Option adjustable-rate mortgages (ARMs) have bled into the once profitable prime mortgage industry. Once reserved for only trustworthy borrowers with good lines of credit, the lending standards became relaxed and option ARMs began to grow in popularity. It isn’t difficult to see why this would happen.

An option ARM is similar to the standard ARM that we’re familiar with. Borrowers become attracted to an extremely low introductory, or teaser, interest rate that lasts for the first few months. These teaser rates can sometimes be as low as 2%. Of course, nothing good lasts forever, and very quickly the rates shoot up.

The difference is that with option ARMs, borrowers have the choice to pay as much or as little as they want per month. The first option they can choose is the traditional way to pay on a mortgage. With this option, the borrower pays the principal and the interest every month for either a 15- or 30-year term. The principal amount of the mortgage decreases with every payment.

The second option is an interest-only payment, in which the interest is paid every month, but the principal amount remains unchanged.

The third, and most attractive, option is the minimum monthly payment. This option does not pay on the principal, nor does it fully cover the interest due. This kind of payment comes in very handy when a borrower is strapped for cash or is expecting to have an increase in income in the near future.

The problem, of course, is that it isn’t as simple as just delaying your payments. The amount of interest not paid is just added to the principal amount owed. This comes back to hurt borrowers in two ways. First, the rates adjust after the introductory period and then reset at a certain point, usually the five-year mark. What happens then is that the amount of money that you owe has increased, rather than decreased, over time. Essentially, this is just adding to the price of your house.

Once the rates reset, the new interest rate is calculated on the new amount owed, which is the original principal plus any unpaid interest. Borrowers find themselves in the unenviable position of having to pay more money in less time. The amount of interest owed has also risen exponentially, and many homeowners will find themselves simply unable to pay.

Countrywide Financial Corp. began to offer these kinds of loans in 2003 and is currently one of the largest lenders of option ARMs. The amount of option ARMs that Countrywide sold began to grow and grow as the loan officers realized how simple they were to sell. Commissions began to rise and Countrywide itself noticed how profitable these mortgages were.

Now, just like we’ve seen in the subprime sector, loose lending practices and overall foolish planning by top mortgage companies like Countrywide have led to many late payments and defaulted loans. Not quite at the level of subprime, but certainly rising, option ARMs, according to The Wall Street Journal, currently account for 41% of Countrywide’s loans. Of those option ARMs held by Countrywide, 5.7% were at least 30 days late.

Although many issues have arisen along with the popularity of option ARMs, this does not mean that they are fundamentally flawed. For many borrowers who have an unfixed income, these types of mortgages can sometimes be the smartest option. For example, real estate agents whose income can swing severely from month to month would be wise to finance their homes with an option ARM. That way, they can pay more during good months and less during less successful months.

That being said, many of the borrowers who got themselves into this mess were not set up that way. Many were simply trying to purchase a loan that they really couldn’t afford. If blame is going to be passed around, it must then be given on both sides of the spectrum. Borrowers should certainly be much more realistic when it comes to the type of home they can afford. Lenders should also carry a moral and financial obligation to make sure that they do not push a loan on someone who will later be crushed by its growing weight.

This does not mean that the “big bad” mortgage companies should shoulder the responsibility for making sure that every lender makes a wise decision. But with stricter lending practices, and an eye to making sure that the customer is actually capable of keeping up their end of the bargain, many companies would not find themselves in this predicament.

Countrywide, which previously was one of the biggest offenders with these lax lending practices, is now leading the charge in tightening up its standards. Of the option ARMs that Countrywide lent last year, 89% of them would now not meet its new standards. The mortgage giant is expecting a housing market fallout soon and is bracing itself with new standards and better philosophies.

Better late than never, Congress has introduced a bill that would put strict regulations on these lending practices. Democratic Representative Barney Frank (Mass.) introduced a bill that would go after mortgage brokers who engage in “predatory lending practices.” Frank has long pushed for federal regulations on mortgage lending in which lenders would not be able to make any loans that a borrower would be unable to pay back.

While the public may see this as a step in the right direction with the government swooping in to help the little guy, critics of the bill believe that it would simply be too little, too late. Federal regulations would merely set a regulatory floor while many state laws that currently exist are already far stricter. Many critics claim that this would only add confusion to an already muddled situation.

Under that thinking, it appears that Congress is trying to fight a fire with a squirt gun. Damage has already been done, and without the mortgage companies policing themselves, more deterioration could occur. Mortgage companies need to look out, not only for their borrowers, but for themselves in the long run by making wise and responsible decisions, instead of going after a quick buck.

Until next time,
Jamie Ellis

November 1, 2007

A Prime Example was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

And where are these trends going to take us? We ask that question a lot here at Agora Financial. And sometimes it helps me to clear my head and collect my thoughts if I listen to some music.

Let’s Go to the Opera

So let’s go to the opera. Consider for a moment the opus Treemonisha by the great American musician and composer Scott Joplin (1868-1917). Written in 1910 and never performed in its entirety during Joplin’s lifetime, Treemonisha is the only large-scale work to survive from the great ragtime master. Overlooked for many decades, and indeed almost lost to history, Treemonisha was not performed in its entirety until 1970, but thereafter, it went to Broadway, became a hit and won a Pulitzer Prize (posthumous) for composer Joplin in 1976. Thus Treemonisha is a classic that transcends time and space, and serves well to remind us of another era with a very different set of values. And the reminders inherent in those old, value-laden chestnuts from Joplin are presented in easily understood comparisons that are almost, if you will excuse the expression in this context, black and white.

A Bag of Luck

Treemonisha has a simple plot. The story takes place in September 1884, on a plantation in Arkansas. The namesake of the opera, a young girl named Treemonisha, encounters a group of local conjurers who deal in voodoo and mysticism. These conjurers are at root nothing but scam artists, trying to sell Treemonisha’s poor mother what they call a “bag of luck.” Treemonisha refuses to go along with this transparent rip-off and denounces the conjurers. The conjurers retaliate by kidnapping Treemonisha, who is, in turn, heroically rescued by her beau, Remus (this is opera, after all). Having exposed the conjurers as frauds, Treemonisha leads a campaign to educate and improve the lives of the members of her community. And this being opera, there is much delightful singing and dancing.

What prompts me to think of Treemonisha in light of the recent market volatility is the Joplin opera’s forceful emphasis on certain basic elements of living an honest and decent life. One song is entitled, “When Villains Ramble Far and Near.” The lyrics say it all: “When villains ramble far and near/With their hearts full of sin/They do much wrong without a fear/But someday right will win.”

Or try this operatic ditty, entitled “Wrong Is Never Right.” The lyrics are, “Wrong is never right/That is very true/Wrong is never right/And wrong you should not do.”

OK, I admit it. There may be a certain dramatic lightness to the work. The libretto can legitimately be viewed as juvenile, if not condescending toward the poor, ill-educated sharecroppers (mostly former slaves) who form the characters of the tale. So the story line of Treemonisha is not exactly The Brothers Karamazov by Dostoevsky. But Treemonisha is also something of an idyll, certainly an Americana musical marvel. It is downright sweet and a resourceful and multidimensional mixture of rags, dances, waltzes, sentimental ballads and full-scale arias. Treemonisha is filled with expressive ranges, syncopated rhythms, harmonies and instrumental sonorities of ragtime. Oh, would that much else in this life could imitate such art.

In Treemonisha, composer Joplin takes a simple folk message and uses complex ragtime musical elements to create set pieces that go far beyond the conventions of the style. Joplin takes you back to the basics, back to plain old right and wrong, and with his musical background drives home the key points like a lightning bolt hitting the tree outside your window. Yes, dear readers, you can go home again.

Back to the Stock Markets

So now that we have been to the opera, let’s get back to the financial markets. What has been happening? How can Treemonisha help us to understand our predicament? Well, we are now witnessing the end result of too many economic conjurers peddling too much of the equivalent of that “bag of luck” to gullible, if not greedy, borrowers and investors over the past decade or so.

Looking back, the biggest purveyor of superstition, voodoo and a “bag of luck” was the No. 1 macroeconomic witch doctor of our era, the so-called “maestro” Alan Greenspan. Between 2001-2004, Mr. Greenspan engineered the decline of what is called the fed funds target rate from 6% to 1%. In consequence, banks borrowed cheap money from the Fed and in due course searched high and low for ways to pump that liquidity into the economy. Much of the money wound up in risky mortgages, clinically enabled — like a bartender pouring more drinks for the inebriated sot on the adjacent stool — by a convenient decline in traditional lending protocols as the subprime mortgage market took off like a rocket.

Between 2001-2005, subprime mortgages grew from 2% to 14% of all mortgages issued in the U.S. In 2003, in fact, the Fed cut rates to only 1%, causing subprime lending to increase by 150%, from 4% of total lending to more than 10%. The money supply of not just the U.S. housing market, but of the entire U.S. economy and the related dollar-using world just went haywire. But then again, as is the case with cancer and petroleum dependency, there were and are more people living with the disease than dying from it. For now, at least.

In the Olden Days

Some of those tunes from Treemonisha are still humming in my head. In the olden days, and not even as far back as the pre-Fed gold standard era when Treemonisha was composed, first-time home buyers paid about 20% of the value of the houses upfront. Borrowers took out long-term, fixed rate mortgages, and not those bizarre “interest only” or “negative amortization” loans.

On the other side of the transaction, in the olden days, the lenders were usually local bankers, and not faceless Dilberts who worked in some cubicle of a national lending institution on the other side of the continent. And the lenders tended to be from the serious, skeptical faction of the human gene pool. That is, the lenders understood that they were loaning out the depositors’ money and that the depositors eventually wanted it back. When it came to mortgage lending, those uptight bankers knew generally that, in the words of Scott Joplin, “Wrong Is Never Right.”

So in the olden days, the lending system was tilted, if not rigged and structured, so that homeowners bought houses that they could actually afford, at prices and mortgage terms that they could pay over the long term. If one did not qualify under the bank’s lending protocols, then one remained a renter. It was not considered illegal or unpatriotic redlining to deny a mortgage to someone with little or no prospect of paying it back. When borrowers ran into financial trouble (and to be sure, on occasion they did), it was usually due to some unforeseen event in their lives like the loss of a job, an illness or a divorce. Yes, as former Defense Secretary Donald Rumsfeld once said, “Stuff happens.” But in the olden days, the mortgage was almost never the “stuff” of the main problem.

Villains Ramble Far and Near

Yet in a world of easy money from the Fed, and in the words of Scott Joplin, “Villains Ramble Far and Near.” Subprime mortgages have now become the financial culprit that is wrecking the national and international credit markets from the ground up, like Samson pulling down the Temple. And by extension, those subprime mortgages are bringing down the related financial markets and disrupting the predictability of interest rates. This subprime disaster is particularly toxic due to the so-called “zero-down,” ninja loans (“ninja,” as in no income, job or assets) issued with two- or three-year terms, followed by floating rates that are keyed to reset upward (right about now, sad to say, with much more due to hit the fan in the next year) in a higher interest rate environment.

These home-wrecking loans were arranged, for the most part, by those national mortgage brokers and bankers who earned lucrative fees (and permit me to add, purchased many a flashy automobile and tawdry 14-carat bling), peddling their own “bags of luck.” The selling point was that interest rates were low and real estate prices were rising, so the overstretched borrower could eventually refinance at a lower rate or sell his overpriced hacienda into that proverbial “rising market.” Yes, and children believe in Santa Claus, while some adults think they can get rich by gambling at casinos in Las Vegas.

Where Are We Headed?

So where are we headed in all of this? I seldom make guarantees, but in this case, I will pretty much guarantee you that all borrowers, in whatever sector of the economy you care to name, are now likely to face significantly higher borrowing costs for years to come. This will be the case whether the loan is personal or business, and even for those with stellar credit histories.

And according to Edward Chancellor, author of Devil Take the Hindmost: A History of Financial Speculation, there is another profound problem:

“The credit system is losing its, well, credibility. People no longer trust the triple-A ratings that many complex debt securities carry. The risk models used by rating agencies, hedge funds and banks have also come under suspicion. The effects of subprime losses are being felt in unexpected places, including supposedly impregnable money market funds. Hedge funds and other highly leveraged investment vehicles are being forced to unwind. After years of excess, credit is beginning to contract. There has been a run on Wall Street finance… but no one knows how long it will last, or where it will end.”

The companies that we recommend in Outstanding Investments do not own, make or sell the proverbial “bags of luck.” We screen for that. Still, any company may be whipsawed by the business cycle or by an economic contraction caused by a slowdown in consumer spending or deterioration of lending or capital spending. So if you have a gain on the books and are nervous about hanging onto it, you should sell some shares and take your money off the table to the point where you can sleep at night. As we said above, cash is good. Going forward, you should keep an eye on any decline in share prices and consider it a chance to acquire great energy or mining shares for the long haul, and at a discount.

Until we meet again…
Byron W. King

P.S.: Scott Joplin’s wonderful opera Treemonisha is rarely performed these days, so if you ever have the opportunity to see a performance, you should buy a ticket and go. The only recording that is still widely available is from Deutsche Grammophon, based on a performance by the Houston Grand Opera in 1975. Enjoy the show.

September 14, 2007

A Day at the Stock Market, A Night at the Opera was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

State Tax Revenues Slump

In “Housing Slump Pinches States in Pocketbook,” The New York Times is reporting on tax shortfalls:

“‘It’s the year of the housing hangover,’ said Sean M. Snaith, director of the Institute for Economic Competitiveness at the University of Central Florida.”

Lower Earnings, Less Capital Spending, Less Hiring

MarketWatch is reporting, “Lower earnings could cut into capital spending, hiring”:

“U.S. corporate profits fell in the fourth quarter of 2006, signaling the end of one of the greatest profit cycles in postwar era, economists say.

“Economic growth is slowing, hurting corporations’ top line. Meanwhile, costs are rising, squeezing profit margins.

“‘Profits growth has turned decisively down, and the end is not yet in sight,’ wrote Gabriel Stein, an economist for Lombard Street Research.

“‘As the expansion matures and unit labor costs rise, profit margins will be under pressure,’ said Stephen Stanley, chief economist for RBS Greenwich Capital…

“‘The deceleration of profits may be dramatic,’ wrote Mickey Levy, chief economist for Bank of America, in a research note. ‘If so, weaker profit growth may affect business hiring and capital spending decisions, and will likely influence financial markets.’

“‘Weaker profits may undercut any rebound in capital spending,’ Levy said.”

Pink Slips Litter Loan Industry

The Chicago Tribune is reporting, “Turmoil in the subprime mortgage sector hits some workers as hard as borrowers”:

“The tumult in the subprime mortgage sector has hit some of the industry’s employees as hard as its borrowers.

 ”Nationwide, job losses in the category that includes mortgage lending, real estate, and construction climbed 346% in the first quarter, to 21,245 from 4,764 in the same period last year, according to outplacement firm Challenger, Gray & Christmas Inc.

“‘It’s a whole sector of the economy that’s leaking,’ Chief Executive John A. Challenger said.

“In California, the 3,679 mortgage industry jobs lost in the quarter pales compared with the 70,000 construction jobs that economists figure could disappear over the next two years. When considered individually, though, the loss of a higher-paying white-collar position can be more significant for the economy.

“‘Each one of these finance jobs is worth at least two construction jobs,’ said Ryan Ratcliff, an economist with UCLA’s Anderson School of Business.

“Added Esmael Adibi, director of the Center for Economic Research at Chapman University in Orange: ‘The ripple effect is significant.’

“The layoff wave began about a year ago, when Ameriquest Mortgage Co. fired one-third of its employees. In December, Ownit unloaded 800 workers. Last month, the Orange-based parent of Ameriquest Mortgage and Argent Mortgage Co. announced major layoffs, as did Fremont General Corp. of Santa Monica. General Electric Co.’s WMC mortgage unit, a major player in the subprime business, said it would snip 20% of its payroll.

“‘We went on a big real estate bender,’ Ratcliff said. ‘And this is sort of the beginning of the hangover.’

“Shelly Dusing of Aliso Viejo, who lost her $48,000-a-year job at Ameriquest last month, said she would not return to the industry. In fact, she said she would work ‘anywhere but’ because mortgage lending was too volatile, ‘whether you’re prime or subprime.’

“For Dusing, who’s nearly eight months pregnant, the situation at Ameriquest became so tense that getting fired was a relief.

“‘You go to work every day and you don’t know if you’re going to have a job or not. You don’t know if your badge is going to open the door,’ she said. ‘We knew bad things were coming and it was just a matter of time’”…

“The abrupt end is a bitter memory for Tamika Williams, her family’s primary breadwinner when Ownit collapsed shortly after she bought a home in Phoenix.

“The 29-year-old mother of four lost a job that paid $21 an hour, plus commissions. Williams landed a new job March 2, making $12 an hour handling collections for a bank.

“‘I’m surprised I haven’t called myself yet,’ she said.

“The end came quickly at Ownit, said Lisa Seeley, another former employee.

“‘Now you wake up every morning and wonder, “Who’s wheezed their last today?,”‘ she said. ‘If there’s anybody who isn’t wondering about their job today, they’re not paying attention.’”

Property Tax Soup

The Orange County Register is asking, “Are Property Taxes in Subprime Soup?”:

“If you’ve got a mortgage from a subprime lender in deep financial trouble — and that’s a good-sized bunch — you may want to gulp.

“The county’s tax collector is concerned that some ailing lenders may be unable to get borrowers’ payments to their rightful place, such as prepaid property tax payments.

“‘This is a very serious issue,’ says [tax collector Chris] Street, who adds the unsettling notion that property owners are still liable for a tax bill — even it goes unpaid due to a lender’s failure to forward your cash to the tax collector.

“Street’s not yet seen evidence in his tax collecting efforts of such mistakes or misappropriations. Still, O.C.’s overall late tax payments are already running at an 11-year high. But one company in the subprime game claims they’ve witnessed borrowers’ mortgage payments go awry.

“Wall Street banker UBS sued New Century Financial, the once subprime giant now mired in bankruptcy. The UBS beef? That the Irvine [Calif.] lender failed to forward $3.8 million in borrowers’ payments — plus $1.7 million in escrow payments for house expenses — to UBS-sponsored owners of certain mortgages.

“A New Century spokeswoman would not comment on the UBS allegations. She did say that protections are in place to keep borrower payments separate from New Century’s other financial obligations. Court filings indicate that New Century has the right to continue forwarding prepaid bills to tax officials.

“‘I’m just being prepared that one, two or many of these lenders will have used the money that should have been set aside,’ says Street, who notes that New Century forwarded its borrowers’ tax payments to his office on Friday. The current installment of tax bills is due Tuesday.”

Imagine you are a subprime borrower who paid taxes to New Century Finance or some other now bankrupt subprime lender and you wake up and find that those tax escrows you made were not paid. Subprime being what it is, exactly how are you going to come up with $2,000-4,000 or more to pay tax bills you have already paid?

Some borrowers have avoided escrow payments simply because they could not afford those on top of a mortgage. Where are those borrowers going to come up with the money to pay property taxes?

California Foreclosure Sales Near $2 Billion in March

The Central Valley Business Times is reporting, “Unprecedented’ foreclosure activity”:

“Foreclosure sales are now 15% of all home sales in California.”

“5,316 homes were lost to foreclosure sales in March in California, according to figures compiled by Foreclosure Radar, a Discovery Bay-based foreclosure listings and software company.

“The homes sold at auction last month represented a 27% increase from February and a 264% increase in the last six months, the company says. Of the $2 billion worth of properties sold in March, 4,796 went back to the lender after receiving no bids, representing $1.82 billion, it says.”

4,796 homes out of 5,316 homes at foreclosure sales received no bid. That is a pretty stunning 90% of homes at foreclosures auctions receiving no bid. Obviously, those homes have a bigger mortgage than what they are worth.

Hot Employment Numbers?

In regards to the highly touted 180,000 March payroll numbers, there are some anomalies that need to be addressed. I talked about this in “March Employment Numbers & Leading Indicators,” and Paul Kasriel talked about the job numbers in “An Autopsy on the March 2007 Employment Situation Report.” From the latter:

“With regard to the 35,800 person increase in general merchandising retail, it seems odd that this accounted for all but 100 positions in the net monthly increase in total retail payrolls. Something very volatile appears to be going on in general merchandizing hiring.General merchandise employment in relation to total retail employment has gone from 18.81% in November 2006 to 19.25% in March 2007, a very sharp reversal, as shown in Chart 5 [below]. I wonder if there are not some seasonal adjustment issues in play here. Whatever the case, if a lot of our job growth is occurring in retailing in general, then this is unlikely to result in strong consumer spending from income growth inasmuch as the average hourly wage in this sector is only $12.74, with only leisure and hospitality paying less ($10.19 per hour). If Circuit City’s hourly pay cut plan is successful, other retailers might opt for a variation of it, which will lower the wages in this hotbed of employment growth even more.

“Now, let’s turn to the March 2007 Household Survey, which also provided a surprise in the form of a 0.1 point decline in the unemployment rate, to 4.4% — matching a cycle low. In terms of age groups, the largest decline in the unemployment rate occurred among teenagers, where the rate fell to 14.5% in March, from 14.9% in February. But the ‘adult’ unemployment rate also fell a tick, to 3.9%, matching its cycle low. Did teenage employment increase in March? No, it declined by 59,000. What was driving force behind the sharp decline in the teenage unemployment rate? A 0.6 point decline in the teenage participation rate to a cycle low 41.6%. In fact, as shown in Chart 6, the March 2007 teenage participation rate of 41.6% is a post-WWII low”…

Judging from the enormous drop in the teenage participation rate, the latest drop in the unemployment rate is a complete fabrication of reality. While Kasriel and I focus on different aspects of the payroll numbers, we both reach the same conclusion, expressed by Kasriel: “In sum, an autopsy of the March 2007 Employment Situation report suggests that labor market conditions are not nearly as robust as the headlines that accompanied the report.”

Now factor in the fact that 2.1 million homeowners missed a mortgage payment in 2006, according to USA Today. Does that look like containment? I suggest that the containment is spreading, even as Bernanke and others deny its existence.

Regards,
Mish

April 10, 2007

Containment Is Spreading was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.