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Subprime Loans Caused the Initial Illness, Option ARMs will Cause the Relapse

Our economy is about to relapse into the disease that sent us into the Great Depression: Part Deux. Subprime loans caused the initial illness. Option-ARMs will cause the relapse.

In the first half of the past decade, subprime loans were king. They were cheap and easy to get approved. Along with the subprime boom came subprime adjustable-rate mortgages (ARMs), which were equally easy to afford…for a while.

Of course, the “A” and the “R” in ARM meant that the interest rate borrowers pay changes, or resets. The majority of these resets occurred between the summer of 2007 and the summer of 2008.

This period saw a massive amount of mortgage interest rate hikes, which caused millions of foreclosures. Things spiraled down from there, eventually freezing nearly all credit and causing the panic of 2008.

Of course, that’s the 50-cent version of recent history. There were plenty of other financial calamities that went along with this, including the bundling of mortgage-backed securities and risky derivative products.

If you believe the Obama White House and the glass-half-full press corps, you’d think this mess is now behind us. We are, after all, in a recovery…right?

Unfortunately, no one is talking about the second wave of ARM resets and foreclosures…

You see, this second wave will come crashing even harder than the first. It’s made up of a type of mortgage called “Option ARMs.” These give borrowers the option of how much they want to pay during the first five or 10 years of repayment:

1) The full amortized rate, including interest and principal.
2) Interest only, or…
3) A token payment, well below the amount needed to cover the interest on the loan.

This third option causes the mortgage balance to INCREASE instead of decrease. And usually, the borrower can continue to make minimum payments until the mortgage balance increases to 125% of the original amount. That’s when the trouble begins…especially if the interest rate increases at the same time.

This is the exact situation in which many homeowners now find themselves.

Obviously, these option ARMs were supposed to be reserved for customers with better credit than those who took out subprime mortgages. But apparently, they were handed out to almost anyone who wanted them.

According to Whitney Tilson and Glenn Tongue of T2 Partners, who are experts on this subject, about 80% of option ARMs are negatively amortizing. Meaning these so-called top-tier borrowers are heading further into the hole. Once their rates reset, they could be in serious trouble.

And that could be happening very soon:

Subprime ARM Resets

The chart above shows the two peaks in the mortgage-reset wave. The first peak is comprised of subprime ARM resets. And the second is mostly constructed of option ARM resets. We appear to be in the eye of the storm.

That fact alone shook our nerves when we first discovered it. But it was a different chart in Tilson and Tongue’s most recent presentation that really got us startled… It’s also the reason I’m predicting the dollar spike in 2010.

Instead of resetting as expected after the first five years, many option ARMs are so negatively amortized that they are hitting their automatic reset cap.

That means they are resetting early…like right now.

Early Option ARM Resets

As you can see from the second chart, the expected reset peak was to occur in 2011. But the real peak is happening now. You can also see that the amount of mortgages resetting is spread over a longer period of time than originally thought, but is peaking much earlier. Unfortunately, it’s not the peaks that matter.

You see, those are just resets. But with unemployment reaching quarter- century highs every month, and the massive number of homeowners about to receive mortgage bills for two to three times what they are used to paying, we find ourselves in an even scarier environment than this time last year.

It takes anywhere between 3-12 months for most homeowners to actually go into foreclosure. Therefore, the wave of Option-ARMs that are now resetting could cause a major wave of foreclosures over the next 6 to 18 months.

It’s tough to say exactly when the storm will come. But my guess is the second half of 2010.

This second wave of foreclosures will not be good news for the economy or the stock market…At least that’s my guess.

Regards,

Jim Nelson
for The Daily Reckoning Australia

Jim Nelson
Jim Nelson is the managing editor of Penny Sleuth, a daily small-cap e-letter with more than 160,000 subscribers. Jim has been playing the stock market since he was 14, always with a preference toward smaller companies.

6 Comments

  1. Justin says:

    Interesting news Ned, the US Treasury has agreed to fully backstop the GSE’s no matter the co$t.

    Should be good for the USD price of GSE securities.

    But I’m wondering who will fully backstop the US Treasury?

    Here’s an interesting article; http://www.marketskeptics.com/2009/12/2010-food-crisis-for-dummies.html

    Not saying I believe it but seems a credible explanation as to a point where foreign governments can/will no longer buy the obligations to pay…….nothing, spewing forth from the “paper mill on the Potomac”.

  2. Ned S says:

    Thanks Justin – I take your point. The general issue just might be that at the moment we seem to be struggling a bit even though in reality there isn’t any absolute shortage of anything. Could get interesting if and when there is though. In such circumstances it would seem reasonable to assume that printing more money won’t help too much at all! :)

  3. Justin says:

    The thing is though Ned, the recent backwardation in the soybean market indicates that there IS a shortage, otherwise the market would remain in contango (futures price higher than spot).

    The contango consists of the ‘cost of carry’ into the future; storage fees, interest charges on loans etc, of the relevant commodity. Backwardation is implying that not only is there no carrying cost, you can buy the commodity cheaper in the future than now ie. a free lunch, but as you well know, there is no such thing.

    Someone here posted a link a couple of months ago about how the price of wheat futures contracts were no longer converging on the spot price at maturity. It can’t be denied there are some serious problems in the agricultural markets.

  4. Ned S says:

    Think a genuine supply side shock could be huge concern right now Justin. Food strikes me as a really strange one though – In that it just doesn’t seem to affect things as much as one might be tempted to think it should. A few reasons maybe? :
    * It hits the truly poor nations first; And when push comes to shove “we” are happy enough to see “them” starve – Leastways in preference to “us”.
    * The more affluent nations can decrease expenditure on food – A lot – Without too much pain – Given what we’ve been used to consuming anyway.
    * Governments in all but the very poorest of countries tend to subsidise the most basic of foodstuffs – And even more so if things get tough.
    * It is almost as if once things get so bad people are reduced to standing in food queues, a lot of the fight has gone out of them?
    Just my observations/thoughts?
    Thanks for the info on contangos etc – That was certainly informative.

  5. Option ARMs resets are certainly likely to continue to weigh heavily on the US economy’s prospects of recovery, but calling it the “Second Wave” seems like an exaggeration of the risks posed. That’s because the problems that arose in 2007/08 were not simply that US mortgages began to experience defaults and foreclosures (although this in itself would not have been good for the US economy) but also the fact that there were so many investments linked to these mortgages–Asset-backed Securities (ABS) and CDOs of ABS, etc–that were held by institutions all around the world. The collapse in value of these securities created a liquidity crisis that became a credit crisis before developing into a fully-fledged economic crisis. This will not happen again as a result of resets in option ARM mortgages. This is because it has already happened! Even though most of the resets on these mortgages are out in the futures, ABS with Option ARM collateral also experience massive collapses in value, particularly in 2008.

    So option ARMS resets are certainly not bad news, but are not going to have anything like the impact of the initial subprime crisis.

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