Foreclosures Frighten Investors

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Includes: DIA, IEF, SPY
by: Ockham Research

The bearish stock market of late reflects investor’s fearful reaction to the deepening housing crisis. New data reveals just how bad it is for American homeowners, as home foreclosures reached a record in the fourth quarter of 2007. The Mortgage Bankers Association estimates that more than 2% of all mortgages are in foreclosure, the highest level in the 35 years that such data has been tracked.

When it comes to subprime and adjustable rate mortgages this number could be as high as an astounding 13%, with about 20% behind on their payments. American home owners took “advantage” of easy money and the ability to buy and over-buy, and now the share of home owners with equity in their houses has dropped to its lowest level since World War II, just 48%.

Fed Chairman Bernanke, who just a week ago echoed Treasury Secretary Paulson’s rebuke of a bailout, seems to have significantly changed his tune. He is encouraging lenders to forgive a portion of distressed home owner’s mortgages. However, there seems little incentive for lenders to just give away assets in order to avert recession, especially since these companies are struggling as it is. Furthermore, most mortgages are no longer held by the loan originator but were bundled into complex debt securities and sold to investors. So, working out any future agreements between lender and borrower will be infinitely more complicated than in the past.

So, Bernanke has floated the idea of having the FHA insure the debt write-downs, and thus expose the government (read taxpayer) to the mess. Bernanke continues to lose credibility with his handling of the crisis and one clear reason is this sort of double talk. Bernanke’s suggestion seems to reward the profligate at the expense of those who acted responsibly in taking on a mortgage debt level that they could reasonably hope to repay in any market condition or economy.

When will it end? Right now, a vicious cycle is in play and money parked on the sidelines is in no hurry to rush in as long as it is perceived that conditions will continue to get worse and better bargains will be found later. The best solution we have seen proposed thus far is that off Martin Feldstein from his recent article in the Wall Street Journal, “How to Stop the Mortgage Crisis”. He proposes that the government pass legislation enabling voluntary federal loans to homeowners in crisis. Homeowners with negative equity and facing rising interest rates could finance up to 20% of the value of their current mortgage with a 15 year add-on loan with an adjustable interest rate tied to the rate on two year U.S. Treasury debt (currently 1.6%).

The great part of this loan substitution plan is that it is voluntary and would obligate home owners to repay their debt on a systematic basis over many years. It would enable many home owners to afford the option of staying in their homes without rewarding past profligacy. It would also help stabilize a housing market that appears increasingly at risk--in some parts of the country--of falling off a cliff. This strikes us as a sensible solution that involves government as a major player but will not leave taxpayers “footing the bill”.

Disclosure: None