The federal government needs to give taxpayers an ownership stake in the future. The SAM does just this. For example, a homeowner unable to support payments on a house purchased for $200,000 that today is worth only $150,000 might be offered a write-down of up to $50,000. But this would not be a free lunch.
With the SAM, once the value began appreciating above $150,000, the mortgage holders would be due their share. The details of the write down and the appreciation sharing could be tailored to different circumstances. But one way to give lenders a share of the upside would be to pay back some of the write down if the house is later sold, in the scenario above, for more than $150,000. This is a model in which both parties benefit, preventing default while giving future taxpayers a fighting chance at some real upside to the investment we're forcing on them.
Read the whole thing.
Treasury Secretary Henry M. Paulson Jr. outlined the plan on Monday to nine of the nation's leading bankers at an afternoon meeting, officials said, in which he essentially told the participants that they would have to accept government investment for the good of the American financial system. This capital injection plan will use a huge chunk of the money authorized for Troubled Assets Relief Program.
Citigroup and JPMorgan Chase were told they would each get $25 billion; Bank of America and Wells Fargo, $20 billion each (plus an additional $5 billion for their recent acquisitions); Goldman Sachs and Morgan Stanley, $10 billion each, with Bank of New York Mellon and State Street each receiving $2 to 3 billion. Wells Fargo will get $5 billion for its acquisition of Wachovia, and Bank of America the same for amount for its purchase of Merrill Lynch.
The goal is to inject massive liquidity into the banking system. The government will purchase perpectual preferred shares in all the largest U.S. banking companies. The shares will not be dilutive to current shareholders, a concern to banking chie executives, because perpetual preferred stock holders are paid a dividend, not a portion of earnings.
The capital injections are not voluntary, with Mr. Paulson making it clear this was a one-time offer that everyone at the meeting should accept.
The statement came after U.S. business television channel CNBC reported the Fed was planning talks with the Chicago Mercantile Exchange, or CME, and the Intercontinental Exchange, or ICE, on the creation of a CDS exchange. The companies declined to confirm the report, although they said they would be willing to participate in any initiative.
Apparently CNBC's Steve Leisman reported (I didn't see it) that the Fed might announce tomorrow morning some sort of program to buy commercial paper.
The consensus among economists is now clear, the best strategy for dealing with the financial crisis is to recapitalize the banks that need recapitalization. Paul Krugman, John Cochrane, Luigi Zingales, Douglas Diamond, Raghuram Rajan and many others all advocate some form of recapitalization as do Tyler Cowen and myself. Krugman would prefer a recapitalization in the form of nationalization. In my view, there is still plenty of private money to buy banks at the right price and my preferred model is the FDIC leading a speed bankruptcy procedure, as was done brilliantly with Washington Mutual (Cochrane also supports this model.) In the middle are most of the others who have a variety of good ideas to require the banks to raise equity in various ways.
...
There is also a consensus among economists that the bailout bill is not the right policy. None of the above economists, for example, is enthusiastic about the bailout. My bet is that all of us think that the bailout has a substantial likelihood of failing. The support that exists is born out of hope and fear not judgment and experience. Nevertheless, the political consensus is that a bailout is what we will get whether it is likely to work or not.
So I am fairly confident that a "workable" solution will be reached before the markets open on Monday. I do not look for an "optimal" solution. If an optimal solution exists, it is undoubtedly too complicated to be "workable". But I believe that a number of ideas on the table have the potential to avert a complete meltdown. I think that when all the parties (including both McCain and Obama) meet behind closed doors and really come to grips with the magnitude of the problem and the fact that a workable solution exists, we'll get one.
I sure hope I'm right.
Indeed. Whatever "bailout" happens, if any, it will not be a permanent intrusion of socialism into the financial markets. In fact, this represents a tremendous opportunity to modernize the financial system. By "modernize", I don't mean the kind of derivatives that got us into trouble, but rather a sensible set of regulations that acknowledge the moral hazard problem and prevent institutions from doubling-down on a bad bet. Read the rest of Shiller's column for more specifics. I agree with his assessment.So is the government's bailout a major departure? Hardly. Today's federal involvement offers bailouts as a strictly temporary measure to prevent a system-wide financial calamity. This is entirely in keeping with our basic principles -- as long as the bailout promotes, rather than hinders, financial democracy.
Which, so far, it seems to. Congressional critics may be right to demand more help for homeowners and more accountability for Wall Street blunders, but the core idea of the plan is sound: to protect the financial infrastructure. Remember, Fannie Mae used to be a government entity, and by taking it over, the federal government is merely returning to the status quo ante. The measures to take toxic debts off the hands of financial and insurance firms are intended only to deal with a crisis, not to transform our financial system. The proposals do not represent any landmark change in the American way of prosperity. Everyone should take a deep breath. Changing our thinking about finance does not mean abolishing capitalism, but it does raise questions about what the changes mean.
Sweden did not just bail out its financial institutions by having the government take over the bad debts. It extracted pounds of flesh from bank shareholders before writing checks. Banks had to write down losses and issue warrants to the government.
That strategy held banks responsible and turned the government into an owner. When distressed assets were sold, the profits flowed to taxpayers, and the government was able to recoup more money later by selling its shares in the companies as well.
Worth a look.
Federal Reserve officials aren't inclined to veer from plans to hold short-term interest rates steady at Tuesday's meeting, even though financial markets are putting strong odds on a quick rate cut.
The Fed's thinking could change, particularly if there is another sharp deterioration in markets and the financial sector Tuesday. And even if officials decide to stay on hold, they could signal in their end-of-meeting statement a greater willingness to consider rate cuts if the economy or markets worsen.
A rate cut would be a confidence booster, to be sure. Ordinarily, one might expect a rate cut in this case would prevent the financial market problems from spreading to Main Street. I'm not sure that 25 basis points (or even 50) would really have much of an effect in that regard. Plus, if the Fed were to cut 50 b.p. tomorrow (as some are expecting), it leave only another 1.50% to go before hitting the zero lower bound. Given that this could go on for a while, it is imperative that they hold back some ammunition just in case things get much worse.
But most importantly, I don't see how 25 points (or even 50) does anything substantial to ease the credit crisis that the expansion of the quantity of credit through the various lending facilities can't do.
In the end, they may decide that a 25 or 50 point move is necessary to inspire confidence. I would like to think that in the last year the market has wised up in that regard and can understand that this problem will not be solved by a rate cut any time a financial firm runs into trouble.
These are momentous times, the likes of which we will be talking about for years to come.
The Federal Reserve Board on Sunday announced several initiatives to provide additional support to financial markets, including enhancements to its existing liquidity facilities.
"In close collaboration with the Treasury and the Securities and Exchange Commission, we have been in ongoing discussions with market participants, including through the weekend, to identify potential market vulnerabilities in the wake of an unwinding of a major financial institution and to consider appropriate official sector and private sector responses," said Federal Reserve Board Chairman Ben S. Bernanke. "The steps we are announcing today, along with significant commitments from the private sector, are intended to mitigate the potential risks and disruptions to markets."
"We have been and remain in close contact with other U.S. and international regulators, supervisory authorities, and central banks to monitor and share information on conditions in financial markets and firms around the world," Chairman Bernanke said.
The collateral eligible to be pledged at the Primary Dealer Credit Facility (PDCF) has been broadened to closely match the types of collateral that can be pledged in the tri-party repo systems of the two major clearing banks. Previously, PDCF collateral had been limited to investment-grade debt securities.
The collateral for the Term Securities Lending Facility (TSLF) also has been expanded; eligible collateral for Schedule 2 auctions will now include all investment-grade debt securities. Previously, only Treasury securities, agency securities, and AAA-rated mortgage-backed and asset-backed securities could be pledged.
By expanding the types of collateral accepted, the Fed addressing the need for liquidity by immediately expanding the quantity available. At this point, that is what is needed (as opposed to any action on interest rates).
Justin Fox has a pretty good summary:
We'll learn much more about the exact chain of events over the coming days and weeks and months, but the basics go something like this: New York Fed boss Tim Geithner (and his pals from Washington) tried to figure out some way to avert the failure of Lehman Brothers without offering any kind of federal guarantee. But nobody wanted to buy Lehman without help from Uncle Sam, so it looks like Lehman will go under. Which meant Merrill Lynch would take over Lehman's spot as Most Obviously Troubled Investment Bank. So Merrill sold out to Bank of America at $29 a share ($44 billion total). Which is an awful lot less than the $97 a share Merrill was selling for a year-and-a-half ago, but also a lot more than nothing.
So on Monday we'll get to see what the failure of an investment bank with $600 billion in assets looks like. And more important, we'll get to see if the obviously deeply flawed American financial system will be able to retain the confidence of the foreign lenders and investors who keep it going.
One crucial thing to remember in all of this is that none of the experts on Wall Street have any real idea of what they're dealing with. What has worked for the past quarter century or so has stopped working. And nobody knows what American financial institutions are going to look like going forward. Probably a lot more like the universal banks of Continental Europe. But anybody who says they know for sure is lying.
Want to read a little history about the last time something like this happened? Here's what the NY Times had to say about Drexel Burnham Lambert in 1990. It reads a lot like today's news, right down to the weekend meetings. Just replace "junk bonds" with "subprime mortgages".
There are some differences, of course. The biggest difference is that there are still so many firms in similar condition that there is no guarantee that this crisis is over. I think that Fox is right in saying that "anyone who says they know [what American financial institutions will look like after this] for sure is lying." But I am confident that the system will get through this very troubling time.
As this Wall Street Journal piece by Justin Lahart points out, there needs to be quick and decisive action to prevent something like what happened in Japan during the 1990s. The sooner everybody confronts that reality, the quicker we can get back to business. It is good to get the "unwinding" process started as soon as possible. Make sure that the smaller firms don't become collateral damage from counterparty risk, and let the consolidation result in the inevitable (but probably only short-to-medium run) shrinkage of the sector.
Every time one of these trouble firms is finally taken aside and shown the handwriting on the wall, we take one more step toward the day when someone gets to write one pretty massive after-action report. And of course, now that the extent of the damage to these three firms has been revealed, the rush is on to find who is next. Until the answer to that question is "no one", there will be more rough days ahead. I don't think we're there yet.
John Jansen has some excellent commentary and I'm sure will be adding more in the morning. He is quite worried about how all of this will end.
Government has not been able to hold bank the forces which have taken down financial giant after financial giant. Capitalism demands pain. Good risk is rewarded and imprudent risk is punished. We were engaged in an orgy of imprudent risk taking for nearly a decade and now a heavy price will be paid for the violation of so many simple and common sense precepts of trading.
Very true. On a related topic, Tyler Cowen opines in the NY Times:
There is a misconception that President Bush's years in office have been characterized by a hands-off approach to regulation. In large part, this myth stems from the rhetoric of the president and his appointees, who have emphasized the costly burdens that regulation places on business.
But the reality has been very different: continuing heavy regulation, with a growing loss of accountability and effectiveness. That's dysfunctional governance, not laissez-faire.
Blame enough to go around, to be sure. Like I said, it's going to be some after-action report.
Mark Thoma has a good collection of links for your morning reading as well.
Buckle up. It could be an interesting day.
UPDATE: Here's one more comment on the AIG situation. First the Wall Street Journal:
During a weekend scramble to shore up its finances, AIG turned down a capital infusion from a group of private-equity firms led by J.C. Flowers & Co. because an option tied to the offer would have effectively given them control of the company, an 89-year-old giant that does business in nearly every corner of the world.
Which prompted Yves Smith of Naked Capitalism to say:
That is not going to endear them to the Fed, turning down a deal, particularly when Merrill did the right thing and sold itself to avert a possible systemic event. This is brassy and risks overplaying their hand. If I were the powers that be, I'd tell them to stuff it and take the deal.
Indeed. I think the Fed is really trying to limit the taxpayers' exposure on this one. If AIG turns down a deal, it gives others license to do so. I don't like where that leads.
From Arnold Kling:
Anyone could see that the GSE dominance of the mortgage market was unhealthy. But the political process was unable to get the job done. What the central planners tend to forget is that political failure is even more entrenched than market failure.
Maybe the taxpayers will have to pay today or maybe in some future tomorrow but the benefits of the GSEs are intimately tied to the costs - there is no such thing as a free lunch. The lunch may look free for a long time - as in the classic peso problem - but what that means is that when the bill comes due it will be big.
Better will be to simply remove these guarantees; if it pushes mortgage rates up 25-50 bp, that would simply be recognition of a subsidy that has long since lost its usefulness.
King also points to Gerald O'Driscoll:
We must also realize that, whatever the deficiencies of the mortgage market in Depression-era America, that era is over. There is no "market failure" in housing finance today, except the one created by government-backed institutions dominating housing finance. Money flows where it is rewarded. Home mortgages are plain vanilla financial instruments, perhaps partly due to Fannie and Freddie. So by all means, let us thank them for their service as we bid them adieu in their present form.
Taken together, these sentiments sum it up nicely. The GSEs served a purpose. As the credit market developed, that purpose became somewhat less relevant than it once was. Yet, because of the implicit (now made explicit) government backing, they were able to offer what looked like a free lunch. As long as things remained stable, they helped shave a few basis points off of mortgage rates by absorbing some of the risk. If they only held loans of the highest quality (creditworthy customers, 20% down payments, etc), we wouldn't be having this conversation. But if those were the only loans that they held, the irrelevance of the GSEs would be more apparent and would have been vulnerable to being legislated out of existence.
So, given that people respond to incentives (and that includes people in government agencies [i.e. regulators and Congress]), it was entirely natural that the GSEs would bite off a little more than they could chew. They traded on their name and their implicit government backing, promising a little bit of a free lunch. But when things turned sour, we saw that the lunch was not free.
We live and we learn (though some people do not get the message the first time). Fannie and Freddie are too big to be allowed to fail. They need access to that lifeline that for too long we pretended wasn't ever going to be needed. Allow them to unwind this in an orderly way rather then letting it all unravel at once.
But then, for goodness sake, learn from this mistake. There is no reason for the GSEs to ever again be as large as they were.
UPDATE: Clarified the sentence about government agencies responding to incentives. I was referring to the fact that the regulators and Congress had no incentive to get tough with the GSEs and the GSEs then in response naturally expanded their reach.
Also in the Wall Street Journal today is a piece by Martin Feldstein. Here are some excerpts.
Further interest-rate cuts can reduce the risk of recession and increase output and employment in 2008 and 2009. The current 4.5% fed-funds rate is essentially neutral -- not low enough to stimulate growth and not high enough to reduce inflation. Although there are risks that the rise in oil prices and the falling dollar will raise the inflation rate, the greater potential damage of an economic downturn calls for a more stimulative policy. The Fed should reduce the fed-funds rate at its December meeting and continue cutting toward 3% in 2008, unless there is a clear sign of an economic improvement.
Because of current credit market conditions, there is a risk that interest rate cuts will not be as effective in stimulating the economy as they were in the past. The current credit crunch reflects not only a lack of liquidity, but also a lack of confidence in the creditworthiness of counterparties and in the accuracy of asset prices. This problem is now being compounded by the banks' loss of capital as they recognize past losses, and by their need to use large amounts of the remaining capital to support existing off-balance-sheet credits that have to be shifted to their balance sheets. All of this implies that lower interest rates may not raise lending and economic activity to the same extent that they did in the past.
The latter paragraph is a good follow up to Greg Ip's piece. In old fashioned Keynesian terms, what we've got here by this reckoning, is the basis for a liquidity trap. Later in the article, Feldstein adds the second part of his strategy.
What's really needed is a fiscal stimulus, enacted now and triggered to take effect if the economy deteriorates substantially in 2008. There are many possible forms of stimulus, including a uniform tax rebate per taxpayer or a percentage reduction in each taxpayer's liability. There are also a variety of possible triggering events. The most suitable of these would be a three-month cumulative decline in payroll employment. The fiscal stimulus would automatically end when employment began to rise or when it reached its pre-downturn level.
Enacting such a conditional stimulus would have two desirable effects. First, it would immediately boost the confidence of households and businesses since they would know that a significant slowdown would be met immediately by a substantial fiscal stimulus. Second, if there is a decline of employment (and therefore of output and incomes), a fiscal stimulus would begin without the usual delays of the legislative process.
You're probably familiar with the term "automatic stabilizers". Well this takes the concept to the next level. A tax cut conditional on economic data--that's an interesting suggestion. Unfortunately, the temporary nature of the cuts would tend to reduce their impact. Anyway, read on.
Even if the Fed decides that it should not cut rates further at the present time, it would not raise rates to offset the stimulus effect of the fiscal change. From the Fed's point of view, the tax cuts can provide a desirable short-run stimulus without the inflationary impact that would result from a lower interest rate and an increase in the stock of money.
Dust off your trusty old IS-LM model and let the fun begin.
Some reliance now on a fiscal stimulus rather than easier money would also take pressure off the exchange-rate adjustment. While further declines of the dollar are necessary to shrink the massive U.S. trade deficit, continued rapid declines might lead to counterproductive retaliatory actions by some of our trading partners.
Add a dash of Mundell-Fleming.
The excessive asset-price increases caused by some past monetary expansions -- especially the induced rise in the prices of real estate -- provide a further reason to use fiscal as well as monetary policy. By cutting the fed-funds rate to just 1% in 2003 and promising that it would be raised only slowly, the Fed contributed to the sharp rise in house prices and the market's current weakness. A mixed strategy that included a prospective fiscal stimulus would have reduced the Fed's perceived need for a sustained negative real fed-funds rate, and would therefore have produced a more balanced expansion of demand.
But didn't we cut taxes in 2001 and 2003? Yes, however those cuts were aimed in large measure at increasing long run growth--the success of which is a fair topic of debate. That's not to say that the short-run stimulative effect was nil. But the question is: would a temporary tax cut with a similar order of magnitude to the 2001 and 2003 cuts have any more stimulative effect? Or would people just save it?
Mark Thoma also mentions the permanent income hypothesis, but doesn't mention the 2001 and 2003 tax cuts. Interestingly, a lot of prominent economists opposed the 2003 tax cut because they thought it should be temporary (contrary to Thoma) in order to provide stimulus without threatening the long term budget outlook and that it should include a spending component (in agreement with Thoma).
I think temporary tax cuts won't work very well (in agreement with Thoma) and I have my doubts about temporary spending increases (more bridges to nowhere?), contrary to Thoma. So where does that leave us?
With a lower funds rate in 2008, that's where.
Chairman Bernanke gave testimony to Congress on the subprime situation today. Read it on the Fed's newly redesigned website. The only mention of monetary policy is at the end, and it includes nothing new, only some quotes from the press release Tuesday.
In other related news, initial jobless claims were down, reaching their lowest level since July 28. This suggests that the employment report may have been a blip. Employment is somewhat of a lagging indicator, so don't get too worked up and thinking that the threat is over. More trouble could still be to come. Nevertheless, we'll take good news when we can get it. The Index of Leading Indicators, however, was down slightly.
Meanwhile, a certain former Fed chairman is enjoying his time in the spotlight. It is hard to get used to seeing Alan Greenspan all over the place talking to the media candidly, but get used to it we will. (Reuters)
Asked in an interview on Bloomberg television whether the Fed's half-percentage-point rate cut on Tuesday had lowered the chances of a recession, Greenspan said: "I think so, but remember that we still have a problem out there, which is a large overhang of unsold newly constructed homes."
...
Greenspan said the chances for a recession in the United States were still "somewhat more" than 1 out of 3, despite the cut in the Fed's overnight federal funds rate to 4.75 percent, but cautioned it was hard to be more precise.
"We are often wrong but never in doubt on too many issues," he said.
Indeed.
We're watching history unfold here, folks. The unwinding of the subprime mess is without precedent. But the monetary policy action has parallels in the past. Will this episode be more like 1998 (heading of systemic risk, short lived easing and a return to previous levels in a year) or like 2001 (the beginning of a series of cuts and the re-inflation of a bubble)?
To apply the wisdom of Greenspan, someone who doesn't have some doubt stands a good chance of being wrong.
It's probably a good thing that the determination of a recession is not subject to a majority vote.
Via Reuters:
NEW YORK (Reuters) - Just over two-thirds of Americans believe the country is either already in recession or headed for one over the coming year, according to a new poll conducted jointly by The Wall Street Journal and NBC.
Nearly half the survey respondents, 46 percent, believed a recession was already under way.
The conviction comes despite a 3.4 percent rebound in economic growth during the second quarter, according to Commerce Department data released last week.
A recession is generally defined as two consecutive quarters of declines in gross domestic product.
Turning points in the economy are notoriously difficult to predict. In 2001, many Wall Street and government forecasters waited until growth had already turned negative before acknowledging a period of contraction.
Can we lose the definition of "two consecutive quarters of declines in GDP"? By that definition, we didn't have one in 2001. What we had was three quarters of negative growth, but they were every other quarter. One down, one up... one down, one up.... one down, one up. Definitely a recession, there's no question about that. But the standard textbook definition is obsolete.
Likewise, even though the most recent quarter posted growth above 3% doesn't mean that this is a trouble-free economy. Just about everyone acknowledges that growth for the rest of 2007 will be weaker, perhaps significantly weaker. If we have two quarters of growth around 1%, will it feel like a recession? Perhaps in many ways, yes. Would it meet the textbook definition? No.
This is not your father's economy, and the textbook definitions that worked in the '70s and '80s to explain the malaise of the time are not applicable now. We need to get out there and educate the next generation as to the subtleties of economic statistics, lest they become disillusioned that economists and the media are out of touch with their textbook definitions from the '70s.
At least we don't wear bell-bottoms.
David Leonhardt explains why records are made to be broken and why one must always adjust for inflation. (NY Times)
The S.& P. 500, which is a much better measure than the Dow, closed yesterday at 1,549, just 1.4 percent higher than the peak it reached in March 2000. Think about what that means. While the price of nearly everything has risen over the least seven years — while the price of bread has increased almost one-third, for instance — stocks have barely budged. They have only marginally outperformed cash sitting in a bureau drawer. So if we are going to talk about a stock market record, we should be doing the same for a whole lot of other things: Loaves of Bread Surge to New Highs
Last week, James Hamilton led off a post with the line,
Let's admit it-- the other shoe is not yet dropping.
Opinions differ on what it will sound like when it does. April employment numbers came out day (+88,000 non-farm payroll jobs), and PGL doesn't like what he heard.
The fall in the household survey reporting of employment was 468,000. The unemployment rate would have risen even more had it not been for the fall in the labor force participation rate (LFP). The decline in the employment to population ratio (EP) was disappointing. Maybe it’s time that the Federal Reserve lower interest rates.
Then Craig Newmark points us to a Bloomberg article that says,
April 30 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke's assertion that interest rates may need to increase to curb inflation is wrong. That's what Goldman Sachs Group Inc., Merrill Lynch & Co. and UBS AG are saying.
While Bernanke warned last month that the odds of worsening inflation have increased, chief economists at the three firms say the worst housing slump in a decade may drive the U.S. economy into a recession and stifle consumer prices. Their chief economists say the Fed will cut its target for overnight loans between banks at least three times this year.
...
Bernanke is missing ``the linkage between residential housing investment and the broader economy,'' Jan Hatzius, chief U.S. economist at New York-based Goldman, the world's most profitable securities firm, said in an interview. ``The housing downturn is of the first order of importance.'' Hatzius says the Fed will cut rates three times this year, to 4.5 percent from 5.25 percent.
Kash says it's too early to tell if and when rates will fall.
While disappointing, it is hard to imagine today's data having any impact on the outcome of next week's FOMC meeting, at least in terms of the policy action. Whether it will cause policymakers to prepare to soften their stance in the coming months is another question. My guess is, not yet. The change in language in the last FOMC statement made a lot of people thing that rate cuts are now off the table. I don't think that is the case, but rather that a rate cut in 6 to 9 months is more likely than it was a few months ago.
After today's employment report, my subjective probability assessment for the funds rate in 6 to 9 months has edged even a bit more towards a rate cut.
So as we head into the week of the FOMC meeting, the question is whether and when they will make a more direct reference in the press release acknowledging that the risk of slower growth is greater than the risk of inflation. Predicting when and if that will come is like predicting when "measured pace" would disappear last year. Lots of people will call it before it happens, and a few will be surprised. But the Fed knows that they have to choose their words carefully, and in this instance it may mean that a rate cut will come without a lot of advance warning provoking speculation in the financial markets. The relevant reference for you is January 2001. If a rate cut comes, it could very well take us by surprise in terms of its timing. If, on the other hand, things improve this summer and a rate hike becomes necessary, the signs will be much more clear.
And so we sit, still waiting for the other shoe to drop.
I've often wondered about the big vacant lot in the Chicago Loop bounded by State, Washington, Randolph, and Dearborn. Just what are they going to put in there? I don't need to wonder any longer. (NY Times article on Block 37.)
More on the history of Block 37, and a construction cam.
The latest housing statistics, released yesterday by the Commerce Department, suggested that the months ahead would be equally bleak. The number of building permits issued in October fell for the ninth straight month, dipping to the lowest rate since 1997.
The report deepened concerns that the slowdown in the housing market could brake economic growth more than analysts have anticipated.
The number of new homes that builders started in October was down 14.6 percent from September, at seasonally adjusted annual rates, to 1.49 million. The number of building permits issued fell 6.3 percent, to 1.54 million.
James Hamilton has more. I don't think this is over. All eyes will be on next month's data to see if this rate of decline holds up. By itself, this does not necessarily mean a recession, but it does shift the balance of risks. Combined with yesterday's CPI news which were lower than what most were hoping, but not outside the range I had in my head, this is enough to get me to raise my probability of a Fed rate cut in early 2007 by a little bit. Earlier this week, I would have said that a rate cut in the first 3 months of 2007 had about a 1 in 4 probability. Today I'd go up to 1 in 3.
The charts at the Cleveland Fed show a small rise in the probability of a cut in January as well as a perceptible rise in the probability that the rate in March will be 4.75%. Chew on that over the weekend.
Source: Cleveland Fed
The NY Times has a good article on the re-fi boom.
It is the latest twist in the gravity-defying world of the high housing prices and exotic low-rate mortgages: As monthly payments on adjustable-rate mortgages are starting to balloon, many Americans have found a way to put off the day of reckoning.
...
When that happens, for instance, a typical borrower with a $200,000 A.R.M. could see his monthly payments increase nearly 25 percent when the A.R.M. adjusts from 4.5 percent to 6.5 percent. In total dollars, that is an increase from $1,013 a month to $1,254.
Yet instead of paying more now, many borrowers are refinancing into their second or third adjustable-rate mortgage, loan data indicate and industry experts confirm.
So far, the number of borrowers refinancing this way is relatively small — several hundred thousand in the estimate of the credit ratings firm Fitch Ratings — but mortgage industry officials and analysts expect the numbers will surge next year. In doing so, these borrowers are pushing out any eventual shock of higher payments by another two or three years, if not longer.
“They get another two- or three-year hybrid with a low introductory rate to keep payments down,” said Frank E. Nothaft, a vice president and chief economist at Freddie Mac, the mortgage buyer. “They’re trying to put it off forever, which is O.K. as long as interest rates are low. But when they start to spike, then it’s going to be more problematic.”
Obviously they are chasing after the low "teaser" rates that come with a new ARM, which, though higher than a year ago, are still reasonable. They'd just better hope that Bernanke does a good job of warding off inflation...and that their house continues to appreciate. Do you feel lucky? The article continues...
But the refinancing also represents a doubling-down on a bet that housing prices will continue to rise on the West and East Coasts and in other hot markets. If the value of the home falls closer to the amount of the loan, that could curb the ability to refinance, and may prompt the homeowner to either invest more in the home or to sell it.
Such would be the case if you had an interest only ARM and a high loan-to-value ratio.
With his new loan, his third adjustable-rate mortgage, Mr. Perry, a former technology project manager, cashed about $200,000 out of his home’s equity and is investing it into his four-year-old financial planning business. “I could have sold my house and made my family move,” said Mr. Perry, 42, who lives with his wife and a 3-year-old son in Danville, about 20 miles east of Oakland. “But I didn’t do that. I said, ‘Look, I want to start a new business,’ and this product allowed me to do that.”
He said he was taking on more risk than many of his clients would be willing to because he believes his business will continue to grow. After spending 15 years in the technology industry, which put him on the road constantly, Mr. Perry said that being self-employed allowed him to spend more time with his family, which he also expects to grow. As far as the house, he said: “I am not going to be here for 30 years. Why is it important to have a fixed mortgage?”
And who am I to fault a person for taking a risk. This strategy can pay off, and it is quite possible that the subject of the article is just the type of person who can really benefit from this. It all depends on a person's willingness to take on a risk and their fallback position if things don't work out as planned. That is a highly individual decision. I predict that these stories will be told with increasing frequency. Some will turn out better than others.
However, there is one piece of this story that the Times left out. I was about to write that they omitted the fees that go along with refinancing. But a new blog worth reading, Credit Slips, beat me to it. (Hat tip to Stephen Bainbridge for calling attention to this new site.)
The Times article does not emphasize how expensive this re-refinancing is. Closing costs and fees all get lumped back in to increase the outstanding balance. Keep in mind that these buyers couldn’t make market-based payments on the old, lower balance. The odds of making those payments on the new, higher balance are worse than those in any Las Vegas gambling parlor.
In the industry, these mortgages are called 2/28s. The numbers refer to the teaser period (the 2) and the real payout period with the higher-than-market interest rates (the 28). How can the “2” be profitable for the lender, if the debtor re-fi’s the loan without paying the high 28 period? Many of these loans carry a pre-payment penalty, along with up-front fees and closing costs that make them instantly profitable. Even if the debtor refi’s immediately, the amount paid off includes all these costs, making the effective interest rate for the “2” ten or twenty times higher than the stated interest rate. In the 2/28 game, the lender nearly always wins.
Could re-refinancing be the knife that will cleave what is left of the middle class? There will be those who have fixed-rate mortgages, who pay off their homes, and who have something for retirement or savings if a catastrophe hits. And then there will be those who live in houses, paying high rent, always vulnerable to rate hikes, flat real estate markets, job layoffs, etc. That last group will nominally be called "homeowners" just like the first, but they won't really be. They will play the 2/28 game until they go bust.
In Vegas, the odds always favor the house. In banking, transaction costs can make it difficult (though not impossible) to get free money. Those prepayment penalties can be steep. So shop around for the lowest fee structure. With good credit, there are probably still some to be had. However, many of these people do have less than perfect credit. They will end up paying the fees. While I stop short of condemning these types of mortgages, it suffices to say that one has to weigh the risks carefully, and check the fee structure on the loan. Such loans do increase the housing opportunities for many people, and many will use them to their long-run advantage. However, the bank needs its cut, and someone, somewhere will pay the freight.
Or, as economists are fond of saying, "TANSTAAFL!"
Read it here (NY Times). Much has been made lately of the apparent bubble in housing in certain areas of the country. As a measure of that bubble, we can look at the price-rent ratio. Calculated Risk, for one, has been keeping track of it. The Times article indicates that the tide might be turning, at least in some areas.
Throughout the South, in cities like Atlanta and Charlotte, N.C., fewer apartments are empty, building managers say. Nationwide, the vacancy rate for rentals fell to 9.8 percent in the second quarter after having climbed early in 2004 to 10.4 percent, the highest level since the Census Bureau began keeping statistics in 1956.
That might reverse the trend that I noted here.