MBA Shows That Delinquency and Foreclosure Rates are Up in the US

For Q2 2007 the delinquency rate is up almost 17%, mortgages in foreclosure are up 41%, and loans entering the foreclosure process are up 51% compared to the second quarter of last year according to the Mortgage Bankers Association. The culprits states seem to be driven by CA, AZ, FL, and NV. The upper Midwest states of MI, OH, IN, and IL continue to be a problem along with PA, KY, and TN. The culprit loan types are subprime and ARMs. There is nothing new here, but the proof of a very weak housing market continues to roll in.

The delinquency rate for mortgage loans on one-to-four-unit residential properties stood at 5.12 percent of all loans outstanding in the second quarter of 2007 on a seasonally adjusted (SA) basis, up 28 basis points from the first quarter of 2007, and up 73 basis points from one year ago, according to MBA’s National Delinquency Survey.

The delinquency rate does not include loans in the process of foreclosure. The percentage of loans in the foreclosure process was 1.40 percent of all loans outstanding at the end of the second quarter, an increase of 12 basis points from the first quarter of 2007 and 41 basis points from one year ago.

The rate of loans entering the foreclosure process was 0.65 percent on a seasonally adjusted basis, seven basis points higher than the previous quarter and up 22 basis points from one year ago. This quarter’s foreclosure starts rate is the highest in the history of the survey, with the previous high being last quarter’s rate.

Similar to last quarter, the national delinquency and foreclosure rates are being driven by what is taking place in a few large states. Additionally, the performance of prime and subprime adjustable rate mortgages (ARMs) is contributing significantly to the overall results.

“The percent of mortgages in Ohio that are 90 days or more past due or in foreclosure is still more than twice the national average and 1% of all of the mortgages in Michigan had foreclosure actions started on them during the last quarter, essentially the same rate as during the last quarter. Problems are still significant in the nearby states of Indiana, Illinois, Kentucky, Tennessee and Pennsylvania. While Michigan’s problems continue to escalate, however, Ohio’s have shown signs of leveling off, albeit at a high level,” said Doug Duncan, MBA’s Chief Economist and Senior Vice President of Research and Business Development.

“What continues to drive the national numbers, however, is what is happening in the states of California, Florida, Nevada and Arizona. Were it not for the increases in foreclosure starts in those four states, we would have seen a nationwide drop in the rate of foreclosure filings. Thirty four states had decreases in their rates of new foreclosure and the increases were very modest in the states with increases, other than those four,” Duncan said.

“In addition, there is a clear divergence in performance between fixed rate and adjustable rate mortgages due to the impact of rate resets. While the seriously delinquent rate for prime fixed loans was essentially unchanged from the first quarter of the year to the second, and the rate actually fell for subprime fixed rate loans, that rate increased 36 basis points for prime ARM loans and 227 basis points for subprime loans.

“What is not clear, however, is whether subprime ARM loans are causing the problems for California or whether California is causing the problems for subprime loans. California has 17 percent of the subprime ARMs in the country and over 19% of the foreclosure starts on subprime ARMs. The four states of California, Florida, Nevada and Arizona have more than one-third of the nation’s subprime ARMs, more than one-third of the foreclosure starts on subprime ARMs, and are responsible for most of the nationwide increase in foreclosure actions.
“There are special circumstances driving conditions in those four states that will likely make things worse:

• Declining home prices make refinancing of these ARMs difficult, particularly if the borrower originally put down little if any down payment. Home prices have dropped in all four of these states and 52 of the 59 MSAs in the four states saw home price declines during the second quarter according to the Office of Federal Housing Enterprise Oversight (OFHEO).

• The root of the home price problem there is that the inventory of new homes available for sale in the Western Region hit an all-time record high at the end of the second quarter. In addition, Florida continues to see a major supply of condos and other new homes on the market.
• These four states have a disproportionately high share of investor loans, or loans to buyers who do not plan to live in the house. As of June 30, the non-owner occupied share of defaulted loans (90 days of more past due or in foreclosure) was 32 percent in Nevada, 25 percent in Florida, 26 percent in Arizona and 21 percent in California, compared with 13 percent in the rest of the nation. These investors are much more likely to default on their mortgages if they see the value of their investments falling due to falling home prices.

“Therefore, the problems in these states will continue, and they will continue to drive the national numbers, but they do not represent a national problem,” Duncan said.

Change from last quarter (first quarter of 2007)

The SA delinquency rate increased 15 basis points for prime loans (from 2.58 percent to 2.73 percent) and 105 basis points for subprime loans (from 13.77 percent to 14.82 percent). The delinquency rate increased 43 basis points for FHA loans (from 12.15 percent to 12.58 percent) and decreased 34 basis points for VA loans (from 6.49 percent to 6.15 percent).

The foreclosure inventory rate increased five basis points for prime loans (from 0.54 percent to 0.59 percent), and increased 42 basis points for subprime loans (from 5.10 percent to 5.52 percent). FHA loans saw a four basis point decrease in foreclosure inventory rate (from 2.19 percent to 2.15 percent), while the foreclosure inventory rate for VA loans decreased three basis points (from 1.05 percent to 1.02 percent).

The SA foreclosure starts rate in the second quarter was 0.65 percent, seven basis points higher than the first quarter of 2007 rate of 0.58 percent. By loan type, the foreclosure starts rate increased two basis points for prime loans (from 0.25 percent to 0.27 percent), 29 basis points for subprime loans (from 2.43 percent to 2.72 percent). The foreclosure start rate decreased 11 basis points for FHA loans (from 0.90 percent to 0.79 percent) and four basis points for VA loans (from 0.41 percent to 0.37 percent).

The seriously delinquent rate, the non-seasonally adjusted (NSA) percentage of loans that are 90 days or more delinquent, or in the process of foreclosure, was up from both last quarter and from last year. This measure is designed to account for inter-company differences on when a loan enters the foreclosure process. During the second quarter, the seriously delinquent rate increased 24 basis points to 2.47 percent from 2.23 percent. The rate increased nine basis points for prime loans (from 0.89 percent to 0.98 percent), increased 94 basis points for subprime loans (from 8.33 to 9.27 percent), decreased eight basis points for FHA loans (from 5.26 percent to 5.18 percent) and decreased 10 basis points for VA loans (from 2.45 to 2.35 percent).

Change from last year (second quarter of 2006)

The SA delinquency rate increased for prime, subprime, and FHA loans and decreased for VA loans. The delinquency rate increased 44 basis points for prime loans, increased 312 basis points for subprime loans, and increased 13 basis points for FHA loans. The delinquency rate for VA loans decreased 20 basis points.

The foreclosure inventory rate increased 18 basis points for prime loans and 196 basis points for subprime loans. The foreclosure inventory rate decreased five basis points for FHA loans and eight basis points for VA loans.

The SA foreclosure starts rate increased 22 basis points overall, nine basis points for prime loans, 93 basis points for subprime loans, four basis points for FHA loans, and two basis points for VA loans.

The seriously delinquent rate was 23 basis points higher for prime loans and 304 basis points higher for subprime loans. The rate decreased 22 basis points for FHA loans and 18 basis points for VA loans.

Another Article About the Increased Chances of a Recession

Mark Zandi, the chief economist at Moody's Economy.com, has increased his chances of a recession in the US to 40% over the next 12 months, from CNNMoney.com. Admittedly, no one knows if or when the next recession will occur, but the point of the this post and two previous posts on this site (#1 and #2) is that many are beginning to state that the chances are getting higher for a recession within the next year. The real problem is that we are in uncharted territory with regard to the housing slump. Everyone knows that there will be job losses, wealth losses, and less spending money due to housing, but no one is sure how this will impact consumer spending.

Moody's Economy.com is forecasting an increased risk for recession in the next six to 12 months due to the subprime mess, which has shaken investor and consumer confidence, bumped up foreclosures and led to a tightening of credit standards for most loans.
Mark Zandi, Economy.com's chief economist, now sees a 40 percent chance of recession, up from the roughly 12 percent chance he was forecasting in August. Nevertheless he doesn't think the economy will actually sink into recession, by which he means broadly persistent declines in economic activity.

"The economy may be contracting now, but for it to be a recession it has to last more than a few months," Zandi said. And it has to broadly affect most sectors. For now, he thinks the greatest risk is concentrated in housing.

"I think the housing sector is going to get hammered," Zandi said. That will show up as continued declines in construction and median home prices as well as job losses in companies with ties to the housing industry.

Economy.com is forecasting that foreclosures will peak at close to 1 million in 2008, and that the existing single family median house price will bottom out at just over $200,000 by mid-2008.

That's down from $220,000 today, a level that likely won't be recovered until 2010, Zandi predicts.

But, Zandi said, "I don't think consumer spending will fall unless the job market is contracting. And I'm fundamentally optimistic we won't see job loss," Zandi said.

He does, however, expect slower growth in jobs and hiring as well as in consumer spending, which he forecasts will grow 1.5 percent over the next year, down from the 3 percent recorded in the second quarter.

Another Heavy Hitter is Increasing the Chances for a Recession

The former Secretary of the Treasury is stating that the chances of a recession have gone up. Tighter credit standards, higher interest rates, etc. could cause a slow down in consumer spending, from Bloomberg:

The pain from higher borrowing costs may be spreading as consumers and businesses follow investors in shying away from risk, increasing the odds of a recession.

``While there is no basis for predicting a recession right now, the risks have surely gone up,'' says former Treasury Secretary Lawrence Summers, now a professor at Harvard University in Cambridge, Massachusetts. ``The combination of softness in the housing sector, contractions in credit, increased uncertainty and volatility, and losses in wealth make the chances significantly greater now.''

Economists at JPMorgan Chase & Co., Lehman Brothers Holdings Inc. and Merrill Lynch & Co. are among those lowering economic forecasts as the rising cost of credit prolongs the worst housing recession in 16 years. Now, two areas of the economy that have held up well so far, jobs and consumer spending, no longer appear immune to the fallout. . . . .

. . . . ``We're taking the pulse of the economy a little more frequently,'' says Jonathan Basile, an economist at Credit Suisse Holdings in New York. ``If the spillover from the credit crunch gets into autos, it would be the second major sector to fall and would solidify a lot of the fear in the markets.'' . . . .

. . . . Confidence is critical at key junctures in the economy. If consumers and companies turn more pessimistic about the outlook and cut back on their spending, such gloominess can prove to be self-fulfilling, triggering a recession.

A sudden drop in consumer confidence at the end of 2000, coupled with a contraction in manufacturing and a two-year-low in motor-vehicle sales, helped set the stage for the last recession, which began in March 2001.

The omens today aren't particularly promising. An index of global business confidence compiled by Moody's Economy.com in West Chester, Pennsylvania, fell in late August to its lowest level since the middle of the U.S.-led invasion of Iraq in 2003.

Consumers are also showing signs of being spooked by the turmoil in financial markets. U.S. consumer confidence tumbled last month by the most since Hurricane Katrina struck two years ago, according to the Conference Board, a private research group in New York.

Credit Market Fall-Out # 25 – Changes in the Reserve Requirements for Banks

The excerpts below from a WSJ article on the changing reserve requirements of banks and how this played into the current problems in the credit markets is interesting. Markets are “funny” places if you push in one place, it gives in another that no one anticipated. See the post below to see how this “give” fits into the capital markets.

Even before the current financial firestorm passes, the search for people and institutions to blame has begun: Greed and hubris overtook common sense and propriety. Excessively easy credit overwhelmed good judgment and fueled a housing bubble. Profit-grubbing crooks took advantage of unsophisticated home buyers. Rating services blew it. Government overseers couldn't keep up with financial innovation. U.S. regulators let shady subprime lenders slip through cracks in archaic rules. European bank regulators were blind.

The right answer will prove to be some combination of the above. One culprit, however, has gone unnoticed: A sweeping change in international rules governing the capital banks must hold. By requiring banks to boost the capital held in reserve against the loans carried on their books, the rules encouraged banks to get rid of those loans by turning them into securities to be sold to investors. Banks took the hint.

That's complicating the Federal Reserve's efforts to put out the current fire.

For more than 20 years, a club of central bankers has been tinkering with rules -- known as Basel, for the Swiss city in which officials meet -- to get banks to hold more capital so they can absorb major losses without threatening the financial system. Details are so technical that only insiders pay attention. Most of the time that's just fine. The battles over the rules typically have had more to do with banks and countries jockeying for advantage than anything that mattered to borrowers in Boise or Bremen.

The rules are rooted in the worries of wise men like Paul Volcker, the former Fed chairman, that banks didn't have enough capital, an especially acute concern after Germany's Herstatt Bank defaulted on obligations to foreign banks in 1974 and the U.S. government rescue of big Continental Illinois National Bank & Trust in 1984.

The solution: A 1988 international accord required banks (in countries where national authorities adopted the rules) to hold more capital if they make riskier loans and investments. A bank that loans $100 million to other solid banks needs only $1.6 million in capital; a bank that loans $100 million to ordinary companies needs $8 million capital.

Banks are a special case. They're traditionally at the center of the financial system; bank panics led Congress to create the Fed in 1913. And government insurance of bank deposits means most depositors needn't worry if their banks make foolish loans. That can give bankers a heads-we-win/tails-you-lose incentive to gamble that regulators must monitor.

The original Basel rules were crude, overwhelmed when banks figured out how to game them and were recently revised. The rules did succeed in getting banks to strengthen their financial footing. They did reduce the risks most banks take. Was that the intention? Yes. Is that always a good outcome? Well, maybe not.

Among other things, the rules required banks to hold more capital against an ordinary mortgage than against pools of mortgages turned into securities. So banks sold off individual mortgages and many replaced them with securities comprising pools of mortgages. Between 1988 and 1993, these mortgage-backed securities rose to more than 9% of bank assets from 2.9%.

This huge change in finance has advantages. Banks still make loans and hold them, but are more likely to originate and distribute loans. As a result, much of the risk of delinquencies on mortgages in inner-city Detroit isn't shouldered by local banks but has been shifted to investors all over the world. (How many of these hot potatoes may actually return to bank balance sheets is a question for another column. Short answer: More than some bankers would like.)

It turns out, the folks who hold mortgage-backed securities are forced to be much quicker than banks are to acknowledge reality when the value of the collateral for loans drops. And banks now behave more like securities firms, more likely to mark down the value of assets when market prices fall -- even to distressed levels -- rather than sitting on bad loans for a decade and pretending they'll be paid back.

It's a huge contrast to the bad old days of the early 1980s when big New York banks found themselves holding lots of bad loans to Latin American governments and took years to write them down -- or when Japanese banks' reluctance to admit the size of their bad-loans problem paralyzed Japan's economy.

But it may have some unwelcome effects: Banks aren't the shock absorbers they once were at a moment of market panic. Because they hold fewer loans on their books, banks don't have the ability to say, "These mortgages are more likely to be paid off than the market thinks today, and we'll just hold on until the market comes to its senses." Instead, the holders of mortgage-backed securities are dumping them, pushing down the price. This forces other leveraged players -- those backed by borrowed money -- to sell their holdings and, if not interrupted, an economically devastating downward spiral can take hold.

The Fed is now laboring to prevent such an outcome. But its tools are designed with banks in mind, not for a world in which banks have shifted risks to all sorts of other leveraged investors who are now forced to be obsessed with the value of their collateral.

The Fed, which was an enthusiastic proponent of these risk-based capital standards and securitization, is trying to prime the banking pump to put out the fire. Ironically, it's discovering that's harder because of unappreciated consequences of the Basel rules that were intended to make the banking system more fire-resistant.

This Weekend’s Contemplation – New Currency Arrangements?

If you couple the continued weakness of the dollar, with capital market problems, and the rise of other countries in terms of their economic status, I have suspected for some time there will be changes in the level of importance of US dollar for international trade. I do not know where the push will come from (i.e. Europe, Russia, the Middle East, etc.), but it is something in which to be aware. From the WSJ earlier this week.

American fighter jets scrambled to intercept Russian bombers earlier this month near the island of Guam. It was the first time since the end of the Cold War that the Kremlin sought to provoke a U.S. response. It likely will not be the last. Fueled by revenues from energy exports, Russia appears bent on ratcheting up tensions.

But don't expect the next foray to take place over international waters. Vladimir Putin laid bare his ambitions at the St. Petersburg International Economic Forum in June by calling for a "new international financial architecture" to provide a base for economic development. Russia's next move is to challenge U.S. supremacy in world financial markets.

The notion of nudging America off its central perch in global economic affairs hardly seems plausible. But Russia's leader strikes a chord with other emerging-market economies -- Brazil, China, India -- when he describes current monetary and financial arrangements as "archaic, undemocratic and unwieldy."

Given the recent turmoil in world financial markets, Mr. Putin can expect heightened interest in his pitch for new regional alliances "based on trust and mutually beneficial integration" versus continued dependence on global institutions like the International Monetary Fund. Both Europe and Asia blame U.S. credit woes for their own unsettled markets. And newly independent nations on the periphery of established trade and security blocs have their own reasons to align with powerful patrons.

Mr. Putin even suggests that central banks should begin to hold reserves in a wider selection of currencies than dollars and euros in recognition of the "existing balance of power." It's hard to miss the implication: the ruble as a global reserve currency.

Is the man serious? The only reason the European Central Bank, say, or China's central bank, might hold reserves in rubles would be to pay for purchases from Russia. Today it is possible to buy Russian oil and gas using dollars or euros. The leading market exchanges for conducting international energy transactions are located in New York and London. But that is why officials at the White House, the Federal Reserve and the U.S. Treasury should be scrambling right now.

Mr. Putin is more than serious. He is determined to establish a world-class oil exchange on Russian territory and shift energy business away from existing global financial centers. A new facility is being readied in St. Petersburg's historic Bourse -- an imposing, white-colonnaded Greek Revival building that dominates the majestic sweep of the Strelka, or Spit, of Vasilievsky Island in the Neva delta and which is visible from the Winter Palace -- that will open to market traders within months and where transactions will be denominated in rubles.

It's a daring gambit and it constitutes no less than a demand for new international monetary arrangements on the scale of the post-World War II Bretton Woods agreement. "The global economy has experienced a transition," Mr. Putin notes pointedly. "Fifty years ago, 60% of world gross domestic product came from the Group of Seven industrial nations. Today 60% of world GDP comes from outside the G7."

Mr. Putin's plan to confront the privileged global role of U.S. currency resonates with Russians eager to recapture nationalist pride. Lampooning the sickly American dollar is popular with members of the Kremlin-financed youth group Nashi (meaning "ours"). And it potentially accommodates the burgeoning economic aspirations and swelling egos of Russia's partners in the Shanghai Cooperation Organization: Kazakhstan, Kyrgyzstan, Tajikistan, Uzbekistan and China.

China, like Russia, bristles at its second-tier status within the global financial architecture. Harangued by the U.S. over exchange-rate policies, China has recently been flexing its monetary muscle by hinting that it might dump a portion of its considerable dollar reserves. The prospect of such a shock to the U.S. economy in the midst of a housing slump threatens to bring the whole edifice crashing down. Throw in statements of support from oil-producers Venezuela and Iran, and you have the makings of a devastating dollar rout.

If Russia insists that its energy clients pay in rubles, we cannot expect our allies to strenuously resist. Europe purchases nearly 30% of its energy from Russia. Rising energy demand in Asia will likewise boost demand for rubles as Russia targets China, India and Japan. Last month, Japan quietly acquiesced to Iran's request that it switch from dollars to yen in payment for Iranian oil.
Can U.S. leaders and financial authorities meet the challenge from the Kremlin? Is America prepared to offer its own proposals for establishing more stable currency and financial conditions for global trade? Or are we just interested in protecting our turf?

The next Bretton Woods should be launched as an earnest initiative from the nation that gave birth to democratic capitalism. Not as an act of aggression from a pumped-up Russian pretender.

Some Perspective on Bernanke’s Speech

The excerpts below are from a WSJ article giving some perspective on Bernanke’s speech in Wyoming.

The Federal Reserve won't bail investors out of their bad decisions but will act if recent market turmoil threatens economic growth, Chairman Ben Bernanke said Friday.

Mr. Bernanke's much-anticipated speech solidified investor expectations the Fed will cut its target for the federal-funds rate -- charged on overnight loans between banks -- from 5.25% when policy makers meet Sept. 18. Markets see some probability the rate will drop to 4.75% but several economists said a drop to 5% is more likely, accompanied by a statement suggesting more cuts could come. Those expectations helped boost stocks.

The speech was Mr. Bernanke's first since credit-market turmoil erupted shortly after the Fed's latest policy meeting, on Aug. 7. He sought to delineate the Fed's separate responsibilities for keeping the financial system operating smoothly and maintaining economic growth. At the same time, he made clear that financial instability also affects growth and thus the Fed's interest-rate deliberations.

"It is not the responsibility of the Federal Reserve, nor would it be appropriate, to protect lenders and investors from the consequences of their financial decisions," Mr. Bernanke told the audience of academics, central bankers and Wall Street economists from around the world gathered at the Kansas City Fed's annual symposium in Jackson Hole, Wyo. "But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy." . . . .

. . . . Elaborating Friday, Mr. Bernanke said financial markets reflect not just a concern about the eventual economic impact of a weaker housing market, but also a rise in uncertainty and risk aversion generally. Risk premiums -- the additional return lenders and investors require for dicey investments -- had been "exceptionally low" so some increase "is probably...healthy." But he said heightened risk aversion, when mixed with "heightened concerns about credit risks and uncertainty about how to evaluate those risks," created "significant market stress."

While not explicitly signaling the Fed's plans, the speech did make clear, according to some economists, that Mr. Bernanke is intimately aware of what has gone on in markets and the implications. That alone, some say, can help confidence. "There was a time...when a lot of Wall Streeters were referring to Bernanke as an academic who had no clue what was going on out in the real world," said Stephen Stanley of RBS Greenwich Capital Markets. "He has done his best to disabuse market participants of that impression over the last few weeks without giving in to their pleas for immediate help."

President of NBER Wants the Fed to Cut the Fed Funds Rate by 1% to Avoid Recession

The following is an article from Bloomberg concerning a speech given by Martin Feldstein, President of the NBER, the people that define recessions. Dr. Feldstein basically wants the Fed to cut the Fed Funds rate by 1% in the hopes of avoiding a recession. From any other source you may disregard this request as so much self-serving rhetoric. For example, may be the guy has a hedge fund to save. But, Martin Feldstein is head of the outfit that defines when a recession starts and stops. What is he seeing in he tea leaves that the rest of us do not see?

Harvard University economist Martin Feldstein said the U.S. housing slump threatens a broader recession, and the Federal Reserve should lower interest rates.

``The economy could suffer a very serious downturn,'' Feldstein, head of the group that charts America's business cycles, told a Fed conference in Jackson Hole, Wyoming, yesterday. ``A sharp reduction in the interest rate, in addition to a vigorous lender-of-last-resort policy, would attenuate that very bad outcome.''

Feldstein made a case for lowering the overnight lending rate between banks to 4.25 percent from 5.25 percent to cushion the economy from the fallout of defaults on subprime mortgages.

Chairman Ben S. Bernanke told the same gathering on Aug. 31 that the Fed will do what's needed to stop the past month's credit- market rout from ending the six-year expansion.

Lowering interest rates may result in a ``stronger economy with higher inflation than the Fed desires,'' a situation that Feldstein described as the ``lesser of two evils.''

``If that happens, the Fed would have to engineer a longer period of slow growth to bring the inflation rate back to the desired level,'' said Feldstein, 67, president of the National Bureau of Economic Research. Some investors speculated that Feldstein was a candidate for Fed chairman before Bernanke was picked to succeed Alan Greenspan.

Bernanke wasn't in the room for Feldstein's speech, though most other Fed officials were, along with central bankers and economists from around the world who traveled to the annual mountainside conference hosted by the Kansas City Fed bank.

``Marty is a guy of good judgment,'' said former Fed Governor Lyle Gramley, who attended the event. ``Everybody in the room recognizes that. Everybody, including the people at the Fed, will think carefully about what he said.''

The U.S. economy expanded at a 4 percent annual rate in the second quarter, the fastest pace in more than a year, before turmoil in the credit markets forced the Fed to warn in an Aug. 17 statement that risks of slower growth had increased ``appreciably.''

Already, some indicators are suggesting a weakening economy. First-time applications for jobless benefits rose to the highest level since April in the week ended Aug. 25. Property values in 20 metropolitan areas fell 3.5 percent in June from a year earlier, according to an Aug. 28 report by S&P/Case-Shiller.

The economy was last in recession from March to November 2001, according to NBER.
Feldstein outlined a ``triple threat'' from housing: a ``sharp decline'' in home prices and construction; higher borrowing costs and a ``freeze'' in credit markets stemming from subprime-mortgage losses; and fewer home-equity loans and refinanced mortgages, leading to less consumer spending.

Investors expect the Fed to cut the federal funds rate on overnight loans between banks to 5 percent on Sept. 18 and at least another quarter-point by year's end. The central bank has left the rate at 5.25 percent since June 2006 after raising it from 1 percent over a two-year period.
Gramley, a senior economic adviser at Stanford Group Co. in Washington, said he was surprised by the gloominess of Feldstein's 25-minute speech, which capped a conference where many participants were pessimistic.

Kansas City Fed President Thomas Hoenig, speaking briefly after Feldstein, said the symposium gave him and probably his colleagues ``a lot of useful information to use as we deal with some difficult issues that confront us all.''

Earlier in the day yesterday, Fed Governor Frederic Mishkin presented a paper in which he said that U.S. banks can cope with ``stressful'' conditions and that the financial system is in ``good health'' even with the disruptions of the mortgage market.

Mishkin also reiterated that policy makers should avoid setting interest rates according to swings in the housing market and respond ``only to the extent that they have foreseeable effects on inflation and employment.'' That point was challenged by some participants, including Bank of Israel Governor Stanley Fischer.

Feldstein had said in an interview on Aug. 31 that there is a ``significant risk'' of a downturn and urged the Fed to cut borrowing costs.

Feldstein is a member of the Business Cycle Dating Committee of the NBER, which like Harvard is located in Cambridge, Massachusetts. The panel includes six other economists and is chaired by Robert Hall, an economist at Stanford University's Hoover Institution.

CDOs, Credit Derivatives, Capital Markets, Etc. – How It All Fits Together

Below are excerpts from an article in the NY Times that gives an excellent summary of the capital market insturments and how it all fits together.

. . . . . the global financial turmoil — set off by problems with subprime mortgages — has prompted a backlash in some quarters against such financial engineering (derivatives and structured products).

More broadly, it has led to a better understanding of the downside of spreading risk so well — it can be felt in all corners of the world, unsettling hedge funds, banks and stock markets as far away as Australia, Thailand and Germany. In effect, reducing risk on a global scale appears to have increased it for some players.

“The market appears to be finding it harder to truly understand the inherent and underlying risks involved,” said Chris Rexworthy, who was a regulator with the Financial Services Authority in Britain for 10 years before moving recently to the private sector.

The backlash is particularly sharp abroad, in countries that were surprised to find that problems with United States homeowners could be felt so keenly in their home markets. Foreign politicians and regulators are seeking a role in the oversight of American markets, banks and rating agencies. The head of the Council of Economic Analysis in France has called for complex securities to be scrutinized before banks are authorized to buy them.

In the United States, regulators appear to think that the new and often unregulated investment vehicles — which have shrunk the world and speeded up business in much the same way as the Internet — are not all inherently flawed.

This opinion is captured in an analogy offered by Peter Douglas, the founder of GFIA, a hedge fund research firm in Singapore. He likens using derivatives to power tools. If you know how to use them, he said, they are exponentially better and faster for building a house, compared with using hammers, screwdrivers and handsaws.

If you don’t, “you could drill a hole in your head," he said.

Funds and banks around the world have taken hits because they purchased bonds, or risk related to bonds, backed by bad home loans, often bundled into financial instruments called collateralized debt obligations, or C.D.O.’s.

The losses have often surprised the investors, and in some cases the funds and the executives of the banks, who were unaware of the extent of their risks.

The crisis extended as far as the $2.2 trillion money market that finances the day-to-day operations of businesses, as investors wondered whether the underlying assets were sound. “It’s amazing how much ignorance and fear are out there,” said Kevin Davis, a professor of finance at the University of Melbourne.

The confusion about these products lies in part in their complexity. Structured products are pooled assets that have been sliced and diced into ever more smaller, more specialized pieces.
They offered investors higher returns at a time when traditional fixed income, or debt-related products, were producing low returns.

As low interest rates fueled a lending boom to borrowers with weak credit, banks looked for new ways to package those loans, so they could sell more. A central building block to offset the risk was asset-backed securities, which are bonds backed by pools of mortgages or other income-producing assets, like student loans, auto loans, and credit card receivables.

Banks and other financial institutions pooled those asset-backed securities into new units, dividing them up again and issuing securities against them, creating collateralized debt obligations.

The idea took off, with new combinations that were further removed from the original asset. New creations included C.D.O.’s of C.D.O.’s, called C.D.O.-squared. There is even a C.D.O.-cubed.
According to JPMorgan, there are about $1.5 trillion in global collateralized debt obligations, and about $500 billion to $600 billion in structured-finance C.D.O.’s, referring to those made up of bonds backed by subprime mortgages, slightly safer mortgages and commercial mortgage backed securities.

Many of the products have proved to be highly problematic as the underlying assets — the subprime mortgages — have gone bust, revealing dangerous amounts of leverage in the securities that few people could value. As a result, they have become like a potent computer virus, leaving many people fearful that they too will be affected.

“A lot of risk in the subprime asset-backed market is embedded in, and amplified by, C.D.O.’s,” said Rod Dubitsky, head of asset-backed research at Credit Suisse.

Weaknesses in the system were laid bare, including ratings that did not accurately reflect risk and faulty assumptions on how diversified pools with multiple layers of leverage would react.

That in turn spooked investors in other markets, who started selling anything they thought might be risky, from stocks to loans, and in some cases putting their money into cash.

The combination of a subprime shock, “untested financial innovation and leverage has led to a confidence crisis,” said Pierre Cailleteau, Moody’s Investors Service chief economist in London.
The advent of radically more complex structured products coincided with another trend in finance: the explosion of credit derivatives, financial tools that enabled institutions like banks and hedge funds to try to hedge exposure to the huge credit market, like loans to corporations.

“Credit derivatives are the fastest-growing part of any bank,” says Derek Smith, head of flow credit trading at Deutsche Bank. He cited 80 percent growth in 2007 for his firm and average annual growth of about 40 percent for the industry.

Blythe Masters, a veteran of the credit derivatives revolution and the global head of currencies and commodities at JPMorgan Securities, added, “There has been a wall of money coming at the credit markets in the past five years.”

Credit default swaps (what are widely known as a credit derivatives) allow two parties to exchange the credit risk of an issuer, such as a company. For example, if an investor buys a credit default swap on General Motors, called buying protection, he or she makes money when the credit weakens and makes a lot of money if G.M. goes bankrupt.

In the meantime, the seller of protection makes a fee from the buyer and profits if the company’s credit improves.

Credit derivatives radically shifted the financial landscape for two reasons: they allowed banks to hedge some of their exposure to the huge loans they give corporations, and they have allowed investors to bet against, or short credit, as a hedge and to speculate.

For banks, shedding exposure to the credit risk of companies, or governments, or individuals, means not having to reserve as much capital for potential losses. That frees up capital to make even more loans — to homeowners, institutional investors, corporations or hedge funds.

The banks found a perfect partner in hedge funds, lightly regulated pools of capital with high fees that were looking for better returns. Insurance companies and pension funds also sought the higher returns, called yield, as interest rates hit historically low rates.

“Fundamentally, having 100 or 1,000 people with a slice of the risk is better than a bank holding 100 percent of the risk,” said Robert G. Pickel, chief executive of the International Swaps and Derivatives Association.

As the market for C.D.O.’s backed by structured products choked in recent weeks, the overall credit derivatives market has performed well, say some industry participants.

“Credit derivatives have done a good job at doing exactly what they should do: they have accurately and immediately reflected the markets’ pricing of risk throughout this crisis,” Ms. Masters said. But there has been a lot of pain. Investors purchasing derivatives are making a bet that the underlying stock or bond or loan is going to rise or fall, but they do not own it. Because buying a derivative requires much less capital than buying the loan or bond it is derived from, banks and traders can buy more of them than they could loans or bonds. That can translate into huge gains — or, in times of stress, outsize losses.

Some institutions are not parsing what products are riskier than others, but rather they are rushing for the door. First State Investments in Singapore has slashed its holdings in all Asian financial firms in recent weeks.

At this point “it doesn’t really matter what their exposure is” to subprime products through derivatives, said Alistair Thompson, the deputy head of Asia-Pacific equities at First State. “What concerns us is the sentiment” in the market, he said.

The surprises are certainly not over: there were whispers among investors in Australia this week that some local funds were still turning up unexpected subprime exposure because of credit derivatives, weeks after the problems first surfaced.

While that happens, markets are sure to remain skittish.

“Liquidity can just be turned off, and essentially it is a confidence game,” Mr. Thompson said.

A Short History of the Mortgage Markets

Another short history of the mortgage markets just in case you need a refresher, from the NY Times. The last paragraph is an interesting comments about liquidity.

We are no longer shocked when the Dow Jones industrial average plunges 10 percent — as it did this summer — or when a single hedge fund, this one run by Goldman Sachs, drops 30 percent in a week. But real estate, we thought, was different. Hedge funds execute hundreds of trades a day, often according to the whims of a computer; people buy their homes one at a time and usually retain them for years. But last month’s market turmoil revealed a doleful transition for real estate. Formerly the most prosaic and dependable of investments, homes over the last 30 years had been turned into trading chips for Wall Street. And now, even at a time when the economy is still growing apace, two million Americans are suddenly said to be at risk of losing their homes to foreclosure. How did real estate become an industry with the vulnerabilities of esoteric financial instruments?

In the golden age of American home buying — the years after World War II — savings-and-loan institutions or government agencies supplied returning G.I.’s with fixed 30-year mortgages. Home prices appreciated, steadily but at modest rates, and lending fiascoes were rare. And homeownership rates climbed. The buyers of that era were not necessarily more cautious than today’s; they simply spent what their bankers lent them. The bankers, persnickety folks that they were, required that buyers demonstrate sufficient income to qualify for a mortgage. They did this because a) they would get stuck with the property if the buyer defaulted and b) regulators insisted on prudence.

The world began to change in the late 1970s, when Salomon Brothers, in the person of a banker named Lewis Ranieri, pioneered the mortgage security. This showed a flash of genius. Even though each unit of real estate continued to be a slow-moving, illiquid asset, Ranieri perceived that the underlying mortgages could be traded as rapidly as stocks and bonds. Instead of keeping his mortgages in a drawer, the banker on Main Street could unload his risk by selling them to Salomon. The banker was thus converted from a long-term lender to a mere originator of loans.

Salomon and other institutions would take the mortgages sold by banks and stitch together bonds backed by the payments of many mortgagees, which they sold to investors. Voilà! Ranieri had knitted a group of inert mortgages into a tradable security. The mortgage market thus obtained liquidity, which, according to Wall Street, made mortgages cheaper and benefited us all. Once the mortgage originator became, in effect, a supplier to Wall Street, new, often unregulated nonbanking companies jumped into the game of brokering and also issuing mortgages. Over time, this weakened lending standards.

As Robert Rodriguez, a mutual fund manager for First Pacific Advisors, declared in a speech in June, “The distancing of the borrower from the lender has contributed to the development of lax underwriting standards.” Rodriguez’s point was that investors in the securities, being remote from the actual real estate, could hardly be expected to scrutinize the underlying mortgages loan by loan. Most delegated the task to ratings agencies, and in time the agencies, intoxicated by the booming market, also grew lax. Meanwhile, Wall Street, sensing the appetite of investors, devised exotic ways of repackaging mortgages. Investors bought these securities in bulk, just as Goldman bought stocks.

The absence of scrutiny on Wall Street had a profound effect on mortgage origination. As mortgage bankers discovered that investors would buy virtually any loan whatsoever, they naturally lowered their standards. What difference whether a loan was sound if you could flip it in 48 hours? The market thus corrupted, it only wanted for the right circumstances to implode. And over the last few years, as Robert Barbera, the chief economist at the investment advisory firm ITG, observed, the Federal Reserve took short-term interest rates from 1 percent to 5 1/4 percent. This raised mortgage rates and put home buyers at risk of being priced out of the market. But bankers lent to them anyway, offering, in effect, “junk mortgages” — risky loans with low teaser rates (and much higher rates later), as well as other deviations from sound finance. Lenders and borrowers alike knew that such loans were dicey; they were counting on the borrowers to refinance — which, as long as home prices kept rising, was a cinch. Naturally, when prices stopped rising, the music stopped.

What happened over the last generation is that housing was turned from a market that responded to consumers to one largely driven by investors. Liberal mortgage financing pushed home prices higher — and younger, first-time buyers were effectively priced out of the market. Rates of homeownership are scarcely any higher than in the mid-1960s.

There is no going back to the 3 percent fixed mortgages, single-earner households and tract housing of that era, but housing — like any investment market — could surely use a dose of (re-)regulation. At the very least, there should be a clear line between a mortgage company and a casino. Homeowners should not be induced to gamble on mortgages that will leave them insolvent should prices fall. Fewer mortgages might be written, but more mortgagees would stay solvent. And if the mortgage market surrendered a smidgen of its vaunted liquidity, it would be no great loss.

It was John Maynard Keynes who observed the paradox of securities markets: their very liquidity, which investors perceive as a safeguard, creates the conditions for disaster. “Each individual investor flatters himself that his commitment is ‘liquid,’ ” Keynes wrote, and the belief that he can exit the market at will “calms his nerves and makes him much more willing to run a risk.” The catch is that investors, collectively, can never exit in unison. Whenever they try, panic and losses are the sure result. Once, you had to be a hedge-fund player to experience such a trauma. Now, thanks to the dubious wonders of financial engineering, home buyers are exposed to the very same risks.

An Interview With Larry Fink Concerning the Credit Markets – Just Something to Think About

Some brief comments from Larry Fink concerning the credit markets, from CNNMoney.com.

Before he co-founded money-management firm BlackRock, Larry Fink, 54, was an early pioneer of the mortgage-backed-securities market. Now his firm, which went public in 1999 and merged with Merrill Lynch's investment-management business last year, oversees $1.2 trillion in assets -- and has been advising Wall Street clients reeling from the subprime lending meltdown. He spoke with Fortune's Peter Eavis about the ongoing credit crunch.

Where do you stand on interest rates?

I don't believe the Federal Reserve should ease. It's a foolish, foolish statement for people to make with the economy performing in line with the Fed's current forecast. It's a good thing for regulators to see risk premiums become more appropriate.

How does the current liquidity crisis compare with what you saw in 1998?

Oh, this is much worse. This problem is greater, broader, harder to contain. Without the central banks injecting liquidity, this could have become a big problem.

Are you buying any subprime-mortgage-backed securities right now?

No. We never really trafficked in subprime. Our CDO [collateralized debt obligation] complex has been a historical buyer of subprime, but as a firm we cut back in late 2005.

A lot of the big-name brokerages are highly exposed. If you had been heading one, would you have gone into the subprime business?

Wall Street made tens of millions in the mortgage arena over the past five years. Now we have a setback. But you can't look at the losses that people may incur this year without the context of their profitability in the past four or five years.

So you're saying it was the right call?

Depends on what we learn about the scale of losses. We saw in 2005 that it was getting a little dicey. The better firms should have downsized their role.

How broad are the ripple effects of this subprime crisis, in mortgages and beyond?

The market is struggling with the valuation of even prime mortgages. There are many fine mortgages that may be over $500,000 with good payment history, but the market is questioning the value of all mortgage- and asset-backed products. But you're not seeing as much of an effect in the corporate bond market, and certainly not in the equity markets, apart from homebuilders.

It seems that the U.S. can hardly bear interest rates above 5.5%. What does that say about our level of debt?

We as a country need to liquefy our balance sheets. It's a generational project. It's five years for some people and 20 years for others. It just takes behavior change.