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Tuesday, January 06, 2009

We'll See How This Works Out

This may be an exercise in hubris, because according to two thermometers, I have a temperature of over 104. Still, I really feel better than earlier, and as soon as I recover I have a bunch of stuff to do and will have limited time for blogging. But if this post seems incoherent, it's due to the feverish maniac who wrote it, and I apologize. In that case, come back later, because the problem is temporary. And I do apologize.

First news item: Bloomberg on Obama's prediction of trillion dollar deficits for "years to come":
President-elect Barack Obama said he expects to inherit a $1 trillion budget deficit and that similar shortfalls are in store “for years to come” as the government grapples with a recession and other spending demands.
This suggests to me that the government had better be darned careful about all those promises, such as universal health care, etc. In the comments on the previous post, Ron was arguing for investment in alternative energy. My reply is that we have very limited spare cash to play with, so we'd better be demanding one heck of a bang for our bucks.

Second news item: Bloomberg carries an opinion article
Obama’s Billions Could Render Furnaces Obsolete: Kevin Hassett:
President-elect Barack Obama has pledged to commit billions of dollars to providing America with a greener future. A big part of that agenda will be an effort to reduce the amount of energy that is consumed heating and cooling our houses.

Public policy generally proceeds in two steps. First, identify the objective. Then, craft policies to achieve it.

In the sphere of green building, the first step is easy. German engineers have identified and produced successful models of energy Nirvana. The question for policy makers is, how can we bring Nirvana to Newark? Given Obama’s strong commitment to a greener future, I expect we will see an answer soon.

Energy Nirvana is what Germans call the Passivhaus, or passive house. It accomplishes the almost unthinkable: During cold months, it maintains an acceptable temperature without relying on a traditional furnace. During hot months, it cools itself without relying on air conditioning.
If this doofus honestly believes we can afford to raze the housing we've got now and rebuild it, he's running a higher fever than I am. Kevin Hassett is the chump who said before the election that Obama would have the EPA declare CO2 a HAP. I hope he's not right. If he is, the US will enter a depression. There appears to be no end to people pushing unachievable agendas right now, and looking longingly at the federal government as a means.

Third news item: Bloomberg covers Alan Blinder's complaints about bank lending:
While inter-bank lending rates have fallen since Congress approved the $700 billion Troubled Asset Relief Program on Oct. 3, most bank lending to consumers remains tight and interest rates high. The average credit-card rate was 14.33 percent on Dec. 16, according to IndexCreditCards.com in Cleveland, almost unchanged from 14.41 percent in October 2007.
That’s prompted criticism from Alan S. Blinder, a professor of economics at Princeton University in New Jersey and a former Federal Reserve vice chairman, who says the government should take a more active role as a stakeholder in the nation’s banks.

With the banks in a state of catatonic fear now, they’re just sitting on the capital,” Blinder said in an interview. “I don’t fault the banks one bit, since this shows Wall Street they’re safer, but then this doesn’t get you much improvement. If you’re taking money from the public purse, we should get something in return, and we’re really not.”

Jeffrey Garten, a professor of international trade and finance at the Yale School of Management in New Haven, Connecticut, and a Commerce Department undersecretary during the Clinton administration, says banks should be forced to increase their lending or risk having taxpayer money taken away.
I laughed out loud at this. This comes back to David Foster's post on Chicago Boyz about the perils of pure theory, to which post I linked in this post.

Banking is a business. Ya gotta make money at it or you go out of business, and when you do, it generally costs the taxpayers money. The way you make money is by keeping up your NIM (Net Interest Margin). You can't lend below the sum of Cost of Funds + Cost of Reserves + Cost of Servicing + necessary Interest Margin. Just like any other business, the marginal interest pays for buildings, utilities, marketing, compliance, payroll, and all the other costs.

Needless to say, cost of Servicing goes up as defaults rise. Cost of Reserves does also. The only thing the Fed has accomplished is to push down Cost of Funds.

Let's look at Credit Card lending. Go to the Chargeoffs and Delinquency report by the FRB. While the delinquency rate has only risen slightly in a year (from 3rd quarter 07 to 3rd quarter 08) rising from 4.45% to 4.90%, the chargeoff rate has risen from 4.05% to 5.62%. Nor is it going to go down or stabilize anytime soon given rising unemployment. It will probably rise for a while and remain elevated for two to three years to come.

Given that increase, one can confidently predict that the cost of servicing one's credit card portfolio has risen considerably over the last year. For some it may have increased over 1.00% annually, but I would think hardly anyone is getting away with less than .5% annually. The percentage of income allocated to reserves must also rise. If you want to add costs of servicing 1.00% + 1.57%, you know that real returns on interest rates have dropped by more than 2.57%. Thus if cost of funds had not dropped, one would expect CC rates to be running around 17.5%.

Chargeoffs are writeoffs reported as an annualized percent of portfolio, and thus are exactly equivalent to interest rates. All other things being equal, you get the same return from a portfolio with face interest rate of 9.5 and chargeoffs of 0.5% as from a portfolio with face interest rate of 17% and chargeoffs of 8%. (Actually, all other things are never equal, and you will get a lower return on the second portfolio.)

Naturally, credit card issuers are trying to hold down their chargeoffs by tightening credit limits to riskier customers, raising rates and rejecting riskier customers. They do this so they can offer lower interest rates overall. If you demand that credit card issuers continue the same lending policies they had in place recently, you will force the credit card issuers to raise rates to cover necessary reserves.

Stop and think about this for a while. If I am lending at 14.50%, and I am writing off 5.50% each year, my return before reserve allocations and costs of servicing is 9.5%. Costs of servicing probably push that down to 7.5%. If I have to increase reserves to allocate for expected future losses, I may really need to put by 2-3% extra annually. Credit card margins have mostly tightened.

Credit card margins for those specializing in "subprime" CC and auto debt are at the bust level. Here is a bit from Compucredit's third quarter 2008 results:
CompuCredit's net interest margin was 15.1 percent in the third quarter of 2008, as compared to 18.7 percent for the third quarter of 2007 and 12.9 percent in the previous quarter, and its adjusted charge-off rate was 14.2 percent in the third quarter of 2008, as compared to 10.0 percent for the third quarter of 2007 and 19.2 percent in the previous quarter.
Needless to say these folks are running at a loss currently.

Now let's turn to mortgages and HELOCs for consumers. Chargeoff rates for consumer RE lending had increased to 1.45% in the third quarter of 2008 from 0.25% in the third quarter of 2007. In tandem, I can assure you that costs of servicing have sharply increased. For some institutions they have only gone up about a quarter of a percent (0.25 > 0.50), but for others they have increased by as much as 75 basis points. Thus a drop in cost of funds of 2% would equate to the same interest rates overall. That, however, does not cover the need to greatly increase reserve allocations.

The only way to lend at reasonable rates is to tighten credit standards. Mind you, in this environment if you have a bad loan you are probably stuck with working it out yourself. It is getting harder and harder to roll it over on FNMA, for example.

Therefore it is not that banks are paralyzed with terror. They are simply rolling with the punches. Before we are done credit card chargeoffs will go over 6% annually even with considerable tightening, and lord only knows how high consumer RE chargeoffs will go.

We have records since 1991 of consumer RE bank chargeoffs. Before the last year, the highest rate ever reported was 0.45% in third quarter 2001, and that only lasted for one quarter. It was a shock at the time. In fourth quarter 2007 the consumer RE lending chargeoff rate moved to 0.47%, and it has been rising steadily. No institution had the reserves to deal with this, and so now they have to cover the old bad loans from the proceeds of the new, hopefully better loans.

This is, by the way, because of lax lending standards, most especially low downpayment loans and/or piggyback loans. Delinquencies have risen much less in comparison to past downturns than chargeoffs have risen in comparison. Loss severity is stunningly high, but that's the problem with writing mortgages as they were written. The See No Evil, Hear No Evil, Speak No Evil School of Underwriting did not work out, and therefore, inevitably, banks must tighten lending standards. Therefore, the Even Blinder School of Stimulus is doomed to fail as well.

Alan Blinder is pretty blind to basic reality. Banks will all go bust unless they tighten new lending standards to a sustainable level. The commercial RE chargeoffs are soaring as well. In the the third quarter, we were just a touch away from exceeding the all time chargeoff rate for RE lending. We should have met and exceeded that level without any trouble in the fourth.

If Alan Blinder were to spend a month with a bunch of bank examiners, he might have a little more of a real-world perspective. As it is, he's a well-paid, prestigious idiot, and when I read this stuff I have trouble believing I'm not having neurological trouble. One would think that the reporter would at least call a bank or something. Why not call a bank examiner?

The two esteemed experts quoted above want to know what the public is getting out of this. Well, if the Fed had not pushed down cost of Funds, interest rates would be sharply higher for consumer lending than they are now.

The other factor in consumer lending, especially, is that people who didn't indulge in the debt orgy are mostly the financial conservatives. The thing about financial conservatives is that they are risk-averse. As these people stare at their diminishing portfolios and 401Ks, plus get notices about pay and benefit cuts at work, they are not that likely to start spending now even if rates are favorable.

Banks do not go out and abduct creditworthy customers. If they could, they probably would at this juncture, but thank heavens it is still illegal for press gangs of loan officers to roam the streets abducting prospects. It came close enough to that in the heyday of the boom, what with brokers hanging out at flea markets.

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