The Mortgage Corner

What happened to the toxic mortgage problem? It was touted several months ago that perhaps up to $4 trillion in toxic mortgages were being held by financial institutions that could blow up and blow more holes in our financial system.

But in fact lower interest rates are lowering the risk of such a wave of defaults. First, the facts. What is a toxic mortgage? It is probably either an Option ARM, or shorter-term 5, 7, or 10-year fixed rate ARM that will go to a fully amortized ARM interest rate at the end of the fixed term. So the problem occurs when it adjusts and borrowers must begin to pay back the principal loan amount at current interest rates.

In the case of the Option ARMs (OA), borrowers had the choice of paying a minimum payment—originally as low as 1 percent—an interest only payment, or pay down principal with a 15 or 30-year amortization payment. Most, of course, chose the minimum payment, which for most OAs wouldn’t be recast to a fully amortizing payment until the fifth year (except for World Savings’ loans—see below).

Since most of these loans originated in 2005-07, they will be recast 2010 to 2012. So the question is what will interest rates be at that time? Today, if recast, the OA or fixed rate ARM borrower is in the best of worlds. Their index will probably be either the LIBOR (London Interbank Overseas Rate), or MTA (monthly treasury average), which are now at or below 1 percent, thanks to the Federal Reserve.

And since most borrowers have margins that were between 2 and 2.5 percent on a primary home, that means the real interest rate is currently hovering between 3 to 3.5 percent; much better than today’s interest rates. Actually, OA holders should be taking advantage of the record low interest rates by paying more than the minimum payment. It could be at least interest only, for instance, or even the 30-yr amortized payment. In fact, the minimum payment amount, which rises 7.5 percent annually for 4 years before the recast, may itself help to pay down any negative amortization that had accrued when interest rates were higher.

Fitch Ratings says there are just $189 billion in securitized OAs outstanding, so the number of toxic mortgages may not even be a major problem, but only if the Fed keeps interest rates low for a prolonged period of time, as they say they will do. The holders of World Savings pick-a-payment Option Arms are in an even better position, as their loans don’t recast for 10 years.

And borrowers are paying down their mortgages with a vengeance, as I have said. For Q2 2009, the Net Equity Extraction was minus $48 billion, or negative 1.8% of Disposable Personal Income (DPI). The Fed’s latest flow of funds report shows the amount of mortgage debt outstanding is declining, and this is partially because of debt cancellation per foreclosure sales (and a little from modifications), and partially due to homeowners paying down their mortgages (as opposed to borrowing more).

Credit Suisse came out with an even more radical forecast. The Option ARM problem could be over by 2014! I.e., those loans would either be paid off or written off by then.

What happened? Firstly, Credit Suisse is reckoning that perhaps 40 percent will have walked away from their homes and loans. And with such low interest rates, many in fact are paying down their principal even with minimum payments, since those payments keep rising until the fifth year, while the underlying interest rate, which adjusts monthly, continues falling. Therefore, the danger of reaching maximum negative principal balance (usually from 115 to 125 percent) seems to have passed for several years, at least.

This is why this is a window of opportunity for Option ARM (and fixed rate ARM) holders to keep their homes—by bringing down their principal balance so that it coincides with current housing values.

Harlan Green © 2009

Popular Economics Weekly

We discussed in past weeks about the possibility that consumers—who account for 40-70 percent of U.S. domestic economic activity (depending on who you ask)—will become healthy enough to shop again this year. More evidence of that possibility is out.

The Federal Reserve just announced that American households were $2 trillion richer on June 30 than they were three months earlier, the first time in two years that household net worth has increased, said the Fed in its quarterly flow of funds report.

Household wealth rose in Q2 at a 17 percent annual rate, or $2 trillion to $53.1 trillion, more than replacing the 13 percent rate decline in the first quarter. The rally on Wall Street was the main reason for the increase in household wealth, but rising home prices contributed as well, as was reported by the latest Case-Shiller home price index.

Consumers also continue to pay down debts or have their debts written off at a record pace, with revolving and installment debt levels falling back to 2005 levels. In the second quarter alone, household debt fell at a 1.75 percent annual rate to $13.7 trillion, matching the record percentage decline in the fourth quarter.

Mortgage debt fell 1.5 percent and consumer credit usage decreased a huge 6.5 percent in Q2, as well.

A further indication of consumers recovering was the August surge in retail sales along with a big jump on consumer confidence, which behavioral economists argue guides 50 percent of consumers’ spending decisions. Retail sales surged 2.7 percent, the largest increase in 3 years, in part because of increased auto sales. Excluding car sales it was up 1.1 percent.

Both the Michigan and Conference Board confidence surveys jumped in August. The Conference Board’s Expectations Index surged 10 points, while the U. of Michigan’s sentiment survey jumped 5 points, continuing its rise from the January low.

Lynn Franco, the Conference Board’s research director, said, “The Expectations Index improved considerably and is now at its highest level since December 2007 (Index, 75.8). Consumers were more upbeat in their short-term outlook for both the economy and the job market in August, but only slightly more upbeat in their income expectations. And, as long as earnings continue to weigh heavily on consumers’ minds, spending is likely to remain constrained.”

Will consumers continue their thrifty ways? The Fed’s quarterly flow of funds report highlighted why consumers are spending more, in spite of their thrifty ways. Consumers’ confidence levels are being boosted by the so-called wealth effect, the feeling that their financial situation is finally beginning to improve after 21 months of the Greatest Recession on record.

Harlan Green © 2009

Popular Economics Weekly

Nonfarm payroll employment continued to decline in August (-216,000), and the unemployment rate rose to 9.7 percent, reported the U.S. Bureau of Labor Statistics. Although job losses continued in many of the major industry sectors in August, the declines have moderated in recent months.

But the question remains how long will it take for employment to turn positive again? The guess is anywhere from later this year to mid-2010. Why? Because this recession had the greatest job losses since WWII (and the Great Depression). Most jobless recoveries have taken 2 years or less to return to normal. The G. W. Bush 2001 recovery was longest—it was 4 years before the job losses were replaced.

It looks like manufacturing will be the sector that recovers first. The Fed’s Beige Book survey of its 12 Reserve Districts remarked on the nascent manufacturing recovery, saying that “most districts reported modest improvements in the manufacturing sector.”

The Institute of Supply Managers latest manufacturing survey also reported a huge jump in new orders, employment, and prices. Its index surged above 50 percent—a sign of expansion—for the first time in 18 months.

Real estate may be the second sector to recover, believe it or not. With home prices and interest rates making record drops—prices are back to 2003 levels—a combination of greater affordability and pent up demand from record household formation has brought increases in both new and existing-home sales during this selling season.

Lastly will come the recovery in consumer spending. So-called personal consumption expenditures are the main measure, and they now are showing a very slight upward trend, in spite of record indebtedness. More improvement will depend on rising personal income, which hasn’t happened yet. But the huge cut back in expenses (e.g., paying down debts to 2005 levels and discount shopping) will enable consumers as well as businesses to spend and invest more in coming quarters.

Much of this recovery will be due to ARRA, the American Reinvestment and Recovery Act, which may have added 2 to 3 percent to second economic growth, according to Obama’s White House Council of Economic Advisors in their just released second quarter report.

"…our multiplier analysis and estimates from a wide range of private and public sector forecasters confirm the estimates from the statistical projection analysis. There is broad agreement that the ARRA has added between 2 and 3 percentage points to baseline real GDP growth in the second quarter of 2009 and around 3 percentage points in the third quarter.”

There is also broad agreement among economists that it has likely added between 600,000 and 1.1 million to employment (again, relative to what would have happened without stimulus) as of the third quarter.

Retail sales are beginning to recover, increasing 2.7 percent from July to August (seasonally adjusted), though sales are off 5.3 percent from August 2008 (retail ex food services decreased 6.3 percent). The main impetus was a 10.6 percent surge in auto sales due to the cash-for-clunkers program. Excluding motor vehicles, retail sales were up 1.1 percent. This confirms the prediction for higher GDP economic growth in the third quarter.

But it begs the question as to when job formation will bring back the more than 7 million workers who have lost jobs in this recession to date. Even though it is the worst recession since the Great Depression, and given the fact that next year is an election year, my bet is that we will see strong job growth by next summer.

Harlan Green © 2009

Popular Economics Weekly

Nobelist and New York Times columnist Paul Krugman recently wrote about “zombie” economics coming back from the grave to haunt us. By that, he meant a version of Adam Smith’s classical, free market economics that advocated less regulation and lower taxes that was in vogue in the 1980s. Their mantra was “Government is the problem”.

It was labeled ‘trickle-down’ economics as the ticket to greater prosperity for all because it advocated tax breaks to the wealthiest while allowing financial markets to regulate themselves.

Dr. Krugman lamented the fact that even though its principles had long since been discredited—only a few prospered, while it meant greater debt for government, and the majority whose incomes didn’t rise—its proponents were using its arguments to attempt to discredit the various stimulus plans, as well as health care reform.

The zombie economists maintained that cutting taxes always created jobs, forgetting that it depended on whose taxes were cut. When it was the investor class, then it usually resulted in an oversupply of goods and services that tended to create the various asset bubbles–such as housing. Unless the majority of consumers’ incomes were also boosted, there would be no one to buy the products.

That is why the various stimulus plans accentuate direct job creation more than tax cuts and cash rebates. Tax rebates provide a temporary stimulus but peter out when the money is gone. Putting the stimulus monies into various public projects-such as high-speed rail transport—creates not only jobs, but new industries in the better-paying high tech sector for the longer term.

The Cash for Clunkers is another example. By encouraging consumers to buy high-mileage cars, it nudges the auto industry and its affiliates towards energy conservation and lower pollution, as well as creating more jobs.

The stimulus monies were designed to feed into the economy over the next 2 years, once the financial markets stabilized. And so the just released minutes of the Federal Reserve’s latest Open Market Committee meeting point to continued concern that economic growth will take at least 2 years to recover. They are in no hurry to increase interest rates for that reason.

That’s a good thing for real estate values, in particular, not to speak of consumer debt loads, which have now fallen to 2005 levels. Low rates are spurring the real estate recovery, with fixed interest rates up to $729,750 now at or below 5 percent with a 1 point origination fee. The June Case-Shiller home price index increased for the first time in a year.

What about the federal debt? It is currently $9 trillion and on track to become $12 trillion by the end of 2009. That is approximately 80 percent of our Gross Domestic Product. That is high but nowhere near the record of 120 percent set in WWII, and it took that amount of government spending to get us out of the Great Depression.

This is important, because without the government stimulus spending we could be in a full-blown recession. Interest rates would not be this low and job losses would be much more serious. So though the government debt is troublesome, we won’t be able to pay any of it back without a sustained economic recovery, which means when the private sector is willing again to expand.

Harlan Green © 2009