But what is more important: the actual inflation rate, or what people perceive is the actual inflation rate?

The predominant view at the Federal Reserve remains that the underlying rate of inflation is not on the verge of a dangerous acceleration, but mounting public concern about inflation has increased markedly, and yes, this can cause rates to creep higher in a preemptive fashion.

The Fed is more attuned to high unemployment (although it is not the Fed’s responsibility to increase jobs), a depressed housing market, relatively sluggish economic growth and downside risks to the expansion.

Many are quick to point out that conducting monetary policy is difficult when the economy is sluggish. But it’s very difficult when inflation, or fears of inflation, begin to pick up. The futures market believes that the odds of the Fed leaving overnight rates near 0% through August are higher than 90%. One can look for continued Fed pronouncements that the risk of inflation is low… until it is not.

So what does it mean to our mortgage business (rates) if Europe “tightens its belt”? This would actually continue to help our rates since it would slow the recovery in Europe, reduce the chance of inflation around the world, and allow our Fed to keep short-term rates low (monetary policy to be more accommodative) for longer than expected. A stronger US dollar is good for keeping inflation down.

What Does Negative Bond Convexity Mean?
It is a fact of life that after Monday and Tuesday even the calendar says “W T F…” It is Thursday, which means Jobless Claims. But for mortgages yesterday, they “widened”, and there was some “convexity related buying” as 10-yr yields moved down near 3.50%. What does “negative convexity” actually mean? With price volatility increasing, it helps to know. In the past, mortgage prices would compress into rallies and expand into sell-offs, relative to US Treasury prices. Yesterday, for example, current coupons mortgages were “wider” versus Treasuries.

Remember that for fixed income instruments, when rates go up, prices go down, and if rates go down, prices go up – simple! But if the bond is “callable”, meaning that the issuer can pay it off, like a borrower and a mortgage, as interest rates fall, the incentive for the issuer to call the bond at par increases; therefore, its price will not rise as quickly as the price of a non-callable bond. In fact, the price of a callable bond (like a mortgage) might actually drop as the likelihood that the bond will be called increases. This is why the shape of a callable bond’s curve of price with respect to yield is concave, or “negatively convex.” A very simple way to explain it is that mortgages pay off when rates drop, just when servicers and investors don’t want them to pay off, so mortgage prices don’t improve as much in a rally as, say, a Treasury bond.

U.S. Bonds News Summary
On Wednesday the flight to quality, fortunately of holders of US debt, continued with our fixed income securities rallying in price and dropping in rates to December levels. Notes and bonds rose .5 in price by day-end, and mortgages improved by .250. As a quick aside, the U.S. Treasury cuts its debt offerings for the first time in three years and reduced its overall planned sales for its upcoming quarterly refunding due to a growing economy. Next week’s quarterly refunding was cut to $78 billion from $81 billion in the previous quarter: $38 billion of 3-yr notes, $24 billion 10-year notes, and $16 billion of 30-year bonds. The frequency of auctions of 10-year TIPS will increase from four to six to meet increased market demand.

Freddie Mac Reports Loss
Freddie Mac reported a net loss of $6.7 billion in the 1st quarter of 2010 (compared to a loss of $9.9 billion a year ago) and needs an additional $10.6 billion in assistance from U.S. taxpayers. Freddie has gone for three straight quarters in not needing any cash infusions from the Treasury. Analysts point to a change in accounting rules whereby starting this year companies like Freddie are required to move all mortgages they guarantee – but don’t own – onto their books. This shift alone caused Freddie’s equity to drop by $11.7 billion, and when combined with the firm’s loss and a $1.3 billion dividend payment to the Treasury, led to the red ink.

Job Report Preview
Turning to our employment picture, yesterday we had the ADP National Employment report, which measures private sector employment, today we had Initial Claims, and tomorrow we Non-farm Payroll numbers. The ADP number has always had a reputation for being a dubious predictor of the Non-farm Payroll number (under or overestimating it for long stretches) although it was pretty accurate from Dec-Feb. The four-week moving average of Initial Claims yesterday, generally thought to be a better measure since it irons out weekly volatility, are much better than they were a year ago but still high on a relative basis. Deutsche Bank reminds us that other employment measures are improving: employee tax receipts, corporate profits per worker, lay-offs have decreased, temporary hiring has picked up, etc. Forecasts for tomorrow’s April number seem to be running around+225k or +150k excluding census workers, with the unemployment rate perhaps moving lower to 9.6% versus 9.7% in March.

Economic Stat Roundup
Today we will have another day of credit crisis hearings in Washington DC, along with a number of Fed speakers. The economic news scheduled is pretty much limited to Initial Claims for Unemployment and a Productivity/Unit Labor Cost number, both already out. Initial Claims were expected to drop slightly. Jobless Claims indeed came in at 444,000, with Continuing Claims dropping somewhat, and the 4-week moving average dropped by 4,750. Productivity rose to a level +3.6%, and Unit Labor Costs were reported as declining. After this news the yield on the 10-yr is at 3.56%, and mortgage prices are better by between .125 and .250, depending on coupon.

Daily Humor
A man dies and goes to hell. There he finds that there is a different hell for each country.
He goes to the German hell and asks, “What do they do here?”

He is told, “First they put you in an electric chair for an hour. Then they lay you on a bed of nails for another hour. Then the German devil comes in and whips you for the rest of the day.”

The man does not like the sound of that at all, so he moves on.

He checks out the American hell, as well as the Russian hell and many more. He discovers that they are all more or less the same as the German hell.

Then he comes to the Greek hell and finds that there is a long line of people from all nationalities waiting to get in. Amazed, he asks, “What do they do here?”

He is told, “First they put you in an electric chair for an hour. Then they lay you on a bed of nails for another hour. Then the Greek devil comes in and whips you for the rest of the day.”

But that is exactly the same as all the other hells. Why are there so many people waiting to get in?”

He is told, “Because the maintenance crew is always on strike, there is no electricity so the electric chair doesn’t work; Albanians have stolen all the nails from the bed; and the Greek devil is a former Greek government employee, so he comes in, signs the register, and then goes to have his kafethaki (coffee) and eat kourabiethes (cookies) all day.”

Excerpted below are some estimated credit score hits a borrower would take by being late on their mortgage, and eventually going into foreclosure and/or bankruptcy. These are based on models from Fair Isaac, one of the three major credit bureaus … in other words, these aren’t real consumer scores. But it’s still a useful ballpark for debt-strained consumers who need scenarios of what might happen to their credit score. Every profile will be different based on overall credit profile, and the recovery time to get back to a favorable score vary based on credit history prior to the derogatory filings. Derogatory reports remain on the credit scores for 7 years (and in the case of bankruptcy, it’s 7 years from the time of discharge), but if an otherwise top-tier credit score consumer is hit by default, foreclosure or bankruptcy, their score can rebound in less than half that time if they resume a well-maintained credit profile immediately.

Recently, Fair Isaac, which developed FICO scores, pulled back the curtain a bit, revealing some estimates of point-score declines following mortgage delinquency problems.

Here are the average hit your credit will take:

30 days late: 40 – 110 points

90 days late: 70 – 135 points

Foreclosure, short sale or deed-in-lieu: 85 – 160

Bankruptcy: 130 – 240

To come to these figures, Fair Isaac created two hypothetical consumers, one who starts out with a fair-to-middling score of 680 and the other with a very good one of 780. (FICO scores range from 300 to 850.)

The hypothetical person with the 780 FICO has 10 credit accounts versus six for the 580, plus a longer credit history, lower utilization of total credit limit and no missed payments on any account. The other consumer has two slightly damaged accounts. Neither have any accounts in collection or adverse public records.

“It used to be that we could ‘underwrite’ a loan and use common sense to navigate individual circumstances and actually make a decision that a loan was a good credit risk. Then DU and LP [Fannie and Freddie's automated underwriting engines] came along and gave us the laundry list that had to be followed. We were still able to manually underwrite loans for those transactions that did not fit the box. Then the bottom fell out of the business and everyone got scared and new rules came out. Investors and Wall Street were to blame for allowing individuals who were not telling the truth to buy homes. Today investors are pre-underwriting loans prior to purchase and we have to ‘march to their tune’ including getting pieces of paper that seem ridiculous, but since we need the investor to purchase the loan so we obtain them anyway. Only the most qualified borrowers with all their ducks in a row get loans these days. Manually underwritten loans are subject to scrutiny such as we have never seen before and frankly, we do not have the courage to paint outside of the lines because we cannot afford to have a loan purchase refused. Today, it takes two to three times as long to underwrite a loan and we have checklist upon checklist that help us make sure all of the i’s are dotted and the t’s are crossed. I have been doing this for over 30 years and frankly we are back to the rules of the early 80′s or worse when it comes to documentation.”

And Even More On Why Loan Approvals Are So Hard
Speaking of analyzing credit, are you ready to have an underwriter at the closing table? In Fannie’s latest letter to lenders, the company states, “Borrower Credit – Undisclosed Liabilities: Lenders are responsible for determining that all debts incurred or closed by the borrower, up to and concurrent with settlement on the subject mortgage loan, are disclosed on the final loan application that is signed by the borrower at closing. These debts must be evaluated and included in the qualification for the subject mortgage loan. Lenders must have adequate internal controls and processes to support this requirement.”

Overview of ‘Millennial’ Consumers Ages 18-29
What is a “millennial”? It is anyone currently age 18-29, and the Pew Research Center released a comprehensive study of the 50 million people in the millennial generation, which is useful to anyone trying to reach this audience. But doesn’t this group contain the next critical segment of potential borrowers? They tend to be pro-government Democrats, liberals, likely to not join a church, favoring non-military solutions, and very diverse: only 60% white. (38% of them have tattoos, and of those, half have more than one.) The millennial generation says older people have better moral values and a better work ethic. 68% believe that either now or at some time in the future they will earn enough money to lead the kind of life they want, higher than previous generations even though they have this high level of unemployment. 1 in 8 have moved back home after college. Most of their education about ads, trends, and news comes from the web, through Facebook, Twitter, blogs they find their information from these sources.

The Tail-End of the Fed’s MBS Program
The market has twenty trading sessions before the cessation of the MBS purchase program. Traders believe that mortgage rates should increase, most noticeably in the lower coupon, current production area. At this point, besides the Fed, traders are not seeing much buying outside of some hedge funds and money managers for current coupon product. There was some hope that with the agencies buying delinquent mortgages out of pools, demand would pick up, but so far they have seen little interest in spite of the ultra-clean current production. Possibly their reinvestment decisions are now going to coincide with the end of the fed program. Much of this community is concerned with higher yields because of this and the overall macro environment.

Unexpected Increase in ISM, Beige Book, Unemployment Predictions
Mortgage prices got off to a softer start Wednesday as the Non-Manufacturing ISM number showed an unexpected increase. The 8:15AM EST ADP employment number suddenly had analysts lowering their forecasts for tomorrows Non-Farm Payroll number, and the estimates now seem to be -60,000 jobs with an unemployment rate of 9.8%. Yesterday, as stocks lost some steam and the results of the Beige Book came out, bonds rallied somewhat and mortgage spreads tightened, and investors produced some intra-day price improvements which were welcomed. The Fed’s Beige Book (which is literally beige, but is a report of the various Fed districts) showed some improvement but with soft labor markets and a weak commercial real estate sector.

Today we have Jobless Claims, some productivity numbers, and Factory Orders, along with the Treasury announcing the amounts of next week’s 3, 10, and 30-year auctions. And tomorrow we could see some volatility with the unemployment data. Greece is still in the spotlight as investors are still wary, but most agree that a bailout is likely with Greece issuing a 10-yr note and a meeting scheduled for tomorrow between the Greek Prime Minister and the German Chancellor. Currently the US 10-yr is, once again, hovering around 3.62% and current coupon mortgage prices are roughly unchanged.

Daily Humor
(Warning: PG)
One dark night outside a small town on the Wisconsin – Minnesota border, a fire started inside the local chemical plant and in a blink of an eye it exploded into massive flames. The alarm went out to all the fire departments for miles around.

When the volunteer fire fighters appeared on the scene, the chemical company president rushed over to the fire chief. “All our secret formulas are in the vault in the center of the plant. They must be saved. I will give $100,000 to the fire department that brings them out intact!”

But the roaring flames held the firefighters off.

Soon, more fire departments had to be called in as the situation became desperate. In the distance, a lone siren was heard as another fire truck came into sight. It was the nearby Norwegian Rural Township volunteer fire company composed mainly of Norwegians well over the age of 65. To everyone’s amazement, the little run-down fire engine roared right past all the newer sleek engines that were parked outside the plant and, without even slowing down, drove straight into the middle of the inferno.

Outside, the other firemen watched as the Norwegian old-timers jumped off right in the middle of the fire and fought it back on all sides. It was a performance and effort never seen before. Within a short time, the Norse old timers had extinguished the fire and saved the secret formulas.

The grateful chemical company president announced that for such a superhuman feat he was upping the reward to $200,000 and walked over to personally thank each of the brave fire fighters. The local TV news reporter rushed in to capture the event on film, asking their chief, “What are you going to do with all that money?”

“Vell,” said Ole Oleson, the 80-year-old fire chief, “Da first ting ve gonna do is fix da brakes on dat focking truck!!”

Q: Are FHA loans even relevant for the San Francisco Bay Area?
A: Yes. In the 9 county San Francisco Bay Area, FHA loan limits are $729,750. With a 3.5% down payment, this translates into a $756,217 home purchase price. So on a condo with $350 HOA dues, all-inclusive pretax monthly costs are $5632 and all-inclusive cash-to-close is $46,172. With a 10% down payment, this translates into a $810,833 home purchase price. So on a single family home, all-inclusive pretax monthly costs are $5405 and all-inclusive cash-to-close is $103,252. Cash-to-close figures include 8mo prepaid taxes and 1yr prepaid insurance. About $145,000 gross annual household is needed to qualify for these scenarios.

OVERVIEW OF FHA LOANS

Q: What are FHA home loans?
A: FHA home loans are mortgages best suited for borrowers with steady income but without 20% down payments, including first-time buyers, individuals or families trying to conserve cash, and early-career buyers. They’re also well suited for borrowers with past credit problems.

Q: Does FHA lend money?
A: The FHA guarantees your loan but doesn’t lend money. An-FHA approved lender approves and funds the loan. The FHA’s role is to guarantee the loan if the borrower misses payments or goes into foreclosure.

Q: Do FHA loans benefit lenders or borrowers?
A: Both. If the borrower misses at least 4 payments, the FHA can help them get current. If troubled borrowers qualify for this one-time FHA default assistance but then eventually go into foreclosure, the FHA covers the debt for the lender. Since this reduces lender risk, lenders can offer very attractive rates and down payment terms to FHA borrowers.

Q: What’s the catch? How can the FHA guarantee these loans?
A: All FHA borrowers pay a Mortgage Insurance Premium (MIP). Currently, FHA loans have 1.75% up-front MIP and 0.5% to 0.55% monthly mortgage insurance. These percentages are based on loan amount. The FHA’s MIP fund—not taxpayer dollars—is what enables them to back loans for borrowers and lenders.

Q: Are these MIP fees permanent?
A: No. Monthly MIP is paid for at least 5 years. At or after 5 years into a 30yr fixed FHA loan, if the borrower’s FHA loan reaches 78% of the original purchase price, the monthly MIP goes away. The up-front MIP will be refunded on a prorated basis if borrower refinances into a new FHA loan within 36 months. Up-front MIP can be financed, paid in cash, or covered by a seller credit.

Q: Are these MIP fees tax deductible?
A: Under existing legislation, FHA MIP fees are tax deductible on purchases and refinances through 2010. Single people with adjusted gross income (AGI) of $50,000 or married couples with AGI of $100,000 can deduct all monthly and some up-front MIPs on their Federal tax filings. Note that many elect to finance the up-front MIP for budget reasons, which makes that portion fully deductible under the mortgage interest deduction rules. The tax deductible amount phases out between $100,000 and $109,000 AGI. Consult a licensed tax professional on all tax issues.

FHA LOAN TYPES & RATES

Q: What kinds of FHA loans are available?
A: The most common FHA terms are 30-year and 15-year fixed loans. These loans have no prepayment penalties and are assumable.

Q: How are FHA rates?
A: FHA rates are the same and often lower than Conventional Conforming loans. Currently 30-year FHA rates for loans up to $417,000 are about 5.0%. Rates on loans from $417,001 to $729,750 are about 5.25%.

Q: Can I use FHA loans for investment property or second homes?
A: No. FHA loans are for owner-occupied property only. Borrowers must move into the property within 60 days of closing a purchase, and must occupy the property for at least 1 year.

QUALIFYING BORROWERS FOR FHA LOANS

Q: What are the basic qualifying rules for FHA loans?
A: FHA loans allow down payments as little as 3.5% (depending on property—see property section below). To qualify, a borrower’s total monthly housing obligation (mortgage payment, taxes, HOA/insurance, mortgage insurance) plus all other debt (credit cards, student loans, car loans, etc.) shouldn’t be more than 45% of their income. There’s some flexibility on this “debt-to-income” ratio for borrowers with strong credit or larger down payments.

Q: Do borrowers need money left over in reserves after they close?
A: There are no reserve requirements for FHA loans, though ever borrower should strongly consider their reserves in relation to their monthly obligation.

Q: How is income verified?
A: For salaried employees, 2 years of W2 forms and 1 month of paystubs are required, and income is calculated off of current base salary. For commissioned or bonused employees, two years of full federal tax returns and 1 month of paystubs are required, and income is calculated off base salary plus an average of bonus/commission of the last two years plus year-to-date.

Q: How are assets verified?
A: All assets must be verified using 2 months bank statements. Abnormally large deposits, whether gift funds or anything else, must be fully paper-trailed and adequately explained.

Q: Are gift funds allowed? Are co-signers allowed?
A: Gift funds for some or all of cash-to-close are allowed from family members or friends that can be proven as long-term relationships. Co-signers are also allowed, and the co-signer doesn’t have to live in the property. Primary borrowers’ and co-signers’ profiles combine to form the target 45% debt-to-income ratio. The full loan amount and payment will show up on the co-signers credit report.

Q: Are co-signers allowed?
A: Co-signers are also allowed, and the co-signer doesn’t have to live in the property. Primary borrowers’ and co-signers’ profiles combine to form the target 45% debt-to-income ratio. The full loan amount and payment will show up on the co-signers credit report.

Q: Are seller credits allowed?
A: Yes. Seller can credit up to 6% of sale price toward cash-to-close (which includes closing costs, prepaid items, and mortgage insurance). It’s critical to let lender know about possible seller credits prior to submitting an offer so lender can advise on how to apply seller credits to maximize budget and tax benefits.

QUALIFYING PROPERTIES FOR FHA LOANS

Q: Are there special FHA qualifications for single family homes?
A: Not really. Single family home approvals for FHA loans are similar to Conventional loans. If the purchase contract or appraisal calls for pest work or deferred maintenance, this work will need to be cured prior to funding.

Q: Are there special FHA qualifications for condos?
A: Yes. If a condo project isn’t FHA approved, a unit-specific “Spot Approval” is allowed for a a specific condo unit a borrower wants to buy up until February 10, 2010, which includes this partial list of requirements: project must be 4 units or larger, 90% sold, 51% owner-occupied, and no single entity can own more than 10% of the project. Unit owners must be in control of the HOA for 1 year, and the HOA must have roughly 50-60% of annual budget in reserves. The borrower’s lender does the Spot Approval and the borrower can close a transaction within a normal 25-30 day escrow period.

What happens to non-FHA approved condos after February 1, 2010?
A: Effective with any transaction from February 1, 2010 forward, the unit-specific ‘Spot Approval’ process for FHA condo loans is eliminated by HUD, and HUD will directly approve entire condo projects; once they have approved a project for one lender, all FHA-direct lenders can lend on that project. As of print date on this Q&A (see last page) HUD is taking 8 weeks to approve condo projects for FHA loans, this queue is likely to grow significantly after February 1, 2010. If a buyer who is looking for an FHA condo loan on a non-FHA approved project (see next question for more on already-approved projects), they should plan to be in contract on a Spot Approval-eligible project by January 29.

Q: What if the condo is FHA approved? Is the process different?
A: Yes, it’s different. An FHA-approved condo project might be simpler because the approval guidelines are published on HUD’s condo website, and new developments under one year old don’t fall out like they might based on Spot Approval guidelines. Currently, there are two big issues to be aware of:

(1) Any project shown on this site as approved before February 2009 will have to be re-approved per the February 1, 2010 guidelines noted above. A condo developer or HOA can call the FHA Resource Center at 1-800-225-5342 for information about how to submit an approval package. Homebuyers/borrowers can also ask their Realtor or lender about specific projects they’re interested in. Some lenders can work with HOAs and developers to help get their condo projects approved.

(2) If a new development doesn’t have a “2-10 Warranty,” a 10-year insurance policy covering latent defects throughout the building (which many new projects don’t because of cost issues), FHA limits down payments to no less than10%. Again, borrowers should have their lenders and/or Realtors do an initial check for compliance with core guidelines BEFORE submitting an offer on a condo even if it is on the FHA-approved list.

Q: Where does someone find out of a condo project is FHA approved?
A: On the HUD website for condo FHA-approved condos. As of this publication date, only 16 condo projects in all of San Francisco are approved. This is why Spot Approvals are critical.

Q: What about 2-4 unit TIC properties? Are those FHA eligible?
A: Yes. A group of borrowers can buy a 2, 3 or 4 unit building with FHA financing, but the group must vest as Joint Tenants. Commonly used Tenants In Common vesting isn’t allowed. So if unit sizes dictate different ownership shares, the TIC agreement has to spell this out. However, in the event of a dispute between owners, establishing the parties’ “true” ownership shares may become complicated. As with any TIC purchase, borrowers need to reconcile FHA lender rules with advice from the attorney advising on their TIC agreement. Note: certain TIC attorneys may not yet be aware of these FHA vesting rules since FHA is so newly relevant.

Q: Can someone get an FHA loan to buy 2-4 units (to live in 1 unit and rent others)?
A: Yes. For 2 units, this is possible but if total financing is above 75% of value, borrower(s) can’t use non-occupant co-borrower(s) to qualify—they must qualify on their own. For 3-4 units, fair market rents (determined by appraiser) for all units must be enough to cover total monthly cost of the property.

PRE-APPROVAL PROCESS FOR FHA LOANS

Q: What should borrowers do if they want to use an FHA loan?
A: Below is a list of the most important things borrowers need to do for a smooth transaction.

• Get pre-approved by an FHA-direct lender before looking at properties. A good pre-approval means borrower is ready to close, leaving only property approval prior to loan documents and funding.
• Tell lender about every property you are serious about so they can look into any potential issue on each specific property BEFORE you write an offer.
• Make sure Realtor and lender know if you’re seeking seller credits—credits must be assigned to line-item cash-to-close items prior to loan submission, and proper application of credits in advance can have significant monthly payment and tax benefits.

What Are Fed Funds?
What are Fed Funds? These are cash balances held by banks with their local Federal Reserve Bank, typically involved in an “inter-bank sale” of a Fed fund deposit for one business day – overnight. And the Fed Funds Rate is the overnight interest rate charged by those banks with excess reserves on hand. Why would this impact the mortgage rate that James & Jen Borrower pay on their mortgage? They don’t, directly, since the credit profile of a borrower, or house, is more complicated and riskier than a bank with excess funds, and an overnight rate is obviously different than a 30 year rate.

As was expected, the FOMC kept its central message and the Fed Funds rate unchanged, noting that “economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” Of course the current economic conditions are low rates of resource utilization, subdued inflation trends, questionable housing situation, a weak labor market, and stable inflation expectations. The FOMC (Federal Open Market Committee) reduced the size of their Agency debt (bonds issued by the agencies, not directly backed by mortgages) purchase program to “about” $175 billion from $200 billion, but is still set on purchasing $1.25 trillion of agency mortgage-backed securities. Even with this adjustment the Fed balance sheet should peak above $2.6 trillion at the end of March 2010. Yesterday Wall Street dealers reported that mortgages have maintained their bid all session as sellers have been few and far between.

The Fed sees some signs of life, just like all of us do, in certain parts of the economy, and inflation not being an issue. Conditions in financial markets were roughly unchanged, but activity in the housing sector has increased over recent months. “Household spending appears to be expanding but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit.”

Fannie Mae Changes
Fannie Mae will never be accused of not giving clients enough notice on changes. Instead of starting March 1, and now starting July 1, 2010, Fannie will “require the submission of electronic appraisal reports and their addenda in an acceptable XML format for all loans requiring an appraisal report. In support of electronic appraisal delivery, Fannie Mae is updating the 2000-Character Loan Delivery File Format.” Fannie letter goes on to list the fields and identifiers in question.

GMAC Loss
GMAC, to whom some lenders sell loans and warehouse with, reported a third-quarter loss tied to mortgage defaults. The net loss from continuing operations was $671 million, compared with $2.5 billion a year earlier, and was the eighth loss in nine quarters. Their Residential Capital LLC unit was specifically mentioned. GMAC received $13.5 billion in two rounds of taxpayer bailout funds and was negotiating a third infusion last month with federal regulators – expected to be announced on Monday. Res Cap’s loss narrowed to $747 million from $1.95 billion a year earlier. GMAC is boosting deposits at its Ally Bank unit to help fund new loans.

Radian Loss
Radian Group, one of the top MI companies, reported a net loss for the quarter ended September 30 of about $70 million versus net income of about $37 million a year ago. Their chairman said, “We are encouraged by Radian’s lower-than-expected claims activity again this quarter, and the consistently high-quality, lower-risk mortgage insurance business we added to our book.” The mortgage insurance provision for losses of $376.5 million reflects higher delinquency counts and the continued aging of delinquencies. (Radian expects delinquencies to continue to rise during the fourth quarter.) MI paid claims were $243.2 million, which again were lower than the company’s forecast, and consisted of $210.1 million of first liens and $33.1 million of second liens and Radian has reduced its claims-paid expectations from the $1.1 billion range, to a current estimate of $940 million, which includes $87 million of second-lien termination payments. And their current book of business ($3.4 billion in the last quarter) for new mortgage insurance written includes 99.9% prime credit quality and 74.6% with FICO scores of 740 or above.

Condo Lending Guidelines for Union Bank
Union Bank of California, owned by the Bank of Tokyo-Mitsubishi, adjusted their broker guidelines. More specifically, “two-unit condominium projects, where the HOA is inactive or “dormant”, are generally acceptable as long as the master documents allow for unit owners to obtain their own insurance, and there are no common elements other than common walls.” And for their “Portfolio Express Refinance” product, the maximum loan amount is $4,000,000 for one Portfolio Express loan but when the borrower has multiple Portfolio Express, Low Doc, Hassle Free or Fast Track loans, the $3,000,000 maximum applies. In addition, following other investors, the IRS Form 4506-T must be completed for the applicable tax years and executed by the borrower at time of application and again at closing.

FHA Reserves Below 2% Min
Although it is rumored to be delayed, some time this month the FHA is to release the findings of its annual audit, which is expected to show that the projected value of the agency’s reserves has fallen below a federally mandated level of 2%, raising concerns that the FHA may need taxpayer money for the first time in its 75-year history. The price to pay for being a rescue agency? FHA officials say the agency has enough capital to withstand expected losses. Cynics say that the FHA (which doesn’t make loans but insures lenders against losses if a borrower defaults) is guaranteeing half of all home-purchase loans in some pretty badly hit areas, and delinquencies on refinance loans have risen faster than those on new loans in the past three years. Granted, practically all investors have overlays in place that improve the credit quality of the loans, but still many view an FHA loan as a substitute for the now-extinct popular subprime loan (although hard money lenders have also stepped in).

FHA Refinancing Guidelines
Speaking of them, the FHA has made substantial changes to their guidelines pertaining to Streamline Refinance Transactions. U.S. Bank Home Mortgage Wholesale Division is the latest to outline the most crucial changes in regards to FHA Streamline Refinances. After November 18, FHA loans will require the borrower to have made at least 6 payments on the FHA-insured mortgage at the time of application. And at the date of loan application, the borrower must have an acceptable payment history which for mortgages with less than a 12 months payment history, the borrower must have made all mortgage payments within the month due, or for mortgages with a 12 months payment history or greater, the borrower must have experienced no more than one 30 day late payment in the preceding 12 months and made all mortgage payments within the month due for the three months prior to the date of loan application. In addition, there are other standard criteria regarding net tangible benefit, moving from a fixed rate loan into an ARM loan, and reducing the term.

Jobless Claims 10mo Low
For economic news we had Jobless Claims. Yesterday, however, in addition to the Fed announcement, Treasury officials announced a record $81 billion refunding package for next week. Sales include $40 billion in 3-year notes, $25 billion 10-year notes, and a $16 billion 30- year bonds to be held on Monday, Tuesday and Thursday. (Wednesday is a holiday.) Claims for jobless insurance hit a 10-month low. Are things improving or are the unemployed, or under-employed, just going off the radar screen? Initial claims for state unemployment benefits dropped 20,000 to a seasonally adjusted 512,000 in the week ended Oct. 31, the lowest since early January. The four-week moving average for new claims dropped for the ninth week in a row. Tomorrow, of course, the Labor Department is expected to report that the decline in employment is slowing and that payrolls fell 175,000 in October, compared with a decline of 263,000 in September. Currently the yield on the 10-yr stands at 3.54% and mortgage prices are a shade better than yesterday afternoon.

Daily Humor
A guy was sitting quietly reading his paper when his wife walked up behind him and whacked him on the head with a magazine.
“What was that for?” he asked.
“That was for the piece of paper in your pants pocket with the name Laura Lou written on it,” she replied.
“Two weeks ago when I went to the races, Laura Lou was the name of one of the horses I bet on,” he explained.
“Oh honey, I’m sorry,” she said. “I should have known there was a good explanation.”
Three days later he was watching a ball game on TV when she walked up and hit him in the head again, this time with the iron skillet, which knocked him out cold.
When he came to, he asked, “What the heck was that for?”
She replied…”Your horse called.”

“Some people say they want to wait for a clearer view of the future. But when the future is clear, the present bargains will have vanished. In fact, does anyone think that today’s prices will prevail once full confidence has been restored?”

These words have particular relevance for homebuyers and owners today, about 3.25 years after home prices began crashing and eventually led to what many economists have called the Great Recession.

The scale of this recession has been great indeed. Consumer and business confidence has been rattled to the core, which has led to negative GDP growth every quarter since 3Q2008 and a 9.8% unemployment rate (as of this October 5 writing).

But the latest S&P Case Shiller home price data through July shows that the decline in U.S. home prices has decreased for the past six months. At the same time, home loan rates are also at record lows.

It’s impossible to predict the bottom of any market, but these home price and rate data suggest we may be as close to the bottoms of rate and housing markets as we can be at the same time.

Why Mortgage Rates May Not Go Lower
The chart below of conventional conforming 30-year fixed rates from 1971 to 2009 paints a clear picture of how rates have behaved through full market cycles over the last 38 years. [note: we updated chart on 12/4/09]

These are relevant years too because it wasn’t until October 1979 that the Fed began the process it still uses today of fixing the money supply and letting rates float. At the time it was done as a way to fight the 10.75% inflation that year (compared to 0.4% now), and the result was an unprecedented rate spike. In October 1981, a borrower had to pay 2.3 points to buy their rate down to 18.45%.

We’ve been nowhere near those levels since, and the reason we’re at record lows now is because of a Fed decision to buy mortgage bonds throughout 2009. The effect of this buying has been to push mortgage bond prices higher which pushes yields (or rates) lower.

Last month they announced that their $1.25 trillion bond buying budget wouldn’t increase but they’d extend their buying from December 31, 2009 to March 31, 2010. They’ve already spent about $960 billion to get rates to current levels, and now they have about $290b left to make it through March.

Extending the timeline without extending the budget means the Fed’s average weekly mortgage bond buying won’t be as effective in keeping rates low. It also reminds private holders of mortgage bonds that it may be time to trim positions and take profit before the Fed is done with their budget. When mortgage bond prices decrease in selloffs, rates rise, and this is the probable scenario between now and March 2010—and beyond.

Six Months Of Home Price Improvement
The chart below of home prices from 1987 to present shows that, although still negative (-13.3% year-over-year through July), the annual rate of decline of prices has improved every month for six months through July.

The S&P Case Shiller home price index measures prices across 20 major U.S. metropolitan areas, and is widely regarded as the most credible national home price data. The latest month’s data show that all 20 metro areas also showed an improvement in the annual rates of decline.

A word on reading this chart: it shows an ‘index’ level rather than actual value, and the indices have a base value of 100 in January 2000. So for example, the dotted line represents the 20-city index, currently at 144, which translates into a 44% appreciation rate since January 2000 for a typical single family home in the 20-city index.

Two Contexts For Investment Decisions
No investment decision is easy, and this is especially true when all market participants are still shaky from a few stormy years. Witter’s comments are worth consideration now because they were spoken at a time when the market situation was resoundingly similar.

Presenting home price and rate data against the backdrop of these comments doesn’t set out a formula for homebuyers to buy or owners to refinance. Those decisions require specific context: each individual’s or family’s objectives, budget and transactional costs. But what this data does do is provide much needed market context to combine with your objectives.

Some interesting news came out yesterday. Barclays reported that most major credit card companies saw positive performance in July: aggregate charge-offs declined and yields increased, payment rates were higher, and delinquencies continued to improve for the third consecutive month. Do you have a credit card? Does your child? How many? US citizens hold 1.3 billion credit cards, which means that there are roughly 4 cards for every man, woman, and child. In China, where there are about 1.25 billion people, there are only 5 million credit cards. The ability spend, and in some sense capitalism in general, makes it profitable for producers to sell what consumers want to buy, but it also makes it profitable to cause consumers to buy what producers want to sell. (Think about that one! Said another way, capitalism does not just sell people what they really want, it also sells them what they think they want.) Interestingly enough, studies indicate that Americans who don’t own a credit card save more than those that do.

California Real Estate Rebound?
Is California real estate turning around? SunTrust thinks that it is. Not only are they going to $2 million loan amounts, but they have updated the “SunTrust Declining Markets Index” to reflect only seven (7) Metropolitan Statistical Areas (MSA) in the State of California which remain in areas that continue show declines in property value. Those MSAs are Hanford-Corcoran, Madera-Chowchilla, Merced, Modesto, Riverside-San Bernardino-Ontario, Sacramento-Arden-Arcade-Roseville, and Salinas. All other MSAs in the State of California have been removed from the SunTrust Mortgage Declining Markets Index, which is obviously subject to change.

Loan Mod Software
First there was “Loan Prospector”. Now Freddie has introduced “Workout Prospector”. For the Home Affordable Modification program (HAMP), starting in November servicers will be required to use Workout Prospector for evaluating all borrowers for a modification under HAMP, and Freddie revised, and put on line, the HAMP Modification Agreement, Trial Period Plan, and Hardship Affidavit. “Workout Prospector helps you analyze and structure foreclosure alternatives on your Freddie Mac loans…evaluate a borrower for a modification under HAMP…In the future, Freddie Mac plans to require Servicers to use Workout Prospector to process all foreclosure alternatives.” For more details one should go to Freddie Mac’s Home Affordable Modification program Web site.

How Far Can Rates Drop
The roller coaster of economic news continues. (I guess it would be too easy if everything pointed to one outcome.) Last week rates improved, as they did again yesterday morning after Asian stocks fell significantly. Oil, gold, and other commodities were down (although sugar is at a 28 year high, which doesn’t help people who make jam at home and kids who eat Captain Crunch).

How far can rates drop? I haven’t heard too many agents complain about rates in general, as mortgage rates remain near their lows but the government’s borrowing needs are at historical highs. This limits the amount that rates will be able to fall so as to attract buyers of our debt, and most analysts believe that soon the buyers of our debt will be demanding higher yields. Last week the Fed left overnight rates unchanged. So what? If anything, what the last year or two has taught us is that mortgage rates have little or no correlation with Fed Funds, so even though CNBC and the media make a big deal out of the Fed’s decision, mortgage rates are not impacted. Granted, any changes in rates can impact the Prime Rate (currently 3.25%), but that obviously is not the same as a 30-yr mortgage rate. So how do mortgage rates change? Mortgage rates are the result of supply and demand forces, just like any other security that is bought and sold in the open market. Securities that are backed by mortgages trade in the market, just like other fixed-income debt, and just like stocks which garner the headlines, with the prices in turn determining rates.

Economic News
In spite of some second-tier news from the “Empire State General Economic Index” that showed growth, the equities market followed Asia and had their worst day since early July. So if an investor thinks that we’re not out of the economic woods yet, where can they put their money? One answer is fixed income securities, which rallied. The yield on the 10-year note hit 3.46%, the lowest level in almost a month. And it didn’t hurt that a) the Fed bought Treasury notes maturing in the next four to seven years, and b) the Fed officials said they will extend TALF loans against newly issued asset-backed securities and legacy commercial mortgage-backed securities through March 31, 2010.

PPI Down More Than Expected
Although we had some potentially market-moving data out this morning, the market hasn’t moved much since yesterday afternoon. The Producer Price Index for July was -.9%, a larger drop than expected and mostly due to gasoline prices being down last month. In June the PPI was +1.8%, so we are certainly seeing some volatility month-to-month, and versus a year ago the PPI is -6.8%! (Remember when the Fed was worried about inflation?) Ex-food & energy, the PPI was -.1%, +2.6% versus a year ago. On the residential front, Housing Starts dropped 1%, below expectations, although the June numbers were revised slightly higher. Multifamily unit starts dropped over 13%, but single family home starts were up almost 2%. New Building Permits were down almost 2%, and down over 39% versus a year ago. After the news we find the 10-yr yielding 3.49% and mortgage prices roughly unchanged from Monday afternoon’s levels.

Daily Humor
Three Rednecks were working up on a cell phone tower: Cooter, Ronnie and Donnie.
As they start their descent Cooter slips, falls off the tower and is killed instantly.
As the ambulance takes the body away, Ronnie says, “Well, someone should go and tell his wife.”
Donnie says, “OK, I’m pretty good at that sensitive stuff, I’ll do it.”
Two hours later, he comes back carrying a case of Budweiser. Ronnie says, “Where did you get that beer, Donnie?”
“Cooter’s wife gave it to me,” Ronnie replies.
“That’s unbelievable, you told the lady her husband was dead and she gave you a case of beer?”
“Well, not exactly”, Donnie says. “When she answered the door, I said to her, ‘you must be Cooter’s widow.’”
She said, “You must be mistaken, I’m not a widow.”
Then I said, “I’ll bet you a case of Budweiser you are.”

1. Read Publication 30: Residential Property Assessment Appeals

2. Watch the 25 minute video: Your Assessment Appeal

3. Email the Assessor’s office with your question. The SF Assessor’s office is good at responding.

4. Call or visit the Assessor’s office to speak to the appraisers that are on duty all day: 415-554-5596 (Matt Thomas is the chief appraiser).

5. One can also attend the assessment appeals board hearing for other people to see how they work. They are open to the public.

6. As a step in the appeal, one can request an “Exchange of Information” with the Assessor’s office. You supply your application and the comparable sales data you are going to use in your appeal hearing. They are then obliged to respond with the data they will use at the hearing. New data (not included in the exchange) cannot be introduced at the hearing without the other party having the right to request a continuance to respond to the new data.

Monetary Policy as the Economy Recovers
At present, the focus of monetary policy is on stimulating economic activity in order to limit the degree to which the economy falls short of full employment and to prevent a sustained decline in inflation below levels consistent with the Federal Reserve’s legislated objectives. Economic conditions are likely to warrant accommodative monetary policy for an extended period. At some point, however, economic recovery will take hold, labor market conditions will improve, and the downward pressures on inflation will diminish. When this process has advanced sufficiently, the stance of policy will need to be tightened to prevent inflation from rising above levels consistent with price stability and to keep economic activity near its maximum sustainable level. The FOMC is confident that it has the necessary tools to withdraw policy accommodation, when such action becomes appropriate, in a smooth and timely manner.

Monetary policy actions taken over the past year have led to a considerable increase in the assets held by the Federal Reserve. This increase in assets reflects both the expansion of Federal Reserve liquidity facilities and the purchases of longer-term securities. On the margin, the extension of credit and acquisition of assets by the Federal Reserve has been funded by crediting the reserve accounts of depository institutions (henceforth referred to as banks). Thus, the increase in Federal Reserve assets has been associated with substantial growth in banks’ reserve balances, leaving the level of reserves far above that typically observed when short-term interest rates were significantly greater than zero.

To some extent, a contraction in the stock of reserve balances will occur automatically as financial conditions improve. In particular, most of the liquidity facilities deployed by the Federal Reserve in the current period of financial turmoil are priced at a premium over normal interest rate spreads or have a minimum bid rate that is high enough to make them unattractive under normal market conditions. Thus, the sizes of these programs, as well as the stock of reserve balances they create, will tend to diminish automatically as financial strains abate. Indeed, as noted elsewhere in this report, total credit extended to banks and other market participants (excluding support of critical institutions) declined from about $1.5 trillion as of December 31, 2008, to less than $600 billion as of July 15, 2009, as financial conditions improved. In addition, redemptions of the Federal Reserve’s holdings of agency debt, agency MBS, and longer-term Treasury securities are expected to occur at a rate of $100 billion to $200 billion per year over the next few years, leading to further reductions in reserve balances.

But even after lending facilities have wound down and holdings of long-term assets have begun to run off, the volume of assets on the Federal Reserve’s balance sheet may remain very large for some time. Without additional actions, the level of bank reserves would continue to remain elevated as well.

Despite continued large holdings of assets, the Federal Reserve will have at its disposal two broad means of tightening monetary policy at the appropriate time. In principle, either of these methods would suffice to raise short-term interest rates; however, to ensure effectiveness, the two methods will most likely be used in combination.

The first method for tightening monetary policy relies on the authority that the Congress granted to the Federal Reserve last fall to pay interest on the balances maintained by banks. By raising the rate it pays on banks’ reserve balances, the Federal Reserve will be able to tighten monetary policy by inducing increases in the federal funds rate and other short-term market interest rates. In general, banks will not supply funds to the money market at an interest rate lower than the rate they can earn risk free at the Federal Reserve. Moreover, they should compete to borrow any funds that are offered in the market at rates below the rate of interest paid by the Federal Reserve, as such borrowing allows them to earn a spread without any risk. Thus, raising the interest rate paid on balances that banks hold at the Federal Reserve should provide a powerful upward influence on short-term market interest rates, including the federal funds rate, without the need to drain reserve balances. A number of foreign central banks have been able to maintain overnight interbank interest rates at or above the level of interest paid on bank reserves even in the presence of unusually high levels of reserve balances (see the box titled “Foreign Experience with Interest on Reserves”).

Despite this logic, the federal funds rate has been somewhat lower than the rate of interest banks earn on reserve balances; the gap was especially noticeable in October and November 2008, when payment of interest on reserves first began. This gap appears to have reflected several factors: First, the Federal Reserve is not allowed to pay interest on balances held by nondepository institutions, including some large lenders in the federal funds market such as the government-sponsored enterprises (GSEs). Such institutions may have an incentive to lend at rates below the rate that banks receive on reserve balances. Second, the payment of interest on reserves was a new policy at the time that the gap was particularly noticeable, and banks may not have had time to adjust their operations to the new regime. Third, the unusually strained conditions in financial markets at that time may have reduced the willingness of banks to arbitrage by borrowing in the federal funds market at rates below the rate paid on reserve balances and earning a higher rate by increasing their deposits at the Federal Reserve. The latter two factors are not likely to persist, particularly as the economy and financial markets recover. Moreover, if, as the economy recovers, large-scale lending in the federal funds market by nondepository institutions threatens to hold the federal funds rate below its target, the Federal Reserve has various options to deal with the problem. For example, it could offer these institutions the option of investing in reverse repurchase agreements. Under these transactions, the Federal Reserve sells securities from its portfolio, thereby removing funds from the market, and agrees to buy back the securities at a later date.15 Eliminating the incentive of nondepository institutions to lend their excess funds into short-term money markets would help ensure that raising the rate of interest paid on reserves would raise the federal funds rate and tighten monetary conditions even if the level of reserve balances were to remain high.

The second method for tightening monetary policy, despite a high level of assets on the Federal Reserve’s balance sheet, is to take steps to reduce the overall level of reserve balances. Policymakers have several options for reducing the level of reserve balances should such action be desired. First, the Federal Reserve could engage in large-scale reverse repurchase agreements with financial market participants, including GSEs as well as other institutions. Reverse repurchase agreements are a traditional tool of Federal Reserve monetary policy implementation. Second, the Treasury could sell more bills and deposit the proceeds with the Federal Reserve. The Treasury has been conducting such operations since last fall; the resulting deposits are reported on the Federal Reserve balance sheet as the Supplementary Financing Account. One limitation on this option is that the associated Treasury debt is subject to the statutory debt ceiling. Also, to preserve monetary policy independence, the Federal Reserve must ensure that it can achieve its policy objectives without reliance on the Treasury if necessary. A third option is for the Federal Reserve to offer banks the opportunity to hold some of their balances as term deposits. Such deposits would pay interest but would not have the liquidity and transactions features of reserve balances. Term deposits could not be counted toward reserve requirements, nor could they be used to avoid overnight overdraft penalties in reserve accounts.16 Each of these three policy options would allow a tightening of monetary policy by draining reserve balances and raising short-term interest rates. As noted earlier, measures to drain reserves will likely be used in conjunction with increases in the interest rate paid on reserves to tighten conditions in short-term money markets.

Raising the rate of interest on reserve balances and draining reserves through the options just described would allow policy to be tightened even if the level of assets on the Federal Reserve’s balance sheet remained very high. In addition, the Federal Reserve retains the option to reduce its stock of assets by selling off a portion of its holdings of longer-term securities before they mature. Asset sales by the Federal Reserve would serve to raise short-term interest rates and tighten monetary policy by reducing the level of reserve balances; in addition, such sales could put upward pressure on longer-term interest rates by expanding the supply of longer-term assets available to investors. In an environment of strengthening economic activity and rising inflation pressures, broad-based increases in interest rates could facilitate the achievement of the Federal Reserve’s dual mandate.

In short, the Federal Reserve has a wide range of tools that can be used to tighten the stance of monetary policy at the point that the economic outlook calls for such action. However, economic conditions are not likely to warrant a tightening of monetary policy for an extended period. The timing and pace of any future tightening, together with the mix of tools employed, will be calibrated to best foster the Federal Reserve’s dual objectives of maximum employment and price stability.

Foreign Experience with Interest on Reserves
Paying interest on excess reserve balances, either directly or by allowing banks to place excess balances into an interest-bearing account, is a standard tool used by major foreign central banks. Many have used interest on reserves, in combination with other tools, to maintain a floor under overnight interbank interest rates both in normal circumstances and during the period of financial turmoil. The European Central Bank (ECB), for example, has long allowed banks to place excess reserves into a deposit facility that pays interest at a rate below the ECB’s main refinancing rate (its bellwether policy rate). The quantity of funds that banks hold in that facility increased sharply as the ECB expanded its liquidity-providing operations last fall and has remained well above pre-crisis levels; as a result, the euro-area overnight interbank rate fell from a level close to the main refinancing rate toward the rate the ECB pays on deposits–but, importantly, not below that rate. Since November 2008, the Bank of Japan (BOJ) on a temporary basis has paid interest on excess reserve balances, at a rate of 10 basis points per year, which is also its current target for the overnight uncollateralized call rate; the BOJ noted that its action was intended to keep the call rate close to the targeted level as it supplied additional liquidity to the banking system. Indeed, the overnight rate has traded near 10 basis points in recent months, even as reserve balances at the BOJ have risen substantially, returning to their level during much of 2002, when the BOJ was implementing its Quantitative Easing Policy and the call rate was trading at 1 basis point or below. The Bank of Canada and the Bank of England also have used their standing deposit facilities to help manage interbank interest rates.