Professor Cole's Finance Blog

For the first time during the past 36 months, Lender Processing Services (LPS) reported this month that the percentage of non-current mortgages (either delinquent or in foreclosure) declined during February to 13.48% from 13.61% in January. While this is the second highest reading in the history of the LPS survey, it does suggest that the U.S. residential housing market has reached a bottom, as least temporarily. The surge in recasting of option-ARMs during 2010 and 2011 may make this improvement short-lived, but, at least for now, this is the best news that the residential housing market has had in three years. Even so, there remain 1.8 million properties in foreclosure and another 5.6 million properties that are delinquent. Moreover, there are more than 11 million properties that, according to First American CoreLogic, are worth less than their outstanding mortgage balances, and underwater homeowners are increasingly likely to default.

With this background, the Obama administration announced yesterday that it was dipping into the $50 billion kitty for its foreclosure mitigation program know as Home Affordable Modification Program (“HAMP”) for $14 billion. This portion of the kitty, which was taken from the $787 billion Troubled Asset Relief Program (“TARP”), is to be used incentivice lenders to modify delinquent mortgages not only by reducing interest rates and extending maturies, but also by reducing outstanding principal balances. Research has shown that reduction of principal is the most effective component of successful mortgage modifications, although redefaults within 12 months of modifications remain above 50% for all modifications. Of the permanent modifications done under HAMP, only about one in four have included principal reduction. The newly announced changes to the HAMP also would allow unemployed borrowers to skip from three up to six months of mortgage payments.  

Posted by m1rac01 at 06:35 PM | Permalink

For the past decade, I have toiled as a finance professor, teaching hundreds of students—primarily MBAs—how to perform capital budgeting. Like almost every major corporation around the world, we use a tool known as Net Present Value (NPV), which is perhaps the most important tool in finance. As I listen to the health-care debate, especially the CBO cost estimates, I cringe because the CBO has violated just about every rule for performing capital budgeting using NPV.

As finance professionals, why do we like NPV for valuing a project? Primarily for three reasons: (1) It values only the incremental cash flows relevant to the project (2) it values all of the relevant cash flows relevant to the project and (3) it discounts all of the relevant cash flows relevant to the project properly using a risk-adjusted discount rate. Now, let us use these three reasons to examine how the CBO values the project known as health-care reform, and why I, and most finance professionals, assign the CBO a grade of “F” in Finance 101.

First, the CBO includes cash flows that are irrelevant to the project. The most obvious of these are the cash flows associated with the student loan program and Medicare. These projects are irrelevant because they occur whether or not we do the project known as health care reform.  This old trick allows bad managers to hide bad projects by tying them together with good projects.

Second, the CBO includes only the cash flows from the first ten years of the project; it fails to include all of the relevant cash flows. In many projects like health care reform, the majority of the value comes from cash flows after ten years. We include these by capitalizing the cash flows in year ten and discounting them back to the present. CBO fails to do this. Instead, CBO includes ten years of costs but only about four years of benefits.

Third, CBO appears to be ignorant of the most fundamental concept in all of finance—the time value of money. The time value of money simple states that a dollar received today is worth more than a dollar received next year. We relate the two by the annual interest rate. When dealing with cash flows across ten years, as the CBO does, it is critically important to account for the time value of money. At an interest rate as low as 4%--the current rate on a ten-year Treasury Bond rate—a dollar received in ten years is worth only 67 cents today. At 12%—the 1981 rate on ten-year Treasury Bonds in 1981 that we are likely to see in coming years if we do not reign in the national debt—a dollar received in ten years is worth only 32 cents today. Yet the CBO treats a dollar received in ten years as exactly equal to a dollar received today. Compounding this problems is the fact that much of the cost comes during the early years, whereas the benefits only come much later during the project, when they are worth less. So much for the most important concept in all of finance.

Beyond these three points, another critical part of the NPV valuation process is what is known as sensitivity analysis, which is where we test how sensitive are our estimates of value to our assumptions. Of special interest are assumptions about growth rates. The CBO makes a number of heroic assumptions that drive its analysis, including changes in the growth rates of health costs with and without the reform project, yet  it does so without doing any analysis of how different costs would be if it’s assumed growth rates are wrong (as they most probably are). What if growth in future medical costs don’t decline as the bill assumes? What if we can’t “save” $500 billion from Medicare? Is it still a good project? No.

So we see, on al l four of these counts, the CBO earns a failing grade in its approach to valuing health-care reform—and everything else. How am I, as an educator, supposed to teach my students the right way to value a project when our government’s “watch dog” violates virtually every rule I am trying to teach. Let’s reform the CBO’s arcane and inaccurate costing methodology before it bankrupts our country. Finance 101 is a good place to start.

Posted by m1rac01 at 09:08 PM | Permalink

On March 4, 2009, the U.S. Treasury Department announced the Obama administration’s Making Home Affordable program, which included a “comprehensive $75 billion Home Affordable Modification Program now known simply as “HAMP.” HAMP was supposed to help 3 to 4 million at-risk homeowners avoid foreclosure by permanently modifying their mortgages in such a way as to reduce their monthly mortgage payment to a “sustainable amount.”

As the program reaches its one year anniversary, we must ask about how responsibly the Administration is spending $75 billion of our taxpayer dollars. Treasury released the most recent numbers on Feb. 16, which covers the program results through January 2010. According to this report, about 1.3 million borrowers have been extended an offer for a trial modification, 1.0 million borrowers have started a trial modification, of which 830 thousand are still active, 60 thousand have been canceled, and 117 thousand permanent modifications were started.

So, after 11 months, the program has “reached” more than a million of the targeted 3 to 4 million at-risk homeowners, but has produced permanent loan modifications for only a hundred thousand. That said, the January results were a vast improvement over November and December 2009, when only 31 thousand and 66 thousand permanent modifications had been started, respectively. So it appears that the program is beginning to hit its stride, but it will need to continue this progress if it is to make a real dent in the problem because the problem continues to grow.

On Feb. 19, 2010, the Mortgage Bankers Association released results from its National Delinquency Survey for the fourth quarter of 2009. This report showed that the combined percentage of loans in foreclosure or at least one payment past due reached 15.02%, the highest level on record, up from 14.41% in the third quarter of 2009. In the fourth quarter, the percentage of loans in foreclosure was 4.58% and the percentage past due was 10.44%, up from 4.47% and 9.94%, respectively, in the third quarter. This translates into an additional 335 thousand new delinquencies and an additional 60 thousand foreclosures during the fourth quarter.

On Feb. 23, 2010, First American CoreLogic released a report in which it estimated that, in the fourth quarter of 2009, 11.3 million residential properties representing 24% of all properties with mortgages were “under water,” meaning that the borrower had negative equity because the value of the property had fallen to where it was less than the outstanding mortgage balance. This was an increase of approximately 600 thousand properties from the third quarter of 2009. More than 10 percent of properties are estimated to be underwater by more than 25% of loan value. The report goes on to demonstrate a strong correlation between negative equity and foreclosure.

So we see that delinquencies are growing by 100 thousand per month, foreclosures by 20 thousand per month, and underwater mortgages by 200 thousand per month. Against this backdrop, HAMP has managed a total of only 120 thousand permanent modifications, although 50 thousand of these took place during January. In order to reach its goal of 3 million permanent modifications by 2012, HAMP will need to average 125 thousand permanent modifications per month. Good luck with that.

Unaddressed thus far is the knotty issue of re-defaults. Some researchers estimate that re-default rates on modified mortgages will exceed 50% within 12 months of modifications.

Posted by m1rac01 at 11:47 AM | Permalink