Deficits, Dollar, Federal Reserve, Obama Says, Trust

A Second Mortgage Meltdown?


As we all know, the recession is over. Joe Biden told us so. Ben Bernanke said the same. Obama’s chief economic officer Lawrence Summers even said “everybody agrees that the recession is over.” (1) Honestly, how could anyone disagree? After all, the Dow Jones is up almost 50% over the last year and we only lost 36,000 jobs last quarter, which is apparently great.

So we’ve had a jobless recovery because our economy grew 2.2% last quarter. Unfortunately, as Anthony Randazzo points out in Reason Magazine, most of that “growth” is based on temporary government programs:

“Consider that 37 percent of the third-quarter GDP growth was due to motor vehicle purchases, which were stimulated almost entirely by the Cash for Clunkers program… Another 20 percent of third-quarter GDP growth came from new residential investments, propped up largely by the First-Time Homebuyer Credit… Overall, government support accounts for roughly 77 percent of economic growth in the third quarter of 2009, according to my analysis of Commerce Department statistics. This means that non-Washington GDP growth was closer to 0.34 percent from July to September 2009, instead of 2.2 percent.” (2)

He concludes, “This is not real growth. It’s the national equivalent of a credit-card buying spree, with the bills—in the form of debt service and unfunded liabilities—to be paid off later. It is a faux recovery.”

Still, 0.34 percent growth, and continuously shrinking job losses does, potentially, show signs the recession will be over soon. The key word is ‘potentially.’ Regrettably, the fundamentals of our economy are still way out of whack. Stimulating home purchases just prolongs the needed correction in the vastly overinflated housing market and stimulating car purchases is just a way to increase consumer spending when Americans desperately need to rebuild their savings.

These programs also add to our immense national debt. The deficit for 2009 alone was $1.4 trillion, which was put on top of the $12.6 trillion in national debt. Some have estimated unfunded liabilities at over $100 trillion. (3) Sooner or later, we are going to have to pay back these debts. Or even worse, foreigners may stop lending to us, or even start liquidating our debt, which would cause a run on our currency. Furthermore, the Federal Reserve has more than doubled the monetary base which could have massive inflationary consequences if lending and velocity of circulation ever pick up. (4) And if the Fed tries to stop inflation by increasing interest rates, it would surely throw the economy back into a recession.

As bad as all that sounds, it ignores the dire situation we are facing in a very familiar setting: the housing market. Contrary to popular wisdom, the ‘toxic assets’ have not been cleaned out. It is very likely we are heading for a second mortgage meltdown.

A fantastic website called DoctorHousingBubble.com, has compiled a vast array of data on housing trends and the future looks bleak. Most of this data is for California, but much of it illustrates a larger trend in the country. The following chart shows when California mortgages are timed to reset from a low ‘teaser’ rate to an actual adjustable rate. See if you notice anything disturbing:

Source: DoctorHousingBubble.com

California is moving straight into some very dangerous territory. While most of the subprime loans have reset, most option ARMs have yet to reset. Option ARMs are even more dubious than the infamous interest-only loans, which allowed homeowners to pay none of the principle and simply rely on appreciation (i.e. inflation) to gain equity. Option ARMs allow homeowners to pay even less than the full amount of interest due each month (called negative amortization), which then just pads the unpaid interest onto the principle of the loan. And these teaser rates are about to disappear en masse.

Given the recent fall in housing prices, it is no surprise that the vast majority of Option ARMs are attached to houses that are severely underwater (the owner owes more than the home is worth). 73 percent of Option ARMs are severely underwater as compared to 50 percent of subprime and 25 percent of prime loans. (5)

Given all that, it should be no surprise that the percentage of Option ARMs becoming delinquent is skyrocketing. The following graph shows the percentage of Option ARMs in California that are delinquent:

Source: DoctorHousingBubble.com

Fortunately, only four states have major exposure to Option ARMs; California, Arizona, Florida and Nevada. (6) Unfortunately, what happens in these states can reverberate throughout the country. And even more unfortunately, as far as properties being underwater, it’s not as if California is the only state facing this problem. Not by a long shot:

Source: DoctorHousingBubble.com

There’s another problem in the housing market looming beneath the surface. Banks are not clearing out bad debt nearly as fast as it is coming across their desks. Loss mitigators are overloaded with case files and can barely keep up with them. Stephanie Armour of USA Today concludes, “Banks dealing with a surge in refinancing, mortgage modifications and defaults are overwhelmed with demand, so it can take longer to initiate a foreclosure sale.” (6)

Furthermore, banks have at least a short-term incentive to not recognize losses. If a loan is not performing, the loan is still recognized as an asset on the bank’s balance sheet. However, if the property is brought to foreclosure, that asset disappears. And banks typically lose the majority of their investment in the foreclosure process. Thereby, taking a property to foreclosure may be the right financial decision for a bank, but it makes their income statements look worse, which in turn makes their stock look worse.

What we see is a massive glut of ‘shadow inventory.’ These are properties in the process of being foreclosed on or sold by short sale (when the bank agrees to discount a mortgage so a property can sell). The following graph shows that not only are delinquencies continuing to increase, but there has been a massive increase in shadow inventory:

As you can see, while the foreclosure-in-process rate mirrors the 90+ day delinquency rate, the REO rate does not. REO (real estate owned) are properties that were foreclosed on but did not sell at auction. These are properties the bank owns and must sell to recoup as much of their original investment as possible (usually a relatively small fraction). In essence, it means there is a large glut of soon-to-be-foreclosed properties, which haven’t flooded their way into the market yet. According to the Amherst Securities Group, another 7 million properties are set to be foreclosed (as compared to 1.27 million in 2005).(8) Furthermore, based on data from the Lender Processing Servicers database, 7.5 million loans are delinquent and another 1 million are REO’s. The number of delinquencies has risen by 25% from January of 2010 as compared to January of 2009, while 31 percent of delinquent loans have been delinquent for over six months without a foreclosure process being initiated and 22.8% over 12 months. (9)

Sooner or later, these properties will have to go to market. At that point, the additional glut of housing on the market will create an oversupply of homes. This, in turn, will further reduce housing prices and cause even more homes to go underwater, meaning fewer homeowners will be able to refinance or sell a home without doing a short sale.

Some would argue this requires government action to stimulate the housing market. I would say that is like treating a heroin addict with heroin. Housing was artificially inflated and it’s going to come down, whether we like it or not. Furthermore, attempts at re-inflating bubbles usually end up inflating other bubbles. For example, the attempt to re-inflate the stock market after the dot-com bust brought much more inflation into housing than it did into the stock market.

Policy prescriptions are a moot point here, however. The big point is it appears we are heading straight into a second mortgage meltdown. Of course, that’s assuming the first one ever ended.
___________________________________________________________
(1) George Stephanopoulos, “Summers: Job Growth by Spring,” ABC News, December 12, 2009, http://blogs.abcnews.com/george/2009/12/summers-job-growth-by-spring.html
(2) Anthony Randazzo, “The Myth of the Recovery,” Reason Magazine, March 10, 2010, http://reason.com/archives/2010/03/10/the-myth-of-the-recovery
(3) For the deficit, see Brian Faler and Julianna Goldman, “CBO Projects 2009 Deficit Will Reach $1.85 Trillion,” Bloomberg, March 20, 2009, http://www.bloomberg.com/apps/news?pid=20601103&sid=aA8lChe4zUQU, for debt, see “U.S. National Debt Clock,” Last update March 22, 2010, http://www.brillig.com/debt_clock/, for unfunded liabilities, see Pamela Villarreal, “Social Security and Medicare Projects,” National Center for Policy Analysis, June 11, 2009, http://www.ncpa.org/pdfs/ba662.pdf
(4) George Melloan, “We’re All Keynesians Again,” Wall Street Journal, January 13, 2009, http://online.wsj.com/article/SB123180502788675359.html
(5) “California Sending out Approximately 475,000 Notice of Defaults for 2009 yet Overall Foreclosures Declining, Shadow Inventory, Q3 Defaults, Toxic Loans, The State of the National Housing Market, DoctorHousingBubble.com, October 21, 2009, http://www.doctorhousingbubble.com/california-sending-out-approximately-475000-notice-of-defaults-for-2009-yet-overall-foreclosures-declining-shadow-inventory-q3-defaults-toxic-loans-the-state-of-the-national-housing-market/
(6) “Option ARMs Enter the Eye of the Hurricane: The $189 Billion Recast Problem Targeted Directly at the California Housing Market, Of $189 Billion in Securitized Option ARMS $109 Billion in California,” DoctorHousingBubble.com, October 30, 2009, http://www.doctorhousingbubble.com/option-arms-enter-the-eye-of-the-hurricane-the-189-billion-recast-problem-targeted-directly-at-the-california-housing-market-of-189-billion-in-securitized-option-arms-109-billion-in-california/
(7) Stephanie Armour, “Another wave of foreclosure looms, USA Today, 11/19/2009, http://www.usatoday.com/money/economy/housing/2009-11-19-shadow19_ST_N.htm
(8) Ibid
(9) “Lender Processing Services’ February 2010 Mortgage Monitor Report Shows Pace of Delinquencies Slowing, But Delinquency Rates At All-Time Highs,” Lender Processing Services, February 2010, http://www.lpsvcs.com/NewsRoom/Pages/20100315.aspx

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