Mortgage Meltdown on the Horizon

We are at the threshold of a further frightening scenario in the mortgage and housing arena. This next wave of the mortgage crisis stands the possibility of not just forcing people out of their homes, but enhancing serious ripples throughout the economy that are starting to be seen and felt.

In the upcoming months approximately 2 million adjustable-rate mortgages [ARMS] will reset with a valuation of approximately $600 billion. Some economists have stated that this is not going to affect the general welfare of the 14 trillion dollar U.S. economy. I find this hard to fathom. This reset will cause higher interest rates for homeowners which will cause many of them to be unable to make their payments. Bill Gross, chief investment officer of PIMCO, the world’s largest Bond fund manager stated "We haven't faced a downturn like this since the Depression”. The mortgage defaults have shaken the basic financial foundation of many institutions, but the greater fear is the contagion to the general economy.

The contagion and the domino effect is what bother me the most. There is diminished liquidity from the financial sectors. Lending standards have risen and in many cases negated the possibility of obtaining mortgages. There is a diminished level of consumption by U.S. consumers, and consumer spending makes up a vast majority of the U.S. economy. There are countless jobs lost in the construction sector. Jobs in the financial sector - ranging from Wall Street to local mortgage brokers - as well as, on the horizon, jobs at retailers and even car dealers, due to their dependence on consumer spending, are all at stake. It seems an ever increasing dollar amount of potentially worthless paper is appearing on the balance sheets and the SIVs of the world’s largest banks. (Last guess estimate was approx 500 billion dollars).

The situation is unfolding into a much harder situation to contain. Potentially we are witnessing the start of one of the country’s worst banking crisis. The question is as with the S&L crisis in the 1980’s, or even in 1907, can the government come to the rescue? The worst-case scenario is anyone's guess and can cause economic tremors we have not seen in our lifetimes. With these dire warnings tremendous opportunities will present themselves. One needs to have a plan, maintain liquidity and be available for the upcoming opportunities. My suggestion is raise cash and place it in short term U.S. Government Treasuries, prepare your list of wide moat stocks so when they are screaming buys - as Warren Buffet would say Fat Pitch - you are ready to take action, and look at other asset classes such as managed futures. Managed Futures is not contingent on the stock market and historically has outperformed in volatile and inflationary times.

Comments

[Malkiel]

It's difficult to understand why some enterprising financial services company hasn't stepped in to the breach by offering up packaged mortgage products based on high underwriting standards, giving the market a way to buy into a safe mortgage pool, which is what investors are waiting for. It shouldn't take very long to construct such a pool of high-safety mortgages, and once the shares begin to sell other mortgage writers will see what standard is expected by the market and adjust their practices accordingly. It shouldn't be difficult to come up with a small number of absolute factors that quality mortgages would have in common, such as verifiable incomes, debt/income ratios and certain down payment levels, that investors would expect mortgage brokers to use (and could cross-check easily on their own). Why it's taking so long to get to that point is a mystery, but it's what must happen to restore liquidity to the lending market, so the players need to get on with playing by the new rules...

[Jay Jay]

Perhaps there are so few people smart enough to have these qualifications for a mortgage but dumb enough to be buying in this market?

[jcrash]

The problem will be solved. Assuming that banks will just let them reset and take the defaults is ludicrous. That serves the interest of no one.

Interest rates are low, so far, I have yet to see a valid argument stating why banks will not simply allow the refinance at a lower rate.

Sure, the LTV is negative, but the prospect of taking the hit on the house is a much worse option. The loans will be renegotiated, to longer terms or lower rates or both. The consumers don't want to default and only the real gamblers (i.e. flippers, etc) will end up taking a hit. An honest home owner will want to make his payments, and the vast majority of these loans will be fine.

Subprime doesn't mean people without a means to pay.

Yes, it is a problem. Is it as bad as the pundits are saying? No. Two years from now we will look at Q1 2008 or Q2 2008 as the beginning of the realization that it isn't as bad as people said in 2007.

All this doom and gloom means is that some people are gonna go out of business and others are going to make a WHOLE lot of money on these supposed "bad" loans.

[HarrisonBergeron]

Jcrach seems to buy into the popular delusion that this whole problem is subprime. Loans from subprime, to alt-a to prime will all be affected. Assuming that there are so many "honest" homeowners in this market is dangerous.