CIT Puts "Too Big to Fail" to the Test

This post first appeared on Minyanville and Cirios Real Estate.

We have truly become a bailout nation.

As regulators mull over the possibility of rescuing CIT Group (CIT) -- a small-business lender that counts over 1 million US firms as customers -- analysts debate whether the relatively small firm is deserving of a taxpayer-funded bailout. Or for that matter, a bailout at all.

After converting to a bank holding company last year, CIT received $2.3 billion in TARP money to help solidify its financial footing. Yet even this injection of taxpayer capital couldn't prevent its financial position from deteriorating further, and the company now faces the maturity of over $1 billion in bonds next month. Without government support, CIT doesn't believe it will survive the summer.

The specter for a CIT bailout is a tricky political issue: It pits those that argue Washington must step in wherever necessary to support the reeling US economy, against those who are starting to wonder when the bailouts will stop and when bureaucrats will step back and allow the free market to determine who survives.

Few would argue that CIT presents a systemic risk to the US financial system; with a balance sheet of around $75 billion, the company is one-eighth the size of Lehman Brothers, according to research firm BTIG.

CIT is, however, a key lender to small businesses around the country. This means its failure could threaten salary payments for millions of American workers if the company's customers are unable to get lines of credit with other financial institutions. Under different circumstances, banks like Wells Fargo (WFC), Citigroup (C), and Bank of America (BAC) would be eagerly serving CIT's clients. Instead, they're focused on reining in lending of their own.

If CIT were to fail, it would mark the biggest bank failure since Washington Mutual -- now part of JPMorgan Chase (JPM) -- collapsed last September.

By letting CIT fail and coordinating an orderly shuttering of its operations, the Obama administration has the opportunity to re-establish an old precedent long since forgotten in these turbulent economic times: Firms that should fail actually fail.

If, instead, the government rescues CIT, the yardstick by which we measure "Too Big to Fail" will be severely shortened. This wouldn't be a welcome development.

For the past year, government power brokers -- rather than market forces -- have picked the winners and losers as financial firms have been besieged by a massive deflationary debt unwind. Further, as Washington wades deeper and deeper into the day-to-day operations of American business, companies are starting to compete for government cash, not customers.

Moral hazard is a concept quickly brushed to the side during times of crisis, but it's precisely during these trying times that market principles should be the most firmly upheld. Sadly, over the past 24 months, the opposite has held true.

Keepin' It Real Estate: Just How Bad Are the New Appraisal Rules?

This post first appeared on Minyanville and Cirios Real Estate.

Appraisers just can't get it right.

During the housing boom, mortgage brokers, real-estate agents, and even borrowers sought out appraisals supporting the highest possible home price. Appraisers, fearful of losing business, inflated their valuation findings, which exacerbated the run-up in home prices.

Now, after nearly 4 years of home-price declines, appraisers are getting it wrong again -- but in the other direction.

On May 1 -- while the financial media focused on construing a blip up in housing data as signs of an imminent bottom -- little was made of new appraisal guidelines that went live and immediately began to eat away at the core of the nascent housing "recovery." To be sure, trade groups like the Mortgage Bankers Association and the National Association of Realtors (NAR) fought the revised rules, but to no avail.

Stemming from a lawsuit filed by New York Attorney General Andrew Cuomo alleging Washington Mutual (JPM) and First American Corp illegally conferred on the results of home appraisals with the goal of inflating prices, the new rules put up a Chinese wall between banks like Citigroup (C), Wells Fargo (WFC), Bank of America (BAC), and appraisers. The goal was to create an environment where appraisals would reflect an expert's unbiased assessment of a home's true value, rather than evaluations tailored to a lender's desire to make a loan.

The new rules affect loans guaranteed by Fannie Mae (FNM) and Freddie Mac (FRE), but since the 2 government-run mortgage giants effectively control the secondary mortgage market, they've become the defacto guidelines for the entire industry.

In order to separate lenders and appraisers, appraisal-management companies (AMCs), cropped up, offering banks access to a network of appraisers around the country. This makes the appraiser selection process random, preventing collusion. And while AMCs claim appraisers are selected using proprietary scoring algorithms that evaluate performance, the reality is that jobs are handed out on the basis of fastest turnaround time and lowest cost.

In short, we've traded bias for incompetence.

Readers of this column know that I have little, if anything good to say about the NAR -- which is not only the Realtors' trade organization, but a powerful Washington lobby. Nevertheless, earlier this week, when the NAR released data on existing home sales, their statement about appraisers' role in killing purchase transactions was dead on the mark:

"The increase in sales is less than expected because poor appraisals are stalling transactions. Pending home sales indicated much stronger activity, but some contracts are falling through from faulty valuations that keep buyers from getting a loan. Lenders are using appraisers who may not be familiar with a neighborhood, or who compare traditional homes with distressed and discounted sales."

Currently embroiled in this very scenario, my firm, Cirios Real Estate, is witnessing first-hand just how bad the new appraisal rules are.

Assessing a property's value in't rocket science, despite appraisers' claim that their extensive training and years of experience make them the only people qualified to determine home prices. All it takes is access to the right information, an understanding of what drives desirability, and a little pride in one's work.

That last criterion is perhaps the most difficult to find. Appraisers earn a flat fee for their services, giving them little incentive to provide the best analysis possible. Knowing they can now earn repeat business by turning around jobs in 48 hours and charging less than their competitors, there's little reason to go the extra mile to ensure appraisals take into consideration only the best information to come up with the best possible results.

Sure -- there are good appraisers out there with integrity that offer up great analysis. But as lower priced, lower quality work becomes the norm (thanks to the new appraisal guidelines), the best appraisers will seek greener pastures - as well they should.

Lawrence Yun, the NAR Chief Economist, finally got it right when he said, "Sometimes policy can lead to unintended consequences."

Mortgage Rates Still Not Allowed to Return to Normal

This post first appeared on Minyanville and Cirios Real Estate.

Despite Herculean efforts, the Federal Reserve is losing its battle to keep mortgage rates at all-time lows.

As fear that we're headed for imminent collapse slowly wanes, investors' appetite for risk is coming back. This renewed confidence has helped buoy stocks, and the major equity indices have rallied more than 30% from their March lows. The shift, however, has come at the expense of the Treasury market, which has been in a 7-week slump.

According to Bloomberg, big money managers like Blackrock (BLK) are betting the Fed will step in to support the Treasury market (again), as regulators hope renewed Treasury purchases will push down mortgage rates (again).

Bond prices and yields move in opposite directions. When investor demand falls, so do prices, pushing up yields. And as investors shun the safety -- but relatively low return -- of government-backed debt, the impacts are felt throughout the credit markets. Of concern to the Fed, and what has led Chairman Ben Bernanke to increase Treasury purchases in the past, is the effect this dynamic has on mortgage rates.

A mortgage is nothing more than a long term bond, given to a borrower to purchase a home. So when lenders get fearful they're not being compensated for tying up money for as long as 30 years, they increase rates. Further, as the specter of inflation rises, lenders demand bigger interest payments to keep up with higher prices. In other words, when dollars in the future are worth less than dollars today, banks demand higher payments to make up the difference.

Keeping mortgage rates low has been a cornerstone of Washington's efforts to jump start the flagging housing market. But with rates at the highest level since April, the "smart money" is betting the Fed may return to the Treasury market en masse.

Paradoxically, even as the Fed tries to keep interest rates low -- which are rising in part due to the expectation that higher prices loom in the years ahead -- its actions increase the likelihood of future inflation. Running its printing presses around the clock has consequences, even if Fed officials are loathe to admit it.

Minyanville's Mr. Practical often discusses the fallacy that credit markets are improving. As he points out, only in corners of the market where the government has stepped in to support lending is any so-called "normalcy" returning.

So too in the mortgage market.

Loans backed by Fannie Mae (FNM), Freddie Mac (FRE) and the Federal Housing Administration account for the lion share of mortgages currently being issued in this country. Aside from the occasional jumbo loan written by banks like JPMorgan (JPM) or Wells Fargo (WFC), government mortgages are the only game in town. Coupled with the Troubled Asset Lending Facility (or TALF), which funnels money into the market for mortgage-backed securities, the home-loan market remains completely dependent on government support.

This is one reason recent "strength" in the housing market will provide transitory. There's a limit on how much government can control markets, as evidenced by mortgage rates that move persistently higher every time the Fed eases its aggressive intervention. Fundamentals, not subsidies, will provide a true floor in prices.

And as banks prepare to unleash a firestorm of foreclosure inventory into the market, fundamentals will remain pointed south, thereby pushing down prices. And as foreclosures continue to infect higher end real-estate markets, these price declines will be felt by a growing -- and more prosperous -- segment of the population.

Mortgage rates, left to their own devices, would be far, far higher without government support. This is the message of the market - one bureaucrats in Washington seem unwilling to learn.

Keepin' It Real Estate: Beware The False Bottom in Housing

This post first appeared on Minyanville and Cirios Real Estate.

Residential real estate is about to get very weird.

In the coming months, housing-market data is likely to show price stabilization in many of the country’s hardest hit areas. Pundits, government officials and real-estate professionals will loudly proclaim the worst of our real estate woes are behind us. Back in reality, however, this data will simply reinforce the axiom that there are lies, damn lies, and statistics.

The lion share of home price declines have, thus far, been focused in low-end markets -areas where property values became the most detached from housing-market fundamentals. Even though the high end is now declining, sales activity is still heavily concentrated in the country's most distressed markets.

Taking a look at the data below compiled by my firm, Cirios Real Estate -- which depict sales transactions for the part of the San Francisco Bay Area between San Francisco and San Jose known as the Peninsula -- one can see how rising home prices from 2003 to 2007 shifted sales transactions towards more expensive properties. This makes intuitive sense, and should naturally push up both average and median home prices.


Click to enlarge

Since the market peaked, however, notice how the percentage of sales of homes under $400,000 shot up to more than 50% of sales in the first quarter of this year, from as low as 9% in 2007.

Conversely, sales over $1,000,000 that accounted for almost a quarter of transactions in 2007 now make up less than 9% of total sales so far in 2009.

This heavy concentration of sales in low-end markets is skewing home price data to the downside, exaggerating the impact of depressed markets on broad measures of prices.

As the foreclosure epidemic spreads outwards to more well-to-do areas, and job losses force previously stable homeowners to sell into a weak high-end market, more expensive homes will begin to make up a greater percentage of total transactions. This dynamic -- not an overall rise in property values -- is likely to push up average and median home price measures.

In other words, high-end markets will be falling as price discovery rears its ugly head, while low-end markets are flat at best, as price declines reach exhaustion levels and investors step in to buy. High levels of supply and looming shadow inventory of foreclosures will prevent meaningful appreciation in these distressed areas for the foreseeable future.

Meanwhile, data will show a housing market on the rebound.

No doubt, banks like Wells Fargo (WFC), Citigroup (C) and Bank of America (BAC) will cheer the end of the real-estate slump. Real estate professionals will pound the table that now's the time to buy (just like they said back in 2007). Government officials will proudly assert their mortgage-relief efforts were a success.

Nothing, however, could be further from the truth.

GE: We Don't Believe in the Housing Crisis

This post first appeared on Minyanville.

At a time when commercial real-estate investors are scrambling to unload properties, General Electric (GE), the world’s biggest landlord, is looking at 2009 through rose-colored glasses.

Tomorrow, when the company releases details of its finance arm’s real-estate holdings, investors may get a better sense of just how exposed they are to tumbling rents and rising vacancies. According to the Wall Street Journal, GE owns about $34 billion in commercial real estate, which it believes may slip in value this year by a mere 1.5%.

Compared to a 60% decline in the Dow Jones REIT Index over the past 12 months, that forecast seems unusually optimistic.

The trick here -- like that at the heart of the mark-to-market debate -- is how GE classifies its property holdings. Since they were primarily bought with cash (and thus aren't subject to the whims of creditors), the company views its assets as long-term holdings. Cash flow, not resale price, determines the value it slaps on assets for accounting purposes.

But with the market for commercial real estate essentially frozen, tenants demanding better lease terms, and the company scrambling to raise capital, GE may find dumping properties onto an illiquid market is an unpleasant experience.

Commercial real-estate losses went a long way toward sinking Wachovia -- ultimately purchased by Wells Fargo (WFC) -- and Lehman Brothers, which ultimately collapsed under the weight of housing bets gone wrong.

GE is hoping its conservative use of leverage can save it from a similar fate.

US to G20: Spend, Spend, Spend

This post first appeared on Minyanville.

4 months ago, as financial markets spun out of control, the world’s brightest economic minds engineered a coordinate global cut in interest rates. Their aim: Save the financial system from imminent collapse.

The move sparked a sharp 20% rally in the S&P 500. The index has since tumbled more than 30% to lows not seen since the 1990s.

If markets are jittery once again, it’s not without justification: In just under a month, global leaders will once again put their heads together, this time to hash out the best way to solve the deepening economic malaise. Hopes are high lawmakers will dream up new (and better) ways to get the world's largest economies back on track.

On April 2, in London, the US is expected to encourage its counterparts at the Group of 20 Summit to increase government-spending efforts to revitalize flagging economies. According to the Wall Street Journal, President Obama and Treasury Secretary Tim Geithner are expected to butt heads with European officials, who would prefer to shift the focus onto crafting stricter financial regulations.

The European Union, many believe, is facing an even worse economic outlook than the US. But those across the pond could need fewer new spending initiatives, since they have further-reaching social programs already in place. In addition, the European Central Bank, or ECB, is far more hawkish (read: concerned) about inflation than is our Federal Reserve.

Digging ourselves out of this mess with more borrowing could spark renewed inflation.

The ECB took longer to lower interest rates last year despite deteriorating economic conditions, citing worries about rising prices. In contrast, Fed Chairman Ben Bernanke aggressively reduced borrowing costs in the hope that companies would borrow to jumpstart new growth. Frozen credit markets didn’t cooperate, plunging the financial system into widespread disarray.

Of the countries that make up the G20, only Saudi Arabia, Spain and Australia plan to spend more propping up their economy than the US, according to data compiled by the International Monetary Fund. Of course, that doesn’t include the hundreds of billions already wasted - um, injected into the likes of Goldman Sachs (GS), Morgan Stanley (MS), JPMorgan (JPM), Citigroup (C), Bank of America (BAC) and Wells Fargo (WFC).

Also left out of these figures are the trillions of dollars the Fed has pumped into the financial system to keep credit flowing -- however reluctantly -- throughout the economy.

The upcoming meeting marks President Obama's first chance to woo world leaders on the global stage. And while his social programs may gain favor among certain European lawmakers, his country's role in creating this mess certainly won't.

The rest of the world increasingly feels its being forced to clean up a problem that was largely American-made.

Consumers Still Not Consuming

This post first appeared on Minyanville.

As lawmakers busily laud their own efforts to unlock credit markets and jumpstart lending, consumers yawn. They just don’t want to spend.

And it’s not just those out of work who are paring back expenditures. According to the Wall Street Journal, even the dwindling ranks of the employed are getting thrifty. Computer users are enduring slow machines rather than buying new ones, clothes-shopping trips are being delayed, and coupon clipping is once again the vogue.

Discounters like Wal-Mart (WMT) are benefitting from bargain hunters looking to save a couple bucks, while AutoZone’s (AZO) stock sprinted to a 52-week high last week, as drivers opt to do it themselves.

Politicians, rushing to restore the “prosperity” we so recently enjoyed, are confident this is just a passing fad, and that we’ll soon return to our spend-happy ways. Indeed, the viability of President Obama’s new $3.4 trillion budget is predicated on the US economy's skipping along at a 3.4% growth rate next year - and expanding even faster in 2011.

This optimism -- idealistic at best, delusional at worst -- ignores the extent to which Americans are embracing a new, sustainable way of making ends meet: Spending less.

Meanwhile, the Federal Reserve, busy waving its magic wand over reeling credit markets, is similarly out of touch with reality.

As noted by our friends at BTIG, new federal lending initiatives aimed at funneling money to credit-starved consumers are undersubscribed. In his speech last Friday, New York Fed President Bill Dudley pointed to weak demand as evidence that financial markets were in better condition than many believed, and that investors could be willing to start taking risk again.

Not likely.

As I noted a few weeks back, consumers are roundly rejecting the idea that more debt is a good thing. Even small community banks that have money to hand out can’t find any takers. (Wells Fargo (WFC), Bank of America (BAC) and Citigroup (C) are quietly thanking their lucky stars, since they’re out of cash anyway.)

The ongoing foreclosure crisis, rising bankruptcy filings and tumbling equity values, though they do cause meaningful hardships for millions of Americans, do have a silver lining: The realization that unbridled consumerism does ultimately come at a cost. This is fostering a renewed understanding of the importance of fiscal responsibility.

Most media outlets report this in terms of increased savings, which is almost universally viewed as bad in the short run, if good long-term.

But saving now is good. Period. The notion that spending what you don’t have is somehow the patriotic thing to do is absurd. The only way out of this mess is through saving, not spending.

That is, of course, if one's time horizon extends beyond the 2, 4 or 6-year election cycle.

Keepin' It Real Estate: How to Play the Housing Rebound

This post first appeared on Minyanville and Cirios Real Estate.

There isn’t an economic forecaster or media pundit alive who isn’t angling to be the first to (correctly) call the bottom in housing. Many have tried; they all have failed.

But what happens when one’s right?

At some point in the future, broad home price indicators will cease to slide, then stabilize and even begin to move back up. When, and in what shape that trajectory will be, of course remains a mystery. As I've written in the past, the eventual recovery in housing will be a prolonged, localized event. The rising tide will not lift all boats, as the fundamentals of the old cliché “location, location, location” will be truer than ever.

And although predicting the date of this event is a fool’s errand, savvy home buyers will be ready to jump in ahead of those who remain in their shells long after the best bargains are behind them.

Here are 5 simple things you, the future home buyer can do now, without putting your nest egg at risk, to be ready for the coming opportunities in real estate:

1. Have patience.

There will be false bottoms, dead-cat bounces and treacherous pitfalls on the path to a recovery in real estate. Be patient. Don’t believe the hype - a couple months of strong sales numbers don’t foretell and imminent rebound in prices. Let the beginnings of a trend develop before you begin your home search in earnest. Future appreciation will come slowly, as tightened mortgage guidelines and fear of the collapse we’re now experiencing will not be soon forgotten.

2. Find a market, do your homework.

Had your eye on that classic Victorian around the corner from your kids’ future grade school, and hoping the elderly couple living there knock off just in time for you to swoop in at the estate sale? Expand your search.

Pick a couple of areas you could be happy in - look in multiple cities even. By focusing too narrowly on a single street, or even a single neighborhood, you could be missing out on what could be a fantastic opportunity on the other side of town. Don’t compromise, but play with your list of priorities to give yourself the most “exposure” to localized markets that may become increasingly attractive.

Tour the schools, scope the neighbors - hang around on Halloween to see who gets egged. RealtyTrac.com is a great resource for watching foreclosure activity all over the country and in your backyard. Their free site provides a great overview of cities and neighborhoods, but you have to pay for the house-by-house detail. Unfamiliar with an area? Use RealtyTrac to eyeball major neighborhood dividers (railroad tracks, highways, main roads, etc.) and examine foreclosure activity on either side.

3. Find a broker and start a housing “tracker”.

Real estate brokers can be a valuable tool in your home search - use them.

An aside: The commonly used term “realtor” denotes an association with the National Association of Realtors, or NAR, the lobbyists who have been predicting a bottom since the downturn began over 3 years ago. Tread carefully with anyone proudly bearing an NAR pin. Contrary to what many tell you, you don't need to be a realtor to have access to MLS. But I digress.

Today, with transactions down in all but the most distressed areas, any broker worth his (or her) salt should be out prospecting for future clients, not proclaiming the time to buy is now. Collect referrals, test drive a broker or 2 and find one you’re comfortable with. Your broker should not just understand the local market but be up to speed on the macro-level events affecting the real estate and mortgage markets. Ask him what a CDO (collateralized debt obligation) is - watch for a flinch. For better or for worse, understanding the state of Wall Street is as important these days as understanding the state of your street.

Ask your broker to help you develop a “housing tracker,” a simple tool that allows you to watch homes as they come on the market to see when and for how much they sell. Watching the life cycle of homes in a given market will give you a sense of how desperate sellers are, when asking prices drop and what concessions buyers are able to receive from sellers. As concessions begin to swing in favor of the sellers, the bottom may be nigh.

4. Start saving money.

If there’s one sure bet in the housing market, it’s that mortgage requirements will remain tight for the foreseeable future. Banks -- Citigroup (C), Bank of America (BAC), JP Morgan (JPM) and Wells Fargo (WFC) being the obvious examples -- are hoarding cash and reticent to lend even to the most qualified buyers. Unless a loan falls within guidelines set by Fannie Mae (FNM) and Freddie Mac (FRE), rates remain elevated and approvals elusive. This isn’t likely to change any time soon.

Save for a down payment and be able to point to liquid reserves (i.e. money in the bank) during the application process. Think about this as the lender’s cushion should you fall on hard times - and banks will need all the cushion they can get.

5. Think of your home as an investment, not just a place to raise your kids.

This may seem counter-intuitive, since speculation on housing prices played a huge role in creating the recent housing bubble. But speculating and investing are not the same thing.

A home, in addition to being a place to raise kids, is a massive financial obligation. Becoming emotionally attached to a house, rationalizing the financial realities away and hoping paychecks keep coming simply isn’t a viable home-buying strategy. As un-romantic as it may be, treat a home as you would a stock: Examine it, turn it upside down, run the numbers. Love it every day you’re there, but financial responsibility and emotional attachment don’t need to be mutually exclusive.

The time to buy may not be today -- and it may not be tomorrow -- but we’ll be closer to that day tomorrow than we are today. However, just as prices overshot to the upside, they'll likely overshoot to the downside - be ready when that day comes.

Preparation, not hoping, will be the key to taking advantage of the opportunities that will present themselves on the other side of this mess.

Banks Brace for Stress Tests

This post first appeared on Minyanville.

As financial markets reel, equities probe lows unseen in over a decade, and optimism wanes on Main Street, President Obama and Treasury Secretary Tim Geithner are rolling out a series of so-called “stress tests” to firm up confidence in the country’s banks.

The tests, designed to ensure banks will survive even if economic conditions continue to deteriorate, focus on the books of 20 of the country’s largest banks. According to Bloomberg, the stress tests begin today.

The approach harkens back to tactics used during the Great Depression - yet another reminder of just how bad things have gotten for the US banking system.

Last week, Federal Reserve Chairman Ben Bernanke explained how a similar approach in 1933 solidified confidence in the nation’s banks:

“Roosevelt shut down the banks for a week and said we are just going to check the books and open them up only when we think they are solvent. And a lot of the banks opened up pretty quick. So, it's not really clear how much they really looked through the books, but when they opened them up again, people felt much more comfortable, and more confident in the bank.”

The current plan doesn’t just aim to “check the books.” Instead, regulators will evaluate the strength of banks like Citigroup (C), Bank of America (BAC) and JPMorgan (JPM), already up against the ropes, based on how the'll perform if put through a more “stressful” economic test.

In other words, what happens if the wheels really fall off the wagon.

For example, let’s assume most economists believe housing prices, which have already corrected more than 20%, will stabilize after having fallen 30%. The last 10% of declines would have a certain effect on residential mortgage losses (among other assets), so Treasury bean-counters try to estimate whether banks could withstand the losses such a scenario would create.

The next step is to assume things get worse than expected - say, a 40% peak-to-trough decline in property values. More losses would ensue, and, after tallying each bank’s projected losses, officials can try to determine how much capital banks need to to remain solvent through this “worst-case scenario.”

After injecting the requisite capital to keep banks alive if things get really, really bad, newfound confidence could entice private capital back into the market. At least, that's the theory. If instead they find out certain banks wouldn't survive without massive amounts of capital, they could then become targets for nationalization.

Myriad troubles arise with this approach, bold as it may be. A few to consider:

First, selecting the “worst case” is problematic, particularly since conditions during this crisis have gotten worse than almost anyone expected. Anyone in Washington, that is, since many private commentators had been saying the sky is falling for years. Still, regulators have to make guesses about how bad things could possibly get, and their guesses could be wrong.

Second, any assumptions about future losses are based on guesses based on assumptions based on guesses based on assumptions based on wild stabs in the dark. In short, the complexity of the global financial system, the unintended consequences of various government actions, and a general difficulty predicting the future, make predictions exactly that - predictions.

Third, and possibly most importantly, regulators have lost almost all credibility over the past 18 months.

Some may argue that the guys in charge are different, but that’s just not the case. Ben Bernanke still runs the Federal Reserve, Tim Geithner ran the New York Fed for the past 5 years, Lawrence Summers is back at the economic helm, and Barney Frank and Chris Dodd are still mouthing off on Capitol Hill. Sure, there's a different face in the White House - but by and large the same folks who got us into this mess are now trying to get us out.

The American public recognizes this, investors recognize this, and the world recognizes it.

Even if the stress tests go off without a hitch and Geithner and Obama loudly proclaim the banking system is safe and sound, the market may simply, quietly shrug - and continue heading south.

Government Moves Into Citi?

This post first appeared on Minyanville.

It may not be nationalization, but it’s pretty close.

Last night, the Wall Street Journal reported the federal government is considering taking a large step closer to outright control of Citigroup (C). Having already sunk tens of billions of dollars into the troubled bank, the Treasury Department may now convert its non-voting preferred stock into Citgroup common stock. This would give government officials voting rights and more control over management's decisions. The Journal reports the government could own as much as 40% of the company, although bank executives are hoping the stake will come out closer to 25%.

And while taxpayers wouldn’t be asked to pump in additional funds, the move would further dilute current shareholders. But there isn’t much left to dilute: The company’s shares traded below $2 Friday, and were off more than 50% as recently as February 10.

Reeling from credit losses and worsening economic conditions in the US and abroad, Citigroup is at the leading edge of the financial storm. And nervous politicians are taking a more active role in bank management, concerned that capital injections, debt guarantees and loss-sharing agreements may not be sufficient to allow banks to retain their independence.

The Obama administration did say on Friday, however, that nationalization isn't in the cards for Citi and Bank of America (BAC). Nevertheless, nationalization calls are being heard loudly across the globe. Politicians, academics and pundits are weighing in, many arguing state control is the system's only hope to survive.

Banks, for their part, claim they don’t need the help: They claim that fear, rather than fundamentals, are driving their shares into the ground. In addition to Bank of America CEO Ken Lewis, JPMorgan (JPM) chief Jamie Dimon and Wells Fargo (WFC) CEO John Stumpf have asserted that their institutions are solvent enough to go it alone.

In his public remarks on Friday, Stumpf even managed to sound upbeat about the future. “There is so much to look forward to. I don’t know what we’re going through today, but it will probably define our generation. This can be the next greatest generation.”

Indeed. As Toddo often says, “In order to get through this, we need to go through it.” And with stress tests on tap for the nation's biggest banks, we may soon find out just how much we'll have to go through to get to the other side.

Stanford Takes Page from Ponzi Playbook

This post first appeared on Minyanville.

It turns about Bernie Madoff wasn’t the only one cooking the books: Texas banking icon R. Allen Stanford is the latest to be charged with a massive, multi-billion dollar fraud.

In a story conveniently drowned out by President Obama’s signing of the $789 billion economic stimulus package and the auto industry’s latest plea for taxpayer money, the Securities and Exchange Commission raided Stanford’s Houston headquarters yesterday morning, alleging he perpetrated an $8 billion fraud based on “false promises and fabricated historical data.”

According to the Wall Street Journal, Stanford lured in investors by promising steady, safe returns for cash deposited in a bank he owns in Antigua, one of the many Caribbean banking havens. Instead of investing in liquid, low-risk assets as promised, Stanford allegedly funneled the money into high-risk private equity and real estate deals. Oversight was scant, as decisions were reviewed by 2 people: the bank’s chief financial officer, James Davis, and Stanford himself.

Much like Madoff’s much-publicized Ponzi scheme, consistently high returns that seemed impervious to market gyrations were the hallmark of Stanford’s scam.

The SEC claims Stanford International Bank returned between 6-10% from 1992-2006 on its certificates of deposit, or CDs. Yields on comparable investments issued by American banks like JPMorgan (JPM), Bank of America (BAC) and Wells Fargo (WFC) are significantly lower - but carry FDIC insurance to protect depositors from loss.

Strong returns on its investment portfolio, Stanford claimed, allowed the bank to pay out the oversized returns. In 2008, a year that saw the S&P 500 lose 39%, the bank said its portfolio lost just 1.3%.

The SEC says Stanford used these inflated returns to woo investors, many of which hailed from Latin American countries. Shaky banks in South America led many wealthy individuals to invest with Stanford, believing he could earn them strong returns with little risk.

But as their North American counterparts have learned from the ongoing Madoff affair: Where there’s return, there’s always risk.

This lax attitude towards risk, one that was fostered for decades by the Federal Reserve's overly accommodating monetary policy, was instrumental in sowing the seeds of our current financial crisis. It also helps explain how so many investors around the world were so easily duped by cons that, in retrospect, seem so easy to identify.

“Malinvestments,” a term popularized in recent years by Texas Congressman Ron Paul, occur when cash is poured into assets that return a yield that isn't commensurate with their risks.

When times are good, losses remain low and Washington comes to the rescue of the financial industry every time it gets into trouble, investors become accustomed to earning high rates of return without taking much risk. As this belief becomes the status quo, more and more money is funneled towards these seemingly low-risk, high-return opportunities.

Peddlers of financial instruments, from Madoff and Stanford to Goldman Sachs (GS) and Morgan Stanley (MS), dream up increasingly complex places for investors to park their money. Risk, they claimed, was as low as ever, thanks to their financial wizardry.

When real losses did occur, loan defaults began to rise, and the government wasn't deft enough to stem the tide, investors got burned. Badly.

Assets that suddenly become very risky lost value rapidly, since they carried such a low rate of return. Losses beget losses, which beget more losses. We all know how the story ends.

Meanwhile, even as it acted as enabler to Wall Street's (and Main Street's) incessant greed, the federal government now insists on pointing fingers and acting as savior for a system it was complicit in creating.

Where was the SEC to root out Madoff and Stanford before investors lost billions? Where was the Federal Reserve to act on its own findings about the risks of exotic mortgage lending?

Yet, even now, we're counting on these same institutions and politicians to invest nearly $1 trillion of our money to rescue us.

How low-risk is that investment strategy?

Auto Bailout: Part Deux

This post first appeared on Minyanville.

The turnaround plans are in, and it doesn’t look good: No more Hummers.

In a scene reminiscent of last year’s near-collapse, General Motors (GM) and Chrysler LLC told government officials that, without more than $20 billion in additional rescue money, bankruptcy is their only option. Required to submit restructuring plans under the terms of the first federal bailout, GM and Chrysler outlined a strategy for revitalizing their firms and returning to profitability.

Twenty billion dollars, GM’s CEO Rick Waggoner argues, is a paltry sum when compared to the estimated $100 billion the firm would need to make it through a traditional bankruptcy process, according to the Wall Street Journal. Chrysler, for its part, said $24 billion would suffice to skate through bankruptcy proceedings, should Washington fail to produce the requested funds.

In addition to squeezing taxpayers for more cash, the firms announced tens of thousands of layoffs and other cost-cutting measures.

GM plans out phase out its Hummer brand as early as this year, since no buyer emerged for the production facilities that crank out the oversized gas guzzlers. Saturn could be gone by 2011, as could Pontiac, and the company is trying to sell Saab. Five factories will be shut, 47,000 jobs will be cut, and dealerships will be closed as GM tries to rein in its bloated cost structure.

Chrysler is fighting battles of its own, as Congress is becoming increasingly hostile toward the company’s majority owner, private-equity firm Cerberus Capital Management. Lawmakers want to see Cerberus pony up cash for its struggling investment before any additional taxpayer funds are put to work.

Progress has been made by GM, Chrysler as well as Ford (F) in negotiations with the powerful United Auto Works union, but there are still outstanding items that need to be resolved before any restructuring can be pushed through.

Earlier this week, President Obama announced that the so-called “car czar” would never be crowned, opting instead to task Treasury Secretary Tim Geithner and Lawrence Summers, chairman of the National Economic Council, with cleaning up Detroit’s mess.

And quite a mess it is.

With the economy in free fall and the nearly $1 trillion stimulus package now approved, allowing the automakers to fail could be a severe setback for the Obama administration. On the other hand, growing public discontent over handouts to industries that brought about their own demise makes this a prickly political issue.

Ultimately, Obama may be looking to treat the situation in Detroit as a trial run: The relatively simple task of unwinding 2 cash-starved companies will be child’s play compared to fixing the country’s ailing financial system.

The nation's biggest banks, Bank of America (BAC), Citigroup (C), JPMorgan (JPM) and Wells Fargo (WFC), continue to reel as losses mount, and the economic crisis deepens. And as Treasury Secretary Geithner muddles along with his bank-rescue package, officials may be biding their time and sharpening their management skills.

Americans to More Debt: Talk to the Hand

This post first appeared on Minyanville.

Washington just doesn’t get it: We don’t want more debt.

While congressmen berating bank CEOs for their unwillingness to lend out their bailout money makes for a nice media clip, it reflects the growing disconnect between our elected officials and any semblance of reality. Not that the relationship was ever particularly close - but lawmakers are floundering for good press while the nation’s economic future slips further and further from their tenuous grasp.

Bloomberg reports American consumers are wary of taking on more debt, as expectations about eroding economic conditions are forcing people, to *gasp* make responsible decisions about their personal finances.

Bloomberg cites Midsouth Bancorp (MSL) president C.R “Rusty” Cloutier, who says that, despite aggressive marketing, town hall meetings, and $20 million in TARP money, Midsouth's customers just aren’t taking out new loans.

This is the rejection of debt Professor Depew speaks of when discussing the structural deflation we’re currently experiencing.

Credit is based on trust. And while conventionally we view this relationship as one in which the lender must trust the borrower to repay his debt -- at least to an extent that’s commensurate with the interest rate -- it does go both ways.

As lenders like Citigroup (C), Bank of America (BAC) and Wells Fargo (WFC) are increasingly being painted as corporate marauders out to rape and pillage the American public, would-be borrowers are wary of putting their financial future in the hands of these men of questionable repute. And with credit-card companies rushing to alter terms, it’s no surprise consumers are reluctant to extend themselves further.

Still, lawmakers are pushing through an economic stimulus package that depends, in part, on a willingness on the part of consumers to keep spending. Their delusion is only outmatched by their hubris - the belief that a bunch of self-interested politicos can coerce the average American into making ruinous financial decisions for the betterment of the country.

Floundering industries -- notably automakers and homebuilders -- are counting on government subsidies to encourage Americans to keep borrowing to buy their products. But what General Motors (GM), Ford (F), Centex (CTX) and KB Homes (KBH) don't understand is this: We just don't want what they're peddling. And we certainly don't want to borrow against it.

The transition from a debt-dependent, credit-drunk consumerist society won't be immediate: It's taken 18 months of financial panic for evidence of the shifting social mood to make its way into the mainstream.

But as the economic outlook continues to darken, the country becomes more disenfranchised, and the government grows ever-more addicted to sound bites and empty promises, reality will set in.

For the past 20 years, we've been blithely driving along an economic road that ends in a cliff. And that cliff is now in our rear-view mirror. We're tumbling, groping for any branch that can save us from the fall. But each one of these new government programs, bailouts and rescues simply tries to set us gently back on the road from which we only just plummeted.

We already know where that path ends, and it ain't pretty. What say we try another road?

The Mortgage Rescue Plan: Will It Work?

This post first appeared on Minyanville and Cirios Real Estate.

The answer? An emphatic no. This is simply the latest example of legal plunder perpetrated by the federal government against law-abiding, tax-paying citizens.

The Obama administration’s scheme to help troubled borrowers centers on subsidizing interest payments, which would help borrowers make ends meet without angering those investors expecting full payments each month. This marks the first time the government is intervening directly with taxpayer funds to ease the burden of monthly mortgage payments.

Bloomberg reports the plan will be voluntary for lenders like Wells Fargo (WFC), Citigroup (C) and Bank of America (BAC), and will employ many of the tactics previous modification efforts have used (ineffectively), such as loan extensions and principal reductions. Modifications identified as having a net present value will be targeted, where foreclosing would be more expensive than changing the loan terms.

The program aims to establish a standard for loan modifications that can be used industry-wide. That's an absurd claim, which demonstrates the extent to which lawmakers misunderstand the scope of the problem. It's a bit like saying every American must cut their hair the same way: It would be laughable it weren’t so sad.

Each mortgage, each borrower, each lender, each home is unique; each situation is different. Individual banks can barely standardize the documents required to close a loan, so the notion that there can be one standard for approving a loan modification -- an intensely complicated procedure involving countless interested parties -- is ridiculous.

It would be one thing if the plan offered even the remotest possibility of stabilizing the housing market. It doesn't. The few borrowers who may be helped will have little effect on a massive, disjointed housing market that remains determined to run its course despite government efforts to stop the bleeding.

The societal implications of this program are downright frightening.

Washington cutting checks to borrowers who can’t make their mortgage payments sounds like a benevolent act attempt to reach down to struggling families -- and in some cases, it may certainly help. But it also fosters dependency on the federal government and incentivizes bad behavior.

It now appears we've reached a point in this crisis where differentiating between those worthy of help and those left to pick up the tab is determined primarily by how poorly one managed their personal finances. The worse the decision, the greater the federal assistance - and it's true for government bailouts of bad choices on the part of individuals and institutions alike.

The message this sends to the rest of us - those who are still living up to their obligations and trying in good faith to eke out a living during tough times: Throw in the towel.

Keepin' It Real Estate: How Good is Zillow?

This post first appeared on Minyanville and Cirios Real Estate.

Americans finally get it: Home prices are falling.

This may seem like a preposterous statement, what with the entire global financial system in disarray after the collapse of the US housing market, but we Americans are stubbornly optimistic people, content to ignore calamity as long as we possibly can.

A study released this week by Zillow, a real estate information website best known for its wildly inaccurate estimates of property valies, shows Americans have finally succumbed to the notion that home prices aren't going up anymore. 57% of homeowners polled believe their own home lost value during 2008, up from 38% who felt that way just 6 months earlier.

Interestingly, when asked about the future, respondents were upbeat: Only 30% estimate the value of their house will decrease in the next 6 months. Of course, their neighbors aren’t so lucky: Forty-seven percent believe home values in their local markets will fall during the same time period.

Zillow has become something of a cult phenomenon in the past few years, as it allows homeowners to go online and see how much their house is “worth.” By its own admission, Zillow’s values are merely estimates based on amalgamating sales data from nearby homes, comparing bedroom counts, living area, lot size and other salient characteristics.

What few people realize, however, is that Zillow’s valuation algorithm isn’t just used by John Q. Homeowner: Every big lender in the country uses a similarly opaque formula to price real estate.

Wells Fargo (WFC) -- now the biggest US home lender in the country after its acquisition of Wachovia -- holds tens of thousands of mortgages on its books, each backed by a unique house. It’s impractical to regularly review each home for a fresh value, so Wells and other big banks like Citigroup (C), JP Morgan (JPM) and Bank of America (BAC) rely on analytics firms to provide property values churned out by what are called Automated Valuation Models, or AVMs.

AVMs rely heavily on recent sales data to drive their valuation estimates. This works reasonably well in a vanilla market, one where home prices move uniformly in a single direction - namely up. Even rapidly rising prices are well accounted for, since liquid markets provide reliable, normal data sets upon which calculations can be made.

AVMs are a bit behind the curve in an appreciating market, offering a conservative estimation of a home’s value. But in a declining, choppy, illiquid market like the one we’re in now, AVMs fall apart.

As sales volume dries up and prices gap down, transactions that are even 3 months old become woefully out of date. Even in distressed markets that are now seeing frenetic buying activity, active listings -- and therefore true market prices -- are well below all but the most recent sales.

By using AVMs to value housing assets, banks are constantly underestimating losses in a declining market. Unfortunately, there isn’t much of an alternative.

Small, independent valuation firms offer the most reliable estimations of value, but they specialize in local markets by definition, which limits the scale with which huge lenders can effectively use their results to evaluate nationwide portfolios of loans.

Next time you laugh at Zillow’s estimation that a home that just sold for $250,000 is really “worth” between $315,000 and $375,000, remember that your bank is looking at the same data. No wonder they keep asking Uncle Sam for so much money.

Bank Rescue? What Bank Rescue?

This post first appeared on Minyanville.

In a move reminiscent of John McCain’s suspension of his campaign to return to Washington for the vote on the first bailout, Barack Obama is putting the latest iteration of a bank-rescue package on hold while he addresses the economy.

So as not to distract Congress from imminent debate on the $800 billion economic stimulus package, newly minted Treasury Secretary Timothy Geithner delayed a speech outlining his bailout plan for the financial markets till tomorrow.

Details about the latest initiative are still cloudy, but over the weekend, reports by both Bloomberg and the New York Times focused on difficulties pricing illiquid, toxic assets, which seem to be new scheme’s the biggest sticking point.

Banks, laden with hard to price and impossible to sell assets, can’t make new loans since any fresh capital they receive is simply eaten up by mounting losses. And while big lenders like Wells Fargo (WFC) and JPMorgan (JPM) would love to unload troubled assets onto the government above their market price, politicians are wary of the negative press such a taxpayer burden would cause.

Even though the Treasury, the Federal Reserve and the FDIC have guaranteed almost half a trillion dollars in lousy debt owned by Citigroup (C) and Bank of America (BAC), bureaucrats have now found it politically expedient to play hardball with the nation’s bankers. And by hardball, I mean slow-pitch softball.

The Wall Street Journal reports President Obama’s much-heralded executive-compensation restrictions, far from squaring off with Wall Street fat cats in the UFC Octagon, is attacking Manhattan’s uber-rich with kid gloves.

Executive-pay experts and management attorneys have identified loopholes in the President’s plan, which could allow the very executives Obama means to punish to reap the very same benefits he seeks to limit. This shouldn’t come as much of a surprise, since Wall Street’s expertise lies in staying one step ahead of regulators and lawmakers, figuring how to bust new, supposedly tough rules the moment they’re announced.

As the ongoing efforts to rescue the American economy and fix the banking system roll on, the extent to which Washington is waging primarily a public relations campaign, rather than a true battle against the demons of Depression, becomes increasingly clear. Even the most well-designed stimulus takes months to filter into the economy and effect actual economic decision-making, so in the mean time politicians are focused on swaying public opinion.

Oddly, the current tactic is to frighten the public with ominous warnings about the risks of doing nothing. This is just exacerbating the contraction, as purchasing decisions are delayed for fear things may keep getting worse.

The focus on social mood rather than actual, sound policy highlights the extent to which the turmoil of the past 18 months has altered the American psyche.

Consumers are recoiling, shunning debt and extravagance for savings and thrift. Washington and Wall Street, more joined at the hip than ever, know this combination could topple their carefully constructed house of cards - economic expansion founded on unsustainable levels of debt.

We'll know more tomorrow about the latest in a string of attempts to fix our ailing financial system - unless of course something more important gets in the way.

Keepin' It Real Estate: Capitulation Now!

This post first appeared on Minyanville and Cirios Real Estate.

Finally, housing is starting to act like a market searching for a bottom.

Well, sort of.

In former boom states like California, Arizona and Florida, distressed sales are driving the local real-estate markets. After a near-complete evaporation of buying activity last year, buyers have been brought off the sidelines by continued price declines, a glut of homes for sale, and low interest rates. Comparisons with last year are easy: Some areas are seeing activity up more than 300% year-over-year.

Many contend this is a healthy development, as prices return to more affordable levels and latent demand sops up overhanging supply. The bottom, they argue, is nigh.

However, even in areas seeing strong buying activity, median home prices continue to tumble. Banks and private sellers alike are finding the only way to guarantee a sale is to list the house below the market. This constant undercutting is pushing prices down, sometimes well below affordability levels derived from median income data.

This trend is not indicative of the capitulation most market watchers believe must happen before prices can truly bottom.

Capitulation is a concept more often reserved for equity-market analysis than for housing. Since real estate is vastly more fragmented and localized than stocks, housing trends take months, even years to develop, while equities can reverse course in a manner of days, if not hours.

Still, drilling down into individual transactions, evidence of capitulation in certain markets is becoming evident. Sellers, after 4 years of price declines, are finally throwing in the towel.

Homebuilders are becoming desperate: Toll Brothers (TOL) is trying to lure in buyers with 3.99% interest rates through a partnership with Wells Fargo (WFC). Centex (CTX) did them one better by offering rates as low as 3.25% (that rise to 4.50% after 2 years) and Pulte Homes (PHM) also offers a 3.99% fixed rate option for qualified buyers.

Banks like JPMorgan (JPM), Bank of America (BAC) and Citigroup (C), desperate to shed their growing inventory of foreclosed homes, are beginning to accept bids 10, 15 or even 20% below their asking prices.

And its not just banks. Just in the past few weeks, private sellers have started to jump at low-ball offers. Better to take less cash now than be constantly priced out of the market, chasing it all the way down.

Although this type of sale is still very much the exception rather than the rule, it’s an indication that sellers are becoming despondent, willing to accept any reasonable price to rid themselves of what could be months of headaches, upkeep expenses and deteriorating market conditions.

To be clear: This analysis is by no means a call that housing has bottomed, or is even remotely close to a bottom. It’s merely evidence that certain areas are closer to stabilization that others, and these signs -- which may look like capitulation -- should be viewed as a positive development in a market deeply in need of hope.

Bank CEOs Beg For Bailout, Their Jobs

This post first appeared on Minyanville.

Business schools around the country would be wise to add a new course to this fall’s curriculum: How to Run A Bank into the Ground, But at the Last Minute Get it Rescued by the Government, Thereby Saving Your Cushy, High Paying Job.

Guest speakers from the American banking industry would be easy to come by.

Despite having sopped up hundreds of billions of dollars from US taxpayers, the Associated Press reports almost 9 out of 10 of the most senior executives at banks which have received federal bailout money still have their jobs. It appears the only way to get fired is to perform so poorly that your bank gets snatched up by another for a song:

• Ken Thompson, CEO Wachovia, gone. Bought by Wells Fargo (WFC).
  
  
• Kerry Killinger, CEO Washington Mutual, gone. Bought by JPMorgan Chase (JPM).
  
  
• Alan Schwartz, CEO Bear Stearns, gone. Also bought by JPMorgan.
  
  
• Stan O’Neal and John Thain, CEO Merrill Lynch, gone. Bought by Bank of America (BAC).

Most of the above crept quietly out of the spotlight after their respective departures to avoid Congressional inquiries about their lavish pay and severance packages. Others, however, have gone less quietly.

John Thain, for example, has become a bit of a media mainstay after reports of his $1.2 million office redecoration were leaked to the press. To his credit, Thain is repaying the money. However, he was also spotted last week -- just before news of his $35,000 commode hit the press -- making a scene at a New York restaurant by conspicuously ordering tap water; the sincerity of his act is suspect, to say the least.

Among the banking titans who managed to keep their jobs, despite needing to be rescued by the Treasury Department, Federal Reserve, FDIC or some combination thereof:

• Ken Lewis, CEO Bank of America: $25 billion in capital and $118 billion loss protection.
  
  
• Vikram Pandit, CEO Citigroup (C): $25 billion in capital and over $300 billion in loss protection (although, to be fair, Pandit inherited a mess and his predecessor Chuck Prince was shown the door way back in late 2006).
  
  
• John Mack, Morgan Stanley (MS): $10 billion in capital, used in part to buy Smith Barney from Citigroup.
  
  
• Lloyd Blankfein, Goldman Sachs (GS): $10 billion in capital.
  
  
• John Stumpf, Wells Fargo: $25 billion in capital so his firm could keep paying its dividend, despite recording its first loss since 2001.

Meanwhile, layoffs in the financial sector have topped 100,000 in the past 2 years.

More troubling still: With last night's news of the possible creation of a “bad bank” to absorb the illiquid, worthless assets clogging up existing banks' balance sheets, most banks will continue to be run by the incompetent boobs who drove them to insolvency in the first place.

Okay, maybe "incompetent boob" is a bit harsh. To be sure, these men are well-educated, shrewd, and groomed for some of the most challenging jobs in the world of business. Nevertheless, their collective willingness to allow wild risk-taking, insane leverage and virtually non-existent risk management should at the very least cost them their current positions.

After all, now that we, the people, are shareholders in nearly every major financial institution in the country -- without any voting say as to how they’re run -- the least our elected representatives could do is kick out the incompetent boobs who got us here in the first place.

Freddie Blows Through Another $35 Billion

This post first appeared on Minyanville and Cirios Real Estate.

$100 billion just isn’t what it used to be.

Over the weekend, Freddie Mac (FRE) requested a second draw on its Treasury Department credit facility, saying $30-35 billion would suffice to keep its net worth above zero, thank you very much. After taking $14 billion in the third quarter of last year, Freddie has now chewed through almost half its $100 billion taxpayer-provided safety net in just 5 months.

According to Bloomberg, Freddie’s fourth -quarter operating losses triggered the need for additional funds, as its massive mortgage portfolio continues to sour. Analysts expect Freddie’s sister company, Fannie Mae (FNM), to request a similar draw when it announces fourth-quarter results in February.

As one analyst told Bloomberg, “[Fannie and Freddie’s] losses are going to be much higher than anyone anticipated. The more and more that people are digging into these portfolios, they’re finding out the more and more these guys were doing subprime and Alt-A loans and classifying them as prime.”

Defaults on prime mortgages, which are supposed to be given out to borrowers with good credit and stable jobs, are now increasing at a faster rate than the subprime loans that get so much headline play. According to the latest Mortgage Bankers Association Delinquency Survey, 2.87% of all prime loans were delinquent in the third quarter of last year, up 85% from the same period a year ago.

Keep in mind those figures are through September 2008 and don’t include the abysmal economic conditions of the past 4 months. And as layoffs mount and the economy continues to contract, the previously well-to-do are facing the same economic hardships those “subprime” people have been dealing with for almost 2 years.

Fannie and Freddie, despite not technically being involved in subprime lending, drove industry trends, and, in many ways, set precedents followed by the rest of the mortgage industry. Their drive to automate the loan underwriting process created massive opportunities for fraud. Both savvy and ignorant originators easily duped the system, jamming subprime borrowers into prime loans, which neatly showed up on bank balance sheets as AAA-rated assets.

The sieve-like automated systems were adopted by other big lenders, such as Countrywide, Washington Mutual, Bear Stearns, Lehman Brothers, IndyMac and Wachovia.

Now that none of those firms exist, loans originated under the guise of “prime” are turning out to be anything but. Bank of America (BAC), JPMorgan (JPM) and Wells Fargo (WFC), heretofore the strongest banks in the country, who absorbed many of those defunct lenders, are now faced with mounting losses on loans they thought were of the highest quality.

As I noted about this time last year, while everyone was so focused on subprime, prime mortgages -- a market about 4 times as large -- quietly presented a far bigger threat to the financial system. Now, as the government has bailed out 2 of the 4 remaining big American banks, those loans threaten the federal balance sheet.

Where's TARP 2 when you need it?

Falling Rents Signal Deflation

This post first appeared on Minyanville and Cirios Real Estate.

In recent months, headlines have been popping up noting that rents -- finally -- are beginning to follow home prices into the abyss.

Since the housing market began to crumble, would-be homeowners were forced to become renters, keeping demand for rental units relatively strong even as home prices fell. Now, however, as landlords convert condos into rentals, supply is beginning to move in tenants' favor.

And while this is welcome news for millions of renters around the country, its impact on consumer price measurements could materially impact mounting deflation expectations.

The reason can be found in the nuances of how the US Bureau of Labor Statistics measures the Consumer Price Index, or CPI. The CPI is the most widely quoted gauge of inflation, it being the easiest to explain to the consuming public. Tally up a basket of commonly purchased items, see how their prices compared to last month, then last year and voila! consumer prices at your fingertips.

In realty, of course, it’s a bit more complicated: Just take a gander at this sophomoric equation from a recent CPI release:



Riiiiiiiiiight.

The most heavily weighted item in the CPI is something known as Owners’ Equivalent Rent, or OER, which accounts for almost 24% of the total index. OER is the government bean counters’ preferred method for measuring the cost of owner occupied housing, calculated by figuring out how much the median homeowner in the country would have to pay to rent his or her family’s dwelling.

Many observers, Minyanville’s Professor Mish Shedlock included, believe the CPI has been understating inflation for years by ignoring housing prices. Now, that rents are beginning to fall, however, inflation readings could become dire.

As Professor Kevin Depew noted last week, the December CPI registered the lowest inflation reading since 1980. And while most media outlets touted the effect of dramatically lower energy prices, OER is quietly reversing a long-standing trend and contributing to the decline.

Examining the data, available on the BLS’ website, OER has been steadily trending upwards for years. Even though the housing market peaked in late 2005, OER rose in 2006, 2007 and even 2008. The rate of change, however, is slowing. Notably, in December 2008, OER rose just 0.08% from November, breaking from the rest of the year’s trend.

And while 1 month does not a trend make, the data support stories from Manhattan to Los Angeles of landlords giving into thrifty tenants shopping for the best deal. With mounting job losses and weak economic conditions persisting, this will be an important trend to watch in coming months. Property liquidations by big banks like Wells Fargo (WFC), Bank of America (BAC) and Citigroup (C) will add to housing supply, further pressuring rents.

CPI data matter, despite their myriad of potential problems, because of their effect on inflation expectations - or in this case, deflation expectations.

Federal Reserve officials, including Chairman Ben Bernanke, are wary of these expectations because they represent future consumer behavior. In a speech last summer, as energy prices rose to all-time highs, Bernanke said “Some indicators of longer-term inflation expectations have risen in recent months, which is a significant concern for the Federal Reserve.”

Fearful of higher prices in the future, consumers increase buying now, spurring demand and pushing prices up even further. The same is true the other way. If the public thinks prices will keep falling, they will delay purchases, waiting for a better deal down the road. This weakens aggregate demand, accelerating price declines.

So as rents, the largest component of the CPI, continue to fall, pricing measurements are likely to signal deflation, even as conventional wisdom calls for hyperinflation. And as a deflationist attitude gains currency, social mood continues to darken, and consumerism is shunned, lower prices will ultimately become a self-fulfilling prophecy.