30 year fixed rates jump to 6.71%; Congress has reached agreement on rescue bill

Interest rates on Conforming 30 year fixed-rate mortgages rose to 6.71% on Tuesday, up from 6.44% last Friday according to HSH Associates. For 35 year from 1967 to 2002, 6.5% was the lowest the rates had been. Rates reached 18.8% during the 1982 recession. Rates jumped because of concern about the financial health of Fannie Mae and Freddie Mac.

The government is actively firming up plans to make the implicit government backing of Fannie Mae and Freddie Mac explicit.  The federal government has already proposed a rescue plan and Congress has reached agreement on the plan on Tuesday per a report on Bloomberg:

Under a modified version of proposals made by the Bush administration, the Treasury Department would gain authority to inject capital into the two largest U.S. mortgage finance companies, through loans and equity investments.

The Treasury would be barred from providing aid that would cause a breach in the federal debt ceiling under the agreement, a constraint aimed at limiting any taxpayer losses. The debt limit would be raised to $10.6 trillion from the current $9.815 trillion.

The legislation would also raise the limit on the size of the mortgages the companies may purchase. The new cap would be $625,000, or the median home price plus 15 percent, whichever is lower, Frank said.

A Congressional Budget Office estimate released today put the cost of Paulson's plan at $25 billion, a figure below the total that some lawmakers had expressed concern about.

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The Fed Minutes Spook the Market

The Federal Reserve's April meeting minutes were released today. They believe that the threat of the credit crisis has dissipated.

Although participants anticipated that further improvement in market conditions would occur only slowly and that some backsliding was possible, the generally better state of financial markets had caused participants to mark down the odds that economic activity could be severely disrupted by a further substantial deterioration in the financial environment.

The TED spread has lessened in recent weeks to under 1%, the lowest it has been since July 2007.

However, compared to January, the Fed's forecast has changed considerably. The projections of the Federal Reserve Governors and Reserve Bank Presidents for real 2008 GDP growth now range from 0.0% to 1.5% (down from 1.0% to 2.2% in January). The projections for the Unemployment rates range from 5.3% to 6.0% (was 5.0% to 5.5%). The projections for PCE inflation ranges from 2.8% to 3.8% (was 2.0% to 2.8%). The Core PCE inflation projections range from 1.9% to 2.5% (was 1.9% to 2.3%).

Due to the improvement in the Financial markets and the threats of inflation, the Fed signaled that they are probably done with the rate cuts. The possibility of the rate cuts combined with the gloomy economic projections spooked the markets today.

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Option ARM delinquencies continue to spike up; many borrowers are underwater

Indymac reported their first quarter losses today. They posted a loss of $184 million or $2.27 a share. Last quarter they announced that they expected to post a profit of $13 million for 2008. Today they reversed course announcing that they expect to lose money every quarter this year. They also released information on their non-performing assets.

In January, I had a detailed post on the intricacies of option ARMs. The delinquencies are continuing to surge. Countrywide's non-performing Option ARMs (non-performing loans are more than 90 days delinquent) jumped from 5.70% to 9.40% in just 3 months. In the beginning of the third quarter of 2007, Downey Savings launched a borrower retention program "to provide borrowers who are current with their loan payments a cost effective means to change from an adjustable rate loans subject to negative amortization to a less costly financing alternative. At March 31, 2008, approximately 91% of such borrowers had made all loan payments due." Any loans that were modified in that fashion are included in the Downey Savings' non-performing assets even they they may be current. Using this method, Downey Savings' non performing assets is at 11.90%. However that is more of an accounting measure than an accurate guage of delinquencies. Excluding those borrowers who are current but have received modifications, Downey Savings' non-performing assets jumped from 4.78% to 7.41%. 65% of Downey Savings loan portfolio is comprised of Option ARMs. This is down from December 31, 2007 when 74% of their portfolio was comprised of Option ARMs. Washington Mutual's non-performing assets went from 2.17% at the end of 2007 to 2.87% in the first quarter of 2008. 45% of Washington Mutual's portfolio is comprised of Option ARMs. Indymac's non-performing assets now total 6.51% up from 4.61% in the previous quarter. Option ARMs are now 29% of their portfolio held for investment, up from 22% last quarter. Wachovia's non-performing assets increase to 1.70% from 1.14%. As of the end of last year 46% of their residential mortgage portfolio was comprised of Option ARMs. Bank of America and Wells Fargo's non-performing assets increased more modestly rising to 0.84% and 1.16% respectively. Bank of America and Wells Fargo did not offer Option ARMs.

Since I posted the article on Option ARMs, there is some good news and bad news. The good news is the rates have come down quickly. A fully indexed rate on the Option ARM example I used is 5.125%. This is down from the peak of 8.375% where it was for seven months in the beginning of 2007. However, the 12 month MTA index is a 12 month average so it takes time to move up or down. The example loan with a first payment due in January 2005 in the previous post, had a beginning payment of $574.06 on a balance of $178,480. If the loan had a 110% recast and the borrower had made the minimum payments then the loan would have reset in February 2008 with new payments of $1,468.43. If the loan that had a 115% recast and assuming that rates stay the same as they are this month, then the loan won't recast until the end of five years (01/10). The payments at that time would be $1,196.80 (with a fully indexed rate of 5.125%).

The bad news is that the declining home prices have deteriorated faster. Using the Case Shiller CME futures to project future home prices, in January I posted that a borrower would owe 110% of what the house was worth at the end of 2009. Using the current futures prices they will owe 120%. The borrower in that example, will have been on a roller coaster ride. Their interest rate went from 5.375% to 8.375% and is now heading back down possibly to 5.125% or lower. Their house values went from $223,100 in January 2005 to $261,108 in June of 2006. In June of 2006 their CLTV was 79.2%. Their equity position went from their 10% down payment of $22,310 to an equity position of $54,359. Today, the example house would be worth $213,081 and if they made the minimum payments the whole time, they would now owe $221,226. They would have to bring in cash just to sell the property even without considering real estate commissions. The delinquency rates are spiking up on these option ARMs and the bad news is the majority of borrowers with these loans have not had their payments recast into fully amortized payments. At that point we will be moving into uncharted waters.

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Compounding Interest

Here is a hypothetical scenario I created to take a peek at the past returns of the S & P 500. I used the data collected by Robert Shiller as discussed in this post.

I took a person earning the Per Capita Income for the U.S starting to invest when they were 22 in 1965 and ending in 2007 at the age of 65. The Per Capita Income in 1965 was $2,563 and $33,712 in 2007. Using Shiller's S&P 500 index return and dividend yield for the last 43 years, if a person was to have saved 15%, they would end having accumulated $877,220. If a person was to save $100 a month and matched the S & P 500 return, then they would end up at $1,074,937. If a person was to save $100 a month and return 11% a year, then they would end up at $1,064,355. The S & P 500 has averaged returns of 11.15% from 1929-2007.

This illustrates the exponential nature of compounding interest. You can scroll down on this spreadsheet by using the scroll button on the right of the spreadsheet.

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Irrational Exuberance Part 2

I visited some of Robert Shiller's graphs on Home Prices from his book “Irrational Exuberance” in this post last month.

Here are some updated charts on the historical prices of the S & P 500 index that Robert Shiller pieced together going back to 1881.

You can see his data here. S & P has a spreadsheet with 20 years of data that they update regularly here.

The real question for the stock markets going forward will be earnings. Real earnings adjusted for inflation dropped by 50% from 2000 to 2001. They started dropping in the third and fourth quarter of 2007 after rising steadily from over the previous 4 years.

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