June 15: Notes on the LIBOR transition, Modern Monetary Theory, the Option ARM’s origins & principals
We’re a week away from the official beginning of summer: vacations, fewer conferences, home buying, arriving at work early to snag the shady parking place. (A week is a long time. Just ask Quicken, which settled its False Claims Act action this week, or the Golden State Warriors who, in the span of a week, lost a title, said goodbye to their home arena, and lost two starters and potential hall of famers for a year each due to injury! For me it was time in Vermont, New York, Kansas, Nevada, and California; today off to Boulder, CO.) What’s been on reader’s minds this week?
Historical perspective
The death of World Saving’s Herb Sandler refreshed many thoughts about the early days of the fabled Option ARM product and brought out thoughts in defense of its underlying guidelines.
From the Mortgage Bankers Association Pete Mills sent, “The original pay option ARM dates back to the mid-1980s. I bought my first house with one. In 1988 or ’89, I worked in the research and policy shop at the California Association of Realtors and we conducted a research report for the California DRE on the ARM market and the product options/features available at that time.
“Needless to say, on behalf of Realtors, we were not fans of any product with negative amortization, while World was a huge fan of their 7.5% payment-capped product. After we completed the project (with a strong lean against the pay option/neg am features) we were summoned by Herb and Marion Sandler to the World Savings HQ office on Lake Merritt in Oakland to explain/defend our findings. It was a fascinating 90 minutes. We engaged with Herb for most of the time while Marion knitted and listened.
“Herb made a compelling case for his product, we defended our research, and we thought we had done fairly well and were wrapping up when Marion interrupted, and said she had a few questions. She then proceeded to challenge almost every aspect of our report for another 45 minutes. We survived, the report survived, and the product likely would have survived had it stayed close to its original late-1980s construct: no deep teaser start rates, no scheduled neg am from the first payment, full documentation, and conservative ratios.” Thanks Pete!
Dave Stevens sent, “It is important to understand the origins of the product. The first COFI ARM was offered by world in 1982. I started there as an LO in 1983 and that was the only product we offered.
“We did not have teaser rates back then. The fully indexed rate was based on the 11th district cost of funds and we offered a 2% margin on average. Our first no income verification was offered at 70% LTV, but we would go through exaggerated reviews to ensure the income stated was reasonable including verbal VOE’s. I remember going to a restaurant and having lunch where a borrower worked to determine if her income stated seemed reasonable.
“World was very focused on the property. After all, it’s the home that cannot sell that ultimately results in default even if a borrower has personal financial challenges. Every LO was provided a camera and could not submit the file without photos of the home. We spent countless days per month in a van with the heads of appraisal, underwriting, and origination touring homes that we had originated and discussing the value, the comps, other risk factors that may have been missed. The culture on risk was extraordinary.
“The loan was created to avoid basis risk for the bank. Lending long on fixed rates and borrowing short on deposit rates was the basis for the S&L crisis. Herb and Marion developed a product that had an almost perfect match in asset to liability timing which significantly reduced risk to the bank. Their performance was unmatched.
“The point here is that the monthly adjustable rate was not the enemy to consumers. As a matter of fact consumers who took this loan beginning in 1981 saw their rates steadily decline over time for decades as did rates in general. When appropriate risk factors are considered and with a healthy equity position to allow for resale should economic hardship occur, the portfolio was extremely high performing for decades and World produces consecutive 20% Roe’s for generations. It was risk layering (deeply discounted teaser rates, 100% LTV’s, and laxer collateral standards, etc.) that drove defaults on this and other products.” Thanks Dave!
Dick Lepre with RPM Mortgage in California sent over a link to his article from the Scotsman Guide, March 2006, on Option ARMs.
From the Atlantic Seaboard Ken Sonner telegraphed, “These folks that blame the No Doc loans for the financial crisis appear to be rather selective in presenting the past. I had heard that job loss and occupancy fraud were the leading causes for foreclosures. No Doc loans certainly contributed to the crisis but that was not the leading cause.
“Many folks that had obtained full doc loans lost their jobs and many of the owner-occupied specs used full doc financing to get a loan. When the borrowers lost their jobs, they quickly cut out their largest expense (mortgage payment). When property values dropped, the speculators walked away from their loans since they no longer could turn a quick profit. This caused an immediate drop in value in many communities and regions. (The New Yorker had a great article about this happening in Florida.)
“FHA suffered during the downtown but this was not a result of No Doc loans. It continues to come back to job loss, no skin in the game (Nehemiah), property value declines, and HECM causing a serious strain on the fund.
“I heard one industry leader blame mortgage brokers for the crisis. Really? What about the big lenders and investors, Wall Street, real estate professionals and the borrowers? Blanket statements are a quick impulse to assign blame rather than stepping back to recognize that many factors contributed to the Great Recession.
It’s the economy, stupid!
Economist Elliot Eisenberg, Ph.D. sent over is recent article titled “Modern Monetary Theory Is Voodoo Economics Redux.”
“There is currently widespread frustration with the performance of the global economy. Traditional policy approaches are not delivering the economic results they have in the past. In the US, Millennials are poorer, have lower incomes, marry less often, and have fewer children than the generations before them. In Europe, the rise of previously fringe parties is unmistakable as voters express their frustrations with the status quo at the ballot box. All this has led to the rise of Modern Monetary Theory (MMT), a set of ideas that reflect a significant and unfortunate break with previous orthodoxy.
“During the late 1970s, a similar economic malaise gave rise to supply-side economics popularized by Arthur Laffer. It began with the age-old observation that taxes had important incentive effects and that, in conceivable circumstances, tax cuts could raise revenue. That said, from these two well understood underpinnings, it grew into the ludicrous idea that tax cuts would always pay for themselves. In the 1980 presidential primaries, future President George H.W. Bush called this idea ‘voodoo economics’ and in the following decades this doctrine did substantial damage to the US economy and has largely short-circuited meaningful debate about taxes.
“Now comes MMT, which, like supply-side economics, makes a good observation, that fiscal policy needs to be rethought in an era of low real interest rates, but then stretches it into a ludicrous claim that massive deficit spending on job guarantees can be financed by central banks without any burden on the economy. At a moment of deep economic and political frustration, some fringe wing of the out-of-power party is again offering the proverbial economic free-lunch as a politically attractive way out of a fiscal bind. Regrettably, MMT is flawed at many levels.
“First, it promises that by printing money the government can finance deficits at zero cost. Not true! The government in fact pays interest on money it creates as it becomes reserves held by commercial banks and the Fed pays interest on reserves. Second, contrary to MMT, governments cannot simply print money to pay bills and avoid default. Looking back at developing nations that have employed MMT demonstrates that beyond a certain point printing money leads to hyperinflation. Third, MMT conveniently assumes an economy that does not trade with other nations. Regrettably, money printing will result in a collapsing exchange rate that will in turn boost inflation, raise long-term interest rates, encourage capital flight and reduce real wages.
“And it is not only in emerging markets where MMT has played out badly. France in the early to mid-1980s and West Germany in the late 1980s employed what now would be called MMT but both nations had to reverse course. Separately, the UK and Italy both had to be bailed out by the IMF in the mid-1970s because of an excessive reliance on inflationary finance.
“Supply-side economics was an unreasonable extension of valid ideas. To that end, few support a return to the very high marginal tax rates that prevailed before the tax reform of the 1980s. Similarly, in an era of very low inflation, and of real interest rates of close to zero, we can and should carefully reconsider our traditional views of federal borrowing; they need at a minimum a careful and thoughtful rethink. That said, when something sounds too good to be true, as was the case with supply-side economics, and is the case with MMT, it’s important to make this clear to improve debate and hopefully prevent us from making another costly and unnecessary economic policy mistake.”
LIBOR
Yes, $350 trillion of financial instruments is estimated to be tied to this index. We’ve had plenty of lead time to create, evaluate, and discuss alternatives (like SOFR from the Federal Reserve Bank of New York) ahead of the end of 2021 when it “goes dark.”
Randal Quarles, vice chairman for supervision at the Federal Reserve, told the Alternative Reference Rates Committee the industry must move faster to switch to the Secured Overnight Financing Rate from Libor. “With only 2½ years of further guaranteed stability for Libor, the transition should begin happening in earnest,” he said.
But Marc Perez raises an interesting point. “My biggest concern with SOFR is that it hasn’t been stress-tested to handle another financial meltdown. I was recently at the National Secondary MBA in NY and attended the session discussing the LIBOR transition. I asked the committee the following but I never got a real answer. They simply repeated what I said and diverted the question.
“Given that Libor was more ‘committee-based’ (for example: Barclays and the LIBOR Scandals), versus SOFR which is more quantitative & stratified (underlying data set to US Treasuries & follows Fed Funds rate), what happens if we ever went back into a financial crisis environment? In that instance, LIBOR goes up and SOFR goes down, which is an issue for the banks and not the customer. Would all banks have to jointly start short selling Treasuries to guide the Yield up (like in a Bond Convexity Vortex)?
Here, 14 dog quotes that capture the special bond between a human and their pup.
“I’m suspicious of people who don’t like dogs, but I trust a dog when it doesn’t like a person.” — Bill Murray
“It’s just the most amazing thing to love a dog, isn’t it? It makes our relationships with people seem as boring as a bowl of oatmeal.” — John Grogan
“Happiness is a warm puppy.” — Charles M. Schulz
“When your children are teenagers, it’s important to have a dog so that someone in the house is happy to see you.” — Nora Ephron
“I have found that when you are deeply troubled, there are things you get from the silent devoted companionship of a dog that you can get from no other source.” — Doris Day
“I’ve seen a look in dogs’ eyes, a quickly vanishing look of amazed contempt, and I am convinced that basically, dogs think humans are nuts.” — John Steinbeck
“My dogs have taught me to be more loving, more nurturing, and happier.”— Nicollette Sheridan
“When an 85-pound mammal licks your tears away, then tries to sit on your lap, it’s hard to feel sad.” — Kristan Higgins
“I love my pets so if they are happy, I am happy … I have treated all my dogs like my kids. To me, they’re just kids I didn’t birth.” — Kristen Bell
“My fashion philosophy is, if you’re not covered in dog hair, your life is empty.” — Elayne Boosler
“Some of my best leading men have been dogs and horses.” — Elizabeth Taylor
“Reason No. 106 why dogs are smarter than humans: Once you leave the litter, you sever contact with your mothers.” — Jodi Picoult
“It’s not the size of the dog in the fight, it’s the size of the fight in the dog.” — Mark Twain
Visit www.robchrisman.com for more information on our industry partners, access archived commentaries, or to subscribe to the Daily Mortgage News and Commentary. If you’re interested, visit my periodic blog at the STRATMOR Group web site. The current blog is, “Are You Ready for CECL?” If you have both the time and inclination, make a comment on what I have written, or on other comments so that folks can learn what’s going on out there from the other readers.
Rob
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