Transcript: 357 Forecast and Mortgage Interest Rates

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FORECAST FRIDAY

Today on the podcast, Mortgages and Debt, what went wrong and what is going to go wrong, focusing on the upcoming exit of the Fed from the MBS market, its effect on interest rates, and what that is likely to do to prices.  Then we look at the right way to do things, featuring the writings of two-time Nobelist Joseph Stiglitz (once for economics, once as part of the IPCC for peace).

And speaking of the Nobel, we see Assar Lindbeck made it to the short list of the Dynamite prize.  The Dynamite Prize, you may be aware, was originally called the Ignoble Prize in Economics.  It will be awarded to the three economists who contributed most to enabling the Global Financial Collapse (GFC), or more figuratively, to the three economists who contributed most to blowing up the global economy.  

By working to make the Riksbank Prize in Economic Sciences (“Nobel Prize in Economics”) almost exclusively a prize for neoclassical economists, this Swedish economist has contributed significantly to the conversion of the economics profession and of world public opinion to market fundamentalism. 

There are other, more notable economists up for the prize, which you yourself can vote on at rwer.wordpress.com.  I voted for only one.  The P.T. Barnum of economics, Milton Friedman, whose hash of history melded neatly with a theory that never worked and was promoted tirelessly by the man to the detriment of real economics.  

The blog has it right in their dossier:

"Milton Friedman propagated the delusion, through his misunderstanding of the scientific method, that an economy can be accurately modeled using counterfactual propositions about its nature.  This, together with his simplistic model of money, encouraged the development of the financial theories with unrealistic assumptions that facilitated the GFC.  In short, he opened the door for everyone subsequently to theorize without fear of having to be attached to reality."

But there are others, and you don't need to limit yourself to one.  You get three votes.

But now to mortgages and debt.

Our view of Alan Greenspan was not the mainstream's view, even in 2000.  Greenspan is also on the short list at the Dynamite Prize.  We referred to him as Maestro Magoo, since whatever he did, no matter how obtuse or dangerous, since the economy landed on its feet and he was still smiling, he got credit for doing something right.  Hopefully some of you will remember Mister Magoo, the myopic cartoon character voiced by Jim Backus who escaped calamity time and time again, and because he escaped, or more rightly because he never knew he was in danger, his confidence in himself never wavered.  "Oh, Magoo, you've done it again."

By cutting rates, Greenspan let people reach for more house.  As rates went down, house prices began to go up.  The same monthly payment could afford a more expensive house.  House prices rising brought in people running from the dot.com bust, then it brought in the archetypical Ponzi investors, who were not looking for a productive asset, but for an increase in its price.  These combined with the simple savers, who bought and paid for as much house as they could buy because, hey, the increase in every year is doing a lot better than anybody's stocks or savings accounts.  

So that is what is needed for a bubble, the only necessary and sufficient conditions, easy money and rising asset prices.  Other elements of bubbles, such as the corruption that inevitably preys on the phenomenon -- and which we should say is often blamed for the process -- are not sufficient to cause one.  Of course, much of the professional and intellectual corruption sponsored innovations that brought money down to free.  Now, of course, we have the reverse playing out

The Fed is winding down its MBS purchase program, specifically designed to keep interest rates low.  For the past year, the Fed has been virtually the only purchaser of these securities.  Most predictions are for 5.5 to 7 percent mortgages, up 50 to 150 basis points.  See a list on the blog transcript.

•  Guy Cecala, publisher of Inside Mortgage Finance. "My opinion is that rates will go up a full percentage point initially," meaning that 30-year fixed conforming loans, now hovering around 5 percent, would hit 6 percent.
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•  Keith Gumbinger, vice president of HSH Associates, which compiles mortgage loan data, thinks that rates will slowly rise to about 5.75 percent after the Fed withdraws. 
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•  Julian Hebron, branch manager at RPM Mortgage's San Francisco office, anticipates a bump up to around 5.5 percent by summer ...
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•  Christopher Thornberg, principal at Beacon Economics in Los Angeles [said] "Clearly, when they stop printing all that money, it's going to be a shock to the system. I have to assume that when they pull back on it, it will cause a 100- to 200-basis-points rise" to rates of 6 percent or 7 percent ...

And a couple earlier predictions:

•  Eric S. Rosengren, president and chief executive of the Boston Fed, expects a 50 to 75 bps increase.
•  Pimco's Bill Gross expects about a 50 bps increase. He also thinks the Fed will restart the program later in 2010.
  
  Calculated Risk's estimate is based on the 10 Year Treasury -- an increase in the spread of about 35 bps (maybe 50 bps).

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It is worthwhile to reflect on another episode when interest rates went up.  In the early 1980s when Paul Volcker tried to crush inflation with high interest rates.  Back up.  No.  He was applying Milton Friedman's prescription and restricting the money supply.  In any event, interest rates went up and the Savings & Loan business model was crushed.

Inflation came down, but it was not the painless exercise Friedman had promised.  Instead it was the deepest recession between the Great Depression and now.  The value of the S&L held mortgages collapsed.  The S&L's quickly became essentially bankrupt.  Accounting rules allowed them to forestall the day of reckoning.  They didn't have to write down the mortgages to reflect reality.  Some tried to solve the problem by continuing to grow -- a kind of Ponzi scheme, as Stigltiz says.  Ronald Reagan helped them along by softening accounting standards.  The S&L's were zombies -- dead banks that remained among the living.  They began a gamble on resurrection.  The result was a much bigger hole than the original one and in the process of gambling, a lot of corruption and scandal was birthed.

So will interest rates go up with the end of the Fed's MBS purchases and the sunsetting of these other programs?  Well, house prices will fall.  If interest rates don't go up, it will be for lack of demand.  Terms will also get much tighter and prices will go lower on the downslope of the interest rate bell curve.  One thing for sure, zero financing to the banks will not increase the number of mortgages they are writing.  Another reason to raise the rate and squeeze them toward productive, real economy loans.

Lower prices mean more people under water.  What is the opposite of a bubble?  A black hole?

And consider Stiglitz' point, a mortgage for one hundred percent of the value of a house in a non-recourse environment -- where the borrower can just send the keys back to the lender with no recourse open to the lender, this type of contract is also known as an option.

On Wall Street, if you had this deal, you would look at the price and the cost and make a calculation.  It is absurd to see bankers trying to bully people with moral intimidation when they have done much worse and given themselves bonuses for it.  But we're not going there.  Sorry.

We are not going to deal with the corruption today, nor the toxic derivatives, nor the many and manifold asymmetries between social purposes and banking incentives.  And we're going to take as given the fact that the huge privately held debt, household and business, is the mountain that must be removed before the economy can recover.

Following Stiglitz, securitzation made it more difficult to renegotiate mortgages.  They were packed and sliced.  The mortgage servicers have little incentive to renegotiate, particularly when the securities contain specific restrictions making such action more difficult.

Add to this that a typical highly indebted homeowner has a first mortgage for, say, 80 percent of the value of the house, and a second mortgage for, say, 15 percent.  If the home falls 20 percent in value, we have a problem.  A single mortgage of 95% would be easier to write down because both borrower and lender would be interested in a -- theoretically both would be interested in getting the financial incentives right to stay in the home.  But the second mortgage holder has no reason, since he will be wiped out in foreclosure.  A dim chance of recovery in the housing market is the only light he sees in terms of getting any of his money back.  The interests of the first and second mortgage holders are thus diametrically opposed.  

Add to this the fact that the holder of the second mortgage was often, who else?  the mortgage servicer who has responsibility for renegotiation.

And beneath it all, there is the trepidation of the banks themselves, or the mortgage holders, who would be required to recognize losses that bad accounting allows them to ignore at present.

So what is the answer?

The economy needs to reduce this debt.  Stiglitz suggests the best of all options.  Homeowners Chapter 11.

One in seven mortgages is delinquent.  The proportion of those 90 days or more and in the foreclosure process continues to expand.  Check the blog for Calculated Risk's chart.

Click on graph for larger image in new window.

Homeowners Chapter 11 is modeled on the corporate bankruptcy process, which he discusses in his must-read book FREEFALL.  This would be a speedy restructuring of liabilities of poorer homeowners.  In a corporate Chapter 11, the stock holders, those who own the equity, are wiped out, and the bondholders become the new equity owners.  In a home, it is the homeowner who holds the equity, so to speak, and the bank is the bondholder.  Here, along with writing down the value of what the homeowner owes, the bank receives equity, and when the house is eventually sold, a large fraction of the capital gain on the house would go to the lender.  Obviously those who bought mainly to speculate would not find such a deal attractive.

With Homeowners' Chapter 11, people would not have to go through the full bankruptcy process, discharging all of their debts.  The home would be treated as if it were a separate corporation.  The house would be appraised and the individual's debt would be written down to, say, 90 percent of the appraisal.  The bank avoids foreclosure losses and gets upside potential.  The foofaraw around renegotiation is greatly diminished.  Debt disappears.

Another idea Stiglitz presents in his book, which you have heard here, is using the very low borrowing costs of the federal government to directly benefit citizens, rather than going a long way around through the banks and maybe getting someday back to something to do with what could be a real economy.

The government not only has low borrowing costs, but it is in a much better situation to ensure payment.  If the government lends to the homeowner at 2 percent rather than 6 percent, for example, the interest payments on a $300,000 mortgage drop to $1,500 a month from $6,000.  Quoting now, rather than paraphrasing.  

"For someone struggling to get along at twice the poverty rate, around $30,000 a year, that cuts house payments from 60 percent of the before-tax income to 20 percent.  Where 60 percent is not manageable, 20 percent is.  And apart from the cost of sending out the notices, the government makes a nice $6,000 profit per year on the deal.  

"Moreover, becaue the house is not being forced into foreclosure, real estate prices remain stronger, and the neighborhood is better off.  There are advantages all around -- except for the banks.  The government has an advantage," Stiglitz says again, "both in raising funds and in collecting interest." 

and later,

""If banks can't make the easy money by exploining poor Americans, they might go back to the hard business, what they were supposed to be doing all along -- lending money to help set up new enterprises and expand old ones."

The same type of scheme could be used to help consumer credit holders.  It has its precedent in the student loan programs and in government mortgages.  Here it reduces debt burdens without touching the principle, and makes the economy better off at everybody's benefit except -- again -- the banks.

As we mentioned when we first brought this up, oh, a year ago, however, these sorts of remedies -- which go directly to the heart of the debt problem -- are not even on the table.

The inevitability of a slide absent such measures is complete.  The effect of interest rate rises on housing and housing prices is sure.  The follow-on hit to effective demand for all goods is assured.  Thus the forecast.  The rosy 3 percent plus GDP numbers coming out of the Administration are imaginary.  Our 1 percent is optimistic.  (That is out the stimulus bump we are now enjoying).  One percent.  Demand equals supply.  Contracting credit.

Political weight on top of the required public investment will not go away soon, is our guess.  And there is no other way out than reducing debt and increasing public investment.  We can all be looking through the windows at the predatory casino capitalism, or we can get to work educating and building in a society of solvent citizens.  Only the second option leads to economic vitality.