Wednesday, January 7, 2009

The Next Wave of Mortgage Defaults

Cram-Down Provisions
Get used to hearing this term, because it will be a key sticking point in the Obama “Stimulus Plan”. A Cram-Down is when a Bankruptcy Judge looks at an individual’s debt and decides to lower the amount on the mortgage they owe. It is Judicial Principal Reduction. The banks hate it. The economy needs it.

The Goal of the Creation of the Federal Reserve Bank
The goal of the creation of the Fed was to establish a system for creating debts, where the banks would get a constant stream of profit-producing interest payments.

The problem with the current system is that banks got too good at extracting every last dollar out of the borrower, short of making the borrower go bankrupt. The two top vehicles for this were Credit Cards and “Exotic” Mortgages. Now, the system clearing bankruptcy mechanism is not being allowed to function. This is to the benefit of the Bank Shareholder and the detriment to the Taxpayer.

Allow Me to Explain
In 2002, the economy was stuck, so the Fed cut interest rates to effectively zero (actually below zero when you factor in inflation). This, by definition, created a lot of cheap money to lend. The biggest leveraged asset was real estate, so banks loaned and homeowners refinanced their mortgages.

This refinancing at artificially low interest rates allowed homeowners to make lower payments, thus increasing their cashflow for consuming stuff. Even better, rising home prices allowed homeowners to refinance and take out appreciation in the form of a larger mortgage than the one they were paying off. From 2002-2006, homeowners withdrew $4.1 trillion of equity out of their houses, via refinancing and Home Equity Loans/Lines of Credit.

The goal of the Fed was to use housing price appreciation as a mechanism for creating new capital to fuel consumer spending and drag the economy out of recession or worse. The way to increase housing prices was to find methods for lowering monthly payments for each dollar of mortgage debt. The lower your monthly payment, the bigger mortgage and more expensive house you could afford.

“Exotic Mortgages”
Sub Prime –People who have bad credit and no money for a down payment
Near Prime – People who have less bad credit and/or poor documentation
(Near Prime will be termed as “Alt-A” in this piece)

Origination History
Up until 2000, there were approximately 700,000 Sub Prime mortgages originated annually. These mortgages allowed people with bad credit, the ability to own a home. These borrowers were forced to pay higher interest rates than those paid by a borrower with good credit and a large down payment.

Alt-A originations were running at 300,000 annually, before 2003.

In 2003, Everything Changed!
The implosion in Interest Rates made it easy for people to refinance and save money on their monthly payment. In 2000, the rate on a 30-year Fixed was 8.3%. By June 2003, the rate had fallen to 4.6%! That reduced the payment per $100,000 borrowed from $755/month to $512/month.

People didn’t save this extra money. They spent it either on a more expensive house, or they consumed products. If they plowed all of that money into a house, then they could afford to buy a 32% more expensive house and still have the same mortgage payment as they did in January 2000.

This fueled a major housing boom. Housing sales and starts increased from 6.7 million units in 2001 to 8.5 million units in 2003! 75% of existing homes were refinanced and $1.8 trillion of new mortgage debt was created.

But It Didn’t Stop There
The first leg of the housing bubble was fueled by falling interest rates. It ended in Q4 2003, as interest rates rose and mortgage originations fell 56%! Remember, mortgages originated in 2003 are not defaulting at ridiculously high rates. The mortgages were written when housing prices were still at sort of reasonable prices.

Once interest rates bottomed, new tools were needed to keep the Housing Bubble going.

The favorite tool was to build a “hybrid” mortgage, where the borrower would pay an artificially low interest rate (a “teaser rate”) for a set period of years (2 years and 5 years were most popular). After the teaser rate period expired, the interest on the mortgage would shoot up for the remainder of the term of the mortgage.

75% of all Sub Prime mortgages originated between 2003 and 2007 were “Short Term Hybrid” 30-year Mortgages.

Alt-A Mortgages did their interest rate games slightly differently. Instead of having a formal interest rate for several years, Alt-A mortgages allowed the borrower to “pick a payment”. They had the choice of paying some of the monthly interest, all of the monthly interest, or all of the monthly interest + monthly principal due. Unpaid monthly balances of interest and principal were simply added each month to the size of the mortgage.

64% of Alt-A mortgages written from 2003-2007 allowed for this practice of paying less than was actually owed each month.

Alt-A loans have what is called a “recast” provision. Recasting occurs either when the mortgage principal reaches 110 - 125% of the original mortgage, or when the mortgage has existed for a set period of time (usually 5 or 10 years). The mortgage is then recalculated, so that the homeowner must now repay the mortgage by the end of the original 30-year term. Only the monthly calculations are now made with a larger principal balance and a higher interest rate.

Both Alt-A and Sub Prime mortgages were written with the intention of refinancing the debt before the Sub Prime payment reset or the Alt-A recast. The assumption was that the value of the property would increase and the homeowner could refinance and take principal out of the house to fuel even more consumption, with a teaser rate on the new mortgage.

Extending Mortgage Terms
Another trick to decrease monthly payments was to extend the term of the mortgage. Assuming that you would pay off a mortgage in 40 or 50 years, instead of 30 years allowed a homeowner to take on a bigger mortgage and buy a bigger house. It also allowed them to take out more cash on a refinancing of their current mortgage.

This practice started in 2006. In 2006 & 2007, 25% of Sub Prime loans were calculated using greater than 30 year loan periods.

The only beneficiary of a 40 or 50 year mortgage is the bank. The homeowner will never pay off the principal, but the bank will get a stream of interest payments for the entire working life of the homeowner. That disgusts me! Who was the advocate for the Consumer?

Loan To Value
It used to be that you were required to put down 20% of the cost of the house as a “down payment”. That gradually became “nothing down at signing”.

Debt Service
It used to be that banks would only make a loan when the total monthly cost of home (Mortgage + Taxes + Insurance) was less than 28% of Gross Income. The total acceptable level of all debt service was 38% of Gross Income.

The most recent Mortgage Modification program announced by the FDIC takes the following form –

The mortgage principal will be reduced to a level where the Mortgage Payment equals 38% of their Gross Income
The Interest on the new mortgage will be artificially low (think Teaser Rate)
The difference between the new mortgage principal and the old mortgage principal is due to the bank at – the sale of the property, the death of the homeowner or in 30 years
You are not allowed to refinance or every to renegotiate the terms of the mortgage.
You cannot file for bankruptcy

Oh my goodness, the FDIC has gotten into the “Hybrid Mortgage” business…

And welcome to debtor prison, where your house is the jail and you spend the rest of your days trying to pay it off.

Where We Are Today
Over 90% of all Alt-A mortgages written between 2004 and 2007 now have mortgage principal greater today than when the loans were created. Remember, these suckers will “recast” when they get too big!

The average Alt-A mortgage written in 2007 was for $400,000. The average person is under-paying their monthly obligation by $1,250 per month on these mortgages!

People are walking away from their houses, because they owe a lot more than the homes are worth. Any plan short of a reduction in principal to make the mortgages affordable and more in line with the reality of what the home is currently worth and was actually worth, is futile.

Recasts
Sub Prime mortgages have already seen massive defaults. The Alt-A Recast Wave will hit the markets in 2009. An estimated $30 billion in mortgages will recast in 2009 and at least $66 billion more will recast in 2010.

My guess is that all of these will default. We already know that over 90% are underwater and housing prices continue to fall. The banks will have to write off these losses.

Obama
It doesn’t matter what Obama does. The simple fact remains that the banking system is still insolvent and loaded with bad loans priced at artificially high prices.

The banking system was designed to make the banks rich by making loans and collecting interest. They got too good at the game and made loans they should not have made, to people who could never afford to pay them off.

The Government was complicit, by turning a blind eye to the regulation of the lending standards banks used for making mortgage loans, the quality of the assets “Rating Agencies” rated as “Investment Grade”, the quality of the assets Insurance Companies “Insured” and the quality of assets Banks were allowed to own and use as leverage for future lending.

Now the Taxpayer is on the hook for Trillions of bad debts. We now either face massive inflation, higher taxes or a default on national debt. There are no other options. I'm not being cranky. There are no other options, short of asset confiscation (like when FDR stole everybody's Gold in 1932). My job the next few years is to participate in any market appreciation, while paying attention to protecting capital from inflation and Dollar devaluation.

The powers that be will try and inflate one last Asset Bubble, first in US Treasury Debt and then in Real Assets like Gold and Commodities. But in the end, there will be nobody large enough to bail out the Treasury, when all of those rotten assets they bought turn out to be worth pennies on the dollar of what was paid to buy them (thanks PIMCO, Blackrock, et al).

Do you see why I am so reluctant to buy stocks right now? I just do my homework and then figure out how to position money. When the Big Boys start buying again, then I will hold my nose and start buying again too. But I will be a nervous buyer with one foot out the door for as long as the last great Asset Bubble carries us.

You can read the following if you want more data –

http://www.ftc.gov/be/workshops/mortgage/presentations/mayer_christopher.pdf

http://www.aeaweb.org/assa/2009/retrieve.php?pdfid=264

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