Originally uploaded by R_Thull
About a year ago, as our nation began to assimilate the shock of the subprime collapse, there was a growing sentiment that the worst of the real estate correction was over. In response to this notion, I posted an SA article entitled “Market Prices: The Great Chasm” in which I went on record as saying the true real estate correction had yet to begin in earnest.
I explained my thesis that subprime was not a socio-demographic thing, but rather a math thing. I pointed to a chart that suggested a year hence the prime market would first show signs of cracking, and then follow the same brutal course.
Well unfortunately, right on schedule, and despite unprecedented fiscal policy to hold the dam together, it appears the cracks have begun. According to a 12/21/09 report issued by the Office of the Comptroller of the Currency, Office of Thrift Supervision, in the shadow of slightly rosier news about loan modifications, the report states:
…serious delinquencies rose to 6.2 percent… of particular note was the deterioration among prime mortgages, the largest category of mortgages. Serious delinquencies at the end of the third quarter increased to 3.6 percent of prime mortgages, up almost 20 percent from the previous quarter and more than double a year ago.
Predictably enough the banks, government, and media will all point to this next wave of the real estate collapse as subprime contagion, spreading its toxic cloud over the rest of the country. But make no mistake… this result will be a direct reaction to 5yr rate re-sets on prime, interest-only loans.
The trigger point of the subprime collapse was the re-setting of 2yr interest-only loans to principal and interest, which got re-amortized over the remaining 28 years of their 30yr term. The paying the principal part is what spurred the collapse.
As our 5yr terms approach expiration, I hear many folks say stuff like, “well the rates are so low, and the Fed can bluff all they want, but the fact is they’re gonna keep ‘em low”. Well, an increase in rates would be devastating, and an increase indeed may be approaching faster than consensus suggests… but that’s not what’s going to do us in. It is the switch to paying principal and interest that will crash our real estate and equity markets.
We are now seeing the 5yr loans re-set. Roughly half of these loans will be re-casting to 25yr amortization. This means the payment shock will be even greater than it was during the subprime collapse.
It does not matter than you are well insulated. What does matter is that some, if not many, if not most of your neighbors are earning less than they were when they secured their loan… and darn it if their expenses haven’t seemed to increase concurrently.
Now consider these points:
- 25% of mortgage holders are already under water.
- The biggest driver of loan defaults is when mortgages fall under water.
- Just ask Morgan Stanley about this.
- The average loan size of prime mortgages is significantly higher than subprime.
- The aggregate size of the prime mortgage pool is roughly three times greater than the subprime pool.
- Ever since the record foreclosures we saw two years ago… loan defaults have been increasing… at a faster rate.
- Defaults are not triggered as a loss until the lender forecloses, so lenders have not even been foreclosing. I can’t seem to find any good statistics on shadow inventory, so until someone shows me something better, my front line experience will rule, which tells me to estimate that only about one quarter of the toxic inventory has even been dealt with by foreclosure and subsequent resale. Mark to market relaxation aided this. The government moratoriums aided this. And mainstream media aided the groupthink that the recovery cavalry is on the way. It is not.
- Wall Street seems to think the subprime losses are baked into the market. I don’t see how this is possible if three quarters of the shadow inventory hasn’t made its way onto the books yet. Houses are sitting vacant… and they are sitting with deadbeats… and they are sitting with tenants who either pay deadbeats or think their landlords own the property, but instead are identifying empty homes to rent to unsuspecting tenants.
- Not only have derivatives remained an issue, but from the best I can gather, it seems they continue to be written on an ongoing basis. Isn’t the amount of money at risk so astronomical it exceeds the GDP of many nations?
- More than 50% of loan modifications ended up re-defaulting again. This statistic is so old it’s getting stale, but it remains relevant until it is not true any longer.
- Unemployment is 12%-20% depending upon whom you ask.
Even if all of these problems were hypothetically already baked into the market… wouldn’t a correction in the prime real estate market put more downward pressure on consumer discretionary spending? Which further suppresses GDP? Which causes the bottom line of corporations to shrink? Which leads to more unemployment? Which causes more defaults?
The forthcoming prime mortgage meltdown is not very hard to predict. What is hard to predict is what will be left when it does?
Disclosure: No positions
