Credit Markets for Dummies / Bankers

Last week, I was complaining about the idiocy of the CEO's of the major banks in their sub-prime and general end-of-cycle lending practices. Although I thought that these folks should be smart enough to understand cyclical risk in mortgage lending, apparently it has escaped them.

While your servant is just a humble real-estate appraiser in his real life (and a former branch manager for Household Finance), I didn't think understanding changes in real estate values or basic credit lending (and hence, value at risk for a bank) was too complicated.

Apparently, though, I was mistaken. Hence, my new class, Credit Markets and Residential Real Estate Values 101. Now, I want the heads of Citibank, Bank of America, et.al. to stop goofing off, and sit at the front desks here.

Prince! Up Front!! What? You've been canned? (oops, "resigned under pressure") Well, all the more reason to sit up front here. Now pay attention!

This is pretty simple.

1. First of all - don't lend to people who can't afford to repay you - yes, over the long term - not just based on the teaser rates!


2. Check their references - i.e. confirm their income, debts, payments, etc.


3. Medium-to-longer term changes in real estate values (which is really what the bank's security is predicated upon) is based almost completely on just three factors. Pay attention to those factors, since they can affect values!

The three factors affecting the medium-term plus value of real estate are:

a. Changes in population in an area;

b. Changes in after-tax income;

c. Changes in interest rates.

Prince, note that unsustainable changes or trends (as an example, interest rates at historic or near historic lows, eg 2001-2005) will have the effect of exagerating short-term property values. Meaning, in the context of real estate values, circa 2002-2007, they are likely to become OVERSTATED due to "c" above. And thus impair balance sheets.

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No one could have predicted this? I pull some narrative commentary from my own appraisals dealing with values in 2003 ...

"... the local housing market continues to set records, fuelled by both low interest rates, and a relative shortage of product."

... in 2004 ...

"Lending rates remain at near-historic lows, and continue to support economic activity of all kinds, but low rates are well-known to provide significant boosts in pricing and activity in the housing sector."

... and in 2006 ...

"Lending rates remain at near-historic lows, and continue to support economic activity of all kinds, but low rates are well-known to provide significant boosts in pricing and activity in the real estate sector."

Prince, Prince!! Pay attention.

JW

The Confused Capitalist

Dancing Hippos - Inflation and Subprime Cleanup

The "unforeseeable" crash in the sub-prime market has resulted in central banks around the world both lowering their lending rates, and to agreeing to co-ordinated activity to ensure the credit markets don't freeze up again.

Unfortunately, while necessary, this has all the hallmarks of weening the alcoholic off the juice, by just letting them have a little bit more to limit the potential for the D.T.s

I still don't understand how most of these large banks got caught up in the lending to extreme value-to-loan ratios that characterizes the end of many mortgage lending cycles. Were ALL the CEO's drunk? Can they not figure out what lending at low rates for long periods of time does for real estate prices? Do they not read? Are they completely ignorant of both Econ 101 and history? Can they not predict a cause and effect scenario for real estate values? Are they stupid? Unable to think for themselves?

Keeping Fed Rates at 2% or below, as was done from Nov 6, 2001 to Dec 14, 2004 for over three years, is unprecedented in the past fifty years. In the late 1950's and early 1960's, there were three periods where the Fed Rate was 2% or under, but none of these periods exceeded 9 months in duration. (See for yourself).

A simple scaling-back of loan-to-value ratios as rates began to rise - and in response to the booming real estate price increases - would have both protected the banks capital and balance sheet and, as a group, protected society from this mess. Instead, we're all destined to pay for this fiasco, surely through higher inflation rates, if not in other ways.

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Ultimately, the unwinding of the party of these drunken sailors will have implications on nascent inflation, something that'll probably take even longer to unwind than the couple of years the credit market will be in the sick bed for. One of these two "dancing hippos" may well cause further damage as they twirl about the room with abandon.

Aside from Greenspan, there are many others implicit in this whole mess, including a lot of people who should know better. Maybe Citigroup et. al. needs to open its own form of McDonalds "Hamburger University". Credit Markets 101.

Merry Christmas - bah humbug!



JW

The Confused Capitalist

Betcha a $Billion or two ... Warren Buffett buys more bank stock

Filings covering the period ending September 30 2007 showed that Berkshire Hathaway added to stakes in three large U.S. banks with increased stakes in Wells Fargo & Co (NYSE:WFC), U.S. Bancorp (NYSE:USB) and Bank of America Corp (NYSE:BAC).

Between then and now, prices in two of those three banks fell by around 10% at one point or another, while stock in US Bancorp was available at around the same price as its lowest price in the quarter ending Spetember 30th.

Given Mr. Buffett's well-known penchant for buying discounted, out-of-favour stocks, do you think his next filing will show he added to those positions with his ~$40 Billion cash hoard?

Betcha a billion or two he did.

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JW

The Confused Capitalist