eventually, the consumer buckles. Only now it becomes apparent that he erred — he knew all along that he was paying off his mortgage with cheaper dollars, but he didn’t realize that the same cheap dollars made up his monthly salary. Even a mortgage with a fixed interest rate and fixed monthly payments did not help. Many fell for this in the 1970s, but few saw it coming. Worse, many seem to fall for this today, yet no one warns them. Forewarned is forearmed!

Thus, leveraged real estate is not only a poor hedge against inflation, but also a very risky one. However, if you must hedge, then hedge with gold, not with real estate.

Sincerely,
Dr. Krassimir Petrov
January 24, 2008

Is Real Estate a Good Hedge Against Hyperinflation? was originally featured on Whiskey and Gunpowder

Eventually we came to terms, and the professor agreed to teach a few lessons at the bargain-basement price of nothing. Without further ado, here is professor Hardious Knocks of the prestigious School of Hard Knocks, teaching Relationship Management 101. Each lesson in this series is based on current events. There will be a written assignment after each lesson. Class is now in session.

Lesson 1
Relationship Management by the Book

“The stalled real estate market turned Stoneybrook at Venice into a very different community than its residents paid for: a half-built subdivision dotted with slow-moving construction sites and ‘For Sale’ signs.

“Many residents of the 560-acre east Venice subdivision said they are willing to weather those inconveniences. But the latest news — that mega-developer Lennar will dump more than $6 million in costs on homeowners — has Stoneybrook residents crying foul and preparing a lawsuit…

“Lennar had asked the county for designation as a community development district, a special taxing district that issues bonds to pay for things such as drainage and roads.

“The commission’s vote was 3-2 in favor of Lennar’s request…

“The tax will add more than $700 a year to some residents’ yearly payments…

“Residents said they were under the impression they would only have to pay for future maintenance through their homeowners dues. But commissioners ruled the developer did everything by the book.

“The decision, coupled with Lennar’s recent increase in some homeowner’s dues by $200 a year — another move residents say wasn’t properly announced — has a group of more than 150 Stoneybrook residents ready to take Lennar to court…

“Stoneybrook residents loudly applauded a speech by [resident community group leader Gary] Natiss, in which Natiss threatened a lawsuit and said the ‘only thing Lennar could be building in this county are license plates while they are wearing their little orange uniforms’…

“Others cited a petition, with more than 150 signatures, protesting the levy. Many residents held signs with slogans such as, ‘We have been Lennarred.’

“Lennar attorney Dan Bailey called the residents’ claims ‘reckless allegations.’ He said Lennar made clear there would be more costs when it started selling homes in Stoneybrook…

“Today, the complex is about 43% sold, which county staff said is less than two-thirds as far along as Lennar hoped. County staff said Lennar will fall almost $8 million short of its revenue goals for its first two years if the sales trend keeps up.”

Homework Assignment 1

• Discuss the need to get it in writing and read the fine print
• Is “by the book” the best way to treat customers?
• Does Lennar care about its relationships once the closing is finished?
• If you have to enter a lottery to start a relationship, what can you expect out of the relationship down the road?
• Is the proposed relationship the homeowners have with a lawyer likely to be beneficial to anyone but the lawyer?
• Does the commission just want the work done regardless of who pays?
• Is the commission just acting to avoid a lawsuit by Lennar?
• Do you even know who your commissioners are?

Lesson 2
You Are No Longer Needed. Goodbye.

“Centex Sees More Layoffs to Get to ‘Fighting Weight’

“Centex Corp. chief executive Tim Eller, during the company’s quarterly earnings call Wednesday, said the homebuilder’s head count is down 17% since the beginning of its fiscal year. ‘There will be more reductions in the [fiscal] fourth quarter,’ the CEO said. ‘We’re taking the necessary steps to get our balance sheet and our organization to their fighting weight,’ he added.”

Homework Assignment 2

• You think you have a job in an industry going gangbusters
• You are a loyal employee in for the long haul
• Does it matter?
• Who are golden parachutes for, anyway?
• Do you have a plan in case you are fired?
• Should you?

Lesson 3
Blame the Auctioneer

“Low Bids Take Glow off Property Auction

“One Cape Coral homeowner left an auction sponsored by the Miloff Aubuchon Realty Group Inc. elated her home fetched a $400,000 bid.

“Then, the bottom fell out.

“‘The bid came over the Internet. They said there was a computer glitch,’ said Rosemarie Leibert, 79. ‘They put it back on auction and the bid was $250,000.’

“Leibert declined to take the bid…

“Leibert was upset with the auction, calling it a ‘farce.’ She believes the bids were too low and the auction didn’t deliver serious bidders…

“Calling the effort a learning experience, Jeff Miloff, the realty group’s sales manager, said another auction planned for March could have different rules.

“The bids were so unrealistic the auction showed people didn’t do their homework, Miloff said.

“‘The next auction could have suggested opening bids,’ Miloff said. ‘People had no sense of what they were bidding. It made no sense.’”

Homework Assignment 3

• Is the auctioneer to blame for low bids?
• Will any bids come in if there are minimums?
• Who has no sense here, the bidders or the sellers?
• Exactly who failed to do their homework?
• Assign the blame in percentages to the bidders, the sellers, and the auctioneer.

Lesson 4
We’re All in This Together

“Foreclosures Put Added Burden on Association-Run Communities

“If you think you’re paying more to live in your condo, townhouse, or gated community, consider this: It may get worse before it gets better.

“Experts fear that with homes selling slowly, owners who can no longer afford payments may soon abandon them. If that happens, those left behind in communities run by associations must make up the missing share of money to maintain roofs, roads, landscaping, and pools.

“‘We’re seeing a 100% increase in the number of files turned over to us [by associations] for lien and foreclosure,’ said Gary Poliakoff, whose Fort Lauderdale-based law firm, Becker & Poliakoff, represents 4,200 associations in Florida…

“An association’s expenses are constant, so budgets are based on the community’s number of homes and apartments.

“‘Other owners have to make up the shortfall because service providers aren’t going to say, “We feel sorry for you and will reduce the cost,”‘ said Poliakoff.”

Homework Assignment 4

• If a condo tower is only 50% sold, who is going to pay those dues for the empty units?
• Should one believe that initial assessment the builder/developer stipulated?
• What happens if your neighbor defaults on his mortgage and the bank owns the property before the condo association failed to get a lien for assessments?
• How will increasing insurance rates affect your neighbor’s ability to pay?
• What about the guy 18 stories up whom you’ve never met?
• When the tuckpointing fails, how many new relationships will be formed?

Lesson 5
Who Do You Believe?

“The 0.8% drop in sales in December came after two straight months of improving sales, the first back-to-back sales gains since the spring of 2005.

“David Lereah, chief economist for the Realtors, said that even with the December setback, he still believes that sales of existing homes have hit bottom and will start to gradually improve.

“‘With fingers and toes crossed, it appears that we have hit bottom in the existing home market,’ he said.

“In other economic news, the number of Americans filing applications for unemployment benefits shot up last week by the largest amount in 16 months, reversing two weeks of big declines.

“The Labor Department reported that 325,000 newly laid-off workers filed claims for jobless benefits last week, an increase of 36,000 from the previous week. That was the biggest one-week rise since a surge of 96,000 claims the week of Sept. 10, 2005, when devastated Gulf Coast businesses laid off workers following Hurricane Katrina.

“But economists said they believe the low point for housing has been reached and they are forecasting a slow rebound in 2007. Because of that optimism, analysts don’t believe the slump in housing will drag the overall economy into a recession.”

Homework Assignment 5

• Is Lereah believable?
• Is the NAR believable?
• Who do you believe?
• If you cross your fingers and toes, does it help?
• What about wishing on a star?
• 36,000 more people formed a new relationship with their local unemployment office. Estimate the percentage of those above who were prepared for this new relationship.

Extra Credit Assignment
Lower Your Costs or You’re Fired

“Faced with a $195.6 million loss in the fourth quarter, the Miami-based homebuilder is telling subcontractors that it wants further cost cuts or they’ll be excluded for six months from future bidding.

“Lennar Corp. is asking its homebuilding subcontractors to cut their current charges by 5% or more or face a minimum six-month ban on bidding for work, a company executive said late Tuesday…

“‘As our customers continue to pay us a lower price for our homes, we must in turn pay you a lower price for your services,’ said a letter circulated to subcontractors in Lennar’s Orange Coast, Corona, Temecula, and Palm Springs divisions.

“[Lennar Southwestern U.S. regional Vice President Jeff] Roos, said similar requests are being made of Lennar subcontractors nationally.

“‘Every builder is doing the same thing,’ added Roos, who works in the company’s Western region office in Aliso Viejo. ‘Everybody understands that the market has softened…I think everybody realizes in times like this…they need to manage their business accordingly.’

“Roos said 90% of the subcontractors in the region had a positive response to the letters.”

Extra Credit Homework

• How likely is it that there was a “positive response” from the subcontractors when asked to cut prices?
• Will the subcontractors cut prices anyway?
• Find at least three more “special relationships” involving Lennar and report on them.

Hmmm. There seem to be some questions for professor Hardious Knocks about this extra credit assignment.

Mr. Plumber: I can’t cut my costs, I have bills to pay.

Professor Knocks: It seems you have a relationship problem with your bills. We cover that in Relationship Management 102. The first two lessons are “How to avoid paying your creditors” and “How to terminate expensive relationships.”

Mr. Carpenter: This sounds like extortion. My inventory is stacking up, and if I cut prices, I will lose money on the bid.

Professor Knocks: It does not matter what your costs are. You can lower your prices and lose money, or not lower them and do no business.

Mr. Economist: You can’t fool me. This extra credit assignment is really about deflation.

Professor Knocks: Don’t confuse falling prices with deflation or rising prices with inflation. I highly recommend that you take Deflation 101. The first lesson is how to put the horse in front of the cart. But if the carpenters and plumbers of the world go bankrupt, or if too many of those new relationships at the unemployment line end up in bankruptcy court, then yes, we are talking deflation. I look forward to seeing you in class next semester.

Please e-mail your finished assignments to HardiusKnocks@SchoolofHardKnocks.Edu

Class dismissed.

Regards,
Mike Shedlock ~ “Mish”

January 29, 2007

Relationship Management 101 was originally featured on Whiskey and Gunpowder