Posts Tagged ‘housing’

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There were many perpetrators involved in the 2007-09 financial crisis and most of them have gotten off scott free. Credit rating firms were a major player that have experienced limited fallout for their role in creating and exacerbating the global financial crisis.

And now it looks like despite a 3-year old Congressional directive for the Federal Securities and Exchange Commission to alter credit rating industry’s business model in which a bond issuer pays for the credit rating, little or nothing will actually be done to change how the industry works. So reports The Wall St. Journal.

This is very unfortunate for a couple of reasons:

  1. An inherent conflict of interest and lack of transparency for investors means that it will be difficult to judge the accuracy of credit ratings on a variety of debt instruments.
  2. The potential for another bubble, which could contribute to another global financial crisis.

The model in which an issuer pays a credit rating agency is inherently flawed because the rating agencies have a financial stake in making their clients happy by assigning the highest rating possible, regardless of the merits of the issue in question. This happened en masse during the housing bubble, when all sorts of questionable mortgage backed securities received top ratings.

Many of those issues later experienced extremely high levels of default, which was a “key cause” of the financial crisis, Congress concluded. Duh.

The SEC conducted a day-long meeting yesterday to get advice from experts about what to do about this problem, but hasn’t said what, if anything, they plan to do with this information. I mean, at this point, what more information do they need?

If they do the right thing, in a few months we’ll see some proposed rules that will change how ratings firms are compensated. If not, nothing will change. Of course, the ratings agencies are firmly in favor of the status quo because it would upset their very profitable apple cart if they had to be paid by investors or supervised more closely.

In the meantime, the U.S. Justice Dept. has somewhat tardily sued S&P — but not Moody’s, the other major ratings agency — for fraud, accusing the company of inflating ratings to gain more business during the real estate bubble. It cites 30 deals in which S&P rated collateralized debt obligations that included bundles of subprime mortgages, most of which fell steeply in value after they were sold to investors.

According to the Wall Street Journal, the Justice Department suit alleges that S&P “knowingly and with the intent to defraud, devised, participated in and executed a scheme to defraud investors.” The Justice Dept.  is seeking $5 billion in what would be the largest fines imposed on any firm for actions during the financial crisis.

S&P has filed to have the case dismissed, saying that the firm is being targeted for failing to foresee the financial crisis and bursting of the housing bubble.

On another front, S&P and Moody’s recently settled civil cases brought by investors. The firms were accused of “negligent misrepresentation” regarding their ratings of several structured investment vehicles.

What does all this mean to you and me? That another one of the major players in the global financial crisis may get off scott free and that a big part of the system that led to the crisis may go on  its merry way, completely unchanged. We can only hope that the SEC may actually do something and that failing that, the Justice Department will get some justice in it’s suit against S&P. Stay tuned…

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Ever since Fannie Mae and Freddie Mac collapsed and were bailed out by the U.S. government in 2008, in one of the largest government bailouts in history, the future of the 30-year fixed mortgage has been in doubt. Both President Obama and the Republicans have expressed support for the idea of eliminating Fannie and Freddie and  privatizing the U.S. mortgage guarantee process.

But it hasn’t happened yet, and it’s been nearly 5 years. The reason why is that killing the 30 year mortgage, which an editorial in Bloomberg espoused yesterday, is extremely unpopular politically. Consumers love fixed-rate mortgages because they provide certainty in terms of the monthly payment, lessening risks that are posted by adjustable rate mortgages.

Interestingly enough, adjustable rate mortgages are the rule in Europe, where the government never developed the role in the mortgage process or the investment in the idea of homeownership that the U.S. government did. Here in the U.S., the government has for more than the past half century played a central role in the mortgage process, either outright owning or guaranteeing many fixed rate mortgages.

From a risk point of view, assuming the interest rate risk on a 15 or 30 year basis is something that few, if any, financial institutions are willing to take on given what happened in the financial crisis and what has happened with interest rates over the past few decades.

That’s because if interest rates increase — and they, will eventually — a financial institution would be stuck paying out higher interest rates on savings accounts, certificates of deposit and IRAs, while receiving a very small return on interest on fixed rate long term mortgage commitments made years ago. In contrast, an adjustable rate mortgage will eventually increase to market rates, which poses much less risk for banks and other lenders.

That leaves the U.S. government as the default lender of last resort for fixed rate mortgages. Today, the U.S. government owns or guarantees 90 percent of all new mortgages, which is a major increase from the 50 percent it owned or guaranteed in the mid-1990s. Given the boom and bust nature of U.S. real estate markets, that means it’s all too likely that at some point the U.S. government will be left holding the bag when the real estate market goes bust again and large numbers of homeowners default.

That’s not as likely with rates so low, because the underwriting environment is so conservative currently and payments are affordable. However, as underwriting standards loosen and rates go higher, the table will be set for another housing market disaster. After all, the most recent real estate market boom/bust wasn’t the first, just the latest in a long line of U.S. real estate market ups and downs.

So when the next bust happens, the U.S. government, as the guarantor of last resort will be on the hook for all those defaults, obligated to pay — wait for it — billions of dollars to banks for the homeowners who are unable to make those payments. And since the U.S. government is us, the taxpayers, we could be left footing the bill for another expensive bailout.

The solution, many say, is to abolish fixed rate mortgages altogether and leave adjustable rate loans as the only option for consumers. This would take the long-term interest rate risk out of the picture for both the government and financial institutions. Unfortunately, that leaves consumers holding the bag and assuming the vast majority of risk surrounding interest rates.

Well, that’s hardly fair. Why should consumers bear most of the risk from an unpredictable, speculative real estate market? We saw the impact of a variety of adjustable rate loans during the real estate bust. Lax underwriting standards, outright fraud on the part of some unscrupulous mortgage brokers and appraisers and exotic loans left homeowners at the mercy of sky high payments and many lost their homes or were stuck making unsustainable payment that they could barely afford.

The Bloomberg editorial mentions some creative solutions that could help fill the gap if the 30 and 15-year fix rate mortgage is abolished. These intriguing options include:

  • Pegging monthly mortgage and interest payments to neighborhood home values
  • Allowing borrowers to pay more up front for the ability to make lower payments later if home prices go down

If the 30-year mortgage is indeed toast, we need to see more innovative ideas like those above so that homeowners aren’t forced to bear all the risk from unpredictable real estate markets. It’s certainly not fair to expect the government or financial institutions to do so and there is no reason why consumers should have to either.

I’m a bit late to the party on this, but here goes: last week the St. Louis Fed released its U.S. Recession Probabilities chart, which shows the risk of a U.S. recession near zero. I’ve been following the progress of the U.S. economy pretty closely for the past couple years as it has struggled to emerge from the Great Recession and gain a more steady footing, so I’m finding this assessment interesting.

While I believe that the risk of recession is less than it has been in the past few years, I wouldn’t say that it is near zero. Although the recovery does seem to be gaining more traction, that’s happened before. The last couple of Springs, the economy will seem to firm up on a couple of different fronts, whether that’s housing, consumer spending, business investment, industrial production or whatever, only to fallback later in the year because of external or internal issues.

Last year the political uncertainty surrounding the election and the Fiscal Cliff slowed the economy down in the second half, the year before — and the year before that — Europe was the focus of economic fears along with the continuing housing crisis. This year, we’re into Sequestration and the debt ceiling battle is coming up.

Risks from Europe seem to be on the back burner and less fraught than they used to be, but the fact is that nothing fundamental has changed about the European situation except that the European Central Bank is printing a lot of money. Austerity is taking a huge tool, unemployment is sky high and EU leaders are no closer to solving the region’s problems than they were a few years ago.

Anyone of these risks, or a combination of them or other risks that we are unaware of at this time could push the economy into recession. There are a number of positive developments that could continue to keep the economy on a growth track, including the recovering housing market and the brightened employment picture — I’m hopeful because I want a growing economy and it’s benefits just as much as the next person.

Re big picture risk, whether the risks of a recession are low or high, I do believe that we eventually will experience another financial crisis. I actually had an argument on Twitter the other day based on expressing the opinion that another global financial crisis is all but inevitable.

I base that belief on the fact that the fundamental problems in the global economy that lead to the Great Recession haven’t been solved in any meaningful way and that the systems that we have are so complex and interact in so many unforeseen ways that it is a matter of when, not if, another crisis occurs. It could be next month, next year or in five years. I have no idea.

But if you look at economic cycles and the recent history of boom and busts, it is evident that these crises occur periodically and that they are happening more frequently. I would love to be wrong, because the havoc they create causes so much suffering. We’ll just have to wait and see.