Washington Post, September 28, 2008
By Elizabeth Razzi
We interrupt this financial crisis with a word from its sponsor: the families who are losing homes to foreclosure.
They're still circling the drain, to pick up on Federal Reserve Chairman Ben S. Bernanke's colorful metaphor describing credit markets as the economy's plumbing. Right now, the plumbing is clogged with bad securities backed by bad home mortgages. The federal bailout is designed to free up the system.
A separate bailout for troubled homeowners is supposed to launch this week. The new "Hope for Homeowners" program, passed in late July, is scheduled to go into effect Wednesday. (That's lightning speed by government standards.) It's designed to allow refinancing for people who cannot pay their mortgage and who can't refinance into something better because their home value is now too low to pay off the unaffordable old loan.
Under the program, those borrowers may qualify for a new, 30-year, fixed-rate mortgage insured by the Federal Housing Administration if (and it's a huge if) their current lender agrees to forgive enough of their debt so that they would have at least 10 percent equity, right now.
These FHA loans are not available to people who could afford to keep paying their current loans but who don't want to because the home has lost value. Nor are they available to investors, flippers or to anyone who owns a second home.
Lender participation is voluntary, and writing off principal is the last technique most will employ when trying to save borrowers from foreclosure. At a hearing before the House Financial Services Committee on Sept. 17, Molly Sheehan, senior vice president of Chase Home Lending, said, "The investor community still disfavors principal reduction."
In other words, the investors who own the bonds backed by these bad mortgages don't like to write off part of the debt owed so the homeowner can avoid foreclosure. They would rather try something else first, such as reducing the interest rate or stretching out the repayment period, which causes smaller losses to them. Or they might even prefer that the home goes into foreclosure.
Bank of America, which earlier this year bought big mortgage lender Countrywide, seems more accommodating than some other lenders. Michael Gross, managing director for loss mitigation, said BofA postponed all 1,650 foreclosures that were scheduled from Sept. 8 to Sep. 22 until at least Oct. 15 and is evaluating whether those borrowers might benefit from the new Hope refinance. "We will use this program where it is needed," he said. An estimated 30,000 to 40,000 of the bank's customers may qualify.
Relief will probably not arrive on the Wednesday start date. The final details of the program hadn't been published as of last week. And the folks on the front lines of the housing crisis -- housing and debt counselors -- certainly don't have the details.
Those counselors are overwhelmed right now. In Prince George's County, for example, it can take weeks to schedule an appointment with a counselor certified by the Housing and Urban Development Department. It's even tough to get a live person to answer the phone at many agencies.
Mary Dade, the housing counseling program manager for United Communities Against Poverty, a nonprofit community-action agency in Capitol Heights, said many of the people coming in for help simply have too much debt -- of all types -- to enable them to keep their homes. "We do have a problem with the economy right now," she said. "Just the amount of debt you see is overwhelming."
She has heard about the new Hope refinance program but isn't prepared to field questions from borrowers. "I don't think the housing-counseling agencies have been given a detailed briefing on that," she said. She added that she doesn't tend to get too excited about new programs because in the past they have helped relatively few borrowers.
Dade said she was trying to back away from focusing so much on foreclosures so that her program can still meet its other missions, such as providing pre-purchase counseling, assisting troubled renters and educating consumers about how to manage debt. "We can't spend 80 percent of our time on foreclosures," she said, noting that each foreclosure-prevention client requires about 20 hours of work.
She stressed that she's "not a mean person." It's just that many of the people who come through the door simply don't have the income to handle the debts, even with help. "This is my heart here," she said. "I want these people to come back into homeownership another time when they know what they are doing. . . . Homeownership is not for beginners."
Dade added that there's as big a problem with struggling renters in Prince George's County as with foreclosures. The number of evictions this year is on pace to match last year's 4,600, she said. Dade estimates that her organization is able to help about 56 percent of its cases. About 30 percent have other social issues or mental-health problems that they can't address. And the rest never follow up beyond the initial contact.
Sometimes the best help her office can provide is toward getting together the two or three months' worth of rent a person with bad credit needs for a security deposit on a rental.
William Johnson, executive director of Roots of Mankind, a nonprofit agency in Temple Hills, also said there are some owners they cannot help. "Most of them, we can," he said.
He said some lenders are already writing off some of the debt to make mortgages more affordable. But too many are still offering workouts that try to make up for missed payments by raising the amount owed each month. "If you can't pay $1,000, how are you going to pay $1,800? They're ridiculous," he said.
Johnson said it's all up to the lenders whether they offer "a decent workout." Chase and GMAC, he noted, have been excellent about creating workouts that actually work.
If you're in danger of losing your home, and you think you might qualify for one of the new Hope refinances -- or for other assistance, for that matter -- take the initiative. Call your loan servicer and ask about the Hope for Homeowners program. And, by all means, if your lender tries to reach you by mail, e-mail or phone, respond to the outreach. They may have good news about your eligibility for a refinanced loan you can afford.
28 September 2008
How the Rescue Affects Homeowners
Washington Post, Saturday, September 27, 2008
By Kenneth R. Harney
Whether you see it as an exorbitantly costly taxpayer bailout of Wall Street and the banks or you're cheering from the sidelines, you can agree: The new federal moves to rescue the mortgage system could have huge effects on consumers in the months ahead.
The chief architect of the plans, Treasury Secretary Henry M. Paulson Jr., says the costs could run into the "hundreds of billions" of dollars -- and that probably means higher taxes somewhere down the line.
On the other hand, Paulson argued persuasively to Congress that the costs to taxpayers of not acting, and allowing the global financial system to unravel day by day, would ultimately be much higher.
The jury will be out on that issue for years. But for consumers, especially those looking for a new mortgage or who are deep in trouble on their house payments, the plan could have more immediate, life-changing effects. Here's why:
A key part of the Treasury's plan requires no approval from Congress -- pumping billions of dollars of fresh capital into the home loan market through purchases of mortgage-backed securities. The Treasury already is committed to inject $10 billion this month, and it is expected to announce substantial purchases for an extended period.
Fannie Mae and Freddie Mac, now under conservatorship by the federal government, also have been directed to accelerate their investments in mortgage securities. The effect should be to supply additional dollars for home buyers and refinancers, and to keep a damper on interest rates. So far, so good: Rates for 30-year, fixed-rate loans have remained near 6 percent.
A second key impact of the rescue plan addresses the dire situations faced by the estimated 5 million homeowners who are behind on their mortgage payments, many of whom own houses that are worth less than the principal balances owed.
The new government-controlled entity that will buy portfolios of troubled mortgage assets from lenders and bond investors is likely to take a different approach to delinquent borrowers than does the private sector. Rather than the slow, loan-by-loan modification typical of banks -- what are known as "workouts" to lower rates, payments and even loan balances -- the new government entity is likely to adopt a fix-the-problem-in-bulk approach advocated by the Federal Deposit Insurance Corporation, the regulator and insurer of federally chartered banks.
The FDIC has decades of experience handling the acquired assets of failed banks, including, recently, the giant IndyMac Bank, which went under in July. IndyMac had 742,000 mortgages in its portfolio,
60,000 of which were 60 days delinquent or at some stage of foreclosure. One of the first actions the FDIC took after stepping in to pick up IndyMac's pieces was to declare an immediate halt to all foreclosure actions, pending a portfolio-wide review.
The idea, according to FDIC Chairman Sheila C. Bair, was to whistle a time out to "evaluate the problems and identify the best ways to maximize the value of the institution." Simply pushing through scheduled foreclosures on the bank's delinquent customers would not achieve that goal because foreclosures are extremely costly to lenders -- and catastrophic financially for borrowers.
A smarter strategy, Bair said, is to work out better terms for as many borrowers as possible, turning unaffordable, delinquent mortgages into affordable loans at current income levels. The best way to do that in a large portfolio is not on a retail, loan-by-loan basis, she argued, but rather by using a "systematic" approach where all delinquent borrowers who fit pre-set criteria could automatically qualify for a modification of terms.
After an initial review of the 60,000 late borrowers in the IndyMac portfolio, the FDIC deemed about 40,000 customers eligible for the loan-modification program. Modification terms include rate reductions, lengthening of payback timetables, rescheduling unpaid principal and interest, rate caps, and other techniques. In some cases, rates are reduced to 3 percent for five years, with increases of 1 percent a year until the note rate reaches a ceiling tied to current 30-year rates.
Unlike private-sector servicers, the FDIC charges no fees for its modifications. In the two months since taking over IndyMac, Bair said, more than 7,400 modification proposals have been sent to delinquent borrowers, and "thousands more" have received calls attempting to prevent "unnecessary foreclosures."
That sort of wholesale remedial strategy -- including a halt to potentially hundreds of thousands of foreclosures -- is what probably awaits financially distressed homeowners when the new federal rescue program kicks in and acquires their mortgages.
Call it what you want. But if you're one of those troubled borrowers, two words are likely to come to mind: home saver.
By Kenneth R. Harney
Whether you see it as an exorbitantly costly taxpayer bailout of Wall Street and the banks or you're cheering from the sidelines, you can agree: The new federal moves to rescue the mortgage system could have huge effects on consumers in the months ahead.
The chief architect of the plans, Treasury Secretary Henry M. Paulson Jr., says the costs could run into the "hundreds of billions" of dollars -- and that probably means higher taxes somewhere down the line.
On the other hand, Paulson argued persuasively to Congress that the costs to taxpayers of not acting, and allowing the global financial system to unravel day by day, would ultimately be much higher.
The jury will be out on that issue for years. But for consumers, especially those looking for a new mortgage or who are deep in trouble on their house payments, the plan could have more immediate, life-changing effects. Here's why:
A key part of the Treasury's plan requires no approval from Congress -- pumping billions of dollars of fresh capital into the home loan market through purchases of mortgage-backed securities. The Treasury already is committed to inject $10 billion this month, and it is expected to announce substantial purchases for an extended period.
Fannie Mae and Freddie Mac, now under conservatorship by the federal government, also have been directed to accelerate their investments in mortgage securities. The effect should be to supply additional dollars for home buyers and refinancers, and to keep a damper on interest rates. So far, so good: Rates for 30-year, fixed-rate loans have remained near 6 percent.
A second key impact of the rescue plan addresses the dire situations faced by the estimated 5 million homeowners who are behind on their mortgage payments, many of whom own houses that are worth less than the principal balances owed.
The new government-controlled entity that will buy portfolios of troubled mortgage assets from lenders and bond investors is likely to take a different approach to delinquent borrowers than does the private sector. Rather than the slow, loan-by-loan modification typical of banks -- what are known as "workouts" to lower rates, payments and even loan balances -- the new government entity is likely to adopt a fix-the-problem-in-bulk approach advocated by the Federal Deposit Insurance Corporation, the regulator and insurer of federally chartered banks.
The FDIC has decades of experience handling the acquired assets of failed banks, including, recently, the giant IndyMac Bank, which went under in July. IndyMac had 742,000 mortgages in its portfolio,
60,000 of which were 60 days delinquent or at some stage of foreclosure. One of the first actions the FDIC took after stepping in to pick up IndyMac's pieces was to declare an immediate halt to all foreclosure actions, pending a portfolio-wide review.
The idea, according to FDIC Chairman Sheila C. Bair, was to whistle a time out to "evaluate the problems and identify the best ways to maximize the value of the institution." Simply pushing through scheduled foreclosures on the bank's delinquent customers would not achieve that goal because foreclosures are extremely costly to lenders -- and catastrophic financially for borrowers.
A smarter strategy, Bair said, is to work out better terms for as many borrowers as possible, turning unaffordable, delinquent mortgages into affordable loans at current income levels. The best way to do that in a large portfolio is not on a retail, loan-by-loan basis, she argued, but rather by using a "systematic" approach where all delinquent borrowers who fit pre-set criteria could automatically qualify for a modification of terms.
After an initial review of the 60,000 late borrowers in the IndyMac portfolio, the FDIC deemed about 40,000 customers eligible for the loan-modification program. Modification terms include rate reductions, lengthening of payback timetables, rescheduling unpaid principal and interest, rate caps, and other techniques. In some cases, rates are reduced to 3 percent for five years, with increases of 1 percent a year until the note rate reaches a ceiling tied to current 30-year rates.
Unlike private-sector servicers, the FDIC charges no fees for its modifications. In the two months since taking over IndyMac, Bair said, more than 7,400 modification proposals have been sent to delinquent borrowers, and "thousands more" have received calls attempting to prevent "unnecessary foreclosures."
That sort of wholesale remedial strategy -- including a halt to potentially hundreds of thousands of foreclosures -- is what probably awaits financially distressed homeowners when the new federal rescue program kicks in and acquires their mortgages.
Call it what you want. But if you're one of those troubled borrowers, two words are likely to come to mind: home saver.
Behind Insurer’s Crisis, Blind Eye to a Web of Risk
New York Times, September 28, 2008
By GRETCHEN MORGENSON
“It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.”
— Joseph J. Cassano, a former A.I.G. executive, August 2007
Two weeks ago, the nation’s most powerful regulators and bankers huddled in the Lower Manhattan fortress that is the Federal Reserve Bank of New York, desperately trying to stave off disaster.
As the group, led by Treasury Secretary Henry M. Paulson Jr., pondered the collapse of one of America’s oldest investment banks, Lehman Brothers, a more dangerous threat emerged: American International Group, the world’s largest insurer, was teetering. A.I.G. needed billions of dollars to right itself and had suddenly begged for help.
The only Wall Street chief executive participating in the meeting was Lloyd C. Blankfein of Goldman Sachs, Mr. Paulson’s former firm. Mr. Blankfein had particular reason for concern.
Although it was not widely known, Goldman, a Wall Street stalwart that had seemed immune to its rivals’ woes, was A.I.G.’s largest trading partner, according to six people close to the insurer who requested anonymity because of confidentiality agreements. A collapse of the insurer threatened to leave a hole of as much as $20 billion in Goldman’s side, several of these people said.
Days later, federal officials, who had let Lehman die and initially balked at tossing a lifeline to A.I.G., ended up bailing out the insurer for $85 billion.
Their message was simple: Lehman was expendable. But if A.I.G. unspooled, so could some of the mightiest enterprises in the world.
A Goldman spokesman said in an interview that the firm was never imperiled by A.I.G.’s troubles and that Mr. Blankfein participated in the Fed discussions to safeguard the entire financial system, not his firm’s own interests.
Yet an exploration of A.I.G.’s demise and its relationships with firms like Goldman offers important insights into the mystifying, virally connected — and astonishingly fragile — financial world that began to implode in recent weeks.
Although America’s housing collapse is often cited as having caused the crisis, the system was vulnerable because of intricate financial contracts known as credit derivatives, which insure debt holders against default. They are fashioned privately and beyond the ken of regulators — sometimes even beyond the understanding of executives peddling them.
Originally intended to diminish risk and spread prosperity, these inventions instead magnified the impact of bad mortgages like the ones that felled Bear Stearns and Lehman and now threaten the entire economy.
In the case of A.I.G., the virus exploded from a freewheeling little 377-person unit in London, and flourished in a climate of opulent pay, lax oversight and blind faith in financial risk models. It nearly decimated one of the world’s most admired companies, a seemingly sturdy insurer with a trillion-dollar balance sheet, 116,000 employees and operations in 130 countries.
“It is beyond shocking that this small operation could blow up the holding company,” said Robert Arvanitis, chief executive of Risk Finance Advisors in Westport, Conn. “They found a quick way to make a fast buck on derivatives based on A.I.G.’s solid credit rating and strong balance sheet. But it all got out of control.”
The London Office
The insurance giant’s London unit was known as A.I.G. Financial Products, or A.I.G.F.P. It was run with almost complete autonomy, and with an iron hand, by Joseph J. Cassano, according to current and former A.I.G. employees.
A onetime executive with Drexel Burnham Lambert — the investment bank made famous in the 1980s by the junk bond king Michael R. Milken, who later pleaded guilty to six felony charges — Mr. Cassano helped start the London unit in 1987.
The unit became profitable enough that analysts considered Mr. Cassano a dark horse candidate to succeed Maurice R. Greenberg, the longtime chief executive who shaped A.I.G. in his own image until he was ousted amid an accounting scandal three years ago.
But last February, Mr. Cassano resigned after the London unit began bleeding money and auditors raised questions about how the unit valued its holdings. By Sept. 15, the unit’s troubles forced a major downgrade in A.I.G.’s debt rating, requiring the company to post roughly $15 billion in additional collateral — which then prompted the federal rescue.
Mr. Cassano, 53, lives in a handsome, three-story town house in the Knightsbridge neighborhood of London, just around the corner from Harrods department store on a quiet square with a private garden.
He did not respond to interview requests left at his home and with his lawyer. An A.I.G. spokesman also declined to comment.
At A.I.G., Mr. Cassano found himself ensconced in a behemoth that had a long and storied history of deftly juggling risks. It insured people and properties against natural disasters and death, offered sophisticated asset management services and did so reliably and with bravado on many continents. Even now, its insurance subsidiaries are financially strong.
When Mr. Cassano first waded into the derivatives market, his biggest business was selling so-called plain vanilla products like interest rate swaps. Such swaps allow participants to bet on the direction of interest rates and, in theory, insulate themselves from unforeseen financial events.
Ten years ago, a “watershed” moment changed the profile of the derivatives that Mr. Cassano traded, according to a transcript of comments he made at an industry event last year. Derivatives specialists from J. P. Morgan, a leading bank that had many dealings with Mr. Cassano’s unit, came calling with a novel idea.
Morgan proposed the following: A.I.G. should try writing insurance on packages of debt known as “collateralized debt obligations.” C.D.O.’s. were pools of loans sliced into tranches and sold to investors based on the credit quality of the underlying securities.
The proposal meant that the London unit was essentially agreeing to provide insurance to financial institutions holding C.D.O.’s and other debts in case they defaulted — in much the same way some homeowners are required to buy mortgage insurance to protect lenders in case the borrowers cannot pay back their loans.
Under the terms of the insurance derivatives that the London unit underwrote, customers paid a premium to insure their debt for a period of time, usually four or five years, according to the company. Many European banks, for instance, paid A.I.G. to insure bonds that they held in their portfolios.
Because the underlying debt securities — mostly corporate issues and a smattering of mortgage securities — carried blue-chip ratings, A.I.G. Financial Products was happy to book income in exchange for providing insurance. After all, Mr. Cassano and his colleagues apparently assumed, they would never have to pay any claims.
Since A.I.G. itself was a highly rated company, it did not have to post collateral on the insurance it wrote, analysts said. That made the contracts all the more profitable.
These insurance products were known as “credit default swaps,” or C.D.S.’s in Wall Street argot, and the London unit used them to turn itself into a cash register.
The unit’s revenue rose to $3.26 billion in 2005 from $737 million in 1999. Operating income at the unit also grew, rising to 17.5 percent of A.I.G.’s overall operating income in 2005, compared with 4.2 percent in 1999.
Profit margins on the business were enormous. In 2002, operating income was 44 percent of revenue; in 2005, it reached 83 percent.
Mr. Cassano and his colleagues minted tidy fortunes during these high-cotton years. Since 2001, compensation at the small unit ranged from $423 million to $616 million each year, according to corporate filings. That meant that on average each person in the unit made more than $1 million a year.
In fact, compensation expenses took a large percentage of the unit’s revenue. In lean years it was 33 percent; in fatter ones 46 percent. Over all, A.I.G. Financial Products paid its employees $3.56 billion during the last seven years.
The London unit’s reach was also vast. While clients and counterparties remain closely guarded secrets in the derivatives trade, Mr. Cassano talked publicly about how proud he was of his customer list.
At the 2007 conference he noted that his company worked with a “global swath” of top-notch entities that included “banks and investment banks, pension funds, endowments, foundations, insurance companies, hedge funds, money managers, high-net-worth individuals, municipalities and sovereigns and supranationals.”
Of course, as this intricate skein expanded over the years, it meant that the participants were linked to one another by contracts that existed for the most part inside the financial world’s version of a black box.
Goldman Sachs was a member of A.I.G.’s derivatives club, according to people familiar with the operation. It was a customer of A.I.G.’s credit insurance and also acted as an intermediary for trades between A.I.G. and its other clients.
Few knew of Goldman’s exposure to A.I.G. When the insurer’s flameout became public, David A. Viniar, Goldman’s chief financial officer, assured analysts on Sept. 16 that his firm’s exposure was “immaterial,” a view that the company reiterated in an interview.
Later that same day, the government announced its two-year, $85 billion loan to A.I.G., offering it a chance to sell its assets in an orderly fashion and theoretically repay taxpayers for their trouble. The plan saved the insurer’s trading partners but decimated its shareholders.
Lucas van Praag, a Goldman spokesman, declined to detail how badly hurt his firm might have been had A.I.G. collapsed two weeks ago. He disputed the calculation that Goldman had $20 billion worth of risk tied to A.I.G., saying the figure failed to account for collateral and hedges that Goldman deployed to reduce its risk.
Regarding Mr. Blankfein’s presence at the Fed during talks about an A.I.G. bailout, he said: “I think it would be a mistake to read into it that he was there because of our own interests. We were engaged because of the implications to the entire system.”
Mr. van Praag declined to comment on what communications, if any, took place between Mr. Blankfein and the Treasury secretary, Mr. Paulson, during the bailout discussions.
A Treasury spokeswoman declined to comment about the A.I.G. rescue and Goldman’s role. The government recently allowed Goldman to change its regulatory status to help bolster its finances amid the market turmoil.
An Executive’s Optimism
Regardless of Goldman’s exposure, by last year, A.I.G. Financial Products’ portfolio of credit default swaps stood at roughly $500 billion. It was generating as much as $250 million a year in income on insurance premiums, Mr. Cassano told investors.
Because it was not an insurance company, A.I.G. Financial Products did not have to report to state insurance regulators. But for the last four years, the London-based unit’s operations, whose trades were routed through Banque A.I.G., a French institution, were reviewed routinely by an American regulator, the Office of Thrift Supervision.
A handful of the agency’s officials were always on the scene at an A.I.G. Financial Products branch office in Connecticut, but it is unclear whether they raised any red flags. Their reports are not made public and a spokeswoman would not provide details.
For his part, Mr. Cassano apparently was not worried that his unit had taken on more than it could handle. In an August 2007 conference call with analysts, he described the credit default swaps as almost a sure thing.
“It is hard to get this message across, but these are very much handpicked,” he assured those on the phone.
Just a few months later, however, the credit crisis deepened. A.I.G. Financial Products began to choke on losses — though they were only on paper.
In the quarter that ended Sept. 30, 2007, A.I.G. recognized a $352 million unrealized loss on the credit default swap portfolio.
Because the London unit was set up as a bank and not an insurer, and because of the way its derivatives contracts were written, it had to put up collateral to its trading partners when the value of the underlying securities they had insured declined. Any obligations that the unit could not pay had to be met by its corporate parent.
So began A.I.G.’s downward spiral as it, its clients, its trading partners and other companies were swept into the drowning pool set in motion by the housing downturn.
Mortgage foreclosures set off questions about the quality of debts across the entire credit spectrum. When the value of other debts sagged, calls for collateral on the securities issued by the credit default swaps sideswiped A.I.G. Financial Products and its legendary, sprawling parent.
Yet throughout much of 2007, the unit maintained that its risk assessments were reliable and its portfolios conservative. Last fall, however, the methods that A.I.G. used to value its derivatives portfolio began to come under fire from trading partners.
In February, A.I.G.’s auditors identified problems in the firm’s swaps accounting. Then, three months ago, regulators and federal prosecutors said they were investigating the insurer’s accounting.
This was not the first time A.I.G. Financial Products had run afoul of authorities. In 2004, without admitting or denying accusations that it helped clients improperly burnish their financial statements, A.I.G. paid $126 million and entered into a deferred prosecution agreement to settle federal civil and criminal investigations.
The settlement was a black mark on A.I.G.’s reputation and, according to analysts, distressed Mr. Greenberg, who still ran the company at the time. Still, as Mr. Cassano later told investors, the case caused A.I.G. to improve its risk management and establish a committee to maintain quality control.
“That’s a committee that I sit on, along with many of the senior managers at A.I.G., and we look at a whole variety of transactions that come in to make sure that they are maintaining the quality that we need to,” Mr. Cassano told them. “And so I think the things that have been put in at our level and the things that have been put in at the parent level will ensure that there won’t be any of those kinds of mistakes again.”
At the end of A.I.G.’s most recent quarter, the London unit’s losses reached $25 billion.
As those losses mounted, and A.I.G.’s once formidable stock price plunged, it became harder for the insurer to survive — imperiling other companies that did business with it and leading it to stun the Federal Reserve gathering two weeks ago with a plea for help.
Mr. Greenberg, who has seen the value of his personal A.I.G. holdings decline by more than $5 billion this year, dumped five million shares late last week. A lawyer for Mr. Greenberg did not return a phone call seeking comment.
For his part, Mr. Cassano has departed from a company that is a far cry from what it was a year ago when he spoke confidently at the analyst conference.
“We’re sitting on a great balance sheet, a strong investment portfolio and a global trading platform where we can take advantage of the market in any variety of places,” he said then. “The question for us is, where in the capital markets can we gain the best opportunity, the best execution for the business acumen that sits in our shop?”
By GRETCHEN MORGENSON
“It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.”
— Joseph J. Cassano, a former A.I.G. executive, August 2007
Two weeks ago, the nation’s most powerful regulators and bankers huddled in the Lower Manhattan fortress that is the Federal Reserve Bank of New York, desperately trying to stave off disaster.
As the group, led by Treasury Secretary Henry M. Paulson Jr., pondered the collapse of one of America’s oldest investment banks, Lehman Brothers, a more dangerous threat emerged: American International Group, the world’s largest insurer, was teetering. A.I.G. needed billions of dollars to right itself and had suddenly begged for help.
The only Wall Street chief executive participating in the meeting was Lloyd C. Blankfein of Goldman Sachs, Mr. Paulson’s former firm. Mr. Blankfein had particular reason for concern.
Although it was not widely known, Goldman, a Wall Street stalwart that had seemed immune to its rivals’ woes, was A.I.G.’s largest trading partner, according to six people close to the insurer who requested anonymity because of confidentiality agreements. A collapse of the insurer threatened to leave a hole of as much as $20 billion in Goldman’s side, several of these people said.
Days later, federal officials, who had let Lehman die and initially balked at tossing a lifeline to A.I.G., ended up bailing out the insurer for $85 billion.
Their message was simple: Lehman was expendable. But if A.I.G. unspooled, so could some of the mightiest enterprises in the world.
A Goldman spokesman said in an interview that the firm was never imperiled by A.I.G.’s troubles and that Mr. Blankfein participated in the Fed discussions to safeguard the entire financial system, not his firm’s own interests.
Yet an exploration of A.I.G.’s demise and its relationships with firms like Goldman offers important insights into the mystifying, virally connected — and astonishingly fragile — financial world that began to implode in recent weeks.
Although America’s housing collapse is often cited as having caused the crisis, the system was vulnerable because of intricate financial contracts known as credit derivatives, which insure debt holders against default. They are fashioned privately and beyond the ken of regulators — sometimes even beyond the understanding of executives peddling them.
Originally intended to diminish risk and spread prosperity, these inventions instead magnified the impact of bad mortgages like the ones that felled Bear Stearns and Lehman and now threaten the entire economy.
In the case of A.I.G., the virus exploded from a freewheeling little 377-person unit in London, and flourished in a climate of opulent pay, lax oversight and blind faith in financial risk models. It nearly decimated one of the world’s most admired companies, a seemingly sturdy insurer with a trillion-dollar balance sheet, 116,000 employees and operations in 130 countries.
“It is beyond shocking that this small operation could blow up the holding company,” said Robert Arvanitis, chief executive of Risk Finance Advisors in Westport, Conn. “They found a quick way to make a fast buck on derivatives based on A.I.G.’s solid credit rating and strong balance sheet. But it all got out of control.”
The London Office
The insurance giant’s London unit was known as A.I.G. Financial Products, or A.I.G.F.P. It was run with almost complete autonomy, and with an iron hand, by Joseph J. Cassano, according to current and former A.I.G. employees.
A onetime executive with Drexel Burnham Lambert — the investment bank made famous in the 1980s by the junk bond king Michael R. Milken, who later pleaded guilty to six felony charges — Mr. Cassano helped start the London unit in 1987.
The unit became profitable enough that analysts considered Mr. Cassano a dark horse candidate to succeed Maurice R. Greenberg, the longtime chief executive who shaped A.I.G. in his own image until he was ousted amid an accounting scandal three years ago.
But last February, Mr. Cassano resigned after the London unit began bleeding money and auditors raised questions about how the unit valued its holdings. By Sept. 15, the unit’s troubles forced a major downgrade in A.I.G.’s debt rating, requiring the company to post roughly $15 billion in additional collateral — which then prompted the federal rescue.
Mr. Cassano, 53, lives in a handsome, three-story town house in the Knightsbridge neighborhood of London, just around the corner from Harrods department store on a quiet square with a private garden.
He did not respond to interview requests left at his home and with his lawyer. An A.I.G. spokesman also declined to comment.
At A.I.G., Mr. Cassano found himself ensconced in a behemoth that had a long and storied history of deftly juggling risks. It insured people and properties against natural disasters and death, offered sophisticated asset management services and did so reliably and with bravado on many continents. Even now, its insurance subsidiaries are financially strong.
When Mr. Cassano first waded into the derivatives market, his biggest business was selling so-called plain vanilla products like interest rate swaps. Such swaps allow participants to bet on the direction of interest rates and, in theory, insulate themselves from unforeseen financial events.
Ten years ago, a “watershed” moment changed the profile of the derivatives that Mr. Cassano traded, according to a transcript of comments he made at an industry event last year. Derivatives specialists from J. P. Morgan, a leading bank that had many dealings with Mr. Cassano’s unit, came calling with a novel idea.
Morgan proposed the following: A.I.G. should try writing insurance on packages of debt known as “collateralized debt obligations.” C.D.O.’s. were pools of loans sliced into tranches and sold to investors based on the credit quality of the underlying securities.
The proposal meant that the London unit was essentially agreeing to provide insurance to financial institutions holding C.D.O.’s and other debts in case they defaulted — in much the same way some homeowners are required to buy mortgage insurance to protect lenders in case the borrowers cannot pay back their loans.
Under the terms of the insurance derivatives that the London unit underwrote, customers paid a premium to insure their debt for a period of time, usually four or five years, according to the company. Many European banks, for instance, paid A.I.G. to insure bonds that they held in their portfolios.
Because the underlying debt securities — mostly corporate issues and a smattering of mortgage securities — carried blue-chip ratings, A.I.G. Financial Products was happy to book income in exchange for providing insurance. After all, Mr. Cassano and his colleagues apparently assumed, they would never have to pay any claims.
Since A.I.G. itself was a highly rated company, it did not have to post collateral on the insurance it wrote, analysts said. That made the contracts all the more profitable.
These insurance products were known as “credit default swaps,” or C.D.S.’s in Wall Street argot, and the London unit used them to turn itself into a cash register.
The unit’s revenue rose to $3.26 billion in 2005 from $737 million in 1999. Operating income at the unit also grew, rising to 17.5 percent of A.I.G.’s overall operating income in 2005, compared with 4.2 percent in 1999.
Profit margins on the business were enormous. In 2002, operating income was 44 percent of revenue; in 2005, it reached 83 percent.
Mr. Cassano and his colleagues minted tidy fortunes during these high-cotton years. Since 2001, compensation at the small unit ranged from $423 million to $616 million each year, according to corporate filings. That meant that on average each person in the unit made more than $1 million a year.
In fact, compensation expenses took a large percentage of the unit’s revenue. In lean years it was 33 percent; in fatter ones 46 percent. Over all, A.I.G. Financial Products paid its employees $3.56 billion during the last seven years.
The London unit’s reach was also vast. While clients and counterparties remain closely guarded secrets in the derivatives trade, Mr. Cassano talked publicly about how proud he was of his customer list.
At the 2007 conference he noted that his company worked with a “global swath” of top-notch entities that included “banks and investment banks, pension funds, endowments, foundations, insurance companies, hedge funds, money managers, high-net-worth individuals, municipalities and sovereigns and supranationals.”
Of course, as this intricate skein expanded over the years, it meant that the participants were linked to one another by contracts that existed for the most part inside the financial world’s version of a black box.
Goldman Sachs was a member of A.I.G.’s derivatives club, according to people familiar with the operation. It was a customer of A.I.G.’s credit insurance and also acted as an intermediary for trades between A.I.G. and its other clients.
Few knew of Goldman’s exposure to A.I.G. When the insurer’s flameout became public, David A. Viniar, Goldman’s chief financial officer, assured analysts on Sept. 16 that his firm’s exposure was “immaterial,” a view that the company reiterated in an interview.
Later that same day, the government announced its two-year, $85 billion loan to A.I.G., offering it a chance to sell its assets in an orderly fashion and theoretically repay taxpayers for their trouble. The plan saved the insurer’s trading partners but decimated its shareholders.
Lucas van Praag, a Goldman spokesman, declined to detail how badly hurt his firm might have been had A.I.G. collapsed two weeks ago. He disputed the calculation that Goldman had $20 billion worth of risk tied to A.I.G., saying the figure failed to account for collateral and hedges that Goldman deployed to reduce its risk.
Regarding Mr. Blankfein’s presence at the Fed during talks about an A.I.G. bailout, he said: “I think it would be a mistake to read into it that he was there because of our own interests. We were engaged because of the implications to the entire system.”
Mr. van Praag declined to comment on what communications, if any, took place between Mr. Blankfein and the Treasury secretary, Mr. Paulson, during the bailout discussions.
A Treasury spokeswoman declined to comment about the A.I.G. rescue and Goldman’s role. The government recently allowed Goldman to change its regulatory status to help bolster its finances amid the market turmoil.
An Executive’s Optimism
Regardless of Goldman’s exposure, by last year, A.I.G. Financial Products’ portfolio of credit default swaps stood at roughly $500 billion. It was generating as much as $250 million a year in income on insurance premiums, Mr. Cassano told investors.
Because it was not an insurance company, A.I.G. Financial Products did not have to report to state insurance regulators. But for the last four years, the London-based unit’s operations, whose trades were routed through Banque A.I.G., a French institution, were reviewed routinely by an American regulator, the Office of Thrift Supervision.
A handful of the agency’s officials were always on the scene at an A.I.G. Financial Products branch office in Connecticut, but it is unclear whether they raised any red flags. Their reports are not made public and a spokeswoman would not provide details.
For his part, Mr. Cassano apparently was not worried that his unit had taken on more than it could handle. In an August 2007 conference call with analysts, he described the credit default swaps as almost a sure thing.
“It is hard to get this message across, but these are very much handpicked,” he assured those on the phone.
Just a few months later, however, the credit crisis deepened. A.I.G. Financial Products began to choke on losses — though they were only on paper.
In the quarter that ended Sept. 30, 2007, A.I.G. recognized a $352 million unrealized loss on the credit default swap portfolio.
Because the London unit was set up as a bank and not an insurer, and because of the way its derivatives contracts were written, it had to put up collateral to its trading partners when the value of the underlying securities they had insured declined. Any obligations that the unit could not pay had to be met by its corporate parent.
So began A.I.G.’s downward spiral as it, its clients, its trading partners and other companies were swept into the drowning pool set in motion by the housing downturn.
Mortgage foreclosures set off questions about the quality of debts across the entire credit spectrum. When the value of other debts sagged, calls for collateral on the securities issued by the credit default swaps sideswiped A.I.G. Financial Products and its legendary, sprawling parent.
Yet throughout much of 2007, the unit maintained that its risk assessments were reliable and its portfolios conservative. Last fall, however, the methods that A.I.G. used to value its derivatives portfolio began to come under fire from trading partners.
In February, A.I.G.’s auditors identified problems in the firm’s swaps accounting. Then, three months ago, regulators and federal prosecutors said they were investigating the insurer’s accounting.
This was not the first time A.I.G. Financial Products had run afoul of authorities. In 2004, without admitting or denying accusations that it helped clients improperly burnish their financial statements, A.I.G. paid $126 million and entered into a deferred prosecution agreement to settle federal civil and criminal investigations.
The settlement was a black mark on A.I.G.’s reputation and, according to analysts, distressed Mr. Greenberg, who still ran the company at the time. Still, as Mr. Cassano later told investors, the case caused A.I.G. to improve its risk management and establish a committee to maintain quality control.
“That’s a committee that I sit on, along with many of the senior managers at A.I.G., and we look at a whole variety of transactions that come in to make sure that they are maintaining the quality that we need to,” Mr. Cassano told them. “And so I think the things that have been put in at our level and the things that have been put in at the parent level will ensure that there won’t be any of those kinds of mistakes again.”
At the end of A.I.G.’s most recent quarter, the London unit’s losses reached $25 billion.
As those losses mounted, and A.I.G.’s once formidable stock price plunged, it became harder for the insurer to survive — imperiling other companies that did business with it and leading it to stun the Federal Reserve gathering two weeks ago with a plea for help.
Mr. Greenberg, who has seen the value of his personal A.I.G. holdings decline by more than $5 billion this year, dumped five million shares late last week. A lawyer for Mr. Greenberg did not return a phone call seeking comment.
For his part, Mr. Cassano has departed from a company that is a far cry from what it was a year ago when he spoke confidently at the analyst conference.
“We’re sitting on a great balance sheet, a strong investment portfolio and a global trading platform where we can take advantage of the market in any variety of places,” he said then. “The question for us is, where in the capital markets can we gain the best opportunity, the best execution for the business acumen that sits in our shop?”
Everybody’s Business: In Financial Food Chains, Little Guys Can’t Win
New York Times, September 28, 2008
By BEN STEIN
Imagine, if you will, that a man who had much to do with creating the present credit crisis now says he is the man to fix this giant problem, and that his work is so important that he will need a trillion dollars or so of your money. Then add that this man thinks he is so indispensable that he wants Congress to forbid any judicial or administrative questioning of anything he does with your dollars.
You might think of a latter-day Lenin or Fidel Castro, but you would be far afield. Instead, you should be thinking of Treasury Secretary Henry M. Paulson Jr. and the rapidly disintegrating United States of America, right here and now.
But I am getting ahead of myself. First, I am furious at what the traders, speculators, hedge funds and the government have done to everyone who is saving and investing for retirement and future security. Millions of us did nothing wrong, according to the accepted wisdom of the age. We saved. We put a large part of our money into the stock market, as we were urged to do. Because the market wasn’t at ridiculously high levels, it seemed prudent to invest in broad indexes, foreign indexes and small- and large-cap indexes.
Now we have had the rug pulled out from under us. Our retirements have been put into severe jeopardy. The “earnings” part of those price-to-earnings ratios turns out to have been fiction for some financial companies, which normally account for a big part of total corporate earnings. In fact, earnings of giant finance players were often wildly negative, creating a situation rarely seen since the Great Depression, when the aggregate earnings of the Dow 30 were negative.
The current negativity occurred because of wild, casino-type operations of big finance players, creating liabilities way beyond anything we could have reasonably expected. This looks a lot like theft on a spectacular scale — of our wallets, our peace of mind, our futures.
Second, according to what I hear from my betters in the world of finance, the most serious problems are not with the bundles of subprime mortgages themselves — a large but not lethal quantum as far as I can tell — but with derivatives contracts tied to subprime and other dicey debt. These contracts are superficially an attempt to “insure” against risks of default, hence the name “credit-default swaps.” In fact, they are an immense wager — which anyone with lots of money or borrowing ability can enter — about how mortgage-backed bonds, leveraged loan bonds, student loan bonds, credit card bonds and the like will perform.
These wagers entail amounts many times larger than the total of subprime loans. In fact, there are roughly $62 trillion in credit-default swap derivatives out there, compared with about $1 trillion of subprime mortgages. These derivatives are “weapons of financial mass destruction,” in the prophetic words of Warren E. Buffett. (Apparently believing that the worst is over, at least for one big investment bank, Mr. Buffett is now investing in Goldman Sachs.)
The swaps market has been unregulated. It has been just a lot of people making bets with one another. Some of them made incredibly fortunate payoff wagers against the mortgage bonds, using credit-default swaps as their wagering vehicle. I am not sure who the big winners are, but they are out there, and the gains were big enough to cripple the part of Wall Street on the losing side of the bets.
Almost no one (except Mr. Buffett) saw this coming, at least not on this scale. But let’s get back to the man of the hour. Why didn’t Mr. Paulson, the Treasury secretary, see it? He was once the head of Goldman Sachs, an immense player in the swaps world. Didn’t people at Treasury have a clue? If they didn’t, what was going on in their heads? If they did, why didn’t they do something about it a year ago, when saving the world would have been a lot cheaper?
If Mr. Paulson and Ben S. Bernanke, the chairman of the Federal Reserve, didn’t see this train coming, what else have they missed? What other freight train is barreling down the track at us?
All of this would be bad enough. But by far the most terrifying item I read in my morning paper last week was this: Mr. Paulson demanded that Congress forbid judicial review of his decisions on use of the money in the mortgage bailout. This would amount to an abrogation of the Constitution. Not only would his decisions be sacrosanct and above the law, but so would the actions of his pals in the banking world in connection with this bailout.
The people whose conduct got us into this catastrophe have not only taken our money, hopes and peace of mind, but they apparently also want a trillion or so more dollars to put into their Wall Street Buddy System Fund. This may be the most dangerous attack on the law in my lifetime. What anarchists even dared consider this plan? Thank heaven that minds more devoted to the Constitution on Capitol Hill are questioning this shocking request.
By the way, if we are actually thinking about tossing the Constitution out the window, why not simply annul these credit-default swap contracts? With that done, the incomprehensibly large liability of the banks would cease, and we wouldn’t need this staggering bailout. Shouldn’t we consider making the speculators pay some of the price?
WE have survived housing-price corrections before. Why is this one causing so much anguish? It must be the side bets, the credit-default swap bets, multiplying the effect of the housing downturn many times over. Maybe we should just get rid of these exotic bets and start again without them. “Insurance” on market moves is always a bad idea, because it does not tamp down market disruptions but instead greatly magnifies them — as in the disastrous effect of “portfolio insurance” in the 1987 crash.
Then there was Mr. Paulson’s insistence that there be no compensation caps for executives of companies being bailed out by the factory workers, the farmers, the schoolteachers and the medical doctors. He told a skeptical Congress on Tuesday that if these caps were put into place, bank executives simply wouldn’t participate in the bailout or sell us suckers their debts. Fine with me. If the banks are in good enough shape so that petulant executives can simply opt out rather than live on a few million a year, maybe we don’t need the bailout at all. Maybe we would be better off if those executives simply bailed out and were replaced by people with more sense and more patriotism.
One final little thought bubbles into my mind: Maybe the bailout should not be of the banks at all, but of homeowners themselves. Maybe if we make the government the buyer of last resort of homes, we will stabilize the markets, stabilize the debt associated with the markets and take the gain out of the credit-default swaps for the speculators. Yes, price would be a huge issue, but so it is for Mr. Paulson’s plan for buying debt from banks.
Why not? We do it for farmers. Why not for the individual homeowner? Oh, right. Because Treasury secretaries don’t know any of those people.
Ben Stein is a lawyer, writer, actor and economist. E-mail: ebiz@nytimes.com.
By BEN STEIN
Imagine, if you will, that a man who had much to do with creating the present credit crisis now says he is the man to fix this giant problem, and that his work is so important that he will need a trillion dollars or so of your money. Then add that this man thinks he is so indispensable that he wants Congress to forbid any judicial or administrative questioning of anything he does with your dollars.
You might think of a latter-day Lenin or Fidel Castro, but you would be far afield. Instead, you should be thinking of Treasury Secretary Henry M. Paulson Jr. and the rapidly disintegrating United States of America, right here and now.
But I am getting ahead of myself. First, I am furious at what the traders, speculators, hedge funds and the government have done to everyone who is saving and investing for retirement and future security. Millions of us did nothing wrong, according to the accepted wisdom of the age. We saved. We put a large part of our money into the stock market, as we were urged to do. Because the market wasn’t at ridiculously high levels, it seemed prudent to invest in broad indexes, foreign indexes and small- and large-cap indexes.
Now we have had the rug pulled out from under us. Our retirements have been put into severe jeopardy. The “earnings” part of those price-to-earnings ratios turns out to have been fiction for some financial companies, which normally account for a big part of total corporate earnings. In fact, earnings of giant finance players were often wildly negative, creating a situation rarely seen since the Great Depression, when the aggregate earnings of the Dow 30 were negative.
The current negativity occurred because of wild, casino-type operations of big finance players, creating liabilities way beyond anything we could have reasonably expected. This looks a lot like theft on a spectacular scale — of our wallets, our peace of mind, our futures.
Second, according to what I hear from my betters in the world of finance, the most serious problems are not with the bundles of subprime mortgages themselves — a large but not lethal quantum as far as I can tell — but with derivatives contracts tied to subprime and other dicey debt. These contracts are superficially an attempt to “insure” against risks of default, hence the name “credit-default swaps.” In fact, they are an immense wager — which anyone with lots of money or borrowing ability can enter — about how mortgage-backed bonds, leveraged loan bonds, student loan bonds, credit card bonds and the like will perform.
These wagers entail amounts many times larger than the total of subprime loans. In fact, there are roughly $62 trillion in credit-default swap derivatives out there, compared with about $1 trillion of subprime mortgages. These derivatives are “weapons of financial mass destruction,” in the prophetic words of Warren E. Buffett. (Apparently believing that the worst is over, at least for one big investment bank, Mr. Buffett is now investing in Goldman Sachs.)
The swaps market has been unregulated. It has been just a lot of people making bets with one another. Some of them made incredibly fortunate payoff wagers against the mortgage bonds, using credit-default swaps as their wagering vehicle. I am not sure who the big winners are, but they are out there, and the gains were big enough to cripple the part of Wall Street on the losing side of the bets.
Almost no one (except Mr. Buffett) saw this coming, at least not on this scale. But let’s get back to the man of the hour. Why didn’t Mr. Paulson, the Treasury secretary, see it? He was once the head of Goldman Sachs, an immense player in the swaps world. Didn’t people at Treasury have a clue? If they didn’t, what was going on in their heads? If they did, why didn’t they do something about it a year ago, when saving the world would have been a lot cheaper?
If Mr. Paulson and Ben S. Bernanke, the chairman of the Federal Reserve, didn’t see this train coming, what else have they missed? What other freight train is barreling down the track at us?
All of this would be bad enough. But by far the most terrifying item I read in my morning paper last week was this: Mr. Paulson demanded that Congress forbid judicial review of his decisions on use of the money in the mortgage bailout. This would amount to an abrogation of the Constitution. Not only would his decisions be sacrosanct and above the law, but so would the actions of his pals in the banking world in connection with this bailout.
The people whose conduct got us into this catastrophe have not only taken our money, hopes and peace of mind, but they apparently also want a trillion or so more dollars to put into their Wall Street Buddy System Fund. This may be the most dangerous attack on the law in my lifetime. What anarchists even dared consider this plan? Thank heaven that minds more devoted to the Constitution on Capitol Hill are questioning this shocking request.
By the way, if we are actually thinking about tossing the Constitution out the window, why not simply annul these credit-default swap contracts? With that done, the incomprehensibly large liability of the banks would cease, and we wouldn’t need this staggering bailout. Shouldn’t we consider making the speculators pay some of the price?
WE have survived housing-price corrections before. Why is this one causing so much anguish? It must be the side bets, the credit-default swap bets, multiplying the effect of the housing downturn many times over. Maybe we should just get rid of these exotic bets and start again without them. “Insurance” on market moves is always a bad idea, because it does not tamp down market disruptions but instead greatly magnifies them — as in the disastrous effect of “portfolio insurance” in the 1987 crash.
Then there was Mr. Paulson’s insistence that there be no compensation caps for executives of companies being bailed out by the factory workers, the farmers, the schoolteachers and the medical doctors. He told a skeptical Congress on Tuesday that if these caps were put into place, bank executives simply wouldn’t participate in the bailout or sell us suckers their debts. Fine with me. If the banks are in good enough shape so that petulant executives can simply opt out rather than live on a few million a year, maybe we don’t need the bailout at all. Maybe we would be better off if those executives simply bailed out and were replaced by people with more sense and more patriotism.
One final little thought bubbles into my mind: Maybe the bailout should not be of the banks at all, but of homeowners themselves. Maybe if we make the government the buyer of last resort of homes, we will stabilize the markets, stabilize the debt associated with the markets and take the gain out of the credit-default swaps for the speculators. Yes, price would be a huge issue, but so it is for Mr. Paulson’s plan for buying debt from banks.
Why not? We do it for farmers. Why not for the individual homeowner? Oh, right. Because Treasury secretaries don’t know any of those people.
Ben Stein is a lawyer, writer, actor and economist. E-mail: ebiz@nytimes.com.
Fair Game: Your Money at Work, Fixing Others’ Mistakes
New York Times, September 21, 2008
By GRETCHEN MORGENSON
It looks as if we may get through this weekend without another scramble to save a troubled financial firm with a trillion-dollar balance sheet.
But that doesn’t mean taxpayers are out of danger. No, sir. No, ma’am. Because lawmakers are at work on a bailout fund that would buy the kind of distressed assets (defaulted mortgages, for example) that have ignited this firestorm.
Treasury Secretary Henry M. Paulson Jr. has called the fund the “troubled asset relief program.” I’ll just call it TARP for short (you know, the kind of thing they spread over muddy fields so you don’t soil your Guccis).
And depending on how TARP is operated, and how the assets are valued before taxpayers are forced to buy them, it could bloat our final bill for this mess while benefiting the very institutions that got us into it.
Yes, we need a smart plan and a concerted effort to get the frozen credit markets up and running. But we also have to be certain that the types of conflicts of interest that riddle Wall Street aren’t visited upon TARP.
Consider: A bank wants to sell the TARPistas (also known as TAXPAYERS) a pile of stinky mortgage securities that it currently values at 60 cents on the dollar. Let’s assume that the most recent actual trade between market participants for similar assets was struck at 30 cents on the dollar.
So what’s a fair price that we TARPistas should pay for the assets?
If we bought at 60 cents, a price that the bank would argue is appropriate, we would most likely face a loss. The bank, however, would be much better off than if it had to dump at 30 cents.
Conversely, if the assets were sold at 30 cents, taxpayers could wind up making a profit on the purchase if the assets performed better than expected over time. But the bank would have to write down the value of the assets as a result of the sale, possibly threatening its financial standing yet again.
Do you think, perchance, that financial services lobbyists might be working their Hill contacts right this very minute to ensure that the TARP valuations are rigged in their favor?
You know the answer to that.
And you also know that we should steel ourselves for heavy losses as the TARP gets pulled over our eyes. Never mind that it was the banks, with their reckless lending and monumental leverage, that drove us into this ditch.
Such is our lot today: They break it. We own it.
Taxpayers deserve better than this, of course. But we have no lobbyists, so we get skinned.
IF federal regulators and political leaders want to earn back some trust, they could do two things. First, they could provide us with some transparency about whom precisely we are backing in the recent bailouts.
Take, for example, the rescue on Tuesday of the American International Group, once the world’s largest insurance company. It was pretty breathtaking. Since when do insurance companies, whose business models seem to consist of taking in premiums and stonewalling claims, deserve rescues from beleaguered taxpayers?
Answer: Ever since the world became so intertwined that the failure of one company can topple a host of others. And ever since credit default swaps, those unregulated derivative contracts that allow investors to bet on a debt issuer’s financial prospects, loomed so big on balance sheets that they now drive every bailout decision.
The deal to save A.I.G. involves a two-year, $85 billion loan from taxpayers. In exchange, the new owners — us — get 80 percent of the company. If enough of A.I.G.’s assets are sold for good prices, we may get our money back.
Credit default swaps, which operate like insurance policies against the possibility that an issuer of debt will not pay on its obligations, were the single biggest motivator behind the A.I.G. deal.
A.I.G. had written $441 billion in credit insurance on mortgage-related securities whose values have declined; if A.I.G. were to fail, all the institutions that bought the insurance would have been subject to enormous losses. The ripple effect could have turned into a tsunami.
So, the $85 billion loan to A.I.G. was really a bailout of the company’s counterparties or trading partners.
Now, inquiring minds want to know, whom did we rescue? Which large, wealthy financial institutions — counterparties to A.I.G.’s derivatives contracts — benefited from the taxpayers’ $85 billion loan? Were their representatives involved in the talks that resulted in the last-minute loan?
And did Lehman Brothers not get bailed out because those favored institutions were not on the hook if it failed?
We’ll probably never know the answers to these troubling questions. But by keeping taxpayers in the dark, regulators continue to earn our mistrust. As long as we are not told whom we have bailed out, we will be justified in suspecting that a favored few are making gains on our dimes.
A.I.G.’s financial statements provided a clue to the identities of some of its credit default swap counterparties. The company said that almost three-quarters of the $441 billion it had written on soured mortgage securities was bought by European banks. The banks bought the insurance to reduce the amounts of capital they were required by regulators to set aside to cover future losses.
Enjoy the absurdity: Billions in unregulated derivatives that were about to take down the insurance company that sold them were bought by banks to get around their regulatory capital requirements intended to rein in risk.
Got that?
Which brings us to Item 2 for policy makers. Stop pretending that the $62 trillion market for credit default swaps does not need regulatory oversight. Warren E. Buffett was not engaging in hyperbole when he called these things financial weapons of mass destruction.
“The last eight years have been about permitting derivatives to explode, knowing they were unregulated,” said Eric R. Dinallo, New York’s superintendent of insurance. “It’s about what the government chose not to regulate, measured in dollars. And that is what shook the world.”
And it will continue.
By GRETCHEN MORGENSON
It looks as if we may get through this weekend without another scramble to save a troubled financial firm with a trillion-dollar balance sheet.
But that doesn’t mean taxpayers are out of danger. No, sir. No, ma’am. Because lawmakers are at work on a bailout fund that would buy the kind of distressed assets (defaulted mortgages, for example) that have ignited this firestorm.
Treasury Secretary Henry M. Paulson Jr. has called the fund the “troubled asset relief program.” I’ll just call it TARP for short (you know, the kind of thing they spread over muddy fields so you don’t soil your Guccis).
And depending on how TARP is operated, and how the assets are valued before taxpayers are forced to buy them, it could bloat our final bill for this mess while benefiting the very institutions that got us into it.
Yes, we need a smart plan and a concerted effort to get the frozen credit markets up and running. But we also have to be certain that the types of conflicts of interest that riddle Wall Street aren’t visited upon TARP.
Consider: A bank wants to sell the TARPistas (also known as TAXPAYERS) a pile of stinky mortgage securities that it currently values at 60 cents on the dollar. Let’s assume that the most recent actual trade between market participants for similar assets was struck at 30 cents on the dollar.
So what’s a fair price that we TARPistas should pay for the assets?
If we bought at 60 cents, a price that the bank would argue is appropriate, we would most likely face a loss. The bank, however, would be much better off than if it had to dump at 30 cents.
Conversely, if the assets were sold at 30 cents, taxpayers could wind up making a profit on the purchase if the assets performed better than expected over time. But the bank would have to write down the value of the assets as a result of the sale, possibly threatening its financial standing yet again.
Do you think, perchance, that financial services lobbyists might be working their Hill contacts right this very minute to ensure that the TARP valuations are rigged in their favor?
You know the answer to that.
And you also know that we should steel ourselves for heavy losses as the TARP gets pulled over our eyes. Never mind that it was the banks, with their reckless lending and monumental leverage, that drove us into this ditch.
Such is our lot today: They break it. We own it.
Taxpayers deserve better than this, of course. But we have no lobbyists, so we get skinned.
IF federal regulators and political leaders want to earn back some trust, they could do two things. First, they could provide us with some transparency about whom precisely we are backing in the recent bailouts.
Take, for example, the rescue on Tuesday of the American International Group, once the world’s largest insurance company. It was pretty breathtaking. Since when do insurance companies, whose business models seem to consist of taking in premiums and stonewalling claims, deserve rescues from beleaguered taxpayers?
Answer: Ever since the world became so intertwined that the failure of one company can topple a host of others. And ever since credit default swaps, those unregulated derivative contracts that allow investors to bet on a debt issuer’s financial prospects, loomed so big on balance sheets that they now drive every bailout decision.
The deal to save A.I.G. involves a two-year, $85 billion loan from taxpayers. In exchange, the new owners — us — get 80 percent of the company. If enough of A.I.G.’s assets are sold for good prices, we may get our money back.
Credit default swaps, which operate like insurance policies against the possibility that an issuer of debt will not pay on its obligations, were the single biggest motivator behind the A.I.G. deal.
A.I.G. had written $441 billion in credit insurance on mortgage-related securities whose values have declined; if A.I.G. were to fail, all the institutions that bought the insurance would have been subject to enormous losses. The ripple effect could have turned into a tsunami.
So, the $85 billion loan to A.I.G. was really a bailout of the company’s counterparties or trading partners.
Now, inquiring minds want to know, whom did we rescue? Which large, wealthy financial institutions — counterparties to A.I.G.’s derivatives contracts — benefited from the taxpayers’ $85 billion loan? Were their representatives involved in the talks that resulted in the last-minute loan?
And did Lehman Brothers not get bailed out because those favored institutions were not on the hook if it failed?
We’ll probably never know the answers to these troubling questions. But by keeping taxpayers in the dark, regulators continue to earn our mistrust. As long as we are not told whom we have bailed out, we will be justified in suspecting that a favored few are making gains on our dimes.
A.I.G.’s financial statements provided a clue to the identities of some of its credit default swap counterparties. The company said that almost three-quarters of the $441 billion it had written on soured mortgage securities was bought by European banks. The banks bought the insurance to reduce the amounts of capital they were required by regulators to set aside to cover future losses.
Enjoy the absurdity: Billions in unregulated derivatives that were about to take down the insurance company that sold them were bought by banks to get around their regulatory capital requirements intended to rein in risk.
Got that?
Which brings us to Item 2 for policy makers. Stop pretending that the $62 trillion market for credit default swaps does not need regulatory oversight. Warren E. Buffett was not engaging in hyperbole when he called these things financial weapons of mass destruction.
“The last eight years have been about permitting derivatives to explode, knowing they were unregulated,” said Eric R. Dinallo, New York’s superintendent of insurance. “It’s about what the government chose not to regulate, measured in dollars. And that is what shook the world.”
And it will continue.
Worst Crisis Since '30s, With No End Yet in Sight
Wall Street Journal, September 18, 2008
By JON HILSENRATH, SERENA NG and DAMIAN PALETTA
The financial crisis that began 13 months ago has entered a new, far more serious phase.
Lingering hopes that the damage could be contained to a handful of financial institutions that made bad bets on mortgages have evaporated. New fault lines are emerging beyond the original problem -- troubled subprime mortgages -- in areas like credit-default swaps, the credit insurance contracts sold by American International Group Inc. and others. There's also a growing sense of wariness about the health of trading partners.
The consequences for companies and chief executives who tarry -- hoping for better times in which to raise capital, sell assets or acknowledge losses -- are now clear and brutal, as falling share prices and fearful lenders send troubled companies into ever-deeper holes. This weekend, such a realization led John Thain to sell the century-old Merrill Lynch & Co. to Bank of America Corp. Each episode seems to bring government intervention that is more extensive and expensive than the previous one, and carries greater risk of unintended consequences.
Expectations for a quick end to the crisis are fading fast. "I think it's going to last a lot longer than perhaps we would have anticipated," Anne Mulcahy, chief executive of Xerox Corp., said Wednesday.
"This has been the worst financial crisis since the Great Depression. There is no question about it," said Mark Gertler, a New York University economist who worked with fellow academic Ben Bernanke, now the Federal Reserve chairman, to explain how financial turmoil can infect the overall economy. "But at the same time we have the policy mechanisms in place fighting it, which is something we didn't have during the Great Depression."
Spreading Disease
The U.S. financial system resembles a patient in intensive care. The body is trying to fight off a disease that is spreading, and as it does so, the body convulses, settles for a time and then convulses again. The illness seems to be overwhelming the self-healing tendencies of markets. The doctors in charge are resorting to ever-more invasive treatment, and are now experimenting with remedies that have never before been applied. Fed Chairman Bernanke and Treasury Secretary Henry Paulson, walking into a hastily arranged meeting with congressional leaders Tuesday night to brief them on the government's unprecedented rescue of AIG, looked like exhausted surgeons delivering grim news to the family.
In the wake of this past week's market meltdown, WSJ's economics editor David Wessel looks at the shakeup and sees one of two outcomes: the crisis as catharsis or a drawn-out mess.
Fed and Treasury officials have identified the disease. It's called deleveraging, or the unwinding of debt. During the credit boom, financial institutions and American households took on too much debt. Between 2002 and 2006, household borrowing grew at an average annual rate of 11%, far outpacing overall economic growth. Borrowing by financial institutions grew by a 10% annualized rate. Now many of those borrowers can't pay back the loans, a problem that is exacerbated by the collapse in housing prices. They need to reduce their dependence on borrowed money, a painful and drawn-out process that can choke off credit and economic growth.
At least three things need to happen to bring the deleveraging process to an end, and they're hard to do at once. Financial institutions and others need to fess up to their mistakes by selling or writing down the value of distressed assets they bought with borrowed money. They need to pay off debt. Finally, they need to rebuild their capital cushions, which have been eroded by losses on those distressed assets.
But many of the distressed assets are hard to value and there are few if any buyers. Deleveraging also feeds on itself in a way that can create a downward spiral: Trying to sell assets pushes down the assets' prices, which makes them harder to sell and leads firms to try to sell more assets. That, in turn, suppresses these firms' share prices and makes it harder for them to sell new shares to raise capital. Mr. Bernanke, as an academic, dubbed this self-feeding loop a "financial accelerator."
[annualized yield on the 3 month Treasury bill]
"Many of the CEO types weren't willing...to take these losses, and say, 'I accept the fact that I'm selling these way below fundamental value,'" said Anil Kashyap, a University of Chicago Business School economics professor. "The ones that had the biggest exposure, they've all died."
Deleveraging started with securities tied to subprime mortgages, where defaults started rising rapidly in 2006. But the deleveraging process has now spread well beyond, to commercial real estate and auto loans to the short-term commitments on which investment banks rely to fund themselves. In the first quarter, financial-sector borrowing slowed to a 5.1% growth rate, about half of the average from 2002 to 2007. Household borrowing has slowed even more, to a 3.5% pace.
Goldman Sachs Group Inc. economist Jan Hatzius estimates that in the past year, financial institutions around the world have already written down $408 billion worth of assets and raised $367 billion worth of capital.
But that doesn't appear to be enough. Every time financial firms and investors suggest that they've written assets down enough and raised enough new capital, a new wave of selling triggers a reevaluation, propelling the crisis into new territory. Residential mortgage losses alone could hit $636 billion by 2012, Goldman estimates, triggering widespread retrenchment in bank lending. That could shave 1.8 percentage points a year off economic growth in 2008 and 2009 -- the equivalent of $250 billion in lost goods and services each year.
"This is a deleveraging like nothing we've ever seen before," said Robert Glauber, now a professor of Harvard's government and law schools who came to Washington in 1989 to help organize the savings and loan cleanup of the early 1990s. "The S&L losses to the government were small compared to this."
Hedge funds could be among the next problem areas. Many rely on borrowed money to amplify their returns. With banks under pressure, many hedge funds are less able to borrow this money now, pressuring returns. Meanwhile, there are growing indications that fewer investors are shifting into hedge funds while others are pulling out. Fund investors are dealing with their own problems: Many have taken out loans to make their investments and are finding it more difficult now to borrow.
That all makes it likely that more hedge funds will shutter in the months ahead, forcing them to sell their investments, further weighing on the market.
Debt-driven financial traumas have a long history, from the Great Depression to the S&L crisis to the Asian financial crisis of the late 1990s. Neither economists nor policymakers have easy solutions. Cutting interest rates and writing stimulus checks to families can help -- and may have prevented or delayed a deep recession. But, at least in this instance, they don't suffice.
In such circumstances, governments almost invariably experiment with solutions with varying degrees of success. President Franklin Delano Roosevelt unleashed an alphabet soup of new agencies and a host of new regulations in the aftermath of the market crash of 1929. In the 1990s, Japan embarked on a decade of often-wasteful government spending to counter the aftereffects of a bursting bubble. President George H.W. Bush and Congress created the Resolution Trust Corp. to take and sell the assets of failed thrifts. Hong Kong's free-market government went on a massive stock-buying spree in 1998, buying up shares of every company listed in the benchmark Hang Seng index. It ended up packaging them into an exchange-traded fund and making money.
Today, Mr. Bernanke is taking out his playbook, said NYU economist Mr. Gertler, "and rewriting it as we go."
Merrill Lynch & Co.'s emergency sale to Bank of America Corp. last weekend was an example of the perniciousness and unpredictability of deleveraging. In the past year, Merrill had hired a new chief executive, written off $41.4 billion in assets and raised $21 billion in equity capital.
But Merrill couldn't keep up. The more it raised, the more it was forced to write off. When Merrill CEO John Thain attended a meeting with the New York Fed and other Wall Street executives last week, he saw that Merrill was the next most vulnerable brokerage firm. "We watched Bear and Lehman. We knew we could be next," said one Merrill executive. Fearful that its lenders would shut the firm off, he sold to Bank of America.
Traders on the floor of the New York Stock Exchange Wednesday. Expectations for a quick end to the crisis are fading fast.
This crisis is complicated by innovative financial instruments that Wall Street created and distributed. They're making it harder for officials and Wall Street executives to know where the next set of risks is hiding and also contributing to the crisis's spreading impact.
Swaps Game
The latest trouble spot is an area called credit-default swaps, which are private contracts that let firms trade bets on whether a borrower is going to default. When a default occurs, one party pays off the other. The value of the swaps rise and fall as the market reassesses the risk that a company won't be able to honor its obligations. Firms use these instruments both as insurance -- to hedge their exposures to risk -- and to wager on the health of other companies. There are now credit-default swaps on more than $62 trillion in debt, up from about $144 billion a decade ago.
One of the big new players in the swaps game was AIG, the world's largest insurer and a major seller of credit-default swaps to financial institutions and companies. When the credit markets were booming, many firms bought these instruments from AIG, believing the insurance giant's strong credit ratings and large balance sheet could provide a shield against bond and loan defaults. AIG believed the risk of default was low on many securities it insured.
As of June 30, an AIG unit had written credit-default swaps on more than $446 billion in credit assets, including mortgage securities, corporate loans and complex structured products. Last year, when rising subprime-mortgage delinquencies damaged the value of many securities AIG had insured, the firm was forced to book large write-downs on its derivative positions. That spooked investors, who reacted by dumping its shares, making it harder for AIG to raise the capital it increasingly needed.
Credit default swaps "didn't cause the problem, but they certainly exacerbated the financial crisis," said Leslie Rahl, president of Capital Market Risk Advisors, a consulting firm in New York. The sheer volume of CDS contracts outstanding -- and the fact that they trade directly between institutions, without centralized clearing -- intertwined the fates of many large banks and brokerages.
Few financial crises have been sorted out in modern times without massive government intervention. Increasingly, officials are coming to the conclusion that even more might be needed. A big problem: The Fed can and has provided short-term money to sound, but struggling, institutions that are out of favor. It can, and has, reduced the interest rates it influences to attempt to reduce borrowing costs through the economy and encourage investment and spending.
But it is ill-equipped to provide the capital that financial institutions now desperately need to shore up their finances and expand lending.
Resolution Trust Scenario
In normal times, capital-starved companies usually can raise money on their own. In the current crisis, a number of big Wall Street firms, including Citigroup Inc., have turned to sovereign-wealth funds, the government-controlled pools of money.
But both on Wall Street and in Washington, there is increasing expectation that U.S. taxpayers will either take the bad assets off the hands of financial institutions so they can raise capital, or put taxpayer capital into the companies, as the Treasury has agreed to do with mortgage giants Fannie Mae and Freddie Mac.
One proposal was raised by Barney Frank, the Massachusetts Democrat who is chairman of the House Financial Services Committee. Rep. Frank is looking at whether to create an analog to the Resolution Trust Corp., which took assets from failed banks and thrifts and found buyers over several years.
"When you have a big loss in the marketplace, there are only three people that can take the loss -- the bondholders, the shareholders and the government," said William Seidman, who led the RTC from 1989 to 1991. "That's the dance we're seeing right now. Are we going to shove this loss into the hands of the taxpayers?"
The RTC seemed controversial and ambitious at the time. Any version today would be even more complex. The RTC dispensed mostly of commercial real estate. Today's troubled assets are complex debt securities -- many of which include pieces of other instruments, which in turn include pieces of others, many steps removed from the actual mortgages or consumer loans on which they are based. Unraveling these strands will be tedious and getting at the underlying collateral, difficult.
In the early stages of this crisis, regulators saw that their rules didn't fit the rapidly changing financial system they were asked to oversee. Investment banks, at the core of the crisis, weren't as closely monitored by the Securities and Exchange Commission as commercial banks were by their regulators.
The government has a system to close failed banks, created after the Great Depression in part to avoid sudden runs by depositors. Now, runs happen in spheres regulators may not fully understand, such as the repurchase agreement, or repo, market, in which investment banks fund their day-to-day operations. And regulators have no process for handling the failure of an investment bank like Lehman Brothers Holdings Inc. Insurers like AIG aren't even federally regulated.
Regulators have all but promised that more banks will fail in the coming months. The Federal Deposit Insurance Corp. is drawing up a plan to raise the premiums it charges banks so that it can rebuild the fund it uses to back deposits. Examiners are tightening their leash on banks across the country.
Pleasant Mystery
One pleasant mystery is why the crisis hasn't hit the economy harder -- at least so far. "This financial crisis hasn't yet translated into fewer...companies starting up, less research and development, less marketing," Ivan Seidenberg, chief executive of Verizon Communications, said Wednesday. "We haven't seen that yet. I'm sure every company is keeping their eyes on it."
At 6.1%, the unemployment rate remains well below the peak of 7.8% in 1992, amid the S&L crisis.
In part, that's because government has reacted aggressively. The Fed's classic mistake that led to the Great Depression was that it tightened monetary policy when it should have eased. Mr. Bernanke didn't repeat that error. And Congress moved more swiftly to approve fiscal stimulus than most Washington veterans thought possible.
In part, the broader economy has held mostly steady because exports have been so strong at just the right moment, a reminder of the global economy's importance to the U.S. And in part, it's because the U.S. economy is demonstrating impressive resilience, as information technology allows executives to react more quickly to emerging problems and -- to the discomfort of workers -- companies are quicker to adjust wages, hiring and work hours when the economy softens.
But the risk remains that Wall Street's woes will spread to Main Street, as credit tightens for consumers and business. Already, U.S. auto makers have been forced to tighten the terms on their leasing programs, or abandon writing leases themselves altogether, because of problems in their finance units. Goldman Sachs economists' optimistic scenario is a couple years of mild recession or painfully slow economy growth.
By JON HILSENRATH, SERENA NG and DAMIAN PALETTA
The financial crisis that began 13 months ago has entered a new, far more serious phase.
Lingering hopes that the damage could be contained to a handful of financial institutions that made bad bets on mortgages have evaporated. New fault lines are emerging beyond the original problem -- troubled subprime mortgages -- in areas like credit-default swaps, the credit insurance contracts sold by American International Group Inc. and others. There's also a growing sense of wariness about the health of trading partners.
The consequences for companies and chief executives who tarry -- hoping for better times in which to raise capital, sell assets or acknowledge losses -- are now clear and brutal, as falling share prices and fearful lenders send troubled companies into ever-deeper holes. This weekend, such a realization led John Thain to sell the century-old Merrill Lynch & Co. to Bank of America Corp. Each episode seems to bring government intervention that is more extensive and expensive than the previous one, and carries greater risk of unintended consequences.
Expectations for a quick end to the crisis are fading fast. "I think it's going to last a lot longer than perhaps we would have anticipated," Anne Mulcahy, chief executive of Xerox Corp., said Wednesday.
"This has been the worst financial crisis since the Great Depression. There is no question about it," said Mark Gertler, a New York University economist who worked with fellow academic Ben Bernanke, now the Federal Reserve chairman, to explain how financial turmoil can infect the overall economy. "But at the same time we have the policy mechanisms in place fighting it, which is something we didn't have during the Great Depression."
Spreading Disease
The U.S. financial system resembles a patient in intensive care. The body is trying to fight off a disease that is spreading, and as it does so, the body convulses, settles for a time and then convulses again. The illness seems to be overwhelming the self-healing tendencies of markets. The doctors in charge are resorting to ever-more invasive treatment, and are now experimenting with remedies that have never before been applied. Fed Chairman Bernanke and Treasury Secretary Henry Paulson, walking into a hastily arranged meeting with congressional leaders Tuesday night to brief them on the government's unprecedented rescue of AIG, looked like exhausted surgeons delivering grim news to the family.
In the wake of this past week's market meltdown, WSJ's economics editor David Wessel looks at the shakeup and sees one of two outcomes: the crisis as catharsis or a drawn-out mess.
Fed and Treasury officials have identified the disease. It's called deleveraging, or the unwinding of debt. During the credit boom, financial institutions and American households took on too much debt. Between 2002 and 2006, household borrowing grew at an average annual rate of 11%, far outpacing overall economic growth. Borrowing by financial institutions grew by a 10% annualized rate. Now many of those borrowers can't pay back the loans, a problem that is exacerbated by the collapse in housing prices. They need to reduce their dependence on borrowed money, a painful and drawn-out process that can choke off credit and economic growth.
At least three things need to happen to bring the deleveraging process to an end, and they're hard to do at once. Financial institutions and others need to fess up to their mistakes by selling or writing down the value of distressed assets they bought with borrowed money. They need to pay off debt. Finally, they need to rebuild their capital cushions, which have been eroded by losses on those distressed assets.
But many of the distressed assets are hard to value and there are few if any buyers. Deleveraging also feeds on itself in a way that can create a downward spiral: Trying to sell assets pushes down the assets' prices, which makes them harder to sell and leads firms to try to sell more assets. That, in turn, suppresses these firms' share prices and makes it harder for them to sell new shares to raise capital. Mr. Bernanke, as an academic, dubbed this self-feeding loop a "financial accelerator."
[annualized yield on the 3 month Treasury bill]
"Many of the CEO types weren't willing...to take these losses, and say, 'I accept the fact that I'm selling these way below fundamental value,'" said Anil Kashyap, a University of Chicago Business School economics professor. "The ones that had the biggest exposure, they've all died."
Deleveraging started with securities tied to subprime mortgages, where defaults started rising rapidly in 2006. But the deleveraging process has now spread well beyond, to commercial real estate and auto loans to the short-term commitments on which investment banks rely to fund themselves. In the first quarter, financial-sector borrowing slowed to a 5.1% growth rate, about half of the average from 2002 to 2007. Household borrowing has slowed even more, to a 3.5% pace.
Goldman Sachs Group Inc. economist Jan Hatzius estimates that in the past year, financial institutions around the world have already written down $408 billion worth of assets and raised $367 billion worth of capital.
But that doesn't appear to be enough. Every time financial firms and investors suggest that they've written assets down enough and raised enough new capital, a new wave of selling triggers a reevaluation, propelling the crisis into new territory. Residential mortgage losses alone could hit $636 billion by 2012, Goldman estimates, triggering widespread retrenchment in bank lending. That could shave 1.8 percentage points a year off economic growth in 2008 and 2009 -- the equivalent of $250 billion in lost goods and services each year.
"This is a deleveraging like nothing we've ever seen before," said Robert Glauber, now a professor of Harvard's government and law schools who came to Washington in 1989 to help organize the savings and loan cleanup of the early 1990s. "The S&L losses to the government were small compared to this."
Hedge funds could be among the next problem areas. Many rely on borrowed money to amplify their returns. With banks under pressure, many hedge funds are less able to borrow this money now, pressuring returns. Meanwhile, there are growing indications that fewer investors are shifting into hedge funds while others are pulling out. Fund investors are dealing with their own problems: Many have taken out loans to make their investments and are finding it more difficult now to borrow.
That all makes it likely that more hedge funds will shutter in the months ahead, forcing them to sell their investments, further weighing on the market.
Debt-driven financial traumas have a long history, from the Great Depression to the S&L crisis to the Asian financial crisis of the late 1990s. Neither economists nor policymakers have easy solutions. Cutting interest rates and writing stimulus checks to families can help -- and may have prevented or delayed a deep recession. But, at least in this instance, they don't suffice.
In such circumstances, governments almost invariably experiment with solutions with varying degrees of success. President Franklin Delano Roosevelt unleashed an alphabet soup of new agencies and a host of new regulations in the aftermath of the market crash of 1929. In the 1990s, Japan embarked on a decade of often-wasteful government spending to counter the aftereffects of a bursting bubble. President George H.W. Bush and Congress created the Resolution Trust Corp. to take and sell the assets of failed thrifts. Hong Kong's free-market government went on a massive stock-buying spree in 1998, buying up shares of every company listed in the benchmark Hang Seng index. It ended up packaging them into an exchange-traded fund and making money.
Today, Mr. Bernanke is taking out his playbook, said NYU economist Mr. Gertler, "and rewriting it as we go."
Merrill Lynch & Co.'s emergency sale to Bank of America Corp. last weekend was an example of the perniciousness and unpredictability of deleveraging. In the past year, Merrill had hired a new chief executive, written off $41.4 billion in assets and raised $21 billion in equity capital.
But Merrill couldn't keep up. The more it raised, the more it was forced to write off. When Merrill CEO John Thain attended a meeting with the New York Fed and other Wall Street executives last week, he saw that Merrill was the next most vulnerable brokerage firm. "We watched Bear and Lehman. We knew we could be next," said one Merrill executive. Fearful that its lenders would shut the firm off, he sold to Bank of America.
Traders on the floor of the New York Stock Exchange Wednesday. Expectations for a quick end to the crisis are fading fast.
This crisis is complicated by innovative financial instruments that Wall Street created and distributed. They're making it harder for officials and Wall Street executives to know where the next set of risks is hiding and also contributing to the crisis's spreading impact.
Swaps Game
The latest trouble spot is an area called credit-default swaps, which are private contracts that let firms trade bets on whether a borrower is going to default. When a default occurs, one party pays off the other. The value of the swaps rise and fall as the market reassesses the risk that a company won't be able to honor its obligations. Firms use these instruments both as insurance -- to hedge their exposures to risk -- and to wager on the health of other companies. There are now credit-default swaps on more than $62 trillion in debt, up from about $144 billion a decade ago.
One of the big new players in the swaps game was AIG, the world's largest insurer and a major seller of credit-default swaps to financial institutions and companies. When the credit markets were booming, many firms bought these instruments from AIG, believing the insurance giant's strong credit ratings and large balance sheet could provide a shield against bond and loan defaults. AIG believed the risk of default was low on many securities it insured.
As of June 30, an AIG unit had written credit-default swaps on more than $446 billion in credit assets, including mortgage securities, corporate loans and complex structured products. Last year, when rising subprime-mortgage delinquencies damaged the value of many securities AIG had insured, the firm was forced to book large write-downs on its derivative positions. That spooked investors, who reacted by dumping its shares, making it harder for AIG to raise the capital it increasingly needed.
Credit default swaps "didn't cause the problem, but they certainly exacerbated the financial crisis," said Leslie Rahl, president of Capital Market Risk Advisors, a consulting firm in New York. The sheer volume of CDS contracts outstanding -- and the fact that they trade directly between institutions, without centralized clearing -- intertwined the fates of many large banks and brokerages.
Few financial crises have been sorted out in modern times without massive government intervention. Increasingly, officials are coming to the conclusion that even more might be needed. A big problem: The Fed can and has provided short-term money to sound, but struggling, institutions that are out of favor. It can, and has, reduced the interest rates it influences to attempt to reduce borrowing costs through the economy and encourage investment and spending.
But it is ill-equipped to provide the capital that financial institutions now desperately need to shore up their finances and expand lending.
Resolution Trust Scenario
In normal times, capital-starved companies usually can raise money on their own. In the current crisis, a number of big Wall Street firms, including Citigroup Inc., have turned to sovereign-wealth funds, the government-controlled pools of money.
But both on Wall Street and in Washington, there is increasing expectation that U.S. taxpayers will either take the bad assets off the hands of financial institutions so they can raise capital, or put taxpayer capital into the companies, as the Treasury has agreed to do with mortgage giants Fannie Mae and Freddie Mac.
One proposal was raised by Barney Frank, the Massachusetts Democrat who is chairman of the House Financial Services Committee. Rep. Frank is looking at whether to create an analog to the Resolution Trust Corp., which took assets from failed banks and thrifts and found buyers over several years.
"When you have a big loss in the marketplace, there are only three people that can take the loss -- the bondholders, the shareholders and the government," said William Seidman, who led the RTC from 1989 to 1991. "That's the dance we're seeing right now. Are we going to shove this loss into the hands of the taxpayers?"
The RTC seemed controversial and ambitious at the time. Any version today would be even more complex. The RTC dispensed mostly of commercial real estate. Today's troubled assets are complex debt securities -- many of which include pieces of other instruments, which in turn include pieces of others, many steps removed from the actual mortgages or consumer loans on which they are based. Unraveling these strands will be tedious and getting at the underlying collateral, difficult.
In the early stages of this crisis, regulators saw that their rules didn't fit the rapidly changing financial system they were asked to oversee. Investment banks, at the core of the crisis, weren't as closely monitored by the Securities and Exchange Commission as commercial banks were by their regulators.
The government has a system to close failed banks, created after the Great Depression in part to avoid sudden runs by depositors. Now, runs happen in spheres regulators may not fully understand, such as the repurchase agreement, or repo, market, in which investment banks fund their day-to-day operations. And regulators have no process for handling the failure of an investment bank like Lehman Brothers Holdings Inc. Insurers like AIG aren't even federally regulated.
Regulators have all but promised that more banks will fail in the coming months. The Federal Deposit Insurance Corp. is drawing up a plan to raise the premiums it charges banks so that it can rebuild the fund it uses to back deposits. Examiners are tightening their leash on banks across the country.
Pleasant Mystery
One pleasant mystery is why the crisis hasn't hit the economy harder -- at least so far. "This financial crisis hasn't yet translated into fewer...companies starting up, less research and development, less marketing," Ivan Seidenberg, chief executive of Verizon Communications, said Wednesday. "We haven't seen that yet. I'm sure every company is keeping their eyes on it."
At 6.1%, the unemployment rate remains well below the peak of 7.8% in 1992, amid the S&L crisis.
In part, that's because government has reacted aggressively. The Fed's classic mistake that led to the Great Depression was that it tightened monetary policy when it should have eased. Mr. Bernanke didn't repeat that error. And Congress moved more swiftly to approve fiscal stimulus than most Washington veterans thought possible.
In part, the broader economy has held mostly steady because exports have been so strong at just the right moment, a reminder of the global economy's importance to the U.S. And in part, it's because the U.S. economy is demonstrating impressive resilience, as information technology allows executives to react more quickly to emerging problems and -- to the discomfort of workers -- companies are quicker to adjust wages, hiring and work hours when the economy softens.
But the risk remains that Wall Street's woes will spread to Main Street, as credit tightens for consumers and business. Already, U.S. auto makers have been forced to tighten the terms on their leasing programs, or abandon writing leases themselves altogether, because of problems in their finance units. Goldman Sachs economists' optimistic scenario is a couple years of mild recession or painfully slow economy growth.
Realtors Aiming for Full Rebound in 2009
Arlington Sun-Gazette, September 15, 2008
By BRIAN TROMPETER
The U.S. economy will continue struggling through the fourth quarter of this year, but rebound steadily next year, George Mason University economics professor Stephen Fuller predicted on Sept. 11 at the Northern Virginia Association of Realtors' 12th Annual Economic Summit.
The heavily government-supported Washington-area economy likely will not suffer as much as other parts of the country, he said.
“We won't get any whiplash,” said Fuller, who also is director of the university's Center for Regional Analysis.
The Washington region gradually is slimming down its excess housing inventory and will pass the peak of its foreclosure difficulties around Halloween, Fuller said.
The housing market downturn - especially in the reduced rate of new housing construction - has been a key factor in the nation's ongoing economic problems, he said.
Real estate in recent years was treated as a commodity, rather than a long-term investment, and this led to overbuilding and price inflation, Fuller said.
“We changed how we thought,” he said. “This is like going to a banquet and overeating. The next morning, or sometimes even the same night, I regret it. It takes a long while to work off the consequences.”
The Washington area added 35,400 new jobs between July 2007 and July 2008. This figure is lower than the average 45,000-job increase and is due to a loss of retail, construction and financial-services positions, Fuller said.
National unemployment numbers have not been encouraging. About 400,000 fewer people are employed at full-time jobs now than at this time last year, he said.
While consumer expectations have been lower ever since the last presidential election, those numbers have ticked slightly upward of late, he said.
“There is an increase in optimism among the pessimists,” Fuller said.
John Mason, executive director of the Northern Virginia Transportation Authority, also addressed the summit, which was held at George Mason University.
Mason told the Realtors that Virginia must finance new transportation projects if it is to avoid miserable gridlock in the future.
“You can't make all your sales on Sunday morning,” Mason said.
When analyzing the area's traffic congestion, authority members decided the A-through-F rating scale just didn't cut it. They then created a new low rating of G to categorize Northern Virginia's mess, he said.
The transportation authority, made up of officials from nine participating jurisdictions, last year received permission from the Virginia General Assembly to raise about $300 million per year for transportation projects.
But the Virginia Supreme Court in late February ruled the General Assembly, constitutionally, could not delegate taxing authority to an unelected body. The transportation authority has returned most of the taxes it collected and is now reducing the scope of its operations.
Mason showed a slide of projected traffic gridlock if the General Assembly does not resolve the transportation financing question.
“I am here to tell you that without that additional dedicated funding for Northern Virginia transportation, you are going to be severely challenged as you move around Northern Virginia in the process of selling homes,” he said.
Christine Todd, CEO of the Northern Virginia Association of Realtors, said the economic summit added a “great dose of optimism” about the real estate market, which is still in the midst of a recovery.
“We can now understand that there is light at the end of the tunnel - and it's not a train,” she said. “What was especially important to me was it was documented that our economy in Northern Virginia is in really good shape. No one is going to lose any money if they buy a house in this area and hold it for several years. The economy is just too strong.”
Luis Lama, the association's immediate past chairman, said Northern Virginia's economy remains strong and its real estate market will be helped by the recent federal takeover of Fannie Mae and Freddie Mac.
“We expect a very good year next year,” Lama said. “We need the news media to reflect that to the consumer.”
By BRIAN TROMPETER
The U.S. economy will continue struggling through the fourth quarter of this year, but rebound steadily next year, George Mason University economics professor Stephen Fuller predicted on Sept. 11 at the Northern Virginia Association of Realtors' 12th Annual Economic Summit.
The heavily government-supported Washington-area economy likely will not suffer as much as other parts of the country, he said.
“We won't get any whiplash,” said Fuller, who also is director of the university's Center for Regional Analysis.
The Washington region gradually is slimming down its excess housing inventory and will pass the peak of its foreclosure difficulties around Halloween, Fuller said.
The housing market downturn - especially in the reduced rate of new housing construction - has been a key factor in the nation's ongoing economic problems, he said.
Real estate in recent years was treated as a commodity, rather than a long-term investment, and this led to overbuilding and price inflation, Fuller said.
“We changed how we thought,” he said. “This is like going to a banquet and overeating. The next morning, or sometimes even the same night, I regret it. It takes a long while to work off the consequences.”
The Washington area added 35,400 new jobs between July 2007 and July 2008. This figure is lower than the average 45,000-job increase and is due to a loss of retail, construction and financial-services positions, Fuller said.
National unemployment numbers have not been encouraging. About 400,000 fewer people are employed at full-time jobs now than at this time last year, he said.
While consumer expectations have been lower ever since the last presidential election, those numbers have ticked slightly upward of late, he said.
“There is an increase in optimism among the pessimists,” Fuller said.
John Mason, executive director of the Northern Virginia Transportation Authority, also addressed the summit, which was held at George Mason University.
Mason told the Realtors that Virginia must finance new transportation projects if it is to avoid miserable gridlock in the future.
“You can't make all your sales on Sunday morning,” Mason said.
When analyzing the area's traffic congestion, authority members decided the A-through-F rating scale just didn't cut it. They then created a new low rating of G to categorize Northern Virginia's mess, he said.
The transportation authority, made up of officials from nine participating jurisdictions, last year received permission from the Virginia General Assembly to raise about $300 million per year for transportation projects.
But the Virginia Supreme Court in late February ruled the General Assembly, constitutionally, could not delegate taxing authority to an unelected body. The transportation authority has returned most of the taxes it collected and is now reducing the scope of its operations.
Mason showed a slide of projected traffic gridlock if the General Assembly does not resolve the transportation financing question.
“I am here to tell you that without that additional dedicated funding for Northern Virginia transportation, you are going to be severely challenged as you move around Northern Virginia in the process of selling homes,” he said.
Christine Todd, CEO of the Northern Virginia Association of Realtors, said the economic summit added a “great dose of optimism” about the real estate market, which is still in the midst of a recovery.
“We can now understand that there is light at the end of the tunnel - and it's not a train,” she said. “What was especially important to me was it was documented that our economy in Northern Virginia is in really good shape. No one is going to lose any money if they buy a house in this area and hold it for several years. The economy is just too strong.”
Luis Lama, the association's immediate past chairman, said Northern Virginia's economy remains strong and its real estate market will be helped by the recent federal takeover of Fannie Mae and Freddie Mac.
“We expect a very good year next year,” Lama said. “We need the news media to reflect that to the consumer.”
Mortgage Q&A: Federal Bailout Results
Washington Times, September 12, 2008
By Henry Savage
Most readers undoubtedly have heard about the federal government's takeover of mortgage giants Freddie Mac and Fannie Mae. While many in the media are lamenting the decision as another costly government bailout, I thought I would take this opportunity to explain what it all means and how it could affect the average American.
First, let me explain what Fannie Mae and Freddie Mac do, as many folks have no idea. They are nicknames for the Federal National Mortgage Corp. and the Federal Home Loan Mortgage Corp. Both of these companies were chartered by the federal government with a design to provide mortgage money to as many Americans as possible. Here's how these companies work.
Before the establishment of Fannie and Freddie, Americans would obtain their mortgages from local banks and so-called building and loan associations. These banks would take savings deposits, pay out an interest rate and then turn around and lend mortgage money to homeowners at a higher interest rate.
The problem is that a bank would run out of money to lend because it had a limited amount of savings deposits from its customers. Enter Fannie Mae and Freddie Mac.
Fannie and Freddie would purchase the loans from the bank, freeing up cash so the bank could make new loans. Fannie and Freddie then would package their loans into mortgage-backed-securities and sell them to investors. Investors would enjoy a nice return on an asset that was collateralized by residential real estate.
Fannie and Freddie established underwriting standards that each loan applicant must meet. It is the lender's responsibility to ensure that each loan applicant meets Fannie's and Freddie's criteria or risk having the loan be rejected for purchase.
This arrangement worked quite well for many years. As interest rates dropped and property values rose beginning in the 1990s, Fannie and Freddie relaxed their guidelines and began to offer so-called Alt-A mortgages. Those programs carried slightly higher rates and were offered to folks who didn't quite fit the conventional guidelines.
Meanwhile, direct lenders and Wall Street investors teamed up to offer subprime loans. Those carried far higher rates and were offered to folks with no down payment and poor credit. Lenders and mortgage investors didn't worry because property values kept rising. If the borrower got into trouble, he simply could sell his house, pay back the mortgage and take a profit.
Am I painting the picture of a train wreck waiting to happen?
Here's the perfect storm: Property values fall, subprime loan holders owe more than the properties are worth, teaser interest rates expire, and balloon payments come due. Delinquencies and foreclosures rise, and mortgage investors get stuck with the hot potato.
Once Wall Street got burned, it lost its appetite for mortgage-backed securities, creating the credit crunch. Meanwhile, Fannie and Freddie get stuck with mortgage paper they can't sell during a period of skyrocketing delinquency and foreclosure rates.
One of the byproducts of this mess is a combined loss of $14 billion for Fannie and Freddie in the past year.
So the Feds decide they had better spend some taxpayer money and prop up these two giants to avert an economic catastrophe. No one really knows how much the bailout will cost the American taxpayers, but the consensus is it depends upon Fannie's and Freddie's financial performance in the coming years.
What does this mean for future homeowners and those who want to refinance their loans? As part of the bailout, the Treasury Department has agreed to purchase Fannie's and Freddie's mortgage-backed securities in the open market, alleviating the credit crunch.
It also should bring down mortgage rates. It's anyone's guess as to how low rates may go, but rates dropped about three-eighths of a percent in the first day after the announcement.
If the trend continues, potential home buyers will see more affordable housing and homeowners will be able to save some money by lowering their interest rate through a refinance.
By Henry Savage
Most readers undoubtedly have heard about the federal government's takeover of mortgage giants Freddie Mac and Fannie Mae. While many in the media are lamenting the decision as another costly government bailout, I thought I would take this opportunity to explain what it all means and how it could affect the average American.
First, let me explain what Fannie Mae and Freddie Mac do, as many folks have no idea. They are nicknames for the Federal National Mortgage Corp. and the Federal Home Loan Mortgage Corp. Both of these companies were chartered by the federal government with a design to provide mortgage money to as many Americans as possible. Here's how these companies work.
Before the establishment of Fannie and Freddie, Americans would obtain their mortgages from local banks and so-called building and loan associations. These banks would take savings deposits, pay out an interest rate and then turn around and lend mortgage money to homeowners at a higher interest rate.
The problem is that a bank would run out of money to lend because it had a limited amount of savings deposits from its customers. Enter Fannie Mae and Freddie Mac.
Fannie and Freddie would purchase the loans from the bank, freeing up cash so the bank could make new loans. Fannie and Freddie then would package their loans into mortgage-backed-securities and sell them to investors. Investors would enjoy a nice return on an asset that was collateralized by residential real estate.
Fannie and Freddie established underwriting standards that each loan applicant must meet. It is the lender's responsibility to ensure that each loan applicant meets Fannie's and Freddie's criteria or risk having the loan be rejected for purchase.
This arrangement worked quite well for many years. As interest rates dropped and property values rose beginning in the 1990s, Fannie and Freddie relaxed their guidelines and began to offer so-called Alt-A mortgages. Those programs carried slightly higher rates and were offered to folks who didn't quite fit the conventional guidelines.
Meanwhile, direct lenders and Wall Street investors teamed up to offer subprime loans. Those carried far higher rates and were offered to folks with no down payment and poor credit. Lenders and mortgage investors didn't worry because property values kept rising. If the borrower got into trouble, he simply could sell his house, pay back the mortgage and take a profit.
Am I painting the picture of a train wreck waiting to happen?
Here's the perfect storm: Property values fall, subprime loan holders owe more than the properties are worth, teaser interest rates expire, and balloon payments come due. Delinquencies and foreclosures rise, and mortgage investors get stuck with the hot potato.
Once Wall Street got burned, it lost its appetite for mortgage-backed securities, creating the credit crunch. Meanwhile, Fannie and Freddie get stuck with mortgage paper they can't sell during a period of skyrocketing delinquency and foreclosure rates.
One of the byproducts of this mess is a combined loss of $14 billion for Fannie and Freddie in the past year.
So the Feds decide they had better spend some taxpayer money and prop up these two giants to avert an economic catastrophe. No one really knows how much the bailout will cost the American taxpayers, but the consensus is it depends upon Fannie's and Freddie's financial performance in the coming years.
What does this mean for future homeowners and those who want to refinance their loans? As part of the bailout, the Treasury Department has agreed to purchase Fannie's and Freddie's mortgage-backed securities in the open market, alleviating the credit crunch.
It also should bring down mortgage rates. It's anyone's guess as to how low rates may go, but rates dropped about three-eighths of a percent in the first day after the announcement.
If the trend continues, potential home buyers will see more affordable housing and homeowners will be able to save some money by lowering their interest rate through a refinance.
13 June 2008
Realtor Notebook: Foreclosures are NOT bargains
Inman News, June 5, 2008
By Teresa Boardman
Radio ads, printed ads, Web sites, news broadcasts and television shows give consumers the message that they can find bargains or even achieve wealth by purchasing bank-owned homes. Media hype is all around and in my market we even have bus tours of foreclosed homes.
Real estate agents are bombarded with information on how to get rich selling foreclosures. Opportunities exist for investors and agents who want to run a high-volume, low-commission business. The homes and the opportunities are not as wonderful as the marketing leads us to believe.
For most Realtors, foreclosures are a growing part of the inventory and we work with them because we have buyers who want to purchase them. The process of buying a home from a bank is different than buying it from a private party -- it is slower, and there is more paperwork and it always seems like the bank doesn't really care if the home gets sold.
Getting these homes inspected is a challenge because often the water has been turned off by the city. The bank has a process and policies, which means it takes longer to get the simple things done that most of us handle on the spot with a phone call.
Large asset management departments handle foreclosures. Employees are in charge of "files," and they have hundreds of them. They get sick, take vacations and don't answer the phone. These employees play the role of the seller. They don't get to make decisions; they follow rules and they get paid vacations, and do not receive commissions or bonuses when their "file" closes.
Buyers' agents make less money on lower-priced foreclosures and end up doing about four times as much work as they would with any other type of sale, mainly because of the extra paperwork and because our buyers will have to make a few offers. About one in every two or three offers a buyer's agent writes will result in a sale that closes.
Often no effort is made to clean bank-owned homes or remove refuse. I have toured unheated bank-owned homes in sub-zero weather. I once had a client slip and fall on the ice on the kitchen floor. There are holes in the ceilings, missing windows, missing water heaters and no appliances. Snow accumulates on the sidewalks and stairs making it challenging to get to the front door. Sometimes a screwdriver is needed to remove the screws from the porch door to get to the door with the lockbox. Yet members of the media call me and ask if bank-owned homes are "staged" to sell faster. No, they are not staged, and they stay on the market longer than other homes do.
The houses tell me stories. A child's toy on the kitchen counter, phone numbers for the pediatrician and family dentist on the refrigerator. It hurts to go inside some of them. Clients ask why the homes are in such disrepair and wonder where the children are now. I don't know where the children are, but I do know that people who are losing their homes don't make repairs and that some of the homes were owned by investors who never made a repair and tenants were left homeless with little warning. In some cases, the tenants take their frustration out on the walls and the windows as they leave.
Buyers contact me and say they are interested in buying a foreclosure property. No matter what I say to them they don't get it until they see the home. Some foreclosures are in better shape than others. My clients make offers on them and we wait for weeks to find out if the offer was accepted. After going through that a couple of times, some buyers say no to foreclosures.
It is a myth that bank-owned properties are a bargain -- some are, but many are not. The bank-owned homes that are priced very low often need so much work that the cost of the repairs is more than the value of the home after the repairs are done.
It will be interesting to see what my town will look like in a few years. About 25-30 percent of the inventory of available homes is foreclosures and that number is growing. The number of foreclosures locally and nationwide will have a measurable impact on the social fabric of our neighborhoods and on our economy. Some will make money from it, but right now it is not obvious to me who the winners will be. I don't want to sell these homes, but they make up too much of the market to be ignored.
By Teresa Boardman
Radio ads, printed ads, Web sites, news broadcasts and television shows give consumers the message that they can find bargains or even achieve wealth by purchasing bank-owned homes. Media hype is all around and in my market we even have bus tours of foreclosed homes.
Real estate agents are bombarded with information on how to get rich selling foreclosures. Opportunities exist for investors and agents who want to run a high-volume, low-commission business. The homes and the opportunities are not as wonderful as the marketing leads us to believe.
For most Realtors, foreclosures are a growing part of the inventory and we work with them because we have buyers who want to purchase them. The process of buying a home from a bank is different than buying it from a private party -- it is slower, and there is more paperwork and it always seems like the bank doesn't really care if the home gets sold.
Getting these homes inspected is a challenge because often the water has been turned off by the city. The bank has a process and policies, which means it takes longer to get the simple things done that most of us handle on the spot with a phone call.
Large asset management departments handle foreclosures. Employees are in charge of "files," and they have hundreds of them. They get sick, take vacations and don't answer the phone. These employees play the role of the seller. They don't get to make decisions; they follow rules and they get paid vacations, and do not receive commissions or bonuses when their "file" closes.
Buyers' agents make less money on lower-priced foreclosures and end up doing about four times as much work as they would with any other type of sale, mainly because of the extra paperwork and because our buyers will have to make a few offers. About one in every two or three offers a buyer's agent writes will result in a sale that closes.
Often no effort is made to clean bank-owned homes or remove refuse. I have toured unheated bank-owned homes in sub-zero weather. I once had a client slip and fall on the ice on the kitchen floor. There are holes in the ceilings, missing windows, missing water heaters and no appliances. Snow accumulates on the sidewalks and stairs making it challenging to get to the front door. Sometimes a screwdriver is needed to remove the screws from the porch door to get to the door with the lockbox. Yet members of the media call me and ask if bank-owned homes are "staged" to sell faster. No, they are not staged, and they stay on the market longer than other homes do.
The houses tell me stories. A child's toy on the kitchen counter, phone numbers for the pediatrician and family dentist on the refrigerator. It hurts to go inside some of them. Clients ask why the homes are in such disrepair and wonder where the children are now. I don't know where the children are, but I do know that people who are losing their homes don't make repairs and that some of the homes were owned by investors who never made a repair and tenants were left homeless with little warning. In some cases, the tenants take their frustration out on the walls and the windows as they leave.
Buyers contact me and say they are interested in buying a foreclosure property. No matter what I say to them they don't get it until they see the home. Some foreclosures are in better shape than others. My clients make offers on them and we wait for weeks to find out if the offer was accepted. After going through that a couple of times, some buyers say no to foreclosures.
It is a myth that bank-owned properties are a bargain -- some are, but many are not. The bank-owned homes that are priced very low often need so much work that the cost of the repairs is more than the value of the home after the repairs are done.
It will be interesting to see what my town will look like in a few years. About 25-30 percent of the inventory of available homes is foreclosures and that number is growing. The number of foreclosures locally and nationwide will have a measurable impact on the social fabric of our neighborhoods and on our economy. Some will make money from it, but right now it is not obvious to me who the winners will be. I don't want to sell these homes, but they make up too much of the market to be ignored.
Your Money - Negotiating for a House? Start With ‘Dear Seller’
New York Times, May 31, 2008
By RON LIEBER
A few years ago, when multiple bidders would show up at a real estate open house, the truly desperate resorted to writing love letters to the sellers.
Their plaintive scribblings painted a picture of first-time buyers chasing the American dream or growing families hungry for more space. The letters dripped with compliments for the property and ended with a plea for mercy (and a signed contract).
Today’s real estate market, however, calls for a different kind of letter, less a fuzzy valentine and more like a cold splash of water. It’s what you write to accompany a bid that is so far below the listing price that it cries out for explanation.
Inspired by the success of a friend who used this tactic, I drafted a sample letter that buyers who fear overpaying might send to homeowners. Then, I crafted a reply that confident sellers could fire back.
No seller would be happy to get a letter like this. The most powerful missives stoke doubt and create fear. Sellers who get them may be tempted to write off the bidders as lowballers. But it makes little sense not to at least reply, given the number of competing properties in most places and the difficulty lately in getting mortgages.
The sample letters below, which I wrote after conversations with representatives of the National Association of Realtors and the National Association of Exclusive Buyer Agents, don’t mention local economic conditions, comparable sales or other such data. You’ll want to fill in those details yourself. But the templates below should work as a starting point.
One caveat is that you’ll generally be relying on real estate agents to deliver your letter. Ask them point blank whether they intend to do so.
Dear Seller:
I’m writing to let you know that I would like to make a bid on your property. I love the area and am committed to buying a house nearby. And your home fits my needs.
But given that my offer is well below your asking price, I also feel I owe you an explanation.
First, consider the big picture. Nationwide, home prices in the first quarter of 2008 fell 14.1 percent compared with the same period a year earlier, according to the Standard & Poor’s/Case-Shiller U.S. National Home Price Index.
That’s the biggest decline in the 20-year history of the data. And just in case you’re wondering, during the housing downturn of the early 1990s, the decline was never worse than 2.8 percent.
Not only that, earlier this month, the National Association of Realtors pointed to the huge number of existing homes on the market. As of the end of April, the total number was 4.55 million. At the rate people are buying right now, that represents an 11.2-month supply.
So buyers have options right now. A lot of them. I’m no different. Your home is great, but it isn’t unique. Few homes are. I know this may be hard to hear, since you’ve spent years creating memories here. But you may be waiting a long time if you hope to find a buyer with the same emotional connection that you have.
My mindset is hardly unique. We’ve all been reading the headlines. The accompanying articles appear prominently in major newspapers and sit on the Web pages where people check their e-mail every day. Everyone sees them, and the psychological impact is real.
Has your real estate agent laid any of this out for you? Maybe so, and you didn’t want to believe it. But it’s also possible that your agent, afraid of offending you and losing the listing, simply doesn’t want to initiate that sort of discussion. It may be worth sitting down for a candid reassessment.
It will be tempting to view my low bid as an insult. Please don’t make that mistake. Your home is genuinely appealing, and I wouldn’t have written this note unless I was serious about buying it. Getting a firm offer in this market is an accomplishment. So congratulations!
Oh, and one more thing. You presumably need someplace to move. My guess is that you’ll find these same points compelling when it’s your turn to buy. You just might succeed in buying for a better price, too.
I look forward to hearing from you soon.
Yours Truly,
The Realist
Dear Bidder:
Thanks so much for your note. I’m truly glad that you like our home as much as we do. You’re right that my family and I have many great memories of this place, and we hope someday you will, too.
And I just want you to know that I’m not insulted in any way by your offer. The fact is, none of us are very good at buying and selling homes. We don’t do it often, and as much as we know we’re not supposed to let emotions get in the way, it’s hard not to. After all, few people buy or sell anything else as expensive as a home in their lifetimes.
That said, your offer disappointed me. You seem to believe that I’m not aware of how bad things are out there or that I’m in denial. But I do read the headlines, and I priced the house accordingly. I knew I might have to wait awhile to sell it.
I should point out that your data draws on what has already happened in the housing market. Instead, I’d ask you to consider what’s about to happen.
One big reason for the falling prices is that it’s harder to get mortgages. Lenders went from giving money to anyone with a pulse to demanding higher credit scores and larger down payments. All sorts of buyers simply couldn’t make the numbers work anymore.
That may now change. Starting June 1, Fannie Mae and Freddie Mac, which buy mortgages from lenders and help make it possible for them to lend more money, are loosening restrictions on the sorts of loans they’ll buy in many markets. That is supposed to make it easier for people to buy a home with a down payment of 5 percent, or even less. Many more qualified buyers should mean more bids, and I’m willing to wait to see if it turns out that way.
I know you talked about having choices, but presumably we wouldn’t be engaging in this correspondence unless you liked my home best. Given that, I’d ask you to think about something: How often do you find a place that you can actually imagine living in? Sure, there are a lot of other properties out there. But an increasing number are in foreclosure and probably have problems lurking within the walls. So don’t let fear of a falling market keep you out of a home that you truly want.
It’s probably obvious by now that I’m not going to counter with a particular number. This doesn’t mean that I do not want to negotiate. I’d just like you to consider what I’ve said and see if you find it convincing. In the meantime, other shoppers who are interested in my home now have a price to beat. So thanks for helping me out with that.
Just one more thing. Please take another look at whatever mortgage calculator you’re using and see how your monthly payment will change if you brought your price up a bit. It almost certainly is not going to be enough to break you. But it may be enough to get us to a deal.
I look forward to your reply.
Yours,
The Undaunted
By RON LIEBER
A few years ago, when multiple bidders would show up at a real estate open house, the truly desperate resorted to writing love letters to the sellers.
Their plaintive scribblings painted a picture of first-time buyers chasing the American dream or growing families hungry for more space. The letters dripped with compliments for the property and ended with a plea for mercy (and a signed contract).
Today’s real estate market, however, calls for a different kind of letter, less a fuzzy valentine and more like a cold splash of water. It’s what you write to accompany a bid that is so far below the listing price that it cries out for explanation.
Inspired by the success of a friend who used this tactic, I drafted a sample letter that buyers who fear overpaying might send to homeowners. Then, I crafted a reply that confident sellers could fire back.
No seller would be happy to get a letter like this. The most powerful missives stoke doubt and create fear. Sellers who get them may be tempted to write off the bidders as lowballers. But it makes little sense not to at least reply, given the number of competing properties in most places and the difficulty lately in getting mortgages.
The sample letters below, which I wrote after conversations with representatives of the National Association of Realtors and the National Association of Exclusive Buyer Agents, don’t mention local economic conditions, comparable sales or other such data. You’ll want to fill in those details yourself. But the templates below should work as a starting point.
One caveat is that you’ll generally be relying on real estate agents to deliver your letter. Ask them point blank whether they intend to do so.
Dear Seller:
I’m writing to let you know that I would like to make a bid on your property. I love the area and am committed to buying a house nearby. And your home fits my needs.
But given that my offer is well below your asking price, I also feel I owe you an explanation.
First, consider the big picture. Nationwide, home prices in the first quarter of 2008 fell 14.1 percent compared with the same period a year earlier, according to the Standard & Poor’s/Case-Shiller U.S. National Home Price Index.
That’s the biggest decline in the 20-year history of the data. And just in case you’re wondering, during the housing downturn of the early 1990s, the decline was never worse than 2.8 percent.
Not only that, earlier this month, the National Association of Realtors pointed to the huge number of existing homes on the market. As of the end of April, the total number was 4.55 million. At the rate people are buying right now, that represents an 11.2-month supply.
So buyers have options right now. A lot of them. I’m no different. Your home is great, but it isn’t unique. Few homes are. I know this may be hard to hear, since you’ve spent years creating memories here. But you may be waiting a long time if you hope to find a buyer with the same emotional connection that you have.
My mindset is hardly unique. We’ve all been reading the headlines. The accompanying articles appear prominently in major newspapers and sit on the Web pages where people check their e-mail every day. Everyone sees them, and the psychological impact is real.
Has your real estate agent laid any of this out for you? Maybe so, and you didn’t want to believe it. But it’s also possible that your agent, afraid of offending you and losing the listing, simply doesn’t want to initiate that sort of discussion. It may be worth sitting down for a candid reassessment.
It will be tempting to view my low bid as an insult. Please don’t make that mistake. Your home is genuinely appealing, and I wouldn’t have written this note unless I was serious about buying it. Getting a firm offer in this market is an accomplishment. So congratulations!
Oh, and one more thing. You presumably need someplace to move. My guess is that you’ll find these same points compelling when it’s your turn to buy. You just might succeed in buying for a better price, too.
I look forward to hearing from you soon.
Yours Truly,
The Realist
Dear Bidder:
Thanks so much for your note. I’m truly glad that you like our home as much as we do. You’re right that my family and I have many great memories of this place, and we hope someday you will, too.
And I just want you to know that I’m not insulted in any way by your offer. The fact is, none of us are very good at buying and selling homes. We don’t do it often, and as much as we know we’re not supposed to let emotions get in the way, it’s hard not to. After all, few people buy or sell anything else as expensive as a home in their lifetimes.
That said, your offer disappointed me. You seem to believe that I’m not aware of how bad things are out there or that I’m in denial. But I do read the headlines, and I priced the house accordingly. I knew I might have to wait awhile to sell it.
I should point out that your data draws on what has already happened in the housing market. Instead, I’d ask you to consider what’s about to happen.
One big reason for the falling prices is that it’s harder to get mortgages. Lenders went from giving money to anyone with a pulse to demanding higher credit scores and larger down payments. All sorts of buyers simply couldn’t make the numbers work anymore.
That may now change. Starting June 1, Fannie Mae and Freddie Mac, which buy mortgages from lenders and help make it possible for them to lend more money, are loosening restrictions on the sorts of loans they’ll buy in many markets. That is supposed to make it easier for people to buy a home with a down payment of 5 percent, or even less. Many more qualified buyers should mean more bids, and I’m willing to wait to see if it turns out that way.
I know you talked about having choices, but presumably we wouldn’t be engaging in this correspondence unless you liked my home best. Given that, I’d ask you to think about something: How often do you find a place that you can actually imagine living in? Sure, there are a lot of other properties out there. But an increasing number are in foreclosure and probably have problems lurking within the walls. So don’t let fear of a falling market keep you out of a home that you truly want.
It’s probably obvious by now that I’m not going to counter with a particular number. This doesn’t mean that I do not want to negotiate. I’d just like you to consider what I’ve said and see if you find it convincing. In the meantime, other shoppers who are interested in my home now have a price to beat. So thanks for helping me out with that.
Just one more thing. Please take another look at whatever mortgage calculator you’re using and see how your monthly payment will change if you brought your price up a bit. It almost certainly is not going to be enough to break you. But it may be enough to get us to a deal.
I look forward to your reply.
Yours,
The Undaunted
13 May 2008
Profiles in Tenacity: Short-Sale Buyers
Washington Post, Sunday, May 11, 2008
By Elizabeth Razzi
Laurel Wittman and her husband, Eduardo Lopes, are examples of a rare species: successful short-sale buyers.
The unfortunate trio of nothing-down mortgages, sharp increases in adjustable-rate payments and shrinking home values has driven more strapped owners to ask their lenders to approve short sales as an alternative to foreclosure. The sales price is short of the amount owed to the lender, but lenders will sometimes accept such deals because foreclosures cost them even more money.
It's not an easy way to buy a house.
Wittman and Lopes endured a five-month wait to buy a five-bedroom Fairfax County house that was headed for foreclosure. They offered to pay the full asking price, aware that their offer would have to be approved by the seller's lender.
They didn't expect to be the only ones interested in making the deal.
Months went by with no response from the lender, SunTrust Mortgage. At times, the couple wondered if the deal was worth the hassle.
But persistence won them a nice house with a garage for $510,000, which was $90,000 less than its recent appraised value and nearly $117,000 less than the latest tax assessment. If you believe that time is money, though, they paid plenty. "If you had any urgency, you couldn't have done this," Wittman said. "It was all about just trying to get anyone to respond."
The couple wanted to move from their house in Dale City to be closer to Wittman's job in Alexandria. They planned to rent out the Dale City house, which allowed them a more flexible schedule than if they had to coordinate a sale and a purchase.
The Dutch Colonial they found sits smack against Interstate 66 near Falls Church.
The house has several features that made it a good choice for Lopes, who has used a wheelchair since 2005 because of multiple sclerosis. There's a main-level bedroom and bathroom, plus an updated kitchen with plenty of maneuvering room. It can easily accommodate a ramp to the front porch and a chair lift to the back door.
The home went on the market last May at $575,000, which was out of the couple's price range. By September, the asking price was down to $550,000, still more than they could afford. On Sept. 19, the asking price dropped to $499,950.
Until then, Lopes hadn't wanted to get involved with the hassle of trying to buy anything at a short sale, but that price cut changed his mind. "Suddenly, it was inside our price range, and it was a lot of house," Lopes said. "It became worth our time."
They thought the lender's review would add only a few weeks to the process. After all, they were offering the full asking price. So their purchase offer called for settlement no later than Nov. 15 -- only six weeks away.
"We thought that was reasonable," Wittman said. And the waiting began.
Their home inspection revealed problems with heating and plumbing systems, plus an elevated radon level. The seller had no money to cover any repairs, so they removed the inspection contingency from their offer and estimated that they could face as much as $20,000 in repairs.
But they found the lack of communication about the sale particularly frustrating. "We could not directly contact the lender," Lopes said. The lender would communicate only with the seller and the seller's real estate agent.
Repeatedly, the couple extended the expiration date on their purchase offer. They said the seller and his agent seemed at times unaware that the contract was about to expire, but Wittman and Lopes needed to keep the deal alive so they would not have to reapply for a mortgage.
Behind the scenes, SunTrust, the lender that held both a first mortgage for $480,000and a second mortgage for $120,000 on the home, was communicating with the title insurance company, AIG United Guaranty. According to a letter Lopes obtained, the mortgage insurer told the lender that it wanted to increase the payoff on the second mortgage to $50,000. Wittman and Lopes weren't sure whether that meant they were going to get a counteroffer raising the price by $50,000.
"At that price, we weren't going to be able to do it, but we might have counteroffered," Wittman said. But there was nothing for them to respond to. Neither the bank nor the seller had made them a counteroffer, and their original offer continued to gather dust.
"At this point, we just started having doubts," Wittman said. They began to look at other houses. With hope that it might finally nudge the deal along, on Dec. 24 they increased their offer by $10,000, to $510,000. "It was just kind of a shot in the dark," Wittman said. "This was our last, best offer."
Their patience was running out. "You almost get a little offended," she said. After all, they weren't the ones who were behind on payments. All they wanted to do was to buy the house -- and for more than the listed price.
It took another month to get a response. On Jan. 25, SunTrust informed the seller's agent that it would accept the $510,000 offer. The commission to the seller's agent was cut to 2 percent of the sales price. The buyer's agent was also asked to cut his commission, but he refused.
The net to SunTrust: $476,548, nearly $124,000 less than was owed. I don't know what additional compensation, if any, the bank received from mortgage insurance. SunTrust representatives did not respond to requests for comment.
SunTrust required closing by Feb. 29. But Wittman and Lopes needed to close more quickly, as their mortgage commitment would expire Feb. 18. If they had to reapply for a loan, they would have had to increase their down payment by $25,000, which would have killed the deal.
Through the process, they never knew how close the bank was to foreclosing.
"Nobody was putting pressure except us to get this done," Wittman said. Probably that's because they were the only ones to walk away with a gain. The seller lost his house. The bank lost money, but its sluggishness very nearly cost it a sale, too.
By Elizabeth Razzi
Laurel Wittman and her husband, Eduardo Lopes, are examples of a rare species: successful short-sale buyers.
The unfortunate trio of nothing-down mortgages, sharp increases in adjustable-rate payments and shrinking home values has driven more strapped owners to ask their lenders to approve short sales as an alternative to foreclosure. The sales price is short of the amount owed to the lender, but lenders will sometimes accept such deals because foreclosures cost them even more money.
It's not an easy way to buy a house.
Wittman and Lopes endured a five-month wait to buy a five-bedroom Fairfax County house that was headed for foreclosure. They offered to pay the full asking price, aware that their offer would have to be approved by the seller's lender.
They didn't expect to be the only ones interested in making the deal.
Months went by with no response from the lender, SunTrust Mortgage. At times, the couple wondered if the deal was worth the hassle.
But persistence won them a nice house with a garage for $510,000, which was $90,000 less than its recent appraised value and nearly $117,000 less than the latest tax assessment. If you believe that time is money, though, they paid plenty. "If you had any urgency, you couldn't have done this," Wittman said. "It was all about just trying to get anyone to respond."
The couple wanted to move from their house in Dale City to be closer to Wittman's job in Alexandria. They planned to rent out the Dale City house, which allowed them a more flexible schedule than if they had to coordinate a sale and a purchase.
The Dutch Colonial they found sits smack against Interstate 66 near Falls Church.
The house has several features that made it a good choice for Lopes, who has used a wheelchair since 2005 because of multiple sclerosis. There's a main-level bedroom and bathroom, plus an updated kitchen with plenty of maneuvering room. It can easily accommodate a ramp to the front porch and a chair lift to the back door.
The home went on the market last May at $575,000, which was out of the couple's price range. By September, the asking price was down to $550,000, still more than they could afford. On Sept. 19, the asking price dropped to $499,950.
Until then, Lopes hadn't wanted to get involved with the hassle of trying to buy anything at a short sale, but that price cut changed his mind. "Suddenly, it was inside our price range, and it was a lot of house," Lopes said. "It became worth our time."
They thought the lender's review would add only a few weeks to the process. After all, they were offering the full asking price. So their purchase offer called for settlement no later than Nov. 15 -- only six weeks away.
"We thought that was reasonable," Wittman said. And the waiting began.
Their home inspection revealed problems with heating and plumbing systems, plus an elevated radon level. The seller had no money to cover any repairs, so they removed the inspection contingency from their offer and estimated that they could face as much as $20,000 in repairs.
But they found the lack of communication about the sale particularly frustrating. "We could not directly contact the lender," Lopes said. The lender would communicate only with the seller and the seller's real estate agent.
Repeatedly, the couple extended the expiration date on their purchase offer. They said the seller and his agent seemed at times unaware that the contract was about to expire, but Wittman and Lopes needed to keep the deal alive so they would not have to reapply for a mortgage.
Behind the scenes, SunTrust, the lender that held both a first mortgage for $480,000and a second mortgage for $120,000 on the home, was communicating with the title insurance company, AIG United Guaranty. According to a letter Lopes obtained, the mortgage insurer told the lender that it wanted to increase the payoff on the second mortgage to $50,000. Wittman and Lopes weren't sure whether that meant they were going to get a counteroffer raising the price by $50,000.
"At that price, we weren't going to be able to do it, but we might have counteroffered," Wittman said. But there was nothing for them to respond to. Neither the bank nor the seller had made them a counteroffer, and their original offer continued to gather dust.
"At this point, we just started having doubts," Wittman said. They began to look at other houses. With hope that it might finally nudge the deal along, on Dec. 24 they increased their offer by $10,000, to $510,000. "It was just kind of a shot in the dark," Wittman said. "This was our last, best offer."
Their patience was running out. "You almost get a little offended," she said. After all, they weren't the ones who were behind on payments. All they wanted to do was to buy the house -- and for more than the listed price.
It took another month to get a response. On Jan. 25, SunTrust informed the seller's agent that it would accept the $510,000 offer. The commission to the seller's agent was cut to 2 percent of the sales price. The buyer's agent was also asked to cut his commission, but he refused.
The net to SunTrust: $476,548, nearly $124,000 less than was owed. I don't know what additional compensation, if any, the bank received from mortgage insurance. SunTrust representatives did not respond to requests for comment.
SunTrust required closing by Feb. 29. But Wittman and Lopes needed to close more quickly, as their mortgage commitment would expire Feb. 18. If they had to reapply for a loan, they would have had to increase their down payment by $25,000, which would have killed the deal.
Through the process, they never knew how close the bank was to foreclosing.
"Nobody was putting pressure except us to get this done," Wittman said. Probably that's because they were the only ones to walk away with a gain. The seller lost his house. The bank lost money, but its sluggishness very nearly cost it a sale, too.
Rent and Wait, or Sell and Cringe?
Washington Post, Saturday, May 10, 2008
By Benny L. Kass
We have lived in our house for 15 years and have decided to move. We bought a new house six months ago and tried to sell our old one "by owner." We had no success. We had a real estate agent give us a price that he thought the home would sell for. My husband did not like that number. He thinks prices will come up again.
Do you think we should sell our home at the going rate or rent it out for a while until the prices come up again? I'm not sure they will, so I think we should just sell it at the best offer, but we thought we would ask for your professional advice.
My "professional advice" is probably as good -- or as bad -- as that of anyone else who is trying to predict when or even if the real estate market will bounce back. Whether to sell or rent is a personal question that only you and your husband can decide, after taking into consideration a number of important factors. Here are some things to consider:
· Tax implications. I suspect that during the 15 years you have lived there, your house has increased in value. You do not want to get hit with capital gains tax on the profit you have made. That means you will have to have lived in the house for at least two of the five years before it is sold. If you can meet this test, and assuming that you and your husband file a joint income tax return, you can exclude up to $500,000 of the gain from tax. (Single people and those married but filing separately can exclude up to $250,000.)
This means that if you move out and rent the house, you want to sell it before three years have elapsed.
Selling a house that has a tenant is not always easy. Some tenants do not keep the house in the same condition that you or a potential purchaser would like. Some tenants refuse to let you show your house to prospective buyers, even if your lease specifically permits you to do so. You may have to take the tenant to court to get a judge to order showings.
Thus, even with the best intentions of selling the house within three years, you may find yourself thwarted and so lose the valuable tax exclusion.
· Being a landlord. Not everyone is cut out to be a landlord. You have to learn the local landlord-tenant laws and make sure that your lease conforms to those laws. For example, some jurisdictions place limits on the amount of the security deposit you can collect when you lease the house. In the District, tenants have a number of rights they don't have elsewhere, including the opportunity to buy the house even if you find a buyer.
If a tenant does not pay rent, eviction can be time-consuming and expensive.
More important, do you want to get calls in the middle of the night complaining that the toilet is overflowing or that the roof is leaking?
· Carrying costs. You have already bought another home. Can you afford to pay for two houses? Keep in mind that to have a buffer between you and your tenant, you may want to hire a property manager. And the manager will want to get paid whether or not you have a tenant -- and whether or not the tenant is paying rent.
When you rent out a house, there will be months when it is vacant. But you still have to pay the mortgage and the real estate tax, and carry adequate insurance. Maintenance bills don't stop, either.
· Benefits of renting. Yes, there are also benefits to being a landlord. You can get tax deductions that are not available to homeowners, such as depreciation. Discuss the details with your financial adviser.
· Future of the market. Here, no one can assist you. Some "experts" predict that the real estate market will come back by the end of this year, while others say it may take two or three years. The crystal ball on my desk is cloudy.
But here's a suggestion: If you decide to rent out the house and you have a lot of equity, you may want to consider refinancing and pulling out some of that money (assuming you can find a lender in today's economy that is willing to make a cash-out loan). However, first calculate all the potential income and expenses involved with the rental. You do not want to pull out too much money, only to find that the new mortgage payments and other expenses will exceed the monthly rental income.
Another suggestion: Take your time and see if you can get a better offer for your house. Spring is usually a good time to try to sell. Perhaps you will get lucky and find a buyer who will come closer to your price.
In the final analysis, however, if you decide to sell, I am sure you will make a profit. It might not be as large as you would like, or as much as your neighbor got for a similar house two years ago, but it will still be a profit. Too many people want to forget that property values were going crazy in the past few years and are disappointed that they cannot sell at those same exorbitant prices. There's no room for that mind-set today.
By Benny L. Kass
We have lived in our house for 15 years and have decided to move. We bought a new house six months ago and tried to sell our old one "by owner." We had no success. We had a real estate agent give us a price that he thought the home would sell for. My husband did not like that number. He thinks prices will come up again.
Do you think we should sell our home at the going rate or rent it out for a while until the prices come up again? I'm not sure they will, so I think we should just sell it at the best offer, but we thought we would ask for your professional advice.
My "professional advice" is probably as good -- or as bad -- as that of anyone else who is trying to predict when or even if the real estate market will bounce back. Whether to sell or rent is a personal question that only you and your husband can decide, after taking into consideration a number of important factors. Here are some things to consider:
· Tax implications. I suspect that during the 15 years you have lived there, your house has increased in value. You do not want to get hit with capital gains tax on the profit you have made. That means you will have to have lived in the house for at least two of the five years before it is sold. If you can meet this test, and assuming that you and your husband file a joint income tax return, you can exclude up to $500,000 of the gain from tax. (Single people and those married but filing separately can exclude up to $250,000.)
This means that if you move out and rent the house, you want to sell it before three years have elapsed.
Selling a house that has a tenant is not always easy. Some tenants do not keep the house in the same condition that you or a potential purchaser would like. Some tenants refuse to let you show your house to prospective buyers, even if your lease specifically permits you to do so. You may have to take the tenant to court to get a judge to order showings.
Thus, even with the best intentions of selling the house within three years, you may find yourself thwarted and so lose the valuable tax exclusion.
· Being a landlord. Not everyone is cut out to be a landlord. You have to learn the local landlord-tenant laws and make sure that your lease conforms to those laws. For example, some jurisdictions place limits on the amount of the security deposit you can collect when you lease the house. In the District, tenants have a number of rights they don't have elsewhere, including the opportunity to buy the house even if you find a buyer.
If a tenant does not pay rent, eviction can be time-consuming and expensive.
More important, do you want to get calls in the middle of the night complaining that the toilet is overflowing or that the roof is leaking?
· Carrying costs. You have already bought another home. Can you afford to pay for two houses? Keep in mind that to have a buffer between you and your tenant, you may want to hire a property manager. And the manager will want to get paid whether or not you have a tenant -- and whether or not the tenant is paying rent.
When you rent out a house, there will be months when it is vacant. But you still have to pay the mortgage and the real estate tax, and carry adequate insurance. Maintenance bills don't stop, either.
· Benefits of renting. Yes, there are also benefits to being a landlord. You can get tax deductions that are not available to homeowners, such as depreciation. Discuss the details with your financial adviser.
· Future of the market. Here, no one can assist you. Some "experts" predict that the real estate market will come back by the end of this year, while others say it may take two or three years. The crystal ball on my desk is cloudy.
But here's a suggestion: If you decide to rent out the house and you have a lot of equity, you may want to consider refinancing and pulling out some of that money (assuming you can find a lender in today's economy that is willing to make a cash-out loan). However, first calculate all the potential income and expenses involved with the rental. You do not want to pull out too much money, only to find that the new mortgage payments and other expenses will exceed the monthly rental income.
Another suggestion: Take your time and see if you can get a better offer for your house. Spring is usually a good time to try to sell. Perhaps you will get lucky and find a buyer who will come closer to your price.
In the final analysis, however, if you decide to sell, I am sure you will make a profit. It might not be as large as you would like, or as much as your neighbor got for a similar house two years ago, but it will still be a profit. Too many people want to forget that property values were going crazy in the past few years and are disappointed that they cannot sell at those same exorbitant prices. There's no room for that mind-set today.
Buyers and Sellers Cash in with Patience
Washington Post, May 9, 2008
By Michele Lerner
'Patience is the best remedy for every trouble," wrote Roman playwright Titus Maccius Plautus sometime between 254 and 184 B.C. He clearly had no inkling of the tribulations of the modern-day real estate market.
Yet his advice, centuries later, is just what local real estate experts are urging for frustrated buyers and sellers.
Real estate agents with 20 to 30 years of experience with the local real estate market may be a bit more sanguine than newcomers to the real estate market, mostly because they have seen home values drop and sales slow in the past and witnessed the ensuing market comeback.
Some local agents report a lively spring market, with open houses attracting plenty of potential buyers and contracts on the rise.
The Washington-area real estate market is extremely local, with many areas within the District and in close-in suburbs feeling very little effect from the national real estate slowdown.
Other areas, particularly Prince William, Loudoun and Prince George's County, have been hit harder, with slower sales and dropping prices.
Evelyn Lugo, a Realtor with Long & Foster Real Estate in District, with more than 20 years in the real estate business, says that this current real estate cycle is different from the 1990s.
"In the 1990s, we had this huge real estate boom and then a terrible crash," Ms. Lugo says. "This time, especially inside the Beltway, it didn't happen that way. This has been more of an adjustment, which just had to take place since housing prices were increasing so fast. But, at least inside the Beltway, I think the real estate market is recession-proof because of the strong employment with government jobs and government contractors. Now consumers can feel confident that because of this employment infrastructure, there won't be a huge drop in home values."
Ms. Lugo acknowledges that this holds true inside the Beltway, with different scenarios in more distant suburbs.
Barbara Miles, associate broker with Coldwell Banker Residential Brokerage in Bethesda, has been in the real estate business for 25 years. She says this is the third slow market she has experienced.
"People have been saying the same things today that they have said in previous markets, such as that this is the end of the real estate world, but it always comes back," Ms. Miles says. "Recently at a company, we were read quotes from the 1940s that could have been media quotes about today's real estate market. Historically, real estate always goes up, and people need to understand this."
Ms. Miles says she never recommends buying a home for consumers staying in the Washington area for only two years or less, suggesting instead that they rent. She says buying and selling a home costs about 10 percent of the value of the home, which can be hard to make up in just two years.
"If you are not intending to move for at least three or four years, though, it just makes sense to buy a home," Ms. Miles says. "By buying, you have the pride of ownership, a tax write-off, a roof over your head, and, eventually, the value will go up."
Ms. Miles says home values dropped 20 percent overnight in 1992, but then rose in double digits every year between 1999 and 2005.
Dee Rosenberg, associate broker with RE/MAX Realty Group in Gaithersburg with 29 years in the real estate business, says that buyers and sellers need to be patient in this particular market. Sellers may find it takes a long time for their home to go under contract, and buyers may find it hard to choose the right home and obtain financing.
"This real estate market is different because I have never seen so many foreclosures before," Ms. Rosenberg says. "Foreclosures are a big part of the competition for sellers, but they are not always in as good condition, either."
Don Noll, associate broker with RE/MAX Select Properties in Sterling, has been in the real estate business for 25 years.
"The slow market is a lot different this time around because of what I call the 'funny money' loans," Mr. Noll says. "So many of the homes on the market right now are foreclosures and short sales, and not all of them are coming from subprime loans. Some of them are because people went in with these no-documentation loans and 100 percent financing, and they just didn't have a vested interest in the property. It has been easier for them to walk away from the responsibility of owning a home. Other people were just using their home equity as an ATM machine so they could take trips to Hawaii, and now they can't sell their homes because they owe more than it's worth."
On the positive side, Mr. Noll says that while the upturn in home values took place from 1995 to 2005, the Washington area has not seen home values drop all the way down to 1995 prices.
"The people that are hardest hit are those who bought in 2004 and 2005 when prices peaked," Mr. Noll says. "The market won't recover until some of the inventory is absorbed. In Northern Virginia, we have about one year's worth of inventory available. The farther out you are from the city, the longer it will take because now residents are also hurt by rising gas prices that make commuting so expensive."
Ms. Lugo says the biggest hit on the market right now is coming from mortgage lenders.
"Most lenders now want buyers to put 10 to 20 percent down, but consumers have become accustomed to needing little or no money down," says Ms. Lugo. "Single-family homes in this area often cost $600,000, so you are asking people to come up with $60,000 to $120,000 in cash."
Ms. Lugo thinks the recent change in FHA loan limits to $729,750 in the Washington area is already having a big impact on the local market.
"Raising the loan limits on FHA loans has opened up the market to people who want to buy a home with just 3 percent down," Ms. Lugo says. "That down payment can be a gift, too, and they can accept seller contributions towards closing costs of up to 6 percent."
FHA loans typically have easier qualification standards that allow consumers with lower credit scores to be approved.
Barbara Haardt, a senior loan officer with Prosperity Mortgage in the District, says that FHA loans, like other mortgage programs, qualify consumers based on income, assets and credit scores, and require full documentation through tax returns and bank statements.
"The difference is that for FHA loans of $392,900 and below, no minimum credit score is required," Ms. Haardt says. "For higher loan amounts, a minimum score of 600 to 620 is required."
Ms. Haardt says lenders in today's real estate market carefully analyze a variety of factors to determine whether each individual county is considered a stable or declining market, which can impact the approval of mortgage loans in that area.
"Lenders look at the number of units on the market, the values of homes in that market and the number of units on the market for more than 180 days to determine market status," Ms. Haardt says. "Currently, the D.C. market, including Northern Virginia and Prince George's County, is considered a declining or distressed market. Montgomery County has already improved to a soft market."
Ms. Haardt says in a declining or distressed market, most lenders require a minimum down payment of 10 percent for conventional loans. FHA loans are not impacted by this designation.
"Some lenders will automatically insist in lowering appraisals on homes in declining markets by 5 percent," Ms. Haardt says.
Two key pieces of advice that each real estate agent offered are these: Buyers should think conservatively when it comes to determining how much they can afford, and sellers should recognize that while they may sell low, they are also buying low.
"Sellers need to realize that if their home value is down by 10 percent from its peak, so is the value of the home you want to buy," Ms. Miles says. "You may have lost $30,000 by not selling your home in 2005, but you are gaining $60,000 on what the owner of your next house thought he would get. You just need to keep it all in perspective."
Ms. Miles says buyers need to compromise and not overextend themselves when purchasing a home. Plus, they need to make sure they understand their loan program, she says.
"You can always sell and move up later," Ms. Miles says.
Ms. Lugo says potential first-time buyers are "crazy" if they are not buying a home right now, since interest rates are low, financing is available and plenty of homes are available.
Ms. Rosenberg suggests that buyers be patient, since it may take more than one attempt to arrange appropriate financing and find the home they want. She says buyers should expect to make a down payment of at least 3 percent (with an FHA loan) or more, and they need to make sure they have a good credit score.
"Buyers need to be very specific with their buyer agent to make sure the agent understands exactly what they are looking for," Ms. Rosenberg says. "The most important thing is to make sure you are comfortable with the payment and your income. Do not push yourself into a more expensive home until you become uncomfortable with the payments."
Mr. Noll says that when he started in the real estate business, buyers had to make at least a 5 percent down payment, if not more.
"Now lenders are returning to that pattern and cracking down," Mr. Noll says. "They want buyers to have a vested interest in the home. So buyers may need some patience while they fix their credit and save money for a down payment."
Both Ms. Rosenberg and Mr. Noll suggest that sellers who do not have to sell their home now wait out the market.
"If you do have to sell, you need to be patient and understand that you are in it for the long haul," Ms. Rosenberg says. "You have to stage your home to make sure it looks the best it can, and you need to assume you will have to adjust your price."
Mr. Noll preaches patience, as well. "Buyers and sellers need to have realistic expectations in this market," he says. "They need a lot of patience until the market turns around again."
By Michele Lerner
'Patience is the best remedy for every trouble," wrote Roman playwright Titus Maccius Plautus sometime between 254 and 184 B.C. He clearly had no inkling of the tribulations of the modern-day real estate market.
Yet his advice, centuries later, is just what local real estate experts are urging for frustrated buyers and sellers.
Real estate agents with 20 to 30 years of experience with the local real estate market may be a bit more sanguine than newcomers to the real estate market, mostly because they have seen home values drop and sales slow in the past and witnessed the ensuing market comeback.
Some local agents report a lively spring market, with open houses attracting plenty of potential buyers and contracts on the rise.
The Washington-area real estate market is extremely local, with many areas within the District and in close-in suburbs feeling very little effect from the national real estate slowdown.
Other areas, particularly Prince William, Loudoun and Prince George's County, have been hit harder, with slower sales and dropping prices.
Evelyn Lugo, a Realtor with Long & Foster Real Estate in District, with more than 20 years in the real estate business, says that this current real estate cycle is different from the 1990s.
"In the 1990s, we had this huge real estate boom and then a terrible crash," Ms. Lugo says. "This time, especially inside the Beltway, it didn't happen that way. This has been more of an adjustment, which just had to take place since housing prices were increasing so fast. But, at least inside the Beltway, I think the real estate market is recession-proof because of the strong employment with government jobs and government contractors. Now consumers can feel confident that because of this employment infrastructure, there won't be a huge drop in home values."
Ms. Lugo acknowledges that this holds true inside the Beltway, with different scenarios in more distant suburbs.
Barbara Miles, associate broker with Coldwell Banker Residential Brokerage in Bethesda, has been in the real estate business for 25 years. She says this is the third slow market she has experienced.
"People have been saying the same things today that they have said in previous markets, such as that this is the end of the real estate world, but it always comes back," Ms. Miles says. "Recently at a company, we were read quotes from the 1940s that could have been media quotes about today's real estate market. Historically, real estate always goes up, and people need to understand this."
Ms. Miles says she never recommends buying a home for consumers staying in the Washington area for only two years or less, suggesting instead that they rent. She says buying and selling a home costs about 10 percent of the value of the home, which can be hard to make up in just two years.
"If you are not intending to move for at least three or four years, though, it just makes sense to buy a home," Ms. Miles says. "By buying, you have the pride of ownership, a tax write-off, a roof over your head, and, eventually, the value will go up."
Ms. Miles says home values dropped 20 percent overnight in 1992, but then rose in double digits every year between 1999 and 2005.
Dee Rosenberg, associate broker with RE/MAX Realty Group in Gaithersburg with 29 years in the real estate business, says that buyers and sellers need to be patient in this particular market. Sellers may find it takes a long time for their home to go under contract, and buyers may find it hard to choose the right home and obtain financing.
"This real estate market is different because I have never seen so many foreclosures before," Ms. Rosenberg says. "Foreclosures are a big part of the competition for sellers, but they are not always in as good condition, either."
Don Noll, associate broker with RE/MAX Select Properties in Sterling, has been in the real estate business for 25 years.
"The slow market is a lot different this time around because of what I call the 'funny money' loans," Mr. Noll says. "So many of the homes on the market right now are foreclosures and short sales, and not all of them are coming from subprime loans. Some of them are because people went in with these no-documentation loans and 100 percent financing, and they just didn't have a vested interest in the property. It has been easier for them to walk away from the responsibility of owning a home. Other people were just using their home equity as an ATM machine so they could take trips to Hawaii, and now they can't sell their homes because they owe more than it's worth."
On the positive side, Mr. Noll says that while the upturn in home values took place from 1995 to 2005, the Washington area has not seen home values drop all the way down to 1995 prices.
"The people that are hardest hit are those who bought in 2004 and 2005 when prices peaked," Mr. Noll says. "The market won't recover until some of the inventory is absorbed. In Northern Virginia, we have about one year's worth of inventory available. The farther out you are from the city, the longer it will take because now residents are also hurt by rising gas prices that make commuting so expensive."
Ms. Lugo says the biggest hit on the market right now is coming from mortgage lenders.
"Most lenders now want buyers to put 10 to 20 percent down, but consumers have become accustomed to needing little or no money down," says Ms. Lugo. "Single-family homes in this area often cost $600,000, so you are asking people to come up with $60,000 to $120,000 in cash."
Ms. Lugo thinks the recent change in FHA loan limits to $729,750 in the Washington area is already having a big impact on the local market.
"Raising the loan limits on FHA loans has opened up the market to people who want to buy a home with just 3 percent down," Ms. Lugo says. "That down payment can be a gift, too, and they can accept seller contributions towards closing costs of up to 6 percent."
FHA loans typically have easier qualification standards that allow consumers with lower credit scores to be approved.
Barbara Haardt, a senior loan officer with Prosperity Mortgage in the District, says that FHA loans, like other mortgage programs, qualify consumers based on income, assets and credit scores, and require full documentation through tax returns and bank statements.
"The difference is that for FHA loans of $392,900 and below, no minimum credit score is required," Ms. Haardt says. "For higher loan amounts, a minimum score of 600 to 620 is required."
Ms. Haardt says lenders in today's real estate market carefully analyze a variety of factors to determine whether each individual county is considered a stable or declining market, which can impact the approval of mortgage loans in that area.
"Lenders look at the number of units on the market, the values of homes in that market and the number of units on the market for more than 180 days to determine market status," Ms. Haardt says. "Currently, the D.C. market, including Northern Virginia and Prince George's County, is considered a declining or distressed market. Montgomery County has already improved to a soft market."
Ms. Haardt says in a declining or distressed market, most lenders require a minimum down payment of 10 percent for conventional loans. FHA loans are not impacted by this designation.
"Some lenders will automatically insist in lowering appraisals on homes in declining markets by 5 percent," Ms. Haardt says.
Two key pieces of advice that each real estate agent offered are these: Buyers should think conservatively when it comes to determining how much they can afford, and sellers should recognize that while they may sell low, they are also buying low.
"Sellers need to realize that if their home value is down by 10 percent from its peak, so is the value of the home you want to buy," Ms. Miles says. "You may have lost $30,000 by not selling your home in 2005, but you are gaining $60,000 on what the owner of your next house thought he would get. You just need to keep it all in perspective."
Ms. Miles says buyers need to compromise and not overextend themselves when purchasing a home. Plus, they need to make sure they understand their loan program, she says.
"You can always sell and move up later," Ms. Miles says.
Ms. Lugo says potential first-time buyers are "crazy" if they are not buying a home right now, since interest rates are low, financing is available and plenty of homes are available.
Ms. Rosenberg suggests that buyers be patient, since it may take more than one attempt to arrange appropriate financing and find the home they want. She says buyers should expect to make a down payment of at least 3 percent (with an FHA loan) or more, and they need to make sure they have a good credit score.
"Buyers need to be very specific with their buyer agent to make sure the agent understands exactly what they are looking for," Ms. Rosenberg says. "The most important thing is to make sure you are comfortable with the payment and your income. Do not push yourself into a more expensive home until you become uncomfortable with the payments."
Mr. Noll says that when he started in the real estate business, buyers had to make at least a 5 percent down payment, if not more.
"Now lenders are returning to that pattern and cracking down," Mr. Noll says. "They want buyers to have a vested interest in the home. So buyers may need some patience while they fix their credit and save money for a down payment."
Both Ms. Rosenberg and Mr. Noll suggest that sellers who do not have to sell their home now wait out the market.
"If you do have to sell, you need to be patient and understand that you are in it for the long haul," Ms. Rosenberg says. "You have to stage your home to make sure it looks the best it can, and you need to assume you will have to adjust your price."
Mr. Noll preaches patience, as well. "Buyers and sellers need to have realistic expectations in this market," he says. "They need a lot of patience until the market turns around again."
Bernanke Urges More Action to Stem Home Foreclosure Crisis
Associated Press, May 5, 10:04 PM
By JEANNINE AVERSA
WASHINGTON (AP) - A rising tide of late mortgage payments and home foreclosures poses considerable dangers to the national economy, Federal Reserve Chairman Ben Bernanke warned anew Monday as he urged Congress to take additional steps to alleviate the problems.
"High rates of delinquency and foreclosure can have substantial spillover effects on the housing market, the financial markets and the broader economy," Bernanke said in a dinner speech to Columbia Business School in New York. "Therefore, doing what we can to avoid preventable foreclosures is not just in the interest of lenders and borrowers. It's in everybody's interest," he said.
Some 1.5 million U.S. homes entered into the foreclosure process last year, up 53 percent from 2006, Bernanke said. The rate of new foreclosures looks likely to be even higher this year, he said.
To provide more relief, Bernanke again called on Congress to give the Federal Housing Administration, which insures mortgages, more flexibility to help distressed borrowers at risk of losing their homes. He also again urged lawmakers to move ahead on legislation revamping Fannie Mae (FNM) and Freddie Mac (FRE), which finance mortgages. And, he called on the two mortgage giants to quickly raise new capital.
House leaders plan action on those and other housing measures this week.
"Conditions in mortgage markets remain quite difficult," the Fed chief said. A copy of the speech was made available in Washington.
The reasons behind surging late payments and foreclosures can vary and that needs to be taken into account when developing solutions, Bernanke said. For instance, parts of New England, states in the Great Lakes, including Minnesota, Michigan and Wisconsin, show increased mortgage delinquencies and "notable increases" in unemployment rates, he said.
California, Florida and parts of Colorado, on the other hand, saw delinquencies rise during a period when unemployment generally decreased but the value of homes declined, he said.
Mortgage companies are used to dealing with delinquencies related to life events, such as job loss or an illness, with the most common approaches being a temporary repayment plan or the folding of missed payments into the principal balance, Bernanke said.
"A widespread decline in home prices, by contrast, is a relatively novel phenomenon, and lenders and servicers will have to develop new and flexible strategies to deal with this issue," Bernanke said.
The current housing crises has clobbered some borrowers home prices dropped. That left them with mortgages that are bigger than the value of their home. When that's the primary problem, Bernanke said the best solution may be reducing the amount that the borrower owes on the loan or some other permanent modification to the loan.
Rising foreclosures add to the glut of unsold homes and that put more downward pressure on prices, aggravating the housing slump, he said. More rapid declines in house prices could have an "adverse impact" on the broader economy and the stability of the financial system, he said.
In his remarks, Bernanke did not talk about the interest rate policy or the state of the economy.
To help bolster the economy, the Federal Reserve last Wednesday cut a key interest rate by one-quarter percentage point to 2 percent and strongly hinted that it may take a breather in its rate-cutting campaign that started last September.
The Fed hopes that its powerful series of rate cuts - its most aggressive in decades - along with the government's $168 billion stimulus package - including tax rebates that started flowing to bank accounts last week - will be sufficient to lift the country out of its slump in the second half of this year.
The mortgage meltdown started with problems with subprime mortgages - those made to people with tarnished credit. However, they have spread to more creditworthy borrowers.
The trio of crises - housing, credit and financial - have threatened to plunge the country into its first recession since 2001. The situation has roiled Wall Street, rattled consumers and has galvanized politicians in the White House, in Congress and on the campaign trail to come up with proposals to provide relief.
"The Realtor's mantra is 'location, location, location' ... local variation in housing and mortgage markets is considerable," Bernanke said. "This variation is useful for understanding the sources of the increase in mortgage delinquencies and foreclosures, and it should be taken into account as servicers and policymakers consider how best to avoid preventable foreclosures," he said.
By JEANNINE AVERSA
WASHINGTON (AP) - A rising tide of late mortgage payments and home foreclosures poses considerable dangers to the national economy, Federal Reserve Chairman Ben Bernanke warned anew Monday as he urged Congress to take additional steps to alleviate the problems.
"High rates of delinquency and foreclosure can have substantial spillover effects on the housing market, the financial markets and the broader economy," Bernanke said in a dinner speech to Columbia Business School in New York. "Therefore, doing what we can to avoid preventable foreclosures is not just in the interest of lenders and borrowers. It's in everybody's interest," he said.
Some 1.5 million U.S. homes entered into the foreclosure process last year, up 53 percent from 2006, Bernanke said. The rate of new foreclosures looks likely to be even higher this year, he said.
To provide more relief, Bernanke again called on Congress to give the Federal Housing Administration, which insures mortgages, more flexibility to help distressed borrowers at risk of losing their homes. He also again urged lawmakers to move ahead on legislation revamping Fannie Mae (FNM) and Freddie Mac (FRE), which finance mortgages. And, he called on the two mortgage giants to quickly raise new capital.
House leaders plan action on those and other housing measures this week.
"Conditions in mortgage markets remain quite difficult," the Fed chief said. A copy of the speech was made available in Washington.
The reasons behind surging late payments and foreclosures can vary and that needs to be taken into account when developing solutions, Bernanke said. For instance, parts of New England, states in the Great Lakes, including Minnesota, Michigan and Wisconsin, show increased mortgage delinquencies and "notable increases" in unemployment rates, he said.
California, Florida and parts of Colorado, on the other hand, saw delinquencies rise during a period when unemployment generally decreased but the value of homes declined, he said.
Mortgage companies are used to dealing with delinquencies related to life events, such as job loss or an illness, with the most common approaches being a temporary repayment plan or the folding of missed payments into the principal balance, Bernanke said.
"A widespread decline in home prices, by contrast, is a relatively novel phenomenon, and lenders and servicers will have to develop new and flexible strategies to deal with this issue," Bernanke said.
The current housing crises has clobbered some borrowers home prices dropped. That left them with mortgages that are bigger than the value of their home. When that's the primary problem, Bernanke said the best solution may be reducing the amount that the borrower owes on the loan or some other permanent modification to the loan.
Rising foreclosures add to the glut of unsold homes and that put more downward pressure on prices, aggravating the housing slump, he said. More rapid declines in house prices could have an "adverse impact" on the broader economy and the stability of the financial system, he said.
In his remarks, Bernanke did not talk about the interest rate policy or the state of the economy.
To help bolster the economy, the Federal Reserve last Wednesday cut a key interest rate by one-quarter percentage point to 2 percent and strongly hinted that it may take a breather in its rate-cutting campaign that started last September.
The Fed hopes that its powerful series of rate cuts - its most aggressive in decades - along with the government's $168 billion stimulus package - including tax rebates that started flowing to bank accounts last week - will be sufficient to lift the country out of its slump in the second half of this year.
The mortgage meltdown started with problems with subprime mortgages - those made to people with tarnished credit. However, they have spread to more creditworthy borrowers.
The trio of crises - housing, credit and financial - have threatened to plunge the country into its first recession since 2001. The situation has roiled Wall Street, rattled consumers and has galvanized politicians in the White House, in Congress and on the campaign trail to come up with proposals to provide relief.
"The Realtor's mantra is 'location, location, location' ... local variation in housing and mortgage markets is considerable," Bernanke said. "This variation is useful for understanding the sources of the increase in mortgage delinquencies and foreclosures, and it should be taken into account as servicers and policymakers consider how best to avoid preventable foreclosures," he said.
Triple-A Failure
New York Times Magazine, April 27, 2008
By ROGER LOWENSTEIN
The Ratings Game
In 1996, Thomas Friedman, the New York Times columnist, remarked on ''The NewsHour With Jim Lehrer'' that there were two superpowers in the world -- the United States and Moody's bond-rating service -- and it was sometimes unclear which was more powerful. Moody's was then a private company that rated corporate bonds, but it was, already, spreading its wings into the exotic business of rating securities backed by pools of residential mortgages.
Obscure and dry-seeming as it was, this business offered a certain magic. The magic consisted of turning risky mortgages into investments that would be suitable for investors who would know nothing about the underlying loans. To get why this is impressive, you have to think about all that determines whether a mortgage is safe. Who owns the property? What is his or her income? Bundle hundreds of mortgages into a single security and the questions multiply; no investor could begin to answer them. But suppose the security had a rating. If it were rated triple-A by a firm like Moody's, then the investor could forget about the underlying mortgages. He wouldn't need to know what properties were in the pool, only that the pool was triple-A -- it was just as safe, in theory, as other triple-A securities.
Over the last decade, Moody's and its two principal competitors, Standard & Poor's and Fitch, played this game to perfection -- putting what amounted to gold seals on mortgage securities that investors swept up with increasing élan. For the rating agencies, this business was extremely lucrative. Their profits surged, Moody's in particular: it went public, saw its stock increase sixfold and its earnings grow by 900 percent.
By providing the mortgage industry with an entree to Wall Street, the agencies also transformed what had been among the sleepiest corners of finance. No longer did mortgage banks have to wait 10 or 20 or 30 years to get their money back from homeowners. Now they sold their loans into securitized pools and -- their capital thus replenished -- wrote new loans at a much quicker pace.
Mortgage volume surged; in 2006, it topped $2.5 trillion. Also, many more mortgages were issued to risky subprime borrowers. Almost all of those subprime loans ended up in securitized pools; indeed, the reason banks were willing to issue so many risky loans is that they could fob them off on Wall Street.
But who was evaluating these securities? Who was passing judgment on the quality of the mortgages, on the equity behind them and on myriad other investment considerations? Certainly not the investors. They relied on a credit rating.
Thus the agencies became the de facto watchdog over the mortgage industry. In a practical sense, it was Moody's and Standard & Poor's that set the credit standards that determined which loans Wall Street could repackage and, ultimately, which borrowers would qualify. Effectively, they did the job that was expected of banks and government regulators. And today, they are a central culprit in the mortgage bust, in which the total loss has been projected at $250 billion and possibly much more.
In the wake of the housing collapse, Congress is exploring why the industry failed and whether it should be revamped (hearings in the Senate Banking Committee were expected to begin April 22). Two key questions are whether the credit agencies -- which benefit from a unique series of government charters -- enjoy too much official protection and whether their judgment was tainted. Presumably to forestall criticism and possible legislation, Moody's and S.&P. have announced reforms. But they reject the notion that they should have been more vigilant. Instead, they lay the blame on the mortgage holders who turned out to be deadbeats, many of whom lied to obtain their loans.
Arthur Levitt, the former chairman of the Securities and Exchange Commission, charges that ''the credit-rating agencies suffer from a conflict of interest -- perceived and apparent -- that may have distorted their judgment, especially when it came to complex structured financial products.'' Frank Partnoy, a professor at the University of San Diego School of Law who has written extensively about the credit-rating industry, says that the conflict is a serious problem. Thanks to the industry's close relationship with the banks whose securities it rates, Partnoy says, the agencies have behaved less like gatekeepers than gate openers. Last year, Moody's had to downgrade more than 5,000 mortgage securities -- a tacit acknowledgment that the mortgage bubble was abetted by its overly generous ratings. Mortgage securities rated by Standard & Poor's and Fitch have suffered a similar wave of downgrades.
Presto! How 2,393 Subprime Loans Become a High-Grade Investment
The business of assigning a rating to a mortgage security is a complicated affair, and Moody's recently was willing to walk me through an actual mortgage-backed security step by step. I was led down a carpeted hallway to a well-appointed conference room to meet with three specialists in mortgage-backed paper. Moody's was fair-minded in choosing an example; the case they showed me, which they masked with the name ''Subprime XYZ,'' was a pool of 2,393 mortgages with a total face value of $430 million.
Subprime XYZ typified the exuberance of the age. All the mortgages in the pool were subprime -- that is, they had been extended to borrowers with checkered credit histories. In an earlier era, such people would have been restricted from borrowing more than 75 percent or so of the value of their homes, but during the great bubble, no such limits applied.
Moody's did not have access to the individual loan files, much less did it communicate with the borrowers or try to verify the information they provided in their loan applications. ''We aren't loan officers,'' Claire Robinson, a 20-year veteran who is in charge of asset-backed finance for Moody's, told me. ''Our expertise is as statisticians on an aggregate basis. We want to know, of 1,000 individuals, based on historical performance, what percent will pay their loans?''
The loans in Subprime XYZ were issued in early spring 2006 -- what would turn out to be the peak of the boom. They were originated by a West Coast company that Moody's identified as a ''nonbank lender.'' Traditionally, people have gotten their mortgages from banks, but in recent years, new types of lenders peddling sexier products grabbed an increasing share of the market. This particular lender took the loans it made to a New York investment bank; the bank designed an investment vehicle and brought the package to Moody's.
Moody's assigned an analyst to evaluate the package, subject to review by a committee. The investment bank provided an enormous spreadsheet chock with data on the borrowers' credit histories and much else that might, at very least, have given Moody's pause. Three-quarters of the borrowers had adjustable-rate mortgages, or ARMs -- ''teaser'' loans on which the interest rate could be raised in short order. Since subprime borrowers cannot afford higher rates, they would need to refinance soon. This is a classic sign of a bubble -- lending on the belief, or the hope, that new money will bail out the old.
Moody's learned that almost half of these borrowers -- 43 percent -- did not provide written verification of their incomes. The data also showed that 12 percent of the mortgages were for properties in Southern California, including a half-percent in a single ZIP code, in Riverside. That suggested a risky degree of concentration.
On the plus side, Moody's noted, 94 percent of those borrowers with adjustable-rate loans said their mortgages were for primary residences. ''That was a comfort feeling,'' Robinson said. Historically, people have been slow to abandon their primary homes. When you get into a crunch, she added, ''You'll give up your ski chalet first.''
Another factor giving Moody's comfort was that all of the ARM loans in the pool were first mortgages (as distinct from, say, home-equity loans). Nearly half of the borrowers, however, took out a simultaneous second loan. Most often, their two loans added up to all of their property's presumed resale value, which meant the borrowers had not a cent of equity.
In the frenetic, deal-happy climate of 2006, the Moody's analyst had only a single day to process the credit data from the bank. The analyst wasn't evaluating the mortgages but, rather, the bonds issued by the investment vehicle created to house them. A so-called special-purpose vehicle -- a ghost corporation with no people or furniture and no assets either until the deal was struck -- would purchase the mortgages. Thereafter, monthly payments from the homeowners would go to the S.P.V. The S.P.V. would finance itself by selling bonds. The question for Moody's was whether the inflow of mortgage checks would cover the outgoing payments to bondholders. From the investment bank's point of view, the key to the deal was obtaining a triple-A rating -- without which the deal wouldn't be profitable. That a vehicle backed by subprime mortgages could borrow at triple-A rates seems like a trick of finance. ''People say, 'How can you create triple-A out of B-rated paper?' '' notes Arturo Cifuentes, a former Moody's credit analyst who now designs credit instruments. It may seem like a scam, but it's not.
The secret sauce is that the S.P.V. would float 12 classes of bonds, from triple-A to a lowly Ba1. The highest-rated bonds would have first priority on the cash received from mortgage holders until they were fully paid, then the next tier of bonds, then the next and so on. The bonds at the bottom of the pile got the highest interest rate, but if homeowners defaulted, they would absorb the first losses.
It was this segregation of payments that protected the bonds at the top of the structure and enabled Moody's to classify them as triple-A. Imagine a seaside condo beset by flooding: just as the penthouse will not get wet until the lower floors are thoroughly soaked, so the triple-A bonds would not lose a dime unless the lower credits were wiped out.
Structured finance, of which this deal is typical, is both clever and useful; in the housing industry it has greatly expanded the pool of credit. But in extreme conditions, it can fail. The old-fashioned corner banker used his instincts, as well as his pencil, to apportion credit; modern finance is formulaic. However elegant its models, forecasting the behavior of 2,393 mortgage holders is an uncertain business. ''Everyone assumed the credit agencies knew what they were doing,'' says Joseph Mason, a credit expert at Drexel University. ''A structural engineer can predict what load a steel support will bear; in financial engineering we can't predict as well.''
Mortgage-backed securities like those in Subprime XYZ were not the terminus of the great mortgage machine. They were, in fact, building blocks for even more esoteric vehicles known as collateralized debt obligations, or C.D.O.'s. C.D.O.'s were financed with similar ladders of bonds, from triple-A on down, and the credit-rating agencies' role was just as central. The difference is that XYZ was a first-order derivative -- its assets included real mortgages owned by actual homeowners. C.D.O.'s were a step removed -- instead of buying mortgages, they bought bonds that were backed by mortgages, like the bonds issued by Subprime XYZ. (It is painful to consider, but there were also third-order instruments, known as C.D.O.'s squared, which bought bonds issued by other C.D.O.'s.)
Miscalculations that were damaging at the level of Subprime XYZ were devastating at the C.D.O. level. Just as bad weather will cause more serious delays to travelers with multiple flights, so, if the underlying mortgage bonds were misrated, the trouble was compounded in the case of the C.D.O.'s that purchased them.
Moody's used statistical models to assess C.D.O.'s; it relied on historical patterns of default. This assumed that the past would remain relevant in an era in which the mortgage industry was morphing into a wildly speculative business. The complexity of C.D.O.'s undermined the process as well. Jamie Dimon, the chief executive of JPMorgan Chase, which recently scooped up the mortally wounded Bear Stearns, says, ''There was a large failure of common sense'' by rating agencies and also by banks like his. ''Very complex securities shouldn't have been rated as if they were easy-to-value bonds.''
The Accidental Watchdog
John Moody, a Wall Street analyst and former errand runner, hit on the idea of synthesizing all kinds of credit information into a single rating in 1909, when he published the manual ''Moody's Analyses of Railroad Investments.'' The idea caught on with investors, who subscribed to his service, and by the mid-'20s, Moody's faced three competitors: Standard Statistics and Poor's Publishing (which later merged) and Fitch.
Then as now, Moody's graded bonds on a scale with 21 steps, from Aaa to C. (There are small differences in the agencies' nomenclatures, just as a grande latte at Starbucks becomes a ''medium'' at Peet's. At Moody's, ratings that start with the letter ''A'' carry minimal to low credit risk; those starting with ''B'' carry moderate to high risk; and ''C'' ratings denote bonds in poor standing or actual default.) The ratings are meant to be an estimate of probabilities, not a buy or sell recommendation. For instance, Ba bonds default far more often than triple-As. But Moody's, as it is wont to remind people, is not in the business of advising investors whether to buy Ba's; it merely publishes a rating.
Until the 1970s, its business grew slowly. But several trends coalesced to speed it up. The first was the collapse of Penn Central in 1970 -- a shattering event that the credit agencies failed to foresee. It so unnerved investors that they began to pay more attention to credit risk.
Government responded. The Securities and Exchange Commission, faced with the question of how to measure the capital of broker-dealers, decided to penalize brokers for holding bonds that were less than investment-grade (the term applies to Moody's 10 top grades). This prompted a question: investment grade according to whom? The S.E.C. opted to create a new category of officially designated rating agencies, and grandfathered the big three -- S.&P., Moody's and Fitch. In effect, the government outsourced its regulatory function to three for-profit companies.
Bank regulators issued similar rules for banks. Pension funds, mutual funds, insurance regulators followed. Over the '80s and '90s, a latticework of such rules redefined credit markets. Many classes of investors were now forbidden to buy noninvestment-grade bonds at all.
Issuers thus were forced to seek credit ratings (or else their bonds would not be marketable). The agencies -- realizing they had a hot product and, what's more, a captive market -- started charging the very organizations whose bonds they were rating. This was an efficient way to do business, but it put the agencies in a conflicted position. As Partnoy says, rather than selling opinions to investors, the rating agencies were now selling ''licenses'' to borrowers. Indeed, whether their opinions were accurate no longer mattered so much. Just as a police officer stopping a motorist will want to see his license but not inquire how well he did on his road test, it was the rating -- not its accuracy -- that mattered to Wall Street.
The case of Enron is illustrative. Throughout the summer and fall of 2001, even though its credit was rapidly deteriorating, the rating agencies kept it at investment grade. This was not unusual; the agencies typically lag behind the news. On Nov. 28, 2001, S.&P. finally dropped Enron's bonds to subinvestment grade. Although its action merely validated the market consensus, it caused the stock to collapse. To investors, S.&P.'s action was a signal that Enron was locked out of credit markets; it had lost its ''license'' to borrow. Four days later it filed for bankruptcy.
Another trend that spurred the agencies' growth was that more companies began borrowing in bond markets instead of from banks. According to Chris Mahoney, a just-retired Moody's veteran of 22 years, ''The agencies went from being obscure and unimportant players to central ones.''
A Conflict of Interest?
Nothing sent the agencies into high gear as much as the development of structured finance. As Wall Street bankers designed ever more securitized products -- using mortgages, credit-card debt, car loans, corporate debt, every type of paper imaginable -- the agencies became truly powerful.
In structured-credit vehicles like Subprime XYZ, the agencies played a much more pivotal role than they had with (conventional) bonds. According to Lewis Ranieri, the Salomon Brothers banker who was a pioneer in mortgage bonds, ''The whole creation of mortgage securities was involved with a rating.''
What the bankers in these deals are really doing is buying a bunch of I.O.U.'s and repackaging them in a different form. Something has to make the package worth -- or seem to be worth -- more that the sum of its parts, otherwise there would be no point in packaging such securities, nor would there be any profits from which to pay the bankers' fees.
That something is the rating. Credit markets are not continuous; a bond that qualifies, though only by a hair, as investment grade is worth a lot more than one that just fails. As with a would-be immigrant traveling from Mexico, there is a huge incentive to get over the line.
The challenge to investment banks is to design securities that just meet the rating agencies' tests. Risky mortgages serve their purpose; since the interest rate on them is higher, more money comes into the pool and is available for paying bond interest. But if the mortgages are too risky, Moody's will object. Banks are adroit at working the system, and pools like Subprime XYZ are intentionally designed to include a layer of Baa bonds, or those just over the border. ''Every agency has a model available to bankers that allows them to run the numbers until they get something they like and send it in for a rating,'' a former Moody's expert in securitization says. In other words, banks were gaming the system; according to Chris Flanagan, the subprime analyst at JPMorgan, ''Gaming is the whole thing.''
When a bank proposes a rating structure on a pool of debt, the rating agency will insist on a cushion of extra capital, known as an ''enhancement.'' The bank inevitably lobbies for a thin cushion (the thinner the capitalization, the fatter the bank's profits). It's up to the agency to make sure that the cushion is big enough to safeguard the bonds. The process involves extended consultations between the agency and its client. In short, obtaining a rating is a collaborative process.
The evidence on whether rating agencies bend to the bankers' will is mixed. The agencies do not deny that a conflict exists, but they assert that they are keen to the dangers and minimize them. For instance, they do not reward analysts on the basis of whether they approve deals. No smoking gun, no conspiratorial e-mail message, has surfaced to suggest that they are lying. But in structured finance, the agencies face pressures that did not exist when John Moody was rating railroads. On the traditional side of the business, Moody's has thousands of clients (virtually every corporation and municipality that sells bonds). No one of them has much clout. But in structured finance, a handful of banks return again and again, paying much bigger fees. A deal the size of XYZ can bring Moody's $200,000 and more for complicated deals. And the banks pay only if Moody's delivers the desired rating. Tom McGuire, the Jesuit theologian who ran Moody's through the mid-'90s, says this arrangement is unhealthy. If Moody's and a client bank don't see eye to eye, the bank can either tweak the numbers or try its luck with a competitor like S.&P., a process known as ''ratings shopping.''
And it seems to have helped the banks get better ratings. Mason, of Drexel University, compared default rates for corporate bonds rated Baa with those of similarly rated collateralized debt obligations until 2005 (before the bubble burst). Mason found that the C.D.O.'s defaulted eight times as often. One interpretation of the data is that Moody's was far less discerning when the client was a Wall Street securitizer.
After Enron blew up, Congress ordered the S.E.C. to look at the rating industry and possibly reform it. The S.E.C. ducked. Congress looked again in 2006 and enacted a law making it easier for competing agencies to gain official recognition, but didn't change the industry's business model. By then, the mortgage boom was in high gear. From 2002 to 2006, Moody's profits nearly tripled, mostly thanks to the high margins the agencies charged in structured finance. In 2006, Moody's reported net income of $750 million. Raymond W. McDaniel Jr., its chief executive, gloated in the annual report for that year, ''I firmly believe that Moody's business stands on the 'right side of history' in terms of the alignment of our role and function with advancements in global capital markets.''
Using Weather in Antarctica To Forecast Conditions in Hawaii
Even as McDaniel was crowing, it was clear in some corners of Wall Street that the mortgage market was headed for trouble. The housing industry was cooling off fast. James Kragenbring, a money manager with Advantus Capital Management, complained to the agencies as early as 2005 that their ratings were too generous. A report from the hedge fund of John Paulson proclaimed astonishment at ''the mispricing of these securities.'' He started betting that mortgage debt would crash.
Even Mark Zandi, the very visible economist at Moody's forecasting division (which is separate from the ratings side), was worried about the chilling crosswinds blowing in credit markets. In a report published in May 2006, he noted that consumer borrowing had soared, household debt was at a record and a fifth of such debt was classified as subprime. At the same time, loan officers were loosening underwriting standards and easing rates to offer still more loans. Zandi fretted about the ''razor-thin'' level of homeowners' equity, the avalanche of teaser mortgages and the $750 billion of mortgages he judged to be at risk. Zandi concluded, ''The environment feels increasingly ripe for some type of financial event.''
A month after Zandi's report, Moody's rated Subprime XYZ. The analyst on the deal also had concerns. Moody's was aware that mortgage standards had been deteriorating, and it had been demanding more of a cushion in such pools. Nonetheless, its credit-rating model continued to envision rising home values. Largely for that reason, the analyst forecast losses for XYZ at only 4.9 percent of the underlying mortgage pool. Since even the lowest-rated bonds in XYZ would be covered up to a loss level of 7.25 percent, the bonds seemed safe.
XYZ now became the responsibility of a Moody's team that monitors securities and changes the ratings if need be (the analyst moved on to rate a new deal). Almost immediately, the team noticed a problem. Usually, people who finance a home stay current on their payments for at least a while. But a sliver of folks in XYZfell behind within 90 days of signing their papers. After six months, an alarming 6 percent of the mortgages were seriously delinquent. (Historically, it is rare for more than 1 percent of mortgages at that stage to be delinquent.)
Moody's monitors began to make inquiries with the lender and were shocked by what they heard. Some properties lacked sod or landscaping, and keys remained in the mailbox; the buyers had never moved in. The implication was that people had bought homes on spec: as the housing market turned, the buyers walked.
By the spring of 2007, 13 percent of Subprime XYZ was delinquent -- and it was worsening by the month. XYZ was hardly atypical; the entire class of 2006 was performing terribly. (The class of 2007 would turn out to be even worse.)
In April 2007, Moody's announced it was revising the model it used to evaluate subprime mortgages. It noted that the model ''was first introduced in 2002. Since then, the mortgage market has evolved considerably.'' This was a rather stunning admission; its model had been based on a world that no longer existed.
Poring over the data, Moody's discovered that the size of people's first mortgages was no longer a good predictor of whether they would default; rather, it was the size of their first and second loans -- that is, their total debt -- combined. This was rather intuitive; Moody's simply hadn't reckoned on it. Similarly, credit scores, long a mainstay of its analyses, had not proved to be a ''strong predictor'' of defaults this time. Translation: even people with good credit scores were defaulting. Amy Tobey, leader of the team that monitored XYZ, told me, ''It seems there was a shift in mentality; people are treating homes as investment assets.'' Indeed. And homeowners without equity were making what economists call a rational choice; they were abandoning properties rather than make payments on them. Homeowners' equity had never been as high as believed because appraisals had been inflated.
Over the summer and fall of 2007, Moody's and the other agencies repeatedly tightened their methodology for rating mortgage securities, but it was too late. They had to downgrade tens of billions of dollars of securities. By early this year, when I met with Moody's, an astonishing 27 percent of the mortgage holders in Subprime XYZ were delinquent. Losses on the pool were now estimated at 14 percent to 16 percent -- three times the original estimate. Seemingly high-quality bonds rated A3 by Moody's had been downgraded five notches to Ba2, as had the other bonds in the pool aside from its triple-A's.
The pain didn't stop there. Many of the lower-rated bonds issued by XYZ, and by mortgage pools like it, were purchased by C.D.O.'s, the second-order mortgage vehicles, which were eager to buy lower-rated mortgage paper because it paid a higher yield. As the agencies endowed C.D.O. securities with triple-A ratings, demand for them was red hot. Much of it was from global investors who knew nothing about the U.S. mortgage market. In 2006 and 2007, the banks created more than $200 billion of C.D.O.'s backed by lower-rated mortgage paper. Moody's assigned a different team to rate C.D.O.'s. This team knew far less about the underlying mortgages than did the committee that evaluated Subprime XYZ. In fact, Moody's rated C.D.O.'s without knowing which bonds the pool would buy.
A C.D.O. operates like a mutual fund; it can buy or sell mortgage bonds and frequently does so. Thus, the agencies rate pools with assets that are perpetually shifting. They base their ratings on an extensive set of guidelines or covenants that limit the C.D.O. manager's discretion.
Late in 2006, Moody's rated a C.D.O. with $750 million worth of securities. The covenants, which act as a template, restricted the C.D.O. to, at most, an 80 percent exposure to subprime assets, and many other such conditions. ''We're structure experts,'' Yuri Yoshizawa, the head of Moody's' derivative group, explained. ''We're not underlying-asset experts.'' They were checking the math, not the mortgages. But no C.D.O. can be better than its collateral.
Moody's rated three-quarters of this C.D.O.'s bonds triple-A. The ratings were derived using a mathematical construct known as a Monte Carlo simulation -- as if each of the underlying bonds would perform like cards drawn at random from a deck of mortgage bonds in the past. There were two problems with this approach. First, the bonds weren't like those in the past; the mortgage market had changed. As Mark Adelson, a former managing director in Moody's structured-finance division, remarks, it was ''like observing 100 years of weather in Antarctica to forecast the weather in Hawaii.'' And second, the bonds weren't random. Moody's had underestimated the extent to which underwriting standards had weakened everywhere. When one mortgage bond failed, the odds were that others would, too.
Moody's estimated that this C.D.O. could potentially incur losses of 2 percent. It has since revised its estimate to 27 percent. The bonds it rated have been decimated, their market value having plunged by half or more. A triple-A layer of bonds has been downgraded 16 notches, all the way to B. Hundreds of C.D.O.'s have suffered similar fates (most of Wall Street's losses have been on C.D.O.'s). For Moody's and the other rating agencies, it has been an extraordinary rout.
Whom Can We Rely On?
The agencies have blamed the large incidence of fraud, but then they could have demanded verification of the mortgage data or refused to rate securities where the data were not provided. That was, after all, their mandate. This is what they pledge for the future. Moody's, S.&P. and Fitch say that they are tightening procedures -- they will demand more data and more verification and will subject their analysts to more outside checks. None of this, however, will remove the conflict of interest in the issuer-pays model. Though some have proposed requiring that agencies with official recognition charge investors, rather than issuers, a more practical reform may be for the government to stop certifying agencies altogether.
Then, if the Fed or other regulators wanted to restrict what sorts of bonds could be owned by banks, or by pension funds or by anyone else in need of protection, they would have to do it themselves -- not farm the job out to Moody's. The ratings agencies would still exist, but stripped of their official imprimatur, their ratings would lose a little of their aura, and investors might trust in them a bit less. Moody's itself favors doing away with the official designation, and it, like S.&P., embraces the idea that investors should not ''rely'' on ratings for buy-and-sell decisions.
This leaves an awkward question, with respect to insanely complex structured securities: What can they rely on? The agencies seem utterly too involved to serve as a neutral arbiter, and the banks are sure to invent new and equally hard-to-assess vehicles in the future. Vickie Tillman, the executive vice president of S.&P., told Congress last fall that in addition to the housing slump, ''ahistorical behavorial modes'' by homeowners were to blame for the wave of downgrades. She cited S.&P.'s data going back to the 1970s, as if consumers were at fault for not living up to the past. The real problem is that the agencies' mathematical formulas look backward while life is lived forward. That is unlikely to change.
By ROGER LOWENSTEIN
The Ratings Game
In 1996, Thomas Friedman, the New York Times columnist, remarked on ''The NewsHour With Jim Lehrer'' that there were two superpowers in the world -- the United States and Moody's bond-rating service -- and it was sometimes unclear which was more powerful. Moody's was then a private company that rated corporate bonds, but it was, already, spreading its wings into the exotic business of rating securities backed by pools of residential mortgages.
Obscure and dry-seeming as it was, this business offered a certain magic. The magic consisted of turning risky mortgages into investments that would be suitable for investors who would know nothing about the underlying loans. To get why this is impressive, you have to think about all that determines whether a mortgage is safe. Who owns the property? What is his or her income? Bundle hundreds of mortgages into a single security and the questions multiply; no investor could begin to answer them. But suppose the security had a rating. If it were rated triple-A by a firm like Moody's, then the investor could forget about the underlying mortgages. He wouldn't need to know what properties were in the pool, only that the pool was triple-A -- it was just as safe, in theory, as other triple-A securities.
Over the last decade, Moody's and its two principal competitors, Standard & Poor's and Fitch, played this game to perfection -- putting what amounted to gold seals on mortgage securities that investors swept up with increasing élan. For the rating agencies, this business was extremely lucrative. Their profits surged, Moody's in particular: it went public, saw its stock increase sixfold and its earnings grow by 900 percent.
By providing the mortgage industry with an entree to Wall Street, the agencies also transformed what had been among the sleepiest corners of finance. No longer did mortgage banks have to wait 10 or 20 or 30 years to get their money back from homeowners. Now they sold their loans into securitized pools and -- their capital thus replenished -- wrote new loans at a much quicker pace.
Mortgage volume surged; in 2006, it topped $2.5 trillion. Also, many more mortgages were issued to risky subprime borrowers. Almost all of those subprime loans ended up in securitized pools; indeed, the reason banks were willing to issue so many risky loans is that they could fob them off on Wall Street.
But who was evaluating these securities? Who was passing judgment on the quality of the mortgages, on the equity behind them and on myriad other investment considerations? Certainly not the investors. They relied on a credit rating.
Thus the agencies became the de facto watchdog over the mortgage industry. In a practical sense, it was Moody's and Standard & Poor's that set the credit standards that determined which loans Wall Street could repackage and, ultimately, which borrowers would qualify. Effectively, they did the job that was expected of banks and government regulators. And today, they are a central culprit in the mortgage bust, in which the total loss has been projected at $250 billion and possibly much more.
In the wake of the housing collapse, Congress is exploring why the industry failed and whether it should be revamped (hearings in the Senate Banking Committee were expected to begin April 22). Two key questions are whether the credit agencies -- which benefit from a unique series of government charters -- enjoy too much official protection and whether their judgment was tainted. Presumably to forestall criticism and possible legislation, Moody's and S.&P. have announced reforms. But they reject the notion that they should have been more vigilant. Instead, they lay the blame on the mortgage holders who turned out to be deadbeats, many of whom lied to obtain their loans.
Arthur Levitt, the former chairman of the Securities and Exchange Commission, charges that ''the credit-rating agencies suffer from a conflict of interest -- perceived and apparent -- that may have distorted their judgment, especially when it came to complex structured financial products.'' Frank Partnoy, a professor at the University of San Diego School of Law who has written extensively about the credit-rating industry, says that the conflict is a serious problem. Thanks to the industry's close relationship with the banks whose securities it rates, Partnoy says, the agencies have behaved less like gatekeepers than gate openers. Last year, Moody's had to downgrade more than 5,000 mortgage securities -- a tacit acknowledgment that the mortgage bubble was abetted by its overly generous ratings. Mortgage securities rated by Standard & Poor's and Fitch have suffered a similar wave of downgrades.
Presto! How 2,393 Subprime Loans Become a High-Grade Investment
The business of assigning a rating to a mortgage security is a complicated affair, and Moody's recently was willing to walk me through an actual mortgage-backed security step by step. I was led down a carpeted hallway to a well-appointed conference room to meet with three specialists in mortgage-backed paper. Moody's was fair-minded in choosing an example; the case they showed me, which they masked with the name ''Subprime XYZ,'' was a pool of 2,393 mortgages with a total face value of $430 million.
Subprime XYZ typified the exuberance of the age. All the mortgages in the pool were subprime -- that is, they had been extended to borrowers with checkered credit histories. In an earlier era, such people would have been restricted from borrowing more than 75 percent or so of the value of their homes, but during the great bubble, no such limits applied.
Moody's did not have access to the individual loan files, much less did it communicate with the borrowers or try to verify the information they provided in their loan applications. ''We aren't loan officers,'' Claire Robinson, a 20-year veteran who is in charge of asset-backed finance for Moody's, told me. ''Our expertise is as statisticians on an aggregate basis. We want to know, of 1,000 individuals, based on historical performance, what percent will pay their loans?''
The loans in Subprime XYZ were issued in early spring 2006 -- what would turn out to be the peak of the boom. They were originated by a West Coast company that Moody's identified as a ''nonbank lender.'' Traditionally, people have gotten their mortgages from banks, but in recent years, new types of lenders peddling sexier products grabbed an increasing share of the market. This particular lender took the loans it made to a New York investment bank; the bank designed an investment vehicle and brought the package to Moody's.
Moody's assigned an analyst to evaluate the package, subject to review by a committee. The investment bank provided an enormous spreadsheet chock with data on the borrowers' credit histories and much else that might, at very least, have given Moody's pause. Three-quarters of the borrowers had adjustable-rate mortgages, or ARMs -- ''teaser'' loans on which the interest rate could be raised in short order. Since subprime borrowers cannot afford higher rates, they would need to refinance soon. This is a classic sign of a bubble -- lending on the belief, or the hope, that new money will bail out the old.
Moody's learned that almost half of these borrowers -- 43 percent -- did not provide written verification of their incomes. The data also showed that 12 percent of the mortgages were for properties in Southern California, including a half-percent in a single ZIP code, in Riverside. That suggested a risky degree of concentration.
On the plus side, Moody's noted, 94 percent of those borrowers with adjustable-rate loans said their mortgages were for primary residences. ''That was a comfort feeling,'' Robinson said. Historically, people have been slow to abandon their primary homes. When you get into a crunch, she added, ''You'll give up your ski chalet first.''
Another factor giving Moody's comfort was that all of the ARM loans in the pool were first mortgages (as distinct from, say, home-equity loans). Nearly half of the borrowers, however, took out a simultaneous second loan. Most often, their two loans added up to all of their property's presumed resale value, which meant the borrowers had not a cent of equity.
In the frenetic, deal-happy climate of 2006, the Moody's analyst had only a single day to process the credit data from the bank. The analyst wasn't evaluating the mortgages but, rather, the bonds issued by the investment vehicle created to house them. A so-called special-purpose vehicle -- a ghost corporation with no people or furniture and no assets either until the deal was struck -- would purchase the mortgages. Thereafter, monthly payments from the homeowners would go to the S.P.V. The S.P.V. would finance itself by selling bonds. The question for Moody's was whether the inflow of mortgage checks would cover the outgoing payments to bondholders. From the investment bank's point of view, the key to the deal was obtaining a triple-A rating -- without which the deal wouldn't be profitable. That a vehicle backed by subprime mortgages could borrow at triple-A rates seems like a trick of finance. ''People say, 'How can you create triple-A out of B-rated paper?' '' notes Arturo Cifuentes, a former Moody's credit analyst who now designs credit instruments. It may seem like a scam, but it's not.
The secret sauce is that the S.P.V. would float 12 classes of bonds, from triple-A to a lowly Ba1. The highest-rated bonds would have first priority on the cash received from mortgage holders until they were fully paid, then the next tier of bonds, then the next and so on. The bonds at the bottom of the pile got the highest interest rate, but if homeowners defaulted, they would absorb the first losses.
It was this segregation of payments that protected the bonds at the top of the structure and enabled Moody's to classify them as triple-A. Imagine a seaside condo beset by flooding: just as the penthouse will not get wet until the lower floors are thoroughly soaked, so the triple-A bonds would not lose a dime unless the lower credits were wiped out.
Structured finance, of which this deal is typical, is both clever and useful; in the housing industry it has greatly expanded the pool of credit. But in extreme conditions, it can fail. The old-fashioned corner banker used his instincts, as well as his pencil, to apportion credit; modern finance is formulaic. However elegant its models, forecasting the behavior of 2,393 mortgage holders is an uncertain business. ''Everyone assumed the credit agencies knew what they were doing,'' says Joseph Mason, a credit expert at Drexel University. ''A structural engineer can predict what load a steel support will bear; in financial engineering we can't predict as well.''
Mortgage-backed securities like those in Subprime XYZ were not the terminus of the great mortgage machine. They were, in fact, building blocks for even more esoteric vehicles known as collateralized debt obligations, or C.D.O.'s. C.D.O.'s were financed with similar ladders of bonds, from triple-A on down, and the credit-rating agencies' role was just as central. The difference is that XYZ was a first-order derivative -- its assets included real mortgages owned by actual homeowners. C.D.O.'s were a step removed -- instead of buying mortgages, they bought bonds that were backed by mortgages, like the bonds issued by Subprime XYZ. (It is painful to consider, but there were also third-order instruments, known as C.D.O.'s squared, which bought bonds issued by other C.D.O.'s.)
Miscalculations that were damaging at the level of Subprime XYZ were devastating at the C.D.O. level. Just as bad weather will cause more serious delays to travelers with multiple flights, so, if the underlying mortgage bonds were misrated, the trouble was compounded in the case of the C.D.O.'s that purchased them.
Moody's used statistical models to assess C.D.O.'s; it relied on historical patterns of default. This assumed that the past would remain relevant in an era in which the mortgage industry was morphing into a wildly speculative business. The complexity of C.D.O.'s undermined the process as well. Jamie Dimon, the chief executive of JPMorgan Chase, which recently scooped up the mortally wounded Bear Stearns, says, ''There was a large failure of common sense'' by rating agencies and also by banks like his. ''Very complex securities shouldn't have been rated as if they were easy-to-value bonds.''
The Accidental Watchdog
John Moody, a Wall Street analyst and former errand runner, hit on the idea of synthesizing all kinds of credit information into a single rating in 1909, when he published the manual ''Moody's Analyses of Railroad Investments.'' The idea caught on with investors, who subscribed to his service, and by the mid-'20s, Moody's faced three competitors: Standard Statistics and Poor's Publishing (which later merged) and Fitch.
Then as now, Moody's graded bonds on a scale with 21 steps, from Aaa to C. (There are small differences in the agencies' nomenclatures, just as a grande latte at Starbucks becomes a ''medium'' at Peet's. At Moody's, ratings that start with the letter ''A'' carry minimal to low credit risk; those starting with ''B'' carry moderate to high risk; and ''C'' ratings denote bonds in poor standing or actual default.) The ratings are meant to be an estimate of probabilities, not a buy or sell recommendation. For instance, Ba bonds default far more often than triple-As. But Moody's, as it is wont to remind people, is not in the business of advising investors whether to buy Ba's; it merely publishes a rating.
Until the 1970s, its business grew slowly. But several trends coalesced to speed it up. The first was the collapse of Penn Central in 1970 -- a shattering event that the credit agencies failed to foresee. It so unnerved investors that they began to pay more attention to credit risk.
Government responded. The Securities and Exchange Commission, faced with the question of how to measure the capital of broker-dealers, decided to penalize brokers for holding bonds that were less than investment-grade (the term applies to Moody's 10 top grades). This prompted a question: investment grade according to whom? The S.E.C. opted to create a new category of officially designated rating agencies, and grandfathered the big three -- S.&P., Moody's and Fitch. In effect, the government outsourced its regulatory function to three for-profit companies.
Bank regulators issued similar rules for banks. Pension funds, mutual funds, insurance regulators followed. Over the '80s and '90s, a latticework of such rules redefined credit markets. Many classes of investors were now forbidden to buy noninvestment-grade bonds at all.
Issuers thus were forced to seek credit ratings (or else their bonds would not be marketable). The agencies -- realizing they had a hot product and, what's more, a captive market -- started charging the very organizations whose bonds they were rating. This was an efficient way to do business, but it put the agencies in a conflicted position. As Partnoy says, rather than selling opinions to investors, the rating agencies were now selling ''licenses'' to borrowers. Indeed, whether their opinions were accurate no longer mattered so much. Just as a police officer stopping a motorist will want to see his license but not inquire how well he did on his road test, it was the rating -- not its accuracy -- that mattered to Wall Street.
The case of Enron is illustrative. Throughout the summer and fall of 2001, even though its credit was rapidly deteriorating, the rating agencies kept it at investment grade. This was not unusual; the agencies typically lag behind the news. On Nov. 28, 2001, S.&P. finally dropped Enron's bonds to subinvestment grade. Although its action merely validated the market consensus, it caused the stock to collapse. To investors, S.&P.'s action was a signal that Enron was locked out of credit markets; it had lost its ''license'' to borrow. Four days later it filed for bankruptcy.
Another trend that spurred the agencies' growth was that more companies began borrowing in bond markets instead of from banks. According to Chris Mahoney, a just-retired Moody's veteran of 22 years, ''The agencies went from being obscure and unimportant players to central ones.''
A Conflict of Interest?
Nothing sent the agencies into high gear as much as the development of structured finance. As Wall Street bankers designed ever more securitized products -- using mortgages, credit-card debt, car loans, corporate debt, every type of paper imaginable -- the agencies became truly powerful.
In structured-credit vehicles like Subprime XYZ, the agencies played a much more pivotal role than they had with (conventional) bonds. According to Lewis Ranieri, the Salomon Brothers banker who was a pioneer in mortgage bonds, ''The whole creation of mortgage securities was involved with a rating.''
What the bankers in these deals are really doing is buying a bunch of I.O.U.'s and repackaging them in a different form. Something has to make the package worth -- or seem to be worth -- more that the sum of its parts, otherwise there would be no point in packaging such securities, nor would there be any profits from which to pay the bankers' fees.
That something is the rating. Credit markets are not continuous; a bond that qualifies, though only by a hair, as investment grade is worth a lot more than one that just fails. As with a would-be immigrant traveling from Mexico, there is a huge incentive to get over the line.
The challenge to investment banks is to design securities that just meet the rating agencies' tests. Risky mortgages serve their purpose; since the interest rate on them is higher, more money comes into the pool and is available for paying bond interest. But if the mortgages are too risky, Moody's will object. Banks are adroit at working the system, and pools like Subprime XYZ are intentionally designed to include a layer of Baa bonds, or those just over the border. ''Every agency has a model available to bankers that allows them to run the numbers until they get something they like and send it in for a rating,'' a former Moody's expert in securitization says. In other words, banks were gaming the system; according to Chris Flanagan, the subprime analyst at JPMorgan, ''Gaming is the whole thing.''
When a bank proposes a rating structure on a pool of debt, the rating agency will insist on a cushion of extra capital, known as an ''enhancement.'' The bank inevitably lobbies for a thin cushion (the thinner the capitalization, the fatter the bank's profits). It's up to the agency to make sure that the cushion is big enough to safeguard the bonds. The process involves extended consultations between the agency and its client. In short, obtaining a rating is a collaborative process.
The evidence on whether rating agencies bend to the bankers' will is mixed. The agencies do not deny that a conflict exists, but they assert that they are keen to the dangers and minimize them. For instance, they do not reward analysts on the basis of whether they approve deals. No smoking gun, no conspiratorial e-mail message, has surfaced to suggest that they are lying. But in structured finance, the agencies face pressures that did not exist when John Moody was rating railroads. On the traditional side of the business, Moody's has thousands of clients (virtually every corporation and municipality that sells bonds). No one of them has much clout. But in structured finance, a handful of banks return again and again, paying much bigger fees. A deal the size of XYZ can bring Moody's $200,000 and more for complicated deals. And the banks pay only if Moody's delivers the desired rating. Tom McGuire, the Jesuit theologian who ran Moody's through the mid-'90s, says this arrangement is unhealthy. If Moody's and a client bank don't see eye to eye, the bank can either tweak the numbers or try its luck with a competitor like S.&P., a process known as ''ratings shopping.''
And it seems to have helped the banks get better ratings. Mason, of Drexel University, compared default rates for corporate bonds rated Baa with those of similarly rated collateralized debt obligations until 2005 (before the bubble burst). Mason found that the C.D.O.'s defaulted eight times as often. One interpretation of the data is that Moody's was far less discerning when the client was a Wall Street securitizer.
After Enron blew up, Congress ordered the S.E.C. to look at the rating industry and possibly reform it. The S.E.C. ducked. Congress looked again in 2006 and enacted a law making it easier for competing agencies to gain official recognition, but didn't change the industry's business model. By then, the mortgage boom was in high gear. From 2002 to 2006, Moody's profits nearly tripled, mostly thanks to the high margins the agencies charged in structured finance. In 2006, Moody's reported net income of $750 million. Raymond W. McDaniel Jr., its chief executive, gloated in the annual report for that year, ''I firmly believe that Moody's business stands on the 'right side of history' in terms of the alignment of our role and function with advancements in global capital markets.''
Using Weather in Antarctica To Forecast Conditions in Hawaii
Even as McDaniel was crowing, it was clear in some corners of Wall Street that the mortgage market was headed for trouble. The housing industry was cooling off fast. James Kragenbring, a money manager with Advantus Capital Management, complained to the agencies as early as 2005 that their ratings were too generous. A report from the hedge fund of John Paulson proclaimed astonishment at ''the mispricing of these securities.'' He started betting that mortgage debt would crash.
Even Mark Zandi, the very visible economist at Moody's forecasting division (which is separate from the ratings side), was worried about the chilling crosswinds blowing in credit markets. In a report published in May 2006, he noted that consumer borrowing had soared, household debt was at a record and a fifth of such debt was classified as subprime. At the same time, loan officers were loosening underwriting standards and easing rates to offer still more loans. Zandi fretted about the ''razor-thin'' level of homeowners' equity, the avalanche of teaser mortgages and the $750 billion of mortgages he judged to be at risk. Zandi concluded, ''The environment feels increasingly ripe for some type of financial event.''
A month after Zandi's report, Moody's rated Subprime XYZ. The analyst on the deal also had concerns. Moody's was aware that mortgage standards had been deteriorating, and it had been demanding more of a cushion in such pools. Nonetheless, its credit-rating model continued to envision rising home values. Largely for that reason, the analyst forecast losses for XYZ at only 4.9 percent of the underlying mortgage pool. Since even the lowest-rated bonds in XYZ would be covered up to a loss level of 7.25 percent, the bonds seemed safe.
XYZ now became the responsibility of a Moody's team that monitors securities and changes the ratings if need be (the analyst moved on to rate a new deal). Almost immediately, the team noticed a problem. Usually, people who finance a home stay current on their payments for at least a while. But a sliver of folks in XYZfell behind within 90 days of signing their papers. After six months, an alarming 6 percent of the mortgages were seriously delinquent. (Historically, it is rare for more than 1 percent of mortgages at that stage to be delinquent.)
Moody's monitors began to make inquiries with the lender and were shocked by what they heard. Some properties lacked sod or landscaping, and keys remained in the mailbox; the buyers had never moved in. The implication was that people had bought homes on spec: as the housing market turned, the buyers walked.
By the spring of 2007, 13 percent of Subprime XYZ was delinquent -- and it was worsening by the month. XYZ was hardly atypical; the entire class of 2006 was performing terribly. (The class of 2007 would turn out to be even worse.)
In April 2007, Moody's announced it was revising the model it used to evaluate subprime mortgages. It noted that the model ''was first introduced in 2002. Since then, the mortgage market has evolved considerably.'' This was a rather stunning admission; its model had been based on a world that no longer existed.
Poring over the data, Moody's discovered that the size of people's first mortgages was no longer a good predictor of whether they would default; rather, it was the size of their first and second loans -- that is, their total debt -- combined. This was rather intuitive; Moody's simply hadn't reckoned on it. Similarly, credit scores, long a mainstay of its analyses, had not proved to be a ''strong predictor'' of defaults this time. Translation: even people with good credit scores were defaulting. Amy Tobey, leader of the team that monitored XYZ, told me, ''It seems there was a shift in mentality; people are treating homes as investment assets.'' Indeed. And homeowners without equity were making what economists call a rational choice; they were abandoning properties rather than make payments on them. Homeowners' equity had never been as high as believed because appraisals had been inflated.
Over the summer and fall of 2007, Moody's and the other agencies repeatedly tightened their methodology for rating mortgage securities, but it was too late. They had to downgrade tens of billions of dollars of securities. By early this year, when I met with Moody's, an astonishing 27 percent of the mortgage holders in Subprime XYZ were delinquent. Losses on the pool were now estimated at 14 percent to 16 percent -- three times the original estimate. Seemingly high-quality bonds rated A3 by Moody's had been downgraded five notches to Ba2, as had the other bonds in the pool aside from its triple-A's.
The pain didn't stop there. Many of the lower-rated bonds issued by XYZ, and by mortgage pools like it, were purchased by C.D.O.'s, the second-order mortgage vehicles, which were eager to buy lower-rated mortgage paper because it paid a higher yield. As the agencies endowed C.D.O. securities with triple-A ratings, demand for them was red hot. Much of it was from global investors who knew nothing about the U.S. mortgage market. In 2006 and 2007, the banks created more than $200 billion of C.D.O.'s backed by lower-rated mortgage paper. Moody's assigned a different team to rate C.D.O.'s. This team knew far less about the underlying mortgages than did the committee that evaluated Subprime XYZ. In fact, Moody's rated C.D.O.'s without knowing which bonds the pool would buy.
A C.D.O. operates like a mutual fund; it can buy or sell mortgage bonds and frequently does so. Thus, the agencies rate pools with assets that are perpetually shifting. They base their ratings on an extensive set of guidelines or covenants that limit the C.D.O. manager's discretion.
Late in 2006, Moody's rated a C.D.O. with $750 million worth of securities. The covenants, which act as a template, restricted the C.D.O. to, at most, an 80 percent exposure to subprime assets, and many other such conditions. ''We're structure experts,'' Yuri Yoshizawa, the head of Moody's' derivative group, explained. ''We're not underlying-asset experts.'' They were checking the math, not the mortgages. But no C.D.O. can be better than its collateral.
Moody's rated three-quarters of this C.D.O.'s bonds triple-A. The ratings were derived using a mathematical construct known as a Monte Carlo simulation -- as if each of the underlying bonds would perform like cards drawn at random from a deck of mortgage bonds in the past. There were two problems with this approach. First, the bonds weren't like those in the past; the mortgage market had changed. As Mark Adelson, a former managing director in Moody's structured-finance division, remarks, it was ''like observing 100 years of weather in Antarctica to forecast the weather in Hawaii.'' And second, the bonds weren't random. Moody's had underestimated the extent to which underwriting standards had weakened everywhere. When one mortgage bond failed, the odds were that others would, too.
Moody's estimated that this C.D.O. could potentially incur losses of 2 percent. It has since revised its estimate to 27 percent. The bonds it rated have been decimated, their market value having plunged by half or more. A triple-A layer of bonds has been downgraded 16 notches, all the way to B. Hundreds of C.D.O.'s have suffered similar fates (most of Wall Street's losses have been on C.D.O.'s). For Moody's and the other rating agencies, it has been an extraordinary rout.
Whom Can We Rely On?
The agencies have blamed the large incidence of fraud, but then they could have demanded verification of the mortgage data or refused to rate securities where the data were not provided. That was, after all, their mandate. This is what they pledge for the future. Moody's, S.&P. and Fitch say that they are tightening procedures -- they will demand more data and more verification and will subject their analysts to more outside checks. None of this, however, will remove the conflict of interest in the issuer-pays model. Though some have proposed requiring that agencies with official recognition charge investors, rather than issuers, a more practical reform may be for the government to stop certifying agencies altogether.
Then, if the Fed or other regulators wanted to restrict what sorts of bonds could be owned by banks, or by pension funds or by anyone else in need of protection, they would have to do it themselves -- not farm the job out to Moody's. The ratings agencies would still exist, but stripped of their official imprimatur, their ratings would lose a little of their aura, and investors might trust in them a bit less. Moody's itself favors doing away with the official designation, and it, like S.&P., embraces the idea that investors should not ''rely'' on ratings for buy-and-sell decisions.
This leaves an awkward question, with respect to insanely complex structured securities: What can they rely on? The agencies seem utterly too involved to serve as a neutral arbiter, and the banks are sure to invent new and equally hard-to-assess vehicles in the future. Vickie Tillman, the executive vice president of S.&P., told Congress last fall that in addition to the housing slump, ''ahistorical behavorial modes'' by homeowners were to blame for the wave of downgrades. She cited S.&P.'s data going back to the 1970s, as if consumers were at fault for not living up to the past. The real problem is that the agencies' mathematical formulas look backward while life is lived forward. That is unlikely to change.
07 March 2008
Some Borrowers Hit New Snag In Refinancing
Home-Equity Lenders Get Tougher on People Switching To Cheaper First Mortgages
Wall Street Journal, March 6, 2008
By RUTH SIMON
In the latest sign of how the credit crunch is hurting even borrowers with good credit, some home-equity lenders are starting to slam the door on homeowners who want to refinance their primary mortgages.
In some cases, homeowners who in the past would have been easily approved for a mortgage refinancing are finding that they can't get their home-equity lender to give the go-ahead, which is required to complete the transaction. Others are being told by their home-equity lender that they need to reduce the size of their loan or line of credit.
Approvals from home-equity lenders used to be routine, particularly if the borrower wasn't increasing the size of the mortgage as part of the transaction.
But that's no longer always the case -- even in places where the housing market hasn't been hit by huge price declines.
Such approvals, known in the industry as "subordinations," mean that the home-equity lender agrees to stand in second place behind the new mortgage and allow the existing first mortgage to be replaced by another first mortgage.
Many mortgage refinancings continue to go through without a hitch. But some homeowners who want to lower their rates or lock in a fixed-rate mortgage can't,
even if refinancing would save them money and put them in a better position to repay their loans.
"For borrowers trying to improve their situation, this is a nightmare," says Richard Redmond, a mortgage broker in Larkspur, Calif. That's because getting a new home-equity loan to replace the old one in order to get a refinancing approved "may be impossible," he says, as many lenders have significantly tightened their standards as housing prices have fallen.
During the housing boom, many borrowers used home-equity loans as a way to buy a home with little or no money down without having to pay for private mortgage insurance. Others turned to these loans to pay off higher-cost debt or to finance renovations and even vacations. The dollar value of home-equity loans outstanding stood at $1.1 trillion in the third quarter of 2007, according to the Federal Reserve.
The higher hurdles for borrowers come at a time when home-equity lenders are reeling from rising losses in the face of higher delinquencies and falling home prices. More than 5% of home-equity loans were at least 30 days past due in January, according to Equifax and Moody's Economy.com, up from 4.4% in December and 3.4% a year earlier. Delinquencies on home-equity lines of credit have also risen, to 2.2% in January, from 1.9% in December and just 1.2% a year earlier.
Lenders extended an estimated $456 billion of new home-equity loans and lines of credit in 2007, down from a peak of $504 billion in 2006, according to SMR Research in Hackettstown, N.J.
In an effort to stem future losses, home-equity lenders have tightened their standards by, for example, significantly cutting back on how much of a property's value borrowers can finance. They are also going back to some borrowers and freezing their home-equity lines of credit or reducing the maximum amount they can borrow. Charlotte, N.C.-based Bank of America Corp., for instance, began notifying some of its customers last month that it was blocking access to their home-equity lines because of falling home prices.
Cleveland-based lender National City Corp. last month stopped approving refinancing requests from borrowers who received a home-equity loan from the lender through a mortgage broker. Kristen Baird Adams, a National City spokeswoman, says the move was "consistent" with the company's decision last summer to stop making loans through mortgage brokers.
A 'Strategic' Decision
"As a general rule, we are declining" requests related to such loans, says Ms. Adams. "It was a strategic business decision." She adds that "in certain scenarios, if the borrower's first mortgage is with another lender and they are willing and eligible to refinance [the existing mortgage] through National City Mortgage, we could subordinate the existing second mortgage."
Some other borrowers are getting turned down by National City because of tighter lending standards, such as a reduction in the maximum percentage of a home's value a borrower can finance, Ms. Adams says.
Dale Betterton, a financial-software developer, was among those caught short by the change in National City's policies. Mr. Betterton bought a home in Boulder, Colo., this past summer with 5% down. When interest rates dropped last month, he decided to refinance. But National City, which holds his home-equity loan, declined to approve the deal. Mr. Betterton had "superb" credit and the new mortgage would cut his mortgage rate by more than a percentage point, making him a better credit risk, says his mortgage banker, Lou Barnes of Boulder West Financial.
"My understanding was it was pretty straightforward to refinance when rates go down, and there wouldn't be any strange obstacles," says Mr. Betterton, who is now considering paying off his second mortgage so he can refinance.
David Erickson, a mortgage broker in Lynnwood, Wash., says he's had two refinancings declined by National City that "would easily have gotten approval six months ago." In the past, he says, home-equity lenders were eager to keep the loan on their books. Now, he says, "they'd sure love to get paid off and get 100 cents on the dollar."
In some cases, borrowers are getting a thumbs down from their lender because of a change in credit-worthiness or because of falling home prices. Others are getting squeezed by tighter lending standards.
"If there's a material change in the borrower's credit or the value of the home, we might be less willing" to approve a refinancing, says Richard Lieber, mortgage bank chief credit officer for IndyMac Bancorp Inc. IndyMac evaluates refinance requests "on a case-by-case basis," he says. "Due to declines in home values, we are turning down more" of these requests now than in the past.
Other lenders are also giving refinancings more scrutiny. Michael Dunne, a loan officer in Canton, Mass., says one of his clients was unable last month to complete a refinancing that would have reduced his mortgage payments by about $250 a month because local lender South Shore Savings Bank, which held the home-equity loan, refused to give its approval.
South Shore originally held the mortgage, as well as the home-equity loan, but the mortgage was recently sold to investors, Mr. Dunne says. The borrower had good credit, he adds, wasn't pulling out cash and had never missed a payment, but his total mortgage debt exceeded 90% of the home's value at the time the loan was originated. The rejection "really kind of shocked me," Mr. Dunne says, adding that the lender's "situation was not being hurt in the least bit."
Christopher Dunn, an executive vice president with the South Weymouth, Mass., lender, says he can't comment on the specific situation. "I think we are all being more careful," he says. "On the other hand, if our position isn't being worsened and the customer is able to do something to improve their situation," the bank is likely to give its approval.
Reducing Credit Lines
In other cases, home-equity lenders are vetting applications more closely and reducing the size of their line of credit before approving a refinancing. On one recent refinancing, Wells Fargo & Co. asked for copies of bank statements and other documentation to get a better picture of the borrower's assets, even though it had approved the borrower for a home-equity line of credit four months earlier, says David Soleymani, a mortgage broker in Los Angeles.
Wells Fargo ultimately approved the deal, but reduced the size of the credit line to $220,000 from $250,000. The move didn't create a hardship for the borrower because he hadn't tapped the credit line, Mr. Soleymani says. "Historically, they would accept [the borrower's information] at face value" and not ask for the documents, he says. "There's a higher level of scrutiny, and there's no longer the automatic assumption that the holder of the home-equity loan will subordinate."
Wells Fargo evaluates refinancing requests "on a case-by-case basis," says Kevin Moss, head of home-equity for the San Francisco-based lender, "and we consider a variety of factors such as credit experience, the combined loan-to-property value, and the ability to repay the outstanding loans." We want to do everything we can to try to work with our customers," he adds, "and keep their business while following responsible lending practices."
Homeowners with home-equity loans or lines of credit may be able to refinance more easily by simply paying off their loans. With home values falling in his market, Steve Walsh, a mortgage broker in Scottsdale, Ariz., says he's encouraging some borrowers who haven't tapped their credit lines or owe only a small amount to close down those lines, even if they have to pay an early-termination fee, which can run about $300.
Wall Street Journal, March 6, 2008
By RUTH SIMON
In the latest sign of how the credit crunch is hurting even borrowers with good credit, some home-equity lenders are starting to slam the door on homeowners who want to refinance their primary mortgages.
In some cases, homeowners who in the past would have been easily approved for a mortgage refinancing are finding that they can't get their home-equity lender to give the go-ahead, which is required to complete the transaction. Others are being told by their home-equity lender that they need to reduce the size of their loan or line of credit.
Approvals from home-equity lenders used to be routine, particularly if the borrower wasn't increasing the size of the mortgage as part of the transaction.
But that's no longer always the case -- even in places where the housing market hasn't been hit by huge price declines.
Such approvals, known in the industry as "subordinations," mean that the home-equity lender agrees to stand in second place behind the new mortgage and allow the existing first mortgage to be replaced by another first mortgage.
Many mortgage refinancings continue to go through without a hitch. But some homeowners who want to lower their rates or lock in a fixed-rate mortgage can't,
even if refinancing would save them money and put them in a better position to repay their loans.
"For borrowers trying to improve their situation, this is a nightmare," says Richard Redmond, a mortgage broker in Larkspur, Calif. That's because getting a new home-equity loan to replace the old one in order to get a refinancing approved "may be impossible," he says, as many lenders have significantly tightened their standards as housing prices have fallen.
During the housing boom, many borrowers used home-equity loans as a way to buy a home with little or no money down without having to pay for private mortgage insurance. Others turned to these loans to pay off higher-cost debt or to finance renovations and even vacations. The dollar value of home-equity loans outstanding stood at $1.1 trillion in the third quarter of 2007, according to the Federal Reserve.
The higher hurdles for borrowers come at a time when home-equity lenders are reeling from rising losses in the face of higher delinquencies and falling home prices. More than 5% of home-equity loans were at least 30 days past due in January, according to Equifax and Moody's Economy.com, up from 4.4% in December and 3.4% a year earlier. Delinquencies on home-equity lines of credit have also risen, to 2.2% in January, from 1.9% in December and just 1.2% a year earlier.
Lenders extended an estimated $456 billion of new home-equity loans and lines of credit in 2007, down from a peak of $504 billion in 2006, according to SMR Research in Hackettstown, N.J.
In an effort to stem future losses, home-equity lenders have tightened their standards by, for example, significantly cutting back on how much of a property's value borrowers can finance. They are also going back to some borrowers and freezing their home-equity lines of credit or reducing the maximum amount they can borrow. Charlotte, N.C.-based Bank of America Corp., for instance, began notifying some of its customers last month that it was blocking access to their home-equity lines because of falling home prices.
Cleveland-based lender National City Corp. last month stopped approving refinancing requests from borrowers who received a home-equity loan from the lender through a mortgage broker. Kristen Baird Adams, a National City spokeswoman, says the move was "consistent" with the company's decision last summer to stop making loans through mortgage brokers.
A 'Strategic' Decision
"As a general rule, we are declining" requests related to such loans, says Ms. Adams. "It was a strategic business decision." She adds that "in certain scenarios, if the borrower's first mortgage is with another lender and they are willing and eligible to refinance [the existing mortgage] through National City Mortgage, we could subordinate the existing second mortgage."
Some other borrowers are getting turned down by National City because of tighter lending standards, such as a reduction in the maximum percentage of a home's value a borrower can finance, Ms. Adams says.
Dale Betterton, a financial-software developer, was among those caught short by the change in National City's policies. Mr. Betterton bought a home in Boulder, Colo., this past summer with 5% down. When interest rates dropped last month, he decided to refinance. But National City, which holds his home-equity loan, declined to approve the deal. Mr. Betterton had "superb" credit and the new mortgage would cut his mortgage rate by more than a percentage point, making him a better credit risk, says his mortgage banker, Lou Barnes of Boulder West Financial.
"My understanding was it was pretty straightforward to refinance when rates go down, and there wouldn't be any strange obstacles," says Mr. Betterton, who is now considering paying off his second mortgage so he can refinance.
David Erickson, a mortgage broker in Lynnwood, Wash., says he's had two refinancings declined by National City that "would easily have gotten approval six months ago." In the past, he says, home-equity lenders were eager to keep the loan on their books. Now, he says, "they'd sure love to get paid off and get 100 cents on the dollar."
In some cases, borrowers are getting a thumbs down from their lender because of a change in credit-worthiness or because of falling home prices. Others are getting squeezed by tighter lending standards.
"If there's a material change in the borrower's credit or the value of the home, we might be less willing" to approve a refinancing, says Richard Lieber, mortgage bank chief credit officer for IndyMac Bancorp Inc. IndyMac evaluates refinance requests "on a case-by-case basis," he says. "Due to declines in home values, we are turning down more" of these requests now than in the past.
Other lenders are also giving refinancings more scrutiny. Michael Dunne, a loan officer in Canton, Mass., says one of his clients was unable last month to complete a refinancing that would have reduced his mortgage payments by about $250 a month because local lender South Shore Savings Bank, which held the home-equity loan, refused to give its approval.
South Shore originally held the mortgage, as well as the home-equity loan, but the mortgage was recently sold to investors, Mr. Dunne says. The borrower had good credit, he adds, wasn't pulling out cash and had never missed a payment, but his total mortgage debt exceeded 90% of the home's value at the time the loan was originated. The rejection "really kind of shocked me," Mr. Dunne says, adding that the lender's "situation was not being hurt in the least bit."
Christopher Dunn, an executive vice president with the South Weymouth, Mass., lender, says he can't comment on the specific situation. "I think we are all being more careful," he says. "On the other hand, if our position isn't being worsened and the customer is able to do something to improve their situation," the bank is likely to give its approval.
Reducing Credit Lines
In other cases, home-equity lenders are vetting applications more closely and reducing the size of their line of credit before approving a refinancing. On one recent refinancing, Wells Fargo & Co. asked for copies of bank statements and other documentation to get a better picture of the borrower's assets, even though it had approved the borrower for a home-equity line of credit four months earlier, says David Soleymani, a mortgage broker in Los Angeles.
Wells Fargo ultimately approved the deal, but reduced the size of the credit line to $220,000 from $250,000. The move didn't create a hardship for the borrower because he hadn't tapped the credit line, Mr. Soleymani says. "Historically, they would accept [the borrower's information] at face value" and not ask for the documents, he says. "There's a higher level of scrutiny, and there's no longer the automatic assumption that the holder of the home-equity loan will subordinate."
Wells Fargo evaluates refinancing requests "on a case-by-case basis," says Kevin Moss, head of home-equity for the San Francisco-based lender, "and we consider a variety of factors such as credit experience, the combined loan-to-property value, and the ability to repay the outstanding loans." We want to do everything we can to try to work with our customers," he adds, "and keep their business while following responsible lending practices."
Homeowners with home-equity loans or lines of credit may be able to refinance more easily by simply paying off their loans. With home values falling in his market, Steve Walsh, a mortgage broker in Scottsdale, Ariz., says he's encouraging some borrowers who haven't tapped their credit lines or owe only a small amount to close down those lines, even if they have to pay an early-termination fee, which can run about $300.
28 February 2008
Don't Blunder Into The Home Market
Forbes.com - Commentary
By Robert Jenson, February 26, 2008
Buying and selling real estate in today's tumultuous, highly demanding marketplace is not for the faint of heart. While tricks of the trade abound to give buyers and sellers a leg up on the competition, there are a number of basic pitfalls that buyers and sellers should avoid, lest they commence their real estate venture on shaky ground.
First and foremost, whether you are buying or selling, do your homework before hiring a real estate agent, as not all are created equal. Interview at least three real estate professionals and come prepared with questions. How are their track records? How do they market listings? What services do they provide as a buyer's agent that their competitors don't? Due diligence is key to finding a representative prepared to work not just hard but smart on your behalf, and who will be available to answer your questions along the way.
For sellers it's also wise to have listing paperwork and disclosures completed at least one week before your house officially goes on the market. This way your agent can have photos complete, fliers ready and Internet ads up and running on the first day your listing hits the market. Also be sure to get a copy of your home's Multiple Listing Service listing from your agent so you can avoid a costly error. It's entirely possible a bedroom was missed or something was overlooked. Work as a team to make sure your home's listing is accurate--and the description enticing.
Those whose homes have languished on the market for longer than anticipated should start thinking outside the box and contemplate making a reverse offer.
Consider the buyer who has been back for a second or third look but hasn't pulled the trigger. Make an offer. Yes, you, the seller, should put something in writing and submit it to the buyer's agent. This will create an opportunity for the agent to sit down with the buyer and potentially help close the deal.
House still for sale four weeks later? It's time to take a hard look at the price. Your greatest number of showings will happen within the first three to four weeks of a listing hitting the market. This is because there is already a pool of qualified buyers waiting for new homes to come on the market that might match their criteria. So, if you've had no bites by week four, it's time to increase your exposure by making a price adjustment. Repeat this process again every four weeks or sooner, depending on how urgent or motivated your situation is.
For buyers, if you intend to secure a mortgage loan, you'll want to get pre-qualified, which determines how much you can afford. This will allow you to move swiftly when you find the right home, especially when there are other interested buyers. It also indicates to the seller that you are serious and can afford to buy the property. If you plan to pay for the transaction in cash, you'll then need to provide advance proof of available funds.
Buyers should spend the time shopping for the most favorable rates and terms. A difference of even half a percentage point can mean a considerable savings over the life of a loan. For example, the difference in the monthly payment on a $100,000 mortgage at 8% vs. 7.5% is about $35 per month. Over 30 years, that's $12,600.
Once the finances are in order, there are many other things to consider when buying a home, including its resale potential. For example, in neighborhoods with attached three-car garages, a two-car or detached garage may adversely affect the home-sale and future value. Floor plans, the number of bedrooms,
location and proximity to noisy streets are other factors that can prove problematic for a future sale.
The bottom line? Take a macro approach to evaluating homes before signing the dotted line.
By Robert Jenson, February 26, 2008
Buying and selling real estate in today's tumultuous, highly demanding marketplace is not for the faint of heart. While tricks of the trade abound to give buyers and sellers a leg up on the competition, there are a number of basic pitfalls that buyers and sellers should avoid, lest they commence their real estate venture on shaky ground.
First and foremost, whether you are buying or selling, do your homework before hiring a real estate agent, as not all are created equal. Interview at least three real estate professionals and come prepared with questions. How are their track records? How do they market listings? What services do they provide as a buyer's agent that their competitors don't? Due diligence is key to finding a representative prepared to work not just hard but smart on your behalf, and who will be available to answer your questions along the way.
For sellers it's also wise to have listing paperwork and disclosures completed at least one week before your house officially goes on the market. This way your agent can have photos complete, fliers ready and Internet ads up and running on the first day your listing hits the market. Also be sure to get a copy of your home's Multiple Listing Service listing from your agent so you can avoid a costly error. It's entirely possible a bedroom was missed or something was overlooked. Work as a team to make sure your home's listing is accurate--and the description enticing.
Those whose homes have languished on the market for longer than anticipated should start thinking outside the box and contemplate making a reverse offer.
Consider the buyer who has been back for a second or third look but hasn't pulled the trigger. Make an offer. Yes, you, the seller, should put something in writing and submit it to the buyer's agent. This will create an opportunity for the agent to sit down with the buyer and potentially help close the deal.
House still for sale four weeks later? It's time to take a hard look at the price. Your greatest number of showings will happen within the first three to four weeks of a listing hitting the market. This is because there is already a pool of qualified buyers waiting for new homes to come on the market that might match their criteria. So, if you've had no bites by week four, it's time to increase your exposure by making a price adjustment. Repeat this process again every four weeks or sooner, depending on how urgent or motivated your situation is.
For buyers, if you intend to secure a mortgage loan, you'll want to get pre-qualified, which determines how much you can afford. This will allow you to move swiftly when you find the right home, especially when there are other interested buyers. It also indicates to the seller that you are serious and can afford to buy the property. If you plan to pay for the transaction in cash, you'll then need to provide advance proof of available funds.
Buyers should spend the time shopping for the most favorable rates and terms. A difference of even half a percentage point can mean a considerable savings over the life of a loan. For example, the difference in the monthly payment on a $100,000 mortgage at 8% vs. 7.5% is about $35 per month. Over 30 years, that's $12,600.
Once the finances are in order, there are many other things to consider when buying a home, including its resale potential. For example, in neighborhoods with attached three-car garages, a two-car or detached garage may adversely affect the home-sale and future value. Floor plans, the number of bedrooms,
location and proximity to noisy streets are other factors that can prove problematic for a future sale.
The bottom line? Take a macro approach to evaluating homes before signing the dotted line.
Starting the Clock Again - Rule Change Reduces Waiting Period Before Relisting
Washington Post, February 23, 2008
By Mara Lee
When home shoppers see that a house has been on the market for months, they will probably conclude that it's priced too high -- and that there could be room to negotiate a lower offer.
Last week, Metropolitan Regional Information Systems, the Washington area's multiple-listing service, made it easier to hide that information.
The service is the database that real estate agents use to list and find homes for sale, and the information in it is the basis of many Web sites that allow home buyers to shop for themselves.
The change allows sellers to withdraw their property from the market for 90 days, then place it back on the market as a new listing. Previously, a seller had to wait 180 days to do that. As a new listing, it gets more attention from buyers, MRIS says. But others say the change favors sellers at the expense of buyers, who may not know to ask about an earlier failed attempt to sell the house.
The change was made because agents considered the previous six-month resting period too long. Those who favor the new rule say market conditions are changing more rapidly, so 90 days is enough to count as a new market cycle. "The home deserves another look in less than 180 days," said Mary Jo Powell, a spokeswoman for MRIS. The new rule "helps it pop up in the search without changing the facts at all."
Stephen Israel, president of Buyer's Edge, a Bethesda agency that represents only buyers, is indignant about the change.
"If it's been on for three months, that's a very different animal than a property that's been on the market for one day," he said. "It promotes the opportunity for there to be misinformation."
Many Web sites that buyers use to shop do not list how long the property has been on the market, although some, such as Long & Foster's, mark new listings.
But agents have access to the password-protected MRIS, which includes days-on-the-market information, as well as the history of price drops by the seller. The previous attempt to sell the house will still be in the records, but not on the current fact sheet. "Agents know to always look at the property history,"
Powell said. "So you can't deceive because that's always there."
Kim Bradley, owner of Marquee Properties in Haymarket, works as an appraiser and a real estate agent. She said she has mixed feelings about the change. From an agent's perspective, she said, "I prefer to see what's going on."
She said that with a little more effort, she will still be able to tell clients all the information they need to make an informed bid.
But the way it will change the appraisal side of her business underlines what potentially is the bigger impact -- blunting the bad news of declining prices and sales by presenting a lender with a rosier picture of a neighborhood because houses could show as being sold after fewer days on the market.
That's because an appraiser's report shows a year's worth of all comparable sales, or "comps," and three years of history for the property where a sale is progressing.
"As an appraiser, I like it," Bradley said of the change. She said she has seen 10 sales fall through in the past six months because lenders would not offer loans at the terms the buyers needed when they saw the patterns of slow sales and dropping prices.
"So many lenders are requiring [reporting of] days on market. When they see 233 days, they kind of freak out," she said.
If the lenders don't see those long times before a sale, they won't call her for clarification about those properties, which she said is "more work on our part."
"It's a game we play with underwriters, too," she said. "We all have to do our jobs and make things go through."
Ilissa Flamm, an agent with W.C. & A.N. Miller Realtors in Bethesda, supports the change. She said the MRIS argument that 90 days is a full market cycle makes sense because most buyers have found the house they want in that time.
She initially agreed with Bradley's position on leaving out information about previous attempts to sell when listing comparable sales. She said fresher sales statistics are a more accurate reflection of the market than those nine months ago, although she added: "I hate that the word 'game' was used."
But when pressed, she said the lender has the right to decide whether it needs to know a year's history for comps to decide if a neighborhood's prices are declining. That evaluation, she said, has an impact on how large a down payment would be needed to make it less likely that a buyer could owe more on the house than it is worth two years down the road.
"The lender having an interest in this property, the buyer having an interest in this property: Everyone wants [the selling history] accurately reflected," she said.
Nonetheless, she backed the rule change, which was supported by a majority of the 4,169 agents who responded to an MRIS survey.
"I don't think this change would be made if they thought games would be played," Flamm said.
Debra Leafty, owner of Leafty Appraisals in Gaithersburg, said the change makes hiring a buyer's agent more important; the agent can find the full history of listings.
Because the history is not erased, Leafty said, she doesn't think the new rule will change bidding patterns much. "People are going to still look that up and see you're desperate," she said.
And she wonders how many people will take their houses off the market anyway. "If it's vacant, you really can't afford to take it off for three months. You're still making payments."
By Mara Lee
When home shoppers see that a house has been on the market for months, they will probably conclude that it's priced too high -- and that there could be room to negotiate a lower offer.
Last week, Metropolitan Regional Information Systems, the Washington area's multiple-listing service, made it easier to hide that information.
The service is the database that real estate agents use to list and find homes for sale, and the information in it is the basis of many Web sites that allow home buyers to shop for themselves.
The change allows sellers to withdraw their property from the market for 90 days, then place it back on the market as a new listing. Previously, a seller had to wait 180 days to do that. As a new listing, it gets more attention from buyers, MRIS says. But others say the change favors sellers at the expense of buyers, who may not know to ask about an earlier failed attempt to sell the house.
The change was made because agents considered the previous six-month resting period too long. Those who favor the new rule say market conditions are changing more rapidly, so 90 days is enough to count as a new market cycle. "The home deserves another look in less than 180 days," said Mary Jo Powell, a spokeswoman for MRIS. The new rule "helps it pop up in the search without changing the facts at all."
Stephen Israel, president of Buyer's Edge, a Bethesda agency that represents only buyers, is indignant about the change.
"If it's been on for three months, that's a very different animal than a property that's been on the market for one day," he said. "It promotes the opportunity for there to be misinformation."
Many Web sites that buyers use to shop do not list how long the property has been on the market, although some, such as Long & Foster's, mark new listings.
But agents have access to the password-protected MRIS, which includes days-on-the-market information, as well as the history of price drops by the seller. The previous attempt to sell the house will still be in the records, but not on the current fact sheet. "Agents know to always look at the property history,"
Powell said. "So you can't deceive because that's always there."
Kim Bradley, owner of Marquee Properties in Haymarket, works as an appraiser and a real estate agent. She said she has mixed feelings about the change. From an agent's perspective, she said, "I prefer to see what's going on."
She said that with a little more effort, she will still be able to tell clients all the information they need to make an informed bid.
But the way it will change the appraisal side of her business underlines what potentially is the bigger impact -- blunting the bad news of declining prices and sales by presenting a lender with a rosier picture of a neighborhood because houses could show as being sold after fewer days on the market.
That's because an appraiser's report shows a year's worth of all comparable sales, or "comps," and three years of history for the property where a sale is progressing.
"As an appraiser, I like it," Bradley said of the change. She said she has seen 10 sales fall through in the past six months because lenders would not offer loans at the terms the buyers needed when they saw the patterns of slow sales and dropping prices.
"So many lenders are requiring [reporting of] days on market. When they see 233 days, they kind of freak out," she said.
If the lenders don't see those long times before a sale, they won't call her for clarification about those properties, which she said is "more work on our part."
"It's a game we play with underwriters, too," she said. "We all have to do our jobs and make things go through."
Ilissa Flamm, an agent with W.C. & A.N. Miller Realtors in Bethesda, supports the change. She said the MRIS argument that 90 days is a full market cycle makes sense because most buyers have found the house they want in that time.
She initially agreed with Bradley's position on leaving out information about previous attempts to sell when listing comparable sales. She said fresher sales statistics are a more accurate reflection of the market than those nine months ago, although she added: "I hate that the word 'game' was used."
But when pressed, she said the lender has the right to decide whether it needs to know a year's history for comps to decide if a neighborhood's prices are declining. That evaluation, she said, has an impact on how large a down payment would be needed to make it less likely that a buyer could owe more on the house than it is worth two years down the road.
"The lender having an interest in this property, the buyer having an interest in this property: Everyone wants [the selling history] accurately reflected," she said.
Nonetheless, she backed the rule change, which was supported by a majority of the 4,169 agents who responded to an MRIS survey.
"I don't think this change would be made if they thought games would be played," Flamm said.
Debra Leafty, owner of Leafty Appraisals in Gaithersburg, said the change makes hiring a buyer's agent more important; the agent can find the full history of listings.
Because the history is not erased, Leafty said, she doesn't think the new rule will change bidding patterns much. "People are going to still look that up and see you're desperate," she said.
And she wonders how many people will take their houses off the market anyway. "If it's vacant, you really can't afford to take it off for three months. You're still making payments."
With 2007 Dispensed with, VA Realtors Look Forward
Arlington Sun Gazette, February 17, 2008
By SCOTT McCAFFREY
Home sales statewide in 2007 were down 11.8 percent from a year before, with average sales prices down slightly, but the statewide market is likely to fare better in the coming year than the nation as a whole.
That last bit of analysis is from Lisa Fowler, director of the Office of Housing Policy Research of the George Mason University School of Public Policy, who analyzed the current state of Virginia's housing market on behalf of the Virginia Association of Realtors.
“Overall, Virginia faces stronger market fundamentals than many other states, with a relatively strong economy and a housing market with a relatively small share of investors,” Fowler said in the analysis.
She anticipates increases in the demand for housing in the parts of the Old Dominion that have strong job growth and low unemployment rates, areas that include Northern Virginia and most of the commonwealth's other metropolitan areas.
“In some desirable neighborhoods - that is, places close to jobs, amenities and transportation routes - the recovery is already happening,” Fowler says. Looking ahead gives the state's Realtor community the chance to put an ugly 2007 into the rear-view mirror.
Homes sales statewide totaled 95,413, down 11.8 percent from the 108,196 sales recorded in 2006. And, in general, sales in the second half of the year showed more dramatic drops than those in the first half.
(The year-end sales figures for 2006 and 2007 do not include figures from Charlottesville, whose Realtor association does not report them to the Virginia
Association of Realtors.)
In all, 21 of 22 geographic areas across the commonwealth reported fewer sales in 2007 than 2006, with the Southwest Virginia area showing a 1.4-percent increase. Nineteen regions reported double-digit declines from a year before, including seven areas with declines of more than 20 percent.
In December, sales across the commonwealth totaled 6,006, down 25.6 percent from the 8,077 sales recorded a year before (not including Charlottesville sales).
Homes sales across the local region all were in negative territory:
* Sales across the inner suburbs of Arlington, Alexandria and Fairfax County declined 29.9 percent in December, to 1,199.
* Sales in Loudoun County declined 30.5 percent, to 328.
* Sales in Prince William County declined 28.4 percent, to 273.
Statewide, the average sales price of $276,847 in December was up 0.7 percent from a year before. The average sales price in the inner suburbs of Northern Virginia in December rose 1.4 percent, to $536,710, while prices in the outer suburbs declined.
Statewide, it took an average of 138 days for a home that sold in November to go from listing to ratified contract. That compares to the long-term, historic average of 90 days.
Locally, the average number of days on the market was 103 in the inner suburbs, 104 in Loudoun and 143 in Prince William. For the full year, average sales prices in 2007 were down 3.1 percent, compared to a 30-year average annual increase of 6.4 percent. The year-long average number of days on the market was 88 days.
Fowler says the housing market is “inextricably linked” to the health of the economy, but, over the past decade, that linkage has been skewed:
* During the boom market of 2000-06, home prices and sales increased at a level much higher than would be expected, given fundamental laws of supply and demand.
* Over the past year, the reverse occurred: housing activity was below what would be expected in areas that continued to have strong economic health.
“In order for the housing market to return to a more normal state, there will be periods of slower-than-average growth to follow five years of rapid growth,”
Fowler said. “We are currently in that period of slower growth.”
By SCOTT McCAFFREY
Home sales statewide in 2007 were down 11.8 percent from a year before, with average sales prices down slightly, but the statewide market is likely to fare better in the coming year than the nation as a whole.
That last bit of analysis is from Lisa Fowler, director of the Office of Housing Policy Research of the George Mason University School of Public Policy, who analyzed the current state of Virginia's housing market on behalf of the Virginia Association of Realtors.
“Overall, Virginia faces stronger market fundamentals than many other states, with a relatively strong economy and a housing market with a relatively small share of investors,” Fowler said in the analysis.
She anticipates increases in the demand for housing in the parts of the Old Dominion that have strong job growth and low unemployment rates, areas that include Northern Virginia and most of the commonwealth's other metropolitan areas.
“In some desirable neighborhoods - that is, places close to jobs, amenities and transportation routes - the recovery is already happening,” Fowler says. Looking ahead gives the state's Realtor community the chance to put an ugly 2007 into the rear-view mirror.
Homes sales statewide totaled 95,413, down 11.8 percent from the 108,196 sales recorded in 2006. And, in general, sales in the second half of the year showed more dramatic drops than those in the first half.
(The year-end sales figures for 2006 and 2007 do not include figures from Charlottesville, whose Realtor association does not report them to the Virginia
Association of Realtors.)
In all, 21 of 22 geographic areas across the commonwealth reported fewer sales in 2007 than 2006, with the Southwest Virginia area showing a 1.4-percent increase. Nineteen regions reported double-digit declines from a year before, including seven areas with declines of more than 20 percent.
In December, sales across the commonwealth totaled 6,006, down 25.6 percent from the 8,077 sales recorded a year before (not including Charlottesville sales).
Homes sales across the local region all were in negative territory:
* Sales across the inner suburbs of Arlington, Alexandria and Fairfax County declined 29.9 percent in December, to 1,199.
* Sales in Loudoun County declined 30.5 percent, to 328.
* Sales in Prince William County declined 28.4 percent, to 273.
Statewide, the average sales price of $276,847 in December was up 0.7 percent from a year before. The average sales price in the inner suburbs of Northern Virginia in December rose 1.4 percent, to $536,710, while prices in the outer suburbs declined.
Statewide, it took an average of 138 days for a home that sold in November to go from listing to ratified contract. That compares to the long-term, historic average of 90 days.
Locally, the average number of days on the market was 103 in the inner suburbs, 104 in Loudoun and 143 in Prince William. For the full year, average sales prices in 2007 were down 3.1 percent, compared to a 30-year average annual increase of 6.4 percent. The year-long average number of days on the market was 88 days.
Fowler says the housing market is “inextricably linked” to the health of the economy, but, over the past decade, that linkage has been skewed:
* During the boom market of 2000-06, home prices and sales increased at a level much higher than would be expected, given fundamental laws of supply and demand.
* Over the past year, the reverse occurred: housing activity was below what would be expected in areas that continued to have strong economic health.
“In order for the housing market to return to a more normal state, there will be periods of slower-than-average growth to follow five years of rapid growth,”
Fowler said. “We are currently in that period of slower growth.”
Assessment Shock: Know Your Rights
Washington Post, January 6, 2008
By Elizabeth Razzi
Homeowners are about to get black-and-white documentation of the latest changes in their property values. Because of the varying ways local governments go about valuation, don't be surprised if your home is still assigned a high value despite the sluggish housing market.
From now through mid-March, local governments are mailing property tax assessment notices. Be on the lookout for this important piece of mail. It's the foundation for the tax bill you will have to pay later. And its arrival starts the clock on a strictly limited appeals period.
Depending on where you live, you could have less than a month after the notice arrives to review the details and put together an appeal. An appeal would be in order if there are inaccuracies or if you can document that your home has been overvalued compared with similar properties.
Maryland residents were the first to receive their notices. The state assesses a property's value every three years. Notices mailed at end of December reflect a statewide average increase of 33 percent since those properties were last assessed, in 2004. That breaks down to an average annual increase of 11 percent to be phased in over the next three years.
For a Marylander's primary residence, those annual increases will be capped at rates that vary by county. In the Washington area, the caps range from 2 percent in Anne Arundel County to 10 percent in Montgomery and Calvert counties. Bottom line: Your assessment is going up, thanks in part to price increases during the peak of the real estate market.
For the first time, Maryland residents have to take action to ensure that they get the benefit of those annual caps. You must file a homestead-tax-credit application to document that the home is your principal residence and not a vacation or rental property, which wouldn't qualify for the cap. Applications can be filed at http://www.dat.state.md.us.
The District and most Virginia counties and cities assess properties annually. In Virginia, procedures vary significantly among jurisdictions. Appeals windows range from less than 30 days in Falls Church to more than four months in Prince William County.
In Prince William, one of the areas hit hardest by foreclosures and stagnant sales, assessments for existing homes will decline by 14 to 16 percent this year, depending on the type of property, according to Allison Lindner, the county's real estate assessment chief. The reduced number of sales in 2007 has made this year's assessments a challenge, she said.
Although nearby foreclosures make it harder to sell your home at a reasonable price, they may not pull down your property assessment. Lindner said foreclosure prices don't reflect market value because they are not normal, arm's-length transactions.
"We don't put a lot of emphasis on foreclosure sales, and hopefully we will have enough non-foreclosure sales so that it's not an issue," Lindner said. "We are going to have neighborhoods where all we have are foreclosures or no sales at all. In that case, we will try to go to a similar neighborhood and establish market value."
And what if a home identical to yours sells for a bargain price in the next few weeks? Surely, you might think, that would be a strong argument for lowering
your assessment. Alas, it won't. Sales after Jan. 1 will not count for appeals of this year's assessments. "We tell them we will use that sale for next year's assessment," Lindner said.
Valuing real estate is an imprecise art, so there could be reason to contest the government's estimate of your home's value. At a minimum, you need to ensure that the government has its facts straight.
* Be aware of when your assessment notice should arrive. If it's lost or delivered to the wrong address, you could run out of time for an appeal.
* Review the notice for factual errors. Is the lot number correct? (You can find that on the land survey tucked away with your home-purchase records.) Is the square footage correct? Are the numbers of bedrooms, bathrooms and fireplaces correct?
* Verify that your assessed value is in line with the values being assigned to nearby, comparable homes. Most jurisdictions have online databases of local tax records. They often update these records just before mailing assessment notices. An assessment higher than those for homes that are comparable to yours could be a compelling argument for an appeal.
Your first round of appeal should be to contact the assessor's office by the deadline listed on the notice. Local rules vary, with some requiring this first-round appeal to the assessor's office. If you are unsatisfied with the assessor's decision, you can present a more formal appeal to a review panel.
Prince William County is among the jurisdictions that allows a homeowner to skip the administrative appeal with the assessor's office and instead plead a case directly before the county's Board of Equalization by Aug. 1.
"Residents are not required to file an administrative appeal, but we prefer that they do," Lindner said. "If there is an error, or even if it is just too high, our preference is that they come to us first so we can fix it if there is an issue."
Details about your jurisdiction's appeals process will be printed with your assessment notice and can be found on your local government's Web site.
Even with a first-round appeal, you will need facts to back up your case. Assessors may decide to remeasure your home or confirm your claim that it has fewer bedrooms than stated in their records. You will need printouts from their property tax database demonstrating that similar homes are assessed at a lower value. Photos of comparable homes wouldn't hurt. If you need to research sales prices for similar homes, a real estate agent active in your neighborhood may be willing to help. You may also find that information in the county or city's online records.
"What we don't want to hear is people who come in and just say, 'It's too high,' " Lindner said. The appeal isn't the time to rant about local government spending, either. Tax rates and government budgets are beyond the assessor's domain. All the assessor is supposed to do is come up with a value for your home, so keep your arguments focused.
Finally, brace yourself for the idea that even a lower assessed value won't guarantee a lower property tax bill. A number of local governments are still considering increasing the tax rate to compensate for the revenue they stand to lose from lower assessed values.
By Elizabeth Razzi
Homeowners are about to get black-and-white documentation of the latest changes in their property values. Because of the varying ways local governments go about valuation, don't be surprised if your home is still assigned a high value despite the sluggish housing market.
From now through mid-March, local governments are mailing property tax assessment notices. Be on the lookout for this important piece of mail. It's the foundation for the tax bill you will have to pay later. And its arrival starts the clock on a strictly limited appeals period.
Depending on where you live, you could have less than a month after the notice arrives to review the details and put together an appeal. An appeal would be in order if there are inaccuracies or if you can document that your home has been overvalued compared with similar properties.
Maryland residents were the first to receive their notices. The state assesses a property's value every three years. Notices mailed at end of December reflect a statewide average increase of 33 percent since those properties were last assessed, in 2004. That breaks down to an average annual increase of 11 percent to be phased in over the next three years.
For a Marylander's primary residence, those annual increases will be capped at rates that vary by county. In the Washington area, the caps range from 2 percent in Anne Arundel County to 10 percent in Montgomery and Calvert counties. Bottom line: Your assessment is going up, thanks in part to price increases during the peak of the real estate market.
For the first time, Maryland residents have to take action to ensure that they get the benefit of those annual caps. You must file a homestead-tax-credit application to document that the home is your principal residence and not a vacation or rental property, which wouldn't qualify for the cap. Applications can be filed at http://www.dat.state.md.us.
The District and most Virginia counties and cities assess properties annually. In Virginia, procedures vary significantly among jurisdictions. Appeals windows range from less than 30 days in Falls Church to more than four months in Prince William County.
In Prince William, one of the areas hit hardest by foreclosures and stagnant sales, assessments for existing homes will decline by 14 to 16 percent this year, depending on the type of property, according to Allison Lindner, the county's real estate assessment chief. The reduced number of sales in 2007 has made this year's assessments a challenge, she said.
Although nearby foreclosures make it harder to sell your home at a reasonable price, they may not pull down your property assessment. Lindner said foreclosure prices don't reflect market value because they are not normal, arm's-length transactions.
"We don't put a lot of emphasis on foreclosure sales, and hopefully we will have enough non-foreclosure sales so that it's not an issue," Lindner said. "We are going to have neighborhoods where all we have are foreclosures or no sales at all. In that case, we will try to go to a similar neighborhood and establish market value."
And what if a home identical to yours sells for a bargain price in the next few weeks? Surely, you might think, that would be a strong argument for lowering
your assessment. Alas, it won't. Sales after Jan. 1 will not count for appeals of this year's assessments. "We tell them we will use that sale for next year's assessment," Lindner said.
Valuing real estate is an imprecise art, so there could be reason to contest the government's estimate of your home's value. At a minimum, you need to ensure that the government has its facts straight.
* Be aware of when your assessment notice should arrive. If it's lost or delivered to the wrong address, you could run out of time for an appeal.
* Review the notice for factual errors. Is the lot number correct? (You can find that on the land survey tucked away with your home-purchase records.) Is the square footage correct? Are the numbers of bedrooms, bathrooms and fireplaces correct?
* Verify that your assessed value is in line with the values being assigned to nearby, comparable homes. Most jurisdictions have online databases of local tax records. They often update these records just before mailing assessment notices. An assessment higher than those for homes that are comparable to yours could be a compelling argument for an appeal.
Your first round of appeal should be to contact the assessor's office by the deadline listed on the notice. Local rules vary, with some requiring this first-round appeal to the assessor's office. If you are unsatisfied with the assessor's decision, you can present a more formal appeal to a review panel.
Prince William County is among the jurisdictions that allows a homeowner to skip the administrative appeal with the assessor's office and instead plead a case directly before the county's Board of Equalization by Aug. 1.
"Residents are not required to file an administrative appeal, but we prefer that they do," Lindner said. "If there is an error, or even if it is just too high, our preference is that they come to us first so we can fix it if there is an issue."
Details about your jurisdiction's appeals process will be printed with your assessment notice and can be found on your local government's Web site.
Even with a first-round appeal, you will need facts to back up your case. Assessors may decide to remeasure your home or confirm your claim that it has fewer bedrooms than stated in their records. You will need printouts from their property tax database demonstrating that similar homes are assessed at a lower value. Photos of comparable homes wouldn't hurt. If you need to research sales prices for similar homes, a real estate agent active in your neighborhood may be willing to help. You may also find that information in the county or city's online records.
"What we don't want to hear is people who come in and just say, 'It's too high,' " Lindner said. The appeal isn't the time to rant about local government spending, either. Tax rates and government budgets are beyond the assessor's domain. All the assessor is supposed to do is come up with a value for your home, so keep your arguments focused.
Finally, brace yourself for the idea that even a lower assessed value won't guarantee a lower property tax bill. A number of local governments are still considering increasing the tax rate to compensate for the revenue they stand to lose from lower assessed values.
26 December 2007
Bush Plan Leaves Out Borrowers With Option Arms
Wall Street Journal Online, December 25, 2007
By Ruth Simon
• The Issue: The Bush administration's program to help homeowners with subprime adjustable-rate mortgages doesn't include borrowers with good credit who took out an unusually complex type of loan known as an option adjustable-rate mortgage.
• What's at Stake: Loan balances on many option ARMs are rising, even as home values are falling, a scenario that economists say is likely to lead to another spike in foreclosures. Because option ARMs are so complicated, the attorneys general of several states are starting to focus on option ARMs, which they believe were an inappropriate mortgage product for many borrowers.
• What's Next: Some economists call option ARMs "ticking time bombs" that could result in losses of $100 billion, on top of an estimated $400 billion in expected losses on subprime and other mortgages
The Bush administration is pushing its plan to help subprime borrowers whose loans are due to reset to higher interest rates next year. But left out of the mix are hundreds of thousands of borrowers with good credit who could face sharp increases in their payments.
These homeowners could be the next wave of trouble for the mortgage industry. They took out what are known as option adjustable-rate mortgages, or option ARMs, which give borrowers a choice about how much to pay back each month. If they choose to make only the minimum payment on a regular basis, their loan balance can actually rise.
That is particularly a problem when home prices are falling. Borrowers who get in too far over their heads may not be able to refinance their loans or sell their houses for enough money to pay the loans back. The result, some economists say, may be another spike in foreclosures.
In a report issued last week, Merrill Lynch economists called option ARMs "ticking time bombs" that will start "ticking louder next year." Merrill estimates that losses on option ARMs could total $100 billion, on top of an estimated $400 billion in losses on subprime and other mortgages.
Option ARMs generally carry a low introductory rate -- in some cases as low as 1% -- and often have high prepayment penalties that make it expensive to refinance. With lending standards getting tighter, refinancing may be impossible in any case.
Sheila Bair, the chairman of the Federal Deposit Insurance Corp. who has been outspoken about the need for banks to modify large numbers of loans, says option ARMs don't lend themselves to the kind of streamlined modification program recently announced for subprime loans -- yet many of these borrowers also are in financial distress. "We're seeing problems now, and there are going to be more problems," Ms. Bair says.
The attorneys general of several states are also starting to focus on option ARMs. "It is a fundamentally unfair product for most borrowers," says Iowa Attorney General Tom Miller.
Option ARMs exploded in popularity during the housing boom as borrowers were attracted to the flexible terms and low teaser rates. Some $255 billion of option ARMs were originated in 2006, according to Inside Mortgage Finance, up from $145 billion two years earlier.
A small number of borrowers with option ARMs are already facing resets that require them to make payments covering interest as well as some principal. The numbers are set to rise sharply: Nearly $156 billion in option ARMs will face payment resets between 2008 and the second quarter of 2012, according to Lehman Brothers estimates, with resets peaking in 2010 and 2011. For more than $90 billion of those loans, borrowers would owe as much as their home is worth or more, according to Lehman, which assumed that home prices will fall 6% both in 2008 and 2009.
Of course, pressure on borrowers could decrease if the housing market rebounds. The Lehman analysis looked at loans packaged into securities and held in bank portfolios.
At Consumer Credit Counseling Service of San Francisco, about 25% of calls involving adjustable-rate mortgages are from borrowers with option ARMs. About half of the callers, says Erica Sandberg, a spokeswoman for the group, "went into this situation with their eyes wide open," but thought they would be able to refinance before their monthly payments became unaffordable. "The other half are claiming that they did not understand at all what they were getting into," she says.
Jirina Koy, a data operator, and her husband, Savane, who is disabled, took out an option ARM in 2005 when they refinanced the mortgage on their 1,200-square-foot home in Stockton, Calif., pulling out about $60,000 in cash. Ms. Koy says she didn't understand the terms of the loan, which carried a prepayment penalty of more than $12,000.
Refinancing is no longer an option. The balance on the Koys' loan has climbed to $357,000 from $336,000, while the value of their home has dropped to $250,000 or less. The minimum payment on the loan has also climbed, to $1,690 from $1,460.
Countrywide Financial Corp., Ms. Koy's lender, has offered to freeze the interest rate on her loan at 5.25%, down from its current 8.5%, while requiring her to make payments of principal and interest. That would boost the Koys' monthly payment by about $375. Acorn Housing Inc., a nonprofit housing counselor working with Ms. Koy, has asked Countrywide to reduce the loan balance to the original amount to make payments more manageable.
Countrywide says it won't waive the increase in the loan balance. "Based on the financial information we received from the Koys, we believe that the monthly payment would be affordable," a Countrywide spokeswoman says.
Steve Bailey, a senior managing director at Countrywide, said the lender will often modify loans or consider waiving prepayment penalties for people experiencing financial hardship, and for those who discover soon after taking out the loan that it wasn't what they expected.
Acorn Housing says it is seeing calls from borrowers with option ARMs who are from "all walks of life," says Michael Shea, the group's executive director. "What breaks our heart is to see the seniors put in these things [who are] on fixed incomes."
Clifton C. Matthews Sr., a 65-year-old semiretired architect who lives in Fort Washington, Md., was shopping in a local grocery store this year when a mortgage broker approached him about refinancing. Mr. Matthews, who says he was rushed through the closing, wound up with a $300,000 option ARM with a prepayment penalty. "I had a better loan before the refinance," Mr. Matthews says.
He says he is making his monthly payments, but those payments don't even cover the full interest owed. It's like the money "is going into a bag with a hole in it," he says. "I'm extremely nervous." He is working with the National Community Reinvestment Coalition, a nonprofit that works on fair-housing issues, to modify his loan. NCRC has asked the lender, IndyMac Bancorp Inc., to put Mr. Matthews into an interest-only loan that carries a fixed rate for the first five years.
An IndyMac spokesman says the company can't comment on individual customer situations, but adds that the company is working with Mr. Matthews. When customers call the company, "we are very willing to talk with them and work with them to come up with a satisfactory solution for all," he says.
The complaints about option ARMs have drawn the attention of government officials, who believe that borrowers may have been misled about the terms of these loans. Colorado Attorney General John Suthers this year subpoenaed 13 mortgage companies as part of an investigation of option ARM sales practices. He says he will soon sign consent decrees with a number of these firms and take civil-enforcement actions against others. "What was advertised was a lot different from the deal people actually signed up for," Mr. Suthers says.
Illinois Attorney General Lisa Madigan has subpoenaed Countrywide Financial's mortgage-lending arm as part of an investigation that started with a look into a local mortgage broker that had put many borrowers into option ARMs. Option ARMs are "a key focus" of the office's scrutiny of the mortgage industry, says Deborah Hagan, chief of the Consumer Protection Division. Countrywide says it is cooperating with the attorney general.
Taxes Are Reassessed in Housing Slump as Prices Drop
New York Times, December 23, 2007
By JENNIFER STEINHAUER
LOS ANGELES — Home owners across the nation are looking to county governments to reassess the values of their homes in the face of flattening and falling prices that have befallen scores of markets. Downward assessments, done at the request of homeowners or pre-emptively by government, appear to be most pronounced in areas where the housing market was exploding just a few years ago, or where economic conditions are poorest.
In Maricopa County, the largest in Arizona, a “large percentage” of the one million single-family home owners will see their houses reassessed at lower rates in February, said Keith Russell, the county assessor. In Phoenix, the largest city in the county, housing prices fell 8.8 percent over the last year, according to the S&P/Case-Shiller index, which monitors the residential housing market.
Among the roughly 200,000 parcels in Lucas County, Ohio, 7,083 owners requested reassessments in 2007, about 10 times the yearly average, said Anita Lopez, the assessor, who ran for office on a campaign to adjust assessments.
“Citizens know the market is slow if not declining,” Ms. Lopez said, “and they are informed and feel comfortable in challenging their county values. People here can’t sell their homes, they have less money, and they don’t understand why the government is asking for more money in a declining housing market.”
Local governments, which rely heavily on property taxes, will have to find ways to replace lost revenue or face having to cut services, lay off staff members or delay projects. The possibility of those losses has alarmed officials in areas already facing large numbers of foreclosures and slumping sales, products, in part, of the mortgage credit crisis that has rippled through the country. [Sunday Business.]
“Government has been the beneficiary of increasing home prices,” said Relmond Van Daniker, the executive director of the Association of Government Accountants. “And now they are on the other side of that, and they will have to reduce expenses.”
While every state and local government has its own methods for assessing home values for tax purposes — some do it annually, some every five years, and everything in between — many counties are hearing from residents that they would like their homes reassessed, or have taken steps to bring the taxes down of their own volition.
While in some areas, a county or city is required to make whole any loss in revenues to schools, public education is a frequent beneficiary of property tax revenues. “They are obviously concerned,” Ms. Lopez said about her county’s school systems.
No one has aggregated the total number of counties reassessing home values, and many counties take at least a year to catch up to the marketplace. In some places where reassessments are rising, the numbers have yet to approach historical heights.
For example, in 2007 roughly 1,800 homeowners asked for reassessments in Los Angeles County, far above the average of about 500, yet far below the tens of thousands of homeowners in Los Angeles who looked for tax adjustments during some years of the downturn in the 1990s. But elected officials and property tax experts said that the numbers were notable and that they expected them to grow in 2008.
In San Bernardino County near Los Angeles, tens of thousands of owners of the 860,000 homes will have their assessments lowered in the coming year, said Bill Postmus, the assessor, rivaling the numbers during the California real estate crash of the 1990s.
“You should see more of this activity,” said Chris Hoene, director of policy and research at the National League of Cities. “It is mostly in areas most likely to be seeing some decline, like Southern California, Florida, and big cities in the Midwest,” rapid growth areas that are now seeing the other side of the curve.
The United States Conference of Mayors recently released a report showing that the value of taxable residential land had declined by $2.9 billion in California from 2005 to 2008 based on current tax rates, and by hundreds of millions of dollars in other major cities. “We are hearing a lot about this housing market change and its effect on city revenues every day,” Mr. Hoene said
Cities where home values have fallen the most are the obvious first place to look for residents clamoring for reassessments, but that is not always the case. Some states, like California, Michigan and Nevada, have statutory caps in property tax increases, which mean the market value of single family homes almost always exceeds the assessed tax values, except in a major downturn.
However, even in California, if a home buyer made his purchase during a market top in the last several years, he might be in the position of qualifying for lower assessed values. For instance, in Santa Clara County, where pricey Palo Alto and San Jose are located, 17,758 properties were reassessed downward for the 2007-2008 tax period, compared with the same period from 2000 to 2001, when the number was closer to 300.
“Obviously 2001 was the dot-com boom,” said Larry Stone, the Santa Clara assessor. “And the whole assessment role in my county was carried by a very hot residential market,” which has substantially cooled.
In his area, prices, and therefore values, remain strong in high end residential areas with great schools, Mr. Stone said. The coming reassessments are driven in large part in the lower and middle markets, especially the condo market, where the greatest part of the subprime lending problems have occurred.
Indeed, areas with high levels of foreclosures, vacant housing and a reduction in prices expect to see adjustments to the property taxes continue, which is bad news for local governments.
“Rising tax values are not usually a popular thing,” Mr. Hoene said , but homeowners tend to accept it, even begrudgingly, when they know the market value of their home is on the rise. “But the minute you think that your local government assessment practices are out of whack with what is happening in the market,” he said, “you will not accept it.”
By JENNIFER STEINHAUER
LOS ANGELES — Home owners across the nation are looking to county governments to reassess the values of their homes in the face of flattening and falling prices that have befallen scores of markets. Downward assessments, done at the request of homeowners or pre-emptively by government, appear to be most pronounced in areas where the housing market was exploding just a few years ago, or where economic conditions are poorest.
In Maricopa County, the largest in Arizona, a “large percentage” of the one million single-family home owners will see their houses reassessed at lower rates in February, said Keith Russell, the county assessor. In Phoenix, the largest city in the county, housing prices fell 8.8 percent over the last year, according to the S&P/Case-Shiller index, which monitors the residential housing market.
Among the roughly 200,000 parcels in Lucas County, Ohio, 7,083 owners requested reassessments in 2007, about 10 times the yearly average, said Anita Lopez, the assessor, who ran for office on a campaign to adjust assessments.
“Citizens know the market is slow if not declining,” Ms. Lopez said, “and they are informed and feel comfortable in challenging their county values. People here can’t sell their homes, they have less money, and they don’t understand why the government is asking for more money in a declining housing market.”
Local governments, which rely heavily on property taxes, will have to find ways to replace lost revenue or face having to cut services, lay off staff members or delay projects. The possibility of those losses has alarmed officials in areas already facing large numbers of foreclosures and slumping sales, products, in part, of the mortgage credit crisis that has rippled through the country. [Sunday Business.]
“Government has been the beneficiary of increasing home prices,” said Relmond Van Daniker, the executive director of the Association of Government Accountants. “And now they are on the other side of that, and they will have to reduce expenses.”
While every state and local government has its own methods for assessing home values for tax purposes — some do it annually, some every five years, and everything in between — many counties are hearing from residents that they would like their homes reassessed, or have taken steps to bring the taxes down of their own volition.
While in some areas, a county or city is required to make whole any loss in revenues to schools, public education is a frequent beneficiary of property tax revenues. “They are obviously concerned,” Ms. Lopez said about her county’s school systems.
No one has aggregated the total number of counties reassessing home values, and many counties take at least a year to catch up to the marketplace. In some places where reassessments are rising, the numbers have yet to approach historical heights.
For example, in 2007 roughly 1,800 homeowners asked for reassessments in Los Angeles County, far above the average of about 500, yet far below the tens of thousands of homeowners in Los Angeles who looked for tax adjustments during some years of the downturn in the 1990s. But elected officials and property tax experts said that the numbers were notable and that they expected them to grow in 2008.
In San Bernardino County near Los Angeles, tens of thousands of owners of the 860,000 homes will have their assessments lowered in the coming year, said Bill Postmus, the assessor, rivaling the numbers during the California real estate crash of the 1990s.
“You should see more of this activity,” said Chris Hoene, director of policy and research at the National League of Cities. “It is mostly in areas most likely to be seeing some decline, like Southern California, Florida, and big cities in the Midwest,” rapid growth areas that are now seeing the other side of the curve.
The United States Conference of Mayors recently released a report showing that the value of taxable residential land had declined by $2.9 billion in California from 2005 to 2008 based on current tax rates, and by hundreds of millions of dollars in other major cities. “We are hearing a lot about this housing market change and its effect on city revenues every day,” Mr. Hoene said
Cities where home values have fallen the most are the obvious first place to look for residents clamoring for reassessments, but that is not always the case. Some states, like California, Michigan and Nevada, have statutory caps in property tax increases, which mean the market value of single family homes almost always exceeds the assessed tax values, except in a major downturn.
However, even in California, if a home buyer made his purchase during a market top in the last several years, he might be in the position of qualifying for lower assessed values. For instance, in Santa Clara County, where pricey Palo Alto and San Jose are located, 17,758 properties were reassessed downward for the 2007-2008 tax period, compared with the same period from 2000 to 2001, when the number was closer to 300.
“Obviously 2001 was the dot-com boom,” said Larry Stone, the Santa Clara assessor. “And the whole assessment role in my county was carried by a very hot residential market,” which has substantially cooled.
In his area, prices, and therefore values, remain strong in high end residential areas with great schools, Mr. Stone said. The coming reassessments are driven in large part in the lower and middle markets, especially the condo market, where the greatest part of the subprime lending problems have occurred.
Indeed, areas with high levels of foreclosures, vacant housing and a reduction in prices expect to see adjustments to the property taxes continue, which is bad news for local governments.
“Rising tax values are not usually a popular thing,” Mr. Hoene said , but homeowners tend to accept it, even begrudgingly, when they know the market value of their home is on the rise. “But the minute you think that your local government assessment practices are out of whack with what is happening in the market,” he said, “you will not accept it.”
Realtors Looking to Mid-2008 for Local Rebound
Arlington Sun Gazette, December 12, 2007
By BRIAN TROMPETER, Staff Writer
Despite stagnant home sales and a subprime mortgage crisis that won't go away, area real estate officials said they expect regional home sales to rebound beginning next summer.
“I remain optimistic about our region's future,” said Luis Lama, 2007 board chairman of the Northern Virginia Association of Realtors (NVAR). “It's a great time to buy, especially in Northern Virginia.”
Lama and other officials gave their views at a Dec. 11 luncheon at the National Press Club.
Northern Virginia housing sales are down 11.5 percent this year, and there is a nine-month supply of houses, Lama said.
While homes in McLean saw higher prices and fewer days on the market compared with last year, houses in Herndon had the opposite results, he said.
“Like politics, real estate is local,” said Mary Beth Coya, NVAR's vice president of public and government affairs. “Each neighborhood has its own DNA.”
The Washington area's economy, buoyed as always by spending of the federal government and its contractors, continues to outperform other regions nationwide, said John McClain, a senior fellow at George Mason University's Center for Regional Analysis.
Because Washington-area economic fundamentals are so sound, 2008 will be moderately better than this year, McClain said.
Housing sales will stay below historic, long-term levels, and inventories will remain above those averages, McClain said. Housing prices will remain flat at least through the spring, he said.
Foreclosures are up in the Washington area, but still below the national average, officials said. While foreclosures in Prince William and Loudoun counties are above the national rate of 84 per 10,000 housing units sold, rates in close-in areas such as Arlington, Fairfax and Alexandria are considerably lower.
Foreclosures in Detroit and Miami are more than three times the national average, McClain said.
McClain introduced a new statistic, the “kick-out rate,” to his presentation this year. While only 4 percent of home buyers in 2004 and 2005 left their deposits and walked away from a deal, that rate peaked at nearly 66 percent this August, he said.
President Bush's plan to freeze some adjustable-rate mortgages for five years is not a cure-all for the subprime lending crisis, but it's a step in the right direction, they said.
Real estate association leaders defended Realtors' actions during the heyday of subprime loans, saying many professionals - especially lenders are involved in real estate transactions. Buyers also must share in the blame, they said.
“Consumers knew what they were doing,” Lama said. “They're claiming ignorance at this point.”
By BRIAN TROMPETER, Staff Writer
Despite stagnant home sales and a subprime mortgage crisis that won't go away, area real estate officials said they expect regional home sales to rebound beginning next summer.
“I remain optimistic about our region's future,” said Luis Lama, 2007 board chairman of the Northern Virginia Association of Realtors (NVAR). “It's a great time to buy, especially in Northern Virginia.”
Lama and other officials gave their views at a Dec. 11 luncheon at the National Press Club.
Northern Virginia housing sales are down 11.5 percent this year, and there is a nine-month supply of houses, Lama said.
While homes in McLean saw higher prices and fewer days on the market compared with last year, houses in Herndon had the opposite results, he said.
“Like politics, real estate is local,” said Mary Beth Coya, NVAR's vice president of public and government affairs. “Each neighborhood has its own DNA.”
The Washington area's economy, buoyed as always by spending of the federal government and its contractors, continues to outperform other regions nationwide, said John McClain, a senior fellow at George Mason University's Center for Regional Analysis.
Because Washington-area economic fundamentals are so sound, 2008 will be moderately better than this year, McClain said.
Housing sales will stay below historic, long-term levels, and inventories will remain above those averages, McClain said. Housing prices will remain flat at least through the spring, he said.
Foreclosures are up in the Washington area, but still below the national average, officials said. While foreclosures in Prince William and Loudoun counties are above the national rate of 84 per 10,000 housing units sold, rates in close-in areas such as Arlington, Fairfax and Alexandria are considerably lower.
Foreclosures in Detroit and Miami are more than three times the national average, McClain said.
McClain introduced a new statistic, the “kick-out rate,” to his presentation this year. While only 4 percent of home buyers in 2004 and 2005 left their deposits and walked away from a deal, that rate peaked at nearly 66 percent this August, he said.
President Bush's plan to freeze some adjustable-rate mortgages for five years is not a cure-all for the subprime lending crisis, but it's a step in the right direction, they said.
Real estate association leaders defended Realtors' actions during the heyday of subprime loans, saying many professionals - especially lenders are involved in real estate transactions. Buyers also must share in the blame, they said.
“Consumers knew what they were doing,” Lama said. “They're claiming ignorance at this point.”
Home Prices Rise in D.C., Fall in One-Third of U.S. Cities
Bloomberg News, November 22, 2007
By Kathleen M. Howley
Home prices fell in one-third of U.S. cities last quarter as tighter lending standards caused a 14 percent decline in sales nationwide.
Prices declined in 54 of 150 areas in the third quarter, with the median sales price falling 2 percent nationwide, the National Association of Realtors said yesterday. Home sales, including single-family properties and condominiums, fell to an annualized 5.42 million units from 6.29 million units a year ago.
In the Washington area, the median price in the quarter was $438,000, up 1.3 percent from $432,200 a year earlier.
Declines in sales and prices signal that the slump that began in 2006 may extend into a third year, matching the slowdown 18 years ago that ended in the 1991 recession.
"Prices have to continue to fall to deplete a bloated inventory," said Richard Yamarone, chief economist at Argus Research in New York. "The only surprise in housing would be if we didn't see the slump extend into 2008."
Ninety-three U.S. cities had price gains, and three were unchanged from a year ago, the report said.
The U.S. median home price, which is the point at which half the homes sold for more and half for less, was $220,800, down from $225,300, the association said. In the second quarter, prices fell in 50 of 149 cities and the national median dipped 1.5 percent.
Palm Bay, Fla., had the biggest decline, falling 12.4 percent. Prices fell in Sacramento by 10.5 percent, and Sarasota, Fla., dropped 10.4 percent.
The largest price increase was in Bismarck, N.D., up 15.1 percent, followed by Salt Lake City, 14.1 percent, and Yakima, Wash., 13.6 percent.
Home sales fell in all the states covered by the report and the District. Data were not available for New Hampshire and Idaho.
Nevada led the sales drop, at 35 percent. Florida was second, at 32 percent and Arizona, 31 percent.
The U.S. residential market is faltering as rising foreclosures among subprime borrowers have pushed down prices and led to a record supply of unsold homes. Foreclosures among homeowners with subprime adjustable-rate mortgages have reached a five-year high.
By Kathleen M. Howley
Home prices fell in one-third of U.S. cities last quarter as tighter lending standards caused a 14 percent decline in sales nationwide.
Prices declined in 54 of 150 areas in the third quarter, with the median sales price falling 2 percent nationwide, the National Association of Realtors said yesterday. Home sales, including single-family properties and condominiums, fell to an annualized 5.42 million units from 6.29 million units a year ago.
In the Washington area, the median price in the quarter was $438,000, up 1.3 percent from $432,200 a year earlier.
Declines in sales and prices signal that the slump that began in 2006 may extend into a third year, matching the slowdown 18 years ago that ended in the 1991 recession.
"Prices have to continue to fall to deplete a bloated inventory," said Richard Yamarone, chief economist at Argus Research in New York. "The only surprise in housing would be if we didn't see the slump extend into 2008."
Ninety-three U.S. cities had price gains, and three were unchanged from a year ago, the report said.
The U.S. median home price, which is the point at which half the homes sold for more and half for less, was $220,800, down from $225,300, the association said. In the second quarter, prices fell in 50 of 149 cities and the national median dipped 1.5 percent.
Palm Bay, Fla., had the biggest decline, falling 12.4 percent. Prices fell in Sacramento by 10.5 percent, and Sarasota, Fla., dropped 10.4 percent.
The largest price increase was in Bismarck, N.D., up 15.1 percent, followed by Salt Lake City, 14.1 percent, and Yakima, Wash., 13.6 percent.
Home sales fell in all the states covered by the report and the District. Data were not available for New Hampshire and Idaho.
Nevada led the sales drop, at 35 percent. Florida was second, at 32 percent and Arizona, 31 percent.
The U.S. residential market is faltering as rising foreclosures among subprime borrowers have pushed down prices and led to a record supply of unsold homes. Foreclosures among homeowners with subprime adjustable-rate mortgages have reached a five-year high.
24 September 2007
What Really Happened ??
I thought this graphic from the NYT last month was spot-on in providing lucid and sober explication of the subprime mortgage market issue.
This graphical image below corresponds to the NYT article from September 23rd:
This graphical image below corresponds to the NYT article from September 23rd:
They Cried Wolf. They Were Right.
New York Times, September 23, 2007
The Nation - Week in Review
By VIKAS BAJAJ
In May of 2004, Dean Baker, an economist in Washington who had been warning about excesses in the housing market, sold his two-bedroom condo after concluding that the market had lost its moorings from reality.
In a way, he was two years too early. Had he waited until May 2006 when home prices in the Washington area peaked, his home would likely have appreciated by roughly 38 percent from its 2004 value, according to an index that tracks home prices in the metropolitan region.
The case of Mr. Baker, who now happily rents a similar condominium a few blocks away, serves as a useful illustration about the perils of calling and timing financial bubbles. It may be easy to spot an out-of-control market, as Mr. Baker and others did, but quite another to predict when one has truly gotten out of hand.
In a replay of the years before the tech-stock bubble burst in 2000, housing market skeptics have spent much of this decade being tarred as the boys who cried wolf. Their predictions were proved wrong year after year as people continued to bid up the price of condos in Miami and new houses in suburban Phoenix.
Academics and economists like Mr. Baker came across as gloomy sourpusses who did not want Americans to have fun and grow rich by flipping second homes on the New Jersey or Florida coasts.
“The naysayers simply look silly at the end of the bubble,” said Mark Zandi, chief economist for Moody’s Economy.com who was among the experts raising questions about the underpinnings of the housing boom. “They are completely discounted and discredited because they have been saying things are askew for a year or two. It’s when the naysayers’ views have been completely discarded and discredited that the bubble inflates to its apex.”
Mr. Baker said he knew he would never be able to call the top of the real estate market precisely, either as a home seller or an economist. He noted that he was also too early in calling the tech bubble in 1997. “Sure it could go somewhat higher,” he said of the real estate market. But, he added, “I felt the need to talk about it, and do anything I could to bring attention to it.”
Some in the real estate industry say the early cries of bubble should be called to account on the grounds of intellectual fairness. If the boosters have to acknowledge they were wrong when they provided justifications for prices that were, well, unjustifiable, then the doubters should also own up to the fact that they were too negative, too early.
“Even the people that were talking about booms busting, my goodness they were talking about it in 2001 and 2002,” said David Lereah, the former chief economist with the National Association of Realtors. “And they were wrong for four years and they only became right at the end of 2004.” He and his former employer had been criticized for the optimistic forecasts they made during the boom.
Economists, even the famous ones, mostly see the to and fro between the housing bulls and bears as an academic debate. Their influence over markets and the behavior of consumers, they say, was and is at best marginal.
Robert J. Shiller, the Yale economist whose book “Irrational Exuberance” became required reading for bubble watchers, has said that there is a long tradition of naysaying in the face of soaring markets to little effect.
Newspapers during the boom in the 1990s and in the early years of this decade expressed warnings about the housing market, along with more upbeat sentiments. But the critical voices often did not register above the din of the frenzied market.
“You got some of us sitting there in a distance saying that this is a bubble, we don’t know when its going to end,” said Christopher F. Thornberg, an independent economist who is based in Los Angeles. “And then you have mortgage brokers and real estate agents who are much closer to the buyer who are whispering in their ear that, well, yeah, there are some markets that are out of line but not this neighborhood.”
Almost everyone would agree that of far greater import to the timing and performance of bubbles are interest rates and the availability of credit. Both are set by the market, but regulators at the Federal Reserve exert significant influence over them. The main discussion now, with the benefit of hindsight, is whether the central bank should have taken a more muscular approach in regulating mortgage lending and raised interest rates sooner. (After the tech bubble burst, the Fed cut its benchmark rate sharply and left it at 1 percent from the summer of 2003 to the summer of 2004.)
In recent interviews, Alan Greenspan, the former Fed chairman, has argued he did not realize the extent of reckless lending practices in 2005 and 2006. He also defended the central bank’s decision to keep short-term interest rates low early in this decade to avert the risk of deflation.
Last week, the Fed cut rates sharply to ease conditions in the credit market, kindling some fears of inflation.
“We have had two bubbles in the last 10 years,” noted Allen L. Sinai, the president and chief economist at Decision Economics, a consulting firm based in New York. “The only way I would say it won’t happen — and this is arguable — is for the central bank to do something about it before it gets too far, and right now the central bank’s religion is not to interfere.”
The Nation - Week in Review
By VIKAS BAJAJ
In May of 2004, Dean Baker, an economist in Washington who had been warning about excesses in the housing market, sold his two-bedroom condo after concluding that the market had lost its moorings from reality.
In a way, he was two years too early. Had he waited until May 2006 when home prices in the Washington area peaked, his home would likely have appreciated by roughly 38 percent from its 2004 value, according to an index that tracks home prices in the metropolitan region.
The case of Mr. Baker, who now happily rents a similar condominium a few blocks away, serves as a useful illustration about the perils of calling and timing financial bubbles. It may be easy to spot an out-of-control market, as Mr. Baker and others did, but quite another to predict when one has truly gotten out of hand.
In a replay of the years before the tech-stock bubble burst in 2000, housing market skeptics have spent much of this decade being tarred as the boys who cried wolf. Their predictions were proved wrong year after year as people continued to bid up the price of condos in Miami and new houses in suburban Phoenix.
Academics and economists like Mr. Baker came across as gloomy sourpusses who did not want Americans to have fun and grow rich by flipping second homes on the New Jersey or Florida coasts.
“The naysayers simply look silly at the end of the bubble,” said Mark Zandi, chief economist for Moody’s Economy.com who was among the experts raising questions about the underpinnings of the housing boom. “They are completely discounted and discredited because they have been saying things are askew for a year or two. It’s when the naysayers’ views have been completely discarded and discredited that the bubble inflates to its apex.”
Mr. Baker said he knew he would never be able to call the top of the real estate market precisely, either as a home seller or an economist. He noted that he was also too early in calling the tech bubble in 1997. “Sure it could go somewhat higher,” he said of the real estate market. But, he added, “I felt the need to talk about it, and do anything I could to bring attention to it.”
Some in the real estate industry say the early cries of bubble should be called to account on the grounds of intellectual fairness. If the boosters have to acknowledge they were wrong when they provided justifications for prices that were, well, unjustifiable, then the doubters should also own up to the fact that they were too negative, too early.
“Even the people that were talking about booms busting, my goodness they were talking about it in 2001 and 2002,” said David Lereah, the former chief economist with the National Association of Realtors. “And they were wrong for four years and they only became right at the end of 2004.” He and his former employer had been criticized for the optimistic forecasts they made during the boom.
Economists, even the famous ones, mostly see the to and fro between the housing bulls and bears as an academic debate. Their influence over markets and the behavior of consumers, they say, was and is at best marginal.
Robert J. Shiller, the Yale economist whose book “Irrational Exuberance” became required reading for bubble watchers, has said that there is a long tradition of naysaying in the face of soaring markets to little effect.
Newspapers during the boom in the 1990s and in the early years of this decade expressed warnings about the housing market, along with more upbeat sentiments. But the critical voices often did not register above the din of the frenzied market.
“You got some of us sitting there in a distance saying that this is a bubble, we don’t know when its going to end,” said Christopher F. Thornberg, an independent economist who is based in Los Angeles. “And then you have mortgage brokers and real estate agents who are much closer to the buyer who are whispering in their ear that, well, yeah, there are some markets that are out of line but not this neighborhood.”
Almost everyone would agree that of far greater import to the timing and performance of bubbles are interest rates and the availability of credit. Both are set by the market, but regulators at the Federal Reserve exert significant influence over them. The main discussion now, with the benefit of hindsight, is whether the central bank should have taken a more muscular approach in regulating mortgage lending and raised interest rates sooner. (After the tech bubble burst, the Fed cut its benchmark rate sharply and left it at 1 percent from the summer of 2003 to the summer of 2004.)
In recent interviews, Alan Greenspan, the former Fed chairman, has argued he did not realize the extent of reckless lending practices in 2005 and 2006. He also defended the central bank’s decision to keep short-term interest rates low early in this decade to avert the risk of deflation.
Last week, the Fed cut rates sharply to ease conditions in the credit market, kindling some fears of inflation.
“We have had two bubbles in the last 10 years,” noted Allen L. Sinai, the president and chief economist at Decision Economics, a consulting firm based in New York. “The only way I would say it won’t happen — and this is arguable — is for the central bank to do something about it before it gets too far, and right now the central bank’s religion is not to interfere.”
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