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Saturday, November 17, 2012

Q3 Chargeoffs and Delinquencies

Not going in the right direction as far as residential mortgages. This is deeply relevant to quite a lot of discussion that's going on, including FHA prospects.

When I have time I will babble on about this, but the bottom line is that an SA rate of 1.99 chargeoffs on residential mortgages for the 100 largest banks is quite some warning signal. That's the worst it has been since 2010. 

Delinquencies for the 100 largest banks on residential mortgages are up to a staggering 12.13%, the worst since the third quarter of 2010. 

And I have to read Fed droning about mortgage standards being too tight!!! These people have their heads up their butts. I find it hard to blog any more, because all I want to do is cuss in print.

This is mostly due to a bad economy and declining incomes, but the big wave of housing tax credits also generated a stream of bad buyers (overextended) who are now mostly underwater. Defaults on this latest crop will peak around 2014. Bad lending is the gift that just keeps giving.

The FHA actuarial report on the MMI was published yesterday. In one year, they calculate that the MMI present value dropped over 14 billion dollars. The largest single contribution (over 8 billion in the red) was due to low investment returns, largely courtesy of the Fed but also due to a slack economy.

In my opinion the Fed has created a deflationary spiral. It's clear that banks need to tighten credit standards now. This is going to be plug-ugly. Eeyore (CF) wins the palm again.


When you drop interest rates low initially, it gives a big boost. The assets out there are paying higher interest rates, it's cheap to borrow, and for a time the economy is boosted by the ability to borrow at low rates for new investment plus the high returns from prior lending. But as the thing wears on, return on total assets keeps dropping due to turnover/expiration of higher rate loans (assets). 

After half a decade of this, we are into the worst of all possible scenarios in which the need for future saving is skyrocketing due to low investment returns, but lending decisions have to become more conservative due to a poor economy and the disproportionate role that the risk premium must now play in lending. When interest rates for prime borrowing are very low, the relative impact of risk is very high. 

Or to put it another way, to cover that 1.99% chargeoff ratio you need to add 2% to 2.5% to the base interest rate. The 10 year is well below 2%. Thus the risk premium is more than the base interest rate. If you make a mistake and take on a little more risk than you had planned, any possible profits from the loan portfolio will be swallowed up like the whale gulped down Jonah, but unfortunately, there will be no happy ending in three days. 

Therefore, you go conservative. You cannot compensate by charging significantly higher rates to riskier borrowers, because in a couple of years your better borrowers will refi out into significantly lower cost loans and you will be left with a load of disaster. There's no way to compensate for this without throwing yourself into the abyss of adverse selection. The only way out is to lend very very conservatively.   

Go ahead and cut loose. I'm sure your cussing would be right in line with what the rest of us are thinking.
I see this effect in a number of ways. Local business men I know cannot get financing for normal equipment upgrades at a reasonable rate, so what they are doing is keeping their equipment in service longer and saving the money to buy used equipment with case as it comes on market. The net effect is to sharply cut down on the new equipment purchases by these small business men.

This effect seems to be operating in a number of local businesses I am aware of, from EMI test labs, a single proprietor tree service business, to a lawn service.

Not only does the low interest rate hurt their ability to finance capital purchases, but the money saved to purchase these items earn them nothing while they accumulate funds. In fact they are punished, as these funds are booked as profits and taxed, while if the purchases were financed they would reduce the taxable income of the business. Once again this establishes a considerable headwind to these business men.

The bright side of our current condition, MOM, is that only the political class - Congress, the courts, and Obama - can address the problems you cite, so we are really in the very best of hands.
Why thank you, Anon, for those uplifting and inspirational thoughts.

Where DID I leave my hemlock?
TJ - but it has such a low informational content.
Mr. Sensitive - it would be nice if I could point out that you only see a tiny piece of the world, and that there are all these green shoots everywhere.

Yet, as I contemplate the last two quarters of GDP reports, which showed minimal Gross Private Domestic Investment and no gain in Equipment and Software in Q3, I cannot. The data is on your side, and so is NFIB (small biz), which shows extreme slackness in investment plans at this point in the neverending recovery.

Business investment is in the pits, and now that we have spent forward the defense money in Q3, it's hard to forecast huge improvement.

Uncertainty cannot help. Who can plan for the next year right now? We are all up in the air.
If you think delinquencies are bad now, wait til you see what they are when the mortgage interest deduction is removed. Spain and Detroit come to mind.

Those that bought in part because of the interest deduction will cease to buy anything but the bare necessities or will be buying so much on credit cards they will default on those and the banks will be begging for another bailout. But likely they'll just default on their mortgages.

Those that didn't buy based on the deduction will pay off their loans faster thus reducing the value of the loans to the lenders. And those borrowers will cease to buy anything but the bare essentials.

I have 28 more months on my mortgage. The interest deduction is so small for me now it makes little difference. But if the deduction goes away, I will pay off my mortgage within 6 months and go on an austerity plan for 24 months.

What household would borrow for 30 years without an interest deduction? The only housing starts you'd see would be rentals. Any neighborhood farther away than 8 miles from a major job center would be hit hard. Even the ones closer in would be hit pretty good because property taxes would screw things up. And I haven't even mentioned AMT yet.

There's going to be a federal versus state versus municipal fight for tax dollars.

FHA financing for the Housing industry is similar to the auto bailout in that it has provided a temporary relief from the free fall housing values were experiencing ,saved jobs and given Obama a boast in his re-election effort. While I was initially against the FHA program I have come to appreciate that allowing housing values to continue falling at the rate they were was not in the countries long term interest. Housing and the auto industry both will continue to experience rough times and the wisdom or lack of it in providing temporary brakes on the speed of the down draft will unfold over time.
RE: Mr. Sensitive

I know a guy who has a lawn care/landscaping business. He's been in the industry for a while, operating below the level where all of the administrative/government compliance burdens kick in.

Last spring one of his equipment suppliers sold him an expensive basic lawnmower. The seller offered zero percent financing, presumably through the manufacturer. Deals were available for other equipment as well, but this guy only bought the mower.

He normally operates conservatively, buying used equipment. Not sure why he splurged this time, other than the financing.

He voted for Obama, because he thinks everyone should have health care. Yet he is very careful to keep his own business activity below the thresholds for the regulations that Obamaites love to lay on business.
What household would borrow for 30 years without an interest deduction?

Somebody who wants to wind up owning the house at the end of 30 years. By your logic, nobody would buy a car on credit, either. But they do, without deductibility.

And anybody with a brain should be able to figure out that "support" of home ownership via deductibility of interest merely results in the inflation of housing prices.

Let's say a house would go for $100,000 without deductibility of the interest, and further that the average mortgage would result in the average buyer "getting back" $5000 via reduction in taxes. Since the market can make a reasonable guess about this, the upshot is that the house will go for $105,000. That is, the "savings" will just be added in to the cost of the house, since now you're able to spend the $100k you've been able to afford all along plus the "sweetener" from the government.

(Obviously, there's amortization and all the other adjustments for the long-term "benefit" of tax credit compared to the immediate sale price of the house - naturally the $5k was a figure made up out of the blue as a for-instance - but however you want to calculate the tax benefit, the sale price will add on the average extra amount you can be expected to "get" from tax reduction to the amount you could afford without it.)

So, in terms of making housing more "affordable", the deductibility of interest does nothing to benefit the purchaser, since the result is an increase in price to the benefit of the purchaser. Which means that those who are already tied into the inflated prices have a vested interest in maintaining the deductibility since otherwise prices would deflate to reduce them to the lower level that would otherwise prevail. And the banks that hold the mortgages also don't want prices to deflate.

Also, since current prices necessarily factor in the mortgage deduction that most people take, this is disadvantageous to anybody who actually has the cash to purchase without a mortgage, since the market as a whole assumes that the purchaser will take advantage of the "benefit". Just another example of how the system is set up to favor borrowers over savers. Once again, for the benefit of money lenders.
If you think the Fed is the problem (and I do), you need to get your argument correct. Mortgage interest tax deduction isn't a subsidy. A paragraph in wikipedia gives a quick explanation: http://en.wikipedia.org/wiki/Home_mortgage_interest_deduction#United_States

What you really should be asking is how/why we've devolved to the point that households aren't considered proprietorships. And I'm sure you'd find the Fed behind that.
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