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Preparing For the Second Wave

As we discussed in The Outlook Beyond The Great Recovery, we expect a second wave of financial stress on the banking system to develop beyond this year’s synthetic recovery.  The chart below illustrates the expected shift in the character of foreclosure activity in tandem with the second wave of mortgage resets.

Mortgage Rates

Per RealtyTrac’s recently released Q3-09 Foreclosure Report (emphasis added):

Rising unemployment and a new variety of mortgage resets continued to gradually shift the nation’s foreclosure epicenters in the third quarter away from the hot spots of the last two years and toward some metro areas that had avoided the brunt of the first foreclosure wave. While toxic subprime mortgages drove much of that first wave of foreclosures, high unemployment and exotic Alt-A and Option ARMs are spreading the foreclosure flood to more metro areas in 2009.

According to Fitch, nearly 90% of Option-ARMs have yet to reset, and of those, about 94% of them have used the minimum monthly payments to allow the loans to negatively amortize. And according to the Mortgage Bankers Association latest report on delinquencies (emphasis added):

Prime fixed-rate loans continue to represent the largest share of foreclosures started and the biggest driver of the increase in foreclosures. The foreclosure numbers for prime fixed-rate loans will get worse because those loans represented 54 percent of the quarterly increase in loans 90 days or more past due but not yet in foreclosure. The performance of prime adjustable rate loans, which include pay-option ARMs in the MBA survey, continue to deteriorate with the foreclosure rate on those loans for the first time exceeding the rate for subprime fixed-rate loans.

We  think John Hussman accurately portrays the risks ahead in his most recent market commentary:

We face a coupling of weak employment conditions with a mountain of adjustable resets, on mortgages that have to-date been subject to low teaser rates, interest-only payments, and other optional payment features (hence the “Option” in Option-ARM). These are precisely the mortgages that were written at the height of the housing bubble, and therefore undoubtedly carry the highest loan-to-value ratios. In the current situation, the assumption that the credit crisis is behind us is completely out of line with what possibly could result from the marriage of deep employment losses and an onerous reset schedule on mortgages that have extremely high loan-to-value ratios. A major second wave of mortgage losses isn’t a question of whether the economy will post a positive GDP print this quarter or next. Rather, it is a structural feature of the debt market that is baked into the cake because of how the mortgages were designed and issued in the first place.