Bloom of Doom II: Of Mortgage Brokers, ARMs, Attrition and Marathons
When first I started looking at dying mortgage banking companies back in 2007 (the time I began looking at the brewing crisis seriously) I stumbled upon the “implode-O-meter” which had begun tracking this new phenomenon in, I believe, 2006. Casualties were then in the two digit range. Soon it became three digits and ever since it has been “good going“, however, the pace slowed considerably in the second half of 2009 if I recall that correctly only to pick up recently. I remember the figures 372, then 373, then 374 to have had a rather long life span.
(See more statistical material in our References section!)
What might have happened?
We have probably two factors at play here one obvious to all mortgage industry connoisseurs, the ARMs or adjustable rate mortgages beginning to weigh in on the market plus the effects of modification programs slowly wearing off, the other a process of attrition that only can be discerned by those who can look through the veil of superficial economic activity. Let’s first get the ARMs etc. out of the way then deal with the attrition factor as I like to call it because CrisisMaven likes to take the opportunity to teach economic’s enduring wisdoms through contemporary examples everyone can relate to. After all, if you’d fancy college textbooks you wouldn’t be here, would you?
The drama of the affordable mortgage
While votes on the tragedy of the commons are still out, the drama with adjustable rate mortgages (ARMs) is beginning to play out before our very eyes. If we’re not all very lucky it may prove a giant black hole that then drags in everything, even the institutions that our financial shamans just purportedly salvaged. Harmless vocabulary abounds such as “teaser rates”, a thing that rather makes you cry, “no down payment” as if that had any upside, “adjustable rates” with the last person to have a say in that adjustment being you and so forth (of course you can negotiate up front, however, most people were “mortgage illiterate” and had “things done for them“. We all know, marketing, instead of letting you see both sides of a deal relies on painting ice-cream castles in the sky but when you thought of your home as your castle only to end up with less rich, even poor, than before by investing, of all things, in real estate, it gets beyond the joke.
What are these weapons of financial mass destruction then? Any mortgage has by and large the following elements that should fully define it mathematically:
- total amount of credit (also called principal – what you actually owe – not always what is paid out!)
- duration (how long does it run until you are finally debt-free)
- interest to be paid (in percent of principal)
That’s easy and straightforward. If a mortgage had an amount that were fully paid out and later fully paid back at a certain fixed rate of interest for a set length of time then, if you still remembered the rule of three from school, it were easy to understand, and, above all, it would contain no surprises. while we love surprises when spouse happens to remember our wedding day, there’s never a positive surprise in it or you when it comes to mortgages.
But there are any amount of snares in mortgages when it comes to borrowing from a bank, and esp. so in mortgages:
- amount of credit paid out might be less than what you ultimately owe
- the length of the mortgage may be shorter than the total period of repayment intended
- interest rates may vary, esp. they may be adjusted upward after a certain “grace” period.
While we won’t go into all the details here (this would require a complete separate post), let’s look what’s ahead esp. this year 2010 and the next. Take a look at “The downturn in facts and figures“.
The road to hell is littered with good intentions they say and so is the huge effort to save homes by e.g. mortgage modifications and moratoria. CrisisMaven believes they won’t be able to fix is the adjustable rate mortgage problem. It’s like the iceberg that sank the Titanic: you either give it a wide berth or your ship better be unsinkable. Neither was the case then and nor is the ARM problem something that can easily be remedied after the infection has already spread even if both parties, i.e. the bank and the borrower, wanted to. The mortgage is already discounted in the banks’ balance sheet and if it depreciates so does the balance sheet. Unfortunately for you, the debtor or mortgagor, you gain nothing from your bank, the mortgagee or creditor “going under” since your debt won’t be wiped out it only passes on to whoever takes over the failed bank.
Just look at the truly cosmic magnitude of this mess and the tsunami that, while it hasn’t hit the shores yet, is already rolling out there on the “wide accountansea” and gathering speed to boot:
Most commentators and politicians seem to cosy themselves along by thinking the worst was over after the so-called subprime mess had reached its peak. Little do they seem to understand, that what makes a sub-prime mortgage sub-prime is that the debtor can’t (afford to) pay from day one (I know it sounds utterly stupid, but that’s the true story when stripped of all the securitisation jargon!).
An “option adjustable rate” mortgage on the other hand is nothing but a sub-prime mortgage in the making, plain and simple. Imagine you were a home buyer who “just about” were to be able to afford a mortgage back in, say, 2005 or 2006 when the economy was good and you as a couple held down two jobs. Interest, the main chunk of monthly payments on a, say, twenty or thirty year mortgage, esp. in the beginning, is interest. Let’s say (this is just fictitious for the sake of argument, but the underlying mechanism is exactly this), the initial interest rate was 2% per annum. After the adjustment kicks in, it all depends on the long-term interest rates at the time of adjustment! Let’s say, at the time you fixed the mortgage, while the long-term interest rate already stood at 6% while you opted to settle for 2% then all the while your debt must have grown in view of the differential that you did not pay at the time. So your debt will probably actually have grown during that grace period while the value of your house has shrunk considerably. Not a good time to reset an interest rate in any event. But now another beast raises its ugly head: if the current expansion of the monetary base is any guide then to reign in inflation (as the likes of Bernanke or Greenspan “understand” it) the central bank will have to raise interest rates disproportionately, as it did back in the 1970 (and guess who called the shots back then and now again sits on the panel of presidential advisors – Paul Volcker, old school banker who may prefer to walk where others resort to helicopters).
But even if the Fed does not raise short-term rates until after the majority of ARMs have reset, it won’t matter much, as long-term interest rates d not do the Fed’s bidding but rather are determined on (international) money markets. If history is any guide, long-term interest rates will be out of control completely by the time the bulk of ARMs comes up for renegotiation.
See for example MBS WEEKLY – “Adam Quinones: Don’t Expect to See 2009 Rates in 2010“, Feb. 12, 2010:
“The rates of 2009 look to be a thing of the past.”
“If the 10 year Treasury note moves as far as 4.00%, we estimate the par 30 year fixed mortgage rate will move as high as 5.50%.”
“… rates will increase by about a percentage point over the year, ending at just 6.1 percent as a result of widening mortgage spreads and an increase in treasury rates driven by federal budget deficits. Once the Fed stops buying MBS, yields will have to increase before private investors come back into the market.” (Emphasis CrisisMaven – CrisisMaven thinks these to be rather conservativee estimates for the simple reason they don’t look at the perceived risk of lenders in the coming months due to looming sovereign defaults.)
So back to where we were: the “teaser rate” was between 2% or 3%, at the time already only a third of what should have been paid. So at that time real interest rates were already maybe 300% (!) higher than what you paid, 200% of which were clandestinely added to your principal debt, so by now you even pay “interest on interest” in most cases. But even if at the time you were aware of the 6% but thought you could afford the extra 4% but decided to first get your child through college (and maybe speculated on a promotion for yourself at the time) and after that you could “easily” afford to pay interest, even maybe principal at a higher rate, while the house would by the time have appreciated anther 20″ making you look even better on paper, by now, reality has caught up with even the most “cunning plans” and interest rates might now stand at not 6% but easily at 6%, 10% – you choose, while your house is only 50%, one of you has lost a job, son has to work now while at college, extending his stay there while diminishing his later chance of a good career … and there’s millions of more pitfalls that will soon make it into an encyclopaedia “how not to invest”.
And there are other sectors as well, not just the single-family mortgage market is in disarray: The Worst May Still Be Yet To Come For US Banks’ Commercial Real Estate Loans:
“The fallout from Commercial Real Estate exposures for banks has yet to run its course, in Standard & Poor’s opinion. … the homebuilding sector, and are well underway in commercial construction, these are the smaller sectors, S&P says in an Industry Outlook. ‘We believe the problems in the larger mortgage and multifamily sectors are yet to be felt because for now low interest rates and still-adequate cash flows make debt servicing possible. As rates rise and rent rolls decline further, we believe that delinquencies will rise in this sector as well, and prices will fall further, complicating the refinancing of these portfolios. … Our stress tests show that most rated banks are able to absorb the associated losses without eroding capital below 4% of tangible common to RWA, as long as the losses are spread over a few years. … We see no reason to believe the impact of this credit cycle in CRE will be less severe in terms of losses banks incur than that of the 1990s.’” (Emphasis CrisisMaven – Quotes are S&P‘s who have “rated more than US$32 trillion in outstanding debt”)
“The share of borrowers who are falling seriously behind on loans backed by the Federal Housing Administration jumped by more than a third in the past year, foreshadowing a crush of foreclosures that could further buffet an agency vital to the housing market’s recovery.About 9.1 percent of FHA borrowers had missed at least three payments as of December, up from 6.5 percent a year ago, the agency’s figures show.”
“… widespread fraud and other government efforts may already be driving the development of another housing bubble. The FBI says mortgage fraud is still at epidemic levels, which may be fueling the development of local bubbles. Government backed low interest rate mortgages offered by the Federal Housing Administration (FHA) are showing signs of wide abuse by home buyers. The Internal Revenue Service is investigating an estimated 100,000 to 350,000 tax payers who may have cheated taking the first time home buyers tax credit. The U.S. government is in unchartered territory as it moves to stabilize the economy through quantitative easing and is proceeding through a play book of moves to right the worst economic downturn since at least the Great Depression.” (Emphasis CrisisMaven)
Mortgage delinquency rates are constantly rising, despite publicly driven m9odification programs:
(Source: San Diego Union Tribune – Roger Showley: “10 percent reportedly late on mortgages” – hat tip “implode-O-meter“: “Nearly 10 percent of San Diego County homeowners with mortgages are at least two months late on their payments“, see also: BestCashCom.com: “San Diego a Hotbed for Missed Mortgage Payments“)
And you might also want to check out MoneyAndMarkets – Martin D. Weiss, Ph.D.: “Transcript: Nine Shocking New Predictions for 2010-2012“!
Which leads us to another, more subtle, slew of observations:
Economic attrition beginning to take its toll, or: the other shoe begins to drop …
When you run a marathon you should pace yourself well enough to make it through the whole distance. No use in leaving everyone in the dust at the beginning only to later fall by the wayside exhausted. But if you drop out, then drop out early, i.e. by the earliest time after you realise you’re not going to make it.
Let’s say, you participate in the first “wilderness marathon”. There’s lions there and other wild beasts and vultures, just like in the realm of modern finance :-) but as long as you are with the crowd, the escort vehicles will take care of that. Every few hundred yards there’s a tree that you could climb should a lion choose to attack, however, you need to be still fit enough to make the climb.
What of the following two scenarios do you guess is better: you drop out early and when attacked by a lion have enough power left to reach the tree to safety or if you fight on against all hope, don’t make it and can’t even run from a lion cub?
That’s what we’ll see happening now more and more going forward: a lot of businesses and home-owners commendably have held onto their work force resp. their homes in the vain hope the economy would turn around, as all these pundits who get their salary regardless of the state of the economy that has to generate them keep telling them.
By the time these people realise they won’t make it to the shore of the long-promised economic recovery they are already emaciated, their funds drained, the outward depression at large has turned into a state of mind for themselves as well, their car needs repair, as well as their house and their credit card rating has deteriorated to an extent where they now pay penalties even on the money they bought groceries with.
It is then, after that long and, in hindsight, futile process of utter attrition, that all the bad tidings arrive on top of all the misery: higher mortgage payments, lower salary if not outright job loss, lower home values, neighbourhood deserted with increasing danger of burglary or being mugged, longer drive to work to a new job, if any. This is what cyberneticians call negative feedback loops and what those tenured foreboders of economic developments regularly miss completely, for they think in a linear fashion. All those faith healers even with a presidential aura won’t be able to help you if you don’t help yourself!