Sunday, August 22, 2010

Mortgage Refinance: Thanks Uncle Sam!

My wife and I are in the throes of refinancing our mortgage. The impetus was trading down from a 5.875% rate to 4.375%. This week, we received our loan application package, that includes the Good Faith Estimate (GFE) of mortgage costs, on the lesser-known form HUD-GFE.

Background information: Mortgage rates are at all-time lows due to continued economic weakness, Federal Reserve policy keeping short-term Fed Funds rates near zero, the Fed's policy of buying government bonds in the open market and keeping long-term rates low, and government support for Government Sponsored Entities (GSE's, i.e. Fannie Mae, Freddie Mac) that continue to finance home mortgages. My wife and I would like to lower our monthly payments over the same term we have remaining on our current mortgage. Makes sense to me, then we received our application package.

The package contained 36 pages of difficult to understand disclosures. They required us to affix our signature 23 times. The GFE estimated our settlement charges at $7,941.75. Yes folks, to refinance our mortgage through the same financial institution that currently services (although does not own) our current mortgage, we have the opporunity to pay them $8k. To be fair, only $2,175 goes to the lender, which is paydown points for getting the low rate. Another charge is to fund an escrow account, which sounds ridiculous to us considering we have an escrow account with the same lender on the same property for our current mortgage.

Other charges include title services, including insurance. This is another part of the refinance process that makes no sense. We bought our home six years ago and paid for the title search and insurance at that time. Must it be done again to refinance? Where that requirement comes from, I don't know. But it is emblematic of the perplexity of the mortgage financing business.

This is an example of "We're from the government and we're here to help" good intentions combined with bad results. I think there could be mortgage finance rules drafted in a one or two page piece of legislation that makes it easier on all of us... borrowers, lenders, investors, and regulators.

Here is what I recommend to improve the process:

- For refinancing to the same homeowner on the same piece of property, an electronic title search is all that is required for homes where title insurance has been purchased within the last ten years;

- Permissions to verify income and account information can be done on a one-page letter;

- GFE's can be made much simpler and more condense. I predict my 11 year-old could come up with a more understandable form;

- Create an automated form that enumerates tradeoffs with financing closing costs or paying them. I went through a mathematical exercise because of my knowledge of the industry, re-investment rates, etc. to make my determination. Does or could everyone do the same so they make an informed decision?

- Create an automatic query and bid system once a mortgage application is made to settlement agents and title insurers. My guess is not many of us have "relationships" with these firms, so selecting nearby agents that participate in an electronic bid system would be extremely helpful. The same could be done for appraisers. I think if and figured this out for hotels, we could get something going for these service providers. These costs can go on the GFE directly from the bid system.

My guess is costs for the title, settlement, and appraisal engine would come down as a result of the competition. Right now, borrowers probably go with the company(s) recommended by the lender. This puts a premium on getting and staying on the lenders' recommended lists, which probably equates to many expensive dinners and tickets to great seats at sporting events.

At the end of the day, borrowing money and using your home as collateral should be easier, much easier, than it currently is. I think if we sat back and asked ourselves, "what makes sense here", the process would be a lot different... and probably less expensive for the borrower, less difficult for the lender, and easier to regulate.  What are your thoughts on the mortgage process?

Thursday, August 12, 2010

Guest Post: Second Quarter Economic Update

What’s Bothering the Markets?
There used to be an old adage in the stock market: “sell in May and go away.” This year, it certainly seems to be the case. Stock markets did quite well this year into April then began to sell off relentlessly in May; in the meantime, bond markets moved higher, especially Treasuries, as investors sought the safety of bonds. Interest rates have been driven to incredible lows. The month of June has not been much better; after trying to rally from lows, stock markets keep getting battered back. It’s almost as if there is some invisible hand keeping the Dow near 10,000 and the S&P near 1,050. Wait! These were the 1999 levels for these indices. One lost decade later, we are still there. Did you know that since 1999, the Dow has risen above and fallen below the 10,000 mark an astounding 280 times! (Thanks to Doug Ingram for that bit of history).

So what gives? What is wrong with the markets now? We can’t blame it on the Internet stock bubble of ten years ago. We’ve lived through one of the worst recessions and financial market crises of our lifetimes. The stress of September, 2008 to March, 2009 was beginning to be erased by an economic recovery, as signaled by stocks that rallied over 60% from fearful lows to levels that supported growth. Then came this May and June, and it feels like the market psyche is slipping back to emphasizing the negatives. Don’t get me wrong, there are plenty of negatives to go around – Greece and Europe debt crises, China growth issues, a weak employment report for May and unemployment at 9.7%, fear of a “double-dip” recession, weakening data, the BP gulf oil spill, low business confidence, and continued deleveraging by consumers and businesses.

Government and regulators are contributing to the pessimism with financial reform legislation that does not even address some of the causes of the crisis, new FASB proposals to impose harmful mark-to-market accounting on bank loans, and the looming expiration of the Bush tax cuts in 2011. Bummers all. Jim Cramer describes it as a “malaise,” or a general lack of optimism. I describe it as the sound of thousands of vuvuzelas buzzing at a soccer match!

Is There Anything Good Out There?
Now that I have depressed you completely, let’s take a moment to cheer up. Yes! There are positives in the economy and in the markets. In the first five months of 2010, jobs grew by nearly 1 million. Granted, we lost over 8 million jobs since December, 2007, but gaining 1 million pretty quickly is good. (Now I admit many of those jobs are temporary census workers, but these are people working too). Housing prices bottomed based on the Case Shiller indices months ago and are now up almost 4% to 5% on a year-over-year basis. Existing and new home sales fell sharply in May, but this followed the unusually high months of March and April that contained the $8,000 tax credit.

Inflation and expectations for it are both low; inflation is not a serious risk as GDP growth remains steady but below levels (3% to 4%) that can be inflationary. In fact, the battle against the real enemy, deflation, is being fought by the Federal Reserve with easy money. Interest rates, especially Treasury yields and mortgage rates, are at very low levels, which can help consumers and businesses with new loans (if they ever want to add to debt) and refinancing. And our eternal ally, the Federal Reserve, has pledged to keep short term interest rates low for an extended period of time, creating a friendly growth environment indeed. Ben Bernanke has always pledged to print more money, and drop it from helicopters if need be, to kill deflation.

We worry about all of the negatives mentioned earlier. They can lead to a loss of confidence in the economic recovery that is underway. For employers to add jobs, that confidence is essential. For consumers to spend, that confidence is essential. On the positive side, we are now in the fourth consecutive quarter of an economic recovery that started last summer. Most economists believe that the growth momentum will continue at a pace of 2.7% to 3% into 2011. Then we have to worry about federal tax increases, i.e. the Bush tax cuts expire, and state and local government tax increases as these states and municipalities struggle to balance budgets. States are wrestling with reducing projected June, 2011 deficits of $112 billion, according to the Financial Times. Let’s hope the projections of GDP at 3% come true when these tax increases occur.

Putting It All Together
The economy should grow 2.5% to 3% in 2010 and about the same in 2011. This recovery is slower than those we have seen historically, but “slow,” after the crises we have endured is preferable to “no.” Negatives in the markets have been holding us back, in addition to “inventory” issues that I have continued to stress. Two of the inventory issues have been improving – manufacturers adding to goods on the shelves and the pool of available workers declining slightly – while the other two remain weak-houses on the market and bank loans declining.

Short term interest rates are low and can be expected to remain that way until economic recovery is assured and unemployment drops“way” back from its high level near 10%. We are looking at the Federal Reserve holding the Fed Funds rate at 0% to .25% well into 2011 (mid-year at least). Some economic formulas that predict the Fed Funds rate, most notably the Taylor Rule formula, show that this rate should be negative 1.75% right now, making 0% look pretty high. It’s been said that negative interest rates are not an option, thus the Fed must inject money into the system in other ways, such as buying securities. Longer term rates should rise slightly, by .25% to .50%, once the flight-to-safety comes out of the bond market and yields return to where they were before May. But large increases in long term rates are not expected as inflation remains tame for the foreseeable future and the Fed battles the evil of deflation.

Thanks for reading! DJ 06/29/10

Dorothy Jaworski has worked at large and small banks for over 30 years; much of that time has been spent in investment portfolio management, risk management, and financial analysis. Dorothy has been with First Federal of Bucks County since November, 2004.

Sunday, August 01, 2010

Diseconomies of Scale

Have you ever driven on a highway by yourself and forget, if even momentarily, the highway you were on and where you were going? I hope most of you answered yes or I have to make a doctor's appointment. The same sensation you feel for that split second while driving is, at times, what I feel in some strategy sessions I am priveledged to attend.

A common discussion in these strategy sessions is 'how do we grow'? Frequently, I will ask 'why do you want to grow'? The answers typically come back with some variation of achieving economies of scale to leverage the infrastructure to enhance shareholder return. This is particularly true of today's banking reality, where regulators and politicians are heaping non value-added costs on financial institutions. So the easy answer is let's get bigger, right?

Of course there is some merit to growing to a certain size so adding another compliance officer or another branch doesn't tank this year's earnings. But the million dollar question is what is the "certain size"? A bank CEO once told me that his investment banker told him the ideal size was twice his current size, no matter what size he was at that time.

The table below, derived from averages of the last ten years of efficiency and net operating expense ratios, indicates there are advantages to being larger. But look carefully. The advantage diminishes as the asset size grows, to a point where it is not particularly compelling.

The drive for growth in banking always concerned me. Banking is driven by balance sheet, not the income statement like most industries. Banks revenues are the result of the size of its balance sheet. You want to grow revenue 10%, you must grow the balance sheet 10%, all things being equal.

Not so difficult, one might think, if you grow from a $500 million in assets financial institution to a $550 million one. But what if you're a $10 billion bank? Now you must grow another billion to get your growth. What do you do if your markets can't support that growth? You must buy other financial institutions or reach for growth outside of your power alley (either your geography or into lending areas where you have little experience). The result may be fine at first. But as Warren Buffett once quipped, "You don't know who's swimming naked until the tide goes out". Many financial institutions were found to be naked over the past year and a half.

Perhaps it is time to consider a different strategy. If, for example, slow but prudent growth leads you to grow your balance sheet, and therefore earnings, at five percent per annum. This is typically not an acceptable long-term return for equity investors.

But if you are generating sufficient profits, and you don't need to grow capital at a rapid pace to keep up with growth, you could pay higher dividends, delivering acceptable shareholder returns. In this manner you may be taking the growth your markets can deliver, without forcing you to seek growth that is beyond your control (i.e. M&A) or put undue risk on your balance sheet (i.e. lending outside your expertise).

There are strong leanings to grow. I know of banks that are located in the same small town. One grows faster than the other, and is very proud of the accomplishment. Senior management and the Board of the smaller bank lament that they have not grown as quickly. In this context, growing is not a business judgment or a shareholder return issue, it becomes an ego issue. There is no greater testament to the role ego plays in the size of a bank than to see Bank of America and Wachovia's drive to be the highest skyscraper on the Charlotte skyline. Wachovia was winning until their near collapse. But their building was impressive!

What size do you think is big enough?

- Jeff