Tuesday, December 16

Mortgages Meltdown: The Second Wave

"Tilson saw, a year ago, that sub-prime mortgages were just the start."

There is a dissenting view about the "option ARM" (see the first comment on the 60 Minutes website) but I do not think 60 Minutes is scare mongering. In the interests of going right to the 'money' quotes, I've removed the personal anecdotes from the transcript but otherwise it's stet.

Regarding Whitney Tilson's view that there are bargains galore in the stock market right now (see transcript), Jimmy Sinclair wrote recently about bull rallies happening on the way to hell. Yeah sure there are bargains at today's prices, but which bargains? For how long?

We don't do financial advice here on Pundita blog, but in the spirit of presenting a contra view I've tacked onto the end of this post quotes from Jimmy's post about a week ago on the issue.

(WARNING: The mere mention of Jim Sinclair's name around the Federal Reserve brings out the pitch and flamethrowers. Old story, old war, and usually the gold bulls lose. This time perhaps not.)

A Second Mortgage Disaster On The Horizon?

60 Minutes: New Wave Of Mortgage Rate Adjustments Could Force More Homeowners To Default

(CBS) When it comes to bailouts of American business, Barney Frank and the Congress may be just getting started. Nearly two trillion tax dollars have been shoveled into the hole that Wall Street dug and people wonder where the bottom is.

As correspondent Scott Pelley reports, it turns out the abyss is deeper than most people think because there is a second mortgage shock heading for the economy. In the executive suites of Wall Street and Washington, you're beginning to hear alarm about a new wave of mortgages with strange names that are about to become all too familiar. If you thought sub-primes were insanely reckless wait until you hear what's coming:

One of the best guides to the danger ahead is Whitney Tilson. He's an investment fund manager who has made such a name for himself recently that investors, who manage about $10 billion, gathered to hear him last week. Tilson saw, a year ago, that sub-prime mortgages were just the start.

"We had the greatest asset bubble in history and now that bubble is bursting. The single biggest piece of the bubble is the U.S. mortgage market and we're probably about halfway through the unwinding and bursting of the bubble," Tilson explains. "It may seem like all the carnage out there, we must be almost finished. But there's still a lot of pain to come in terms of write-downs and losses that have yet to be recognized."

In 2007, Tilson teamed up with Amherst Securities, an investment firm that specializes in mortgages. Amherst had done some financial detective work, analyzing the millions of mortgages that were bundled into those mortgage-backed securities that Wall Street was peddling. It found that the sub-primes, loans to the least credit-worthy borrowers, were defaulting. But Amherst also ran the numbers on what were supposed to be higher quality mortgages.

"It was data we'd never seen before and that's what made us realize, 'Holy cow, things are gonna be much worse than anyone anticipates,'" Tilson says.

The trouble now is that the insanity didn't end with sub-primes. There were two other kinds of exotic mortgages that became popular, called "Alt-A" and "option ARM." The option ARMs, in particular, lured borrowers in with low initial interest rates - so-called teaser rates - sometimes as low as one percent. But after two, three or five years those rates "reset." They went up. And so did the monthly payment. A mortgage of $800 dollars a month could easily jump to $1,500.

Now the Alt-A and option ARM loans made back in the heyday are starting to reset, causing the mortgage payments to go up and homeowners to default.

"The defaults right now are incredibly high. At unprecedented levels. And there’s no evidence that the default rate is tapering off. Those defaults almost inevitably are leading to foreclosures, and homes being auctioned, and home prices continuing to fall," Tilson explains.

"What you seem to be saying is that there is a very predictable time bomb effect here?" Pelley asks.

"Exactly. I mean, you can look back at what was written in '05 and '07. You can look at the reset dates. You can look at the current default rates, and it's really very clear and predictable what's gonna happen here," Tilson says.

Just look at a projection from the investment bank of Credit Suisse: there are the billions of dollars in sub-prime mortgages that reset last year and this year. But what hasn't hit yet are Alt-A and option ARM resets, when homeowners will pay higher interest rates in the next three years. We're at the beginning of a second wave.

"How big is the potential damage from the Alt-A as compared to what we just saw in the sub-primes?" Pelley asks.

"Well, the sub-prime is, was approaching $1 trillion, the Alt-A is about $1 trillion. And then you have option ARMs on top of that. That's probably another $500 billion to $600 billion on top of that," Tilson says.

Asked how many of these option ARMs he imagines are going to fail, Tilson says, "Well north of 50 percent. My gut would be 70 percent of these option ARMs will default."

"How do you know that?" Pelley asks.

"Well we know it based on current default rates. And this is before the reset. So people are defaulting even on the little three percent teaser interest-only rates they're being asked to pay today," Tilson says.

(CBS) That second wave is coming ashore at a place you might call the "Repo Riviera" - Miami Dade County.


And there are tough years to come because, just like the sub-primes, the Alt-A and option ARM mortgages were bundled into Wall Street securities and sold to investors.

Sean Egan, who runs a credit rating firm that analyzes corporate debt, says he expects 2009 to be miserable and 2010 also miserable and even worse.

Fortune Magazine cited Egan as one of six Wall Street pros who predicted the fall of the financial giants.

"This next wave of defaults, which everyone agrees is inevitably going to happen, how central is that to what happens to the rest of the economy?" Pelley asks.

"It's core. It's core, because housing is such an important part. We're not going to get the housing industry back on track until we clear out this garbage that's in there," Egan explains.

"That hasn't cleared out yet. We haven't seen the bottom," Pelley remarks.

"It's getting worse," Egan says. "There are some statistics from the National Association of Realtors, and they track the supply of housing units on the market. And that's grown from 2.2 million units about three years ago, up to 4.5 million units earlier this year. So you have the massive supply out there of units that need to be sold."

"What with the housing supply increasing that much, what does it mean?" Pelley asks.

"It means that this problem, the economic difficulties, are not going to be resolved in a short period of time. It's not gonna take six months, it's not gonna be 12 months; we're looking at probably about three, four, five years, before this overhang, this supply overhang is worked through," Egan says.

(CBS) In the next four years, eight million American families are expected to lose their homes. But even after the residential meltdown, Whitney Tilson says blows to the financial system will keep coming.

"The same craziness that occurred in the mortgage market occurred in the commercial real estate markets. And that's taking a little longer to show. But there are gonna be big losses there. Credit cars, auto loans. You name it. So, we're still, you know, we're maybe halfway through the mortgage bubble. But we may only be in the third inning of the overall bursting of this asset bubble," Tilson says.

"Does that mean that the stock market is gonna continue plunging as we've seen the last several months?" Pelley asks.

"Actually we're the most bullish we've been in 10 years of managing money. And the reason is because the stock market, for the first time I can say this, in years, has finally figured out how bad things are going to be. And the stock market is forward looking. And with U.S. stocks down nearly 50 percent from their highs, we're actually finding bargains galore. We think corporate America's on sale," Tilson says.

Produced by David Gelber and Joel Bach
© MMVIII, CBS Worldwide Inc. All Rights Reserved.
And now a few word from James Sinclair:
[...] I completely agree that a study of similar historical periods argues strongly for an equity rally. Those rallies in the past have had one year legs but for the moment we must wait to see what transpires.

I am cautious about being bearish on equities right now. Models of 1873 and 1929 show humdinger rallies during the worst of these periods.

The most likely time for a rally to occur is when Obama starts the nation's two trillion fiscal stimulus which will trigger the $8.5 trillion bailout of the system, starting an inflation few people can imagine.

No lender will fail to loan on a government contract that probably guarantees payment.

Over time this fiscal stimulus will be famous for only one thing - triggering hyperinflation.

Gold's rally then can be quite long term, as in more than three years.

Gold will trade at $1,650 but I am sure even that number could be very low. Reasonable people are saying $3,000 to $5,000.

Base metals are not staying as low as they are now in a hyper-inflationary environment.

Gold as honest money will lead everything.

When the fiscal stimulus fails to establish a sustainable recovery, it will have pulled the trigger for hyper-inflation. This is a currency event, not an economic event.

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