March 14, 2007

I Hear Nothing! I Know Nothing!

That's the way it seems to have been in the last twenty years, since Alan Greenspan first sat in the big chair at the Federal Reserve way back in 1987.

Even more so in the last five years.

During his term, the former Fed chairman was much like Sergeant Schultz on the 1960s hit comedy series Hogan's Heroes. Fans will recall that the good-hearted German POW camp guard would invariably look the other way after spotting all sorts of untoward behavior.

"I hear nothing, I see nothing, I know nothing!"

Once in a while a real crisis would develop, but somehow things always worked out.

In a story originating from Irvine, California (aka subprime central), new favorite economist Jim Svinth of Lending Tree wondered why regulators didn't catch on to all the hushed voices and sneaking around over the last few years and acted sooner to avoid the current subprime mortgage mess.

"That horse has left the barn," he commented, adding "the Federal Reserve should have acted three years ago."

It's hard to argue with that assessment or the timeframe.

Early in 2004 would have been an excellent time to have a look at what was going on in mortgage lending. The year before, significant problems were uncovered at both Freddie Mac and Fannie Mae related to derivatives and credit scoring.

The result? At the urging of the Fed chairman, a bigger share of mortgage debt was offloaded to Wall Street. As shown in the chart below and as noted here previously, "three years ago the GSEs were reined in and then the Fed hit the snooze button".

Wall Street firms and mortgage originators began digging tunnels, forging papers, and all sorts of shenanigans followed.

"I hear nothing, I see nothing, I know nothing!"

The Credit Suisse Mortgage Report

The chart above is from the new Credit Suisse paper on mortgage lending, available over at Bill Cara's blog Mortgage Liquidity du Jour: Underestimated No More (.pdf). It is a comprehensive, 67-page accounting of what has happened in the world of real estate finance over the last few years, likely to answer just about any question you might have on the subject.

See pages 52 through 55 for a review of what hasn't happened in the area of mortgage lending regulation - Recent Events May Force Regulators' Hand.

Apparently, back in 2004, it wasn't enough to have short- term interest rates at one percent with U.S. Treasury purchases by the Bank of Japan pushing the 10-year note to about 3.5 percent.

At this same time, mortgage lenders began making "liar loans" in huge numbers. That is, no-documentation and low-documentation loans that make up more than 80 percent of the next mortgage lending trouble spot - Alt-A loans.

What a good time everyone had while home prices rose. Like Sergeant Schultz, many looked the other way including those responsible for regulating the industry.

Now for the bad news - the current subprime mortgage mess is probably just the beginning and all that will be accomplished by new regulation will be to quicken the shakeout currently underway.

Home prices are probably going to go down. Maybe a lot. Here's why.

As noted in the recent report on delinquencies from the Mortgage Bankers Association, the highest rates of foreclosures are occurring in non-bubble states. As noted earlier this week here, the fastest rate of change in delinquencies is now occurring in some of the bubbliest areas.

One possible explanation is that prices have risen so high in bubble areas in recent years that distressed homeowners have still been able to sell and pocket some gains rather than go into foreclosure, though that may be changing.

The foreclosure report was for the fourth quarter of 2006 and if the more recent rate of change in subprime delinquencies is any indication, things are changing very quickly now.

As Mr. Svinth commented, everyone would have been much better off if lenders had been better regulated three years ago.

It looks like Congress is getting ready to do that now.