The Economy

The Energy Tax

Rate Watch #677 The Energy Tax
July 3, 2009
by Dick Lepre
dicklepre@rpm-mtg.com
www.loanmine.com

The Energy Tax

I want to apologize at the start for the somewhat disjointed nature of this piece. I want to get it out Thursday because of the Holiday and my wife was ill yesterday and I had to take her to the ER. She has asthma which triggered a respiratory infection. In any case, I started this and really did not have enough time to finish it as well as I could have. The ideas are all here but not pulled together as well as they could have been.
The House passed an energy tax bill last week which will probably be revised substantially by the Senate. As written by the House this bill is a bit bizarre. It starts from doubtful premises, increases taxes and threatens our trading partners with tariffs if they do not constrain emissions.
I am by no means convinced that man-made global warming is really significant. I wrote about this a few years ago and my views have not changed substantially. My newsletter of four years ago is here.

There is a Good Side to This

To me, the House Bill starts with the dubious proposition that there is an almost existential problem created by our production of CO2. I want to give another view. Since the start of the Industrial Revolution humans have vastly changed the face of the planet. This is done through farming, dam building, creation of cities which are "urban heat islands", and we have created industries which spew stuff into the atmosphere and water. Our consciousness of this is much greater than ever before and our intentions are much better but getting the science correct is still vital.

Concluding that CO2 is the main culprit of the way mankind had reshaped the surface of the planet is a bit narrow. The reality is that this is complex. No one really knows how much man made CO2 has caused temperature increases. The science is simply too complex. I do want to make a very important point about science. Statements such as "most scientists believe that humans are responsible of global warming" or "IPCC concluded that they are 90% certain that global warming is due to man-made CO2" are not scientific. Science is not done by consensus. Any statement that something is 90% likely to be true is, by definition, not scientific. That does not mean that such an opinion is not of value. It only means that it is not science.

Just because a vast majority of scientists believe something does not make it scientific. Science is not the collective opinions of scientists. Science is a process of formulating theories and having them stand by having attempts to disprove them fail. Science rarely reached ultimate answers. It yields our best intellectual estimates of out understanding of the physical world at the present.

I certainly believe that CO2 is a greenhouse gas and causes increases in temperature. I am by no means convinced about the relative impact of man-made CO2 on temperature variations. My opinions are detailed in that piece from four years ago.

Even though I may not believe that anthropogenic global warming is a significant factor in explaining the multidecadenal changes in average temperature and even though I may be concerned about the consequences of the House Bill which also has some "this will never work" pieces decreeing that the US will tariff nations which do not follow suit the fact is that lurking here is the heart of a really good idea. Unfortunately the really good idea was lost.
That really good idea is clean energy independence. Contriving a method of encouraging a method for eliminating imported oil and eliminating shocks associated with energy produced by commodities with volatile prices is a good idea. If the cost of this energy is as low or lower than energy from fossil fuels that this becomes a great idea.

The history of our dependence on oil follows this form: oil prices rise, everyone gets upset, we start talking about alternatives, oil prices fall making alternatives too expensive, we give up on alternatives. The nice things about this very bad bill is that it potentially breaks this mold.

The two obvious present sources are nuclear and solar. While I, as a guy with a degree in Physics who has spent enough times at places like the Nevada Test Site am not afraid of dealing with rad waste I have no interest in spending time convincing others of this. We spent a ton of money developing a place in Nevada to store this and politicians have taken this apart.

A large part of the solution in the short run is solar photovoltaic (PV) power. The disadvantages of solar are that it is much more effective in Arizona than it is in Minnesota. Electrical power has losses when delivered over large distances. PV generates nothing at night. A dependence on PV likely will require more advanced methods of storing energy. The advantage of PV is that it makes use of a source of energy which will not vary in cost.
There is an article on a sort of Moore's Law for PV from IEEE. I would regard that as an optimistic view of the path of PV.
While one might make a case that this cap-and-trade system will help new technologies it would have made a lot more sense to me to simply help these new technologies rather that create more government infrastructure.

I believe that getting into the mind set that energy is a bad thing and we have to use less of it is nonsense. What I believe we need is more research in physics to find massively large new sources of energy which do not have any of the annoying environmental effects of coal or the rad waste storage problems or nuclear.

If I am going to be technical what we need is new sources of power. This is defined in physics which starts with arbitrary units of length, time and mass and goes on from there. Power = work/unit of time. Work = Force x distance (an oversimplification to make a point). Force can be defined by the unit of force called the newton. A newton is the amount of force necessary to accelerate a 1 kilogram object so that its speed increases by 1 meter/second each second.

To make this more casual: work is getting something done (moving a car), energy is the ability to do that work and power is the ability to do that work quickly.
What is lurking in the nether regions of my mind here is the following: we may find that there is nanotechnology which enables us to created macroscopic objects - let's call these "ham sandwiches" - but that these require a lot of energy. It is only breakthroughs in physics which will give us access to these energies. The only such thing out there at present is controlled fusion. This is research which has been going on a very long time. The hope is that the NIF facility here in Livermore will lead to the long sought breakthrough. All of the NIF lasers were fired up in May and the hope is that this machine can achieve fusion in 2010.

It is interesting and rarely discussed that NIF just happens to be at what was one of out two nuclear weapons research facilities - Lawrence Livermore Laboratory. In the 1970's and 1980's there were underground nuclear test done using the basic concepts which NIF seeks to use. That all stopped when testing ceased in 1988.

To me, as someone who used to work there, the amusing part of the NIF story is that is was pitched as "stockpile stewardship". "Stockpile stewardship" more or less means methodologies of testing nuclear weapons so that we are sure they still work after years of storage rather than having underground nuclear test which we agreed by treaty not to do.

Dick Lepre
RPM - SF
580 Pacific Avenue
San Francisco, CA 94133
dicklepre@rpm-mtg.com
Web site: www.loanmine.com
Blog: economy.typepad.com
(415) 343.6789 (direct dial number)
(866) 488-2051 fax

October 17, 2008
by Dick Lepre

Now Make It Work

Most of what Congress, Treasury and the Federal Reserve have to do to cure the problems with the banking system have been set into motion. With Treasury buying pools of distressed mortgage to provide liquidity and making capital investments in banks to provide capital we will be getting to the point where it is up to banks to remember that their role is to take in money in the form of deposits and lend it out at a higher rate to make a profit.

That is easy for me to say. Banks have to be looking at uncertain real estate values and the chance of recession and make some decisions about whom to lend money to.

Let me give some advice:

- lend money to companies and people who can pay it back

- for an individual buying a home this is fairly straightforward. Make sure they have a stake in the home. We could call this something like a "down payment". It may be the case that people who have something to lose are more likely to prevent it from getting lost than people who have nothing to lose.

- actually calculate how much the house will cost each month. With the help of computers we might even be able to calculate the mortgage payment. Insurance companies and counties might even be willing to share ultra secret information about what the tax bill is and the insurance payments are.

- this is radical but let's consider asking people if they would be so kind as to show us what their income really is. Maybe they could make a copy of a couple of pay stubs and even those W-whatsis forms that get sent to IRS each January.

- by taking the two steps above we might actually assure ourselves that folks income exceeds their housing expense. We could even consider letting them have a little money left over to eat.

OK. It sounds as if I am merely being silly but my point is that we always knew what made a good mortgage loan and what did not. We got away from that for a few years.

How did this happen? No one single cause was responsible but I would offer that at least two different things happened. In 1999 HUD decided that FNMA and FHLMC were not making enough mortgage to low and moderate income borrowers and insisted that FNMA & FHLMC ease credit requirements. That may have been a less than good idea.

There are numerous references on the WWW to this NYT article of Sept. 30, 1999.

Once FNMA & FHLMC got into subprime HUD was less than satisfied with the amounts of subprime that went through FNMA & FHLMC and may have compounded the mistake by letting FNMA & FHLMC buy subprime mortgages originated by others. This peaked in 2004 when FNMA & FHLMC purchase 49% of subprime originations. See this graphic from the Washington Post.

In October 2004 SEC in effect gave Goldman Sachs, Merrill Lynch, Lehman Brothers, Bear Stearns and Morgan Stanley the ability to self-destruct by greatly increasing their ability to leverage. Read this NYT article.

I am not by any means making the case that FNMA & FHLMC created the subprime mess but they were complicit. Wall Street deserves the majority of the blame for the manner in which it conjured investment grade securities from this crap. Government oversight of all of this was cast aside by Congress in 1999 when it encouraged FHLMC & FNMA to do subprime and then by SEC. Watching people in Congress castigate Wall Street is, to me, a bit comical. Wall Street could not had achieved this disaster without Congress demanding subprime from the GSEs and magnification by the SEC decision of 2004. We folks in the retail mortgage business gave this our full support. This was a true team effort.

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Dick Lepre
RPM - SF

Rate Watch #639 Why Treasury Has to Help Recapitalize the Banking System

October 10, 2008
by Dick Lepre
dicklepre@rpm-mortgage.com
www.loanmine.com

Banking Capital

Last week's newsletter made the point that in addition to the $700 billion liquidity bill banks needed capital and that capital might have to come from Treasury. Treasury Secretary Paulson announced Thursday that he intends to do just this.

The details as to whether this could or should be part of the $700 billion or need Congressional approval for another few hundred billion are not known at present and will not have to be addressed for at least a few months.

I want to explain why this is needed.

I am revisiting, to some extent, last week's topic: bank capital. Let me make it clear that I am making this seem a lot simpler than it is. There are really 2 tiers of capital and a rather complicated set of rules for calculating capital. A fuller understanding may be ascertained here.

The mortgage mess has created losses for banks. That created a liquidity problem because banks had assets (mortgage and pools of mortgages) which they could not sell. That is illiquidity - having assets but not cash. The much discussed $700 billion liquidity bill helps solve liquidity by having Treasury buy those illiquid assets but has done little so solve the base problem which is capital. The already taken losses and losses on any other sales made will cause the capital of banks to diminish and that needs to be replaced.

This is also where the seize up in credit market is rooted. This is not simply about concern about making loans than will not be repaid. It has to do with how banks treat capital and assets.

There are International rules for bank accounting called Basel I & Basel II created by the Bank for International Settlements. A complete explanation is likely beyond my ability so I will present a simple explanation as to how this works.

Total capital must be at least 8% of total risk-weighted assets.

So you are a bank which has taken losses and your capital and assets are depleted. Now you are in a bad spot because of that risk-weighted assets thing. Remember that is you are a bank loans are assets and deposits are liabilities. You may no longer be in compliance with the 8% rule. You have essentially two choices: 1) bring your assets and liabilities (deposits) down or 2) increase capital.

This is a typical chart of risk by loan type:

Government Bonds = zero risk

Mortgages = 50% risk

FHLMC/FNMA paper = 10% risk (was 20% last week)

Unsecured Consumer loans 100% risk

Unsecured loans to businesses 100% risk

Secured loans to businesses 50% risk.

I want to emphasize that these numbers are for example only.

In short, if you are running a bank and your capital/asset ratio is close to the edge you are ill-disposed to make loans to businesses because doing say may take you "over the edge" regarding capital/asset ratio. You either hold cash or you put it in Treasuries. The effect of this on GDP is very serious.

Having Treasury help recapitalize banks helps solve the problem. Treasury should play no active role in management. It will be an equity holder (or probably a holder of warrants which can be exchanged for equity). Treasury and all of its parts such as FDIC, OTS and OCC must continue to act as the regulator and pay no regard to the fact that it has some sort of "stake" in any entity.

If you have something to add to this discussion please post a comment on the blog.

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Dick Lepre
RPM - SF

Rate Watch #637 The $700 Billion Answer

Congress is being asked to provide $700 billion by allowing Treasury to sell debt and using the proceeds to purchase illiquid mortgage debt. This is similar to what the Federal Reserve does every day with two exceptions: 1) normally the Fed makes, in essence, short term loans to members to give them liquidity and reserves. The present situation is not a loan but an outright purchase of assets 2) the extraordinary events of the past few months have depleted the reserves which the Fed can use to perform market operations.

What I find most disconcerting about the present discussion is that this $700 billion is viewed as if it is gong to be spent and gone.

This $700 billion should in no way be looked upon as gone. Treasury should do this in a manner so that the net cost to the taxpayers is either zero or this is in fact profitable to Treasury. How?

We are addressing illiquid mortgage debt and illiquid residential mortgage debt can be viewed as falling into three categories: Jumbo A paper, Alt-A, and subprime.

Take a plan like this:

- use $300 billion to buy A paper jumbo MBS at a discount of 20%.

- use $200 billion to buy Alt-A debt at a discount of 35%.

- use $200 billion to buy subprime debt at a discount of 65%.

(I am in no way suggesting that these are the correct or best numbers. Regard this only as a framework. There are vital details about the pools of mortgages such as different discounts applying to different note rates for A-paper and rules about how many mortgage lates the Alt-A and subprime can have which must be worked out.)

Treasury would then have $1,253 billion worth of mortgages and be collecting the interest at the weighted average note rate and paying something like 2.5% (0.25% above the current 2 year Treasury) for this.

In short, Treasury should make the sellers take the losses. The losses should not be carried by the taxpayers.

As an extreme, let us assume that not a single dollar is paid on any of this $1,253 billion in mortgages and every one of them is foreclosed, held for a couple of years and sold. If the land were sold for 28% of the value of the mortgages the loss would be half of the $700 billion. An additional $62 billion would have been spent on interest.

A more realistic worst case might be something like this: assume that 60% of the $1,253 billion is foreclosed on and that those foreclosures produce sales worth 27% of the loan amount. Treasury still breaks even.

The salient facts are these: Treasury is purchasing illiquid assets at a low price. These assets are secured by real estate. This Treasury debt is unlike any other Treasury debt because it will purchase assets which produce a monthly cash flow profit.

There are some important accounting details which will impact the effect of these purchases on liquidity. The greatest effect is on paper which has already been written down on the books of the sellers.

If the weighted average note rate on the $1,253 billion portfolio is 6.5% Treasury would be receiving $81.1 billion a year in interest if the entire portfolio performed. It would be spending $21 billion on interest (3% of $700 billion). Clearly this is a money maker for Treasury. The positive carry on this is so large that Treasury can sell this debt back to the market at a time and in a manner to benefit both its own coffers and the economy.

The liquidity provided by this process will have a positive effect on real estate values further enhancing the value of these mortgages and further strengthening the baking system as well as the entire economy. The most likely outcome is that Treasury will sell all of these MBS back into the market at a profit in a period of between 2 and 5 years.

The debate is framed incorrectly. Treasury (the taxpayers) is going to make a handsome profit and the folks who hold this mortgage debt are going to take a loss. This is not to imply that this is disbeneficial to financial institutions. This will take off their books illiquid debt and allow them to regain the function which they have in our economy: making loans to drive the economy forward.

One more important point: this $700 billion in liquidity will not solve the problem by itself. It is necessary that other players in the secondary market start buying again. That is not going to happen any time soon if Congress fails to produce. It is the illiquidity of mortgage debt which is the root of the present credit crisis. To the extent that Congress mitigates the Treasury proposal by having other debt covered by this bill then it will be choosing to water down the solution and the probability of success and increase the risk to the taxpayers.

The flak about CEO salaries is something which I could not care less about. That does however bring up another issue which is for discussion at another time. Namely, business has chosen short sighted methods of compensating executives for producing seeming profits in a given year despite the fact that those executives did not have the long-term viability of their corporation as a priority.

In summary: done correctly Treasury will net a profit and the benefit to the banking system and the economy in general will be massive.

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Dick Lepre
RPM - SF

Rate Watch #632 Treasury Should Take Over FHLMC & FNMA

August 22, 2008
by Dick Lepre
dicklepre@rpm-mortgage.com
www.loanmine.com

What to Do with FHLMC & FNMA

It has become a bit silly to forecast mortgage rates when 1) Jumbo securitization became impossible a year ago 2) Congress increased FHLMC & FNMA loan limits to help the housing market and 3) the only people other than FHA who buy mortgages are those two agencies and their equity value has declined to something approaching zero. It is not time to bail these entities out. It is time to wipe them out.

These two agencies have $5.2 trillion in outstanding bonds that they have guaranteed and they are, in reality, broke. This is a problem because there is no way that the U.S. Government can allow that debt to default. This is not debt which the Treasury department has guaranteed but it has no choice. Not stepping up and taking over these agencies and the guarantee of that debt would devastate the economy, retirement funds, the banking system, the housing market and... did I leave anything out?

Congress recently enacted legislation allowing the Treasury Department to take over the GSEs. Barrons had a recent article which suggested that the end is near for the GSEs and that article has help smash their equity values. In addition it has gotten increasingly expensive for the GSEs to borrow money. This past Tuesday FHLMC paid the highest in its history spread over Treasury debt. On top of that they are no longer properly hedging their rate risk. This head in the sand, hoping things will get better approach is doomed to fail. The GSEs have $223 billion in debt to refinance this quarter. Good luck, guys.

I believe that it is time to get this over with and suggest here a course of action. The plan below should be executed as soon as possible. Preferably within the next couple of weeks.

Let's step back and look at some numbers. If one looked at the balance sheets of these entities and marked the assets at present market value FHLMC would have a net worth of negative $5.6 billion and FNMA would have a positive worth of $12 billion representing a 2/3'rds loss from the start of the calendar year. But that accounting is largely a joke. Each of these entities has a large asset which is solely tax credit. This is not real money but only an imaginary item to offset potential future taxes from profits. Those assets (tax credits) cannot be sold. They are, at present, illusory. Eliminating those assets would chip $36 billion from FNMA's net worth and $29 billion from FHLMC's worth.

In other words: what are we waiting for?

The Plan

The Treasury Department should walk into these GSEs some weekend real soon and literally take them over in the manner in which the FDIC seizes a bank.

This should be accompanied by a press conference at which the President, The Secretary of the Treasury, the Chairman of the Federal Reserve and whoever will head the new entity appear and give public reassurance and answer stupid questions from clueless reporters.

Treasury must set up a receiver for the assets of the 2 GSEs and seize the GSEs and turn over the assets to the new entity. Treasury can capitalize this receiver under the just passed legislation. This entity should merge the 2 GSEs into one new entity preserving the IT systems and the relationships that the GSEs have with the folks who sell them mortgages. A massive management rework must be done. The equity holders of the present GSEs will be wiped out. If Treasury wants to placate FNMA by paying its stockholders some chump change amount like $10 billion to shut them up and make this transition less objectionable let them do so. FHLMC shareholders have no case because they are indisputably broke.

These two agencies would cease to exist. Most of their employees would work for the new entity created as the receiver.

Treasury would now be explicitly responsible for all FHLMC/FNMA debt and Congress must authorize Treasury to issue debt to cover real losses on the old paper. Treasury debt would replace the GSE losses but not actual GSE debt.

The new entity should have a new class of Treasury backed mortgage debt that can be monetized in the same manner in which the Fed deals with existing Treasury debt. Congress should also create explicit authorization of new Treasury debt to guarantee any shortfalls that come to pass from this new class of debt. The new mortgage debt is "off sheet". This does not increase the size of the National Debt because, unlike other Treasury debt, this has assets which offset it. Treasury debt issued to cover shortfall is "on sheet". Treasury could also do what HUD does for FHA loans and collect a fee on each loan up front which becomes part of a reserve for future losses.

Treasury could simply hold the securities and make money on the interest rate differential or it could sell them in the same manner as the GSEs presently do or it could do a combination of the two. The advantage of selling them would be that this debt was always priced to the market rather than subject to political pressures or the effects of inattention. Perhaps there would be times when it was best for this entity to not price to the market but to deliberately price counter to the market in order provide, for example, stability to housing prices as a more general support to the entire U.S. economy.

Also, this entity could forego the expense of interest rate hedging because it can self-insure the rate risk. I am not necessarily saying that self-insurance is best I am only saying that it is viable.

Let me be clear. This is a radical plan. It is the nationalization of GSE debt. The plan I suggest is radical but incredibly simple and straightforward. Mortgage securitization of existing pipelines of FHLMC and FNMA commitments would remain in place and the new entity would have to begin taking commitments for new mortgage debt immediately or with a delay of no more than a couple of days. The existing software support on the front-end that enables folks like me to insure that I can get you a FNMA loan must remain operational and the back-end software which distributes the proceeds to the investors must remain in place.

There is a less aggressive alternative which is to keep the 2 GSEs intact (more or less) and have Treasury issue preferred sock (or some such thing) and have Treasury own the 2 GSEs. The effect would be much the same as what I presented above but I like the utter clarity of my suggestions.

Let's look at some of the nuances here. These agencies have a lot of political clout. They are not likely to go quietly. That will create reticence to execute this plan and post facto grousing. So what?

The notion that I am sitting here typing a suggested plan for the nationalization (see, I did not say "socialization") of what are today 2 corporations is something which I find disturbing. It grates my capitalistic predisposition. But the fact is that there is no alternative. It is necessary for the good of all citizens that the federal government step up and assume this liability. In short, it is in our collective best interests to assume into our national debt when it is all over several hundred billion dollars of loss associated with the obligations of FHLMC & FNMA.

An interesting notion is this: what will happen after this is done? Let's assume that uncertainty about housing values and the real value of this debt will last for at very most two years. At that point the government will likely be pressured to turn this back into a private entity. My own initial look was that this would function best as one single entity. I had a conversation yesterday with Rob Hirt, the owner of RPM, who said that his conversations with folks in the industry saw this as something that would split into as many as 10 different entities. Whatever may be the case, it is certainly not my belief that this is best left in the hands of the government on a permanent basis. That statement is based on the belief that capitalism furnishes a better model for business activity. Its recent performance in everything related to mortgages has displayed a shining example of capitalism at its worse and it is necessary that we legislate and regulate the misdeeds out of any such future activity. We should learn from out mistakes and protect ourselves from making those mistakes again.

If you have something to add to this discussion please post a comment on the blog.

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Dick Lepre
RPM - SF

Rate Watch #626 This Guy Thinks We Need a Dose of Inflation

July 11, 2008
by Dick Lepre

It was not fundamentals but words about FHLMC & FNMA this week which should be of concern to those of us who are interested in the mortgage market. This started when a Lehman analyst said that FHLMC & FNMA had to take significant write downs consequent to new accounting rules. The guy who runs OFHEO said, in effect, "Not so fast! We regulate FHLMC and FNMA and they do not have to follow those rules".

Then William Poole who used to be President of the St. Louis Fed continued the theme suggesting that FHLMC had negative net worth if the portfolio was marked to market. The Secretary of the Treasury chimed in backing OFHEO and FHLMC and FNMA.

In has always been the case that investors regard FNMA & FHLMC debt as if it is backed by the U.S. government even though it is not explicitly the case. If this gets worse the Fed will have to bail out the GSEs. The concerns are threefold: 1) the equity value of the two companies 2) the increased borrowing costs suffered by the GSEs will increase mortgage rates 3) the Fed's ability to help FHLMC and FNMA out is compromised because it has committed so much of its own portfolio of Treasuries to help banks and Wall Street firms.

It may well be the case that there are only two solutions to this:

1) the Fed can increase money supply (sounds better than "print money") and use that to help FHLMC & FNMA or

2) Congress can act immediately to create a new class of debt which is Treasury guarantee of GSE paper. Assuming that Congress could do this the problems are that this must be immediate as in this weekend and also that the Federal Reserve has to deal with, in effect, monetizing this once it exists.

The fact that the solution to this problem is beyond the ability of the Fed to help is disquieting. For me to suggest that Congress must act and must act now makes me uncomfortable.

This issue is important and has unfolded too rapidly for me to treat it more extensively.

One Guy's View on Inflation

A few weeks ago a ran across this article by Paul McCulley of PIMCO. I found it an interesting point of view even though I saw some incompleteness in it. If you are interested read his piece.

The Classic Comics version is as follows:

Soaring commodity prices (and let's be clear: commodity prices have not simply been rising the have been soaring) lead to a negative real terms of trade shock. In plain English the average guy has to work more hours to fill up his tank and stomach. In any sense this makes up less rich or more poor or just plain worse off.

The question is "what should the Fed do about this?" McCulley quotes Fed Vice Chairman Don Kohn:

“… an appropriate monetary policy following a jump in the price of oil will allow, on a temporary basis, both some increase in unemployment and some increase in price inflation. By pursuing actions that balance the deleterious effects of oil prices on both employment and inflation over the near term, policymakers are, in essence, attempting to find their preferred point on the activity/inflation variance-tradeoff curve introduced by John Taylor 30 years ago. Such policy actions promote the efficient adjustment of relative prices: Since real wages need to fall and both prices and wages adjust slowly, the efficient adjustment of relative prices will tend to include a bit of additional price inflation and a bit of additional unemployment for a time, leading to increases in real wages that are temporarily below the trend established by productivity gains."

(The text of Kohn's complete speech is here.)

I think that what these folks are really talking about is this: there are times when the "best" thing for the economy is not the best thing for politicians. Politicians goals are short-term. Economists are (at least trying to) think long-term. Even though it might seem that the goals of the Fed should be to lower unemployment and lower inflation that is not the best policy. The best policy is to allow unemployment to rise a bit. That will translate into lower real wages and profits.

Implicitly the Fed needs to allow negative real interest rates (Fed funds less than inflation) and it is here that McCulley addresses the concern that this would set off a wage-price spiral akin to that started in the 1970's which was also induced by an oil price shock. Will negative real rates set off an inflationary spiral? McCulley believes not but I am a bit skeptical. He points out that the global, less unionized labor force reduces the correlation between prices and wages. The percentage of the U.S. labor force which is unionized is about half what it was when the wage-price spiral started in the 1970's.

So what McCulley is saying is that labor has so little clout that price inflation will not trigger wage inflation as it did in the 1970's.

In this scenario everyone bears the pain. Workers get lower real wages. Companies make smaller profits and the wealthy suffer the deflation of their wealth as interest rates remain less than inflation.

McCulley thus believes that the best interests of the economy are serves by keeping interest rates low and accepting somewhat more inflation than has been regarded as acceptable in the past.

I want to emphasize that I am neither agreeing or disagreeing with him. His notions are somewhat counterintuitive to me but I think this is at least worth thinking about.

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Dick Lepre

Mortgage Fraud

This week I received a memo (see this) from an attorney who works for the Federal Public Defenders Office he in San Francisco. It appears to be a "heads up" that the U.S. Attorneys office for Northern California may be starting an initiative to prosecute more mortgage fraud cases. These have been vigorously prosecuted in some other districts: Charlotte, Dallas, Sacramento and Anchorage.

There was a recent (May 13, 2008) 9th Circuit Court of Appeals decision which sets the tone for these cases. That decisions had two aspects. In the "bad news" for the defendants department this case (US v. Crandall) regards what is a common defense in such cases and is called the Mens rea defense. Mens rea addresses not the facts of a case but the defendants state of mind. Generally the defense is that the individual did not intend to commit a crime but was actually pursuing some other purpose. This is the classic defense in tax protest cases when the individuals swear that they are pursuing some agenda aimed at a high minded purpose of setting straight the IRS which - in their view - is an unconstitutional construct. These folks will insist that they are not really cheating the IRS but upholding the real law. They are almost always found guilty.

In this particular case the defense wanted a mens rea jury instruction that required "knowing and conscious" engagement in "criminal wrongdoing" for a prosecution. The judge said "no" are required an "intent to defraud."

I will not even attempt to explain the rational behind mens rea and mortgage fraud but invite lawyers who read this to e-mail me with their explanations for follow up.

There are two good sources for what is happening in the world of mortgage fraud. This is a mortgage fraud blog. (http://www.mortgagefraud.org/journal/) and this is our friends at the FBI

There is a variety of types of mortgage fraud and the blog at http://www.mortgagefraud.org/journal/ covers them all but they fall into at least four different classes:

1) mortgage companies repeatedly funding loans with bogus income and assets documents. Sometimes this is a systematic corporate thing and sometimes just one of a small set of individuals in a company.

2) identity fraud and property theft cases where folks either misrepresent their ownership interest in the property or actually fraudulently gain title to property with bogus grant deeds.

3) foreclosure prevention scams. These are generated by public noticed of intent to foreclose and the typical scenario is one where someone who is slick on the phone calls the property owners and scams them out of $2,500 with a guarantee that they can prevent the foreclosure.

4) fake buyer transactions where the transaction looks like a sale but is really an attempt by the owner to suck all of the equity out of a property by "selling" it to cohorts at an inflated price and having said cohorts never intending to make a mortgage payment.

I do not see it as likely that individuals who overstated their income on "stated income" loans will get in trouble. There are "bigger fish to fry."

The good news for defendants in the 9th Circuit decision was that sentencing should be base on the net economic loss not the total amounts of the loans. The size of the loss can affect the sentence and persecutors were seeking sentences based on total loan amounts. The Court said "no way." The loss is the loan amount less what is recovered in a foreclosure sale - the real economic loss.

Rate Watch #610 I'll See you $30 Billion and Raise You $200 Billion

March 21, 2008
by Dick Lepre
dicklepre@rpm-mortgage.com
www.loanmine.com

IV) Analysis

The Treasury market is volatile which 1) makes forecasting difficult and 2) creates opportunities. I do believe that this is not going to be a case of constantly declining rates but one of a relatively brief window of opportunity. I say this because we are coming to the end of the secular bull market (long-term trend to lower yields) but the facts are that this is an extremely confusing time and there is a disconnect between Treasuries and mortgage rates. Mortgage rates could start getting lower even if Treasury yields rise.

There is still lack of clarity about the pricing and terms of the new jumbo-conforming loans. The biggest news this week was that FHLMC will do cash-out on these (whereas FNMA will not). Preliminary indication from FHLMC is that the requirement on cash-out jumbo-conforming are: LTV <= 75% and middle credit score >= 720. This is available for primary residence SFR & condo. No multifamily.

You can find the new conforming limit for your county here. That page says "FHA" but those amounts also pertain to FNMA & FHLMC.

If you have a loan which is now conforming as long as it is not a cash out or as long as it meets the FHLMC standards above and are interested please e-mail me or fill out a refi form on my web site. Once I get that I will contact you, discuss what you need and in less than 10 minutes I can take your loan application over the phone. What do I need? The most common things which people do not have at hand is their spouse's social security number and their gross monthly income,

The complete application is accessed from the top right nav bar at www.loanmine.com.

V) Things Are Happening

A lot has happened in the past few weeks regarding which I would like to comment.

1) The Bear Stearns thing. This is most interesting. It represents a daring move by the Fed to accomplish its main purpose which is economic stabilization. Bear was deeply into subprime and clearly had assets which were worth a lot less than folks though. The Fed brought in potential buyers and faced with the necessity of opening its books up it is clear that Bear was exposed a lot more than it had implied. One can figure this out from the fact that JP Morgan's offer was 7% of what the Bear stock closed at on Friday March 14.

In a bigger sense what this is about is the fact that Wall Street firms (primary dealers) act like banks in the sense that folks keep a lot of their liquid assets (which used to be in banks and S&Ls) in accounts with security firms. The Fed's guaranteeing the debt of a non-bank entity really recognizes that for decades it has been the case that the concept of banking was no longer the same. The collapse of one of these firms or even the suggested collapse and the run on its assets was not different in kind and in effect from a bank run.

The important point is that while I often talk about the goals of the Fed (low interest rates, increasing GDP, strong dollar etc.) those goals are less important that the Fed's main task which is stability of the banking system. It is only at time such as the present that this is a goal not to be taken for granted.

Comments that the Fed was somehow "bailing out the rich" while not paying attention to the little guy are inane. The stockholders of Bear were screwed. The people who were bailed out were 1) anyone with a Bear Sterns account and 2) anyone with deposits in any similar Wall Street firm and, to some extent, anyone with deposits in any bank. It is conceivable albeit unlikely that a run on Wall Street firms could set off runs on counterparty banks and then set off runs on those banks.

The point is that if folks decide on a massive scale to take their money out of wherever it is - be in a Wall Street firm, a commercial bank or an S&L the economy will grind to a halt.

The perceived safety of having ones assets in one of these place is the primordial purpose of the Fed.

It has also been suggested that actions such as this or the LTCM bailout in 1998 encourage dangerous practices. Maybe they do but similar logic would indicate that fire departments and insurance companies serve to encourage people to be less careful that their houses do not catch fire. The Fed is like the fire department. They show up in a big way when things go wrong but acting to abate disaster does not per se encourage dangerous practices. The stockholders, employees and executives of Bear Stearns took a beating and the Fed's actions will in no way encourage similar behavior in the future.

It is my belief that once "the dust settles" folks will recognize that having an independent Federal Reserve to adeptly handle the monetary part of federal policy works quite well. Political processes (the fiscal side) take too long to deal with fires. The Federal Reserve is not merely about one guy or even the Governors it is a large collection of economists with a great deal of experience and no political agenda.

As for Bear Sterns the story is truly amazing. Here was one of the firms as the center of the subprime mess and they clearly massively underestimated the risks of the subprime loans they were pushing. There is indeed a sense of justice operating here.

2) the liquidity thing. The Fed offered to provide $200 billion in liquidity by exchanging its Treasuries for MBS of primary dealers. This creates liquidity because those MBS are, at present, illiquid and the Treasuries are liquid. The Fed is to some extent sticking its neck out here by tying up a larger percentage of the Treasuries which it owns but it is doing this for a good reason. This is not mere talk. On Wednesday alone the Fed provided $28.8 billion in lending to primary dealers through this channel.

3) the bigger picture. I suppose that the big picture is reestablishing belief in mortgage backed securities. To some extent the fact that FHLMC & FNMA doing jumbo-conforming this is obviated but banks will eventual want to get back into the mortgage business.

Getting refinancing in place to lower the payments of folks who have ARMs will help to stimulate the economy and getting mortgage rates lower will help to stabilize home values. I still believe that home values will trend downwards for at least another year but the mechanisms for stabilizing the entities that will make those loans have been recast. Housing prices ran up because of unhealthy speculation combined with idiotic lending. The idiotic lending has stopped but it will take time for the demand to catch up with the supply. No act of Congress or Fed intervention will change that.

If you are interested please e-mail me or fill out a loan application or refi form on my web site. The complete application is accessed from the top right nav bar at www.loanmine.com.

If you have something to add to this discussion please post a comment on the blog.

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Dick Lepre
RPM - SF

Presidents and the Economy

I need a break from writing about the mortgage mess so...

With this being an election year I have tried to not discuss politics at all but I would like to discuss the economy and suggest that political rhetoric serves little purpose regarding the economy.

Politicians find out what concerns folks and then suggest that they have solutions regarding those concerns. One thing folks are concerned about is the economy so it is natural that Presidential candidates address that issue.

The problem is that the President of the United States has virtually no significant effect on the economy. The only person who is part of the Federal apparatus who can significantly affect the economy is the Chairman of the Federal Reserve. The fact is that the President is affected by the economy to a vastly greater extent that the economy is affected by him.

Presidents do not create significant numbers of jobs. Jobs are created by a coming together of businesses, labor and capital. We have a gigantic system in place which does this. Folks see opportunities for profit and create and expand businesses and create jobs in the process. This also has the annoying effect of creating business cycles which go with those opportunities. It works like this: opportunity knocks, people see a situation where a product or service can be provided at a profit, business expands, jobs are created, at some point supply exceeds demand and a downturn occurs. This is what happened in the dot-com thing and this is what is happening in the present housing cycle.

To be fair there are marginal cases when political intervention does effect the economy. Tax cuts spur short-term economic growth. The recent stimulus package will provide some economic growth. But these are aberrations not the normative methods for job creation.

In short, when any of the Presidential candidates describe how they will create jobs pay no attention to them. They cannot create jobs and their ability to help business and workers create jobs is rather limited.

All that said, this has to be one of the strangest Presidential elections I have witnessed. There are three people still contending and they are all fairly liberal so the conservative agenda is not exactly having a good year. At present this is all about Obama. It is amazing that someone with so little political experience can be doing so well. It is not merely about Obama-mania or his being a sort of cult hero. The stark political fact is that he has made all the right moves while the experienced Clinton machine has made all the wrong moves.

He certainly has engaged the youth of American and that is a good thing. Getting young people involved in politics and interested in finding out what the government does is good. It is too easy to dismiss young folks saying that they are so inexperienced that it is easy for them to be swayed by someone such as Obama merely because of his speaking ability and his appeal to the liberal notions common to youth. There is more here than that. This guy really has engaged people. Folks feel a lot closer to him than they do the other candidates and certainly closer than they do to anyone who has been President in a long time. That by no means certifies that he will be nominated or elected but this is one darn interesting election.

In my view one effect of the potential nomination or election of Obama would be the perception that foreigners would have of what the U.S. is and what opportunities exist here. This is a guy with one black parent, one white parent and a Muslim name. Foreigners will conclude 1) that this is really a land of opportunity where a guy with mixed race and a Muslim name can get elected 2) we are totally insane and this is just a sort of extension of American Idol or 3) both 1) and 2) are true.

In no way do I suggest that we tailor our vote to what pleases foreigners. That makes little sense.

No matter what - whoever is elected will have little effect on the economy.

About Those Mortgage Losses

The announcement of sizable write-offs in the value of mortgage portfolios by large players: Citigroup and Merrill for starters is a very significant and positive step in getting the mortgage machine functioning again. While the losses are not good they did occur and what is necessary is that participants in the markets feel that they have an accurate assessment of the size of the losses and assurance that the parties that took these losses are adequately capitalized.

While the capital to take the losses has been there for the big players the problem with being a financial institution is that one's asset base is capped by one's net worth. Consequently taking an $18 billion loss means that if you want to maintain the same asset base you need to infuse capital. This has been done by going to large players in the middle East and getting capital infusions.

I think that by mid-February there will be a consensus among market participant that while all mortgage related losses have not been taken most will have been and at least the size of the problem will be known with, say, 90% certainty.

Two things will have to then happen: 1) lending standards need to be made sane (I have written about this many times). In general that means full doc for B-paper and Alt-A and higher adds for stated A-paper. It also means stricter LTV guidelines because values are shrinking 2) the existing participants in the business of providing credit default insurance for pools of Jumbo mortgage need to be recapitalized or replaced.

What must be done is this: liquidity must return to the Jumbo A-paper market. At present it is lack of availability of credit default insurance for Mortgage Backed Securities which is preventing this.

Politics & the Economy

Anyone who has been reading these newsletters for any length of time knows that I am not a big fan of politicians. With this being a Presidential election year we will be subjected to an enormous number of inane statement and suggestions from politicians.

The most important single point I have to make is that politicians have little effect on the economy. Politicians do not create jobs. Jobs are created by a coming together of capital and labor.

I believe that is was important than Bernanke addressed the economy this week with fiscal suggestions. In essence he took the initiative telling politicians what he thought needed to be done to prevent recession.

Bush pitched an economic stimulus package today. My notion on these stimulus packages is that they are always far short of ideal but almost always better than nothing.

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Dick Lepre
RPM - SF