There was a house – a shack, really – that appraised for $132,000 and got a mortgage of $103,000. The owner hadn’t worked in 13 years. Upon foreclosure, a neighbor bought the house and paid $18,000 just to tear the thing down.

America, it seems, just went crazy – borrowers, lenders, nearly everybody. These anecdotes and others are told in a new book titled More Mortgage Meltdown by money managers Whitney Tilson and Glenn Tongue.

But what caused the mania and how we got there is less to the point than what happens from here. Even so, the stories are amazing…

“If the problems in the mortgage market were limited to subprime loans, then the carnage would be mostly behind us,” the authors note. Subprime loans were the riskiest mortgage loans. Prime loans. By contrast, were made to borrowers who made a substantial down payment and had good credit history.

The subprime borrowers were the fuirst to fail…but they certainly will not be the last. The nearby chart, which appeared in the May 22, 2009 edition of the Rude Awakening, shows the other mortgage markets, most of which are only now beginning to show signs of distrress.

The first thing to jump out at you is that subprime is only about a $1.5 trillion market – not anywhere near the biggest of the risky loan categories. There are other layers here.

Subprime is only one slice of low-grade bologna. It sits at the bottom. Alt-A is the next riskiest slice of mortgages above subprime. Alt-A are mortgages to people who are better credit risks than subprime, but still not prime. Documentation is still spotty as far as verifying income, and loan-to-value ratios are high. Plus, about a quarter of these mortgages went to non-owner-occupied homes – which were subject to even greater speculation.

The scary thing is that this mortgage market is 150% bigger than subprime. Unlike subprime, Alt-A loans typically have five-year resets – meaning, the interest rates adjust to higher rates. The Alt-A reset surge doesn’t really get started until 2010! It continues through 2012.

You’ll also see something called “option ARMs” on that chart. Even though the option Arm market is much smaller than the subprime market, it is also much riskier. An “option ARM” is a loan that allows the borrower to pay less than the total amount due from month to month. Whatever amount the borrower does not pay is added to the total loan amount…up to a pre-determined limit.

Obviously, loans like these are very easy to satisfy initially, but can become difficult or impossible if the borrower has been making token payments for a long time. What’s worse, these loans usually offered ultra-low teaser rates at inception, then re-set to higher fixed rates later on. The reset surge for these loans only starts in 2010.

You’ll also see something called “jumbo prime.” These are big loans – on average about $750,000. These were common in the most inflated bubble states, such as California and Florida, and were often made to poor credit risks. This is a market of $1-1.5 trillion – about as big as subprime.

Then there are home equity lines, which you’ll see just below jumbo prime. In calendar 2007, Tilson and Tongue explain, home equity lines funded “30% of new car purchases in California and 20% in Florida.” These loans are second loans, behind all the garbage I mentioned above. That means that many home equity loans will be a total loss for the lenders, as housing prices have collapsed and can’t even support the junk loans in first position, much less junior liens like home equity lines.

I won’t go into all of these loan categories, but I think you get the picture. All together, these “other” loan categories total more than $5 trillion – or more than three times sub-prime. Even worse, issuance peaked during the peak bubble years of 2005, 2006 and 2007.

Moreover, the pattern for all of these loans was the same. You see rapid growth in the bubble years, roughly from 2000-2007.

Through March of 2009, banks had taken only $1.1 trillion in write-downs to date. Even the most conservative estimates put total credit losses at $2.2 trillion. Tilson and Tongue make a convincing case that the losses will be far worse than that – more like $3.8 trillion. And these numbers seem only to grow over time. I remember sitting at a Grant’s conference over a year ago when John Paulson, the fund manager who saw all this coming and profited mightily, tossed out $1 trillion as the number for total losses. That number induced gasps at the time.

So I think Tilson and Tongue will be closer to the mark. It may well be even more than that when it is all said and done. The fallout from all of this is that the banks will have to raise a lot more capital. They’ve raised only $1 trillion so far – yes, “only.” Given the high leverage in the banking sector, they may yet need to raise at least another $1 trillion. I don’t see how that is possible in today’s market. Where is the money going to come from?

The margin for error is extremely small.

As banks’ assets got riskier – with subprime, Alt-A and all the rest – the banks actually borrowed more to hold these assets. The typical bank has only 4 cents of tangible equity for every dollar of assets. That means a 4% drop in asset value wipes out the equity – making the bank insolvent. The banking system is vastly undercapitalized. Throughout the 1990s, banks operated on leverage of about 16-to-1. Today, they operate on 25-to-one leverage…or higher!

And this, then, answers the great fundamental question that seems to baffle so many market commentators. Why aren’t the banks lending? People point to the trillions of dollars the government pumped into the economy, including on bank balance sheets.

The answer is that the bankers know they will need the money to cover losses from their toxic loan portfolios. The banks are clearly not lending. Banks are cutting lines of credit to consumers – and to businesses, too. New loans in various business categories are down 60-80% from where they were a year ago.

It is hard to imagine any economic recovery when the banking system has such gaping funding holes it needs to fill. As it is, banks are failing and the losses are severe – on average, the losses amount to more than 40% of assets. The data coming in on foreclosure recoveries are bleak. In California, recovery is often less than 35 cents on the dollar., which means a loss of 65 cents on the dollar. It’s not supposed to happen like this. If this crisis is anything like previous cycles, we’ve got a long way to go on bank failures.

How do we invest in this environment? For starters, continue to avoid banks and leveraged financial institutions in general. And don’t expect the banks to start lending so freely again anytime soon. That means you should also avoid businesses that depend on regular access to credit to grow – such as real estate investment trusts. I would also say that the housing market is not due for any recovery anytime soon. There is still enormous inventory to work through. So homebuilding stocks and related investments also face stiff head winds.

At the right price, I might buy almost anything else. But investing is hard enough without also taking on problems as big as the ones I’ve outlined here. There are plenty of other great places to fish. Continue to avoid the financials.

Source: The Ghost of Housing Past

That was the day when the Dow Jones Industrial Average hit its historic peak. From there, it was all downhill – slowly but steadily at first, and then violently after last August – until the Dow bottomed (for now) on March 9 of this year. Over that span, the index lost 54% of its value.

It’s been a crushing blow to just about everyone. But it’s already being referred to as the crash. As if the unpleasantness were now all behind us. More likely, in the future it will be seen as, simply, the first crash.

Don’t believe it? In a moment you will, when you see the scariest graph of the year.

But let’s quickly recall what’s already happened. During the late, great housing boom, interest rates were at microscopic levels, while bankers were encouraged to grant home loans on little more than a wink and a nudge. In order to inflate their balance sheets, those bankers resorted to all sorts of gimmicky, adjustable rate mortgages (ARMs), whose common feature was an interest rate that would eventually reset. That is, it would balloon somewhere down the road. And those most likely to come quickly to grief were the riskiest borrowers, who held loans known as “subprime.”

“But not to worry,” borrowers were told. “Betting on ever-rising home prices is the safest wager in the whole wide world. If you have problems with cash flow when the ARM resets, your house will be worth a lot more, so you can simply sell it and walk away with a nice chunk of change in your pocket.” Uh-huh.

The bankers themselves were a little more concerned about the deterioration of their portfolios. They took out insurance in the form of credit default swaps (CDSs). These were a brand-new invention in world financial history, allowing mortgages to be sold and resold until they were leveraged 20 times over. They became the shakiest part of a huge global derivatives market, with a nominal value in the tens of trillions of dollars.

For a while, this Ponzi scheme even worked. But then, as they had to, the ARMs began resetting, and there were defaults. Then more of them. Because at the same time, the housing market was cooling off and the economy was stalling out. More and more people were trapped in a situation where they owed more on their home than they could sell it for. Many simply mailed their keys to the bank and moved on.

All of this wreaked havoc in the derivatives market. Sellers of these exotic packages could no longer establish what they were worth. Buyers couldn’t determine a fair price and so stopped buying. As the ripples spread through the world financial system, trust disappeared and liquidity dried up.

Now consider that the base cause for all that dislocation was the subprime sector. And how big is that? Not very. Subprime mortgages account for only about 15% of all home loans. Their influence has been way out of proportion to their numbers, because of derivatives. Here’s the good news: the subprime meltdown has about run its course. These loans were resetting en masse in 2007 and the first eight months of ’08. Now they’re pretty much done.

And the bad news? No one in the mainstream media seems to be asking what should be a pretty obvious question: What about loans other than subprime? Truth is, the banks didn’t just trick up their subprime loans. ARMs were the order of the day – across the board.

Now, here’s that frightening graph we referred to earlier.

Take a good, long look. You can see that from the beginning of 2007 through September of 2008, subprime loans (the gray bars above) were resetting like crazy. Those are the ones people were walking away from, sending a shockwave from defaults and foreclosures smack into the middle of the economy. Now they’re gone.

The ARM market got very quiet between December 2008 and March 2009, hitting a low that won’t be seen again until November of 2011. Small wonder a few “green shoots” have poked their heads above ground. But in April, resets began to increase and will reach an intermediate peak in June. After that, they tail off a little, going basically flat for the next ten months.

It’s not until May of 2010 that the next wave really hits. From there to October of 2011, the resets will be coming fast and furious. That’s 18 months of further turmoil in the housing market, and the beginning is still nearly a year away! (Although the months in between are likely to be no picnic, either.)

While it isn’t subprime ARMs that are resetting this time, neither are they prime loans. Those eligible for prime loans wisely tended to stay away from ARMs in the first place, as indicated by the relatively small space they take up on each bar.

No, the next to go are Alt-A’s (the white bars), Option ARMs (green) and Unsecuritized ARMs (blue). Alt-A’s are loans to the folks who are a small step up from subprime. Unsecuritized loans are a 50-50 proposition; either the borrowers were good enough that they weren’t thrown into the CDS pool, or they were so risky no one would insure them.

Those two are bad enough. But Option ARMs are the real black sheep, loans with choices on how large a payment the borrower will make. The options include interest-only or, worse, a minimum payment that is less than interest-only, leading to “negative amortization”—a loan balance that continually gets bigger, not smaller. Imagine what happens with those when the piper calls.

Once the carnage begins, will it be as bad as the subprime crisis? That’s the $64K question. Perhaps not. For one thing, subprime loans were a much larger chunk of the market when they started going south. For another, there’s been a lot of refinancing as interest rates dropped; that should help ease the default rate. And the government has massively intervened, with measures designed to prop up those who would otherwise lose their homes.

On the other hand, we’re in a severe recession, which wasn’t the case when the subprime crisis started. More people will be unable to meet payments. And the housing market has continued to decline, pressuring both marginal homeowners and banks that can’t sell foreclosed properties.

Is the stock market’s next 10/9/07 on the way? Yes. Which day will it be? That’s unknowable. It could be in a week, or not for another year.

But make no mistake about it, the second crash is coming. It can’t be prevented, no matter what desperate measures Obama and his hapless financial advisors come up with. All we can hope for is that, with a little luck, it won’t be as severe as the first one. But it will last longer. We aren’t even in the middle of the woods yet, much less on the way out.

Regards,

Doug Hornig

Source: The Unstoppable Second Mortgage Crisis

If we all came from Adam’s rib, where did Adam come from – and where did that special rib of Adam come from?

What came first: the chicken or the egg?

My brother gave me an answer, which is the most logical one that I have heard to date: “The egg,” he said matter-of-factly, “because we have it for breakfast!”

Not quite the philosopher, but puzzled by the daily behavioural patterns of a seemingly intelligent race sent to Mother Earth on some Unknown Mission, I enjoy making observations.

And I have discovered a certain pattern of behaviour in New York city that makes me ask my Big question.

What came first: the labyrinth system of bell boys and bell captains and doormen and taxi drivers that populate New York City or the crooked behaviour of Wall Street?

As any visitor to New York will tell you, the city is out to get your money.

You land at the airport and the money-taking begins in rapid earnest.

The taxi ride into the city is loaded with a toll of USD 8 (INR 325) just to enter the Kingdom of Money.

You reach the hotel. The taxi driver waits to get his “tip”. If it is anything less than 10% of the fare you just paid, be ready for some abuses.

And since the taxi driver is from India, Pakistan, or Bangladesh chances are that you will get a very good idea of his description of your behaviour.

Before you have even allowed yourself to absorb the taxi driver’s impression of your family history and the legitimacy of your birth, the doorman turns to you.

“Anything more, sir?” the doorman asks looking at you with his hand outstretched.

He took the bags out of the trunk of the taxi and kept them on the pavement.

The taxi driver, you see, is not supposed to do that. The taxi driver’s job in New York city is to get you from point A to point B.

Your luggage is your luggage.

So the doorman stands there waiting for his birthright of a tip.

Next in line is the hotel bellman. He rambles along with a luggage cart.

“Good afternoon, sir”, he greets you with enthusiasm, “how are you doing today?”

I am about to tell him that my day was quite fine till I landed in New York, paid toll to enter the city, got abused for giving the taxi driver a tip that seemed good enough for me but not good enough to pay the taxi driver’s down payment on his next condo….but, before I can get my thoughts together, I find myself at the reception area, waiting to be checked in.

“Jim will take care of you from here, sir”, said the bellman, not moving till I pay he required toll for him to get away from me.

Jim ambles along and takes the cart from the previous bellman, “Whenever you are ready, sir.”

I get the gist of it by now and know that there will be another tip that I have to pay to see the bags in my bedroom.

I lean over to the receptionist and ask them to change a ten dollar bill: I figured I would need the “singles” (the one dollar bills) to pay all those tips.

After an estimated USD 19 in tips and tolls, I am in my room – with my luggage.

And that is only for starters.

Every restaurant adds a “suggested tip” to their bill which is usually 15% of the bill amount.

No matter how good or bad the service is.

The waitresses, the bar tenders, the doormen, the bellboys, the taxi drivers get their tip.

It is their birthright.

The “compensation structure” is designed that way.

Now, I don’t wish to discourage not-so-rich people from making money and trying to get rich.

And I recognise the effort that goes into most of those jobs and the desire to earn a living.

But there seems to be a similarity in this New York pay structure and that of another species that lives in New York.

Namely, the CEOs and finance folk who dominate Wall Street and the financial companies.

They, too, get paid “extra” for a lot of doing nothing “extra”.

Think about it.

The financial services industry has built its “compensation structure” to take a lot of money from those they serve and have added layer upon layer of costs as their service fee.

Take the home loan industry.

Since the year 2005, the banks were willing to give loans to buy a house many Americans could not really afford.

According to the WSJ, there is a “rapid rise” in default rates on ARM mortgages,  mortgages that give borrowers with good credit several different monthly-payment options, reports. And a report by Citigroup says losses on ARMs may be “close to subprime” in some cases.

These mortgages, which are sometimes known as “pick-a-pay” or payment-option mortgages but are generically called option adjustable-rate mortgages, are turning out, in some cases, to be even more caustic than subprime loans, in part because the loan balance and the monthly payments on some loans is growing even as home prices are falling.

These loans have become the focus of investigations and a spate of lawsuits by borrowers who believe they were misinformed about the mortgages’ complicated structure.

“Buying real estate isn’t a popular view right now, says Floyd Brown, over at InvestmentU.com. “But that’s what being a contrarian is all about.”

Floyd thinks we could be closer to the end of the bear market in real estate, than the beginning. “This doesn’t mean we are out of the woods yet, but its time to start scouting for under-priced values in real estate, especially in the commercial sector…”

Floyd has found a way to buy $10,000 worth of real estate for $6,700. To find out more, click here.

That’s not an exaggeration. Interest-rate policy normally only affects the world economy at the margin, but it has now been so expansionary for so long that the Fed’s interest-rate strategy has turned into a moral dilemma of sorts. In short, the central bank’s monetary policy will likely determine whether millions of U.S. homeowners lose their homes or millions of the world’s poor starve.

Let me explain…

Expansionist Policies Lead to Market Bubbles

The Federal Reserve has been pursuing an expansionary monetary policy – growing the M3 money supply much faster than Gross Domestic Product (GDP) – since 1995. This has yet to result in U.S. consumer price inflation because a very powerful deflationary force – the introduction of cheap and readily available global communications through the Internet – has counteracted it.

Even though prices of domestically produced goods were increasing, the prices of many goods and services dropped as they became sourced from India (software services, for instance) and China (clothing, for example).

The result has been asset bubbles in both U.S. stocks and then U.S. housing, but without an accompanying big increase in consumer price inflation. Since last September, the Fed has moved to make monetary policy even more expansionary, cutting the benchmark Federal Funds rate six times to bring it down to 2.25% from its starting point at 5.25%, and pumping massive amounts of money into the banking system to bail out the banks that had lost money on subprime loans.

Most experts believe the central bank will cut rates again tomorrow (Wednesday), most likely taking the Fed Funds rate down another quarter point, to an even 2.0%, upon which the central bank will take a rate-reduction breather.

From the point of view of the U.S. housing market, Fed Chairman Ben S. Bernanke should keep cutting interest rates. Low short-term interest rates have a doubly beneficial effect on housing:

• First, low-level short-term rates tend to reduce long-term mortgage rates, while at the same time making banks more profitable. This increases banks’ readiness to lend for housing and reduces the interest rate on mortgages, making finance easier to get and cheaper for prospective homebuyers.

• Second, lower interest rates cause inflation. Consumer-price inflation is currently running at an annualized rate of about 4% over the last 12 months, so interest rates at about 3.6% for 10-year Treasuries and 2.25% for the Fed Funds rate are now significantly below the U.S. economy’s inflation rate. That means savers are getting an even worse deal than they usually get. It also means inflation is almost bound to accelerate: By definition, if borrowing costs are actually less than zero, people will find ways to borrow and then will waste the money they have borrowed.

The bottom line: Inflation is likely to rise rapidly towards the 10% level in the months to come.

The Fed’s Inflation-Fueled Rescue Plan

In most quarters, inflation is viewed as a four-letter word. But in a housing market where home prices are locked in a downward spiral, inflation is actually very good. For instance, should inflation spike to 15% and stay there for all of 2009 – while the U.S. economy remained in decent shape – then wages and prices could be expected to increase by 15% in 2009.

Additionally, the dollar would drop in value against other currencies that did not experience this burst of inflation. That would make housing relatively cheaper both for U.S. homebuyers (house prices would be a smaller multiple of earnings) and for foreigners (fewer European euros, Japanese yen or Chinese Renminbi needed to buy U.S. houses). The decline in housing prices would stop – and probably reverse – and the tsunami of mortgage foreclosures also would slow. The reason: Home mortgages would cease entering the “negative equity” situation in which it is cheaper for borrowers to walk away from both their home and mortgage than to keep making the payments.

If we’re only considering the housing market, Bernanke should lower interest rates as fast as possible. It will cause inflation, but he may well believe that a further series of home-price declines would cause so many problems in the home-mortgage market that moderate inflation is preferable.

Unfortunately, we don’t live in an economic vacuum, and Bernanke and his fellow Fed policymakers have much more to consider than just the travails of the U.S. homeowner.

You see, in addition to U.S. inflation and housing, Bernanke’s monetary policy has affected the world commodity and energy markets – and in a huge way. That’s why oil is now five times more expensive than it was in 2002, and is likely headed higher, still, before consumers get a reprieve.

But it was the rate-cutting campaign the Fed embarked upon last September that’s inflicted the real damage. Fed policymakers fired their first shot at the Fed Funds rate on Sept. 18, when it took short-term rates from 5.25% to 4.75%. On that day, oil closed at $82 per barrel, gold at $770 per ounce and the Reuters-CRB Index (CCI) of commodity prices was at 435. The flood of money poured into the system by the Fed and other central banks in the last seven months has had the anticipated impact: As I write, oil is at $118, gold is at $890 and the CCI Index has reached 544.