'Intelligent discontent is the mainspring of civilization.' -- Eugene V. Debs

Monday, June 16, 2008

The Masque of the Red Death (Part 2) 

Over at Calculated Risk and Mr. Mortgage, they are highlighting the next, even more serious, stage of the credit crunch that I anticipated back in January. The problem? Pay Option Adjustible Rate Mortgages. I know that this is laborious, but stay with me on this:

An "option ARM" is typically a 30-year ARM that initially offers the borrower four monthly payment options: a specified minimum payment, an interest-only payment, a 15-year fully amortizing payment, and a 30-year fully amortizing payment.

These types of loans are also called "pick-a-payment" or "pay-option" ARMs.

When a borrower makes a Pay-Option ARM payment that is less than the accruing interest, so-called "negative amortization" will occur, which means that the unpaid portion of the accuing interest is added to the outstanding principal balance. For example, if the borrower makes a minimum payment of $1,000 and the ARM has accrued monthly interest in arrears of $1,500, $500 will be added to the borrower's loan balance. Moreover, the next month's interest-only payment will be calculated using the new, higher principal balance.

Option ARMs are popular because they are usually offered with a very low teaser rate (often as low as 1%) which translates into very low minimum payments for the first year of the ARM. During boom times, lenders often underwrite borrowers based on mortgage payments that are below the fully amortizing payment level. This enables borrowers to qualify for a much larger loan (i.e., take on more debt) than would otherwise be possible. When evaluating an Option ARM, prudent borrowers will not focus on the teaser rate or initial payment level, but will consider the characteristics of the index, the size of the "mortgage margin" that is added to the index value, and the other terms of the ARM. Specifically, they need to consider the possibilities that (1) long-term interest rates go up; (2) their home may not appreciate or may even lose value or even (3) that both risks may materialize.

Option ARMs are best suited to sophisticated borrowers with growing incomes, particularly if their incomes fluctuate seasonally and they need the payment flexibility that such an ARM may provide. Sophisticated borrowers will carefully manage the level of negative amortization that they allow to accrue.

In this way, a borrower can control the main risk of an Option ARM, which is "payment shock", when the negative amortization and other features of this product can trigger substantial payment increases in short periods of time.

For example, the minimum payment on an Option ARM can jump dramatically if its unpaid principal balance hits the maximum limit on negative amortization (typically 110% to 125% of the original loan amount). If that happens, the next minimum monthly payment will be at a level that would fully amortize the ARM over its remaining term. In addition, Option ARMs typically have automatic "recast" dates (often every fifth year) when the payment is adjusted to get the ARM back on pace to amortize the ARM in full over its remaining term.

For example, a $200,000 ARM with a 110% "neg am" cap will typically adjust to a fully amortizing payment, based on the current fully-indexed interest rate and the remaining term of the loan, if negative amortization causes the loan balance to exceed $220,000. For a 125% recast, this will happen if the loan balance reaches $250,000.

Any loan that is allowed to generate negative amortization means that the borrower is reducing his equity in his home, which increases the chance that he won't be able to sell it for enough to repay the loan. Declining property values would exacerbate this risk.

No doubt most of you have already figured out the severity of the problem based upon the bolded parts of the definition. But let's go through it as if we were presenting a term paper to a demanding, old school professor.

First, lenders offered these mortgages to just about everyone, not just sophisticated borrowers with growing incomes, because they could not otherwise lend money to people to buy homes in most regions of the country. Along these lines, please observe that the notion that the housing bubble was a bi-coastal one, centered predominately in California and Florida, is a myth. As noted by Mr. Mortgage, the fraud and negligence associated with the issuance of these loans, as with subprime ones, is staggering:

. . . This just goes to show you how lax everything was over the past 5-years. The investment banks were so hungry for parts (loans) for their Frankenstein securities that they bought almost anything. Heck, why not when 80% of what was produced was going to be bundled up and sold anyway?

This is why I firmly believe that originating banks and/or original investors will ultimately end up responsible for all of this in the end. Forced buybacks for early payment defaults (first 12-months), ‘white-lie’ fraud (liar loans), unauthorized ‘exceptions’ (outside of investor guidelines without investor approval) and lender ‘negligence’ (sloppy underwriting/quality control) are already being demanded by whole loan and securities owners if an audit on a loan in default unveils any of these deficiencies. If you are diligent enough, I am willing to bet an auditor can find one of the above mentioned deficiencies in 80% of all Prime, Alt-A and subprime loans made over the past five-years.

I have written about this many times and the WSJ recently published an article on May 28th, 2008 confirming many of my views. ‘Investors Press Lenders on bad Loans’ . The article cites a lawsuit filed in LA Superior Court where units of the mortgage insurer, PMI Group, alleged WMC Mortgage Corp breached it’s ’reps and warrants’ on a pool of subprime loans insured by PMI in 2007. Within eight months, the delinquency rate was at 30%. The suit also alleges that a detailed audit of 120 loans that PMI asked WMC to repurchase found evidence of ‘fraud, errors and misrepresentations’. WMC was owned by GE by the way.

The auditing of defaulted loans looking for fraud or lender negligence is escalating at a feverish pace. This is being spearheaded in many cases by the mortgage and bond insurers, but even Fannie, Freddie, banks and the investment banks are picking up the pace. At this point in time considering the damage that has been done to the insurers, the have nothing and everything to lose. The biggest finger-pointing contest of all time is commencing and prize maybe the firm’s very existence.

Perhaps soon one of the insurers will release detailed reports on the amount of fraud and negligence on the defaulted prime, ALT-A, subprime and home equity loans that they insure in an attempt to make themselves look good. When this news breaks it will shock the world.

Second, let's go back to the wikipedia definition: When evaluating an Option ARM, prudent borrowers will not focus on the teaser rate or initial payment level, but will consider the characteristics of the index, the size of the "mortgage margin" that is added to the index value, and the other terms of the ARM. Specifically, they need to consider the possibilities that (1) long-term interest rates go up; (2) their home may not appreciate or may even lose value or even (3) that both risks may materialize.

As already discussed, we know that neither the lenders nor the recipients of Option ARMs were prudent. Certainly, that's cause for serious concern, and, guess what, long term interest rates have gone up and the homes of the borrowers have lost value! In other words, huge numbers of Americans can no longer pay their mortgage and can't sell their house. As Mr. Mortgage rather summarily concludes: This loan was never intended for holding for any significant length of time or in a massively declining value environment.

Really? And yet it has been used for precisely these purposes over the last 3 years. Robin Blackburn, in a New Left Review article recommended here recently, provides us with the obvious explanation in relation to the broad universe of speculative debt instruments such as this one (cdos is shorthand for collateralized debt obligation, an asset backed security commonly backed by home equity loans and various forms of consumer debt, such as credit card receivables, car loans and student debt):

How on earth could such risks build up? The source of the problems which surfaced in 2007—though some had warned about them years earlier—did not lie only in the us deficits or the Fed’s easy money policy. It also lay in an institutional complex and a string of disastrous incentives and agency problems riddling an over-extended system of financial intermediation. To start with, take the incentives relating to those notorious ‘subprime’ cdos. New subprime mortgages rose from $160 billion in 2001 to $600 billion in 2006—by which time they constituted one-fifth of mortgage originations. The salesmen responsible for this surge received a generous commission for each new loan, paid upfront but expressed as a proportion of the redemption payments to be made over several years. Brokers happily signed up ‘ninjas’—no income, no job and no assets—by the hundred thousand. This behaviour was directly encouraged by their incentive structure, while legislation dating back to the 1960s had relaxed credit standards for the low paid and jobless without reckoning with the likely consequences. The Bush administration’s vision of the ‘ownership society’ somehow latched onto codicils of Johnson’s ‘Great Society’ to encourage the poor to take on housing debt at the pinnacle of a property bubble. The quality of the arrangements made for poorer mortgagees was manifestly inadequate—they had no insurance provision—and also avoided the real problem, which is the true extent of poverty in the United States and the folly of imagining that it can be banished by waving the magic wand of debt creation. Indeed the subprime borrowers were lured into inherently bad deals by those low ‘teaser rates’ that bore no relation to the large payments required of them down the line.

The bad mortgage bets were to be hugely compounded by the investment banks that purchased the mortgage debt for resale, supposedly according to the ‘originate and distribute’ model—take on debt, repackage it, and sell it on. As a report in the Wall Street Journal explained:

Upfront commissions and fees are well established on Wall Street. Investment banks get paid when billion-dollar mergers are signed. Firms that create complex new securities are paid a percentage off the top. Rating services assess the risk of a new bond in return for fees off the front end.

Just to complete the picture, one should add that such fees are not only garnered by those in investment banks who construct and sell asset-backed securities. On the day his employer announced a write-down of over $8 billion, a managing director at an investment bank explained that the bank’s own senior risk-assessment officer had received a bonus of $21 million in the previous year for his part in the great cdo bonanza. What was more, this executive still did not report directly to the board.

Bonus points for those of you who are still alert and caught Blackburn's identification of the ideological foundation for the promiscuous extension of credit that has resulted in the credit crunch: The Bush administration’s vision of the ‘ownership society’ somehow latched onto codicils of Johnson’s ‘Great Society’ to encourage the poor to take on housing debt at the pinnacle of a property bubble. The quality of the arrangements made for poorer mortgagees was manifestly inadequate—they had no insurance provision—and also avoided the real problem, which is the true extent of poverty in the United States and the folly of imagining that it can be banished by waving the magic wand of debt creation.

Clearly, a compelling subject, especially Blackburn's wise insight that LBJ and Bush are politically and psychologically linked in terms of their propensity for grandiosity, but one beyond the scope of what I can address today. For now, it is more important to target two critical aspects of the burgeoning crisis involving Pay Option ARMs. The aggregate amount of these mortgages going sour is significantly greater than the amount of the subprime ones that ignited this crisis, and the recipients of them cut across all socioeconomic groups.

Let's go back to Mr. Mortgage:

Pay Option and ALT-A loans are defaulting at an accelerating pace in recent months. A couple of months ago, I made an ALT-A video with real data from the Fed comparing the total subprime vs. ALT-A universe’s. . . The ALT-A universe is much larger than the subprime universe in the higher priced states like CA and even nationally, it is somewhat larger. But due to the sheer exotic nature of many ALT-A loans, such as the Pay Option ARM, the crisis will likely be that much more devastating.

In order to get this right, we must be aspire to be as precise as possible, a challenging task for lefties like me, to be sure. Pay Option ARMs are part of a large universe of dubious mortgages known as ALT-A ones, and the ability of borrowers to pay them is being rapidly degraded by rising interest rates and declining housing values as already noted in relation to Pay Option ARMs. A quick perusal of the definition of an Alt-A instrument reveals why:

Within the U.S. mortgage industry, different mortgage products are generally defined by how they differ from the types of "conforming" or "agency" mortgages, ones guaranteed by the Government-Sponsored Enterprises (GSEs) Fannie Mae and Freddie Mac.

There are numerous factors that might cause a mortgage not to qualify under the GSEs' lending guidelines even though the borrower's creditworthiness is generally strong. A few of the more important factors are:

--Reduced borrower income and asset documentation (for example, "stated income", "stated assets", "no income verification")

--Borrower debt to income ratios above what Fannie or Freddie will allow for the borrower credit, assets and type of property being financed

--Credit history with too many problems to qualify for an "agency" loan, but not so many as to require a subprime loan (for example, low scores or serious delinquencies, but no recent charge-offs or bankruptcy)

--Loan to value ratios (percentage of the property price being borrowed) above agency limits for the property, occupancy or borrower characteristics involved

In this way, Alt-A loans are "alternatives" to the gold standard of conforming, GSE-backed mortgages.

Don't you just love that antiseptic language of the financial industry? An alternative to conforming, GSE-backed mortgages. An amusing way to describe the extension of credit to people on terms who otherwise would not qualify for it. Pay Option ARMs, because of their sensitivity to increase rate increases and reductions in property values, are in the vanguard of Alt-A instruments to go into default.

Remember, Pay Option ARMs reset at markedly higher interest rates after the expiration of the introductory teaser rate, and permit people to make monthly payments at a rate that results in negative amortization, that is, the cashing out of any remaining equity in the property, so, when property values fall, the borrower reaches a principal ceiling amount. Either events triggers a substantially higher monthly payment, and both combined pushes it through the stratosphere. And, yes, you guessed it, by the time the lender gets the property, the house is not worth anything near the amount of the loan. They therefore signal a contagion that will spread throughout all Alt-A instruments.

Strikingly, we are now beginning to see delinquencies and foreclosures in middle and upper middle income neighborhoods, as noted by our friends over at Calculated Risk:

This is not a subprime problem. The reason the delinquency rate is rising rapidly in Orange County is because homes are very expensive, and a large number of recent home buyers used ARMs, especially Option ARMs, as affordability products.

Now that the interest rate is increasing - and in some cases the loans are hitting the maximum allowed principal ceiling - these loans are no longer affordable. Since these same homeowners have negative equity, selling the home is not an alternative.

The important point here is that delinquencies are starting to increase rapidly in middle to upper middle class neighborhoods where buyers used "affordability products" to buy more house than they could really afford.

Of course, long time readers of this blog with good memories are not surprised, James Cramer predicted this last year here and here when he said that he considered nearly all loans issued in 2006 and 2007 to be worthless.

The consequences are likely to be profound. Mr. Mortgage has already outlined some of the dire consequences for the financial sector in the lengthy quote near the top of this post. We can anticipate more writedowns, more dubious interventions by the Federal Reserve and a continued curtailment of the extension of credit, even in transactions between major instituions, due to loss of confidence in the system as it becomes evident that, by traditional accounting standards, much of the US banking system is bankrupt. Time to return to Robin Blackburn:

If the major banks are forced to reduce the book value of their cdos by 50 cents on the dollar, this will wipe out the equity value of their businesses and make them technically bankrupt. Banks which face this danger include Citigroup, Merrill Lynch, Lehman Brothers and Morgan Stanley, but there are likely to be surprises too. Of course no major bank will be allowed to fail. Instead the authorities will devise rescues, buy-outs and mergers. Rather than the stern treatment meted out to Enron and Worldcom, we shall see ‘socialism for bankers’ as public money is mobilized to prop up finance houses that are too big to fail. The Bear Stearns rescue was hard on shareholders but not bondholders or counterparties. JP Morgan, the purchaser, is the beneficiary of a Federal Reserve guarantee covering $29 billion of assets held by Bear. In the weeks following this rescue the Fed lent a broadly similar sum, in confidence, to several other banks, with Level 3 securities as collateral. The main alternative to the injection of public funds would be further input from sovereign wealth funds.

For careful readers, Level 3 securities are frequently CDOs, which have no market that attaches a value to them in daily trading activity, and have been exposed in many instances, such as the obvious subprime catastrophe and the emerging Alt-A one, as worth much less than the value attributed to them by mathematical models created by the financial industry, if not completely worthless. And, yes, you read it right, the Federal Reserve is lending billions and billions of dollars to the financial institutions and accepting them as collateral. I will leave it to you to draw your own conclusions as to whether the market in these instruments will recover sufficiently to enable the Fed to obtain the full recovery of principal.

But there are also alarming social consequences as well. Last summer, as the crisis was first beginning to generate a lot of public attention, I made the following observation:

For the lending industry and Wall Street, it was a great party while it lasted, as the loans were securitized and purchased by hedge funds, with lucrative fees pocketed by all.

Of course, they now have their own problems, as you can read on all over the web, but what about the people who are losing their homes? What is going to happen to them? The answer is, as we all know, it is going to be brutal. Many of them are going to be pushed into the rental market for the rest of their lives, and many are going to have to leave the locations where they currently reside because even the cost of rent is going to be too much for them. So, we are looking at the prospect of two migrations, one from houses to rentals, and the other from expensive parts of the country to less expensive ones. Furthermore, quite a number of communities built for home owners will rapidly become rental ones. Some may even resemble ghost towns, as it becomes impossible to fill all of the homes with residents.

Left academics would say that the socioeconomic life of the US will subtlely display more and more features of sub proletarization, as more and more people in the lower middle class and even the middle class find themselves forced to migrate internally within the country (an economically generated group of internally displaced people?) and live under conditions of financial insecurity.

I still believe that this will happen, if it has not already started. After all, you don't tend to hear a lot about people who have lost their homes. Paradoxically, the people who can afford to pay their mortgage, but live in homes with zero or negative equity, are now stuck in these houses. They can't move for more lucrative and/or fulfilling jobs elsewhere. As noted over at Calculated Risk:

There are probably close to 10 million households currently with zero or negative equity in the U.S. For these homeowners, it will be very difficult to accept a job transfer to a different county or state.

Fore more on the subject, go here. As I said in July 2007, the era of globally subsidized credit, and the conspicuous consumption facilitated by it, is over. Yet the left seems, except in rare instances, to have little to say about it. Meanwhile, if Daily Kos is any indication, liberals are trapped within the debilitating cul-de-sac of presidential electoral politics. Later this week, I will explain why I believe the economic disruption caused by the credit crunch is something that leftists need to begin to address.

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