Tuesday, July 10, 2007
adjustable rate mortgages
"Based on the share of ARMs in some state of negative equity at the end of last year and the decline in home prices so far in 2007, a stunning $693 billion in mortgage loans are already in the red. Assuming lenders are able to recover 70% of those assets -- which seems optimistic given the massive amount of housing inventory yet to be unwound -- that means mortgage lenders are already grappling with $210 billion in outright losses."
pomboy estimates that nearly 1 in 4 adjustable rate loans are already upside-down, and another 5% price decline would increase that figure to nearly 1 in 3. adjustable rate loans constituted a majority of the loans made in the peak bubble years. this means millions of american homes are going to be forced onto the market in the next year or two.
with arm rate resets coming on those loans right now -- many forcing payment increases in excess of 30% to already debt-strapped homeowners, many of whom are participating in the nascent consumer slowdown being confirmed more widely now after having been anticipated for some time -- the setup is there for a infection of the wider economy. subprime isn't the limit of the problem anymore; alt-a loans and their associated cdo's -- a truly huge reservoir of debt by comparison to subprime, one that is not limited to specialty lenders and speculative hedge funds -- are demonstrating that they too are failing to perform as advertised.
this is a strange point that only recently came to my attention.
The subprime pool started out with more overcollateralization, but losses have exceeded excess interest and so the OC is shrinking. The Alt-A pool started out with low OC--it was meant to grow through application of excess interest--but it too experienced losses exceeding the excess, as well as fast prepayments which have reduced the gross excess spread amount, and so its OC has not grown to its target.
You will notice also that both of these pools are fixed rate closed-end second liens. These borrowers did not get caught in a nasty rate adjustment, nor did they max out a credit line in order to pay bills.
The moral of the story, it seems to me, is twofold: Alt-A isn't performing anywhere near as well as its boosters claimed it would, for one thing. For another, a bad security structure can go a long way to offsetting the higher credit quality of the collateral. A security set up with "growing" OC, that is, initial low overcollateralization that is expected to reach its "target" over time, depends absolutely crucially on the accuracy of the prepayment speed estimates and the loss timing projections that went into its initial structure.
note that this is before the rate resets hit.
this is extraordinarily bad news, to the extent that such problems in alt-a-backed securities are widespread. the failure of alt-a may very well shut the mortgage market for all but the surest credits as money simply flees the sector. there's only so much fannie mae and freddie mac can do, after all, to ensure liquidity. that would turn a housing market beset by a shocking dropoff in buyers into a wasteland of oversupply.
bear stearns' recent fund collapse is just the first, most speculative leg of this kind of fallout. more of those are coming, but that's the lesser, if more volatile, aspect. the huge money that fuelled the housing market came through these investment-grade cdo's which connected higher-risk mortgages to much larger reservoirs of money than had previously been available to make them. with that cash spigot shut and everyone already overexposed, i'm not sure how loans will get made to most people trying to buy a house. huge supply will force prices down. who will want to loan money into housing -- at least, at interest rates that anyone can afford -- when significant percentages of mortgages made are going to be underwater and vulnerable?