Front page of the WSJ this morning discussing what readers here will recognize as retty old news: A boatload of 2/28 APR mortgages are about to reset next year, and its not going to pretty::
"The subprime mortgage crisis is poised to get much worse.
Next year, interest rates are set to rise — or "reset" — on $362 billion worth of adjustable-rate subprime mortgages, according to data calculated by Bank of America Corp.
While many accounts portray resetting rates as the big factor behind the surge in home-loan defaults and foreclosures this year, that isn’t quite the case. Many of the subprime mortgages that have driven up the default rate went bad in their first year or so, well before their interest rate had a chance to go higher. Some of these mortgages went to speculators who planned to flip their houses, others to borrowers who had stretched too far to make their payments, and still others had some element of fraud.
Now the real crest of the reset wave is coming, and that promises more
pain for borrowers, lenders and Wall Street. Already, many subprime
lenders, who focused on people with poor credit, have gone bust. Big
banks and investors who made subprime loans or bought securities backed
by them are reporting billions of dollars in losses." (emphasis added)
The most interesting issue raised is in the emphasis added above: The entire credit crisis has been precipitated not due to the resetting mortgages, but rather due to the lack of risk management and the poor quality of the loans themselves.
A quote from the article captures this: "The initial wave was largely driven by a higher frequency of fraudulent loans…and loose underwriting."
Here’s the really bad news: The projected supply of foreclosed homes is about ~45% of existing home sales — adding four months to the
supply of existing homes. According to Dale Westhoff of Bear Stearns, this is a "fundamental shift" in the housing
supply — and as such, home prices are likely to drop
further as lenders dump many repossessed homes.
Foreclosed homes typically sell at a discount of 20%
to 25% compared to the sale of an owner-occupied home, analysts say.
Lenders are eager to unload the properties, and the homes tend to be in
poorer condition.
The question we will find out in 2008 is whether the credit crunch, precipitated by the initial wave of defaults, is going to get that much worse . . .
>
Source:
Rising Rates to Worsen Subprime Mess
Interest Payments Set To Grow on $362 Billion In Mortgages in 2008
RUTH SIMON
WSJ, November 24, 2007
http://online.wsj.com/article/SB119586137992302497.html
Now the real crest of the reset wave is coming, and that promises more pain for borrowers, lenders and Wall Street.
Don’t forget sellers. If buyers aren’t buying, then sellers aren’t selling. This will restrict people who would relocate to find a better job, those who would think about selling to downsize their house and those wanting to sell in order to get from underneath a bad loan. As Tanta said over at Calculated Risk, We’re All Subprime Now.
When you build an economy based on consumption through debt, credit availability becomes the Achilles heel.
Quote John Hussman via Mish Shedlock:
“In Problems with Financials, Hussman states:
The FDIC notes “for the fifth quarter in a row, reserves failed to keep pace with the increase in non-current loans.” If we’re already seeing these signs of credit stress at the peak of an economic expansion, the figures we observe in a recession are likely to be a lot worse.
As of June 30, 2007, the net income of all FDIC insured banking institutions totaled $36.8 billion. At an annual rate, that represents about 2% of all loans outstanding. Meanwhile, net charge-offs for bad loans were already running at an annual rate of about 0.50% in June. That’s in a strong economy, before the recent problems, and loan loss reserves didn’t even budge from a 32-year low. Net charge offs could easily quadruple in a mild recession.”
Low loan-loss reserves, a slowing economy, and growing defauts – not a good combination for loosening credit availability – or for profits. Add to that a frozen ABCP market and credit squeeze may be too tame of word – deflation is more appropriate.
I wonder how long before the Fed pulls out the big guns and drops reserve requirements in a panicky attempt to keep the credit plate spinning atop the pole of unsustainable debt?
Bank writedowns are nice, but, what concerns me is not only the arcane structure of the instruments underlying the writedowns but the manner in which the writedowns are calculated?
Anyone know how they are calculating the extent of quarterly writedowns? It can’t just be in loss of market value (since there isn’t a market), and it can’t be due entirely to loss provisions, so, as always, where are the numbers coming from?
In my mind, they are asking for a level of trust I’m uncomfortable giving.
Have a great holiday season everyone.
Barry,
You are about a year behind the folks with their eyes wide open reporting on this one.
~~~
BR: Uh, guess again squarepants: We have been beating the drum on this subject forever: http://bigpicture.typepad.com/comments/real_estate_/index.html
Grasping at a few potentially positive straws:
1. Given that “many” of the recent defaults are in the first year, it may be that the very worst of the dreck has already been cleared. Not to say there won’t be pain as resets happen, just that the worst of the worst may already have been taken out back.
2. At least some of these people will be anticipating the upcoming reset and have their home for sale proactively. If and to the extent that’s the case, foreclosures wouldn’t actually add to the supply of homes for sale. If the foreclosed end up renting someone else’s vacant and for-sale home, there might even be a net decrease in for-sale inventory if the former vacancy is taken off the market.
3. A pre-foreclosure but for-sale owner may want or be able to short-sale it. Once foreclosed though, the mortgagee will want to clear the property ASAP, and may take whatever price they can get. That means instead of sitting around as inventory, the property becomes a sales stat, thereby improving both ends of the months of supply figure.
Yeah, these are pretty thin reeds. Still, even though we can’t say the glass is half full, we at least have to recognize there’s some water there.
Please pardon the very novice question.
The problem has two prongs:
1. The lenders didn’t do their due diligence, and so have loaned to people who can’t really afford their loans.
2. Those loans are resetting to higher interest rates, which is compounding problem #1.
What if the lenders opted to not reset the interest rates at higher numbers?
(a) Some people can afford their loans, and can afford to pay the higher rates. These people would get a gift bonus–less interest to be paid.
(b) Some people can afford their current interest rates, but cannot afford their higher rates. These people would be spared from foreclosure.
(c) Some people cannot afford their current loans, and will be in foreclosure, whatever the banks do.
Group (c) is borked already, both the families and the lenders. So what really matters is whether group (a) or (b) is larger. I’m an outsider, so I don’t know the numbers on this, but I would think that a loan being repaid at a marginally lower rate was tremendously more valuable than a foreclosed home in a very soft market. I don’t know if it is 5x more valuable or 20x more valuable. But I’m sure some technicians can put an exact number on it. And that multiplier should be used in comparing groups (a) and (b). If the multiplier is 5x, and group (a) is only 3x group (b), then any lender who decides to not exercise their right to reset will be better off.
I can’t be the first person to think of this, can I? What’s wrong with this plan? My gut says that the multiplier is in the neighborhood of 30x to 50x. Is group (a) really that much bigger than group (b)?
I have said it before I will say it again.
The housing credit crunch is of great import to the state of our economy but it is just a template for what is about to come. Any and every form of leveraged debt out there is going to run into similar problems in the very near future.
So, unfortunately the question of whether the housing credit crunch gets worse in 2008 is going to become moot, when we find out how much more bad debt is really out there.
Mac,
In fairness, the banks have a tough row to hoe on the writedown issue. If they under-reserve, they’ll be accused of hiding losses. If they over-reserve, they’ll be accused of “cookie jar” accounting to meet guidance.
Everybody knows the wheels have come off the wagon, but nobody truly knows how bad the spill will end up being.
Randy:
I don’t think you realize the extent of the problem, i.e the level of leverage in the system. Banks lend at 10/1 but with derivatives we’re probably at 30/1.
If you change the rate on those loans to help homeowners, investors get whacked because all paper backed by these loans will need to be repriced. You’ll have even more disruptions in the bond and CP paper than you have today.
There is no easy solution. There is going to be pain.
Randy,
remember this problem began when these ‘liberal’ loans were began because they were able to be sold on the secondary market. Lenders can only lend what they can sell. I worked for a lender with a $150 million dollar warehouse line. We had to turn that over every 30-40 days or we were ‘full’. Most of these loans are owned by the secondary market so its up to them to decide if they want to re-negotiate the terms. Problem is, these loans are being held everywhere around the world now. I am a staunch pro business guy but I have to admit the greed on wall street started this. they wanted higher returns and didn’t assess the appropriate risk to it. I dont know how they didnt see this coming, I was just a little loan officer guy and I saw it coming, thats why I sold my home in Oct 2005 and moved.
I have to agree with Ralph, I really think some bad things are a comin’… (but I have been saying this for 2 years now)
Brian B. “I dont know how they didnt see this coming”
I think they did see it coming, but maybe this little parable will help understand why they did what they did anyway.
Two hikers came across a bear on the path ahead. The first says “let’s run”. The second asks, “do you really think we can outrun the bear?”. As he turns and runs, the first replies with “I don’t have to outrun the bear, I only have to outrun you!”.
In other words, the big fear isn’t losses, but failing to outrun the other guy.
It’s innate greed at work. As long as no realtor, mortgage-broker, banker, CDO originator or CDO reseller has to return his/her salary or bonus, he/she doesn’t care *enough* about what happens to someone else to back away and say “no, I’m not going to participate in this”.
Capitalism harnesses this greed. But, the effectiveness of capitalism is proportional to the extent market participants are held accountable for forseeable consequences. Often, they’re not, thanks to corporate veils, D&O insurance, “heads-I-win-tails-I-don’t-lose” compensation schemes, etc.
>> I have to admit the greed on wall street started this
They had a lot of aiders and abettors *all* over the home-building/selling, loan origination/selling, and investment fund food chain.
I hope very few of the people in those industries use the phrase “personal responsibility” when talking politics. Most of them proved they don’t take responsibility. They road the gravy train while it lasted. “Losses”? They turned the concept of a “loss” into an externality, i.e., gave the empty bag to someone else. Since the amounts are bigger, they’re worse than welfare cheats.
As BR has been saying all along, this has not been a housing bubble so much as a credit bubble, and this bubble will have to be worked out in a variety of debt instruments: consumer credit, CRE loans, Leveraged Lending (LBO debt), junk bonds, etc.
Opaque, thinly traded derivative products based on underlying asset-backed securities collateralized by mortgages that should have never been written is just the main ring of the credit crunch circus.
I expect 2008 will be the year where we start seeing the credit crunch affect other sectors of debt, and if this leads to further consumer pull-back (we are already seeing evidence in retail sales and mass-market food service), then a recession is highly likely.
We are also seeing that economic “decoupling” is not happening as the credit crunch is affect the financial systems in both Eurozone and in China, and slower economic growth is already being seen in Europe.
It is a time to be very vigilant regarding the equity market…
Wunsacon,
I agree exactly. I believe that capitalism is a great system, but some people who “believe” in capitalism think that it automatically keeps things in balance. It does no such thing. It counts on the participants to search out imbalances and makes no guarantee they will do a good job. Capitalism isn’t working as well as it shoudl because the world currently is lacking in good captialists. By that I mean that people expect to be protected from their bad decisions and to profit from their good ones. And they are being made right by bad democrats (I don’t mean the party) who let the bailing out continue. The problem is not with the “schools” it is with the “students”.
http://www.fnarena.com/index2.cfm?type=dsp_newsitem&n=69FD8402-17A4-1130-F592B7B7765FEB9F
i wouldn’t worry about it. this market is going higher this week, month and year.
Estragon-
What I’d really like to see is a representative algorithm that is being used to “price” the derivatives- the “models” in “mark-to-model”.
If that were the case, I could revise and “price” them to suit my perception.
The biggest problem (as I see it) is that the loss provision models currently being used in the “pricing” (and consequent writedowns) are probably too simple to accurately reflect the extremely complex inter-relationships of the types of debt that have been packaged together.
Analogy: weather predictions circa 1930.
Illiquidity of instruments, cost/ availability of short term debt for cash stream refi (the fund sustenance), and underlying asset deflation, macro-eco effects, etc., complicating matters.
Anyway, let the games begin! Someone was saying the other day about how they needed advice on how to short this sector. My take is that sometimes you can’t save any of the furniture, you’ve just got to let the house burn down and pick through the rubble.
The FED will wave its’ wand and cut rates repeatedly over the next 6 months in order to keep the credit spigots open. Fear not!
>Lenders are eager to unload the properties,
>and the homes tend to be in poorer condition.
If they let these places sit vacant too long, they’ll become a complete loss. The local kids have figured out that a “For Sale” sign means “Fun place to throw rocks at windows” –and once the bank notices and boards up the windows, it really doesn’t sell.
Every week these sit unoccupied is another week they get stripped of their air conditioners, heaters, water heaters, washer and dryers, and eventually the sinks and the pipes in the walls. Wonder what’ll happen to all those marble countertops.
In the end, there’s going to be a lot of blighted properties bulldozed.