Another subprime lending blowup

H&R Block released the following news late yesterday. I've highlighted some important passages ...

KANSAS CITY, Mo.--(BUSINESS WIRE)--Aug. 24, 2006--H&R Block Inc. today announced that it expects to record a provision for losses of $102.1 million (after-tax amount of $61.3 million or 19 cents per share) reflecting an increase to the estimated recourse liability recorded by Option One Mortgage Corporation for loan repurchases and premium recapture reserves. The expected provision includes $46.1 million related to loans sold during the quarter ended July 31 and an increase of $56.0 million related to loans sold in previous quarters. The Company expects to increase the estimated recourse liability primarily as a result of recent increases in loan repurchases from its loan sale transactions. The increased level of loan repurchases, which have been noted industrywide, are primarily due to a higher level of repurchase requests from loan buyers and an increase in early payment delinquencies.

I've seen the same kind of bad news about defaults and delinquencies from other subprime lenders like FMT and FICC. Frankly, this is a symptom of a problem I've discussed in a number of forums the past several months. Lenders have given too many easy-money mortgages to too many underqualified borrowers for too many overvalued homes. The repercussions could be severe.

You can read a column I wrote a little while back on the topic in our daily MoneyandMarkets e-newsletter. I also shared some insights recently with the New York Sun's Dan Dorfman.

Why I'm so freaking bearish on housing ... take 2

Again, a picture is worth a 1,000 words. This is the quarterly housing affordability index produced by the National Association of Realtors. Notice anything funny? Housing hasn't been this unaffordable since the tail end of the 1980s. And that's with interest rates (long-term ones, anyway) not that far off their lows.

My take: This isn't an interest rate story. It's a "rampant speculation + too much easy money = way too high prices" story. Declining rates could help cushion the blow of any housing market downturn. But then again, they might not. Plunging rates couldn't (for a long while) alleviate the massive capacity and inventory overhang of the tech boom and bust, and thereby cure the economy. We needed a fresh bubble in housing to do the trick.

But housing is DIRECTLY impacted by rates, as opposed to tech, which isn't, right? Well, yes. But what if people are just "spent up" on housing? What if the psychology changes (like it appears to be doing) and real estate is no longer viewed as a ticket to endless wealth. Might falling rates NOT spark a new housing run-up?

Let's go to the evidence: For yet ANOTHER week, a decline in mortgage rates (-15 basis points on the 30-year FRM) did NOT prompted a corresponding increase in home purchase activity (-1%), according to Mortgage Bankers Association figures. I talked about this anomaly a few posts back and said it was a "tentative" trend. Now, that trend is going on 7 or 8 weeks.

IF this continues, you're going to start hearing "pushing on a string" talk -- talk that no matter how much rates fall (either short-term rates controlled by the Fed or long-term rates set in the bond market), it won't matter -- buyers just aren't interested in buying any more. I'm not wiling to go that far yet. But you can be darn sure I'm watching these numbers very, very closely.

Why I'm so freaking bearish on housing ...

A picture is worth a thousand words. Here's a graph showing the supply of existing, single-family homes for sale, going back as far as I have data (late 1980s). Does this look maybe, just a tiny bit negative?

July Existing Home Sales tank

Ugly numbers out of the National Association of Realtors just now ...

The month over month decline in the sales rate was much worse than expected: down 4.1% from June vs. forecasts for a 1.2% decline. The sales rate of 6.33 million units looks like the worst since January 2004. Sales year-over-year were down 11.2%, also a deterioration from recent YOY declines.

Here's the real kicker: Total inventories increased AGAIN to a fresh all-time high of 3.86 million units. It's also up a whopping 39.9% YOY. And on a months supply at current sales pace basis, inventory ballooned to 7.3 from 6.8 in June. This is the worst reading in that regard since 1993.

OVERALL median prices DID eke out a gain -- 0.9% YOY. That's the same YOY increase as last month. But in 3 out of 4 regions of the country (Everywhere but the South), they did fall. And condo prices also declined again on a YOY basis, but by less (-1%) than in June.

What's the yield curve saying?

Every day, it seems the yield curve gets more deeply inverted. The federal funds rate (5.25%) is now higher than the yield on every kind of Treasury security. As a matter of fact, the yield on 5-year Treasury Notes (recently 4.77%) is almost 50 full basis points below fed funds.

Here's where it gets interesting: The Fed published a yield curve study a few years ago. It concluded that you can use the spread between 3-month Treasury bill yields and 10-year Treasury Note yields to estimate the probability of a recession within the next four quarters.

A year ago, 10-year notes yielded 69 basis points MORE than 3-month bills. That indicated a paltry 10% recession risk. Now, 10-year notes are yielding 27 basis points LESS than 3-month bills. That indicates about a 1-in-3 chance of recession. Stated another way, the odds of a big economic downturn have tripled.

Hard landing anyone?

Let's talk landings ...

"Soft" vs. "Hard" -- that is the question. It's no longer debatable, in my book, that the economy is slowing. The only question is, what kind of landing are we in for?

Wall Street is currently "buying" the soft landing story. That's clear from the big ramp this week in shares. And SO FAR, the evidence would agree. Jobless claims have risen from their lows, but not yet surged. Retail sales have cooled, but not yet tanked. Production has slowed, but not yet plunged.

But here's the problem, as I see it: Every HARD landing starts out looking like a SOFT one. Spending, employment, production don't shut down overnight. Picture a snowball rolling downhill -- it starts out small, then gets bigger and bigger, until ultimately, it steamrolls anything in its path.

I think the chance of a hard landing is much higher than investors appear to believe. The Fed helped inflate, then pop a massive stock market bubble in the late 1990s/2000. To "save" us from a serious recession, it then inflated the biggest housing bubble in U.S. history betwen 2001 and 2005. Now that bubble is clearly bursting.

Just look at the NAHB housing sentiment index I posted a little while back. Or this chart, which shows the seasonally adjusted annual rate of building permit issuance going all the way back to 1991. You'll see a whopping 15-year long trend in which permits were generally rising ... and then an absolute collapse. Is this the stuff soft landings are made of?

The verdict is still out of course. Maybe the rest of the economy will remain just fine and only the housing sector will suffer a recession. But color me skeptical.

Oh, and don't forget the message from the yield curve. Based on the Fed's own research, the current inversion between 3-month T-bill yields and 10-year Treasury Note yields (at about 21-22 basis points) is indicating a greater than 30% chance of recession in the next year. That's up dramatically from virtually nil in the past several months.

What if rates fell ... but home buyers didn't care?

That's a question I've been asking myself for a while. It's true that falling interest rates helped inflate the housing bubble early on. But after a certain point, a speculative mania attitude took over and powered housing higher FAR BEYOND what you would expect given the behavior of interest rates. Indeed, the Fed started raising short-term rates in June 2004, but housing didn't peak until July-October 2005.

Now, let's look at some interesting stats: The average 30-year fixed rate mortgage has come down in price by 26 basis points, from 6.8% to 6.54% between July 7 and August 11. That's a drop of 3.8%. The average rate on a 1-year adjustable rate mortgage has dropped 44 bps, to 5.97% from 6.41%. That's a drop of 6.9% (using Mortgage Bankers Association figures).

But during that same time, the Mortgage Bankers Association's purchase application index has DROPPED to 385.9 from 425. That's a decline of 9.2%. In other words, rates are falling but it is NOT prompting an increase in home buying activity.

So I ask you again: "What if rates fell ... but home buyers didn't care?" What if falling prices, surging inventories and a massive shift in buyer psychology keeps buyers on the sidelines even as rates fall? Food for thought.

CPI in a nutshell

The headline Consumer Price Index gained 0.4% in July. The core CPI rose 0.2%. Both numbers were roughly in line with expectations, though arguably, core was one-tenth below expectations. Initial reaction in 10-year Treasury notes is a 4 basis point decline. Long bond futures up 13/32.

Still, the year-over-year change in the core CPI actually increased to 2.7% from 2.6%. And inflation pressures were fairly broad-based, in transportation, education, recreation, and (not surprisingly) energy.

Home builder index takes Acapulco cliff dive

Aiiieeee!!! That's all I can say about the just-released numbers from the National Association of Home Builders. The NAHB's index plunged a whopping 7 points between July and August to 32. That's the lowest reading since early 1991 for this index. It's designed to measure buyer traffic, current builder sales, and the outlook for future sales.

Benign PPI

Have to call a spade a spade. The July Producer Price Index report was definitely tamer than expected. Headline PPI up just 0.1% on the month versus expectations for a 0.4% gain. "Core" PPI -- which excludes food and energy -- actually dropped 0.3% vs. forecasts of a 0.2% gain.

Seems a bit weird given what we know about energy prices in July, and there may be some "noise" in the numbers. Also, core intermediate goods and core crude goods were both up strong on the month and year-over-year. That's an indication of more inflation pressure in the pipeline.

But bonds definitely like the news in the early going. Long bond futures were recently up 23/32 in price. 10-year yields dropped 6 basis points.

When everybody's on one side of the boat ...

Treasury prices and Treasury yields have been largely rangebound these past several weeks. We've been trading between roughly 4.9% and 5.25%, yieldwise, on the 10-year note. In the past few days, however, the rally that sent 10-year yields roughly 35 basis points below the federal funds rate started petering out.

Fundamentally, retail sales were stronger than expected in July and we just learned that Europe's economy grew at the fastest rate in six years in the second quarter. Beyond that "big picture" stuff, it's worth pointing out that too many bond traders are loaded up on one side of the boat. Look at what Tony Crescenzi at Realmoney.com just had to say about the latest Commitment of Traders report on Treasury futures ...

"In the week ended Tuesday, large noncommercial traders added 63,000 contracts to their existing long position, bringing their collective net long to 261,215 contracts, the second-highest tally ever. The previous record of 263,723 was set in the week ended March 21, at the precipice of a large selloff in the Treasury market."

In short, the "dumb money" is super-long Treasuries on a bet that the Fed will engineer a perfect soft landing, with growth slowing enough to cool inflation pressures. We'll see this week if that's a sucker bet -- both the July Producer Price Index and July Consumer Price Index will be released.

They don't call 'em junk bonds for nothing...

If ever there's been a time to worry about junk bonds (also called "high yield" bonds by those in polite circles), it's now. Over the past few years, there's been a virtual orgy of buying in high risk paper. Buyers snapped up subprime mortgage bonds, higher risk corporate debt, anything that yielded more than Treasuries. Risk? Never heard of it.

All that buying drove the yield spread, or difference, between high risk bonds and Treasuries to extremely low levels. But the times, they are a' changing. Risk aversion is ticking up along with defaults, and there's the potential for some real losses in the next several months, if history counts for anything. A Bloomberg story said the following:

"Corporate defaults jumped and bonds with ratings below investment grade performed worse than Treasuries the previous four times the U.S. central bank ended a cycle of rate increases, according to data compiled by Merrill Lynch & Co. Junk bonds fell an average 5.12 percent in 2000, the last time the Fed stopped boosting borrowing costs, Merrill data show."

The story went on to say that past "spread blowouts" ranged from 49 basis points in 1995 to a whopping 263 bps in 1989. Consider yourself warned.

It just keeps getting "better" in subprime land

Another day, another "subprime" mortgage lender reporting dismal loan performance. This time, it's Fieldstone Investment (FICC), a relatively small player in the business. The 30-day delinquency rate in its mortgage investment portfolio ballooned to a whopping 7.2% as of June 30, up from 6.1% just one quarter earlier and 4.7% a year ago. FICC also talked about how the secondary market for high-risk loans, especially high loan-to-value second mortgages, continues to tighten.

You can read more here, if you like. Suffice it to say this is a major, major problem brewing behind the scenes. I followed the mortgage market back in 1998 at Bankrate.com. That's when the Long-Term Capital Management debacle caused the secondary market for mortgages to seize up. Subprime lenders couldn't sell off their loans (especially the 125% LTV seconds that were that period's "hot" mortgage), they didn't have enough cash on hand to survive, and many went belly up.

Even without a LTCM-magnitude debacle, this nascent credit tightening is definitely something to keep an eye on. The housing bubble is already popping ... through in tighter lending requirements resulting from a subprime industry mess and you've got a recipe for even slower sales. Food for thought.

30-year bond = lead balloon

The Treasury just sold $10 billion worth of 30-year bonds. Let's just say the sale went over like a lead balloon. The bid-to-cover ratio was just 1.77, down from 2.05 previously. That's a key measure of demand -- the higher the number, the more demand there is. The bonds also yielded 5.08% at the sale, above forecasts for 5.054%, according to Bloomberg. Another strike out.

Why such a poor auction? Well, would you want to lock up a pathetic 5.08% yield for 30 years when you can get roughly the same yield on 3-month bills and 1-year Certificates of Deposit .. with much less inflation risk?

Credit deterioration and what it means

One thing I've been closely watching is the potential for significant declines in credit quality. We all know mortgage lenders have been giving loans to anyone with a pulse. The subprime market has literally exploded, and as the overall market started slowing, lenders didn't pull in their horns. They just created more "affordability" products (40-year loans, option ARMs) and scraped the bottom of the credit barrel to keep loan volume humming.

Now, it looks like that is starting to come back to bite these companies. Take a look at Fremont General (FMT). Its shares are down in early trading on an earnings report rife with evidence of credit problems among its subprime borrowers. The full release is available here. But let's look at a couple of excerpts, with the important passages in bold ...

"The Company recorded these increased provision levels primarily as a result of increased loan repurchase and re-pricing trends from its previous whole loan sale transactions, as well as lower secondary market pricing for second mortgages. These increased loan repurchase and re-pricing levels, which have been noted industry-wide, are primarily due to increased levels of early payment delinquencies and a greater incidence of repurchase requests from whole loan purchasers. The Company's loan repurchases and re-pricings increased to $238.4 million during the second quarter of 2006, up from $67.7 million and $107.7 million for the second quarter of 2005 and the first quarter of 2006, respectively.

Given these loan repurchase and re-pricing trends, with an objective of reducing its early payment delinquencies, the Company made modifications in its loan origination parameters during the second quarter of 2006, including eliminating or reducing certain higher loan-to-value products and lower FICO bands. The Company expects to see the impact of these changes during the fourth quarter of 2006 and the first quarter of 2007."

In non-industry jargon, FMT is saying that borrowers are in such bad shape, they're barely able to make their first couple of payments, much less hold onto their homes and pay their loans off longer term. FMT is also saying that the ultimate holders of these loans (wholesale investors and buyers of Mortgage-Backed Securities, or MBS) are getting antsy. They're paying less to buy loans in the secondary market and they're demanding that original lenders buy back some loans that they sold because they're going bad so fast.

This is a big red flag. And please note the OTHER block of text highlighted -- the lender, FMT, is now TIGHTENING lending standards. The government has been trying to get companies to do this for a long time. But they've stuck to namby-pamby "guidance," rather than actually cracked down. Now, the market is (belatedly) starting to do it for them.

Needless to say, this is all too little, too late. The time to raise standards and take steps to avoid future defaults was last year, when the housing bubble started bursting. There is virtually no way many lenders to borrowers with bad credit can avoid a big surge in delinquencies, foreclosures, and loan losses. That's the next big surprise on Wall Street, as I mentioned in a recent Money and Markets email missive. And today's Fed meeting won't make ANY difference.

Questioning the "No more Fed = Buy bank stocks" mantra

"No more Fed = Buy Bank stocks."
"No more Fed = Buy Bank stocks."
"No more Fed = Buy Bank stocks."
"No more Fed = Buy Bank stocks."
"No more Fed = Buy Bank stocks."

That's what passes for deep, cogent analysis on CNBC and Wall Street these days. I don't know how many pundits have paraded before the cameras to say some version thereof.

But does this mantra really make sense? Banks are loaded up with more residential and commercial real estate loan exposure than at any time in history. They've been giving mortgages to anyone with a pulse. Is no one with half a brain concerned about credit deterioration, especially in a slowing economy?

Also, during the rising rate phase of the past couple years, I don't know how many bank stock experts said "It's different this time. These guys make all their money from fees, not the yield curve." Now, we're told "Buy bank stocks. If the yield curve steepens, they'll coin money." Again, am I the only one who sees a disconnect here? Won't fee income fall if banks are making fewer loans due to slumping home prices, cooling commercial borrowing needs, and all that?

One last question: If everyone "knows" to buy the financials when the Fed stops hiking, isn't there a good chance they've ALREADY bought their shares? What happens if the Fed DOES pause? Who's going to be left to buy? Just wondering out loud here.

Jobs data dissection

Some quick thoughts on this morning's July jobs report:

* Big rally in bonds off these jobs numbers in the early going. Report showed gain of below-consensus 113,000 jobs, a pop UP in the unemployment rate to 4.8% (highest since February) from 4.6%. Average hourly earnings (an inflation gauge) showed a 0.4% gain vs. the 0.3% forecast. But traders paid no attention.

* There were big gains in services employment (education, health care), but losses in manufacturing and residential construction (somewhat offset by gains in non-residential construction). Looks like manufacturing weakness was concentrated in tech, autos, textiles, and apparel.

There were plenty of jobs in finance (lots of global M&A, corporate debt sales, etc.) and transportation (shipping cheap goods from China and moving expensive commodities around the country). Lots of growth also in "You want fries with that?" jobs (food service/restaurants).

* An index showing how many industries added jobs vs. did not add jobs was the weakest since last September.

Buckle those seatbelts!

Tomorrow is the first of two major events on the interest rate front -- the non-farm payroll report for July (the other event is next Tuesday's Fed meeting).

Expectations are for job growth of 145,000 and an unemployment rate of 4.6%. Lots of pundits claim a good number = a Fed hike next week and vice versa. I'm not so sure. I think the Fed SHOULD hike given the inflation pressures out there, regardless of what this report shows. But we'll just have to see.

Incidentally, the Australian central bank, the Bank of England and the European Central Bank all raised their rates this week. Do you think "Gentle Ben" will give into peer pressure and do the same? After all, everybody's doing it right? :)

As the credit cycle turns ...

Two interesting stories on Bloomberg today regarding credit quality in the mortgage arena. I've excerpted the important stuff, and thrown my comments in at the end for good measure ...

* On Asset Backed Securities (ABS) -- which include bundles of second mortgages/home equity loans:

Aug. 2 (Bloomberg) -- Moody's Investors Service said the number of upgrades on U.S. asset-backed bonds last quarter fell to the lowest level in two years, reflecting an increase in mortgage payment defaults.

Upgrades accounted for only 14 of Moody's 113 ratings changes in the second-quarter, a 90 percent plunge from the first quarter and the lowest level since the second quarter of2004, Moody's analyst Zoe Wang said in a report released today ... Downgrades increased 70 percent from the first quarter, with three-quarters of the reductions tied to home equity companies, Wang said.

* On California loans going bad -- big time!:

Aug. 2 (Bloomberg) -- California home-loan defaults rose at the fastest pace in 14 years in the second quarter as slowing price appreciation made it harder for homeowners to sell and payoff mortgages, DataQuick Information Systems said.

Banks and other lenders sent 20,275 default notices to California homeowners in the second quarter, up 67.2 percent froma year earlier and up 10.5 percent from the first quarter, the LaJolla, California-based research company said in a statement today. It was the highest year-over-year increase since DataQuick began tracking defaults in 1992.

Bottom line: When you give loans to anyone with a pulse, you're begging to get hosed. And that's exactly what will likely happen to many mortgage companies and holders of junk mortgage paper. The industry is STILL underestimating the likelihood of a hard landing in real estate, as far as I'm concerned.