News has certainly slowed down at the end of the year (and the Bush administration has checked out entirely), but the Fed just announced that it will buy $500 billion in mortgage backed securities (MBS) by the middle of next year. There are a few obvious questions that I have: (a) isn't this what the TARP was supposed to do?; (b) are they just printing money to do this?; and (c) what is the risk we're taking on? Leaving these questions aside, I've been trying to look into what's in these. Is it simply that these distressed assets are severely undervalued, and it's purely an overcorrection in the (illiquid) MBS market? Or are we purchasing something more akin to Madoff "assets"? Again, as I reminded you in part I that I'm just a simple astrophysicist bumpkin...
The mortgage backed security (MBS) is the simplest of the fancy derivatives that have run rampant over the past few years, and the only one that I vaguely understand. (And I'm not sure that anybody really understood the credit default swap (CDS), let alone AIG). In an MBS, individual mortgages are bundled up and sold to investors. In theory, mortgages of borrowers of similar creditworthiness are bundled together, and although some small fraction of these might default, this will be built into the credit rating. In practice, I believe people played fast and loose with bundling these mortgages, especially non-traditional subprime and alt-a mortgages such as the option ARM. The MBS itself has value based on (a) the underlying assets, that is, the houses that were mortgaged, and (b) the interest paid by the borrowers. These MBSs may then sliced up some more, traded around, etc. None of this trading is done on an exchange, however, and thus these are illiquid assets. If you can't find anybody to buy the security, it's hard to tell what it's worth.
As house prices have declined, the values of MBSs have tanked. First, the value of the underlying assets has gone down. Second, with such thinly traded assets, if you need to sell in a down market the buyer has a distinct advantage. But a bigger problem is that the MBSs built on option ARM type mortgages are pretty much a complete sham. As I described in part I, the only way for a borrower with one of these loans to possibly afford it after the introductory teaser rate is to refinance or sell the house. And with prepayment penalties and negative amortization, house prices need to go up by at least 4% annually--without interruption-- for this to be possible.
Meanwhile, there's a wave of foreclosures that still hasn't fully crested. And massive foreclosures are devistating for neighborhoods, driving up blight and driving down prices even further in a painful cycle. In a half-assed attempt to arrest this in November, the Bush administration put together a "plan" to renegotiate some mortgages to keep people in their homes. Some other banks have also signed on voluntarily. For the owner of a mortgage, this can be a good deal: foreclosures are expensive, and houses are sold at fire-sale prices. If you can renegotiate and keep people in their houses, then everybody wins. (Or at least everybody loses a little, rather than everybody losing a lot.)
However, this plan did not help the large numbers of homeowners whose mortgages had been bundled up into MBSs. Instead, the bondholders flatly refuse to allow the mortgages to be renegotiated. This is a many-headed problem. Most notably, when your mortgage has been split up and is owned by thousands of investors, who do you talk to about renegotiating terms? But I think there's the additional unwillingness to fess up that renegotiating the underlying mortgages would show that the current distressed values of MBSs are actually the true values.
Again, there are two ways to calculate the value of the MBSs. The first is the underlying assets -- the houses -- and these have gone down in value, and are probably worth even less if you assume all of them are foreclosed on (of course a worst-case scenario). The second is the cash flow coming from the borrowers. On paper, this looks great: after the initial teaser rate, these borrowers will be paying out like gangbusters! 6%! 8%! Sounds fantastic! But in reality, the borrowers can only really afford that teaser rate. So any renegotiation of terms that will be affordable will end up either (a) fixing the interest rate at the teaser rate of 2% or (b) with a reasonable fixed rate of ~6%, by reducing the value of the mortgage by ~40%. Either way, the MBSs no longer appear to be such a hot deal, barring a sudden and unlikely reinflation of the housing bubble. (But you can't unscramble an egg.)
Right now it looks like the bondholders stonewalling on any renegotiation will work: they'll get bought out by the Fed, without having to admit that the securities are worth much less than they claim they are on paper. We'll all be stuck with the bill, and regular people will be kicked out of their houses. Of course, many of these people took out loans that appeared too good to be true...and were! Others were fleeced. And we all pay the price.
Wednesday, December 31, 2008
Tuesday, December 30, 2008
Unsustainable Lending (part I)
I've been doing way too much reading about the mortgage crisis, and it's kind of depressing how we got ourselves into this mess. The numbers just don't add up...but I guess it never mattered for the people driving us into the ditch, since they get paid based on short-term results, long term be damned.
There are a couple issues that I've been musing about over the break, which I'll break into a couple of posts. The first has to do with prepayment penalties for subprime mortgages, and how they ensure that things were going to blow up even if house prices remained stable. The second (related) issue is why the institutions who own mortgage backed securities (MBS) don't support renegotiating underwater mortgages. Keep in mind that I'm just a humble astrophysicist, and I really don't know what I'm talking about when it comes to these issues.
The stereotypical subprime loan was an "option ARM" where there was a low introductory teaser rate (say, 2%) which lasted a year or so, followed by a reset where the rate would go up significantly (to 6-8%). Notably, the interest rate on the loan would usually reset before the payment rate, so the first year or so would have negative amortization, where the principle on the loan was actually increasing over time. For a modest $100,000 loan, the introductory payment rate would be $370/month, and after the first year or two, this would increase up to $740, or a factor of 2. Although I think I could afford this modest $100,000 loan, in general I don't think I could afford a doubling of my housing costs.
So what's a borrower to do? It seems obvious to me that the only option is to refinance the loan after the teaser rate expires (or sell the house). And this will only work if the price of the house hasn't decreased! But of course the lender doesn't want to see the borrower refinance every year or two to grab the 2% teaser rate over and over again. Other than the fat fees that are grabbed by the brokers, the main impediment to doing this is the prepayment penalty, which is typically 5% of the loan amount, which is $5000 for our $100,000 loan.
Some of this is laid out in this recent (Oct 2008) paper Did Prepayments Sustain the Subprime Market? [pdf] from the St. Louis Fed (mad props to them for using LaTeX!). As they point out for subprime mortgages over the past 5 years, after a reset "prohibitively high rates [leave] the borrower little option but to prepay either by selling or by refinancing," or end up delinquent and finally in foreclosure. As house prices turned around over the past couple years, these subprime borrowers could no long refinance, and were forced into foreclosure, and the authors conclude that "the boom in house prices...was largely responsible for sustaining the subprime mortgage market by allowing distressed borrowers to prepay mortgages."
What the authors don't seem to explicitly state is that because of prepayment penalties even if house prices plateaued, and didn't even decline, these people would be forced into foreclosure. By my back-of-the-envelope calculations, with a 5% prepayment penalty, if the rate resets 2 years after the start of the mortgage, the house price must have increased by at least 2.5% (before any broker fees!) to make a refinancing possible, because you need to pay back $105,000 on your $100,000 loan. It's even worse for the vast majority of subprime loans that start out with negative amortization. In those case, house prices must go up by at least 4-5% to make this all work.
And yes, by some magic, house prices have increased over the long term. But (a) price/rent ratios were so out of whack, it was clear we were in a bubble that couldn't last forever, and (b) even if we weren't in a bubble, there have always been short-term plateaus, declines, etc. But all it takes is one year of trying to pay over 50% of your income toward a mortgage and you'll find yourself broke and out of a house.
Stay tuned for part II...
There are a couple issues that I've been musing about over the break, which I'll break into a couple of posts. The first has to do with prepayment penalties for subprime mortgages, and how they ensure that things were going to blow up even if house prices remained stable. The second (related) issue is why the institutions who own mortgage backed securities (MBS) don't support renegotiating underwater mortgages. Keep in mind that I'm just a humble astrophysicist, and I really don't know what I'm talking about when it comes to these issues.
The stereotypical subprime loan was an "option ARM" where there was a low introductory teaser rate (say, 2%) which lasted a year or so, followed by a reset where the rate would go up significantly (to 6-8%). Notably, the interest rate on the loan would usually reset before the payment rate, so the first year or so would have negative amortization, where the principle on the loan was actually increasing over time. For a modest $100,000 loan, the introductory payment rate would be $370/month, and after the first year or two, this would increase up to $740, or a factor of 2. Although I think I could afford this modest $100,000 loan, in general I don't think I could afford a doubling of my housing costs.
So what's a borrower to do? It seems obvious to me that the only option is to refinance the loan after the teaser rate expires (or sell the house). And this will only work if the price of the house hasn't decreased! But of course the lender doesn't want to see the borrower refinance every year or two to grab the 2% teaser rate over and over again. Other than the fat fees that are grabbed by the brokers, the main impediment to doing this is the prepayment penalty, which is typically 5% of the loan amount, which is $5000 for our $100,000 loan.
Some of this is laid out in this recent (Oct 2008) paper Did Prepayments Sustain the Subprime Market? [pdf] from the St. Louis Fed (mad props to them for using LaTeX!). As they point out for subprime mortgages over the past 5 years, after a reset "prohibitively high rates [leave] the borrower little option but to prepay either by selling or by refinancing," or end up delinquent and finally in foreclosure. As house prices turned around over the past couple years, these subprime borrowers could no long refinance, and were forced into foreclosure, and the authors conclude that "the boom in house prices...was largely responsible for sustaining the subprime mortgage market by allowing distressed borrowers to prepay mortgages."
What the authors don't seem to explicitly state is that because of prepayment penalties even if house prices plateaued, and didn't even decline, these people would be forced into foreclosure. By my back-of-the-envelope calculations, with a 5% prepayment penalty, if the rate resets 2 years after the start of the mortgage, the house price must have increased by at least 2.5% (before any broker fees!) to make a refinancing possible, because you need to pay back $105,000 on your $100,000 loan. It's even worse for the vast majority of subprime loans that start out with negative amortization. In those case, house prices must go up by at least 4-5% to make this all work.
And yes, by some magic, house prices have increased over the long term. But (a) price/rent ratios were so out of whack, it was clear we were in a bubble that couldn't last forever, and (b) even if we weren't in a bubble, there have always been short-term plateaus, declines, etc. But all it takes is one year of trying to pay over 50% of your income toward a mortgage and you'll find yourself broke and out of a house.
Stay tuned for part II...
Sunday, December 14, 2008
Worst. Cookies. Ever.
Last week, Mark Bittman posted a new recipe for The Mother Of All Butter Cookies. His point was that this recipe was akin to a mother sauce and an easy and flexible base that could be turned into butterscotch cookies, chocolate chip cookies, citrus cookies... Sounds great, huh?
Some of you might ask: the Tollhouse Cookies are an all-time classic for a reason, how can you possible improve on them? Good question. I'd like the cookies to be a little more fluffy, but I'm not sure how to do this without using shortening, which I don't like.
There were a few things in the recipe that are certainly unusual, but conventional wisdom in cooking is not always right. First of all, the dough is mixed in a food processor. But this works well for pie dough. Second, it has a lot of cornstarch. Cornstarch? The reason Bittman gives is "to avoid overdeveloping gluten" and to add a "silken quality" to the cookies. Finally, it has unsalted butter, but only calls for a "pinch" of salt. Is that enough? On the other hand, it has a larger butter-to-flour ratio than the tollhouse cookies, and butter is good.
Well, the food processor appeared to work reasonably well; it was definitely cookie dough that came out (though my kitchenaid was standing there watching forlornly). But the cookies? The recipe suggests baking for 11 minutes at 375 F (and our oven is reasonably well calibrated). After 10 minutes, the bottoms were brown and the tops were uncooked. The chocolate chips weren't even melting. After a total of 15 or 16 minutes we just took them out. They were completely uncooked in the middle; the chocolate chips were barely warm; they had the texture and flavor of raw cornstarch; there was no flavor (possibly related to the lack of salt).
I wouldn't serve these cookies to my worst enemies. I put a comment on the Bitten blog, and it's still awaiting moderation. My guess is that the moderator is overwhelmed with people complaining that these are the
Worst. Cookies. Ever.
UPDATE: My comment has finally made it through moderation, along with a few more comments agreeing that these cookies suck.
Some of you might ask: the Tollhouse Cookies are an all-time classic for a reason, how can you possible improve on them? Good question. I'd like the cookies to be a little more fluffy, but I'm not sure how to do this without using shortening, which I don't like.
There were a few things in the recipe that are certainly unusual, but conventional wisdom in cooking is not always right. First of all, the dough is mixed in a food processor. But this works well for pie dough. Second, it has a lot of cornstarch. Cornstarch? The reason Bittman gives is "to avoid overdeveloping gluten" and to add a "silken quality" to the cookies. Finally, it has unsalted butter, but only calls for a "pinch" of salt. Is that enough? On the other hand, it has a larger butter-to-flour ratio than the tollhouse cookies, and butter is good.
Well, the food processor appeared to work reasonably well; it was definitely cookie dough that came out (though my kitchenaid was standing there watching forlornly). But the cookies? The recipe suggests baking for 11 minutes at 375 F (and our oven is reasonably well calibrated). After 10 minutes, the bottoms were brown and the tops were uncooked. The chocolate chips weren't even melting. After a total of 15 or 16 minutes we just took them out. They were completely uncooked in the middle; the chocolate chips were barely warm; they had the texture and flavor of raw cornstarch; there was no flavor (possibly related to the lack of salt).
I wouldn't serve these cookies to my worst enemies. I put a comment on the Bitten blog, and it's still awaiting moderation. My guess is that the moderator is overwhelmed with people complaining that these are the
Worst. Cookies. Ever.
UPDATE: My comment has finally made it through moderation, along with a few more comments agreeing that these cookies suck.
Thursday, December 11, 2008
Does the religious right also not get that the Colbert Report is a parody?
Even if you didn't watch Tuesday's Daily Show, you probably saw the second half of Jon Stewart's interview with Mike Huckabee linked on one of the million liberal blogs out there. I was curious as to what the conservative blogs were saying, though. What did they think of Huckabee's performance? Or about Stewart's line, "Religion is far more of a choice than homosexuality."?
I googled "jon stewart" "mike huckabee" and scrolled through eight pages of links to blog posts on the interview. Not a single one of those blogs was a conservative blog. So what's the deal? Was no one happy with Huckabee's performance? Is Mike Huckabee just not on the conservative radar right now? Or is The Daily Show itself not on the conservative radar? Among the religious right, Newt Gingrich, Ralph Reed, and Bill Bennett* have all been on the show multiple times. So they're not ignoring the show.
However, there are no results when searching for mentions of the Daily Show on the websites of the AFA, Focus on the Family, the FRC, or the Concerned Women for America. These are groups that send out weekly alerts on the latest "pro-homosexual" and "anti-Christian" content in pop culture. I wasn't expecting them all to have found something to be offended by in the program, but I thought at least one of them might have mentioned the show in the past ten years. It's not like basic cable is beneath their notice.
I'm just surprised that a show that is a staple of the left's culture, and that has been a steadfast supporter of gay marriage for years, has been completely ignored by the religious right. Is the religious right really unaware of the influence of the Daily Show? Or am I the one who's missing something?
* That two-part interview with Bill Bennett might be my favorite Daily Show moment ever. What? Like you don't all have similar mental lists.
I googled "jon stewart" "mike huckabee" and scrolled through eight pages of links to blog posts on the interview. Not a single one of those blogs was a conservative blog. So what's the deal? Was no one happy with Huckabee's performance? Is Mike Huckabee just not on the conservative radar right now? Or is The Daily Show itself not on the conservative radar? Among the religious right, Newt Gingrich, Ralph Reed, and Bill Bennett* have all been on the show multiple times. So they're not ignoring the show.
However, there are no results when searching for mentions of the Daily Show on the websites of the AFA, Focus on the Family, the FRC, or the Concerned Women for America. These are groups that send out weekly alerts on the latest "pro-homosexual" and "anti-Christian" content in pop culture. I wasn't expecting them all to have found something to be offended by in the program, but I thought at least one of them might have mentioned the show in the past ten years. It's not like basic cable is beneath their notice.
I'm just surprised that a show that is a staple of the left's culture, and that has been a steadfast supporter of gay marriage for years, has been completely ignored by the religious right. Is the religious right really unaware of the influence of the Daily Show? Or am I the one who's missing something?
* That two-part interview with Bill Bennett might be my favorite Daily Show moment ever. What? Like you don't all have similar mental lists.
Wednesday, December 10, 2008
Share buybacks!
A-ha! In my previous post on owning stocks, I had completely forgotten about stock buybacks, when the company uses excess cash to buy outstanding shares. In this sense, the company itself is placing real value on the stocks, and this gives them some intrinsic value other than (a) producing dividends or (b) liquidation.
The traditional reason for a stock buyback is apparently that the company claims this is a better way to invest its cash than anywhere else...and it gives an advantage to existing shareholders by boosting the share price, and when these shares are sold the profits are taxed at the lower capital gains rate (while dividends are taxed as income). But buybacks can also be used to manipulate the topline numbers in earnings reports (the earnings per share goes up if you remove shares!). I think that buybacks can also be used to prop up a sagging share price...kind of like a central bank propping up a falling currency, which can be an expensive proposition that doesn't always end well.
In any event, as stock prices have fallen in the past year, there have been a lot of stock buybacks. And apparently, over the past four years S&P 500 companies as a whole have given out more money in stock buybacks and dividends ($2.6 trillion) than they have gotten in earnings ($2.4 trillion). I suppose that (a) that can't be sustainable [but hey, a good reason to have stocks as long as you sold them!] and (b) probably involved a lot of leverage.
But I wonder how much of this money going back to shareholders has been due to companies going private, such as the Tribune company. There was a case that Sam Zell borrowed a lot of money to buy out the shareholders, and now Tribune is bankrupt under all that debt...even though all of the Tribune holdings are profitable!
The traditional reason for a stock buyback is apparently that the company claims this is a better way to invest its cash than anywhere else...and it gives an advantage to existing shareholders by boosting the share price, and when these shares are sold the profits are taxed at the lower capital gains rate (while dividends are taxed as income). But buybacks can also be used to manipulate the topline numbers in earnings reports (the earnings per share goes up if you remove shares!). I think that buybacks can also be used to prop up a sagging share price...kind of like a central bank propping up a falling currency, which can be an expensive proposition that doesn't always end well.
In any event, as stock prices have fallen in the past year, there have been a lot of stock buybacks. And apparently, over the past four years S&P 500 companies as a whole have given out more money in stock buybacks and dividends ($2.6 trillion) than they have gotten in earnings ($2.4 trillion). I suppose that (a) that can't be sustainable [but hey, a good reason to have stocks as long as you sold them!] and (b) probably involved a lot of leverage.
But I wonder how much of this money going back to shareholders has been due to companies going private, such as the Tribune company. There was a case that Sam Zell borrowed a lot of money to buy out the shareholders, and now Tribune is bankrupt under all that debt...even though all of the Tribune holdings are profitable!
Group hug! (Grupo abrazo? グループの抱擁 ? ryhmä hali?)
I was looking at the 2008 Google Zeitgeist for the U.S., and there were no real surprises about which search terms were the fastest-rising. However, I was surprised and delighted to see which five terms made it in Google Translate:
Aw! That is going to get me through today -- I'm seriously grinning like a fool here.
Google Translate - Fastest Rising (U.S.)
1. you
2. what
3. thank you
4. please
5. love
Aw! That is going to get me through today -- I'm seriously grinning like a fool here.
Tuesday, December 9, 2008
More thoughts on the stock market
This week, The Economist asks the question: Where have all your savings gone?, with a picture of a guy staring down a bottomless pit. But they're relatively upbeat, now's the time to buy, things will recover, etc. But they also had this nugget:
Yet another way the boomers will screw us all!
The article goes on to talk about a recent report which hypothesizes that Japan's flat market for the past two decades has been because their population got older sooner than in America.
In demographic terms, asset markets could be seen as a pyramid scheme, in which each generation aims to sell its accumulated savings to the next. Provided the next generation is larger than the one that preceded it, the savers can sell their assets at higher prices. That was the case for much of the 20th century.
Illustration by Brett Ryder
The baby-boomers will upset the pattern. If they retire at 65, they will start offloading their assets in 2011. And even in America, which has fewer demographic problems than Japan, there are not enough new savers coming along to replace them. Some hope that emerging markets will solve the problem, by acting as buyers of developed market assets and a source of higher returns for investors in rich countries, but the theory is unproven.
Yet another way the boomers will screw us all!
The article goes on to talk about a recent report which hypothesizes that Japan's flat market for the past two decades has been because their population got older sooner than in America.
Wednesday, December 3, 2008
What's the purpose of owning stocks?
Something I was thinking about the other day...what is the value of stock in a publicly traded company these days? According to the wise people at wikipedia:
But these days, companies don't really pay dividends. I think this trend started during the tech bubble, when people still bought stocks even when there wasn't any revenue, and therefore there weren't any dividends...so other companies said "wait, what? We don't have to pay dividends?"
So the only value to a stock is if the company is liquidated (or sold). If the company is liquidated in the usual sense (bankruptcy) then the stock is worthless.
It seems to me that the only reason to buy stock (in most companies, where you don't have any voting rights to determine the direction of the company) is to speculate that the value will go ever upward. This sounds a lot like the foundation of sand underneath the financial crisis, that everything would be fine as long as house prices went up forever. And if they didn't? Well, we didn't even contemplate what would happen.
I am certainly no economist, and the more I read the less I understand. But it's another sign of the way our whole economy has divorced itself from producing anything, and is more about moving money back and forth and making money by taking a cut of every transaction. That can't bode well.
A share of stock is one of a finite number of equal portions in the capital of a company, entitling the owner to a proportion of distributed, non-reinvested profits known as dividends, and to a portion of the value of the company in case of liquidation.
But these days, companies don't really pay dividends. I think this trend started during the tech bubble, when people still bought stocks even when there wasn't any revenue, and therefore there weren't any dividends...so other companies said "wait, what? We don't have to pay dividends?"
So the only value to a stock is if the company is liquidated (or sold). If the company is liquidated in the usual sense (bankruptcy) then the stock is worthless.
It seems to me that the only reason to buy stock (in most companies, where you don't have any voting rights to determine the direction of the company) is to speculate that the value will go ever upward. This sounds a lot like the foundation of sand underneath the financial crisis, that everything would be fine as long as house prices went up forever. And if they didn't? Well, we didn't even contemplate what would happen.
I am certainly no economist, and the more I read the less I understand. But it's another sign of the way our whole economy has divorced itself from producing anything, and is more about moving money back and forth and making money by taking a cut of every transaction. That can't bode well.
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