Is Fannie Mae the Next Government Bailout?

Voltron says: I was tragically too early on this. I bought Fannie Mae puts in that expired worthless in Jan 2007. It just goes to show that these things can take longer than you expect. A.K.A. the market can be irrational longer than you can remain solvent. BARRON'S COVER

By JONATHAN R. LAING

IT'S PERHAPS THE CRUELEST OF ironies that in the U.S. housing market's greatest hour of need, the major entity created during the Depression to bring liquidity to housing, Fannie Mae, may itself soon be in need of bailout.

Fannie, of course, occupies a curious middle ground between the public and private sector as a result of its privatization in 1968 as a Government Sponsored Enterprise, or GSE. While owned by its shareholders, Fannie is regulated by a government agency and is able to borrow money cheaply, thanks to an implicit guarantee by Uncle Sam. It uses those funds to buy and securitize home loans -- lots of them. At year end, the company owned in its portfolio or had packaged and guaranteed some $2.8 trillion of mortgages or 23% of all U.S. residential mortgage debt outstanding.

The company's balance sheet appears larded with iffy assets and understated liabilities.

Of late, however, Fannie's prospects have darkened notably. The company (ticker: FNM) lost $2.6 billion last year as a surge of red ink in the final two quarters more than wiped out a nicely profitable first half. And by late last week, credit-market jitters had penetrated the once-unassailable hushed precincts of the market in Fannie debt.

In the wake of margin calls on collateral at the investment concern Carlyle Capital, yields on guaranteed mortgage securities issued by Fannie and its GSE sibling Freddie Mac (FRE) rose to their highest level over U.S. Treasuries in 22 years. Likewise credit default swaps, measuring market concerns over the safety of Fannie corporate debt, have ballooned out to 2% of the insured amount from 0.5% just four months ago.

Company executives attribute such concerns to what Fannie CEO Daniel Mudd last month called "the toughest housing and mortgage market in a generation." He also said that much of 2007's loss came from reducing to market levels the value of derivatives that Fannie uses to hedge its interest-rate risk. And those accounting moves should reverse and fatten earnings in the fullness of time once interest rates stop dropping.

But, if the truth be known, a considerable portion of Fannie's losses also came from speculative forays into higher-yielding but riskier mortgage products like subprime, Alt-A (a category between subprime and prime in credit quality) and dicey mortgages requiring monthly payments of interest only or less. For example, Fannie's $314 billion of Alt-A -- often called liar loans because borrowers provide little documentation -- accounted for 31.4% of the company's credit losses while making up just 11.9% of its $2.5 trillion single-family-home credit book. Fannie was clearly looking for love -- and market share -- in some of the wrong places.

Likewise, Barron's has found other areas that may bode ill for Fannie's prospects. Its balance sheet is larded with soft assets and understated liabilities that would leave the company ill-equipped to weather a serious financial crisis. And spiraling mortgage defaults and falling home prices could bring a tsunami of credit losses over the next two years that will severely test Fannie's solvency.

Should Fannie or the similarly hobbled Freddie Mac buckle, the government would no doubt bail them out and honor their debt and mortgage guarantee obligations. Fannie common and preferred shareholders would likely suffer grievously in such a scenario.

Fannie, for its part, insists it's more than adequately capitalized to withstand any future stress. The company also contends that as a result of tightening its standards and making fewer risky loans, the quality of its book of business will improve mightily.

But some financial leaders aren't so sure. At a conference several weeks back, William Poole, president of the St. Louis Federal Reserve Bank, said that the GSEs (clearly a reference to Fannie and Freddie) appeared to be insufficiently capitalized to handle the kind of losses suffered by U.S. major banks in the past six months. "I do not have any information on the GSEs that the market does not have," he said. "Nevertheless, in assessing the risk of further credit disruptions this year, I would put the GSEs at the top of my list of sources of potentially serious trouble."

And, in commenting on the government's "too big to fail doctrine" for financial institutions, he said: "First, firms in trouble ought not to be bailed out, unless the bailout takes a form that imposes heavy costs on managers and shareholders."

POOLE HAS LONG BEEN skeptical -- correctly it turns out -- of Fannie and Freddie's ability to serve both God (their social mission of promoting liquidity and affordability) and Mammon (the shareholder and lush management compensation). At Fannie, a generation of Democratic Party insiders, such as James Johnson, Jamie Gorelik and Franklin Raines, made substantial fortunes in Fannie's executive suite. As Fannie Mae's top regulator, James Lockhart, pointed out in recent congressional testimony, the absence of debt-market discipline (the government guarantee makes Fannie and Freddie all but impervious to credit downgrades) makes pell-mell growth irresistible to shareholders and managers. Have a hunch, bet a bunch.

The Bottom Line:

The stock down 65% since last fall, may well fall a lot farther. As capital declines, the company could issue more stock. But that, too, would hurt shareholders.

A major scandal erupted at Fannie earlier in the millennium when the company was found to be cooking its books to hide a multibillion-dollar loss it had incurred when massive interest-rate bets went awry. Freddie got nailed at the same time for setting hedging profits aside in a cookie jar to boost results in subsequent years. Yet, the recent lending bets made by Fannie are likely to prove far more damaging.

On the surface, Fannie's balance sheet looks fine. At year end, the company reported regulatory net worth of $45.4 billion, some $3.9 billion higher than the expanded minimum capital of $41.5 billion required by federal regulators. But with its extreme leverage -- assets stand at 20 times net worth -- Fannie has little room for error. And there appear to be significant problems with the way Fannie has valued both its assets and liabilities.

For example, some $13 billion of its $45.4 billion in net worth consists of deferred tax assets that have value only if Fannie can earn enough money in the near future (say $36 billion) to employ them. That hardly seems likely. During the housing boom of 2002 to 2006, this tax asset only climbed -- from zero to $8 billion as Fannie reported $23 billion in income from 2003 to 2006.

Last year's $2.6 billion loss compounds the problem, pushing the tax asset to $13 billion. At a minimum, accountants may require the company to sharply write down the value of this asset, thus slashing net worth. Bank regulators, for example, limit the amount of deferred tax assets for regulatory purposes to the lesser of the amount expected to be used within one year or 10% of regulatory capital. So if Fannie were a bank, this entire asset would be wiped out. Fannie maintains the value of the asset will be realized over time.

Another soft asset is Fannie's $8.1 billion of Lower Income Housing Tax Credit partnerships. The partnerships' only value, other than helping fulfill Fannie's housing affordability requirements, are the rich tax credits they generate from their intended operating losses. The problem is that Fannie hasn't made enough money to employ these tax credits. Thus the asset is apt to dwindle away to zero without providing Fannie any benefit. Fannie makes no predictions on the future values.

The story is much the same for the liability side of Fannie's balance sheet. There's an item called guaranty obligation, which represents the company's best estimate on what it will have to pay out to make good on any mortgage defaults in its $2.4 trillion guaranty book. On its regular balance sheet, Fannie carries the item at $15.4 billion, but on its "fair value" balance sheet, which attempts to mark every asset and liability to current market value, the guaranty obligations are pegged at $20.6 billion. The problem was, as Morgan Stanley analyst Kenneth Posner discovered, Freddie went through the exact same drill with its guaranty obligations' fair value and chose to mark them much more aggressively. It valued them at 1.5% of its guaranteed book, double the 0.74% of total book that Fannie saw fit to use, even though Freddie's delinquency rate is lower than its rival's.

Had Fannie taken a similar hit, its fair-value net worth would've shrunk by some $20 billion to a paltry $16 billion, compared with its juiced-up regulatory capital of $45.4 billion. Fannie stands by its estimate and says it doesn't know how Freddie arrived at its own.

Finally, Fannie seemed to have been inordinately easy on itself when, in the fourth quarter, it wrote down its $74 billion holdings of privately packaged, non-agency subprime and Alt-A mortgage securities by a mere 6%, or $4.6 billion. In addition, Fannie declared that only $1.4 billion of the write-down constituted a permanent impairment, something that penalized both Fannie's profits and net worth. The remainder of the write-down was deemed a temporary mark-to-market loss that had no such negative impact.

Had Fannie charged off the remaining $3.2 billion that would have torched most of the $3.9 billion in excess regulatory capital that it held at the end of the fourth quarter. Nearly all the major banks, from Merrill Lynch to UBS, have taken much larger percentage write-downs on their holdings of similar mortgage paper, and ran virtually all the losses through their income statements.

In any event, continued deterioration since year end in indexes like the ABX triple-A index indicate that Fannie, based on the different vintages it owns, should conservatively take another $14 billion charge, according to Barron's estimates. Fannie Mae says that since it's a long-term investor, it should incur no permanent decrease in asset value beyond what it has recognized.

The very survival of Fannie as a going concern hinges on the size and speed of the credit losses it faces in the years ahead. Merrill Lynch's Kenneth Bruce sees Fannie suffering losses on its current book of around $32 billion over the next decade. Yet, he still expects the company to manage recovery earnings per share of between $2.50 to $4 between 2009 and 2011.

His forecast, however, is based on spirited 8% average annual growth in Fannie's credit book over the decade. Although Fannie has just been cleared to deal in mortgages of up to $700,000, from $420,000 now, 8% growth could be hard to come by if the company's capital remains stretched.

Pillars in Peril? Problems at Fannie Mae and Freddie Mac can have big implications. The agencies support some 55% of all mortgage originations, after a dip in 2004-2006, and account for half of all outstanding mortgages.

IN OUR VIEW, THE RAPID DECLINE in home prices and soaring level of foreclosures might cause the wave of credit losses to hit far sooner and with greater ferocity than many imagine, potentially submerging the income Fannie is expecting to harvest from volume growth and higher lending fees.

A new phenomenon of widespread negative equity -- homeowners owing more on their mortgage than the underlying property is worth -- has wrought a sea change in borrower behavior. Borrowers, whether subprime or prime, financially stretched or flush with cash, are walking brazenly from their l obligations in stunning numbers.

To be sure, Fannie has a better book of mortgages than most institutions. Fannie requires a layer of credit insurance on much of its high-loan-to-value mortgages. The GSEs have long insisted on higher underwriting standards on the loans they purchase in the secondary market.

Yet using conservative default rates of 40% on its $133 billion subprime book, 12.5% on its $314 billion of Alt-A mortgages and 4% on its remaining $2 trillion of prime home mortgages, Fannie could well be facing cumulative credit losses of over $50 billion. That's after assuming Fannie will realize recoveries of 60% on its subprime and Alt-A loans and 70% on its prime loans. Should Fannie founder over the next couple of years, the government would have no choice but to step in and back all of its debt and guarantee obligations. Too much of the paper is owned by our major creditors, such as China and Japan.

Perhaps, both Fannie and Freddie can go back to the capital markets to raise more equity, as they did last fall when both sold a combined $13 billion of preferred stock. Both have said they may take such action should circumstances demand it. But with both stocks in steep decline -- Fannie's is down 65% since last fall -- offerings would bring punishing dilution and growing investor skepticism.

Just maybe a bailout of Fannie, in effect a nationalization, would be a good thing. A retooled Fannie could pursue its important social mission without the distraction of trying to please Wall Street. Of course, it's doubtful if this happens that the shareholders would be along for the ride.

TIPS' Yields Show Fed Has Lost Control of Inflation

By Sandra Hernandez and Deborah Finestone

March 10 (Bloomberg) -- Bond investors have never been so sure that the Federal Reserve will lose control of inflation. They're so convinced that they're giving up yields just to buy debt securities that protect against rising consumer prices.

The yield on the five-year Treasury Inflation-Protected Security due in 2012 has been negative since Feb. 29, and traded today at minus 0.17 percent. The notes, which were first sold in 1997, have never before traded below zero. Even so, firms from Deutsche Asset Management to Vanguard Group Inc., the second- biggest U.S. mutual fund company, say TIPS are a bargain.

For the first time in a generation, money managers must come to grips with a central bank that's more intent on spurring the economy than restraining price increases. With oil above $100 a barrel, gold approaching $1,000 an ounce and the dollar at a record low against the euro, TIPS show investors aren't convinced Fed Chairman Ben S. Bernanke will be able to tame inflation once policy makers stop cutting interest rates.

``The way TIPS are trading now, investors believe headline inflation will stay lofty and are willing to give up the real yield for that,'' said Brian Brennan, a money manager who helps oversee $11 billion in fixed-income assets at T. Rowe Price Group Inc. based in Baltimore. Prices for the securities indicate ``a real concern of a recession and high headline inflation,'' he said.

Because TIPS pay a principal amount that rises in tandem with the consumer price index, buyers accept lower yields in a bet the inflation adjustment will make up the difference.

Volcker Fed

Investors typically determine what they are willing to receive in interest by deducting the rate of inflation expected over the life of the securities from the rate on a comparable Treasury. Investors can still earn money from TIPS with sub-zero rates because the principal rises with the CPI.

Five-year TIPS yielded 2.36 percentage points less than similar-maturity Treasuries as of 9:14 a.m. in New York. The so- called breakeven rate has risen from a four-and-a-half-month low of 1.89 percent on Jan. 23, the day after policy makers cut their target lending rate by three-quarters of a point to 3.50 percent in an emergency move.

The last time investors were so worried about faster inflation amid slowing growth, Paul A. Volcker presided over a Fed that would raise rates as high as 20 percent to end the stagflation crisis of the 1970s, according to Seth Plunkett, a bond fund manager at American Century Investment Management in Mountain View, California. The firm manages $20 billion.

Fed Forecast

Inflation ``is going to be higher than the Fed's targeted area,'' said Plunkett, whose fund owns a greater percentage of TIPS than contained in the index he uses to measure performance.

In forecasts released last month, the Fed said it expects inflation to accelerate 2.1 percent to 2.4 percent this year, and 1.7 percent to 2 percent in 2009.

TIPS have returned 6.2 percent this year, compared with 3.7 percent from regular Treasuries, according to indexes compiled by Merrill Lynch & Co. Mutual funds that specialize in inflation-linked debt attracted a net $2.87 billion in January, boosting their assets to $47.6 billion, according the latest data available from Financial Research Corp. in Boston. In all of 2007, the funds added a net $3.54 billion.

``TIPS are a really good buy,'' said Bill Chepolis, a money manager who helps oversee $9 billion at Deutsche Asset Management in New York. He bought five-year TIPS in the last six months. ``They're cheap with the Fed continuing to emphasize growth over inflation and inflation continuing to come in higher.''

Too Expensive

Investors seeking a haven from credit-market losses have pushed yields on all Treasuries lower, including TIPS. Five-year nominal note yields have dropped 1.03 percentage points this year to 2.41 percent.

``It's crazy,'' said Richard Schlanger, a portfolio manager at Boston-based Pioneer Asset Management, which oversees $44 billion in fixed income. ``You're paying the government to buy five-year TIPS. People are hiding in Treasuries for liquidity's sake because of a lack of liquidity in other markets. Eventually this will pass.''

Record-low TIPS yields also reflect bets on surging commodities. Crude oil futures rose to $106.54 last week and are up 70 percent in the past year.

Growth in countries such as China and India mean that rising prices for goods including wheat, gold, and oil ``may be a permanent thing,'' said Paul Samuelson, the second recipient of the Nobel Prize in economics who helped popularize the term ``stagflation.'' ``This time it's primarily not made-in-America inflation.''

Resumed Sales

The Treasury stopped selling five-year TIPS between 1998 and 2003, and resumed auctions in October 2004. In addition to the current five-year security, seven other inflation-indexed notes with up to four years to maturity currently yield less than zero.

Should five-year TIPS continue to have negative yields when the Treasury holds its next sale April 22, federal rules state investors would receive a coupon of zero percent, said Stephen Meyerhardt, a Bureau of Public Debt spokesman in Washington.

``TIPS have performed really well for the right reasons and they will continue to perform well for the right reason,'' said Kenneth Volpert, a fund manager overseeing $14.7 billion in inflation-linked debt at Vanguard in Valley Forge, Pennsylvania.

FBI Investigates Countrywide

	March 8, 2008

U.S. Scrutinizes Filings On Financial Strength, Loan Quality for Fraud By GLENN R. SIMPSON and EVAN PEREZ WASHINGTON -- The Federal Bureau of Investigation is probing subprime lender Countrywide Financial Corp. for possible securities fraud, according to law-enforcement officials and finance-industry executives. The inquiry involves whether company officials made misrepresentations about the company's financial position and the quality of its mortgage loans in securities filings, four people with knowledge of the matter said. It is at an early stage, they emphasized. "We are not aware of an investigation being conducted by the FBI," Countrywide spokeswoman Jumana Bauwens said in an e-mail. A spokesman for Bank of America Corp., which is in the midst of acquiring Countrywide, declined to comment. Fifteen other subprime companies also are under scrutiny by federal agents and prosecutors in a broad look at the subprime industry sparked by huge losses on residential mortgages and the securities used to fund them. The investigations are examining mortgage-origination fraud, conflicts of interest and undisclosed relationships within the industry, and the practices used to package mortgage-backed securities for sale to investors. Countrywide issued more than $100 billion in mortgage-backed securities between 2004 and 2007, according to the newsletter Asset Backed Alert. More than two dozen Wall Street firms helped construct those deals, making it possible that some of them will also face law-enforcement scrutiny. While Countrywide is based in Calabasas, Calif., near Los Angeles, the inquiry is being handled in New York and overseen in Washington, people familiar with the matter said. Federal prosecutors in New York have primary jurisdiction over securities-fraud cases, while FBI and Justice Department officials are coordinating the subprime probes here. Federal investigators are looking at evidence that may indicate widespread fraud in the origination of Countrywide mortgages, said one person with knowledge of the inquiry. If borne out, that could raise questions about whether company executives knew about the prospect that Countrywide's mortgage securities would suffer many more defaults than predicted in offering documents. Another potential issue facing the company is whether it has been candid in its accounting for losses. People familiar with the matter said that Countrywide's losses may be several times greater than it has disclosed. Countrywide, which agreed in January to be acquired by Bank of America for $4 billion, already is under investigation by the Securities and Exchange Commission for possibly improper accounting. SEC investigators are working closely with FBI agents on several subprime investigations, officials said. The attorneys general of Florida and Illinois have launched probes too. Countrywide also is the subject of a class-action, securities-fraud civil lawsuit by various government pension funds and their managers, including the city and state of New York. The lawsuit identifies more than 25 firms that helped Countrywide package and sell mortgage-backed securities, including Goldman Sachs Group Inc., J.P. Morgan Chase & Co. and Lehman Brothers Holdings Inc. The firms have denied any wrongdoing. Countrywide "misled investors by falsely representing that Countrywide had strict and selective underwriting and loan origination practices, ample liquidity that would not be jeopardized by negative changes in the credit and housing markets, and a conservative approach that set it apart from other mortgage lenders," the suit alleges. At its peak, Countrywide was the nation's biggest home lender, originating more than $450 million in mortgages annually, or about one-fifth of all home loans. Its "servicing portfolio" of mortgage loans exceeds $1 trillion. Last month, Countrywide disclosed that its losses for the fourth quarter of 2007 were $422 million, more than double the estimate of analysts. There is no indication that Bank of America, now conducting due diligence at Countrywide, is having second thoughts about completing the acquisition. In fact, people familiar with the matter said Bank of America is rushing to close the Countrywide acquisition as quickly as possible, perhaps in August. --John R. Wilke and Kara Scannell contributed to this article.

Rumour of Second Bail Out Rumour

I love these comments, coming from a pair of clever traders in the UK:

Rumour of second bail out rumour coming in Ambac.

Word is that CNBC have heard from a source close to the fire escape that the Monolines are worried that there will be no new rumours about possible rescues around until the recent rescues are proved to have failed.

That means that there'll be no Friday evening prop for the stock markets.

A source close to the industry said that a consortium is "being put in place to work on new rumours but we can't be sure that these rumours will actually be ready for another five business days."

News of the rumoured rumour of salvation sent MBIA and AMBAC up .01% in pre-market trading. Hank Paulson was rumoured to be delighted with the patriotic rumours, a source close to him on his lifeboat off the coast of Hawaii said Thursday. Ben Bernake has placed pencils in his ears and is wearing his favourite underpants on his head.

-David McCreadie and Dan Davies

When it comes to dry, pithy humor, no one can beat the Brits!

Mozilo defends cashing in Countrywide stock

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Mark Wilson / Getty Images

Angelo Mozilo, founder and chief executive of Countrywide Financial, is sworn today during a House Oversight and Government Reform Committee hearing on executive pay.

The unloading of $141 million in options was in preparation for retirement, the Countrywide founder asserts, denying that he was trying to shield himself from the sub-prime meltdown.

By Jonathan Peterson, Los Angeles Times Staff Writer
March 8, 2008

WASHINGTON -- Countrywide Financial Corp. founder Angelo R. Mozilo defended his fortuitous stock trades before a congressional panel Friday, denying that he had manipulated his trading plan to unload about $141 million in stock options before the company collapsed.

"You had good timing," needled Rep. Henry A. Waxman (D-Beverly Hills), chairman of the House Committee on Oversight and Government Reform.

By making changes to his stock trading plan, Mozilo was able to vastly increase his stock sales before Countrywide shares plummeted during last year's mortgage meltdown.

Mozilo, 69, maintained that the sales, which have drawn the scrutiny of federal investigators, were prompted by deadlines he faced to exercise stock options as well as the desire to diversify his assets in preparation for his retirement.

"The goal was to reduce my holdings because of my retirement . . . almost all my net worth was in Countrywide," he said.

Mozilo also said that the timing of his stock sales was unrelated to a stock buyback program Countrywide had at the time. Such programs are sometimes used to shore up a company's stock value, but Mozilo insisted that there "was absolutely no relationship between the buyback of stock and my sale of options."

Mozilo's remarks were made at a congressional hearing on the lofty compensation levels enjoyed by certain chief executives even as their companies were hammered by losses in the sub-prime mortgage market. He was joined at the witness table by Stanley O'Neal, former head of Merrill Lynch & Co., and Charles Prince, former head of Citigroup Inc., along with members of their boards.

O'Neal and Prince were pushed out after their firms suffered billions of dollars in losses tied to ill-fated mortgage securities. Mozilo remains at the helm of Countywide, the company he founded, although he is expected to leave after Bank of America Corp. completes its acquisition of the Calabasas-based lender this year.

The hearing was meant to showcase a chief complaint of corporate critics -- that financial rewards for top executives often seem disconnected to the performance of their companies, with the current mortgage crisis offering a particularly stark case study.

Countrywide sold many of the sub-prime loans that are now going under, leading to increasing losses and its eventual agreement to be taken over by Bank of America. Merrill Lynch and Citigroup lost billions of dollars in their own dealings with mortgage-related securities that proved far riskier than advertised.

"The obvious question is this: How can a few executives do so well when their companies do so poorly?" Waxman asked. "Are the extraordinary compensation packages these CEOs received reasonable compensation? Or does the hundreds of millions of dollars they were given represent a complete disconnect with reality?"

Little was resolved Friday. The executives and board members politely defended the pay arrangements; Republicans on the panel argued that the mortgage crisis is rooted in problems more broad based than executive compensation.

"Punishing individual corporate executives with public floggings like this may be a politically satisfying ritual, like an island tribe sacrificing a virgin to a grumbling volcano," said Rep. Thomas M. Davis III of Virginia, the panel's senior Republican. "But in the end it won't answer the questions that need to be answered about corporate responsibility and economic stability."

Reports that O'Neal received $161 million after being pushed out of Merrill Lynch at a time of record-breaking losses attracted attention as well as stout defense. John Finnegan, chairman of Merrill Lynch's compensation committee, explained that the $161 million was not intended as payment for the company's troubles during 2007 but instead reflected benefits O'Neal had built up in the past, including stock and stock options, some dating to 2000 and earlier.

"All were amounts to which Mr. O'Neal was entitled," Finnegan said.

Said O'Neal: "I received no bonus for 2007, no severance pay, no golden parachute."

Lawmakers also questioned the $10-million bonus paid to Charles Prince, the former Citigroup leader who was pushed out after the firm also was hammered by losses related to the sub-prime debacle.

The bonus amount "was less than half the bonus he got in his previous year," said Richard D. Parsons, the chairman of Time Warner Inc. and chairman of Citigroup's compensation committee.

"I'm proud of my accomplishments," said Prince, while also conceding he was "ultimately responsible" for the company's actions, which included a misunderstanding of the risks of mortgage-backed securities.

But attention repeatedly returned to Mozilo, a self-made magnate who helped shape the modern mortgage business. Rep. Eleanor Holmes Norton (D-D.C.) pressed him on a recent committee disclosure that Countrywide had boosted his pay deal after a new consultant hired by the board sought to maximize what Mozilo could receive.

"None of this makes sense to me," said Norton, alluding to e-mails on the matter that were obtained by the committee. "I want to know how it makes sense to you."

Harley W. Snyder, the chairman of Countrywide's compensation committee, said he disagreed with Norton's interpretation of events, although he did not offer a detailed rebuttal.

During the hearing, Mozilo expressed regret for angry language he had used after being disappointed by a 2006 pay proposal, complaining in an e-mail that year about the "left wing anti business press and the envious leaders of unions."

The pay proposal was "sharply different than what I expected," Mozilo said Friday. "I regret the words I used. I tend to be an emotional individual."

After four hours of give and take, legislators remained deeply divided on whether the executives and their pay packages helped cause the mortgage problems that now threaten the U.S. economy.

"This is a mess," said Rep. Elijah E. Cummings (D-Md.), referring to executives "with golden parachutes drifting off into the golf field" at the same time that people "are losing their homes."

But Rep. Darrell Issa (R-Vista) had a different view.

"Mr. chairman, I look forward to finding if something is wrong here," he told Waxman. "So far you haven't found it."

Aversion to Risk Deepens Credit Woes

By FLOYD NORRIS

The credit markets came under renewed stress Thursday as investors sought absolute safety and even moved away from debt issued by Fannie Mae and Freddie Mac, the government-sponsored mortgage lending enterprises.

The intensifying credit crisis came as one regulator, Timothy F. Geithner, the president of the Federal Reserve Bank of New York, said that some banks had moved from being too willing to take on risks to being reluctant to take any chance of losing money, a move that was making the crisis worse.

“The rational actions taken by even the strongest financial institutions to reduce exposure to future losses have caused significant collateral damage to market functioning,” Mr. Geithner said in a speech to the Council on Foreign Relations. “This, in turn, has intensified the liquidity problems for a wide range of bank and nonbank financial institutions.”

Those liquidity problems intensified Thursday as a new increase in the number of mortgage foreclosures was reported and two financial companies that had relied on borrowed money said they were unable to raise the cash demanded by their lenders.

Both Carlyle Capital, a company sponsored by the Carlyle Group, a major private equity fund, and Thornburg Mortgage, the second-largest independent mortgage lender in the United States after Countrywide, said they had been unable to meet the demands and had defaulted on some obligations. Their stock prices plunged.

The credit market jitters were blamed for a sharp drop in stock prices, with the Standard & Poor’s 500-stock index falling 2.2 percent. Financial stocks were the hardest hit, with an index of such shares falling to its lowest level in more than four years. Fannie Mae shares fell $2.57, or 10.6 percent, to $21.70, and Freddie Mac shares dropped $1.50, or 6.7 percent, to $20.14. Both are at their lowest level in more than a decade.

As the economy grew through most of this decade, much of the growth was fueled by borrowing, both by individuals taking out mortgages and by investors who sought high returns through highly leveraged investments. Some of those investments are now unraveling because lenders will not lend enough money to enable investors to hold on to them. That reluctance forces the sale of investments, which lowers prices and makes lenders even less willing to risk their capital.

“Leverage is acceptable in a stable economic environment, but not in an economic crisis,” Geraud Charpin, a strategist at UBS, wrote last week.

At the end of last year, Carlyle Capital had $21.76 billion in assets, of which $21.69 billion had been pledged as collateral against loans. It had borrowed $31 for every dollar of equity, and even a $150 million line of credit from its parent, the Carlyle Group, was not enough to keep it out of trouble as lenders demanded more collateral to back up their loans.

Fannie Mae and Freddie Mac, whose debt has been viewed as almost as safe as that of the government itself, have played an essential role in keeping the mortgage markets functioning. That is because many mortgage companies have gone out of business and investors have been unwilling to buy mortgage-backed securities unless the government, or one of the enterprises, guaranteed the mortgages.

The difference between the yield on long-term debt guaranteed by Fannie Mae and that of similar Treasury debt rose to its largest level in more than 20 years, providing a new sign of the nervousness that has affected financial markets.

In Congressional testimony, William B. Shear, an official with the Government Accountability Office, warned that Fannie and Freddie, “with more than $6 trillion in outstanding obligations,” could pose “significant risks to taxpayers” if they ran into difficulty.

Each of the two enterprises has a $2.25 billion line of credit with the Treasury, but that is a small fraction of what they owe. Mr. Shear said it was “generally assumed on Wall Street that assistance would be provided in a financial emergency.”

With the trading levels indicating that some traders were no longer as confident of that assumption as they had been, rumors swirled that the Treasury Department was preparing to issue an explicit guarantee of the debts of government-sponsored enterprises, or G.S.E.’s, to calm the market. A Treasury spokeswoman denied those rumors.

“The rumor of an explicit government guarantee for the G.S.E.’s speaks to the gravity of the current situation,” said Margaret Kerins, a strategist at RBS Greenwich Capital.

The index of yields on Fannie Mae guaranteed loans rose to 5.96 percent on Thursday, an increase of 13 basis points from the previous day. (A basis point is one-hundredth of a percentage point.) At the same time, the yield on 10-year Treasury bonds fell 9 basis points, to 3.58 percent.

The difference in the two yields, of 2.38 percentage points, was the largest since 1986 and was more than twice the difference of a year ago, before credit fears began to grow.

The credit crisis began last year with indications of rising defaults on subprime mortgage loans, a problem that bankers and regulators said could be easily contained. But it gradually spread as confidence declined in the financial engineering that has remade the financial system in recent years.

The bond rating agencies have been forced to reduce the ratings on some structured finance products — many of them ultimately backed by mortgage loans — from AAA to very low levels. That has damaged the credibility of the agencies at the same time that it has made investors wary of taking on any risk.

Many of those structured finance products had been guaranteed by bond insurers like MBIA and Ambac, and the fact that they could face significant claims has led to concerns about their solvency.

An effort to bail out Ambac with guarantees from banks foundered on the reluctance of banks to commit capital they might need for other purposes, and a plan announced Wednesday for the company to raise additional capital by selling stock was greeted with hostility by investors, causing its share price to lose nearly a third of its already depressed value in the last two days.

Concerns have also grown about a recession, with economists forecasting an increase in the unemployment rate when February’s job figures are released Friday. On Thursday, the Federal Reserve reported that the net worth of households fell in the first quarter, the first time that had happened since 2002.

The Mortgage Bankers Association reported that the proportion of borrowers more than 30 days delinquent rose to 5.82 percent, the highest since 1985. The situation was worst among subprime borrowers who had taken out adjustable rate mortgages, but the proportion of prime mortgages that were delinquent also rose, to 3.24 percent.

San Diego FHA loan limit raised to $697,500

Voltron say: This is a re-write of an OC Register article with the numbers changed for San Diego Country.

posted by Matt Padilla, Orange County Register Reporter

Beginning tomorrow, San Diego County’s limit on loans insured by the Federal Housing Administration will be temporarily raised to $697,500, almost double the current limit of $362,790, the U.S. Department of Housing and Urban Development announced today.

The limit, which is good until the end of the year when it reverts back to $362,790, will apply only to loans insured under a program administered by FHA, which targets low to moderate-income home shoppers.

HUD will announce tomorrow the new conforming loan limit for San Diego County and other markets, a spokesman said. Conforming loans are sold to government-sponsored buyers such as Fannie Mae and Freddie Mac and have a current limit of $417,000 in California and most states.

The FHA and conforming limit increases could give San Diego County’s housing market a boost. Rates on jumbo loans, which are above the limit, have risen to about a percentage point above conforming rates.

But Fannie Mae and Freddie Mac have yet to say when they will begin buying larger loans or if they will impose any restrictions, such as requiring larger down payments. Some housing watchers say rates on loans up to the new limit might not drop as much as government officials hope.

President Bush signed a stimulus package into law last month that included granting HUD the power to raise the conforming limit based on 125% of the median home price in high-cost areas. HUD said today San Diego County’s median home price is $558,000.

HUD said it calculated median prices based on government and commercial data.

HUD tomorrow is expected to release limits for areas in other states.

Step by Step, Bush and Fed Move on Mortgage Rescue

By EDMUND L. ANDREWS and VIKAS BAJAJ

WASHINGTON — However much they might oppose it on ideological grounds, the Bush administration and the Federal Reserve are inching closer toward a government rescue of distressed homeowners and mortgage lenders.

Ben S. Bernanke, the Fed chairman, told a group of bankers in Florida on Tuesday that “more can and should be done” to help millions of people with mortgages that are often bigger than the value of their homes.

Though Mr. Bernanke stopped well short of calling for a government bailout, he used his bully pulpit to try to push the banking industry into forgiving portions of many mortgages and signaled his concern that market forces would not be enough to prevent a broader economic calamity.

He also suggested that the Federal Housing Administration expand its insurance program to let more people switch from expensive subprime mortgages to federally insured loans.

And he urged the two government-sponsored mortgage companies, Fannie Mae and Freddie Mac, to raise more capital so they could buy more mortgages. The companies already guarantee or hold as investments about $1.5 trillion in mortgages.

Similarly, the Bush administration, despite its public opposition to bailouts, has set the stage for a bigger government role.

One month ago, President Bush signed an economic stimulus bill that greatly increased the size of loans the F.H.A. can insure, while allowing Fannie Mae and Freddie Mac to purchase significantly larger mortgages from lenders and guarantee them against default by homeowners.

The move, which administration officials had previously opposed, increases the limits on F.H.A., Freddie Mac and Fannie Mae mortgages from $417,000 to as much as $729,750.

Historically, the F.H.A. and the mortgage companies have focused on conservative mortgages for people borrowing relatively modest sums. But they are now being encouraged to finance much bigger mortgages, in some cases to people who put almost no money down.

Last week, the administration went further by removing limits on the volume of mortgages that Fannie Mae and Freddie Mac can hold in their own portfolios. That means the two companies could buy up billions of dollars in mortgages that other investors have been too frightened to touch.

In theory, the change should not cost taxpayers. But because the companies are chartered by Congress, investors have assumed that Congress would bail them out if needed. Fannie Mae and Freddie Mac can borrow money more cheaply than private banks largely because of the assumed government backing.

The Fed has been offering its own resources to soften the credit squeeze that began when investors started to panic about subprime loans. In addition to sharply cutting interest rates, the Fed has lent more than $160 billion to banks since mid-December through a new program, the Term Auction Facility.

Under the program, banks have been able to borrow money for up to a month or so, pledging collateral that includes mortgage-backed securities, even if the securities are not tradable in today’s markets.

In Congress, Democratic lawmakers pounced on Mr. Bernanke’s comments in Orlando, Fla., to bolster their arguments for much costlier rescue plans.

“It is now clear that we will not be able to avert a more serious and prolonged economic slowdown if we don’t address the problem of increasing mortgage foreclosures,” Representative Barney Frank, chairman of the House Financial Services Committtee, said on Tuesday.

Mr. Frank, who praised the Fed chairman’s “willingness to work with us,” proposed legislation last week to allow the F.H.A. to insure up to $20 billion in troubled mortgages if the lenders first agree to forgive a big part of the original loan amounts.

But even without new legislation, the Federal Housing Administration has been active. It has insured 110,000 mortgage refinancings worth $15 billion since it started a program, F.H.A. Secure, in October. It is hard to know how many of the loans would have come to the agency because of the mortgage crisis, but officials estimate as many as 90 percent of the borrowers were previously in subprime loans.

The F.H.A. figures prominently in the proposals being put forth by regulators and lawmakers. The agency insures mortgage loans made by approved lenders.

A longstanding bill to modernize the program would lower the down payment needed for F.H.A. loans to 1.5 percent of a home’s value, from 3 percent. The bill would also let the agency price insurance based on each loan’s risks. The F.H.A. now charges everyone the same premium.

“We will not back loans that do not make sense and cost taxpayers money,” said D. J. Nordquist, a spokeswoman for the Department of Housing and Urban Development, which runs the F.H.A.

But skeptics worry that the plans to expand the scope of the F.H.A. will put taxpayers at risk. They note that home prices are likely to fall further. If the government moves to insure or buy mortgages now, it might help arrest the price decline — but only temporarily.

“The reality is, prices will fall; there is no way to keep them up,” said Dean Baker, co-director of the Center for Economic and Policy Research, a liberal group in Washington. “If we have the government get in, either as the owner of the debt or the guarantor of the debt, a lot of the decline will be shouldered by the taxpayer.”

Created during the Depression to support the mortgage market, the F.H.A. has played a critical role in the housing industry in the past, though in recent years it lost ground to subprime lenders.

Administration officials say the program was meant to step in during tumultuous times like these. They further note that its conservative underwriting standards will ensure that the F.H.A. program’s losses will be within its traditional range.

Congress and the Bush administration are also hoping to soften the mortgage debacle through Fannie Mae and Freddie Mac.

Even before President Bush signed legislation allowing the two government-sponsored companies to guarantee mortgages as big as $729,750 in high-cost markets, Fannie Mae had begun offering personal loans to some borrowers who were behind on their house payments. Known as HomeSaver Advance, the loans could help Fannie Mae keep mortgages current for borrowers who have a temporary setback.

The two companies are now trying to decide how to guarantee the bigger and potentially riskier mortgages. Both want to exclude “no-documentation” loans, but Congress authorized them to buy up big mortgages going back to last July — when a high percentage of such loans were approved without verification of the borrower’s income. As a result, company executives are debating whether to buy up at least some “no-doc” loans made last year.

“One could argue that these things are steps on the bailout continuum, although they are baby steps,” said Karen Weaver, head of securitization research at Deutsche Bank.

Democratic leaders in Congress are pushing for bolder action. The House speaker, Nancy Pelosi, will hold a closed meeting on Wednesday with some of the leading advocates for more extensive rescue measures.

Administration officials remain opposed, but some are at least discussing such ideas.

“Whether government intervention is necessary is something we should all be thinking about,” Sheila C. Bair, chairwoman of the Federal Deposit Insurance Corporation, said at a hearing of the Senate Banking Committee on Tuesday. “But I don’t think we are there yet.”

Bernanke to Lenders: Reduce Principal

Fed Chairman Bernanke today called for lenders to reduce principal on homeowners with negative equity. He also noted that for properties foreclosed in the fourth quarter, the estimated total losses exceeded 50% percent of the principal balance. Bernanke argued this gives lenders significant incentive to avoid foreclosure and write-down principal.

From Fed Chairman Ben Bernanke: Reducing Preventable Mortgage Foreclosures

This situation calls for a vigorous response. Measures to reduce preventable foreclosures could help not only stressed borrowers but also their communities and, indeed, the broader economy. At the level of the individual community, increases in foreclosed-upon and vacant properties tend to reduce house prices in the local area, affecting other homeowners and municipal tax bases. At the national level, the rise in expected foreclosures could add significantly to the inventory of vacant unsold homes--already at more than 2 million units at the end of 2007--putting further pressure on house prices and housing construction.

Bernanke notes that temporary measures just postpone foreclosure, and he urges lenders to consider reducing principal for homeowners underwater:

Measures that lead to a sustainable outcome are to be preferred to temporary palliatives ...

In cases where refinancing is not possible, the next-best solution may often be some type of loss-mitigation arrangement between the lender and the distressed borrower. Indeed, the Federal Reserve and other regulators have issued guidance urging lenders and servicers to pursue such arrangements as an alternative to foreclosure when feasible and prudent. For the lender or servicer, working out a loan makes economic sense if the net present value (NPV) of the payments under a loss-mitigation strategy exceeds the NPV of payments that would be received in foreclosure. Loss mitigation is made more attractive by the fact that foreclosure costs are often substantial. Historically, the foreclosure process has usually taken from a few months up to a year and a half, depending on state law and whether the borrower files for bankruptcy. The losses to the lender include the missed mortgage payments during that period, taxes, legal and administrative fees, real estate owned (REO) sales commissions, and maintenance expenses. Additional losses arise from the reduction in value associated with repossessed properties, particularly if they are unoccupied for some period.

A recent estimate based on subprime mortgages foreclosed in the fourth quarter of 2007 indicated that total losses exceeded 50 percent of the principal balance, with legal, sales, and maintenance expenses alone amounting to more than 10 percent of principal. With the time period between the last mortgage payment and REO liquidation lengthening in recent months, this loss rate will likely grow even larger.
...
To date, permanent modifications that have occurred have typically involved a reduction in the interest rate, while reductions of principal balance have been quite rare. The preference by servicers for interest rate reductions could reflect familiarity with that technique, based on past episodes when most borrowers' problems could be solved that way. But the current housing difficulties differ from those in the past, largely because of the pervasiveness of negative equity positions. With low or negative equity, as I have mentioned, a stressed borrower has less ability (because there is no home equity to tap) and less financial incentive to try to remain in the home. In this environment, principal reductions that restore some equity for the homeowner may be a relatively more effective means of avoiding delinquency and foreclosure.

Of course, if it becomes common for lenders to reduce principal, their phones will be ringing off the hook!

I wasn't invited

Police break up party raging in foreclosed home

BY VANESSA GREGORY, Californian staff writer

About 50 teenagers and young adults broke into an empty, foreclosed home in southwest Bakersfield Saturday, throwing a raging party and making off with the home’s high-end appliances, according to neighbors.

“They’re all out front, they’re drinking,” said Scelina Mitchell, who lives across the street from the home.

Bakersfield police visited the tidy, stone-accented house in the 4500 block of Whitegate Avenue twice in the early morning hours after receiving calls, police Lt. Brad Wahl said.

HSBC Bank USA repossessed the home in November, county records show. It sold for $540,000 in 2006, according to First American Real Estate Solutions, a data firm.

Vacant, foreclosed homes do not seem to be causing police significant problems, Wahl said.

“I haven’t heard or noticed anything like that on my shift,” Wahl said.

Mitchell and her husband, Matt Mitchell, said police simply dispersed the partygoers, and they worry the “nonchalant” response might attract future rabble rousers.

“What I would have liked was at least a reprimand,” Matt Mitchell said. “And a report filed.” On their normally quiet block, two other homes are in foreclosure, he said.

Wahl had limited information Saturday about what officers found at the home, and what actions they took, but he was reasonably certain no arrests were made.

A City Council committee approved a plan to track foreclosures, in an effort to limit neighborhood blight, on Feb. 19.

The plan may come before the full Council as early as this month.

States and Cities Start Rebelling on Bond Ratings

By JULIE CRESWELL and VIKAS BAJAJ

Some states and cities say Wall Street ratings firms assign municipal borrowers inappropriately low credit scores.

Click here to read the full article

Live in a $3mil house for free

Voltron says: There is a chinese saying that if owe the bank a few thousand dollars, you're in trouble. If you owe the bank several million, the bank is in trouble.

Jingle Mail?

Forget that! Its so 2007.

For 2008, let's try a little reverse financial engineering: Squatting in $3 million dollar waterfront mansion in Florida and paying nothing.

At least, that's a new and growing problem we learn of via MW in South Florida. MW is a local developer, and claims this has become "very serious." (I have been able to independently verify this with a local resident, who tells me the local papers are filled with such tales).

He writes:

"There is a very important phenomena that is occurring that has only been covered in an only "glancing" manner. Beyond the concept of "jingle mail" -- which suggests that folks who can pay their mortgages may just choose to walk away given the dramatic loss of equity due to housing's collapse -- consider the following: As a developer, I had stepped to the sidelines and rented beginning in 2005, because I was sure that housing was unsustainable and was bound to collapse; it took 2 more years for it occur.

Nonetheless, as I have followed several of the homes that my wife and I were interested in a few years back, they are all on the market now. What is shocking, that in each and every case, I have been told by brokers and banks that the owners, have ceased paying their mortgages in some cases for nearly 2 years and have continued to occupy these homes. Now, these are homes in excess of $2,000,000 in the very best neighborhoods in South Florida. Brokers have added that these buyers further complicated things by putting huge home equity lines on top of their mortgages and now have no possibility of selling their homes for amounts needed to cover their accumulated debt.

This may not seem like news, but understand what this means: There is currently an 8-10 month wait to get a court date to have a foreclosure filing heard in Dade and Broward counties. The bankers have non-performing loans on their books to the best heeled borrowers in multi-million dollar amounts with no immediate means for recovery; with a non-secured second mortgage in place, there is no possibility for a "short sale" that will satisfy all of the borrower's debt. They are reluctant to take a haircut knowing that they have the home equity debt still around their neck and are likely to frustrate any near-term sale.

There is no clean way to sell the home that would guarantee "clean title" hence a foreclosure is the only means to separate the property from the dead-beat speculator/squattor. Banks do not want to spend the $50,000 required to take a home through a foreclosure and clear the title -- only to put the house back on the market for a deeper loss afterwards. Most likely, they have not revealed these owner occupied defaults to their shareholders, thanks to the sheer numbers of non-performing loans on their balance sheets, and the daunting task of foreclosing on all of them. This is the ultimate seizure and full stop of the market whereby everyone is standing in a stalemate. As one broker said to me, "these bums sitting in $3,000,000 homes overlooking the water are likely to be left alone by the banks for 2 years before the banks even get serious about foreclosure."

So here is the difference between "walking away," these folks are doing anything but walking away, they are sitting on lounge chairs sipping martinis living cost free! (not to mention that they have ceased paying property taxes and insurance). I can only imagine what this market will look like in the coming years . . ."

All I can say is wow.

"MW" has been hearing this for the past six months. He believes both the local and national lenders are in a state of disbelief with no understanding on how to proceed.

Fed chief: Mortgage crisis to continue

By JEANNINE AVERSA, AP Economics Writer

Federal Reserve Chairman Ben Bernanke called Tuesday for additional action to prevent more distressed homeowners from falling into foreclosure.

"This situation calls for a vigorous response," Bernanke said in a speech to a banking group meeting in Orlando, Fla.

Even with some relief efforts under way by industry and government, foreclosures and late payments on home mortgages are likely to rise "for a while longer," Bernanke warned.

Rising foreclosures threaten to worsen the problems in the housing market and for the national economy, which many fear is on the verge of a recession or in one already.

"Reducing the rate of preventable foreclosures would promote economic stability for households, neighborhoods and the nation as a whole," Bernanke said. "Although lenders and servicers have scaled up their efforts and adopted a wider variety of loss-mitigation techniques, more can, and should, be done," the Fed chief said.

One of the suggestions Bernanke made was for mortgage and other financial companies to reduce the amount of the loan to provide relief to a struggling owner. "Principal reductions that restore some equity for the homeowner may be a relatively more effective means of avoiding delinquency and foreclosure," Bernanke said.

With low or negative equity in their home, a stressed borrower has less ability — because there is no home equity to tap — and less financial incentive to try to remain in the home, he said.

Bernanke acknowledged this idea might be a tough sell to lenders. Lenders, he said, are reluctant to write down principal. "They say that if they were to write down the principal and house prices were to fall further, they could feel pressured to write down principal again," Bernanke said.

Still, Bernanke suggested such longer-term permanent solutions may work better than shorter-term and temporary ones, where the distressed homeowner could find himself in trouble again. "When the mortgage is `under water' a reduction in principal may increase the expected payoff by reducing the risk of default and foreclosure," he said.

To date, permanent home mortgage modifications that have occurred have typically involved a reduction in the interest rate, while reductions of the principal balance of the loan have been quite rare, he said.

"Measures that lead to a sustainable outcome are to be preferred to temporary palliatives, which may only put off foreclosure and perhaps increase its ultimate costs," Bernanke said.

Lenders last year were on pace to initiate roughly 1.5 million home foreclosure proceedings, up from an average of fewer than 1 million new foreclosures in the preceding two years, the Fed chief said. More than one half of the foreclosures started in 2007 were on subprime loans given to borrowers with blemished credit histories or low incomes.

The housing collapse dragged down home values, especially clobbering these subprime borrowers. Many were left with mortgages that exceeded the value of their homes. They were further socked by low introductory rates on their adjustable mortgages resetting to higher rates, making their monthly payments difficult or impossible, to afford. Problems in the credit markets have made refinancing a mortgage harder.

This year, about 1.5 million loans — representing more than 40 percent of the outstanding stock of subprime adjustable-rate mortgages — are scheduled to reset to higher rates, Bernanke said. The Fed estimates that the interest rate on a typical subprime ARM slated to reset in the current quarter will increase to about 9.25 percent from just above 8 percent. That would raise the monthly payment by more than 10 percent, to $1,500 on average, he said.

Declines in short-term interest rates and a Bush administration-promoted initiative involving rate freezes will "reduce the impact somewhat, but interest rate resets will nevertheless impose stress on many households," Bernanke said.

On Capitol Hill, a number of measures have been offered to help stressed homeowners.

Overhauling the Depression-era Federal Housing Administration, which insures mortgages for low- and middle-income borrowers, could help, Bernanke said. He also called for strengthened supervision of mortgage giants Fannie Mae and Freddie Mac.

Bernanke, who last week signaled that the Fed stands ready to lower a key interest rate again, did not talk interest rate policy in his speech or in a brief question-and-answer session afterward. The Fed, which has been slicing rates since September to help the economy, is expect to reduce them again on March 18, the Fed's next meeting.

The Federal Reserve's rescue has failed By Ambrose Evans-Pritchard, International Business Editor, International Herald Tribune The verdict is in. The Fed's emergency rate cuts in January have failed to halt the downward spiral towards a full-blown debt deflation. Much more drastic action will be needed. The Federal Reserve building in Washington Yields on two-year US Treasuries plummeted to 1.63pc on Friday in a flight to safety, foretelling financial winter. The debt markets are freezing ever deeper, a full eight months into the crunch. Contagion is spreading into the safest pockets of the US credit universe. It is hard to imagine a more plain-vanilla outfit than the Port Authority of New York and New Jersey, which manages bridges, bus terminals, and airports. The authority is a public body, backed by the two states. Yet it had to pay 20pc rates in February after the near closure of the $330bn (£166m) "term-auction" market. It had originally expected to pay 4.3pc, but that was aeons ago in financial time. advertisement "I never thought I would see anything like this in my life," said James Steele, an HSBC economist in New York. No sane mortal needs to know what term-auction means, except that it too became a tool of the US credit alchemists. Banks briefly used the market as laboratory for conjuring long-term loans at Alan Greenspan's giveaway short-term rates. It has come unstuck. Next in line is the $45trillion derivatives market for credit default swaps (CDS). Last week, the spreads on high-yield US bonds vaulted to 718 basis points. The iTraxx Crossover index measuring corporate default risk in Europe smashed the 600 barrier. We are now far beyond the August spike. Sub-prime debt is plumbing new depths. A-rated securities issued in early 2007 fell to a record 12.72pc of face value on Friday. The BBB tier fetched 10.42pc. The "toxic" tranches are worthless. Why won't it end? Because US house prices are in free fall. The Case-Shiller index for the 20 biggest cities dropped 9.1pc year-on-year in December. The annualised rate of fall was 18pc in the fourth quarter, and gathering speed. As the graph shows below, US households are only halfway through the tsunami of rate resets - 300 basis points upwards - on teaser loans. The UK hedge fund Peloton Partners misjudged this fresh leg of the crunch. After an 87pc profit last year betting against sub-prime, it switched sides to play the rebound. Last week it had to liquidate a $2bn fund. Like many, Peloton thought Fed rate cuts from 5.25pc to 3pc (with more to come) would end the panic. But this is not a normal downturn, subject to normal recovery. Leverage is too extreme. Bank capital is too eroded. Monetary traction eludes the Fed. An "Austrian" purge is under way. UBS says the cost of the credit debacle will reach $600bn. "Leveraged risk is a cancer in this market." Try $1trillion, says New York professor Nouriel Roubin. Contagion is moving up the ladder to prime mortgages, commercial property, home equity loans, car loans, credit cards and student loans. We have not even begun Wave Two: the British, Club Med, East European, and Antipodean house busts. As the once unthinkable unfolds, the leaders of global finance dither. The Europeans are frozen in the headlights: trembling before a false inflation; cowed by an atavistic Bundesbank; waiting passively for the Atlantic storm to hit. Half the eurozone is grinding to a halt. Italy is slipping into recession. Property prices are flat or falling in Ireland, Spain, France, southern Italy and now Germany. French consumer moral is the lowest in 20 years. The euro fetches $1.52 (from $0.82 in 2000), beyond the pain threshold for aircraft, cars, luxury goods and textiles. The manufacturing base of southern Europe is largely below water. As Le Figaro wrote last week, the survival of monetary union is in doubt. Yet still, the ECB waits; still the German-bloc governors breathe fire about inflation. The Fed is now singing from a different hymn book, warning of the "possibility of some very unfavourable outcomes". Inflation is not one of them. The Federal Reserve chairman Ben Bernanke "There probably will be some bank failures," said Ben Bernanke. He knows perfectly well that the US price spike is a bogus scare, the tail-end of a food and fuel shock. "I expect inflation to come down. I don't think we're anywhere near the situation in the 1970s," he told Congress. Indeed not. Real wages are being squeezed. Oil and "Ags" are acting as a tax. December unemployment jumped at the fastest rate in a quarter century. The greater risk is slump, says Princetown Professor Paul Krugman. "The Fed is studying the Japanese experience with zero rates very closely. The problem is that if they want to cut rates as aggressively as they did in the early 1990s and 2001, they have to go below zero." This means "quantitative easing" as it was called in Japan. As Ben Bernanke spelled out in November 2002, the Fed can inject money by purchasing great chunks of the bond market. Section 13 of the Federal Reserve Act allows the bank - in "exigent circumstances" - to lend money to anybody, and take upon itself the credit risk. It has not done so since the 1930s. Ultimately the big guns have the means to stop descent into an economic Ice Age. But will they act in time? "We are becoming increasingly concerned that the authorities in the world do not get it," said Bernard Connolly, global strategist at Banque AIG. "The extent of de-leveraging involves a wholesale destruction of credit. The risk is that the 'shadow banking system' completely collapses," he said. For the first time since this Greek tragedy began, I am now really frightened.

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Greetings from Mammoth mountain. I'm on pre-deployment leave (already!). You can now subscribe to this blog by clicking on the feedburner icon on the bottom of the right column. You can set up feedburner to send you emails as soon as postings appear.

Bye Bye CFC

Voltron says: I have no position in countrywide anymore, but this looks really really bad. I would not be surprised if the CEO got fired and BofA tried to back out of the deal.

March 3, 2008

Countrywide's Mortgage Woes Deepen By JAMES R. HAGERTY March 3, 2008; Page A2 Countrywide Financial Corp.'s mortgage portfolio continues to deteriorate rapidly as defaults increase and home prices fall, a securities filing shows. The Calabasas, Calif., lender's annual filing with the Securities and Exchange Commission, released late Friday, showed a big increase in late payments on option adjustable-rate mortgages, known as option ARMs. These loans give borrowers several choices of payment each month, including one that covers only part of the interest normally due. When borrowers choose that minimal payment, the loan balance grows. Bad Loans Creep Up: Countrywide late last year saw a jump in late payments on option adjustable-rate mortgages. And Home-Equity Loans Deal a Blow: The lender also said it took a big loss in the fourth quarter on home-equity lines of credit. Further losses may lie ahead. The Bottom Line: The details, in a securities filing, shed more light on the degree to which the credit crisis is hitting the nation's largest mortgage lender. As of the end of 2007, payments were at least 90 days overdue on 5.4% of option ARMs held as investments by Countrywide's banking arm, up from 0.6% a year earlier. Countrywide held $28.42 billion of such loans as of Dec. 31. The company said 71% of the borrowers were making minimal payments. Only about a fifth of the borrowers were required to document fully their incomes before receiving the loans. Countrywide, the largest U.S. mortgage lender in terms of loan volume, suffered losses of about $1.6 billion in last year's second half. Early in January, Bank of America Corp. agreed to acquire Countrywide for about $4 billion. That purchase is due to be completed in the third quarter. Countrywide disclosed that half of the $87.04 billion of mortgage loans held by its bank are backed by homes in California and Florida, two of the states hit hardest by falling home prices. The lender also provided more details on a setback that prevented it from fulfilling its October forecast that it would be profitable in the fourth quarter. Countrywide was blindsided during the quarter by obligations on home-equity lines of credit that it had sold to investors in the form of securities. Normally, the trusts that control such securities reimburse the lender when borrowers make further draws on these lines of credit. But if losses on the loans exceed certain levels, Countrywide isn't reimbursed immediately and may never be reimbursed unless income from the loans outstanding is sufficient to meet obligations to investors in the securities. Countrywide said the likelihood of such a situation was "deemed remote" until late 2007. It blamed a "sudden deterioration" in the housing market. As a result, it recorded a $704 million loss to cover the estimated costs of its obligations on the lines of credit. Further losses may lie ahead. Borrowers can pay down these lines of credit and then draw new funds later, Countrywide said. As a result, it said, the company's "maximum obligation cannot be defined." Countrywide officials have said they didn't expect these losses in late October, when Chief Executive Angelo Mozilo forecast a profit for the fourth quarter. The company ended up reporting a loss of $422 million for that quarter. A Countrywide computer model used to gauge risks on these securities didn't take into account the possible effects of exceeding the loss levels that cut off reimbursements, according to a Dec. 28, 2006 internal report reviewed by The Wall Street Journal.

Economic View

How a Bubble Stayed Under the Radar

David G. Klein

By ROBERT J. SHILLER

New York Times

ONE great puzzle about the recent housing bubble is why even most experts didn’t recognize the bubble as it was forming.

Alan Greenspan, a very serious student of the markets, didn’t see it, and, moreover, he didn’t see the stock market bubble of the 1990s, either. In his 2007 autobiography, “The Age of Turbulence: Adventures in a New World,” he talks at some length about his suspicions in the 1990s that there was irrational exuberance in the stock market. But in the end, he says, he just couldn’t figure it out: “I’d come to realize that we’d never be able to identify irrational exuberance with certainty, much less act on it, until after the fact.”

With the housing bubble, Mr. Greenspan didn’t seem to have any doubt: “I would tell audiences that we were facing not a bubble but a froth — lots of small local bubbles that never grew to a scale that could threaten the health of the overall economy.”

The failure to recognize the housing bubble is the core reason for the collapsing house of cards we are seeing in financial markets in the United States and around the world. If people do not see any risk, and see only the prospect of outsized investment returns, they will pursue those returns with disregard for the risks.

Were all these people stupid? It can’t be. We have to consider the possibility that perfectly rational people can get caught up in a bubble. In this connection, it is helpful to refer to an important bit of economic theory about herd behavior.

Three economists, Sushil Bikhchandani, David Hirshleifer and Ivo Welch, in a classic 1992 article, defined what they call “information cascades” that can lead people into serious error. They found that these cascades can affect even perfectly rational people and cause bubblelike phenomena. Why? Ultimately, people sometimes need to rely on the judgment of others, and therein lies the problem. The theory provides a framework for understanding the real estate turbulence we are now observing.

Mr. Bikhchandani and his co-authors present this example: Suppose that a group of individuals must make an important decision, based on useful but incomplete information. Each one of them has received some information relevant to the decision, but the information is incomplete and “noisy” and does not always point to the right conclusion.

Let’s update the example to apply it to the recent bubble: The individuals in the group must each decide whether real estate is a terrific investment and whether to buy some property. Suppose that there is a 60 percent probability that any one person’s information will lead to the right decision.

In other words, that person’s information is useful but not definitive — and not clear enough to make a firm judgment about something as momentous as a market bubble. Perhaps that is how Mr. Greenspan assessed the probability that he could make an accurate judgment about the stock market bubble.

The theory helps explain why he — or anyone trying to verify the existence of a market bubble — may have squelched his own judgment.

The fundamental problem is that the information obtained by any individual — even one as well-placed as the chairman of the Federal Reserve — is bound to be incomplete. If people could somehow hold a national town meeting and share their independent information, they would have the opportunity to see the full weight of the evidence. Any individual errors would be averaged out, and the participants would collectively reach the correct decision.

Of course, such a national town meeting is impossible. Each person makes decisions individually, sequentially, and reveals his decisions through actions — in this case, by entering the housing market and bidding up home prices.

Suppose houses are really of low investment value, but the first person to make a decision reaches the wrong conclusion (which happens, as we have assumed, 40 percent of the time). The first person, A, pays a high price for a home, thus signaling to others that houses are a good investment.

The second person, B, has no problem if his own data seem to confirm the information provided by A’s willingness to pay a high price. But B faces a quandary if his own information seems to contradict A’s judgment. In that case, B would conclude that he has no worthwhile information, and so he must make an arbitrary decision — say, by flipping a coin to decide whether to buy a house.

The result is that even if houses are of low investment value, we may now have two people who make purchasing decisions that reveal their conclusion that houses are a good investment.

As others make purchases at rising prices, more and more people will conclude that these buyers’ information about the market outweighs their own.

Mr. Bikhchandani and his co-authors worked out this rational herding story carefully, and their results show that the probability of the cascade leading to an incorrect assumption is 37 percent. In other words, more than one-third of the time, rational individuals, each given information that is 60 percent accurate, will reach the wrong collective conclusion.

Thus, we should expect to see cascades driving our thinking from time to time, even when everyone is absolutely rational and calculating.

This theory poses a major challenge to the “efficient markets” view of the world, which assumes that investors are like independent-minded voters, relying only on their own information to make decisions. The efficient-markets view holds that the market is wiser than any individual: in aggregate, the market will come to the correct decision. But the theory is flawed because it does not recognize that people must rely on the judgments of others.

NOW, let’s modify the Bikhchandani-Hirshleifer-Welch example again, so that the individuals are no longer purely rational beings. Instead, they are real people, subject to emotional reactions.

Furthermore, these people are being influenced by agencies like the National Association of Realtors, which is conducting a public-relations campaign intended to show that putting money into housing is a reliable way to build wealth. Under these circumstances, it’s easy to understand how even experts could come to believe that housing is a spectacular investment.

It is clear that just such an information cascade helped to create the housing bubble. And it is now possible that a downward cascade will develop — in which rational individuals become excessively pessimistic as they see others bidding down home prices to abnormally low levels.

Robert J. Shiller is professor of economics and finance at Yale and co-founder and chief economist of MacroMarkets LLC.