For more than a year I and Mr. Mortgage have been telling you that the real story in housing isn't "subprime" - its ALT-A in all its incestuous incantations, especially the ultimate "liar loan", the "Pay Option ARM".
These things are literal nitroglycerin where not all the acid was removed (that is, chemically unstable.)
To recap, a "Pay Option ARM" is a mortgage where you can choose to make a payment that is less than a fully-amortizing principal and interest amount. Often these were sold with low "teaser" rates, sometimes as low as 1%.
Any principal and interest on the usual amortization schedule not paid gets rolled back into the loan balance, so the principal outstanding can (and does, if you do that) actually go up!
These products came to the forefront of the marketplace during the bubble for the precise reason that ordinary Americans could no longer afford homes; ergo, they started diddling in complex financial instruments they did not fully understand the risks of and which are nearly always unsuitable products when sold to unsophisticated borrowers.
This, by the way, is a direct consequence of house prices being too high, as I have repeatedly pointed out - and which politicians have repeatedly ignored and are trying to maintain.
Well, now The Wall Street Journal has blown the doors off one lender that is stuffed full of these things - First Federal (NYSE: FED):
"In addition, many borrowers submitted loan applications that overstated their financial condition, making it more likely that they won't be able to afford even a modified loan. FirstFed figured that some borrowers had fudged their incomes and tried to protect itself with tighter credit standards. "But we were shocked by the magnitude of the lies," Ms. Heimbuch says. "You expect a 20% fudge. You don't expect 500%."
Dien Truong, a 35-year-old, water deliveryman, pulled out $156,000 in cash when FirstFed refinanced the $628,000 mortgage on his Richmond, Calif., home in 2005. Mr. Truong used the money as a down payment on another home and turned the FirstFed home into a rental property. But the $2,500 a month he collects in rent is no longer enough to cover his mortgage payments, which have climbed to roughly $5,100 from $1,618."
Yeah.
"You expect a 20% fudge."
This, folks, is what happens when you don't verify information. When you promote, push, and allow "liar loans." When mortgage fraud (its a felony to falsify a mortgage document!) is not prosecuted. When lenders look the other way. And when regulators are willful accomplices, even though HUD warned of this quite some time ago.
Who else is in trouble? Oh, everyone with exposure in the bubble states.
As I have repeatedly made noise about Washington Mutual (NYSE: WM) was the first big financial that caught my attention with the first quarter "earnings" from last year, when they reported more capitalized interest - that is, "booked profit from negative amortization" - than actual cash earnings.
THAT perked my ears up and turned me into a rabid bear on the market going forward, because from that point onward it was clear how this story was going to end.
Oh, and as the situation has deteriorated the banks are still booking this "capitalized interest" as "earnings", which of course they will never collect, and will thus force restatements of earnings into losses going back years - if they don't go bankrupt first (its kinda hard to spend money you claimed you earned but never collected.)
But folks, remember, during all of this, Bernanke and others told us "its contained."
Bullcrap.
Most of these loans are too far underwater on home value to refinance, as the homeowner would have to come with a huge check to close - a check they don't have. When these loans "recast", or reach their limit of negative amortization (typically 110-125% of the original loan value) you are forced into a fully-amortizing payment for the remainder of the term.
This usually happens three or so years from origination if you're making non-amortizing payments and that virtually guarantees a jump in payment of at least 50% and often results in more than a double, especially if a teaser rate was involved.
The losses here will be several times that of Subprime, because there are simply far more of these than there are of subprime loans, and yet default rates will be as high if not higher. Many estimates are that we will see anywhere from 40-50% of all loans that "recast" default, because the borrower has no prayer in hell of making the new payment and they cannot sell the house for anywhere near what is owed.
If the "homeowner" took a second or HELOC (and many did) its even worse as you can't modify the first without the second/HELOC holder agreeing to it. Why should they? They're so far underwater they need Heliox in their dive tanks; they get nothing out of playing nice and given the 100% loss that is on deck for them they're more inclined to rape than kiss. You (the homeowner who is underwater on this beast) gets the brunt of that one; you're headed for the streets.
This is the carnage that awaits folks. These recasts are just starting and will continue through 2009 and into 2010 before tapering off.
There is no chance that these loans can be refinanced as they are deeply underwater and were sold as a "affordability" products in the first place, meaning that often there was no or little down payment.
We will, in the coming months, hear about the defaults in the corporate space of similar structures. PIK/Toggle Bond debt is yet another example - you don't want to pay cash, you issue more debt instead to the debtholder. Almost exactly like an Option ARM, really, and just as toxic. The LBO pipeline was stuffed with this crap and the people who bought it are starting to feel the heat. That heat will increase - a lot.
Credit cards. Do you really think people will pay them? Well, if they can I'm sure. What happens when your FICO goes in the toilet due to a PayOption default and suddenly you get hit with a 35% penalty rate? Still think you can pay? Uh huh.
Car loans? You wouldn't believe the underwater financing that is still being done. Joe comes into the dealer with a Suburban. He can't afford the $200/week for gas, you see. He wants a small car but bought that $45,000 behemoth a year ago, and unfortunately owes about $40,000 on it (he rolled part of his LAST car in there.)
The bad news is that the truck is only worth $20,000 - maybe - because nobody wants these gas-guzzlers. The worse news is that the NEW car costs $20,000. He's screwed.
You think these guys aren't writing paper with negative equity? Ha! Rollovers are common and 125% is absolutely customary - that is, up to 25% of the NEW car's price can be "old car remaining balance", AND they get you for the full sticker.
The problem of course is that if that "new car" is something like a Suburban that suddenly depreciates by 50% in a year and a half due to $4.00 gasoline. These loans were unsafe in good economic times. Now, they're absolutely toxic.
Oh, and in the "bullshit update" department, we have Morgan Stanley being "hired" by Treasury to analyze what proper capitalization of Fannie and Freddie might be (and whether they meet that.)
Only one problem:
"A Treasury spokeswoman said Morgan Stanley would not have access to Fannie's and Freddie's internal books in conducting its analyses."
They're going to render an opinion without looking at the books.
Astounding.
PS: They don't need to do any actual work. The GSE's "regulatory capital requirements" permit them to buy and hold mortgage securities with less than fifty basis points of capital behind them. That's right - less than 1/2 of 1%, or a leverage ratio of more than 200:1. What more do you need to know?
Freddie lost more than three times estimates, $1.63/share and announced intentions to cut its dividend. Oh, and on that capital raise they claimed they'd do before June? They claim that market conditions are "choppy".
Choppy eh? Hmmmm... maybe that "chopping" will be from calls for the CEOs head, or perhaps it'll be to their stock price. Premarket it sure looks like it.
One final note - yesterday on the FOMC announcement we had the usual violent volatility and volume. Most brokerages have trouble with this at the instant of the announcement, with various "fun" coming with hung orders or charting.
ThinkOrSwim (TOS), on the other hand, was absolutely flawless yesterday. Not good, not "ok", flawless. I had tick-level charts up and the updates were instantaneous.
I've worked fairly-extensively with Tom Sosnoff over the last couple of months trying to hammer out where these "hang fires" have been, because when you're an active trader (and I am) these events are murderous on your account balance - you simply HAVE TO be able to get information to you quickly and orders back out quickly, or when you're wrong, you're dead.
The improvements that have come over the last month or so have been astounding. It simply doesn't get better than this - if you're an active trader, you have to look at these guys. I've always loved their charting and study capability - IMHO they're "best of breed" in that regard, and their execution quality is outstanding as well. Now that the "back end" on their side has had the bottlenecks found and removed, if you rely on your data being current and immediate, they're someone to look at.
Oh, and how many brokerages will actually get the people who are in charge - and can make things happen - on either the phone or in an email conversation with you? I can count those on the fingers of one hand with four fingers cut off. Yeah.
No, I don't get paid by Think - I'm just a customer who spends a LOT on commissions. When things are wrong, I bitch - loudly. But with that bitching comes a responsibility to tell people when things are done right as well.
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