AMBAC & Wachovia Threatened by Option – ARM Loans

In New York, regulators are meeting with bankers to see if they can raise capital for the bond insurers. Earlier this week we reported than the credit rating of AMBAC had been down graded from triple-A. When the guys who insure other peoples bonds are broke, their guarantees are worthless.

AMBAC, MBIA and a few other bond insurers have guaranteed some US$2 trillion in assets. We are not suggesting that all those assets would suddenly be in jeopardy. But the truth is, off in the distance, well behind the front lines, there is another wave of dodgy U.S. mortgage products massing. These option-ARMs are threatening billions more in losses for the banks that made the loans and the investors that bought them. They made their first tentative attack yesterday.

"The no-worries lending that inflated the housing bubble is resulting in a flood of soured option-ARM loans, adjustable-rate mortgages that allow borrowers to pay so little every month that their loan balances rise rather than fall, sometimes sharply," reports Scott Reckard in the L.A. Times. The trouble here is that this genre of bad loans came into existence in 2006 and 2007, at the peak of housing bubble.

Last in, first to default, you might say. "Numbers from industry trackers suggest that these borrowers, most of whom boast respectable and often top-tier credit scores and appear to have substantial incomes and home equity, are starting to create a second tide of defaults for lenders swamped by the meltdown in subprime loans made to people with bad credit or overstretched finances."

How much is at stake? Well, we don't know yet. But did you see what happened to Wachovia (NYSE: WB) the other day? America's fourth largest bank took a US$1.7 billion writedown and reported a 98% drop in profits year-over-year. Wachovia has massive exposure to a rapidly deteriorating optionARM portfolio.

Concerned (outraged?) shareholders recently sent the bank's directors a note with the following statement, "Wachovia increased mortgage lending at the peak of the housing bubble. It accelerated investments in mortgage backed securities in late 2006 and early 2007. And it acquired a mortgage lender that exclusively issues option ARMs in some of the most overheated real estate markets in the country. The warning signs were there. Where were the directors?"

Playing golf probably. But guess what? Wachovia wasn't the only one writing exotic and risky mortgages at the top of the housing boom. You'll hear plenty more about this story in the coming weeks. The scary thought is this: equity markets have just barely survived the first wave of U.S.-housing related credit woes. They are in no condition for a second wave, or any unexpected event.

Yet a second wave is already coming. Where is the high ground? Cash and precious metals. But this is one of those rare and unfortunate times in history where there is no real refuge. The world enjoyed a boom like no other thanks to easy credit. The contraction is going to make for very tough market conditions for the rest of this year and probably most of 2009 as well.

Dan Denning
The Daily Reckoning Australia

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