EconoMonitor

Nouriel Roubini's Global EconoMonitor

RGE’s Weekly Roundup

Check out all the great contributions that were published during the past week on RGE’s Nouriel Roubini’s Global EconoMonitor, RGE Analyst’s EconoMonitor, Finance & Markets Monitor, Peterson Institute for International Economics Monitor, Global Macro EconoMonitor, U.S. EconoMonitor, Emerging Markets Monitor, Asia EconoMonitor, Latin America EconoMonitor and Europe EconoMonitor.  

On Nouriel Roubini’s Global EconoMonitor, Kavitha Cherian and Rachel Ziemba discuss negotiating positions countries are bringing to the table at the Climate Change Summit under way in Copenhagen. They hold that the main bone of contention between developing and developed countries will remain emission targets and who will finance the mitigation process. The consensus that global leaders reach will encourage investment in clean technology and open new markets and help build linkages between existing market-based mechanisms to better channel funds from the private sector to cleaner energy projects.  Please read RGE Wednesday Note – The Economics of Copenhagen.

 

On the RGE Analyst’s EconoMonitor, Jennifer Kapila and Arnab Das examine the extent to which a contingent-capital-based bank funding model would counteract boom-bust cycles in financial markets and what other effects such a model would have. The paper’s findings are based on a new RGE case study of HBOS, the British banking group.  See CoCos: No Antidote to Go-Go Boom-Bust Cycles.

Given the Dubai standstill, Michael Moran and Rachel Ziemba ask How Much Unity in the United Arab Emirates?

 

On the Finance & Markets Monitor, there was much discussion of financial regulation and reform and how to address too-important-to fail institutions as well as the potential dangers of not properly dealing with this critical issue.  Please read:

Too Important to Fail? by Jose Vinals

Stiglitz: Too Big to Live by Mark Thoma

The Importance of Capital Requirements by James Kwak

Too Efficient NOT to consolidate by Rebecca Wilder

Non-Reform of Rating Agencies by Yves Smith

Measuring the Fiscal Costs of Not Fixing the Financial System by Simon Johnson

Did Bank Executives Lose Enough to Learn Their Lesson by Mark Thoma

Bankers Had Cashed in Before the Music Stopped by Lucian Bebchuk

Gerry Corrigan’s Case for Large Integrated Financial Groups by Simon Johnson

Also on the Finance & Markets Monitor:

Reaching for Yield in the Post-TARP Era by Edward Harrison

What is the Rally Telling Us? by Barry Ritholtz

 

On the Peterson Institute for International Economics Monitor, C. Fred Bergsten argues that as efforts to recover from the current crisis go forward, the United States should launch new policies to avoid large external deficits, balance the budget, and adapt to a global currency system less centered on the dollar.  This is not just an economic imperative but a foreign policy and national security one as well.  Don’t miss The Dollar and the Deficits: How Washington Can Prevent the Next Crisis.

 

On the Global Macro EconoMonitor, as world leaders are discussing climate change policy, Joseph Mason points out the challenges of measuring carbon and cautions that hasty policy decisions are not the way to go.  See Carbon: The New Financial Frontier.

In Savings Gluts and Bubbles, Mark Thoma presents a piece by Robin Wells, which argues that “until the savings glut is vanquished, asset bubbles and instability will be fed exacerbating income inequality, and short of a miraculous new technology to soak up the savings glut, a global rebalancing of production and consumption will be necessary.”

In Global Growth Forecasts – Seeing is Believing? Claus Vistesen looks at global growth data and argues that we are in a much more shaky position than current sentiment suggests, and considers who is at risk for a double-dip.

Barry Ritholtz presents a very interesting chart that illuminates the debate between the Climate Skeptics vs Scientific Consensus.

 

On the U.S. EconoMonitor, Tim Duy points out the important distinction between Structural and Cyclical dynamics with respect to U.S. economic activity, which has important policy considerations.

In The President’s Jobs Initiative Doesn’t Measure Up, Robert Reich is exasperated by the small numbers that are being bandied about for future stimulus, and argues that stimulus on the cheap would make the deficit worse over the long haul.

Jeffrey Frankel points out Ten Ways to Move the Budget Back Toward a Sustainable Path.

Also on the U.S. EconoMonitor:

Worrisome Thoughts on the Way to the Jobs Summit by Robert Reich

Deposits in Failed Banks as a Percent of GDP by Mark Thoma

The Drop in Unemployment is Give Back from the Prior Month by Edward Harrison

Deficit Links by James Hamilton

Average Weekly Hours Worked, NFP Changes by Barry Ritholtz

Another Rescue Plan Comes in Below the Original Price Tag by David Altig

 

On the Emerging Markets Monitor, Michael Pettis continues to point out the dangers of current account imbalances and the challenging complexities of increasing the consumption rate in China relative to GDP.  Read The Difficult Arithmetic of Chinese Consumption.

 

On the Asia EconoMonitor, Edward Hugh and Edward Harrison provide analysis on the surprising Japanese data.  Read:

Double Dip Alert in Japan by Edward Hugh

Japan’s Growth Embarrassingly Revised Down by 3.5% by Edward Harrison

As foreign direct investment flows into India, Rebecca Wilder points out that India must do more to open its borders to compete with other BRIC countries.  See India: FDI and Saving are Key.

 

On the Latin America EconoMonitor, Alejandro Schtulmann shares his analysis of the financial appointments in Mexico.  See:

Banxico’s Chairman Election Processes: Unnecessary Uncertainty by Alejandro Schtulmann

Carstens Proposed to Lead Banxico; Cordero Goes to Hacienda; Changes Do Not Improve the Status Quo; Political Appointments Prevail at Hacienda and Sedesol by Alejandro Schtulmann

 

On the Europe EconoMonitor, Edward Harrison and Edward Hugh discuss Greece’s financial and structural woes and consider the impact on the rest of the world.  See:

It’s All Greek to Me by Edward Hugh

Buiter: “It’s Five Minutes to Midnight for Greece” by Edward Harrison

In Russia’s Economy Slows in November, Edward Hugh analyzes Russia’s production data.

 

18 Responses to “RGE’s Weekly Roundup”

GuestDecember 11th, 2009 at 9:20 am

First Today – But I will be shut out on Mondaywhen non-paying subscribers are not allowed to access the comments.

GuestDecember 11th, 2009 at 11:23 am

Thursday, December 10, 2009 Robert RiechHow a Few Private Health Insurers Are on the Way to Controlling Health CareThe public option is dead, killed by a handful of senators from small states who are mostly bought off by Big Insurance and Big Pharma or intimidated by these industries’ deep pockets and power to run political ads against them. Some might say it’s no great loss at this point because the Senate bill Harry Reid came up with contained a public option available only to 4 million people, which would have been far too small to exert any competitive pressure on private insurers anyway.To provide political cover to senators who want to tell their constituents that the intent behind a robust public option lives on, the emerging Senate bill makes Medicare available to younger folk (age 55), and lets people who aren’t covered by their employers buy in to a system that’s similar to the plan that federal employees now have, where the federal government’s Office of Personnel Management selects from among private insurers.But we still end up with a system that’s based on private insurers that have no incentive whatsoever to control their costs or the costs of pharmaceutical companies and medical providers. If you think the federal employee benefit plan is an answer to this, think again. Its premiums increased nearly 9 percent this year. And if you think an expanded Medicare is the answer, you’re smoking medical marijuana. The Senate bill allows an independent commission to hold back Medicare costs only if Medicare spending is rising faster than total health spending. So if health spending is soaring because private insurers have no incentive to control it, we’re all out of luck. Medicare explodes as well.A system based on private insurers won’t control costs because private insurers barely compete against each other. According to data from the American Medical Association, only a handful of insurers dominate most states. In 9 states, 2 insurance companies control 85 percent or more of the market. In Arkansas, home to Senator Blanche Lincoln, who doesn’t dare cross Big Insurance, the Blue Cross plan controls almost 70 percent of the market; most of the rest is United Healthcare. These data, by the way, are from 2005 and 2006. Since then, private insurers have been consolidating like mad across the country. At this rate by 2014, when the new health bill kicks in and 30 million more Americans buy health insurance, Big Insurance will be really Big.In light of all this, you’d think the insurance industry would be subject to the antitrust laws, so the Justice Department and the Federal Trade Commission could prevent it from combining into one or two national behemoths that suck every health dollar out of our pockets (as well as the pockets of companies paying part of the cost of their employees’ health insurance). But no. Remarkably, the Senate bill still keeps Big Insurance safe from competition by preserving its privileged exemption from the antitrust laws.From the start, opponents of the public option have wanted to portray it as big government preying upon the market, and private insurers as the embodiment of the market. But it’s just the reverse. Private insurers are exempt from competition. As a result, they are becoming ever more powerful. And it’s not just their economic power that’s worrying. It’s also their political power, as we’ve learned over the last ten months. Economic and political power is a potent combination. Without some mechanism forcing private insurers to compete, we’re going to end up with a national health care system that’s controlled by a handful of very large corporations accountable neither to American voters nor to the market.

GuestDecember 11th, 2009 at 11:28 am

we are out of control…For feds, more get 6-figure salariesPUBLIC GAIN, PRIVATE PAINBy Dennis Cauchon, USA TODAYThe number of federal workers earning six-figure salaries has exploded during the recession, according to a USA TODAY analysis of federal salary data.Federal employees making salaries of $100,000 or more jumped from 14% to 19% of civil servants during the recession’s first 18 months — and that’s before overtime pay and bonuses are counted.Federal workers are enjoying an extraordinary boom time — in pay and hiring — during a recession that has cost 7.3 million jobs in the private sector.The highest-paid federal employees are doing best of all on salary increases. Defense Department civilian employees earning $150,000 or more increased from 1,868 in December 2007 to 10,100 in June 2009, the most recent figure available.When the recession started, the Transportation Department had only one person earning a salary of $170,000 or more. Eighteen months later, 1,690 employees had salaries above $170,000.The trend to six-figure salaries is occurring throughout the federal government, in agencies big and small, high-tech and low-tech. The primary cause: substantial pay raises and new salary rules.”There’s no way to justify this to the American people. It’s ridiculous,” says Rep. Jason Chaffetz, R-Utah, a first-term lawmaker who is on the House’s federal workforce subcommittee.Jessica Klement, government affairs director for the Federal Managers Association, says the federal workforce is highly paid because the government employs skilled people such as scientists, physicians and lawyers. She says federal employees make 26% less than private workers for comparable jobs.USA TODAY analyzed the Office of Personnel Management’s database that tracks salaries of more than 2 million federal workers. Excluded from OPM’s data: the White House, Congress, the Postal Service, intelligence agencies and uniformed military personnel.The growth in six-figure salaries has pushed the average federal worker’s pay to $71,206, compared with $40,331 in the private sector.Key reasons for the boom in six-figure salaries:• Pay hikes. Then-president Bush recommended — and Congress approved — across-the-board raises of 3% in January 2008 and 3.9% in January 2009. President Obama has recommended 2% pay raises in January 2010, the smallest since 1975. Most federal workers also get longevity pay hikes — called steps — that average 1.5% per year.•New pay system. Congress created a new National Security Pay Scale for the Defense Department to reward merit, in addition to the across-the-board increases. The merit raises, which started in January 2008, were larger than expected and rewarded high-ranking employees. In October, Congress voted to end the new pay scale by 2012.• Paycaps eased. Many top civil servants are prohibited from making more than an agency’s leader. But if Congress lifts the boss’ salary, others get raises, too. When the Federal Aviation Administration chief’s salary rose, nearly 1,700 employees’ had their salaries lifted above $170,000, too.

MMCADecember 11th, 2009 at 11:32 am

forget all this double dip BS and we are in a recovery… what we are in is a Decade long Depression!Trade deficit, new home tax credit and easy fed policies threaten double dip recessionBy Peter Morici • December 10, 2009trade deficit, new home buyer tax credits and Federal Reserve support for the mortgage market threaten a double dip recession.More than anything, U.S. businesses need customers — people buying American-made goods and services — to hire workers and continue the economic recovery.Money spent on imports of Middle East oil or Chinese coffee makers cannot be spent on American products unless those dollars return to purchase U.S. exports.Thursday, the Commerce Department will report that imports of goods and services exceeded exports in October by about $35 billion — a $420 billion annual pace.The trade gap subtracts more from the demand for U.S.-made goods and services than President Obama’s stimulus package adds. Moreover, Obama’s stimulus is temporary, whereas the trade deficit is permanent.Petroleum and Chinese manufactures account for nearly the entire U.S. trade imbalance, and the cost of those imports will increase as oil prices rise and consumer spending recovers in 2010.When imports substantially exceed exports, Americans must consume much more than the incomes they earn producing goods and services, or the demand for what they make is less than the supply, inventories pile up, layoffs result, and the economy goes into recession.From 2004 to 2008, the trade deficit exceeded five percent of GDP, and Americans borrowed from China, Middle East oil exporters and others to consume more than they produced and keep the economy going.Americans posted as collateral overvalued homes financed on shaky mortgages. When mortgages and banks failed, home prices and retail sales tanked, and the economy was thrust into the worst recession in 70 years.Now huge stimulus spending is required to resuscitate demand and jump start business activity. However, as the economy recovers, the trade deficit on oil and purchases from China will grow, further taxing demand for U.S. goods and services. Once the stimulus money is spent, the demand for U.S.-made products will fall again, and the economy will risk falling retail sales, more layoffs and a second, much-deeper recession.President Obama ignores fundamental causes of a rising trade deficit — China’s subsidies for domestic oil consumption, which drive up the price of U.S. oil imports, and China’s purposeful manipulation of currency markets to maintain an undervalued yuan and subsidize its exports into U.S. markets.President Obama’s policies to fight the recession are delivering only a moderate lift to the economy. As U.S. payments for imported oil and Chinese consumer goods rise and stimulus spending runs out, the escalating trade deficit will push the economy down again, threatening the feared double-dip recession.Unemployment could rocket to 15 percent.Meanwhile, federal efforts to support the housing market are creating another glut of unsold homes and perhaps a second, menacing bubble in the housing market.During the recent economic expansion, Americans built and bought too many homes, and now the market is oversupplied.Tax credits for new home buyers give builders a temporary reprieve from an adjustment period of slow demand, as population and economic growth work off the surplus of housing, but those policies put off an inevitable period of slack new home construction and falling land values.Similarly, by purchasing mortgage backed securities, the Federal Reserve has pushed borrowing rates to historic lows. Since May, home buyers have used this windfall to bid up prices for existing homes.When the tax credits and Federal Reserve subsidies are withdrawn as planned in 2010, home prices could plummet again, and a downdraft in consumer spending and residential construction could result.Together, the trade deficit, reckless tax subsidies for home builders and excessive liquidity provided by the Federal Reserve threaten a second dip in GDP and depression era unemployment.

mm CADecember 11th, 2009 at 11:37 am

The chart tells the story..12-6 – Millions More At-Risk of Default Than Most ThinkHappy Holidays. This reports contains material from various 2009 Mortgage Pages reports and is a great segue into 2010 events. Talk to you then. Mark HansonWhy Millions More Homeowners are At -Risk than Most ThinkUp to 20 Million Borrowers may be in Imminent RiskWhat 50% DTI Really Means Relative to Time-Tested 28/36Going Exotic in Plain SightBorrower’s Always Borrowed the MaxThe GSEs – A Culture of FraudAffordability – Out of ControlHAMP – More Exotic Than Bubble-Year’s Loans- Overview – Millions More Homeowners are At -Risk than Most ThinkMost look to loan type and equity position as two of the most important factors when forecasting loan default. In fact, I believe that epidemic negative-equity is the overarching reason that the default, foreclosure and housing crisis remains in the early innings. But…negative-equity with a caveat.While negative equity is a threat in and of itself, being in an over-leveraged household debt position is the true default catalyst for most in a negative-equity position. And being over-leveraged is also the primary default catalyst for those is a positive equity position. Being in a negative-equity position with lots of top line and disposable income each month is generally more of a mental burden than a reason to fly the coop.How many homeowners are over-levered and at imminent risk of default? This answer is…a lot more than most think, especially those who got a loan from 2003-2007 due to a radical, yet subtle shift in loan guidelines across the mortgage spectrum that kicked-off the bubble-years.Yes, even Prime full-doc borrowers in 30-year fixed mortgages with 20% equity who got their purchase or refi from 03-07 are at much greater risk than most think. Being over-levered was condoned – all the lenders, investors and loan programs operated in the same manner.In my research, I often assume that everybody knows the subtle idiosyncrasies of how loans are really structured. I understand this is not the case. So, in an attempt to highlight why the total residential mortgage risk exposure is so much greater than anybody’s expectations, this report drills down on Prime, Alt-A and Subprime allowable debt-to-income (DTI) ratios that were made ridiculously lax relative to pre and post 2003 – 2007. This, in my opinion, is the real tempest in the mortgage teapot that buckets millions more loans that are still in existence today across all loan types, as risky.- Time-Tested DTI Standards Thrown out the WindowA long time ago in a mortgage market far, far away (circa-2000 and before!) there was responsibility in lending. Age-old underwriting standards only allowed fully-documented debt-to-income ratios of 28% for housing and 36% for total debt (referred to as front and back DTI). On Jumbo loans, the ratios were 33/38 because Jumbo borrowers typically have more disposable income. On occasion, banks would make exceptions to this rule if the borrower had a large equity position or liquid reserves. At 28/36, homeowners can pay debt, shop, take their annual vacation, and even save money. At 28/36 DTI a house is a place to live first and an investment, second.Bubble year’s loan guidelines not only pushed the boundaries of risk by exotic loan structure but also income leverage. Circa-2002, time-tested DTI standards went out the window. Allowable DTI ratios on Prime loans rose to 50% and much higher when considering that so many loans were made with limited or no income documentation. Alt-A and Subprime full-doc loans would routinely go to 55% DTI…and full-doc are supposed to be the safe loans. Given that full-doc only represented 50% of Subprime and 25% of Alt-A loans it is understandable why these two loan types are experiencing the worst trouble, even though across the Alt-A universe the average FICO was above 700 at the time of origination.Around this same time, the investment bank’s participation and non-Agency lending and securitization began to really heat up. Guidelines expended further…hey, if the loan was going to be off the books in a few months, who cares how over-leveraged the borrower is.- Going Exotic in Plain SightBefore too long — circa-2003 — lending guidelines were fundamentally changing with many lenders allowing leverage through increased DTI ratios never seen before. Obviously, this expanded affordability sharply. When all of a sudden you can spend 50% of your gross income on debt vs 36% before, you can afford to buy much more house or take a much larger cash-out refi.Subtly changing loan guidelines by raising the allowable DTI on traditional loans, such as a 30-year fixed, was a more sneaky way of easing credit and going exotic than blatantly advertising for ‘no doc’. In fact, 30-year fixed loans and the borrowers that chose them were deemed to be so safe, the underwriting was much more lax than on an exotic structured loan, such as a Pay Option ARM.By 2004, as property values pushed house prices to levels that were unaffordable and stated income was not the norm yet, the new-normal in mortgage lending was allowing up to 50% of gross income to go to total debt. The mortgage obviously was the largest chunk.And remember, the 50% is only mortgage PITI and other debt listed on the credit report. It does not include income taxes, auto insurance, food or all the other things that individuals spend money on over the period of a month.And it didn’t stop there. As the mortgage credit strengthened the borrower’s credit profile, other credit was made available, including second mortgages, that could take total DTI far above 50%. Nevertheless, at 50% DTI, the house becomes the largest investment of a person’s life because there is no way for most to put out half of their gross income to debt each month and invest elsewhere.- Borrower’s Always Borrowed the MaxWhen buying or refinancing, most got a purchase or refi loan for as much as their banker or Realtor said they could, which was what 50% of their gross income paid for in most cases. Most borrowers don’t say “we know we qualify for $500k but just to make sure we have some wiggle room in our budget, let’s stick to a $400k loan”. Bottom Line – everybody borrowed too much because all of the lenders and loans — from the safest full-doc Prime loans to Subprime trash — allowed it. And after the fact, most expanded their credit portfolio because all credit was so easily attained until a couple of years ago.- GSE Loans – A Culture of FraudDuring the bubble years the GSE’s looked at DTI secondarily to credit score, LTV, and cash reserves as measured by liquid cash and 70% of retirement. Both Fannie and Freddie have automated underwriting systems called DU and LP respectively. During the bubble years, if the LTV was low enough and/or score and cash reserves high enough, the system would approve virtually anything.Many lenders, especially the big banks, had in-house DU and LP underwriting ‘trainers’ that would go around to the various mortgage branches and teach underwriters how to ‘trip’ the systems in order to achieve automated loan approvals when a declination was certain, or simply get fewer approval conditions on a loan that was borderline. Getting a loan approval out of DU/LP on a borrower with a 100% DTI — with limited documentation required on the automated findings — was not uncommon.In fact, many that needed to pump up a borrower’s strength who was light on income — instead of lying about the income — would pump up another aspect of the loan. The most common was to increase the borrower’s cash reserves, particularly retirement. This way, the retail sales worker buying a house well beyond their means would not need an obviously fraudulent income level, rather a believable household retirement total of maybe $100k. Doing it this way simply raised fewer red flags for the underwriter and investor.Few Loans Were Ever Denied at First PassDuring the bubble years, very few loans were ever denied. Denying loans was not ‘production oriented’. The culture across all lenders was to ‘approve everything subject to’. If you did not do it this way, your competitors would get all of the business.The approval process was for the underwriter to run the loan through DU/LP and if the system did not issue an approval (or an approval the borrower and the loan officer were happy with) to go back into the input file and edit the income, assets, retirement (or all three) until the system approved it. Some loans were edited 30 or 40 times until the GSE system issued an approval.Then, the approval was sent out to the borrower and loan officer even if it required them to verify $100k more in retirement reserves than the borrower had per the original loan application. Within a few days, a new back-dated loan application and a retirement account statement reflecting adequate reserves would arrive, the underwriter would sign it off and the loan would be on its way to the doc department. There was no way to verify if the document was a fake, unless it physically looked altered. In many cases the borrower never even knew this was happening.Note – this process was not GSE exclusive…this is just how it was done across all lenders.- Affordability out of ControlThen circa late-2004, as affordability declined sharply even with 50% DTI the norm, stated income came into play in a big way. This super-charged affordability and house prices in ways we will never see again in our lifetime.Stated income was around for years prior but limited to verified self-employed borrowers. The new-era Stated income loan allowed anyone with a two year job history to get a loan. All of a sudden, everybody earned $150k a year. From then on, the housing market had no shortage of purchases, cash-out refinances or HELOCs and house prices never looked back…well, until the exotic loan programs went away in late 2007.Circa early-2006 when it became obvious that Stated income was being abused because everybody (hair dressers, public sector workers, and anyone that said they were self-employed for two-years and could provide a fraudulent CPA letter that the lender never verified) suddenly was earning $12k a month, lenders became more cautious.What was the answer? Begin to push Pay Option ARMs with low teaser rates and payments. This way the borrowers could earn less so their fake income looked more believable. In addition, this is about the time that No Doc and No Ratio doc type options began to show up on every lender’s rate sheet, which provided the ultimate in plausible deniability.Bottom line – 80% of all Alt-A (including Pay Options), 50% of Subprime, 50% of Jumbo Prime and 30% of Prime loans from 2003-2007 were limited documentation loans for a reason – because the borrowers didn’t even have the 50% DTI needed for full doc.- How Big is the Total At-Risk Mortgage Universe?Of the loans in existence today at least 75% were refinanced or attained through a purchase from 2003-2007 – the bubble years. On several occasions in the past couple of years, Jim Cramer has quantified the at-risk loan universe as being around 14 million, which represents everyone who purchased a home between 2005-2007. But then he says ‘”here is no way everybody who bought a house from 2005-2007 will ever default”. So, he pairs it back to 20% or 25% of 14 million – whatever. He is incorrect on a number of levels.First off, the bubble years were really 2003-2007. But aside from that, the number of people who purchased a home is only a small piece of the entire pie. The bubble years was not about purchases, rather refi’s. During the bubble years refi’s, cash-out refi’s and HELOCs were at least 4:1 over purchases. A purchase is no more risky than an existing homeowner with a great payment history who pulled out 90% or 100% of their equity at a 50% DTI. In fact, the latter are more risky…purchases in general are always considered the safest loans.This means the true potential at-risk loan universe is any Prime, Alt-A, or Subprime borrower that did a purchase or refi from 2003-2007. Obviously, not every single borrower is at-risk but we have no way of really knowing how many of the 43 million + loans from that period still in existence today are destined for trouble. This is especially true when even borrowers with 800 scores and 70% LTV’s are at risk of default because their DTI started out at 50% and after the fact, they expanded their credit portfolio because all credit was so easily attained until a couple of years ago.- 13 to 15 Million Loans at Imminent Risk of Default- Potentially, 20 Million Homeowners over the Next Few YearsThe chart below breaks out all of the loans in existence by loan type. Of the loans originated during the trouble years, the far right columns show the conservative number of loans in which the borrowers either borrowed at 50% DTI or went Limited Doc (stated income, light doc, no doc, no ratio). The two columns are not mutually exclusive.The last Mortgage Bankers Association report estimates that the total number of loans in some sort of delinquency, default, or foreclosure status to be about 8.2 million, or 14.41% of all loans. If the true number of Imminently at-risk loans is somewhere between 13 and 15 million, the default and foreclosure crisis is about 60% over.The problem with the final 40% is that it crushes everyone other than Subprime households and likely happens over a longer period of time than the two-year Subprime Implosion.In addition to the imminent defaulters, a large percentage will default for various unforeseen reasons tied to the macro. Throw in top strategic defaulters and we could easily see a situation over the next few years in which 20 MILLION homeowners are either delinquent, defaulted, or in the foreclosure pipeline.- What a 50% DTI Really Means- Time-tested 36% DTI Means 60% MORE Disposable Income Each Month1) What a 50% DTI Really Means?Borrower Earnings: $100k per year50% Total DTI: $50,000 per year to housing PITI & all other debt on credit report25% Fed & State Taxes: $25,000 per yearDisposable income: $25,000 per year, or $2,083 per monthHow does this well-above average household SAVE MONEY AND pay for utilities (power, water, cable, garbage, insurance (car, life, health), gas, food, car payment, fuel, clothes, household maintenance and more on $2,083 per month? How do they save an emergency fund or take even a drive-away trip for the weekend?How do they shop this holiday season when over a trillion dollar in consumer credit was taken away in the past year?A 50% housing DTI turns the house into the largest investment of your life and ruins most household’s balance sheet at the same time unless the gross income — and disposable income — is much larger.For most in a serious negative equity position, it is better to walk away. Earning your way out of a $200k hole is impossible with disposable income of $2,083 per month less expenses. Why not walk – the borrower’s credit will be trashed for a few years but as long as they maintain their credit rating on all other credit, their overall rating will not be damaged for as long as their house remains underwater.2) Now, let’s look at this with 28/36 time-tested debt-to-income ratios.Bottom Line – 60% MORE disposable income each month.Borrower Earnings: $100k per year36% Total DTI: $36,000 per year per to housing PITI & all other debt on credit report25% Fed and State Taxes: $25,000 per yearDisposable income: $39,000 per year or $3,250 per monthWith $3,250 per month, a $100k household can likely save $20k per year. Still, this is not enough to make a real dent in a $200k neg-equity position. But, with this much disposable income the homeowner is not missing out on much and they are saving money, meaning their house is a place to live.What do households spend money in every year? The U.S. Census bureau provides the answers:• $200 billion on furniture, appliances ($1,900 per household annually)• $400 billion on vehicle purchases ($3,800 per household annually)• $425 billion at restaurants ($4,000 per household annually)• $9 billion at Starbucks ($85 per household annually)• $250 billion on clothing ($2,400 per household annually)• $100 billion on electronics ($950 per household annually)• $60 billion on lottery tickets ($600 per household annually)• $100 billion at gambling casinos ($950 per household annually)• $60 billion on alcohol ($600 per household annually)• $40 billion on smoking ($400 per household annually)• $32 billion on spectator sports ($300 per household annually)• $150 billion on entertainment ($1,400 per household annually)• $100 billion on education ($950 per household annually)• $300 billion to charity ($2,900 per household annually)The average homeowner household spends $22,785 per year, or $1900 per month on the above. When making an allowance for some of the items that are typically financed, the outgo is still roughly $1500 per month.At 50% DTI, the $100k earner with a disposable income of $2083 per month will have extra monthly income of $583 based upon typical spending. That does not leave a lot for savings, or items not listed such as auto insurance, vacations, gas etc. That definitely is not enough to ‘earn their way out’ of their negative equity hole.However, the 36% DTI borrower will have an extra $1750 month, which allows for living life and saving money, significantly reducing the chance of loan default due to negative-equity..Bottom Line – This shows vividly why 50% DTI — even with borrowers making $100k a year and with 20% equity in their property — is in fact over-leveraged and a recipe for loan default for any number of reasons.- HAMP — More Exotic than Bubble-Years LoansNow you know why I have been calling HAMP “the most exotic loan ever created” since its inception.But from the HAMP headlines you could not tell. All that is ever focused upon is the 31% DTI. But that is the front DTI…the housing-only DTI. If you read the guidelines, the back DTI (total debt) allows borrowers to go to 55%!In fact, if the borrower’s DTI is over 55%, the borrowers are required to go to credit counseling. A little news for ya – a borrower paying out 55% of their gross income to debt does not have time for credit counseling because they have a second job.Bottom Line: HAMP was designed to lower ‘payments’ for underwater borrowers, but also designed to suck every bit of disposable income every month to the bank. Being underwater in a high-DTI situation is the recipe for default, so it is no wonder the program is not performing as thought.Borrower’s realize this and are simply using the HAMP multi-month processing and approval process as a way of staying in their home rent-free for a longer period of time. At the end of the day, those that do make it to a permanent mod — but have a high back DTI — will ultimately fail.For a small percentage of those that fit the HAMP sweet-spot, it is great and absolutely the right medicine. However, at what cost? For many that can technically afford the house and would have gone on paying for 30-years — but can’t qualify for a new-vintage refi — a pre-meditated loan default and subsequent HAMP mod is an easy route to a government subsidized no cost refi.For all of these reasons and more, I believe HAMP will be fundamentally changed in 2010, perhaps to finally include principal balance reductions. Principal reductions are the only way modifications will stick. I hate the idea of any gov’t interference, but if they are going to be spending hundreds of billions anyway, they may as well target it.I also believe that HAMP will be ultimately responsible for a sizable wave of foreclosures beginning in the near-term from those who do not make it through their trail period, which as of recent data, is most. With foreclosures averaging 80k a month for the past six months and 700k foreclosures held up in the pipeline due to HAMP, even a trial mod failure rate of 40k a month would increase foreclosures by 50%.However, this is housing market bullish. The biggest threat to the housing market in 2010 is a lack of distress inventory, which is some states still makes up 70% of all sales. Foreclosures are what is in demand and the biggest unintended consequence of HAMP is that it’s keeping those who can’t afford their houses in them and others that can afford — and want to buy them — away.12-6 – Millions More At-Risk of Default Than Most ThinkHappy Holidays. This reports contains material from various 2009 Mortgage Pages reports and is a great segue into 2010 events. Talk to you then. Mark Hanson——————————————————————————–Why Millions More Homeowners are At -Risk than Most ThinkUp to 20 Million Borrowers may be in Imminent RiskWhat 50% DTI Really Means Relative to Time-Tested 28/36Going Exotic in Plain SightBorrower’s Always Borrowed the MaxThe GSEs – A Culture of FraudAffordability – Out of ControlHAMP – More Exotic Than Bubble-Year’s Loans——————————————————————————–Our mission is to provide our clients a significant edge. This is done by turning the daily, market-moving real estate and mortgage news flow and events into old news by the time it makes headlines. – Mark Hanson——————————————————————————— Overview – Millions More Homeowners are At -Risk than Most ThinkMost look to loan type and equity position as two of the most important factors when forecasting loan default. In fact, I believe that epidemic negative-equity is the overarching reason that the default, foreclosure and housing crisis remains in the early innings. But…negative-equity with a caveat.While negative equity is a threat in and of itself, being in an over-leveraged household debt position is the true default catalyst for most in a negative-equity position. And being over-leveraged is also the primary default catalyst for those is a positive equity position. Being in a negative-equity position with lots of top line and disposable income each month is generally more of a mental burden than a reason to fly the coop.How many homeowners are over-levered and at imminent risk of default? This answer is…a lot more than most think, especially those who got a loan from 2003-2007 due to a radical, yet subtle shift in loan guidelines across the mortgage spectrum that kicked-off the bubble-years.Yes, even Prime full-doc borrowers in 30-year fixed mortgages with 20% equity who got their purchase or refi from 03-07 are at much greater risk than most think. Being over-levered was condoned – all the lenders, investors and loan programs operated in the same manner.In my research, I often assume that everybody knows the subtle idiosyncrasies of how loans are really structured. I understand this is not the case. So, in an attempt to highlight why the total residential mortgage risk exposure is so much greater than anybody’s expectations, this report drills down on Prime, Alt-A and Subprime allowable debt-to-income (DTI) ratios that were made ridiculously lax relative to pre and post 2003 – 2007. This, in my opinion, is the real tempest in the mortgage teapot that buckets millions more loans that are still in existence today across all loan types, as risky.- Time-Tested DTI Standards Thrown out the WindowA long time ago in a mortgage market far, far away (circa-2000 and before!) there was responsibility in lending. Age-old underwriting standards only allowed fully-documented debt-to-income ratios of 28% for housing and 36% for total debt (referred to as front and back DTI). On Jumbo loans, the ratios were 33/38 because Jumbo borrowers typically have more disposable income. On occasion, banks would make exceptions to this rule if the borrower had a large equity position or liquid reserves. At 28/36, homeowners can pay debt, shop, take their annual vacation, and even save money. At 28/36 DTI a house is a place to live first and an investment, second.Bubble year’s loan guidelines not only pushed the boundaries of risk by exotic loan structure but also income leverage. Circa-2002, time-tested DTI standards went out the window. Allowable DTI ratios on Prime loans rose to 50% and much higher when considering that so many loans were made with limited or no income documentation. Alt-A and Subprime full-doc loans would routinely go to 55% DTI…and full-doc are supposed to be the safe loans. Given that full-doc only represented 50% of Subprime and 25% of Alt-A loans it is understandable why these two loan types are experiencing the worst trouble, even though across the Alt-A universe the average FICO was above 700 at the time of origination.Around this same time, the investment bank’s participation and non-Agency lending and securitization began to really heat up. Guidelines expended further…hey, if the loan was going to be off the books in a few months, who cares how over-leveraged the borrower is.- Going Exotic in Plain SightBefore too long — circa-2003 — lending guidelines were fundamentally changing with many lenders allowing leverage through increased DTI ratios never seen before. Obviously, this expanded affordability sharply. When all of a sudden you can spend 50% of your gross income on debt vs 36% before, you can afford to buy much more house or take a much larger cash-out refi.Subtly changing loan guidelines by raising the allowable DTI on traditional loans, such as a 30-year fixed, was a more sneaky way of easing credit and going exotic than blatantly advertising for ‘no doc’. In fact, 30-year fixed loans and the borrowers that chose them were deemed to be so safe, the underwriting was much more lax than on an exotic structured loan, such as a Pay Option ARM.By 2004, as property values pushed house prices to levels that were unaffordable and stated income was not the norm yet, the new-normal in mortgage lending was allowing up to 50% of gross income to go to total debt. The mortgage obviously was the largest chunk.And remember, the 50% is only mortgage PITI and other debt listed on the credit report. It does not include income taxes, auto insurance, food or all the other things that individuals spend money on over the period of a month.And it didn’t stop there. As the mortgage credit strengthened the borrower’s credit profile, other credit was made available, including second mortgages, that could take total DTI far above 50%. Nevertheless, at 50% DTI, the house becomes the largest investment of a person’s life because there is no way for most to put out half of their gross income to debt each month and invest elsewhere.- Borrower’s Always Borrowed the MaxWhen buying or refinancing, most got a purchase or refi loan for as much as their banker or Realtor said they could, which was what 50% of their gross income paid for in most cases. Most borrowers don’t say “we know we qualify for $500k but just to make sure we have some wiggle room in our budget, let’s stick to a $400k loan”. Bottom Line – everybody borrowed too much because all of the lenders and loans — from the safest full-doc Prime loans to Subprime trash — allowed it. And after the fact, most expanded their credit portfolio because all credit was so easily attained until a couple of years ago.- GSE Loans – A Culture of FraudDuring the bubble years the GSE’s looked at DTI secondarily to credit score, LTV, and cash reserves as measured by liquid cash and 70% of retirement. Both Fannie and Freddie have automated underwriting systems called DU and LP respectively. During the bubble years, if the LTV was low enough and/or score and cash reserves high enough, the system would approve virtually anything.Many lenders, especially the big banks, had in-house DU and LP underwriting ‘trainers’ that would go around to the various mortgage branches and teach underwriters how to ‘trip’ the systems in order to achieve automated loan approvals when a declination was certain, or simply get fewer approval conditions on a loan that was borderline. Getting a loan approval out of DU/LP on a borrower with a 100% DTI — with limited documentation required on the automated findings — was not uncommon.In fact, many that needed to pump up a borrower’s strength who was light on income — instead of lying about the income — would pump up another aspect of the loan. The most common was to increase the borrower’s cash reserves, particularly retirement. This way, the retail sales worker buying a house well beyond their means would not need an obviously fraudulent income level, rather a believable household retirement total of maybe $100k. Doing it this way simply raised fewer red flags for the underwriter and investor.Few Loans Were Ever Denied at First PassDuring the bubble years, very few loans were ever denied. Denying loans was not ‘production oriented’. The culture across all lenders was to ‘approve everything subject to’. If you did not do it this way, your competitors would get all of the business.The approval process was for the underwriter to run the loan through DU/LP and if the system did not issue an approval (or an approval the borrower and the loan officer were happy with) to go back into the input file and edit the income, assets, retirement (or all three) until the system approved it. Some loans were edited 30 or 40 times until the GSE system issued an approval.Then, the approval was sent out to the borrower and loan officer even if it required them to verify $100k more in retirement reserves than the borrower had per the original loan application. Within a few days, a new back-dated loan application and a retirement account statement reflecting adequate reserves would arrive, the underwriter would sign it off and the loan would be on its way to the doc department. There was no way to verify if the document was a fake, unless it physically looked altered. In many cases the borrower never even knew this was happening.Note – this process was not GSE exclusive…this is just how it was done across all lenders.- Affordability out of ControlThen circa late-2004, as affordability declined sharply even with 50% DTI the norm, stated income came into play in a big way. This super-charged affordability and house prices in ways we will never see again in our lifetime.Stated income was around for years prior but limited to verified self-employed borrowers. The new-era Stated income loan allowed anyone with a two year job history to get a loan. All of a sudden, everybody earned $150k a year. From then on, the housing market had no shortage of purchases, cash-out refinances or HELOCs and house prices never looked back…well, until the exotic loan programs went away in late 2007.Circa early-2006 when it became obvious that Stated income was being abused because everybody (hair dressers, public sector workers, and anyone that said they were self-employed for two-years and could provide a fraudulent CPA letter that the lender never verified) suddenly was earning $12k a month, lenders became more cautious.What was the answer? Begin to push Pay Option ARMs with low teaser rates and payments. This way the borrowers could earn less so their fake income looked more believable. In addition, this is about the time that No Doc and No Ratio doc type options began to show up on every lender’s rate sheet, which provided the ultimate in plausible deniability.Bottom line – 80% of all Alt-A (including Pay Options), 50% of Subprime, 50% of Jumbo Prime and 30% of Prime loans from 2003-2007 were limited documentation loans for a reason – because the borrowers didn’t even have the 50% DTI needed for full doc.- How Big is the Total At-Risk Mortgage Universe?Of the loans in existence today at least 75% were refinanced or attained through a purchase from 2003-2007 – the bubble years. On several occasions in the past couple of years, Jim Cramer has quantified the at-risk loan universe as being around 14 million, which represents everyone who purchased a home between 2005-2007. But then he says ‘”here is no way everybody who bought a house from 2005-2007 will ever default”. So, he pairs it back to 20% or 25% of 14 million – whatever. He is incorrect on a number of levels.First off, the bubble years were really 2003-2007. But aside from that, the number of people who purchased a home is only a small piece of the entire pie. The bubble years was not about purchases, rather refi’s. During the bubble years refi’s, cash-out refi’s and HELOCs were at least 4:1 over purchases. A purchase is no more risky than an existing homeowner with a great payment history who pulled out 90% or 100% of their equity at a 50% DTI. In fact, the latter are more risky…purchases in general are always considered the safest loans.This means the true potential at-risk loan universe is any Prime, Alt-A, or Subprime borrower that did a purchase or refi from 2003-2007. Obviously, not every single borrower is at-risk but we have no way of really knowing how many of the 43 million + loans from that period still in existence today are destined for trouble. This is especially true when even borrowers with 800 scores and 70% LTV’s are at risk of default because their DTI started out at 50% and after the fact, they expanded their credit portfolio because all credit was so easily attained until a couple of years ago.- 13 to 15 Million Loans at Imminent Risk of Default- Potentially, 20 Million Homeowners over the Next Few YearsThe chart below breaks out all of the loans in existence by loan type. Of the loans originated during the trouble years, the far right columns show the conservative number of loans in which the borrowers either borrowed at 50% DTI or went Limited Doc (stated income, light doc, no doc, no ratio). The two columns are not mutually exclusive.The last Mortgage Bankers Association report estimates that the total number of loans in some sort of delinquency, default, or foreclosure status to be about 8.2 million, or 14.41% of all loans. If the true number of Imminently at-risk loans is somewhere between 13 and 15 million, the default and foreclosure crisis is about 60% over.The problem with the final 40% is that it crushes everyone other than Subprime households and likely happens over a longer period of time than the two-year Subprime Implosion.In addition to the imminent defaulters, a large percentage will default for various unforeseen reasons tied to the macro. Throw in top strategic defaulters and we could easily see a situation over the next few years in which 20 MILLION homeowners are either delinquent, defaulted, or in the foreclosure pipeline.- What a 50% DTI Really Means- Time-tested 36% DTI Means 60% MORE Disposable Income Each Month1) What a 50% DTI Really Means?Borrower Earnings: $100k per year50% Total DTI: $50,000 per year to housing PITI & all other debt on credit report25% Fed & State Taxes: $25,000 per yearDisposable income: $25,000 per year, or $2,083 per monthHow does this well-above average household SAVE MONEY AND pay for utilities (power, water, cable, garbage, insurance (car, life, health), gas, food, car payment, fuel, clothes, household maintenance and more on $2,083 per month? How do they save an emergency fund or take even a drive-away trip for the weekend?How do they shop this holiday season when over a trillion dollar in consumer credit was taken away in the past year?A 50% housing DTI turns the house into the largest investment of your life and ruins most household’s balance sheet at the same time unless the gross income — and disposable income — is much larger.For most in a serious negative equity position, it is better to walk away. Earning your way out of a $200k hole is impossible with disposable income of $2,083 per month less expenses. Why not walk – the borrower’s credit will be trashed for a few years but as long as they maintain their credit rating on all other credit, their overall rating will not be damaged for as long as their house remains underwater.2) Now, let’s look at this with 28/36 time-tested debt-to-income ratios.Bottom Line – 60% MORE disposable income each month.Borrower Earnings: $100k per year36% Total DTI: $36,000 per year per to housing PITI & all other debt on credit report25% Fed and State Taxes: $25,000 per yearDisposable income: $39,000 per year or $3,250 per monthWith $3,250 per month, a $100k household can likely save $20k per year. Still, this is not enough to make a real dent in a $200k neg-equity position. But, with this much disposable income the homeowner is not missing out on much and they are saving money, meaning their house is a place to live.What do households spend money in every year? The U.S. Census bureau provides the answers:• $200 billion on furniture, appliances ($1,900 per household annually)• $400 billion on vehicle purchases ($3,800 per household annually)• $425 billion at restaurants ($4,000 per household annually)• $9 billion at Starbucks ($85 per household annually)• $250 billion on clothing ($2,400 per household annually)• $100 billion on electronics ($950 per household annually)• $60 billion on lottery tickets ($600 per household annually)• $100 billion at gambling casinos ($950 per household annually)• $60 billion on alcohol ($600 per household annually)• $40 billion on smoking ($400 per household annually)• $32 billion on spectator sports ($300 per household annually)• $150 billion on entertainment ($1,400 per household annually)• $100 billion on education ($950 per household annually)• $300 billion to charity ($2,900 per household annually)The average homeowner household spends $22,785 per year, or $1900 per month on the above. When making an allowance for some of the items that are typically financed, the outgo is still roughly $1500 per month.At 50% DTI, the $100k earner with a disposable income of $2083 per month will have extra monthly income of $583 based upon typical spending. That does not leave a lot for savings, or items not listed such as auto insurance, vacations, gas etc. That definitely is not enough to ‘earn their way out’ of their negative equity hole.However, the 36% DTI borrower will have an extra $1750 month, which allows for living life and saving money, significantly reducing the chance of loan default due to negative-equity..Bottom Line – This shows vividly why 50% DTI — even with borrowers making $100k a year and with 20% equity in their property — is in fact over-leveraged and a recipe for loan default for any number of reasons.- HAMP — More Exotic than Bubble-Years LoansNow you know why I have been calling HAMP “the most exotic loan ever created” since its inception.But from the HAMP headlines you could not tell. All that is ever focused upon is the 31% DTI. But that is the front DTI…the housing-only DTI. If you read the guidelines, the back DTI (total debt) allows borrowers to go to 55%!In fact, if the borrower’s DTI is over 55%, the borrowers are required to go to credit counseling. A little news for ya – a borrower paying out 55% of their gross income to debt does not have time for credit counseling because they have a second job.Bottom Line: HAMP was designed to lower ‘payments’ for underwater borrowers, but also designed to suck every bit of disposable income every month to the bank. Being underwater in a high-DTI situation is the recipe for default, so it is no wonder the program is not performing as thought.Borrower’s realize this and are simply using the HAMP multi-month processing and approval process as a way of staying in their home rent-free for a longer period of time. At the end of the day, those that do make it to a permanent mod — but have a high back DTI — will ultimately fail.For a small percentage of those that fit the HAMP sweet-spot, it is great and absolutely the right medicine. However, at what cost? For many that can technically afford the house and would have gone on paying for 30-years — but can’t qualify for a new-vintage refi — a pre-meditated loan default and subsequent HAMP mod is an easy route to a government subsidized no cost refi.For all of these reasons and more, I believe HAMP will be fundamentally changed in 2010, perhaps to finally include principal balance reductions. Principal reductions are the only way modifications will stick. I hate the idea of any gov’t interference, but if they are going to be spending hundreds of billions anyway, they may as well target it.I also believe that HAMP will be ultimately responsible for a sizable wave of foreclosures beginning in the near-term from those who do not make it through their trail period, which as of recent data, is most. With foreclosures averaging 80k a month for the past six months and 700k foreclosures held up in the pipeline due to HAMP, even a trial mod failure rate of 40k a month would increase foreclosures by 50%.However, this is housing market bullish. The biggest threat to the housing market in 2010 is a lack of distress inventory, which is some states still makes up 70% of all sales. Foreclosures are what is in demand and the biggest unintended consequence of HAMP is that it’s keeping those who can’t afford their houses in them and others that can afford — and want to buy them — away.12-6 – Millions More At-Risk of Default Than Most ThinkHappy Holidays. This reports contains material from various 2009 Mortgage Pages reports and is a great segue into 2010 events. Talk to you then. Mark Hanson——————————————————————————–Why Millions More Homeowners are At -Risk than Most ThinkUp to 20 Million Borrowers may be in Imminent RiskWhat 50% DTI Really Means Relative to Time-Tested 28/36Going Exotic in Plain SightBorrower’s Always Borrowed the MaxThe GSEs – A Culture of FraudAffordability – Out of ControlHAMP – More Exotic Than Bubble-Year’s Loans——————————————————————————–Our mission is to provide our clients a significant edge. This is done by turning the daily, market-moving real estate and mortgage news flow and events into old news by the time it makes headlines. – Mark Hanson——————————————————————————— Overview – Millions More Homeowners are At -Risk than Most ThinkMost look to loan type and equity position as two of the most important factors when forecasting loan default. In fact, I believe that epidemic negative-equity is the overarching reason that the default, foreclosure and housing crisis remains in the early innings. But…negative-equity with a caveat.While negative equity is a threat in and of itself, being in an over-leveraged household debt position is the true default catalyst for most in a negative-equity position. And being over-leveraged is also the primary default catalyst for those is a positive equity position. Being in a negative-equity position with lots of top line and disposable income each month is generally more of a mental burden than a reason to fly the coop.How many homeowners are over-levered and at imminent risk of default? This answer is…a lot more than most think, especially those who got a loan from 2003-2007 due to a radical, yet subtle shift in loan guidelines across the mortgage spectrum that kicked-off the bubble-years.Yes, even Prime full-doc borrowers in 30-year fixed mortgages with 20% equity who got their purchase or refi from 03-07 are at much greater risk than most think. Being over-levered was condoned – all the lenders, investors and loan programs operated in the same manner.In my research, I often assume that everybody knows the subtle idiosyncrasies of how loans are really structured. I understand this is not the case. So, in an attempt to highlight why the total residential mortgage risk exposure is so much greater than anybody’s expectations, this report drills down on Prime, Alt-A and Subprime allowable debt-to-income (DTI) ratios that were made ridiculously lax relative to pre and post 2003 – 2007. This, in my opinion, is the real tempest in the mortgage teapot that buckets millions more loans that are still in existence today across all loan types, as risky.- Time-Tested DTI Standards Thrown out the WindowA long time ago in a mortgage market far, far away (circa-2000 and before!) there was responsibility in lending. Age-old underwriting standards only allowed fully-documented debt-to-income ratios of 28% for housing and 36% for total debt (referred to as front and back DTI). On Jumbo loans, the ratios were 33/38 because Jumbo borrowers typically have more disposable income. On occasion, banks would make exceptions to this rule if the borrower had a large equity position or liquid reserves. At 28/36, homeowners can pay debt, shop, take their annual vacation, and even save money. At 28/36 DTI a house is a place to live first and an investment, second.Bubble year’s loan guidelines not only pushed the boundaries of risk by exotic loan structure but also income leverage. Circa-2002, time-tested DTI standards went out the window. Allowable DTI ratios on Prime loans rose to 50% and much higher when considering that so many loans were made with limited or no income documentation. Alt-A and Subprime full-doc loans would routinely go to 55% DTI…and full-doc are supposed to be the safe loans. Given that full-doc only represented 50% of Subprime and 25% of Alt-A loans it is understandable why these two loan types are experiencing the worst trouble, even though across the Alt-A universe the average FICO was above 700 at the time of origination.Around this same time, the investment bank’s participation and non-Agency lending and securitization began to really heat up. Guidelines expended further…hey, if the loan was going to be off the books in a few months, who cares how over-leveraged the borrower is.- Going Exotic in Plain SightBefore too long — circa-2003 — lending guidelines were fundamentally changing with many lenders allowing leverage through increased DTI ratios never seen before. Obviously, this expanded affordability sharply. When all of a sudden you can spend 50% of your gross income on debt vs 36% before, you can afford to buy much more house or take a much larger cash-out refi.Subtly changing loan guidelines by raising the allowable DTI on traditional loans, such as a 30-year fixed, was a more sneaky way of easing credit and going exotic than blatantly advertising for ‘no doc’. In fact, 30-year fixed loans and the borrowers that chose them were deemed to be so safe, the underwriting was much more lax than on an exotic structured loan, such as a Pay Option ARM.By 2004, as property values pushed house prices to levels that were unaffordable and stated income was not the norm yet, the new-normal in mortgage lending was allowing up to 50% of gross income to go to total debt. The mortgage obviously was the largest chunk.And remember, the 50% is only mortgage PITI and other debt listed on the credit report. It does not include income taxes, auto insurance, food or all the other things that individuals spend money on over the period of a month.And it didn’t stop there. As the mortgage credit strengthened the borrower’s credit profile, other credit was made available, including second mortgages, that could take total DTI far above 50%. Nevertheless, at 50% DTI, the house becomes the largest investment of a person’s life because there is no way for most to put out half of their gross income to debt each month and invest elsewhere.- Borrower’s Always Borrowed the MaxWhen buying or refinancing, most got a purchase or refi loan for as much as their banker or Realtor said they could, which was what 50% of their gross income paid for in most cases. Most borrowers don’t say “we know we qualify for $500k but just to make sure we have some wiggle room in our budget, let’s stick to a $400k loan”. Bottom Line – everybody borrowed too much because all of the lenders and loans — from the safest full-doc Prime loans to Subprime trash — allowed it. And after the fact, most expanded their credit portfolio because all credit was so easily attained until a couple of years ago.- GSE Loans – A Culture of FraudDuring the bubble years the GSE’s looked at DTI secondarily to credit score, LTV, and cash reserves as measured by liquid cash and 70% of retirement. Both Fannie and Freddie have automated underwriting systems called DU and LP respectively. During the bubble years, if the LTV was low enough and/or score and cash reserves high enough, the system would approve virtually anything.Many lenders, especially the big banks, had in-house DU and LP underwriting ‘trainers’ that would go around to the various mortgage branches and teach underwriters how to ‘trip’ the systems in order to achieve automated loan approvals when a declination was certain, or simply get fewer approval conditions on a loan that was borderline. Getting a loan approval out of DU/LP on a borrower with a 100% DTI — with limited documentation required on the automated findings — was not uncommon.In fact, many that needed to pump up a borrower’s strength who was light on income — instead of lying about the income — would pump up another aspect of the loan. The most common was to increase the borrower’s cash reserves, particularly retirement. This way, the retail sales worker buying a house well beyond their means would not need an obviously fraudulent income level, rather a believable household retirement total of maybe $100k. Doing it this way simply raised fewer red flags for the underwriter and investor.Few Loans Were Ever Denied at First PassDuring the bubble years, very few loans were ever denied. Denying loans was not ‘production oriented’. The culture across all lenders was to ‘approve everything subject to’. If you did not do it this way, your competitors would get all of the business.The approval process was for the underwriter to run the loan through DU/LP and if the system did not issue an approval (or an approval the borrower and the loan officer were happy with) to go back into the input file and edit the income, assets, retirement (or all three) until the system approved it. Some loans were edited 30 or 40 times until the GSE system issued an approval.Then, the approval was sent out to the borrower and loan officer even if it required them to verify $100k more in retirement reserves than the borrower had per the original loan application. Within a few days, a new back-dated loan application and a retirement account statement reflecting adequate reserves would arrive, the underwriter would sign it off and the loan would be on its way to the doc department. There was no way to verify if the document was a fake, unless it physically looked altered. In many cases the borrower never even knew this was happening.Note – this process was not GSE exclusive…this is just how it was done across all lenders.- Affordability out of ControlThen circa late-2004, as affordability declined sharply even with 50% DTI the norm, stated income came into play in a big way. This super-charged affordability and house prices in ways we will never see again in our lifetime.Stated income was around for years prior but limited to verified self-employed borrowers. The new-era Stated income loan allowed anyone with a two year job history to get a loan. All of a sudden, everybody earned $150k a year. From then on, the housing market had no shortage of purchases, cash-out refinances or HELOCs and house prices never looked back…well, until the exotic loan programs went away in late 2007.Circa early-2006 when it became obvious that Stated income was being abused because everybody (hair dressers, public sector workers, and anyone that said they were self-employed for two-years and could provide a fraudulent CPA letter that the lender never verified) suddenly was earning $12k a month, lenders became more cautious.What was the answer? Begin to push Pay Option ARMs with low teaser rates and payments. This way the borrowers could earn less so their fake income looked more believable. In addition, this is about the time that No Doc and No Ratio doc type options began to show up on every lender’s rate sheet, which provided the ultimate in plausible deniability.Bottom line – 80% of all Alt-A (including Pay Options), 50% of Subprime, 50% of Jumbo Prime and 30% of Prime loans from 2003-2007 were limited documentation loans for a reason – because the borrowers didn’t even have the 50% DTI needed for full doc.- How Big is the Total At-Risk Mortgage Universe?Of the loans in existence today at least 75% were refinanced or attained through a purchase from 2003-2007 – the bubble years. On several occasions in the past couple of years, Jim Cramer has quantified the at-risk loan universe as being around 14 million, which represents everyone who purchased a home between 2005-2007. But then he says ‘”here is no way everybody who bought a house from 2005-2007 will ever default”. So, he pairs it back to 20% or 25% of 14 million – whatever. He is incorrect on a number of levels.First off, the bubble years were really 2003-2007. But aside from that, the number of people who purchased a home is only a small piece of the entire pie. The bubble years was not about purchases, rather refi’s. During the bubble years refi’s, cash-out refi’s and HELOCs were at least 4:1 over purchases. A purchase is no more risky than an existing homeowner with a great payment history who pulled out 90% or 100% of their equity at a 50% DTI. In fact, the latter are more risky…purchases in general are always considered the safest loans.This means the true potential at-risk loan universe is any Prime, Alt-A, or Subprime borrower that did a purchase or refi from 2003-2007. Obviously, not every single borrower is at-risk but we have no way of really knowing how many of the 43 million + loans from that period still in existence today are destined for trouble. This is especially true when even borrowers with 800 scores and 70% LTV’s are at risk of default because their DTI started out at 50% and after the fact, they expanded their credit portfolio because all credit was so easily attained until a couple of years ago.- 13 to 15 Million Loans at Imminent Risk of Default- Potentially, 20 Million Homeowners over the Next Few YearsThe chart below breaks out all of the loans in existence by loan type. Of the loans originated during the trouble years, the far right columns show the conservative number of loans in which the borrowers either borrowed at 50% DTI or went Limited Doc (stated income, light doc, no doc, no ratio). The two columns are not mutually exclusive.The last Mortgage Bankers Association report estimates that the total number of loans in some sort of delinquency, default, or foreclosure status to be about 8.2 million, or 14.41% of all loans. If the true number of Imminently at-risk loans is somewhere between 13 and 15 million, the default and foreclosure crisis is about 60% over.The problem with the final 40% is that it crushes everyone other than Subprime households and likely happens over a longer period of time than the two-year Subprime Implosion.In addition to the imminent defaulters, a large percentage will default for various unforeseen reasons tied to the macro. Throw in top strategic defaulters and we could easily see a situation over the next few years in which 20 MILLION homeowners are either delinquent, defaulted, or in the foreclosure pipeline.- What a 50% DTI Really Means- Time-tested 36% DTI Means 60% MORE Disposable Income Each Month1) What a 50% DTI Really Means?Borrower Earnings: $100k per year50% Total DTI: $50,000 per year to housing PITI & all other debt on credit report25% Fed & State Taxes: $25,000 per yearDisposable income: $25,000 per year, or $2,083 per monthHow does this well-above average household SAVE MONEY AND pay for utilities (power, water, cable, garbage, insurance (car, life, health), gas, food, car payment, fuel, clothes, household maintenance and more on $2,083 per month? How do they save an emergency fund or take even a drive-away trip for the weekend?How do they shop this holiday season when over a trillion dollar in consumer credit was taken away in the past year?A 50% housing DTI turns the house into the largest investment of your life and ruins most household’s balance sheet at the same time unless the gross income — and disposable income — is much larger.For most in a serious negative equity position, it is better to walk away. Earning your way out of a $200k hole is impossible with disposable income of $2,083 per month less expenses. Why not walk – the borrower’s credit will be trashed for a few years but as long as they maintain their credit rating on all other credit, their overall rating will not be damaged for as long as their house remains underwater.2) Now, let’s look at this with 28/36 time-tested debt-to-income ratios.Bottom Line – 60% MORE disposable income each month.Borrower Earnings: $100k per year36% Total DTI: $36,000 per year per to housing PITI & all other debt on credit report25% Fed and State Taxes: $25,000 per yearDisposable income: $39,000 per year or $3,250 per monthWith $3,250 per month, a $100k household can likely save $20k per year. Still, this is not enough to make a real dent in a $200k neg-equity position. But, with this much disposable income the homeowner is not missing out on much and they are saving money, meaning their house is a place to live.What do households spend money in every year? The U.S. Census bureau provides the answers:• $200 billion on furniture, appliances ($1,900 per household annually)• $400 billion on vehicle purchases ($3,800 per household annually)• $425 billion at restaurants ($4,000 per household annually)• $9 billion at Starbucks ($85 per household annually)• $250 billion on clothing ($2,400 per household annually)• $100 billion on electronics ($950 per household annually)• $60 billion on lottery tickets ($600 per household annually)• $100 billion at gambling casinos ($950 per household annually)• $60 billion on alcohol ($600 per household annually)• $40 billion on smoking ($400 per household annually)• $32 billion on spectator sports ($300 per household annually)• $150 billion on entertainment ($1,400 per household annually)• $100 billion on education ($950 per household annually)• $300 billion to charity ($2,900 per household annually)The average homeowner household spends $22,785 per year, or $1900 per month on the above. When making an allowance for some of the items that are typically financed, the outgo is still roughly $1500 per month.At 50% DTI, the $100k earner with a disposable income of $2083 per month will have extra monthly income of $583 based upon typical spending. That does not leave a lot for savings, or items not listed such as auto insurance, vacations, gas etc. That definitely is not enough to ‘earn their way out’ of their negative equity hole.However, the 36% DTI borrower will have an extra $1750 month, which allows for living life and saving money, significantly reducing the chance of loan default due to negative-equity..Bottom Line – This shows vividly why 50% DTI — even with borrowers making $100k a year and with 20% equity in their property — is in fact over-leveraged and a recipe for loan default for any number of reasons.- HAMP — More Exotic than Bubble-Years LoansNow you know why I have been calling HAMP “the most exotic loan ever created” since its inception.But from the HAMP headlines you could not tell. All that is ever focused upon is the 31% DTI. But that is the front DTI…the housing-only DTI. If you read the guidelines, the back DTI (total debt) allows borrowers to go to 55%!In fact, if the borrower’s DTI is over 55%, the borrowers are required to go to credit counseling. A little news for ya – a borrower paying out 55% of their gross income to debt does not have time for credit counseling because they have a second job.Bottom Line: HAMP was designed to lower ‘payments’ for underwater borrowers, but also designed to suck every bit of disposable income every month to the bank. Being underwater in a high-DTI situation is the recipe for default, so it is no wonder the program is not performing as thought.Borrower’s realize this and are simply using the HAMP multi-month processing and approval process as a way of staying in their home rent-free for a longer period of time. At the end of the day, those that do make it to a permanent mod — but have a high back DTI — will ultimately fail.For a small percentage of those that fit the HAMP sweet-spot, it is great and absolutely the right medicine. However, at what cost? For many that can technically afford the house and would have gone on paying for 30-years — but can’t qualify for a new-vintage refi — a pre-meditated loan default and subsequent HAMP mod is an easy route to a government subsidized no cost refi.For all of these reasons and more, I believe HAMP will be fundamentally changed in 2010, perhaps to finally include principal balance reductions. Principal reductions are the only way modifications will stick. I hate the idea of any gov’t interference, but if they are going to be spending hundreds of billions anyway, they may as well target it.I also believe that HAMP will be ultimately responsible for a sizable wave of foreclosures beginning in the near-term from those who do not make it through their trail period, which as of recent data, is most. With foreclosures averaging 80k a month for the past six months and 700k foreclosures held up in the pipeline due to HAMP, even a trial mod failure rate of 40k a month wo

PeteCADecember 11th, 2009 at 12:32 pm

A really excellent article! I’m not sure why it was printed twice – but that does not detract from the content.If you think about it … the same general process that undermined the mortgage market in the USA is now actively undermining the credit markets. In order to get liquidity flowing – what did they do? Answer: Push up the allowable DTI ratio, and relegate this financial parameter to a secondary role in the loan evaluation process. Bingo – many more risky loans!Today the Fed is ignoring the DTI for our country, which is more commonly referred to as the ratio of national debt to GDP. The Fed says that this parameter “does not matter” amd it is not factored into Bernanke’s economic models. So it is soaring, and nobody is telling Pres Obama that this will lead to economic disaster.PeteCA

GuestDecember 11th, 2009 at 11:57 am

By Alistair BarrThe financial crisis hammered hedge funds last year, but one of the industry’s oldest firms not only survived but is set to raise billions to pick through the wreckage.”Now the party is truly over,” Paul Singer, head of $16 billion hedge fund firm Elliott Management Corp., wrote in a confidential letter to investors Oct. 15. “The current economic and market environment resembles the one for which Elliott was formed.”Elliott, which Singer started in 1977, is looking to raise money to take advantage of the situation. The firm could take in about $2 billion next year by inviting existing investors to commit more money, according to one investor who is adding to positions and spoke on condition of anonymity.Hedge funds lost a record 19% on average last year as the financial crisis triggered a wave of investor redemptions. The industry has slowly recovered and investors are beginning to return, but raising $2 billion would be notable, even for a respected firm like Elliott.Elliott sometimes raises money more like a private-equity firm, rather than a hedge fund. The firm collects commitments from investors and then calls those in when it needs the money for investments. During 2007, at the peak of the credit boom, Elliott raised roughly $3 billion through such a program. An Elliott spokesman declined to comment.Elliott started out as a convertible arbitrage fund, but after the 1987 market crash Singer’s focus shifted to distressed debt. This strategy involves buying bonds and other securities of troubled companies, then selling at a profit later when they either recover or reorganize in bankruptcy.Some thought distressed debt hedge funds were poised for big gains in early 2008, but the financial crisis was so severe that these managers lost more than 25% on average. This year, performance has improved as credit markets recovered and the economy stabilized.Despite a fledgling economic recovery this year, Singer reckons the rebound won’t be strong enough to prevent a wave of corporate bankruptcies. That should create a lot of opportunities for Elliott.”The economic recovery, virtually regardless of its shape, will not be robust enough to save a number of companies in commercial real estate, retail and other industries,” Singer wrote in his Oct. 15 letter.”Despite large governmental policy actions, many companies both here and in Europe are hanging by a thread,” Singer added. “This will create a pool of new distressed opportunities in the next few months.”Elliott has generated steady returns. The firm’s main hedge fund, Elliott Associates, L.P., was up more than 30% this year through the end of November, one of its best years ever, according to the investor who declined to be identified.Since inception in early 1977, Elliott Associates returned 14.5% through Sept. 30, while the Standard & Poor’s 500 index climbed less than 11% during the same period. Elliott’s returns came with almost a third less volatility than the equity benchmark. Last year, when the average hedge fund lost 19%, Elliott was down about 3%.The firm’s main focus in distressed debt and this is where Singer sees the most opportunity.Most investment firms shun large, complicated bankruptcies and other complex situations, but Elliott actively seeks them out.The current bankruptcy wave should provide lots of complex situations for Elliott to delve into. Moody’s Investors Service counted 250 defaults by companies it rates, through the end of November. That’s already higher than any previous year.- Alistair Barr; 415-439-6400; AskNewswires@dowjones.com

PeteCADecember 11th, 2009 at 12:34 pm

By the way … I second the question raised above.Can someone confirm/deny that comments on this blog will no longer be allowed starting next week – for people who are not paying subscribers?PeteCA

MM CADecember 12th, 2009 at 8:54 am

NO JOBS for a long time? So, Obama and Congress, most of us went to school when they really taught Math, and your numbers dont add up as described below. you need to explain to us how you are going to help us dig out of this Depression we are in. There is no WWII to help. If you dont, this time you will all be replcaced every 2 and 4 years. There are now enough affected people (over 80 million) by NO JOBS for them and thier families…How about1. Capping bank profits2. Capping insurance costs3. low interest small buiness loans for everyone who can write, spell and add4. lower income tax rates on Small buinsness5. Meaningful tax crredits for fortune 3000 companies who hire people6. A real fix the roads, bridges, trains, sewer, water systems that is nationwide…7. Solar/wind energy for every home in america that is located in an area where it would help.8. Fix Education once and for all… College is out of reach for most American youth now and K-12 is broke to the point of not being fixable.Lies, Damn Lies, And Government StatisticsJohn Mauldin|Dec. 12, 2009, 9:29 AM | 26 |PrintTags: Economy, Unemployment, Jobs, EmploymentWe are clearly starting to get some better data points here and there. But as I pointed out this summer, it is going to be a recovery in the statistics and not in the things that count, such as income and employment. This week we look at the nascent recovery (which could be at 3% this quarter) and try to peer out into the future to see what it means. We look at how recoveries come about, and why I am concerned that we will see a double-dip recession. Plus, I learned some new tricks courtesy of my new granddaughter, to whom Tiffani gave birth this week1 There is a lot to cover, but it should be interesting.But first, a quick commercial nod to my subscription service, “Conversations with John.” It was one year ago this week we launched the service, and we are pleased that so many of you have subscribed. As a bonus for renewing or subscribing, I am going to be doing a special predictions issue, where I will interview at least six analysts who have been right the past few years and ask for their specific predictions for the coming year.For new readers, this is where I sit down with some of my friends and hold an in-depth conversation, generally 45 minutes to an hour, and post it on our web site, along with a transcript. We have had some fairly well-known names over the past year, and the reviews from subscribers have been excellent.As a Holiday Special, we are offering a subscription at the special price of $129. Just click on the link and type in the code JM09 when asked to do so in the subscription process (at the conclusion of the process, not the beginning, but we’re working on that.) This is a big savings over the regular $199 price. Just click on the link to learn more and see what subscribers are saying. http://www.johnmauldin.com/newsletters2.htmlPlus, when you subscribe you get access to the Conversation archives. That is worth the price of admission itself. And now, let’s jump into The Statistical Recovery.Thoughts on the Statistical RecoveryIn the ’50s through the early ’80s, recessions were typified by large layoffs at manufacturing businesses, as they had built up too much inventory. Businesses had increased capacity and often borrowed a little too much. Rising prices in the ’70s, along with extremely high interest-rate costs, led to the two severe recessions of the early ’80s, which Paul Volcker had to essentially force into existence, in order to begin the process of wringing inflation out of the economy.But, and this is important, as the economy improved, inventories were eventually worked through and employees were brought back to work. Things returned to normal. The economy would once again grow at a robust rate. Then, in the last two recessions, in the early ’90s and early ’00s, it took longer for employment to rise. A great part of this was because the manufacturing sector of national employment was becoming an ever smaller part of the economic pie. We were, and still are, turning into an economy driven by services.I should note that, on an absolute basis, manufacturing in the US has grown (going back to before this recession started.) We just produced more “stuff” with fewer employees. We became more productive. But this means that there are fewer jobs that will be brought “back” to make up for increasing sales than in past recessions. There are estimates out that as many as 2 million of the 8 million jobs lost are permanent job losses.We know that businesses have made large cuts in numbers of employees in order to address lower sales and to increase their profits. Increasing profits by cutting costs even as the “top-line” sales number is shrinking is not a growth strategy that can be sustained. It also eats into research and development and postpones growth.How likely are businesses to bring back employees if they have found they can produce more with less? This is a prescription for the mother of all jobless recoveries. A few weeks back, I went into some detail outlining why employment is likely to be uncomfortably high for a number of years, and that assumes we do not go back into recession. The graph below is the most likely scenario. You can see the entire piece, which goes into detail on this and other scenarios (developed with Mike Shedlock), by clicking here.Quoting from that letter: “In August, I did an interview with CNBC from Leen’s Fishing Lodge in Maine (http://www.cnbc.com/id/15840232?video=1207956774&play=1). The unemployment numbers had just come out. I did a back-of-the-napkin estimate that we would need about 15 million new jobs over the next five years just to get back to where we were when the recession started.” It rather startled some of the hosts – “Where can we get that many jobs?”Again, quoting from that letter: “That works out to a need for about 125,000 new jobs each month to handle new workers coming into the market (which comes to a total of 7.5 million over five years), plus the 8 million and rising jobs we’ve lost. That is a daunting number. It amounts to 250,000 new jobs a month every month for five years.”As it turns out, Princeton Professor Paul Krugman agrees. He writes in today’s New York Times (http://krugman.blogs.nytimes.com/):”I don’t think many people grasp just how much job creation we need to climb out of the hole we’re in. You can’t just look at the eight million jobs that America has lost since the recession began, because the nation needs to keep adding jobs – more than 100,000 a month – to keep up with a growing population. And that means that we need really big job gains, month after month, if we want to see America return to anything that feels like full employment. How big? My back of the envelope calculation says that we need to add around 18 million jobs over the next five years, or 300,000 a month. This puts last week’s employment report, which showed job losses of “only” 11,000 in November, in perspective. It was basically a terrible report, which was reported as good news only because we’ve been down so long that it looks like up to the financial press.”That just goes to show you that I am an optimist. His back-of-the-napkin number is 20% larger. He is probably right, as he has a Nobel Prize and I don’t, and I didn’t actually use a napkin. I did the math in my head on camera while we were getting ready to go fishing.Krugman uses this to suggest the Fed should double their balance sheet by another $2 trillion (seriously). That would not be very helpful to the dollar, I would think.(Aside: we are in a balance-sheet recession. We overleveraged our banks and consumers. Now they are having to retrench. We are watching consumer and business loans fall. Putting $2 trillion more into the system is not going to make consumers want to borrow more. I can’t quite see where you deal with the problem of too much leverage by trying to create more leverage somewhere else. But that’s a topic for another day.)And just to demonstrate that I am not being too pessimistic, you can go to a study the Bureau of Labor Statistics put out yesterday. They estimate that the economy will create 15.3 million more jobs in the next ten years, which is an average of about 1.5 million a year, or 125,000 a month. That is not a robust number, and suggests that the continued high unemployment projected in the graph above may not be far off target, as the employment assumptions are not that dissimilar. If you have no social life, you can read it yourself at http://www.bls.gov/news.release/ecopro.nr0.htm.Lies, Damn Lies, and Government StatisticsWe are going to look at the unemployment numbers of last week, along with the unemployment claims that came out yesterday. But first, I want to quote a section from Dennis Gartman’s letter this morning. It illustrates why we have to be very careful how we use government data. Too often, we think the data is straightforward math and simply draws on the underlying data sources. The reality is that it is anything but. To wit:”A PROBLEM AT THE VERY HEART OF DATA GATHERING: Recently in Washington a rather large number of economists from academia and from government met to try to hash out a problem with data gathering that has become more and more serious here in the US and has more and more distorted how we value the American economy itself. At heart is how imports into the US are accounted for.”For example, when a part for perhaps $100 is imported from China and is used in an American automobile … something that happens more and more and more often these days … the stats show that the finished car is American-made because it was assembled here in the US and in the process the US GDP is raised by that same $100 when in fact it should have been deflated by that figure instead. In the process, American workers who might in the past have made the part in question are no longer doing so and are obviously made redundant, hence a job or jobs is lost.”The unemployment data then ‘finds’ that unemployed worker and accounts for him or her, but the car that is assembled does not, and when it is produced and sold and its value makes its way through the system, it appears that productivity has risen … and rather dramatically so, when in fact it has not. As one of the economists attending that meeting said,” ‘We don’t have the data collection structure to capture what is happening in a real-time way, or what is being traded and how it is affecting workers. We have no idea how to measure the occupations being ‘offshored’ or what is being ‘inshore.'”Or as the Assistant Commissioner for International Prices at the US Bureau of Labor Statistics (and how “politburo-like” is a title like that?!!) Mr. William Alterman, said regarding this problem” ‘What we are measuring as productivity gains may in fact be nothing more than changes in trade instead.'”This is not an insignificant problem, for as the US has become more and more international in its trading scope the data has become more and more important. Back in the 1975, imports into the US were only 5% of our total economic activity, but in recent years that has swelled to 12%, excluding imports of energy. Thus, many imports into the US are being, and have been, and will continue to be, valued as though they were manufactured here in the US, when indeed they were manufactured abroad and merely assembled here in the US.”In autos, in computers, in appliances, this is a large and growing problem, but this is a problem too in the areas of services. For example, when an accounting firm out-sources some of its number-crunching to an accounting firm in India, for example, and then bills a client here in the US in US dollar terms, the work is done abroad but billed here and the work is recorded as having been done in the US, adding to US GDP when clearly that is not the case. It happens too, these days, more and more often in medicine, when patient files are sent to India or somewhere else abroad for diagnosis and the patient is billed here in the US as if the ‘work’ had been done here. GDP rises here in the US when it really should have been accounted for in India; productivity goes up; GDP goes up, when in reality neither has happened. ‘ Tis a conundrum.”The Problem of Seasonal AdjustmentsYesterday we were told that initial unemployment claims were up slightly to 474,000 on a seasonally adjusted basis. That is down 78,000 from the same week last year. The four-week moving average is almost exactly the same. On a four-week-average basis, initial claims are down about 10% from last year.Let’s look under the hood. The non-seasonally adjusted number (NSA) is 665,000, down almost 95,000 from last year, which is good, but still a very large number. The actual average had been over 550,000 for the last three weeks.Everywhere the headlines said continuing claims are plunging. And they did. But what really happened is that the drop was not from people getting jobs but from people rolling over to the extended benefits programs. The states by and large pay for the first 26 weeks, and that is where we get the continuing-claim reported number from. (In some parts of the US hosever, you can get unemployment insurance for up to 99 months, paid for by the federal government.There are 5.16 million on the continuing-claim rolls. But when you add in the extended benefits rolls, it increases to over 10 million. Average length of unemployment is now over 26 weeks, and the median length is over 33 weeks!It was reported that the unemployment rate dropped to 10% from 10.2%. To get that number, they had to shrink the number of people looking for work by 98,000. Basically, if you have not looked for work in the last four weeks, you are said to be “discouraged” and are taken out of the unemployment statistics. If you add back in the discouraged workers, the rate goes up to 10.5%. And it is worse than that. If you have not looked for a job in 12 months, you are taken off the rolls altogether.Here is one of the reasons that the unemployment number is going to remain stubbornly high through 2010. Let’s assume a modest recovery of 3%, which is maybe enough to get jobs back into the 150,000 range. As people go back to work, that 0.5% of discouraged workers starts to look for jobs and they are now counted as unemployed. That small number of 0.5% is 750,000 people that will be (should be) added back into the unemployment numbers!Let’s use Krugman’s 100,000 jobs a month needed to keep up with population growth. (Studies are all over the place on this. 100,000 is the low estimate and 150,000 is the high.) That means we need 1.2 million new jobs next year just to keep the unemployment rate at 10%. And another 750,000 jobs to go to the discouraged workers who will want to start looking. Close to 2 million jobs will be needed to keep the unemployment rate from rising.And the current business climate says that is not going to happen.The Job Creation EngineSmall businesses employ 85% (or thereabouts) of American workers. That is always where the employment growth comes from. So when we see the ISM surveys, which are mainly of large businesses, that suggest they may start employing more people in the next few months, we need to see how their smaller brethren are doing. Fortunately, we have a very reliable survey by the National Federation of Independent Businesses, which does a lengthy monthly survey to give us the temperature in the small-business world. You can review it at http://www.nfib.com/Portals/0/PDF/sbet/SBET200912.pdf. (My friend and Maine fishing buddy Bill Dunkelberg puts out the report.)It is a mixed bag, as some of the scores of questions in the survey indicate that small businesses are feeling better than a year ago. On the whole, though, they are not very upbeat. 72% of small businesses say their earnings are down over the last three months, and that has been the case for over a year. The most important reason for lower earnings is listed as poor sales volume. Sales expectations, however, are much better than earlier this year, with almost half of those surveyed thinking things will get better.While the number of businesses that are not planning to hire any more employees in the next three months is still slightly negative, it is improving. 54% have job openings. There is not much in the way of wage pressure, as wage levels are dropping; and actual prices of the goods and services they are selling and the materials and services they are buying are falling (on average). Inventory levels have dropped precipitously, and that bodes well for hiring, as inventories at some point are going to have to be built back upHowever, as Bill points out, “In November small business owners reported a decline in average employment per firm of 0.58 workers reported during the prior threemonths, a big improvement from May’s record loss of 1.26 workers per firm – but still a loss of jobs. Nine percent of the owners increased employment by an average of 2.3 workers per firm, but 21 percent reduced employment an average of 4.2 workers per firm (seasonally adjusted). The “job generating machine” is still in reverse. Sales are not picking up, so survival requires continuous attention to costs – and labor costs loom large. But, job reductions are fading and job creation could cross the “0” line by the end of the year.”Owner optimism remains stuck at recession levels. The proximate cause is very weak consumer spending, better than a year ago, but that was pretty bad. Fifteen (15) percent reported gains, while 43 percent reported weakness. With weak consumer spending, there is little need to invest in inventory (and borrow money to support inventory investment). Inventory investment plans are at historically very low levels. Similarly capital spending is on hold, with actual outlays and planned outlays at record low levels along with the demand for loans to finance the outlays. More firms still plan on reducing employment than plan on adding to their payrolls. Inventory reductions are still widespread, eight percent reported accumulation, 33 percent reported reductions. This sets the stage for new orders in future periods, but does not help much now.”The survey kept highlighting the concerns and uncertainty about government plans for new taxes and regulations. It is hard to make plans to expand when you are not certain what your costs will be for health care, taxes, cap and trade, etc.This is a survey we need to watch, because when it turns up we can start to feel confident about the recovery (which is still stimulus-driven). We will look back at it in a few months.A Double-Dip Recession?Finally, this highlights my concern about a double-dip recession. I think we could see one in 2011, as a result of the massive increases in taxes as the Bush tax cuts expire and the Pelosi-Reid-Obama crowd want to raise taxes on the “rich.” Their assumption is that if we could grow quite well in the Clinton years with higher taxes, then we can do it again.First, if there are no changes to the proposed tax increases, this will be a massive middle-class tax hike. Make no mistake, the Bush tax cuts resulted in a huge cut in the taxes of the middle class. The data clearly shows the wealthiest 20% are paying significantly more of the total taxes paid.If you combine a large middle-class tax increase with an even larger new wealth tax (75% of which will affect the very small businesses we just highlighted), it will be a one-two punch to the economic body, when unemployment is already at 10%. You can’t take out well over 2% (and maybe 3%) of GDP from the consumer without it having significant consequences.Obama mentioned minor tax credits for small businesses in his plan, but then proposes to raise their taxes and health-care costs. It doesn’t work that way. But it is time to hit the send button, so I will close.Dad Gets a Lively LessonA few friends noted that there was no Outside the Box this week. I plead a distraction. I got back from New York Sunday night and left my phone in my home office. I wandered in the next morning and got a call from Melissa (#2 daughter). “Dad, are you going to the hospital now?” Hospital, what hospital?”Didn’t you get Ryan’s text? Tiffani has gone into labor.” Almost three weeks early. That was not on my radar screen. I shot a text off to Ryan and then we talked. Seems things were progressing slowly. I would have the morning before I needed to go to the hospital.I settled down and then got a text that Tiffani was starting to push. Oops, that happened faster than we thought. I got to the hospital and went to the waiting room, where some of Tiffani and Ryan’s friends were also waiting.Did I know what was going on? No, but they did. Seems Tiffani’s best friend is now in Belgium, where she was watching the whole process over the MacBook set up in the delivery room! She was posting (G-rated, I was assured) pictures to Tiffani’s Facebook page, where all their friends were keeping up. And of course, blow-by-blow accounts and pictures on Twitter. As we sat there, one of the young men told me my granddaughter, named Lively Bella-Grace Frederick had been born. Did I want to see a picture? And of course the in-laws, who are missionaries in Cyprus, saw the whole thing relayed by the girlfriend in Belgium.Mom, Dad, and Lively were here this afternoon, and doing well. But I am seriously going to have to update my communication skills if I am going to keep up with my kids and grandkids. I feel so, well, out of it. Oh well. I am sure Lively will give Papa John a lesson or three over the years.And finally, I am very excited about my special live webinar next week with Jon Sundt, President and CEO of Altegris Investments. Many of you have already registered, and I look forward to fielding your tough questions. There is still space available for this live event, so please join us! Click here to registerIt’s happening next week on Thursday, December 17th, at 9:00 am PST / 12:00 noon EST. If that time doesn’t work in your calendar, simply register and you will be able to listen to the replay at your convenience.We will be discussing some of the critical macroeconomic forces at work today and how these factors influence your investing decisions. Jon, an expert on alternative investing, will provide his assessment of alternative strategies during these challenging times. Our goal is to support you to better position your portfolio for the year ahead.Click here for the first step in the registration process: my Accredited Investor website. From there, you’ll be automatically directed to the webinar signup page. Due to regulatory issues, this online event is limited to US investors who qualify as “accredited investors” (generally, net worth of $1.5 million or more). If you have already registered on my Accredited Investor site, please contact your Altegris account executive for a streamlined registration process. (In this regard I am president and a registered representative of Millennium Wave Securities, LLC, member FINRA.)Have a great week. I know I am going to!Your going to get this brave new world figured out analyst.John Mauldin

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