Monday, April 16, 2007

My thesis on mortgage banking

has proved wrong. (Early=wrong). My expectation was that loan losses would begin to percolate down up, but that has clearly been NOT the case.

While my expectation is that interest rate resets will continue to be at issue, it is likely not a problem that will reverberate through the investment community until the "if" or "when" unemployment begins to rise.

3 comments:

russell120 said...

I don't understand what exactly it is that you originally thought. Are you saying that you thought resets would cause a collapse in the housing market by now?

It is not clear that resets are what is causing the problem. The immediate issue is the defaults on loans within a very short period of their origination.

The housing market seems to have slowed somewhat under its own weight. This has helped to keep the mortgage rates down (lower demand), and seems to have helped some people refinance out of their reset problems. The banks are also addressing this issue with very generous damage control programs.

However, as the "vitriolic one" (Russ Winter) noted, California Tax receipts are way down:

http://tinyurl.com/yowjam

This brings up the distinct possibility that we are currently in the early phase of a recession. It should be recalled that the start of a recession is generally only retrospectively determined. Often the start of a recession goes unrecognized for up to a year before the lagging indicator of unemployment catches up with the general business climate. So if you set the start the beginning of the recession at late last summer (based on housing numbers), housing is about where you would expect.

The very lenient lending of 2006 (following the very lenient lending of 2005, 2004, etc.) was accompanied by the beginning of a slow down, which helped get the most vulnerable part of the market (sub-prime with very high LTV) in trouble).

I suspect interest rates per se will not be a huge issue going forward unless inflation causes it to become one. Recessions usually cause a drop in interest rates (thus the inverted yield curve). But if the economy continues to weaken you will get exactly the unemployment issue you mentioned. Stagflation (high inflation and interest rates with high unemployment) would of course be a disaster. Let's hope we don't go there.

Leisa said...

"Are you saying that you thought resets would cause a collapse in the housing market by now?"

No. I'm saying that I expected loan loss reserves to start to increase more and I expected a little more up front discounting of future loss reserves.

Regarding interest rates--I still see the rock/hard place scenario. Three outcomes:

1. Rates stay the same
2. Rates increase
3. Rates decrease because of deterioration in the economy.

I'm not sure if 3 is better than 2.

russell120 said...

Most banking numbers are based on net present value (kind of like ENRON). To discount future values would be a disaster for the CEO who is trying to maximize his current income through positive earnings. Because the future earnings are already booked, the write downs would be huge.

I expect to see the loss reserves change when the market finally cools off and the CEOs have no hope of cashing in their options bonanza at the current market pps. At that point they can mix the loss reserve bad news with general market bad news and hope that their bad news gets intermingled with the general market malaise. With Wall Street, bad news is acceptable if it is timed to coincide with ones peers.