The Mortgage Meltdown: Is the Other Shoe About to Drop?

According to a December 14, 2008 segment of 60 Minutes entitled “The Mortgage Meltdown,” we are apparently in the lull of the first half of the mortgage crisis. The first shoe to drop was the $trillion+ write-downs due to defaults in the subprime mortgage sector. The good news is that most of the air has already leaked out of this bubble, but the bad news is that another, perhaps more sizable, bubble is beginning to form.

The other shoe: The Alt-A and Option ARM mortgage bubble

This new bubble is composed of more esoteric types of mortgage instruments, the so-called “Alt-A” and “option ARM” mortgages. (See below for a brief explanation of each.) Credit Suisse estimates this bubble to be roughly the same or even slightly larger than the previous one. Defaults are expected to kick-in now and ramp up rapidly through the next two years peaking in the summer of 2011. If this gruesome scenario pans out, I don't think a depression is out of the question.

But this next bubble may not turn out to be as bad as projected. According to several realtors who posted their opinions on blog threads about this news segment, some of these mortgages have already been priced into the subprime bubble. But don't get too optimistic because the general consensus is that the worst is still far from over.

Assuming we have any money left with which to invest, the question is: How can we profit from this?

Short plays

Obvious choices are long-term bearish plays on any of the major indexes (DIA, SPY, etc.), the banking sector (XLF), the home builders and home construction (ITB, XHB, PKB), consumer discretionary (PEJ), retail (RTH). [Corresponding ETFs in parentheses.] It seems as if a paradigm shift in our saving and spending habits (more saving, less spending) is in process and anything that addresses this shift could be investment-worthy.

Long plays

Although the government is pressuring banks into easing foreclosure requirements that doesn't mean that foreclosures are going to disappear. Far from it. In the 60 Minutes piece, one analyst estimated that 50-70% of the Alt-A and option ARM mortgages will end in default. This means that contrary to the popular belief that the housing market will begin to turnaround this summer, more than likely that will be when it begins a new downward spiral. People will be forced to move to smaller homes (if they can even get a mortgage), into rental units, or (gasp!) move back in with dear ol' mom and dad.

Personally, I believe that the latter is going to be a very popular option simply because it's the cheapest. I'll even go so far as to predict a decline in the high-end rental markets and even an exodus from high-rent metropolitan areas such as New York City, San Francisco, and Los Angeles. (There's already a plethora of “For Rent” signs here on the West Side of LA, the likes of which I haven't seen in a very long time.)

People will be moving and needing a place to store their stuff. The next coming wave of foreclosures could well be a boon for the moving and storage companies: Ryder (R), Amerco (you know it as U-Haul) (UHAL), Public Storage (PSA), Sovran Self Storage (SSS), U Store It (YSI), and Extra Space Storage (EXR). The last four companies operate as REITs and as such pay dividends; Sovran and Extra Space sport dividend yields of 9.3% and 10.6% respectively. Although not a REIT, Ryder does pay a dividend (2.7%).

Other companies who could fare well are furniture and home appliance rental companies such as Aaron Rents (RNT) and Rent-A-Center (RCII). Aaron Rents has been doing extremely well of late. It closed today at $27 and is only $3 away from its all-time high of $30. It's been trading in a rising channel meaning that any break below the lower trend line should be treated with caution as that's usually a strong indication of a price reversal. (See chart below.)

Less money means people will be electing to fix up their cars rather than trading them in for new ones so a case could also be made for auto parts suppliers such as Autozone (AZO), Advance Auto Parts (AAP), O'Reilly Automotive (ORLY), and Pep Boys (PBY). Of this group, Autozone has been kicking the competition's butts. Its stock is looking to test its $140 all-time high for the fourth time. Manny, Moe, and Jack, however, need to tune-up their operations. Their stock is sitting near its historic low of $3 but on the bright side, it does pay a dividend of nearly 8%.

A similar argument could be applied to the home builders but then again what they gain in DIY home repair projects could be offset by projects lost to new housing construction. I'm definitely no expert on this one.

The above is but a tip of the iceberg of possible plays. As always, do your own due diligence before investing.

Conclusion

The above speculation is based on the opinions of a few people interviewed by 60 Minutes. In the interest of full disclosure, I have to say that I've always regarded that program's journalistic integrity. Although I have no evidence to the contrary, I do feel as if they slant their segments to emphasize one side of the story--theirs. But even if their predictions presented in "The Mortgage Meltdown" were exaggerated, I don't believe they're false and neither do most of the real-estate professionals who have seen and commented on it. I think it's only wise and prudent to be prepared for more fiscal pain. Nationalization of the banking and financial industry could well become a reality.

I truly hope not.

Alt-A and Option ARM Mortgages: Alt-A mortgages fall between the prime and sub-prime loan requirements; they're riskier than the former and not as risky as the latter.

Option ARMS are insidious types of loans whereby an ultra-low payment rate (also called a “teaser” rate and often around 1%) is offered initially. The loan resets after a specified period of time (usually 5 years) and depending on the terms of the loan, the rate can go up dramatically. These loans have an inherent negative amortization component and it's entirely possible that the loan principle can exceed the value of the property. These loans are hallelujahs for house flippers in rapidly rising real-estate markets. In declining markets and in rising interest rate environments, you can easily lose your shirt.

Comments

[Sonia:]

More trouble is coming. People who purchased homes many years ago with 20% down are now under water, even if they were not tempted to take money out with second mortgages. A friend in Ohio owes more than 30K more on her modest home than it would sell for; there are a number of foreclosed homes in her long-established neighborhood. Her income as a real estate agent is collapsing and she questions how much longer she can pay her mortgage. To stop a vicious downward spiral, the government needs to refinance all mortgages across the board at 3% interest, allowing owners to stay in their homes and young people to be able to buy. Second mortgages should be outlawed. Not so long ago, TV ads invited "get a loan to take a vacation" - the ultimate stupidity!

Jan 18 11:21 AM

[Richard K:]

"According to several realtors who posted their opinions on blog threads about this news segment, some of these mortgages have already been priced into the subprime bubble."

In other words, the next wave of losses have been forseen by the same wise heads that were completely surprised by the original subprime losses. Unlikely.

Jan 18 01:35 PM

[je:]

I agree with most of the article but I don't think 60minutes or anyone else that I have read has really looked at other things that are happening.

Consider what would happen if in the case of Florida property where so many people have simply walked away. They do not have a perecentage value to these walk aways as far as I know but this is going to become an even greater problem than it is now.

Then consider what will happen once condo assn.'s start to go after people who are collectable for the assn. fees and then the state will go after them for back taxes. Those who can not shake the property will rent the property for whatever they can get to help off set the expenses and consequently driving rents down and that will drive values down even further.

You can go on and on with these types of scenarios. Do not forget to factor in the social consequences of all of this on the property values. You have to remember that HUD pays no property taxes. They credit the new buyers with the back taxes.

Think what happens to police, fire, and other services that will ultimately affect property values and the livability of areas.

I used Florida as an example because I think those problems are magnified there, but the ideas applies to the entire nation.

Jan 18 06:56 PM

[sr9web:]

Having previously been blind to the bundled mortgage securities disaster (CDOs, CLOs, CMOs, etc.) but now having determined that most of the junk in those securities was "subprime", all the armchair pundits are now waking up and forecasting more disaster. However, just like they were a day late and a dollar short or the 1st go-round, they are no over-shooting in their forecast on the 2nd go-round.

The next debt wave of the debt debacle will be credt-card debt in that the 1st wave caught all the pipe-dream mortgage debtors (no $ down, too much ouse, variable rate, etc,) but this next wave will impact a level of debtors with somewhat more acumen. These debtors know that flaking on CC debt is much better than flaking on your mortgage - for the simple reason that you still need a place to live.

Suffice it to say that while "Alt-A" loans will still be trouble, if you look carefully, you'll see that most of those that flake are actually a poor credit risk and never were bona-fide "Alt-A" to begin with. And indeed, much of these people have flaked already.

Jan 19 01:16 AM

[bobbobwhite:]

"The gift that keeps on giving"......... I am sure that places like Hallmark, with it's Pollyanna feelgood phrases of eternal optimism, never in a million years saw this crisis coming. But, the rest of us...........where were our heads?

This recently exposed recession/depression will surely either clear out the vast debris clog of, at best, fiscal irresponsibility, and at worst purposeful criminal activity. If not, the abject failure of well-paid Wall Street financial houses will lead our way downward toward total system failure.

My best clue to what will happen is.... after all that bailout/handout money, nothing is getting any better. The vast infusion of taxpayer dollars to failed banks has done no perceptible good, as all it is seemingly accomplishing is encouraging the undeserving recipients to unashamedly ask for even more. And, the worst of it is....not one word has been spoken by the gov't about helping all the very responsible people who helped build this country get back what they lost in their retirement accounts through no fault of their own. That is a travesty!

Has the last shoe fallen? I do not think so. Not even close.

Jan 19 11:37 AM

[AllStreets:]

Unfortunately, in absence of a very special program of government loans directly to consumers, such as The AllStreets Bailout Plan at www.themortgagenews.in..., the crisis has only just started for many reasons, including the forthcoming interest rate resets on prime ARMs, Alt-A ARMs, recasting of option ARMs payments, ballooning of 5-year and 7-year Agency balloon loans, the end of interest-only payment periods on prime and alt-A ARMs, and recasts of home equity lines of credit as they enter their repayment periods. And we should mention there's a big problem in the commercial real estate lending arena where virtually all loans are 5, 7 or 10-year balloons, of which few can be refinanced now due to loss of property equity and the creditor freeze. Any economic recovery will not be soon enough or strong enough to bail many of those loans. More importantly, the loan programs that would be needed to bail out a large portion of those borrowers are no longer available and won't return under any set of foreseeable circumstances, even if property values wnet back up tomorrow to 2006 levels. We should also mention that the TARP program or program to bail out the lenders, won't do anything at all for the borrowers or for property values. The loans held by the lenders will still default in large numbers; the economy will remain at risk. The new economic stimulus plan in Congress won't solve the credit crisis and will take years to significantly afffect housing values, if at all.

Subprime ARM defaults started the crisis due to the dangerous, usurious terms of their interest rate resets, that to this day have not been modified or regulated by Congress in one of the worst government neglects in history. In spite of the firm warnings of Fed Chairman Bernanke in December, 2006 that a crisis was set to happen, in early 2007 Congress deferred to the promise of the Hope Now Alliance of lenders and servicers to modify the ARMs. They didn't get the job done in time, or at least not done sufficiently to avert the crisis.

Since then, with the big drop in housing values, possibly the biggest problem, that few mention, for borrowers and their lenders, is second mortgages of all kinds: fixed rate, balloons and home equity lines of credit. Probably a large proportion of the approximately 25% of all homeowners of all credit grades who have zero or negative equity have such loans and are trapped so they can't refinance or sell without a short sale. These negative equity positions have demolished lender and investor balance sheets. Lenders of all sizes were huge players in these, but especially the big ones, CitiMortgage, Chase, Wells Fargo, WAMU, US Bank, Wachovia, SunTrust, etc., as portfolio loans, and hundreds of investment banks and lenders who sold all their loans to Fannie or Freddie and Wall Street investment banks. And then there are the investors of mortgage securities for those loans taking big write downs. It looks like many more big write downs and bank failures are likely.

Regardless of the type of mortgage being held, as long as so many borrowers are upside-down, or at least lacking enough equity to sell or advantageously refinance, lenders will be severely at risk of continued walk-aways and defaults for many reasons, including unemployment, medical expenses, necessity to move, inability to payoff or refinance an unsupportable ARM or balloon, etc.

The other huge problem that exists now that didn't in 2006, is that so many of the loan programs are unavailable, including Alt-A, subprime, second mortgages for more than 85% CLTV, option ARMs, and low documentation processing (stated income, no ratio, no doc) for any mortgage loan of any type. That means that probably no more than about 50% of those who could get some type of mortgage in 2006 can get one now, even if they have enough equity, because the loan programs they qualified for no longer exist. In addition, many who still would qualify for loans are now upside down on their property...so the property doesn't qualify.

As far as Alt-A and option ARMs are concerned, as resets begin in large numbers this year the big wild card is the levels of interest rates for the indexes used to reset the rates, mainly the 6-month LIBOR, the 1-year LIBOR and the "MTA" Index based on the 12-month rolling average of 1- year U.S. Treasury securities. With rates where they are now, rate resets would actually yield a drop in rates and payments for most prime ARMs, Alt-A ARMs, and option ARMs. However, if short rates spike, there will be a disaster. Another big issue with option ARMs, aside from the reset rates, is that they all recast to fully amortizing payments five years after origination. That means many will go into recast over the next few years. Due to borrowers' use of the low negative amortizing payments, many have large balances and will need much larger payments with 25-year amortization even with low interest rates, and many are upside-down and can't refinance or sell without a short sale. Also, a large number of those were issued in California where large loans are severely upside-down.

Another category of loans that will definitely have a big problem is the Agency 5-year and 7-year balloon loans that were sporadically popular in 2005-2006, and will require payoff or refinancing in 2010-2012.

Another category of loans that will have new trouble are the "interest-only ARMs. When interest-only payments end, the loan balance is recast with fully-amortizing payments, for 25-years on most of them. That will entail a big jump in payments for many, and many of those can't refinance or move without a short sale. Included in this category are home equity lines of credit, that have interest-only minimum payments during the initial draw period, and then recast to fully amortizing loans for the balance of their terms. Many of those had 5-year draw periods and 15-year repayment periods. Those will be a problem for many borrowers.

The list of insoluble and/or unpredictable major problems is long and troubling. Millions of homeowners, and the entire banking system remain severely at risk for years. To ensure that a financial cataclysm does not develop, the U.S. government, or the President acting alone with his Emergency Economic powers, should enact a direct to consumer lending program, such as The AllStreets Bailout Plan, as soon as possible.

Jan 25 02:12 PM