The Big Picture - Macro Perspective on the Capital Markets, Economy, Technology, and Digital Media

I have long argued that home prices are elevated, and until they normalize, the economy will be stuck in the doldrums. I even wrote a chapter of Bailout Nation, titled “The Virtue of Foreclosure.” I make a basic economic argument that the excess credit of the 2001-07 era is unwinding, and foreclosures are part of that process.

The simple premise is that the abdication of lending standards by both bank and nonbank lenders created an enormous credit bubble. Easy money drove home prices to unsustainable and unaffordable levels. People bought homes far more expensive than they could reasonably afford. Many assumed they would be able to refinance, paying for the excess costs by cashing out the price appreciation everyone knew was sure to follow.

Of course, we know what happened next. Prices rose unsustainably, credit tightened up, and the supply of greater fools abated. So much for the real estate perpetual motion machine.

What we were left with was an oversupply of new homes, and 4-8 million people in homes they couldn’t really afford. When measure by traditional metrics like median price to median income, costs of ownership relative to renting, or Homes as a % of GDP, houses were extremely expensive.

Running 300,000 monthly foreclosures — on pace to do 3 million foreclosures this year — the prior boom process is now unwinding. Excess prices are normalizing — but they still remain somewhat elevated compared to historical ratios. Perverse though it may be, the mass Foreclosures are helping to drive prices back to normalized historic levels.

Although this process is a necessary evil, Politicians of all stripes hate it. Between the NAR and NAHB, they have ready lobby fighting market forces. The lobbyists shamelessly ignore the role their members played in blowing up the bubble, and how they encouraged irresponsible and in many cases illegal behavior. The NAR and the NAHB have yet to offer up their mea culpas for their contributions to the mess, but their roles were substantial.

All of the home mortgage modification programs and foreclosure abatements are attempts by politicos to “ease the pain.” These programs have proven themselves to be ineffective in preventing defaulting mortgages from going into foreclosure. More than 50% of all mods slip into foreclosure again, and in some instances, we see 70-80% delinquency rates.

But the real question is “Why are we trying?” Except for those instances where there has been fraud or predatory lending, we really should not intervene. The foreclosure process is restoring prices to where they should be. (Note I suggested a voluntary program last year that helped banks forestall writedowns, and allowed viable homeowners to keep their houses, but also lowered prices).

Now comes the latest attempt by politicians to intervene in the housing market: Expanding the about to expire, $8,000, first time home buyers tax credit to a $15,000 credit for everyone.  This is counter productive. (Won’t that just make prices more expensive?) The lobbyists want to goose the housing market by any means possible — even if it is an expensive and unhealthy method.

A recent Brookings Institute analysis (found via Barrons) demonstrates persuasively that the $8,000 subsidy actually costs $43,000 per extra house sold; worse yet, the new $15k tax credit will ultimately cost $292,000 per home.

How does that math work? :

“[The] refundable tax credit, which was part of the February stimulus bill, gives $8,000 to first-time homebuyers (but is phased out at higher incomes). It is scheduled to expire on December 1, 2009, although the sponsor of the initial proposal, Senator Johnny Isakson, now wants to extend the credit for another year, and expand it to $15,000. This extension would be a mistake.

Approximately 1.9 million buyers are expected to receive the credit, but more than 85 percent of these would have bought a home without the credit. This suggests a price tax of about $15 billion – which is twice what Congress intended – for approximately 350,000 additional home sales. At $43,000 per new home sale, this is a very expensive subsidy . . .

An extension and expansion of the tax credit will cost far more than the $15 billion of the current credit, likely in excess of an additional $30 billion. And the cost per new house sale will likely be much higher going forward, as a greater proportion of the sales will be for those who would have bought anyway, without the credit. (emphasis added)

In a latter posting, Gayer does the math on the new tax credit: A one-year, $15,000 tax credit  apply to all home buyers, would cost the Treasury ~$73.9 billion. Gayer estimates that beyond the people who would have purchased homes anyway, the increase in house sales would be about 253,000. Each extra home sales costs the Treasury $292,000 ($73.9 billion divided by 253,000.)

Randall Forsyth points out a lower (but still absurd) figures calculated by the NAHB:

The National Association of Home Builders, not exactly a disinterested bunch, figures the subsidy would boost house sales considerably more, by 700,000 homes. That implies each of those additional sales would cost American taxpayers only $133,000 — still “a very expensive and poorly targeted subsidy,” writes Gayer.

Its one thing to argue as to whether the government should be so brazenly intervening into the housing market, and I can understand reasonable people disagreeing. But the subsidy — whether its $133,000 or $292,000 — is absurd.

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Sources:
Extending and Expanding the Homebuyer Tax Credit Is a Bad Idea
Ted Gayer
The Brookings Institution, October 9, 2009

http://www.brookings.edu/opinions/2009/1009_homebuyer_gayer.aspx

Homebuyers’ Handout — Worse Than Cash for Clunkers
Randall W. Forsyth
Barron’s OCTOBER 21, 2009

http://online.barrons.com/article/SB125609957458798391.html

More on the Homebuyer Tax Credit
Ted Gayer
The Brookings Institution, October 14, 2009

http://www.brookings.edu/opinions/2009/1014_home_tax_credit_gayer.aspx

(if video does not load, click here)

In The Warning, veteran FRONTLINE producer Michael Kirk unearths the hidden history of the nation’s worst financial crisis since the Great Depression. At the center of it all he finds Brooksley Born, who speaks for the first time on television about her failed campaign to regulate the secretive, multitrillion-dollar derivatives market whose crash helped trigger the financial collapse in the fall of 2008.

“I didn’t know Brooksley Born,” says former SEC Chairman Arthur Levitt, a member of President Clinton’s powerful Working Group on Financial Markets. “I was told that she was irascible, difficult, stubborn, unreasonable.” Levitt explains how the other principals of the Working Group — former Fed Chairman Alan Greenspan and former Treasury Secretary Robert Rubin — convinced him that Born’s attempt to regulate the risky derivatives market could lead to financial turmoil, a conclusion he now believes was “clearly a mistake.”

Born’s battle behind closed doors was epic, Kirk finds. The members of the President’s Working Group vehemently opposed regulation — especially when proposed by a Washington outsider like Born.

“I walk into Brooksley’s office one day; the blood has drained from her face,” says Michael Greenberger, a former top official at the CFTC who worked closely with Born. “She’s hanging up the telephone; she says to me: ‘That was [former Assistant Treasury Secretary] Larry Summers. He says, “You’re going to cause the worst financial crisis since the end of World War II.”… [He says he has] 13 bankers in his office who informed him of this. Stop, right away. No more.’”

Greenspan, Rubin and Summers ultimately prevailed on Congress to stop Born and limit future regulation of derivatives. “Born faced a formidable struggle pushing for regulation at a time when the stock market was booming,” Kirk says. “Alan Greenspan was the maestro, and both parties in Washington were united in a belief that the markets would take care of themselves.”

Now, with many of the same men who shut down Born in key positions in the Obama administration, The Warning reveals the complicated politics that led to this crisis and what it may say about current attempts to prevent the next one.

“It’ll happen again if we don’t take the appropriate steps,” Born warns. “There will be significant financial downturns and disasters attributed to this regulatory gap over and over until we learn from experience.”

Some of the emails that recently came to light — from prior to the Merrill acquisition closing — makes it pretty hard for the company to claim MAC — Material Adverse Condition. The email exchanges make clear it they had a pretty good idea about the lousy condition Merrill Lynch was in. To my read, it looks like they got cold feet once they realized they bid too much too soon.

I think Kenny has some ‘splainin to do!

“Congressional investigators think that reams of internal documents turned over by Bank of America last Friday show that its executives were alarmed by mounting losses at Merrill Lynch well before shareholders voted to approve the merger, according to sources familiar with the matter.

Investigators also think the documents, combined with prior testimony and fresh interviews with a key executive, suggest that Bank of America chief executive Kenneth D. Lewis used the threat of backing out of the government-backed deal as leverage for billions more in taxpayer bailout money, the sources said.”

The lawyers are not going to be happy about this one . . .

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Source:
Documents raise skepticism on Hill about Bank of America
Tomoeh Murakami Tse
Washington Post October 21, 2009

http://www.washingtonpost.com/wp-dyn/content/article/2009/10/20/AR2009102004159.html

Some quickies for hump day:

• Late edition bonus: Pay Czar to Slash Compensation at Seven Firms (WSJ)

• Car Czar Shocked by Detroit (Fortune)

• Blame It All On Ayn Rand (MarketTalk)

• How to manage the gigantic financial cuckoo in our nest (FT)

• Imperialism, Goldman Sachs Style (NYT)

• Bailout’s hidden costs (CNN/Money)

• Wall Street on edge as SEC top cop gets aggressive (Reuters)

• Persistent pessimism (Marketwatch)

• Google To Release New Music Service (TechCrunch)

• The 8 Best Viral Advertising Videos of 2009 (So Far)

What are you reading?

Mervyn King Speech Break Up Banks

click for video

Governor Daniel K. Tarullo

At the Exchequer Club, Washington, D.C.
October 21, 2009

Confronting Too Big to Fail

The far-reaching financial crisis that has afflicted our country in the past two years has drawn attention to a raft of problems–from the concentration of commercial real estate exposures in some regional and community banks, to the risks associated with some forms of derivatives, to the need for more vigorous financial services consumer protection. Proposals for administrative and congressional responses are thus appropriately diverse. I would suggest, however, that the reform process cannot be judged a success unless it substantially reduces systemic risk generally and, in particular, the too-big-to-fail problem. This afternoon I will address my remarks specifically to the task of forging an effective response to this problem.¹

The Current Form of the Too-Big-to-Fail Problem
The concern is hardly a new one. In one manifestation, too big to fail was an extension of the classic problem of bank runs and panics. If a large bank failed–whether because it was illiquid after a deposit run or insolvent after severe losses–the entire banking system might be endangered. In cases in which other banks held significant deposits in the distressed institution, the failure of a large bank might lead directly to the illiquidity or insolvency of other banks. The result could be a domino effect in the interbank lending market, with one bank’s failure toppling the next. Even where direct losses to other banks were thought manageable, the failure of a large bank might strike panic into depositors, especially uninsured depositors, of other large institutions. The result might be a far-reaching run on the entire banking system that could, in a worst case such as occurred in early 1933, freeze the financial system completely.

Faced with either variant of such a devastating impact on the system, government authorities often believe they have little choice but to intervene. The government may provide funds or guarantees to the bank in order to keep it functioning. Alternatively, the government may allow the bank to fail, but shield some or all of its depositors from loss, even those not covered by existing insurance programs. In 1984, for example, the Federal Deposit Insurance Corporation protected the uninsured depositors of Continental Illinois Bank, then the nation’s seventh largest depository institution, after a foreign depositor run that followed heavy losses.

Read the rest of this entry »

Wow, here is something we haven’t had to write about in a long while — new highs in Crude Oil. (Gee, I wonder if the shrinking dollar has anything to do with this?)

CLZ9 – CRUDE OIL December 2009 (NYMEX)

Source: Barcharts

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Truly the cruelest tax . . .