Round #1 for New Regulations for ARMs for Sub-Prime Borrowers

Bank regulators from a number of federal agencies issued new regulations for banks concerning ARMs for sub-prime borrowers (Bloomberg). The new regs did not outlaw stated income and min doc loans, but it did put make it more difficult to make these types of loans.

The reason I called this Round #1 is because these regs are: 1) not strong enough so there will be another round of rule making; 2) for banks and most ARM mortgages using stated income or min doc underwriting criteria are completed by brokers, so these new rules need to float down to the state regulators; and 3) probably going to be unacceptable to consumer advocacy groups.

U.S. banking regulators told mortgage lenders to tighten standards for subprime home loans in a belated effort to end abuses that led to a surge in defaults and the highest foreclosure rate in five years.

``This guidance on adjustable-rate mortgages underscores that the Federal Reserve and other banking regulators expect lenders to make sure subprime borrowers not only can afford their monthly payments while the introductory rate is in effect, but also after the interest rate resets,''

``Stated-income and reduced-documentation loans should be accepted only if there are mitigating factors that clearly minimize the need for direct verification'' of the borrower's ability to repay, the regulators said.

The banking regulators' guidelines may have a limited effect, because about 70 percent of loans are issued by mortgage brokers, who are regulated by the states, said John Taylor, president of the Washington-based National Community Reinvestment Coalition.

``Good intentions, guidance and best practices are all nice things,'' Taylor said. ``The problem is that brokers are going to do what gives them the highest fee and doesn't break the law.'' (my emphasis).

Borrowers should be able to refinance subprime loans at least 60 days before the interest rate changes without facing penalties, according to the guidelines.

Mortgage Bankers Association Chairman John Robbins said the new standards will ``constrain consumer credit choices.'' The Washington-based group, which represents the mortgage industry, also discouraged Congress from passing legislation that would subject lenders to ``rigid underwriting standards and litigation risk,'' according to Robbins's statement.

My response to the MBA is - borrowing is not a right, it is a privilege. Cramming the unaware into a home with a mortgage they cannot afford is also not a right of the mortgage lending industry.

CFOs Continue to be Pessimistic about the Economy

According to a recently completed survey of CFOs, they continue to be pessimistic about the economy (CNNMoney.com). Limited ability to increase prices, limited capital spending, declining hiring expectations and a declining inventory growth all added up to continued pessimism about the economy. Similar results were found in a different survey published by CNNMoney.com earlier this month.

Once again as with other news reported this week, I am having a hard time finding the silver lining in all these reports.

The optimism of U.S. corporate chief financial officers dimmed a bit in the second quarter, and they cut predictions for growth in business spending and selling prices, a survey released Wednesday found.

An electronic survey of 157 corporate CFOs by Financial Executives International and Baruch College's Zicklin School of Business found they expect prices for their products to rise just 1.9 percent during the next year, down from the 2.1 percent gain they had expected in the first quarter.

"The CFOs forecast of price increases of less than 2 percent during the coming 12 months represents a relatively benign inflation environment," John Elliott, dean of the Zicklin School, said in a statement.

The survey, conducted the week of June 11, also found that the CFOs expect capital spending to increase just 2.3 percent, down from 7.9 percent in the first quarter, and hiring to rise 4.1 percent, off from 5.2 percent.

Sixty-seven percent said they are reducing their rate of inventory growth, with 41 percent saying they are actually reducing the level of their stockpiles.

Real GDP Up Slightly From the Previous Revision in Late May

The June 28 revision of real GDP for Q1 2007 was up slightly from the last revision in late May. The YOY growth rate of 1.91% for Q1 2007 is the lowest YOY growth rate since Q2 2003. The all important personal consumer expenditure (PCE) is basically unchanged with an annual growth rate (YOY) of 3.46%.

The US Dept. of Commerce press release is available at the BEA. A follow-up article can be found at Market Watch.

Another Take on the Housing Industry from Bill Gross at PIMCO

Below is another take on the credit markets for mortgages from Bill Gross at PIMCO, both CDOs and residential mortgage backed securities (RMBS), and the effect it will have on the housing industry. Once again there is more bad news ahead for the consumer.

. . . . Those that point to a crisis averted (Bear Stearns) and a return to normalcy are really looking for contagion in all the wrong places. Because the problem lies not in a Bear Stearns hedge fund that can be papered over with 100 cents on the dollar marks. . . . The flaw, dear readers, lies in the homes that were financed with cheap and in some cases gratuitous money in 2004, 2005, and 2006. Because while the Bear hedge funds are now primarily history, those millions and millions of homes are not. They’re not going anywhere…except for their mortgages that is. Mortgage payments are going up, up, and up…and so are delinquencies and defaults. A recent research piece by Bank of America estimates that approximately $500 billion of adjustable rate mortgages are scheduled to reset skyward in 2007 by an average of over 200 basis points. 2008 holds even more surprises with nearly $700 billion ARMS subject to reset, nearly ¾ of which are subprimes.

The right places to look for contagion are therefore not in the white-washed Bear Stearns hedge funds, but in the subprime resets to come and the ultimate effect they will have on the prices of homes – the collateral that’s so critical in this asset-backed, and therefore interest-sensitive financed-based economy of 2007 and beyond. If delinquencies lead to defaults and then to lower home prices, then we have problems. . . .

Home Sales and Consumer Confidence Are Both Down in May

The bad news in the housing market continues with a drop in sales in May. The Conference Board also reports a drop in consumer confidence for the same time period. I cannot to see how all of this is pointing to a strong Q2 for the economy and better growth throughout the remainder of the year. From the WSJ:

U.S. new-home sales fell in May, and this month's reading on consumer confidence dropped more than expected, weighed down by a stubbornly heavy supply of unsold homes, steep gasoline prices and a softening job market.

The Commerce Department reported that the nation's sales of newly constructed homes fell to a seasonally adjusted annual rate of 915,000 units, a 1.6% drop from April's downwardly revised 930,000 homes. The report also showed that the supply of new homes on the market would take about 7.1 months to sell at last month's sales pace, a slight increase from seven months in April.

Builders have been discounting unsold homes to reduce supply, but they face increased competition from sellers in the existing-home market and from foreclosed homes listed for sale. The National Association of Realtors said Monday that the inventory of existing homes increased to a 8.9 months' supply in May, the largest buildup since the previous housing slump in 1992.

S&P found that 4.21% of Alt-A loans (between sub-prime and prime mortgages) bundled into mortgage-backed securities last year were 90 or more days overdue after 14 months. That was up sharply from 1.59% for loans from 2005 and 0.91% for loans from 2004. The data exclude pay-option loans, which provide borrowers several choices for how much they pay each month.
The figures are the latest indication that the surge in defaults has spread beyond subprime mortgages, or home loans made to consumers with troubled credit histories. . . .

Meantime, a key indicator of consumer confidence dropped to a 10-month low this month. The Conference Board's index of consumer confidence fell to 103.9 from 108.5 in May, led by a downbeat assessment of the job market.

Another Take on the Index of Leading Indicators

Going through the Conference Board news release on the Index of Leading Indicators gives at best a slightly positive message, but mostly the message is mixed. It bothers me that positive numbers are driven in part by stock prices and building permits. The stock market prices are increasing, but the market has been jittery for the last couple of months as the sub-prime story has unraveled. Also building permits are up, but so are cancellations and there is no good count of cancellations. So building permits at this point in the business cycle may be misleading.

The Conference Board announced today that the U.S. leading index increased 0.3 percent, the coincident index increased 0.2 percent and the lagging index increased 0.2 percent in May.

• The May increase in the leading index reverses its April decline. And April's large decrease was revised up slightly due to data revisions in housing permits and manufacturers' new orders components. The leading index grew 0.3 percent from November to May (a 0.6 percent annual rate). In May, unemployment insurance claims (inverted) and stock prices made the largest positive contributions, followed by housing permits.

• The coincident index increased again in May. From November to May, the coincident index rose by 0.8 percent (a 1.6 percent annual rate). In May, employment made the largest contribution to the index. The coincident index grew at an average annual rate of about 2.5 percent in 2006, but in recent months, its growth has been fluctuating in the 1.5 to 2.0 percent range (annual rate).

• Following an essentially flat period in the second half of 2006, the leading index picked up somewhat in December, but this was followed by two consecutive declines. The leading index is still at the same level as in January 2007, and it is 0.3 percent above its May 2006 level (my emphasis). At the same time, real GDP grew only at a 0.6 percent annual rate in the first quarter of 2007, following a 2.5 percent rate in the fourth quarter of 2006. The recent performance of the leading index has been mixed with increases offsetting decreases and the number of components rising roughly equaling the number falling (my emphasis). The current behavior of the composite indexes suggests that economic growth is likely to continue, albeit at a slow pace, in the near term.

LEADING INDICATORS. Five of the ten indicators that make up the leading index increased in May. The positive contributors — beginning with the largest positive contributor — were average weekly initial claims for unemployment insurance (inverted), stock prices, building permits, index of consumer expectations, and vendor performance. The negative contributors — beginning with the largest negative contributor — were real money supply*, average weekly manufacturing hours and interest rate spread. The manufacturers' new orders for consumer goods and materials* and manufacturers' new orders for nondefense capital goods* held steady in May.

The SEC Is Trying to Catch Up With The New Credit Market Infrastructure

Although many will blame the SEC for being late. Sometimes these things need to play out so you can see the effect as opposed to trying to anticipate an outcome, getting it wrong, and still seeing the effect. From the WSJ:

The Securities and Exchange Commission has opened about a dozen investigations involving complex bundled financial products, as well as the related near-collapse of two Bear Stearns hedge funds that invested in the subprime-mortgage market.

Responding to a question at a House committee hearing, SEC Chairman Christopher Cox said the agency's enforcement division has "about 12 investigations" involving collateralized debt obligations, or CDOs, and collateralized loan obligations, or CLOs.

People familiar with the matter said the SEC's enforcement division also has opened a preliminary investigation into the issues surrounding the Bear Stearns hedge funds . . .

Earlier this year, the SEC enforcement division formed a subprime working group, which is looking at a range of topics from the securitization process to troubled subprime issuers. One area of concern involves the lack of accurate pricing in the CDO market.

Pricing could also prove to be an issue in the now-pulled public offering of Everquest Financial Ltd., a company backed by Bear Stearns and its two hedge funds. The company in May filed with the SEC to go public, with Bear Stearns as underwriter. . . . In creating Everquest last fall, Bear transferred to Everquest equity in 10 CDOs, the riskiest slice offered by these vehicles. Observers have questioned Bear Stearns's ability to value those assets, given that it was essentially both buyer and seller.

Mr. Cox said the SEC's market-regulation division was monitoring the situation at Bear Stearns to ensure it didn't risk upsetting the financial system.

Another Credit Facility in the New Credit Infrastructure – The CLO

First the WSJ had an excellent article on the CDO market. Now the WSJ reviews the CLO market. I wonder when the WSJ will review the CMO (collateralized mortgage obligations) market?

Below are some of the essentials on CLOs, but the article is worth a read. One question is – will the sub-prime disease in the CDO market spill over into the CLO market. Like guilt by association.

What worries me about all these “new” types of obligations is when an institution is not responsible for the money you lend only the fees you collect, the emphasis changes from good underwriting to money making expediency. There is a lot of difference in the two goals, especially in the willingness to take responsibility for what was done and why.

The corporate buyout boom of the 1980s was funded in large part by high-yield "junk" bonds. This time around, another financial product is supplying much of the fuel -- collateralized loan obligations.

CLOs, as they're called, are giant pools of bank loans bundled together by Wall Street and sold off to investors in slices. They aim to spread default risk an inch deep and a mile wide. Last year, more than half of the loans behind the record wave of buyouts were parceled out to investors as CLOs, bankers say.

As corporate borrowing soars, however, concerns are growing that CLOs have made it too easy for shaky or debt-laden companies to borrow money. If economic conditions deteriorate, those loans could sour and investors in the riskiest CLO slices could face large losses. That, in turn, could make it harder for buyout firms to borrow money.

"We are witnessing a loan market rife with liquidity and disproportionate power in the hands of borrowers, arrangers and financial sponsors," said credit-rating firm Standard & Poor's Corp. in a June 13 report.

The past decade has seen headlong growth in markets for various complex financial products, from derivatives to mortgage-backed securities to CLOs. These booming markets are mostly opaque: Investment offerings are private and largely unregulated, trading is sometimes thin, and the securities can be hard to value. That makes it especially difficult to predict what will happen if market conditions rapidly turn unfavorable. . . . At the moment, default rates on corporate loans are very low, . . . . An index tied to non-investment-grade corporate loans fell all last week, according to Markit Group, its administrator. The index, LCDX, was launched one month ago and reached its lowest point yesterday.

Borrowing by corporations has soared in recent years, and CLOs have played a big part. Since 2004, more than $210 billion of loans have been packaged into CLOs, up from $51 billion over the prior four years, . . . . Investors searching for higher yields have put so much money into CLOs that even weak companies can get loans at relatively low interest rates. Last winter, for example, ailing Ford Motor Co. was able to borrow $23 billion in a matter of days, $5 billion more than it earlier planned.

More than a thousand U.S. companies were acquired in leveraged buyouts in 2006 -- a record $194 billion of deals, according to data provider Dealogic. More than $163 billion was borrowed to pay for those buyouts, according to S&P Leveraged Commentary & Data, more than total borrowings for the previous two years of buyouts combined. This year, through mid-June, $103 billion of debt was raised to fund buyouts. Over the next few months, more than $100 billion in loans will be sold to fund mammoth deals such as Cerberus Capital Management's acquisition of Chrysler Group and the privatization of SLM Corp., also known as Sallie Mae.

Many companies are counting on a large investor appetite for the debt to push their deals through. "CLOs are a big pillar of loan demand. If they slow down, borrowing will get a lot more difficult for companies," says Steven Miller, a managing director at S&P.

CLOs have been lauded by former Federal Reserve chairman Alan Greenspan and others for dispersing risk. Michael Milken, whose underwriting of junk bonds at Drexel Burnham Lambert Inc. during the 1980s ignited that decade's buyout boom, has said that CLOs are among the most important financial innovations of the past quarter century.

Points of View on Whether or Not the US is Headed for a Recession

The article in yesterday’s WSJ reminds me of an article on the same subject from the IMF about 7 years ago.

Basically, the mainstream forecasting groups (Goldman Sachs, Morgan Stanley, etc.) have relatively rosy forecasts for the US economy. Opposed to this are a number of forecasting groups outside the mainstream who think a recession has already started or starting before the end of the year.

The article from the IMF basically states that there is no advantage to forecasting something different from the “pack”, hence the poor forecasting record for recessions.

The question behind all of this is – are you willing to go along with the consensus, which you know is flawed for a variety of reasons. Or are you willing to put in the time to develop your own point of view and live with the consequences.

By the way, concerning the current situation in the US, Market Watch reports the IMF is optimistic about US growth going forward, but they believe that the US faces some risks to that outcome.

From yesterday's WSJ article:

Talk to just about any economic forecaster on Wall Street, and you'll probably get a relatively upbeat assessment of U.S. economic outlook. They'll tell you that business investment and manufacturing output are bouncing back and that housing might be less of a drag on growth, trends that suggest the worst of the slowdown is behind us.

But outside the mainstream -- and, in most cases, far away from Wall Street -- a small but vocal group of pessimists says the consensus view is wrong and that the economy is getting weaker -- so weak that it could actually be in a recession right now. . . .

Mr. Smith doesn't rely on the yield curve alone; he also collects anecdotal evidence from "real people," like business managers, analysts and workers at companies all over the U.S. He said that before he updates his monthly forecasts he speaks with nearly 100 people: "The steel experts and the shipping experts and the truck experts and the agricultural experts -- you name it," he said. Right now, he says, the real people are telling him that business is slowing. "Demand has gone down for railroad, trucking and air freight -- all three. All housing companies are down. Packaging demand is down -- nobody knows why -- you can't buy more if you're not selling more boxes."

The US Refining Industry: Another Business Where Costs of Production are Key

This is an interesting article from Bloomberg concerning the oil refining industry. It basically states that buying refineries is cheaper than building one. For example, you can buy refinery for $12,000 per processing barrel, where the costs to build the same capacity is $18,000 to $20,000 per processing barrel.

Refining is a difficult business because it cannot control the costs of the input (crude oil) and the refineries ultimately cannot control the price of the output. Therefore, if the refinery does not buy right or the price of the product falls, the margins are squeezed. So even though margins are more generous now, in the future this may not be the case. So trying to re-coup the cost of the refinery from decreasing margins could increase the payback period of the project. This is why so many plans for new refineries or plans for expansion of existing facilities are being shelved.

Refineries are generating record profits of $17 to $24 per barrel, seven times higher than the 1990s average.

Li paid $11,515 for each barrel of refining capacity; Barrack's deal equaled about $12,100. Marathon is spending $17,778 on each barrel of capacity to be added in Louisiana.

A near doubling in engineering costs since 2005 has ended at least 10 new refining projects worldwide, said Fesharaki at FACTS Global.

``For five to six years, you're pouring billions of dollars into a project and getting nothing in return,'' said Lynn Westfall, chief economist at Tesoro. ``Even at today's margins, it's going to take 10 to 15 years to repay that investment.''

Reliance is among the few energy providers ready to complete a new refinery. The 580,000 barrel-a-day plant in Jamnagar, western India, built at a cost of $6.1 billion, in June, 2008 will start making diesel for Europe and gasoline for the U.S.

Each barrel of daily processing capacity will cost Reliance $10,500. Reliance gave final approval for the project in December 2005 and locked in most costs within three months, before they spiraled out of control. Shares of Reliance Petroleum Ltd., the subsidiary that's building the plant, have gained 66 percent since an initial sale in April.

Kuwait Petroleum Corp., the Middle East's biggest exporter of refined products, June 17 invited new bids to design and build a 615,000 barrel a day refinery. A first round of bids at $12 billion, or $19,512 for each barrel of daily capacity, was rejected in February. Kuwait Petroleum originally estimated the construction costs at $6.4 billion.

``Asking anyone to build a brand-new refinery today is asking them to take a 20-year bet that refining margins are going to remain where they are,'' said Tesoro's Westfall.

Gold Market #8 - For Mining It Is All About the Cost of Production

Gold mining, as with many other industries, is all about the cost of production. The mining company cannot control the price of the product, it can only control the cost of production, the difference between the two is profit. From Bloomberg:

Now so-called cash costs -- costs directly related to mining -- for some producers are starting to ease. Companies are finding higher grades of gold (ore) . . . . At the same time, producers . . . . are tapping new gold mines in China and Russia, nations where labor and power are cheaper but where political uncertainty had discouraged exploration before.

Cash costs for North American gold producers covered by National Bank Financial averaged $330 per ounce produced in the first quarter. Average cash costs for those producers have risen from $164 an ounce in 2000, the bank said in a May 25 report. Costs are expected to average $324 an ounce this year and fall to $318 next year after averaging $265 last year, the bank said in a June 5 report.

``Costs have reached a level that is certainly controllable, so any increase in the gold price pretty much goes to the bottom line,'' . . . .

If production costs are more controllable some of the risk to the profitability of a company is also under control. As a result there is less nedd for hedging production, that is locking in the price for of gold.

Miners reduced their hedges against lower gold prices by almost 10 percent in the first quarter, the biggest decline in nine months, Mitsui Global Precious Metals said in a report May 4. This allows the companies to get the full benefit of bullion prices that have more than doubled over the past six years.

The What, How, and When of the CDO Market

The link to a Wall Street Journal article is a very good description of the what, how, and when of CDOs. It also includes an example starting with a single mortgage so it can be followed through the process. Good background information for the situation at Bear Stearns.

So what exactly are CDOs, the structures at the root of so much angst? They are financial vehicles that bundle different kinds of debt -- ranging from corporate bonds, to securities underpinned by mortgages, to debt backed by money owed on credit cards -- and cut it into slices. These slices are sold to investors in the form of bonds. While the slices contain the same debt, they differ in terms of which pay the most interest and which are least at risk of losing money.

. . . . The popularity of CDOs grew as low interest rates caused investors to embrace products that offered the promise of higher yields.

. . . . They also say that CDOs are another tool that allow financial markets to further spread risk so it isn't concentrated in the hands of a few players.

This WSJ link leads to a flowchart of the mortgage security process once the loan has been made.

Bear Stearns Assumes Loans for One of the Funds (update #2)

The linked article from the Wall Street Journal is an excellent summary of the history and issues surrounding the two Bear Stearns hedge funds. It discusses how the issue was not only sub-prime mortgages, but also trading in the ABX index as well. This story is worth watching because 1) it is not over and 2) the success of the moves is not guaranteed.

Bear may have prevented a wider meltdown -- and kept many of the subprime bonds from plunging in value in a fire sale. Its injection of money also will help bring order to the market and pay back loans made by other big Wall Street banks to the Bear-managed hedge fund called the High-Grade Structured Credit Strategies Fund -- though prospects for a sister fund that relied even more on debt, the High Grade Structured Credit Strategies Enhanced Leverage Fund, remain in doubt. . . . And late Friday, as rivals continued to sell or wind down their positions with the one fund, it became clear that Bear may only need to lend $2 billion or less. . . .

Mr. Spector worked the phones . . . . The upshot: save the less leveraged fund that had better-quality assets and let the other fund collapse.

Problems in the Credit Markets with Bear Stearns (update #1) and What Happens Next Time?

The following summarizes the events of the last week concerning the Bear Stearns hedge funds Bloomberg #2, Bloomberg update 4, and WSJ:

Bear Stearns has two hedge funds holding collateralized debt obligations (CDOs) backed in part by sub-prime mortgages: High-Grade Structured Credit Strategies Fund and the High-Grade Structured Credit Strategies Enhanced Leverage Fund. The former fund has lost 10% and the latter 20% since the first of the year. Also the latter fund is more leveraged than the first.

These CDOs are seldom traded in an open market so the true value of the bonds is not known. For the most part they are carried on the books of the hedge funds at par value.

Last week it began to emerge in the press that the Bear Stearns hedge funds had losses since the first of the year and as a result were in violation of some of their loan covenants. Specifically, the funds received ``high levels'' of margin calls from creditors in the past few weeks and had trouble selling enough assets to keep running, Bear Stearns said in the statement.

Creditors extended $9 billion to the funds which made bets of more than $11 billion. . . . Lenders include Merrill, Lehman, JPMorgan Chase & Co., Goldman Sachs Group Inc., Citigroup,Cantor Fitzgerald LP, Bank of America Corp., Barclays Plc, and Deutsche Bank AG.

Bear Stearns tried to arrange a sale of some of the CDOs to bring the loans back into compliance with the loan agreements.

Due to difficulties in selling the CDOs, Merrill Lynch, seized about $850 MM in CDOs from the hedge funds and planned to sell them to repay the loan.

On Wednesday Merrill Lynch auctioned the CDOs. The result of the auction led to the sale of less than half of the CDOs at discounts ranging from 5% - 15%.

Cantor Fitzgerald, JPMorgan, and Lehman seized collateral along with Merrill Lynch. Cantor Fitzgerald auctioned off some of the assets. JP Morgan cancelled plans to auction off their assets. Lehman “had no comment”.

The ultimate issue in seizing the assets and selling them on the open market is:

A sale would give banks, brokerages and investors the one thing they want to avoid: a real price on the bonds in the fund that could serve as a benchmark. The securities are known as collateralized debt obligations, which exceed $1 trillion and comprise the fastest-growing part of the bond market.

Because there is little trading in the securities, prices may not reflect the highest rate of mortgage delinquencies in 13 years. An auction that confirms concerns that CDOs are overvalued may spark a chain reaction of writedowns that causes billions of dollars in losses for everyone from hedge funds to pension funds to foreign banks. Bear Stearns, the second-biggest mortgage bond underwriter, also is the biggest broker to hedge funds.

To combat this possibility:

Bear Stearns Cos. plans to establish a $3.2 billion line of credit for the High-Grade Structured Credit Strategies Fund to stop creditors from seizing assets of one of its money-losing hedge funds in the biggest fund bailout since 1998, . . . . The firm told lenders to the High-Grade Structured Credit Strategies Fund yesterday (June 22) that it would assume their loans . . . .

The question that comes to mind is that even though a credit crisis may have been averted this time. What happens next time when the hedge fund in question does not have the wherewithal to assume the loans of the lenders?

Most American Consumers Think There House is Worth More

The American consumer – always the eternal optimist, but probably a little disconnected from the market (Yahoo):

Although existing homes are selling at their slowest pace in four years, most Americans are confident their homes are worth more now than they were a year ago, according to a survey released on Thursday.

A poll conducted by the Boston Consulting Group found that 55 percent of Americans believe their house would sell for more money now than last year, compared with 59 percent who felt the same way last summer. Eighty-five percent expect their home to be worth even more in five years than it is now.

According to the Office of Federal Housing Enterprise Oversight, the average U.S. home price rose 4.3 percent over the year ended in the first quarter, the smallest gain in nearly a decade.

The reason that the price of homes are going up (or appear to be going up) is that the sale of starter homes as a percentage of the total mix of homes is declining, thereby skewing the prices upward.

The softening housing market also appears to have had little impact on spending behavior. Seventy-six percent of participants in the nationwide telephone survey say it hasn't affected their spending at all.

Most predict the slump will last two years. . . .

If most people plan to live in their house for 2 years or more the results of the survey are not surprising. Their goal is to ride through the trough in housing prices. The only consumers that could be hurt by declining housing prices are those that have to sell.

Credit Market Doomsday #3

First the BBC, then the Wall Street Journal, and now with Bloomberg the central bankers are meeting soon to discuss issues concerning the low risk premiums.

With hedge funds and private equity firms pumping record sums of money around the world economy, central bankers fret that investors are taking on too much risk. As a result, the bankers are increasingly turning to the Basel, Switzerland-based BIS (Bank of International Settlements), the oldest international financial institution, for research and advice, and to coordinate damage-control plans.

The ``central banks' central bank'' now performs many of the functions of a monetary authority, churning out research on everything from derivatives to inflation-targeting. It also holds about 6 percent of central banks' currency reserves on their behalf.

``Funds are flowing across the world with unbelievable speed, and central bankers feel they are in uncharted territory,'' Meyer said. ``Central bankers want to talk to each other about this, and the BIS is the best vehicle.''

While market blowouts such as the Asian crisis of 1997 are always hard to spot in advance, policy makers say, the increasing popularity and complexity of the derivatives used by investors to hedge their bets are making the task even tougher.

Fed Bank of New York President Timothy Geithner argues that the danger that new crises will be harder to manage should be the ``principal preoccupation'' of central bankers.

The agenda for this year's annual meeting may already have been set by a report published last month. The Financial Stability Forum, which is based at the BIS and brings together regulators and central bankers, argued that hedge funds should ``enhance sound practice'' methods for improving risk management and preventing potential shocks to the international financial system.

Investors' perception of risk is near historic lows. The gap between the yield demanded by investors to hold high-yield, high- risk U.S. corporate debt and government bonds fell to the lowest ever on June 5. European companies have borrowed a record $284.7 billion in loans and bonds rated below investment grade since the start of the year.

Growing concern about the extent of investors' risk-taking comes as a global cash glut swamps the ability of central bankers to set policy. . . .

``The problem is that you will inevitably end up fighting the last war,''

This is commonly the problem with a financial crisis.

Credit Market Doomsday #2

This from yesterday’s Wall Street Journal, a different take on the credit markets. It appears that some people are getting nervous about the credit markets.

. . . . In this fast-growing arena of loans to business -- these days, mostly, private equity deals -- lending proceeds as if the subprime debacle were some minor skirmish in a little known, far away land.

How curious that so many in the financial community should remain blissfully oblivious to live grenades scattered around the high-yield playing field. Amid all the asset bubbles that we've seen in recent years -- emerging markets in 1997, Internet and telecoms stocks in 2000, perhaps emerging markets or commercial real estate again today -- the current inflated pricing of high-yield loans will eventually earn quite an imposing tombstone in the graveyard of other great past manias.

In recent months, lower credit bonds -- conventionally defined as BB+ and below -- have traded at a smaller risk premium (as compared to U.S. Treasuries) than ever before in history. Over the past 20 years, this margin averaged 5.42 percentage points. Shortly before the Asian crisis in 1998, the spread was hovering just above 3 percentage points. Earlier this month, it touched down at a record 2.63 percentage points. That's less than 8% money for high-risk borrowers. . . .

. . . . The low spreads have been accompanied by less tangible indicia of imprudent lending practices: the easing of loan conditions ("covenants," as they are known in industry parlance), options for borrowers to pay interest in more paper instead of cash, financings to deliver large dividends to shareholders (generally private equity firms) and perhaps most importantly, a general deterioration in the credit quality of borrowers.

In 2006, a record 20.9% of new high-yield lending was to particularly credit-challenged borrowers, those with at least one rating starting with a "C." So far this year, that figure is at 33%. No exaggeration is required to pronounce unequivocally that money is available today in quantities, at prices and on terms never before seen in the 100-plus years since U.S. financial markets reached full flower.

Why should so many theoretically sophisticated lenders be willing to bet so heavily in a casino with particularly poor odds? Strong economies around the world have pushed default rates to an all-time low, which has in turn lulled lenders into believing these loans are safer than they really are. Just 0.8% of high-yield bonds defaulted last year, the lowest in modern times. And with only three defaults so far this year, we've luxuriated in the first default-free months since 1997. By comparison, high-yield default rates have averaged 3.4% since 1970; higher still for paper further down the totem pole.

Like past bubbles, the current historical performance of high-yield markets has led seers and prognosticators to proclaim yet another new paradigm, one in which (to their thinking) the likelihood of bankruptcy has diminished so much that lenders need not demand the same added yield over the Treasury or "risk-free" rate that they did in the past.

The five most dangerous words in the English language – “it is different this time”.

But to think that corporate recessions -- and the attendant collateral damage of bankruptcies among overextended companies -- have been outlawed would be as foolhardy as believing that mortgages should be issued to home buyers with no down payments and no verification of financial status.

Some portion of this phenomenon seems to reflect tastes in Asia and elsewhere, where much of the excess liquidity resides: Foreign investors own only about 13% of U.S. equities but 43% of Treasury debt. In search of higher yields, these investors are moving into corporate and sovereign debt. Today, the debt of countries like Colombia trades at less than two percentage points above U.S. Treasuries, compared to 10 percentage points five years ago.

Credit Market Doomsday #1

This from the BBC last Thursday talks about the level of increasing volatility in the bond market and the effects this could have on the housing, hedge fund, and stock markets.

Until recently, we have been living in a period of low global interest rates that have let consumers and companies borrow money cheaply.

That has driven demand for mortgages, let companies pay increasingly large sums for takeovers, and allowed consumers to spend freely.

And the results of this credit splurge are hard to ignore:

1. UK house prices have doubled in the past 10 years.
2. China's main stock index has quadrupled in value since the start of 2006.
3. The UK's FTSE 100 and US S&P 500 stock indexes are at levels not seen in almost seven years.
4. Commodity prices have been buoyed by strong global demand, pushing some such as copper to records.
5. Merger and acquisition activity has taken off, and private equity firms are now in control of some of the world's biggest brands.

But as the records have continued to tumble, concerns have kept on mounting. One of the main reasons for the current uncertainty has been the significant changes and volatility in the US bond market.

Simply put, this means that investors are not expecting interest rates to fall anytime soon, especially as the Bank of England, the US Federal Reserve and European Central Bank have all been lifting borrowing costs in recent months.

What has many observers worried is the sudden speed with which the change occurred and the fact that it seems to confirm the view that the era of low interest rates has ended.

First and foremost this will make it more expensive for companies and consumers to get their hands on cash.

That in turn could lead to fewer private equity deals, and a cooling of the housing and stock markets.

Certainly stock markets are exhibiting some classic warning signals as well. . . .

Wall Street giant Morgan Stanley told investors that its indicators were showing a "full-house" in terms of sell triggers, and that this had only happened five times since 1980.

Each time, global equities have lost an average of 15% over the following six months, it said.
"At this stage of bull markets larger corrections become more frequent," Morgan Stanley said.

Peak Oil in the Mainstream Press?????

The following appears in Business Week. Discussions of Peak Oil are not new, but they are not common in the mainstream press. When Peak Oil will occur or if it has already occurred will not be known for some period of time. To reduce of the risk of the effects of Peak Oil, it is time to start a national discussion on the issue. It is not an issue of if, only when it will occur.

Peak oil refers to the point at which world oil production plateaus before beginning to decline as depletion of the world's remaining reserves offsets ever-increased drilling. Some experts argue that we're already there, and that we won't exceed by much the daily production high of 84.5 million barrels first reached in 2005. If so, global production will bump along near these levels for years before beginning an inexorable decline.

What would that mean? Alternatives are still a decade away from meeting incremental demand for oil. With nothing to fill the gap, global economic growth would slow, stop, and then reverse; international tensions would soar as nations seek access to diminishing supplies, enriching autocratic rulers in unstable oil states; . . . .

GIVEN SUCH UNPLEASANT possibilities, you'd think peak oil would be a national obsession. But policymakers can hide behind the possibility that vast troves will be available from unconventional sources, or that secretive oil-exporting nations really have the huge reserves they claim. Yet even if those who say that the peak has arrived are wrong, enough disturbing omens—for example, declining production in most of the world's great oil fields and no new superfields to take up the slack—exist for the issue to merit an intense international focus.

The reality is that it will be here much sooner for the U.S.—in the form of peak oil exports. Since we import nearly two-thirds of the oil we consume, global oil available for export should be our bigger concern. Fast-growing domestic consumption in oil-exporting nations and increasing appetites by big importers such as China portend tighter supplies available to the U.S., unless world production rises rapidly. But output has stalled. Call it de facto peak oil or peak oil lite. It means the U.S. is entering an age when it will have to scramble to maintain existing import levels.

We will know soon enough whether the capacity to raise production really exists. If not, basic math and the clock tell the story. All alternatives—geothermal, solar, wind, etc.—produce only 3% of the energy supplied by oil. If oil demand rises by 2% while output remains flat, generation of alternative energy would have to expand 60% a year. That's more than twice the rate of wind power, the fastest-growing alternative energy. And all this incremental energy would somehow have to be delivered to transportation (which consumes most of the oil produced each year) just to stay even with the growth in demand.

The Debate Concerning New Oil Refining Capacity Continues

The question of new oil refining capacity in the US continues due to issues concerning alternative fuels and higher mileage vehicles (Yahoo News). There are no winners in this situation. The refining industry will be blamed for tight refining capacity and the consumer will continue to pay high prices at the pump.

The issue that is not addressed in either of the articles are feedstocks. Will there be sufficient feedstocks for the refineries to continue operating at a profitable capacity? Based on the new refineries being built in other parts of the world it appears that feedstocks are sufficient. The real issue is future demand for gasoline, heating oil, the cost of new refining capacity, and alternative fuels.

A push from Congress and the White House for huge increases in biofuels, such as ethanol, is prompting the oil industry to scale back its plans for refinery expansions. . . . President Bush' calling for a 20 percent drop in gasoline use and the Senate now debating legislation for huge increases in ethanol production, oil companies see growing uncertainty about future gasoline demand and little need to expand refineries or build new ones.

Oil industry executives no longer believe there will be the demand for gasoline over the next decade to warrant the billions of dollars in refinery expansions — as much as 10 percent increase in new refining capacity — they anticipated as recently as a year ago.

Biofuels such as ethanol and efforts to get automakers to build more fuel-efficient cars and SUVs have been portrayed as key to countering high gasoline prices, but they are likely to do little to curb costs at the pump today, or in the years ahead as refiners reduce gasoline production. . . .

In 2006, motorists used 143 billion gallons of gasoline, of which 136 billion was produced by U.S. refineries, and the rest imported.

Drevna, the industry lobbyist, said annual demand had been expected to grow to about 161 billion gallons by 2017. But Bush's call to cut gasoline demand by 20 percent — through a combination of fuel efficiency improvements and ethanol — would reduce that demand below what U.S. refineries make today, he said.

In the 1980s, Blumenthal (Attorney General of CT) said at a recent hearing, refiners were producing at 77.6 percent of their capacity, "which allowed for easy increases in production to address shortages. In the 1990s, as the industry closed refineries, ... (that figure) rose to 91.4 percent, leaving little room for expansion to cover supply shortfalls."

A somewhat different take with similar results on the refinishing issue came from the Wall Street Journal last week.

The cost of building or expanding oil refineries is rising rapidly, contributing to delays in increasing the U.S. gasoline supply at a time of near-record prices.

The oil industry is blaming cost escalation -- driven by shortages of skilled labor and construction services, along with higher materials prices -- for a spate of pushed-back or scrapped expansion projects. . . . . The decision to rethink construction comes as the industry, flush with profits from high gasoline prices, is under fire from Congress and consumer groups in the U.S. for not doing enough to build capacity. Delays could expose the industry to additional criticism and unwanted oversight.

Years of industry underinvestment have contributed to the current rise. Refiners in past years blamed low fuel prices and poor returns, as well as environmental opposition to major expansion efforts and the cost of keeping up with fuel regulations. In the U.S., no new refinery has been built since 1976.

Janet Yellen of the SF Fed on Risks in the Markets

Summary articles can be found in Bloomberg and CNNMoney (I am sure others as well) and the speeech can be found at FRBSF.

Federal Reserve Bank of San Francisco President Janet Yellen said the recent increase in long-term bond yields hasn't altered the so-called ``conundrum'' of low rates compared with rates on shorter-maturity debt. . . . . ``Long-term rates have risen in recent weeks, but not by nearly enough to resolve what former Fed Chairman Alan Greenspan coined, `the bond rate conundrum,''

After years of failing to move in tandem with rates set by central banks, U.S. and European yields have surged to their highest levels since 2002. The yield on the U.S. 10-year note has climbed 52 basis points in the past month and rose to 5.32 percent on June 13.

While low risk spreads ``may well reflect an environment wherein risk genuinely is reduced,'' Yellen said she's concerned that investors are underestimating risk (my emphasis), given recent losses in subprime mortgages, soaring inflows into hedge funds and the leveraged-buyout boom.

``The possibility of a sudden reversal in risk perceptions cannot be ruled out,'' Yellen said in prepared remarks. While the global financial system has probably strengthened since the Asian crisis of 1997-98, Yellen recalled the ``sharp asset-price declines and a frightening and sudden erosion of market liquidity'' in that instance.

Asset Markets

The Fed and other central banks should rely on supervisory and regulatory tools to make sure financial institutions manage risks well, Yellen said. She agreed with the prevailing Fed view that it's best not to use interest rates to target asset prices, countering some critics who say central banks should ``dampen overly euphoric asset markets.''

``It is exceptionally difficult to distinguish `bubbles' from fundamental-based booms and monetary actions impose certain short-run costs for very uncertain future gains,'' Yellen said. ``I therefore believe that central banks should stand ready to act to cushion the economy in response to shocks when and if they occur.''

Current Account

One risk to the world economy's ``extraordinarily strong'' growth is the U.S. current-account deficit, the broadest measure of trade, which may be ``unsustainable,'' (my emphasis) Yellen said. Last year, the gap, swelled to $856.7 billion, the biggest ever, from $791.5 billion the prior year, and equaled a record 6.5 percent of GDP.

``My concern here is that a sudden unwinding of these imbalances could be associated with sharp movements in exchange rates and asset prices that could produce destabilizing economic impacts around the globe,'' Yellen said.

With delinquencies and foreclosures swallowing the subprime- mortgage market, Yellen said some lenders ``paid a high price'' for ``unduly benign'' views of risk.

In hedge funds and private-equity buyouts, Yellen said that ``some observers question whether the supposedly sophisticated investors in these funds fully understand the complexities of the investment strategies pursued by fund managers and the risks to which they are exposed.''

In addition, the so-called ``carry trade,'' in which investors borrowing currencies such as yen for a cheap rate in order to buy higher-yielding bonds abroad, ``exposes investors to substantial exchange rate risk,'' Yellen said.

Interest Rates

The Fed's Open Market Committee is likely to keep its target rate for overnight loans between banks at 5.25 percent for an eighth straight meeting when Yellen, Chairman Ben S. Bernanke and their colleagues gather June 27-28, according to economists surveyed by Bloomberg. Policy makers see inflation as the ``predominant'' economic risk.

A Different Take on the CPI Released Yesterday

The following is summarized from the US Dept. of Labor CPI Summary released on June 15, 2007. The most reported form of the CPI, Consumer Price Index for All Urban Consumers (CPI-U), increased 0.6% in May, prior to the seasonal adjustment. The May level of 207.949 (1982-84=100) was 2.7% higher than in May 2006.

On a seasonally adjusted basis, the CPI-U advanced 0.7% inMay, following a 0.4% increase in April. The index for energy increased sharply for the third consecutive month--up 5.4% in May. The food index rose 0.3% in May, slightly less than in April. The index for all items less food and energy (core inflation rate) increased 0.1 % in May, following a 0.2 % rise in April.

This discrepancy between the core inflation rate (0.1%) and total inflation rate (0.6%) speaks to the lack of value of the core inflation rate when energy prices are increasing. Admittedly, many will tell you that the FED looks at the core inflation rate to make policy decisions. But let us face facts, Ben Bernanke and friends weren’t born yesterday. They must have their eyes on the total inflation rate.

During the first five months of 2007, the CPI-U rose at a 5.5%seasonally adjusted annual rate (SAAR) compared with an increase of2.5% for all of 2006. The acceleration this year was due to larger increases in the energy and food components. The index for energy advanced at a 36.0% SAAR in the first five months of 2007 compared with 2.9% in 2006. The food index has increased at a 6.2%. SAAR thus far this year, following a 2.1% rise for all of 2006. Excluding food and energy, the CPI-U advanced at a 2.1% SAAR in the first five months, following a 2.6% rise for all of 2006.

The annualized growth rate for the March, April and May for selected items:

All items 7%
Food and beverages 4.2%
Housing 2.5%
Apparel -6.6%
Transportation 30.6%

The same items for the past 12 months:

All items 2.7%
Food and beverages 3.9%
Housing 3.3%
Apparel -0.8%
Transportation 1.3%

This data indicates that life in the US is just recently becoming more expensive. The prices of food and energy are up significantly. Apparel is down because retailers can’t move it and are now dumping their inventory. Housing is down slightly because of the condition of the housing and rental markets.

From a national perspective the data indicates that the growth rate in Q1 and Q2 personal consumption expenditure (PCE, largest portion of the GDP) can be largely attributed to more money being shelled out for energy and food and not real growth in PCE across a wide variety of items.

In addition by using the CPI-U the concerns of the American public are more understandable. The person on the street knows life is costing them more, now we know why.

I Rest My Case on Disclosures

The FTC recently completed a study concerning disclosures for home purchases and found them to be lacking (LA Times via Tim Iacono's blog). This goes back to my earlier post on the “Knowledge Gap” between borrowers and lenders in the mortgage industry and how this gap can be closed. Based on this study more disclosures are not the answer. Basically the borrower does not usually understand the disclosure statements, much less what they are actually mean.

The question continues to be how do you close the “Knowledge Gap”. Personally, I am coming down on the side of eliminating certain types of loans. Specifically, stated income and min doc, the so-called “liar” loans. For both of these loan types the criteria used in decision making (stated income and min doc) are risk related issues that should be eliminated. What “real” banker would make a loan without verifying income or assets? This goes against all the training I ever had.

With regard to ARMs, neg-am, and interest only loans the perspective should be different. For commercial loans a “real” bankers analyze a loan from a cash flow perspective to make certain that there is sufficient cash flow to make the required loan payments. This is the major difference between commercial loans which are made based on cash flow analysis and consumer loans which are based on credit analysis. Credit analysis is based on the applicants previous credit history the chance of the customer repaying the loan based on that history (basis of the FICO score). ARMs, neg-am, and interest only loans should be underwritten using cash flow analysis along with using credit history criteria.

If mortgage lenders were required to complete a cash flow analysis on certain types of mortgage loan products, ARMs, neg-am, interest only, both the lender and borrower would be required to be more knowledgeable about the products and the ramifications of choosing one of the products. Not to mention the fact that a lender could be held liable for cramming a borrower into a product they had no business being in.

These are my thoughts, what do you think?

A study released Wednesday by the Federal Trade Commission found that the required disclosures were ineffective at explaining the costs and risks of home loans. . . . .This has been especially true with increasingly popular but complicated products such as "option ARMs" — adjustable-rate mortgages that let borrowers choose their payment amount each month and can even increase the total amount they owe on their loan.

The FTC doesn't have jurisdiction over loan disclosures, but it decided to examine them after many borrowers complained to it of deceptive tactics used to sell them home loans.The agencies that do oversee mortgage disclosures are the Federal Reserve and the Department of Housing and Urban Development, which respectively monitor the nation's truth-in-lending law and the law governing real estate settlement procedures. Both agencies agreed that home loan disclosures were too complex and said they were working on solutions.

In the FTC study, more than 800 recent mortgage customers were each given disclosure forms for a hypothetical loan. About half got forms of the type currently used. The rest got prototype forms designed by the study authors to be understandable.The study found that when given the disclosures now used:

• Half the borrowers couldn't correctly identify the loan amount.
• Nine in 10 couldn't figure out the total upfront cost of the loan.• Two-thirds did not recognize that they would have to pay a penalty if they paid off the mortgage within two years. And 95% didn't know how much that penalty would be.
• Three-quarters did not know when substantial charges for credit insurance had been included in the loan.
• One in five couldn't correctly identify the annual percentage rate, the amount of cash due at closing or the monthly payment — or whether that payment included charges for property taxes and insurance.

The study's authors said they chose the best disclosures they could find. In other words, many forms used by lenders were less readable than the ones used in the study. Also, the study looked only at fixed-rate loans. Disclosures for adjustable mortgages might be even more confusing.The FTC found that the disclosures it designed improved understanding of 17 of 21 key loan terms.

Gold Market #7 – Some Forecasts from the Former Head of Newmont Mining

Not sure if this is still true, but analysis I did on gold prices back in the 1970s indicated that the price of gold was correlated with inflation. The comments from Lassonde follow that same line of thought. From Bloomberg:

Gold will rise as high as $750 an ounce this year, about $100 more than today, as concern about accelerating inflation spurs demand for the metal as a store of value, Newmont Mining Corp. Vice Chairman Pierre Lassonde said.. . . . Higher interest rates are ``bullish for gold,'' ``The only reason rates are going up is because inflation is going up.''

Gold has climbed 2.3 percent this year, partly on speculation that higher prices for raw materials including crude oil and wheat will spur demand for the precious metal as a hedge against inflation.

The metal's rally has stalled since the end of April mostly because of a seasonal slowdown in jewelry demand in India and Italy, Lassonde said. India was the largest buyer of gold last year and Italy was Europe's biggest manufacturer of gold products, according to London-based research company GFMS Ltd.

``What's going on in my mind is very bullish because if you look at May and June, it's always on a seasonal basis the low months for the gold price,'' Lassonde said. ``It's because the Indian marriage season is over and the Italian jewelers stop buying because they're going into holidays in July.''

The slowdown may cause gold to fall as low as $630 in the next several weeks before rebounding to $700 or $750 by the end of the year, he said.

Toronto-based Barrick Gold Corp. is the world's biggest gold producer.

The PPI is Up in May Due in Large Part to Higher Energy Costs

The economy is beginning to feel the ripple effect as higher energy prices filter through the economy at large. From Bloomberg:

The 0.9 percent increase followed a 0.7 percent rise in April, the Labor Department said today in Washington. So-called core prices, which exclude fuel and food costs, rose 0.2 percent.

The report underscores Federal Reserve concerns that inflation won't moderate as forecast, economists said. Growing demand from overseas has pushed up prices for raw materials such as fuel and metals, giving businesses reason to try to pass on higher costs to customers.

``We have a lot of energy-price pressures that are still working through the system,'' said Stephen Gallagher, chief economist at Societe Generale in New York. . . . .

Yields on Treasury securities rose after the report showed inflation accelerated. The yield on the benchmark 10-year note increased to 5.22 percent at 8:52 a.m. in New York from 5.20 percent late yesterday.

Producer prices rose 4.1 percent from May 2006, the biggest year-over-year increase since June 2006.

Prices excluding food and energy rose 1.6 percent from a year earlier, following a 1.5 percent year-over-year gain the prior month.

Energy prices jumped 4.1 percent last month, the biggest increase since November, after rising 3.4 percent in April.

Today's report showed food prices dropped 0.2 percent in May, led by the biggest decline in vegetable costs in 5 years.

The producer price index is one of three inflation gauges reported by the government. A Labor report yesterday showed prices of goods imported into the U.S. rose more than forecast in May on higher costs for oil and industrial supplies.

The third inflation gauge is the CPI, which is due out tomorrow.

The Bad News in the Housing Market Continues to Roll-In

The following from Bloomberg confirms with numbers the condition of the housing market. When 13% of subprime loans are delinquent there is still a lot of bad news in the pipeline. Don't expect this market to turn around any time soon.

The share of all mortgages entering foreclosure rose to 0.58 percent from 0.54 percent in the fourth quarter, the Mortgage Bankers Association said in a report today. Subprime loans entering foreclosure rose to a five-year high of 2.43 percent, up from 2 percent, and prime loans rose to a record 0.25 percent.

The median U.S. home price probably will fall this year for the first time since the Great Depression in the 1930s, according to Lawrence Yun, an economist at the National Association of Realtors. . . . .

The percentage of total homes in foreclosure, the so-called inventory, also rose for both categories, with subprime loans climbing to 5.10 percent from 4.53 percent, and the prime share rising to 0.54 percent from 0.50 percent.

Living in an area with multiple foreclosures can result in a 10 percent to 20 percent decrease in property values, said John Kilpatrick, president of Greenfield Advisors, a Seattle real estate consulting firm. In some cases that can wipe out the equity of homeowners or leave them owing more on their mortgage than the house is worth.

In the quarter, 2.58 percent of prime borrowers sent their mortgage payments at least 30 days late, a fifth the rate of subprime borrowers, according to the Mortgage Bankers report. The subprime share of late payments rose to 13.77 percent from 13.33 percent in the fourth quarter, according to the report.

Sales of new houses probably will tumble 18 percent this year, on top of an 18 percent drop in 2006, the Chicago-based National Association of Realtors said in a June 6 forecast. Sales of previously owned homes will drop 4.6 percent, following an 8.5 percent decline last year, the trade group said.

The median U.S. price for a previously owned home likely will fall 1.3 percent in 2007 to $219,100, the first national decline on record, and the new-home median likely will drop 2.3 percent to $240,800, the first decrease in 16 years, according to the real estate trade group.
The Mortgage Bankers report is based on a survey of 43.9 million loans by mortgage companies, commercial banks, thrifts, credit unions and other financial institutions.

Issues with Gasoline and Heating Oil Inventories Continue

The US still has issues with inventories of gasoline and heating oil (CNNMoney.com). With a petroleum demand of 21 mb/d (million barrels per day) and a refining capacity of about 17.5 mb/d inventories are critical in the supply pipeline to the consumer.

U.S. heating oil led the gains after a steep fall in supplies over the week left stocks well below year ago levels. Gasoline stocks, keenly watched because of peak summer, were flat. Analysts had expected a sixth consecutive build.

"Seasonal oil product inventory building was already slow in May. It ground to a virtual halt the first week of June," UBS analyst Jan Stuart said in a report, noting total fuel stocks against oil demand stood 4 percent below the five-year average.

If you have an interest in energy related issues read the interview with T. Boone Pickens. User of one of my favorite expressions when people think you naive or unsophisticated, “I didn’t exactly ride into town on a load of water melons”. This "good-ole boy" from Oklahoma has done well for himself and has some good insights on how to succeed in the oil and gas industry.

According to a Harvard Study Housing is Becoming Less Affordable

This is not good news for the US in part because it is home ownership that stabilizes neighborhoods and builds communities. Not to mention that there is no need for parts of the population to feel disenfranchised by not being able to own a home. More from CMMMoney.com:

Home prices may have fallen this year, but a new study says housing has become more unaffordable. . . . .According to the 2007 State of the Nation's Housing report from the Joint Center for Housing Studies of Harvard University, 17 million of American households in 2005 were putting more than half their income into paying for shelter - a rise of 1.2 million from the prior year, and a jump of 3.2 million from 2001.

Three main factors intersect to affect affordability: mortgage rates, income and prices.

Mortgage rates have generally been a favorable part of the equation. Since the start of 2001, they've ranged from an average of 5.23 percent for a 30-year fixed in June, 2003 to 7.16 percent in June of 2006. . . .

Median income, however, has dropped. Real wages fell from 2000 to 2005, according to the report. By 2006 household income was 1 percent below 1999 levels, according to stats from the Current Population Study of the U.S. Census Bureau.

Wages dropped but mortgage rates held steady; affordability shouldn't have suffered too badly if the third part of the equation - housing costs - remained stable.

But they didn't. Single-family home prices skyrocketed, from an inflation-adjusted median of $154,563 in 2000 to $221,900 in 2006, according to the National Association of Realtors (NAR), for an increase of 46 percent.

According to Drew, the affordability decline trend cuts across all incomes. The bottom 25 percent of earners have been hit hardest, but even among the top quarter, the number of households that devote more than half their incomes to housing costs has increased.

That trend accelerated through the housing boom. By 2006, homeowners paid a median of 25.4 percent of their incomes to mortgage payments alone, according to the Harvard study, up from 18.9 percent in 2003.

Some Mortgage Lending Practices Could Be Banned

From Reuters:

The Federal Reserve Board is weighing whether it should ban some mortgage lending practices that fueled the recent housing market boom, Fed governor Randall Kroszner told a panel of lawmakers Wednesday. . . . "We will also seriously consider whether there are mortgage lending practices that should be prohibited,"

Kroszner said the Fed was specifically eyeing 'stated-income' loan applications and prepayment penalties, as well as considering whether lenders should require monthly payments of annual fees like taxes.

This is one way to close the "Knowledge Gap".

Gold Market #6 – Gold and the Dollar

From Bloomberg:

Gold in New York fell to the lowest price in more than two months on speculation that higher interest rates will boost the dollar and reduce demand for the precious metal as an alternative investment. Silver also declined.

Gold generally moves in the opposite direction of the U.S. dollar, which rose for a sixth straight day against the euro as a rout in U.S. Treasuries pushed 10-year yields to the highest rate in more than five years. Holding gold becomes less attractive as interest rates rise because the metal has no fixed returns.

The US Consumer is Hard to Keep Down

Retail sales in the U.S. increased by 1.4% in May compared to April, Bloomberg.

. . . . The increase in sales was the biggest since January 2006. All 13 categories tracked by the government showed an improvement in sales last month, led by a 3.8 percent jump at service stations as gasoline prices rose.

The increase in fuel costs didn't deter Americans from going to the malls and auto dealers. Sales excluding gasoline rose 1.2 percent, the most since July.

Vehicle sales rose 1.8 percent, the must since July, and purchases at department stores surged 1.3 percent, the most since October 2005.

Even housing-related purchases showed gains. Sales at building-materials and garden-supply stores rose 2.1 percent.

Excluding autos, gasoline and building materials, the retail group the government uses to calculate GDP figures for consumer spending, sales rose 0.8 percent, after a 0.1 percent gain in April.

Foreclosure up 90% from May Last Year

It is tough to put a smiley face on the article from CNNMoney.com.

Home foreclosures in May jumped 90 percent from a year earlier, reflecting a poor spring housing market and foreshadowing even higher levels later in 2007, real estate data firm RealtyTrac said Tuesday.

The May foreclosures - a sum of default notices, auction sale notices and bank repossessions - totaled 176,137, up 19 percent from April, the firm said in its May 2007 U.S. Foreclosure Market Report.

Gold Market #5 - Discussion of the Gold Cycle and a Comparison to the 1970s

The following comments come from a South African investment advisor via The Big Picture concerning the gold cycle. The original article contains some good tables and graphs that proves the points made below.

Analyzing the 1971 to 1980 gold bull market, price data show that the first phase from 1971 to 1973 was largely on the back of a weakening dollar, whereas the period from 1974 to 1978 saw increased investment demand, with gold rising in all currencies.

It would appear that we are seeing similar action in the gold market in the current cycle. Although we are all quite familiar with the movements of the dollar gold price, the trend of gold expressed in other currencies receives far less publicity. . . . bullion has been making solid headway since the middle of 2005 in most major (and minor) currencies.

. . . . the bull market in gold that commenced in 2001 goes beyond being only a reflection of dollar weakness. The fact that bullion is rising in all currencies probably points to two aspects, namely: (1) an increasing despondency with paper money, and (2) rising global investment demand for the yellow metal, including more than a modicum of interest from central banks starting to spread their US dollar foreign reserves around.

Another Use of the Higher Levels of Investable Funds in the Economy

There is too much money sloshing around out there and history could be ready to repeat itself. From the Wall Street Journal:

In a world awash in investable funds, even many of the most troubled companies are finding lenders willing to offer them big money. This rescue financing, as it's sometimes called, can give companies time to clean up their balance sheets and avoid a trip to bankruptcy court. U.S. filings for bankruptcy reorganization -- a painful experience for employees, creditors and shareholders alike -- are at a 10-year low. Also at historic lows are U.S. corporations' debt defaults.

But some worry that all the money flowing to troubled companies deters them from solving their problems. At times it just lets them "kick the can down the road," . . . .

It also can be risky to have so much debt sloshing around the economy's shakier regions. When rescue lending fails, the extra debt can make a bust just more spectacular. Among lenders that risk taking it on the chin are some hedge funds, which have largely replaced banks as lenders in this kind of finance. . . .

Rescue money can come in the form of bonds or even equity infusions, but many of the recent deals involve credits known as leveraged loans -- those carrying interest rates of at least 1¼ or 1½ percentage points above the London interbank offered rate, or Libor. . . .

The question that should be asked (and answered) is why would someone lend a troubled comapny money at Libor + 1.5% (about 6.86% at current rates). Currently one can purchase a number of medium term Treasury securities with no risk of default at yields just over 5% . Going to the mutual fund market one can easily obtain yields of 5% to just over 7% with almost no risk of default. If money is "so cheap" individuals lending in high risk situations are not being properly being compensated for their risk. In this case buy no default government or low default corporate debt instruments, relax, go sip a mint julep on the veranda, and stop trying to squeeze an extra 0.5% out of a company by taking on a much higher level of risk.

The Federal Reserve is watching the leveraged-loan market as an "area of possible financial risk," a Fed governor, Randall S. Kroszner, said in a recent speech. He said the Fed was "mindful that high levels of leverage can lead to credit problems relatively quickly for both borrowers and lenders when conditions turn.". . . .

This has happened before.

. . . . late-1980s era of high-yield "junk" bonds gave way in the early 1990s to a recession, the collapse of savings-and-loans and the downfall of the main junk-bond underwriter, Drexel Burnham Lambert Inc. A severe credit crunch ensued, with all but blue-chip companies having trouble securing debt funding.

In 1998, a crisis at hedge fund Long Term Capital Management, amid turmoil in global debt markets, brought on a milder credit squeeze. Three years later the combination of the dot-com meltdown, another recession and the Sept. 11, 2001, terrorist attacks led to a wave of bond defaults. The default rate on high-yield bonds soared to nearly 13% in 2002, according to data compiled by New York University.

Today, the default rate on leveraged loans, which are somewhat akin to high-yield bonds, is running below 1%. Credit-rating agencies expect it to move higher. Standard & Poor's Corp. foresees a 2.7% default rate by next April. That still would be below the 3.3% long-term average.
Meanwhile, last year saw only 30 corporate bankruptcy filings with liabilities over $100 million in the U.S. There were more than 100 a year from 1999 through 2002.

In the past, banks were the main source of leveraged loans. But now hedge funds -- investment partnerships for institutions and the rich -- and other nonbank institutions make up about 75% of investors in this market. Many rescue loans are secured or are fairly senior. In some cases, if they go sour, the lender may be able to turn its loan into equity or control of the borrower. Hedge funds are generally more open to doing that than banks are.

Past experience in banking has shown me that companies that lend money for a living do poorly at running companies such as pipelines, mining companies, shopping malls, etc. that they took over because the borrower could not repay the loan.

Financial Condition of US Households

The Daily Global Commentary from the Northern Trust usually provides an interesting point of view. In Monday’s commentary they discuss the debt and liquidity position of the US household. Needless to say, debt is high and liquidity is low. The question is what numbers define the breaking point for US consumers where they cannot go on any further?

In 2007:Q1, total household debt represented 18.584% of the market value of total household assets – just off the record high of 18.684% set in 2006:Q3.

Unfortunately, I could not reproduce the graphs so you have to trust me on some of my approximations. Basically the total household debt to total household assets went from 6% to 15% in about 40 years (1950 to 1990). This same value remained at about 15% through the mid-1990s and then drop to about 13% by 2000. In 6 years time (since 2000) this same value has increased 42% to about 18.584%. The average household has "levered up" considerably and this value may get worse the value of home values begin to decline.

Households’ single-largest asset, their houses, is carrying record debt relative to its market value. I can’t confirm it, but conventional wisdom has it that about one-third of all owner-occupied housing has no debt associated with it. If that’s case, then with record leverage in housing today, the two-thirds of houses with debt associated with them must have an incredibly high debt-to-value ratio.

The total mortgage debt/market value of owner occupied real estate was about 18% in 1950, increasing to about 30% in 1982. Since that time it has risen steadily to about 48%. Once again this number will only get worse as the value of homes declines.

With total household leverage just off a record high, household liquidity, defined as total household deposits as a percent of total household debt, is just off a record low.

This value 1950 was about 160%. It fell to about 120% by 1960 and hung in that 120%-range until about 1983. Since that time it has fallen steadily to about 50% today.

As alluded to in an earlier post, the high level of debt and low liquidity is unchartered terrirtory for most organizations trying to understand consumer behavior. However, high leverage and limited liquidity is always a bad combination. In this case the US consumer has to keep working, to keep that income rolling-in, to keep all the balls in the air (servicing all that debt). Lose that income and the juggling act ends. Done on a large enough scale and personal consumption expenditure (PCE), the value accounting for 70%+ of the GDP value begins to drop, leading to an economic downturn and recession if the downturn is severe enough.