Friday, June 26, 2009

Chronicles of a Second Wave of Foreclosures

Ross McKitrick's "Green Shoots Reality Check" two part series published in the National Post this week should be a wake up call for those who fell asleep looking at green shoots grow. Please read "They Could be Weeds: the U. S. Fed's ticking monetary timebomb" (part I) and "Converging Storms: subprime round II and cash-strapped California" (part II).

Another incoming large wave of home foreclosures could bring a new series of bank failures and renewed financial distress and, as a result, prolong the current economic recession well beyond 2010. This is because, according to McKitrick, resets on Option-ARM mortgages, currently averaging $2 billion a month, will rise to $25 billion per month by late 2011; mostly in California and neighboring states. This means we could relive the nightmare of the last two last years when we went through a big wave of resets. Look at the following graph:

QUARTERLY MORTGAGE RESETS 2007-2008 (in billions of dollars)

If McKitirck is correct, at $25 billion per month by the fall of 2011(this number needs to be verified), we'll reach quarterly resets of $100 billion; a situation similar to the one we had in 2007-2008 and which was one of the main causes of the financial crisis. Note that in 2007 it took about two quarters of such resets for the financial system to finally show signs of fatigue. This time around, the already weakened financial sector could be on its knees well before the second tsunami hits us. This mean that sometimes next year we could be back to square one.

Here is an excerpt concerning these toxic mortgages from part II of McKitrick's series of articles:

"So-called "Option-ARM" mortgages gave borrowers an interval during which they paid no equity, and less than the full interest, with the unpaid amount accumulating on the principal. When the reset date hits, borrowers must start making full payments, with payment increases often reaching 50% or more."

"These mortgages were popular at the height of the property bubble, with 75% of them written in four states: California, Florida, Arizona and Nevada. Many borrowers expected that house prices would just keep rising, so when the reset date approached they could simply sell the house, pay off the mortgage and pocket the difference."

"But housing prices in places like California have collapsed. Homeowners are now facing payment hikes on houses worth far less than the loan principle. According to a recent Credit Suisse analysis, by fall 2011, the volume of Option-ARM (and related Alt-A) resets will have risen from $2-billion per month to $25-billion per month, dwarfing the size of the subprime wave. And according to data from T2 Partners, 30% of Option-ARM mortgages are already 60 days or more in arrears. A new wave of defaults could bring a new wave of bank failures."

"The best hope is that continuing low interest rates will help many Option-ARM resets go through without default. But this is where the threat of rising interest rates due to the U. S. deficit begins to matter. On May 27, the Treasury conducted an auction of $35-billion in five-year bonds, with a plan to auction $26-billion in seven-year bonds the next day. The market reacted by dumping longer-term bonds, sending mortgage rates from 5% to 6.5% in one day. While this spike tapered off over the next few weeks, it sent an early signal that large-scale government borrowing will raise long-term mortgage rates. In California, foreclosures and Notice-of-Trustee sales are already back to levels observed during last year's subprime crisis, and the trend is up, not down."

Please let me know if you can confirm his data.

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