The Magic of the F.H.A.

Thanks to Calculated Risk for pointing out this remarkable NYT story about FHA insured loans in California.   Now, obviously, we have to be careful drawing conclusions and condemning a program based on one example - but this is not a one of a kind story.    Let me summarize my view up front, in the paraphrased words of Mike Shedlock: "You cannot keep home prices from falling by selling homes to people who cannot afford them."  Some excerpts from the NYT article:

"In January, Mike Rowland was so broke that he had to raid his retirement savings to move here from Boston.  A week ago, he and a couple of buddies bought a two-unit apartment building for nearly a million dollars. They had only a little cash to bring to the table but, with the federal government insuring the transaction, a large down payment was not necessary.

“It was kind of crazy we could get this big a loan,” said Mr. Rowland, 27. “If a government official came out here, I would slap him a high-five.”

In its efforts to prop up a shattered housing market, the government is greatly extending its traditional support of real estate, including guaranteeing the mortgages of middle-class and even upper-class buyers against default."

High five!  Sold to you SUCKA!

"Some F.H.A. borrowers here say they have the cash for a full down payment but would rather invest it in the stock market or use it for remodeling. Others, like Mr. Rowland and his friends, simply do not have the money required by private lenders — which would have been nearly $200,000, in their case.

“We were resigned to waiting another year,” said a second partner, Michael Bedar, 31. “Then we read about the F.H.A. I had never heard of it before, and couldn’t quite believe it. But it was the answer to our problems.” They put down about $33,000, split among the three of them."

Lever it up, bayyyy-beee!  Of course, with a 3.5% down payment, they could be underwater in no time, and then disincented from actually having to pay back their mortgage.    Wait a second - isn't this what caused the housing crisis in the first place?  Banks making reckless, highly levered loans to individuals who couldn't afford the homes?   Now, it's possible that these three gentlemen each make hundreds of thousands of dollars a year, but the article makes it sound unlikely, explaining "Mr. Kurland and Mr. Bedar, who are employed full time, are the buyers of record. Mr. Rowland, a freelancer, will have his interests protected by a legal agreement."   Note - I clearly cannot judge the ability of these three 3 guys to cover the mortgage - but my point is that it's irrelevant  - 3.5% down mortgages are like playing with nitroglycerin.  If borrowers can afford a real downpayment, they shouldn't be given government sponsored leverage, and if they can't afford the downpayment, they shouldn't be given government sponsored leverage!  

 

"“Is this going to be the next wave of the housing downturn?” asked Eileen Bermingham, an agent with Pacific Union. “With such a minimal down payment, how do we make sure people don’t get in over their heads?”"

Good question, Eileen - almost by definition, anyone who can only put down 3.5% is already in over their heads.

"The F.H.A. commissioner, David H. Stevens, said recently that its loans were relatively safe because the buyer was required to live in the property. They “are for shelter. They aren’t speculative-type investments,” Mr. Stevens said.

But the idea of a house as an investment dies hard. Mr. Bedar, Mr. Rowland and the third partner in their property, Jordan Kurland, are all in the technology field, but their dreams of wealth do not feature stock options.

“We’re banking on real estate,” said Mr. Kurland, 24. “Everyone expects prices to keep going up.”

Aiyahhhhhhhhhh!!!! The bubble is still alive!

"A few weeks ago, Congress extended the higher lending limits for another year. Representative Barney Frank, the Massachusetts Democrat who is chairman of the House Financial Services Committee, said in an interview that he planned to introduce legislation next year raising the maximum F.H.A. loan by $100,000, to $839,750."

Oy vey.  And when the real estate market crashes again as a result of this attempted double down strategy (MARTINGALE!), Barney Frank will say that he was against giving these loans, and blame the Bush Administration.   I mean - really - why do we need to have the F.H.A insure $800,000 mortgages?!?!?  Isn't the point of the F.H.A to help poor buyers who can't afford a down payment - maybe we should have them buy MORE AFFORDABLE homes!  As the article notes: "F.H.A. insurance was created for minority and low-income families who could not come up with the traditional down payment of 20 percent required by private lenders. Buyers receive loans from government-approved lenders and are required to document their income and assets."     The F.H.A. limits should be LOWERED, not RAISED!

MISH also touched on the subject last week, exposing the lunacy in Frank's thinking:

First, MISH quoted a Richmond newspaper article:

"Exactly who made Bernadine Shimon think that she could buy a new house shortly after declaring bankruptcy and losing another home to foreclosure? The American taxpayer, that’s who.

Without a Federal Housing Administration willing to guarantee a $125,000-plus mortgage, this Denver-area schoolteacher’s recurring “dream of homeownership” could not come to pass. Shimon’s down payment was a tiny 3.5 percent.

This single mother is so strapped that she had to cash in her retirement savings to come up with the 3.5 percent. Her case was cited in a New York Times article about, not surprisingly, the sad shape the FHA finds itself in."

"With nearly a quarter of FHA loans insured in the last two years now in trouble, you’d think that the agency would show more discretion in deciding which homebuyers to help. And you’d think that Democrats running the House Financial Services Committee would be more upset over the way the FHA still hands out taxpayer guarantees.

But committee Chairman Barney Frank of Massachusetts insists that these mortgages are needed to “keep prices from falling too fast.”

Then he explained the absurdity:

"Home prices are falling precisely because houses people bought homes they could not afford.

Note however, the thought process of Barney Frank: We have to keep selling houses to people who cannot afford them in order to keep home prices from falling.

That mentality all but assures a bailout of the FHA is coming"

This is proof to me that we have not seen the bottom in housing.

-KD

full disclosure - I just bought a house - which is FURTHER evidence (based on my contrary indicator nature) that we have not seen the bottom in housing

Return Free Risk - A Merger Arb Anecdote

Most people are familiar with the concept of risk free return.  Today I want to tell my personal anecdote about return free risk and how I should have seen the liquidity bubble forming back in 2006.  Don't be alarmed by the mention of arbitrage spreads, cost of capital, and short rebates - the concepts are simple.

When I was on the buy side of the business - working for an internal hedge fund at a major sell side firm - we ran a large merger arbitrage portfolio. Merger arb is simple in theory:  when a cash acquisition is announced (ie, ORCL buys JAVA for $9.50 per share), you buy the shares in the target company if the risk vs reward payout being priced by the market is favorable (in your opinion).  If and when the deal closes, you make the spread between where you bought the stock and the acquisition price.  If the acquisition is an offer for shares in the acquiring company instead of cash (ABC is buying XYZ, and giving XYZ shareholders 2 shares of ABC stock for every share of XYZ that they own), you buy shares of the target (XYZ)  and short 2 shares of the acquirer (ABC) for each XYZ share that you've bought.  If and when the deal closes, your long XYZ will be converted into an ABC position that will cover your short hedge, and you'll have captured the spread, and be left with no stock positions.

Now, there are other costs and considerations as well - dividends you will pay (on short positions) and receive (on long positions), and more importantly, the cost of carry.  The cost of carry is the opportunity cost on your money - the risk free rate that you could otherwise be earning, or your "cost" of borrowing money.  At my "fund,"  we had access to a large amount of capital courtesy of the bank's balance sheet.   The catch was, each dollar we used we paid for.  In other words, I could buy $100MM in stock, and they'd charge me for that money - say, 5% annualized.

Thus, when calculating the return on merger arb deals, I had to back out the cost of capital.  For cash deals, this meant basically subtracting 5% from the annualized return that the market was pricing in.  For stock deals, it's a little more complicated, but don't fret, it's not rocket science:  when you short stock, you usually earn a "rebate" on your short position.  This is a fancy way of saying that the proceeds from the short sale earn interest for you - although not quite as much interest as you have to pay on your long position.  Thus, in calculating my cost of carry I need to add the cost of buying the long position, and deduct the rebate that I earn on my short position.   In stock for stock deals where the company I'm shorting (the acquirer) is an easy to short, top rebate level stock, the impact on the cost of carry will be small - since the rebate on the short stock will be very close to the cost of funds for the long stock.

Anyway, fast forward to "ideas dinners" where a bunch of merger arb hedge funds get together and talk about their best ideas in the field.  We'd have 20 supposedly smart guys from different firms sitting around a table, and talking about arb spreads.  "the ABC-XYZ spread is 5% - it's a layup,"  one guy would say, and I'd raise my eyebrow.

"It's not 5%, it's 0%.  You have to adjust for the cost of your funds,"  I'd say.

"We don't pay for funds," he'd respond, as others in the room nodded.  See, most hedge funds just have a pool of client money that they're investing - they don't have to pay to borrow it from their firm.

Now my other eyebrow would go up, and I'd say "Are you guys serious?  Even if you don't actually get charged for the funds, you still need to deduct the risk free rate from your return profile."   I mean - this is finance 101.

Amazingly, most of these traditional hedge fund traders didn't look at it this way - they way they looked at it was that they had $100MM to invest, so if a deal returned 5%, they were making 5%.  Never mind the fact that US Treasuries returned 5% also - they were earning their 5% of RETURN FREE RISK.  ZERO excess return (above the risk free rate) with risk included!  Where do I sign up!  Of course, it's not entiely return free, as there were a number of merger deals in 2005 and 2006 that saw bumps or increases in the bid price to a higher price.

Shockingly,  in stock for stock deals, these same guys would add back in the rebate they earned on their short position to make their "return" look even higher - STILL without accounting for the cost of capital on the long side!   In a room full of twenty people, there were maybe 2 others in the same boat I was who approached me after the events to explain that they understood my point. 

I'd return from the events and explain to my boss that the Street was batshit crazy, and that they were absolutely mispricing the risk in these deals.  Every time a broker called us and said "Check out XYZ-ABC - it's 5% annualized,"  my boss would just mutter "don't educate them,"  and we'd say "thank you," and hang up the phone.  Obviously, you know how this story ends:  the merger arb world blew up in 2007, and guys who were recklessly putting on every spread at rates which didn't compensate them for the risk they were taking on got wiped out.

How does this relate to today?  If you read Bill Gross's monthly piece today, he talks about the Fed's efforts to reflate the market by keeping rates so low that investors are almost FORCED to plow their funds into riskier asset classes to avoid earning a near 0% return on their money - which is what the risk free rate is now paying.

"The Fed is trying to reflate the U.S. economy. The process of reflation involves lowering short-term rates to such a painful level that investors are forced or enticed to term out their short-term cash into higher-risk bonds or stocks. Once your cash has recapitalized and revitalized corporate America and homeowners, well, then the Fed will start to be concerned about inflation – not until."

If you're wondering why the stock market (not to mention the government bond market, oil market, gold market,  corporate bond market, junk bond market) seems to be rising without logic, it's because of all this liquidity that is MANDATING the devouring of risk assets.  In my opinion, this can only end one way... badly.

-KD

Misusing Statistics - Distorting Tax Statistics

Look, I'm a fiscal conservative.  I hate the idea of solving all of our problems by taxing the rich.  I admit that I would normally spout a statistic like I quoted yesterday such as "the top 3.5% of earners pay over 60% of the tax dollars," to illustrate the iniquities in the tax code.    Unfortunately, there's a big problem with that stat  - it's a red herring designed to misdirect the reader, and I'm shocked that every time it's mentioned people don't shoot it down.  I am ashamed to admit that, despite my math background and statistical prowess, it wasn't until AsphaltJesus's comment yeterday on my post that I realized how inane/insane that stat is.

The point is that we need to know what percentage of the income the top 3.5% of earners earns!  If they earn 60% of the income, and pay 60% of the taxes, well then, that seems pretty darn fair.  According to TaxFoundation.org,  the top 5% of earners earn roughly 37% of the income and pay roughly 60% of the taxes.   So, phrasing it as "the top 5% of earners pay 60% of the taxes," while comparing apples to oranges, sounds a lot more "unfair" to the wealthy than "the group that earns 37% of the income pays roughly 60% of the taxes."

Yeah, of course the rich still pay a higher relative share of the tax pool, but it's not quite as absurd as misleading or irrelevant statistics can make it seem.

-KD

Quality Readings Link Dump

I was honored to be included in the Reformed Broker's Periodic Table of Finance Bloggers under the category of "rogues gallery." 

Paul Kedrosky's chart of the price of gold, in gold, is good for a laugh.

Howard Lindzon'z New New NASDAQ is worth a read.

Peter Boockvar on how the Fed has done in its goal to maintain the purchasing power of the dollar (hint:  not very well!)

MISH on the jobs outlook - even with assumptions about job creation, we're going to have very high unemployment for a very long time.

Calculated Risk:  record mortgage delinquency

Barry Ritholtz with a graphic from Mint.com:  Who Pays Taxes in the USA?  (the top 3.5% of earners pay over 60% of the tax dollars)

-KD

Nothing to See Here - Everything is Fine.

I really thought/hoped that this report was lifted from The Onion:

"During the best of the times, Miguel Salcedo’s son, an illegal immigrant in San Diego, would be sending home hundreds of dollars a month to support his struggling family in Mexico. But at times like these, with the American economy out of whack and his son out of work, Mr. Salcedo finds himself doing what he never imagined he would have to do: wiring pesos north."

I mean - come on - things are so bad in the US that Mexican families are wiring money TO their relatives in the US?  That has to be a joke - I've been reading the financial press every day and I've been told that the recession is over and that everything is fine. 

Then, this:

"In other cases, the migrants are returning home, as the many passengers who hop off the bus that runs regularly from northern California to a gas station in Miahuatlán make clear. “There’s nothing up there,” said a young man with an overflowing suitcase who returned one recent night."

Come on - are you kidding me?  Sadly - no - that's the truth of the economic situation in our country.  The ponzi scheme of confidence doesn't solve our problems - telling people that things are better does not make things better.  

"There's nothing up there."   That should be the headline in the mainstream media - not "recession over" or "jobless claims data improves."

Things are so bad here that 1) Mexican workers who came to the US to earn money to send home to their families in Mexico are now having to receive money from their families instead, and 2) Mexican migrant workers are going back to Mexico. 

I mean - what more do I need to say?

-KD

F U NYT - DYKWTFIA?

The NY Times writes an article about bloggers going to the Treasury without nary a mention of Kid Dynamite's throrough, detailed recaps?  WTF?  DYKWTFIA?  

-KD

ps - Mrs. Dynamite spotted a possum in our yard last night.  More wildlife updates to follow as necessary.

Monday Morning Quarterback

Last night's Patriots-Colts game ended in spectacular fashion, with the majority of the sports world coming down hard on Bill Belichick's decision to go for it on 4th and 2 from his own 28 yard line with just over two minutes remaining.  The Patriots led by 6, and Indy had 1 timeout remaining.  The Colts had fought back from deficits of 17 points to start the 4th quarter, and 13 points with only 4 minutes remaining.

After watching Indy put together two quick 79 yard touchdown drives, each taking roughly two minutes (5 and 6 plays respectively), Belichick didn't want to give Indy QB Peyton Manning a chance to win the game, and elected to try to convert a first down, which would have sealed the game for the Patriots.

Obviously, when Belichick's gamble failed, the entire Monday Morning QB universe came down on him for his "horrendous decision."  Advanced NFL Stats, however, attempts to quantify the expected value of the decision to go for it instead of punting:

"With 2:00 left and the Colts with only one timeout, a successful conversion wins the game for all practical purposes. A 4th and 2 conversion would be successful 60% of the time. Historically, in a situation with 2:00 left and needing a TD to either win or tie, teams get the TD 53% of the time from that field position. The total WP for the 4th down conversion attempt would therefore be:

(0.60 * 1) + (0.40 * (1-0.53)) = 0.79 WP

A punt from the 28 typically nets 38 yards, starting the Colts at their own 34. Teams historically get the TD 30% of the time in that situation. So the punt gives the Pats about a 0.70 WP.

Statistically, the better decision would be to go for it, and by a good amount. However, these numbers are baselines for the league as a whole. You'd have to expect the Colts had a better than a 30% chance of scoring from their 34, and an accordingly higher chance to score from the Pats' 28. But any adjustment in their likelihood of scoring from either field position increases the advantage of going for it. You can play with the numbers any way you like, but it's pretty hard to come up with a realistic combination of numbers that make punting the better option. At best, you could make it a wash."

What seems like an asinine decision is actually probably pretty close when you run the numbers.  Obviously, the probabilities are not exact - Indy may be more likely (maybe 70%)  to score from the Patriots 30 yard line, and less likely to score from their own 35 yard line with 2 minutes and one timeout.  New England may be closer to 70% to convert the first down attempt.  Indy also may get better field position if New England punts - or they may fumble the punt (like Buffalo fumbled the Pats' kickoff with 2 minutes remaining in week 1!) - it's not an exact science.  The point is that perhaps Belichick's apparently insane decision wasn't quite as crazy as it seemed.  I'd use the estimates of 70% for New England to convert the first down, 70% for Indy to score if the Patriots failed to get the first down, and 30% for Indy to score if they got the ball inside their own 35 yard line.  Those assumptions yield a win percentage of 79% for "going for it" and 70% for "punting."  I think we actually need to DECREASE the win percentage for "punting" though, because Indy may get better field position.

Now, what I have a problem with is the strategy change the Pats made in the fourth quarter - playing a softer defense - not quite a prevent D, but one that allowed Manning to pick them apart for two quick scoring drives.  Against many teams, when you're up by 17, this strategy is ok - but against Peyton Manning and the Colts, who run a precision no huddle offense, taking less than 12 seconds to re-snap the ball after each completion, time just doesn't become an issue for them.    Similarly, when the Patriots had the ball on their final two drives, they shouldn't have tried to kill the clock - they should have kept up the offensive pressure that Indy couldn't stop all game long.

Anyway, this was a gutwrenching loss for Pats fans - it will be interesting to see if the anger at Belichick is tempered over the next week as fans try to understand his likely considerations - or if they will view him as having jumped the shark and become a crazy old man.

-KD

Stat of the Day

Via CalculatedRisk:

"86 percent of homebuyers relying upon FHA mortgage insurance in FY 2009 had downpayments of less than five percent."

Yowza.

-KD

Veteran's Day

Thanks to all the past, present and future members of the United States Armed Forces.

I have two links today, both from Tyler Cowen of Marginal Revolution:

1) Who knew you could tell so much about a person by the way they phrased a Google search?  This is a fascinating look (Cowen didn't do the research, he just linked to a few different projects) at how beginning your search with a phrase like "how 2" will result in an entirely different class of suggestions than if you begin your search with "how one might."  Cowen's blurb links to this piece and this piece and this piece - both are well worth a click.

2) Whoops!

"If you believed all the talk from Chrysler about how our tax dollars would help finance its fast-track electric-vehicle future, you're in for a big disappointment.

Chrysler has disbanded the engineering team that was trying to bring three electric models to market as a rush job, Automotive News reports today. Chrysler cited its devotion to electric vehicles as one of the key reasons why the Obama administration and Congress needed to give it $12.5 billion in bailout money, the News points out."

-KD