conraddobler

http://www.autodogmatic.com/index.ph...ld_trigger_col

Subprime Credit Crunch Could Trigger Collapse
Posted on 02-02-2007 at 02:19:12 am by Aaron , 929 words, 3874 views
Some of you might have seen my new informational site, the Mortgage Lender Implode-O-Meter. But for those who haven't, I started this site to coherently track a story that is otherwise only quietly developing on a smattering of disparate finance blogs and message boards, with little treatment in the mainstream media (MSM). That story is the collapse of mortgage lending finance, especially in the subprime sector.

I and others had been expecting this for the better part of the last year (many, even longer, but I'm a newer observer). The subprime shakeout is predicated on the deterioration of subprime mortgages and mortgage-backed securities (MBS), which is in turn caused by rising delinquencies, which is in turn caused by the deteriorating financial position of most Americans. So really, it was a no-brainer, except apparently to the brilliant boyz of finance who listen to too many talking heads telling them what they want to hear about the "goldilocks" economy.

Well, I've got news for the goldilocksters: the three bears are home.

The effects of these deteriorating economic fundamentals are now starting to show up in the finance world (which is not the same as, but all too often confused with, the real world):





The chart is a graph of the value of BBB (subprime) mortgage-backed securities dated as of the second half of 2006. I've been following it for months, yet the latest move of just the past couple days still surprised me: it's almost going vertical... downward. Not good.

If you go to MarkIt's ABX credit index home, you can pull up charts for other classes of mortgages (above BBB are A, AA, and AAA), and different date issues, and see how they're doing.

It's a fascinating exercise. You can see that immediately when subprime (BBB) 2006-02 started to crash, there was a "flight to quality" into the As. But as BBB continued to collapse, A began to follow, and then AA, and then even AAA. The effect also began to spread to earlier and later issues; a veritable "shockwave" emanating out from the BBB-2006-02 subprime issues -- ground zero.

I can't quite stress how much this is not good. That's because it gets more complex than just a bunch of holders of mortgage-backed bonds ending up with crappy returns: enter derivatives.

In recent years, derivatives began to be used more heavily, to "buy insurance" on various investments and trades, in case of default or other unexpected moves. Derivatives such as these have skyrocketed to a notational value of somewhere around $400 trillion, by some reports. Why? Because they became so cheap... because nothing financially "bad" had happened in a while. Tremendous quantities of liquidity will do that... until one day exhaustion bursts the bubble. Well, the regular folks down in the "real economy" are seeming quite exhausted.

The tie-in to MBS is as follows: banks and other holders of MBS (like hedge funds) wanted to book their gains immediately ("marking them to market"), so they bought insurance on their MBS in the form of derivatives ("credit default swaps" or "CDS"), and then were able to sell them with a slight markup or use them as "guilt-free" collateral for other speculative plays. Aside from some flogging of these securities to foreigners and the general public (e.g. pension funds), the major financial institutions just sold these things to each other: last I heard, US banks still hold well over 50% of their assets in the form of real estate-related securities.

All this MBS trading and CDS insuring amongst the same pool of entities seems apt to be a setup for a disaster: if MBS returns widely suffer, then someone must pay up on the CDS "insurance". But since retail banks, mortgage banks, investment banks, hedge funds, and private equity have all been both buying selling these things amongst each other, you end up with an undifferentiated soup of liability with no distinct bearers of risk.

And by the way, since derivatives encourage more spending and speculation, they in essence are liquidity (as outlined above), so they essentially beget more of themselves. The credit bubble becomes a self-fulfilling prophecy... for a time.

In sum, the entire financial economy looks vulnerable to a rout here, as the baseline level of default is suddenly becoming much higher. This failure is already cascading through the various grades and vintages of MBS, but as returns fall and CDS obligations must be made good on, there will likely occur a credit crunch that will begin to drive down financial asset prices in general. This will, of course, further harm returns and trigger derivatives obligations, becoming a self-reinforcing, downward-accelerating feedback loop.

The Fed is clearly already trying to stop it, with the accelerated M3 money growth (as was also done in 2000/2001), but it's already too late. The stock market is obediently being inflated, but that does little to distribute wealth to the suffering masses in debt, who are the source of these rising MBS defaults.

New subprime lending is shutting down fast, as reported on the Implode-O-Meter, but not just because of companies going out of business: the risks are now becoming obvious, so financial firms (even large ones, like JP Morgan) are scaling back or eliminating their non-prime lending activities. But this sort of lending, as of late last year, accounted for nearly a quarter of total loan activity. Can anyone guess what is going to happen to the housing market when you forcibly remove at least a quarter of total demand?


This guy explains a pretty complicated situation but it's much much worse than anyone thinks.

These firms financed their portolios by pooling them up and selling them to Wall Street. A quick example would work like this:

Sell 100,000,000 of loans pooled up for 105,000,000 and that extra 5 million was the juice or premium that companies made money off of. It's peachy until you present your 100,000,000 and they offer 98,000,000 and then as it worsens they go to 95 then 90 all based on the problem no one wants the stuff anymore because of excessive default rates and it spirals into oblivion.

That's simple enough but these rocket scientists added derivatives to the equation and that works fine until this exact situation then it worsens it even further and actually spreads the pain all over the place to the holders of the wrong end of the derivatives.

The issue now is will it spread out both financially and economically by hurting financing in other areas and by hurting the economy by removing buyers.

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At what point then is the approach of danger to be expected? I answer, if it ever reach us, it must spring up amongst us. It cannot come from abroad. If destruction be our lot, we must ourselves be its author and finisher. As a nation of freemen, we must live through all time, or die by suicide.

~Abraham Lincoln Lyceum Address

82CardsGrad

I have to ask.. regarding the statement I highlighted above, exactly where did you develop this understanding that "most Americans are experiencing a deteriorating financial position"??

Chris_Sanders

Savings are at a record low. That is just off of the top of my head.

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40yearfan

But savings don't take into account asset holdings. Your savings could be down, but if your assets are up (real estate), what difference does it make?

82CardsGrad

And?? This means that we are worse off because...?? Americans are saving less - why?

AZZenny

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82CardsGrad

Nice try Zenny... I asked for clarification as the broad, long-standing national economic meaures suggest the contrary to the statement I highlighted...
So, if you or others feel differently, I would think it might be instructive to illustrate how you are drawing this conclusion...

conraddobler

What's happening is that houses in our area that appraised for 200,000 6 months ago now appraise for 180,000 which is about average around here and it's not getting any better.

So now a guy that owes 180,000 on a subprime arm that was at 7% for two years comes due and he needs to refi but his credit score still stinks because that's just the way it is and he's toast.

Now his rate may be as high as 11 probably about 10 and his payments just rocketed up and he can't fix it literally.

He defaults which throws one more house onto a saturated market, rinse and repeat all over the place.

Some areas are hit harder by this and it hasn't yet shaken even halfway out, add to this tightening credit standards holding about a quarter of the market out and it will hit everything sooner rather than later.

This is just the other side of the hill from a housing boom, which happens all the time and is not anything new, the new factor in the equation is subprime arms, that IS EXTREMELY recent and not at all normal per the normal old cycles most of the older people around remember, this will be much worse because of them.. The default rates are staggering, HUGE, unbelelievable, truly awe inspiring and getting worse, that's why the rug went out from under huge lenders like New Century. It went from solid as a rock 6 months ago to just vaporized.

40 you are right about asset values except in this particular instance and that would be deflation, once asset deflation hits your entire theory goes poof. I am not for the record talking about general deflation at least not yet, currently prices of everything but houses in some areas is up and staying up which the guy mentions is now partly because the Fed is hitting the market with liquidity to stop this before it gets out of control. That would cause inflation in other areas of the economy in the short run. The problem in viewing this is that it's the event that will trigger the problem, so the rest of the economy might even look quite sound right now because it is so far, this thing will get to it soon enough though, it's on it's way just hang loose and wait if you don't believe me.

This is NOT an economic driven phenom, it will DRIVE economics, "these people aren't defaulting because the economy is bad, it's how the loans were structered" it's big enough to drive the train wherever it wants it to go, so trying to gauge how well the economy is doing is like looking at a house before the tornado hits and wondering what all the fuss is about.

Again what you think something is worth what you want it to be worth means nothing, what's important is what someone will and can pay for it. Some areas will see this faster than others, some will stay insulated for almost 6 months but it will become pervasive an it will hit everywhere but a few select areas if even they are spared.

It's simply supply and demand, the supply of housing in total is too high, foreclosures will raise that further exagerating a normal cycle of boom and bust, making the trough lower and the losses will cause credit tightening that will spiral the whole thing down until it bottoms, good luck guessing where that will be.

__________________
At what point then is the approach of danger to be expected? I answer, if it ever reach us, it must spring up amongst us. It cannot come from abroad. If destruction be our lot, we must ourselves be its author and finisher. As a nation of freemen, we must live through all time, or die by suicide.

~Abraham Lincoln Lyceum Address

justAndy

Everybody that got those type of loans ALWAYS had teh option to make full 30-yr payments. I use mine to give me flexibility - but one or 2 1% payments get your equity going in a negative direction QUICK.
But no - "I gotta have that gigantic truck, or a boob job, or a 1000" LCD TV"
Yes - lotsa fools out there...

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conraddobler

The author and I disagree on that point actually, he details the crisis well but he's missing the point as most do that don't completely understand the type of borrowers he's talking about and he's no different in that.

He as well as you are assuming something must have caused this, loss of income, loss of job, something.

I can tell you that when we take applications on this subset of applicants their application when it comes to assets, liquid assets like.. checking, savings, 401k looks something like this.

Checking 150$

Savings 50$

401k.... what's that?

But I'd like to buy a 300k house please with nothing down and a 560 credit score and the answer used to be, step right up we've got that right here.

Now it's yeah right.


When these peoples payments that were based on 6.5 fixed for a 24 month period " set during a period of ridiculously cheap money" adjust up to 9.5 and higher where exactly are they going to get the extra money?


That defines the problem.

__________________
At what point then is the approach of danger to be expected? I answer, if it ever reach us, it must spring up amongst us. It cannot come from abroad. If destruction be our lot, we must ourselves be its author and finisher. As a nation of freemen, we must live through all time, or die by suicide.

~Abraham Lincoln Lyceum Address

conraddobler

That's an option arm, not the same thing really, although it's bad too, very bad if misused, these are subprime arms that have teaser rates that rocket much higher when fully indexed.

Yours may have had a teaser too but the percentage of adjustment isn't as bad plus it typically requires better credit that allows flexibility of getting out of it again at a later date.

These subprime borrowers have bad credit, they don't by and large get better they don't pay well and it stays bad. A lot of them were sold these with the idea of cleaning up their credit but they aren't by and large built that way, they simply stay bad removing a lot of options from themselves.

__________________
At what point then is the approach of danger to be expected? I answer, if it ever reach us, it must spring up amongst us. It cannot come from abroad. If destruction be our lot, we must ourselves be its author and finisher. As a nation of freemen, we must live through all time, or die by suicide.

~Abraham Lincoln Lyceum Address

conraddobler

I think I should have defined a subprime arm better to illustrate what's going on here.

A subprime arm was typically structured something like this during the periods of boom times.

Start rate of about 6.5 to 7 at the high end with a piggy back 2nd that was fixed at say 10%

So on a 200,000 loan it would look like this.


160000 at 7% and payments of 1064.00 on a 1st

40000 at 10% and payments of 351.00 on a 2nd.

The first is just a teaser rate, by that I mean it's not like most traditional arms that start out fully indexed and float up or down based on that index from there.

These would have been 9.5% say from the get go but were lowered to make them attractive so that when they come to the end of their 24 month teaser rate period the rate goes up to at least 9.5% but say the rates are now half a percent higher also so now it goes straight up to 10%, it's not exactly like this but it's very close to reality so it's fine for an example.


Now the payments are 1404 on the first and still 351 on the 2nd for a total of 1755 or 340$ higher.

That's more than enough to send this type of borrower who spent a lot of money they didn't have furnishing their new abode right off a cliff.

Again these people aren't typical homeowners, they're shaky, never owned a home in most cases and have bad credit with limited access to get credit to help them out of it and if you see my post above live paycheck to paycheck as it is.

This is what I've been saying for years, it was insane, the laws of lending were repealed, no down, interest only, no pricing for risk... see Greenspans testimony where he mentions we lost the ability to price for risk.

This was generated when the Fed funds rate got to like 1%... it stayed there a while and the money flowed like water and the boom made everyone want a home, during this period the lenders lost their mind and threw buckets of money at everyone but the real problem is that they got greedy and boomed subprime to ridiculous levels never seen before.

Why? because at that low of a cost of funds it was like a money machine to lend out money at 7% it was huge and they paid the lenders huge money for those loans, figuring, they're secured, sure they don't pay well but in an ever increasing boom market who cares we'll flip em again if they don't pay but then the music stopped, prices faultered a little and the train ran right off the track and is currently meandering around our economy.

Before the boom I'd be suprised if the subprime market ever broke 5% market share, to say it's at 25% now is INSANE.

FHA used to be subprime lending, although it was a fixed rate and it was a good loan for the people they still had credit standards just lower than the general market, during this boom FHA almost went to nothing, it lost all that share to subprime lending because FHA is simply too much trouble and it's too hard to get an FHA license so they skipped it.

I personally apologize for the idiots in my industry, they nuked us all.

__________________
At what point then is the approach of danger to be expected? I answer, if it ever reach us, it must spring up amongst us. It cannot come from abroad. If destruction be our lot, we must ourselves be its author and finisher. As a nation of freemen, we must live through all time, or die by suicide.

~Abraham Lincoln Lyceum Address

82CardsGrad

Conrad - I just don't see it as being nearly as catostrophic as you seem to believe...
Trust me, I know real estate quite well. Been very "close" to the business - on a national scale, for over 20 years...
On average, real estate values are trending lower and have been since the late 3rd, early 4th quarters of '06. But they have certaihnly not been dropping like a lead balloon. And nobody I know is predicting that to occur. In fact, the majority of experts I speak with and read all say that we are inching closer to having absorbed the massive supply across the country, furthering their opinion that the end of the real estate "recession" is in sight. Of course there will be other media outlets and reporters that will paint the doom & gloom picture. However, the facts just don't support their position.
With specific regard to the sub-prime dynamic... again, nobody is arguing what has and will happen to anyone who was suckered into that arrangement on the ridiculous premise that their home value would never drop. These people have and will deal with a great deal of pain... But in no way will this have any material impact on our national economy. It will not lead into, or in any way spur some sort of recession...

conraddobler

I hope you are right but again it's my opinion it will and some others but not because I'm particualarly gloomy as a person.

It's just a theory I believe in that credit tightening will do a lot of harm to the economy, the tightening is already happening and that has nothing to do with the previous drop that occured just because the cycle finally turned.

If not for this particular phenom I'd agree we either have or would soon hit the bottom, it's just that I think a lot of those thinking the bottom is here haven't factored in this particular issue and the dearth of new buyers to swing it out of this.

I am already busy with purchases, lots of them but they're no subprime ones at all because I hate subprime purchase with a passion it's not my niche anyway. My personal guess is that this year purchases will be about 80% of what people hope the industry will do. Again company by company it can look fine since we are getting a lot of deals that would have gone to now dead mortgage companies but conservative estimates are 66% of last years mortgage staffing will be gone by the end of 07, that explains why some will get busier as the year goes on.

Entire companies had this niche and are dead now, they did a lot of loans in that end and it went from great last year to a ghost town this year.

I do subprime refis though and that's off about 80% or more, no one qualifies now, it's the same everywhere you go, I make up for it in other areas a lot don't and are gone now.

I guess we'll see soon but I think the damage is going to be rather severe.


P.S. What part of the country do you live in?

The fact many on this board are from AZ skews some of those peoples ideas about the mortgage market nationwide, in the colder parts no one buys a house much until about now so the data won't mean a lot for a month or two more, AZ I would guess has no such phenom.

__________________
At what point then is the approach of danger to be expected? I answer, if it ever reach us, it must spring up amongst us. It cannot come from abroad. If destruction be our lot, we must ourselves be its author and finisher. As a nation of freemen, we must live through all time, or die by suicide.

~Abraham Lincoln Lyceum Address

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