A tsunami of bad loans is sweeping across the country.
You can’t open a newspaper without coming across a story chronicling this swift, sharp increase in bad debts …
From the Wall Street Journal, December 5:
Americans who have stretched themselves financially to buy a home or refinance a mortgage have been falling behind on their loan payments at an unexpectedly rapid pace … Based on current performance, 2006 is on track to be one of the worst ever for subprime loans.
From the New York Times, December 6:
Delinquencies and foreclosures, though still low by historical standards, are rising fastest among these [subprime] borrowers.
From the Rocky Mountain News, December 5:
It’s official. A record number of real estate foreclosures have been filed in the Denver area this year.
From the Atlanta Journal-Constitution, December 6:
Hundreds of Georgians lost their homes Tuesday … foreclosures in Georgia are up a stunning 99% in the past year.
The amazing thing is it’s catching the Wall Street “experts†by surprise. Thomas Zimmerman, head of asset-backed securities research at UBS, summed it up by saying, “We are a bit surprised at how fast this has unraveled.â€
These folks are puzzling over questions like …
How can this happen when unemployment has been steadily declining?
Why are so many borrowers defaulting?
And how come they can’t just refinance their way out of trouble?
I’ve got a simple answer: A problem I like to call “Frankenstein Financing.†I told you way back in July that it was going to blow up in lenders’ faces, and now, that’s exactly what’s happening. [Editor’s note: For more, see “Property Values are Falling!â€]
A Speculative Lending Bacchanalia
That Would Make the Romans Blush
The Federal Reserve started raising short-term interest rates in 2004. Longer-term interest rates followed, to a smaller extent, later on. 
Now, higher rates should have suppressed demand, cooled the market off, and caused mortgage lenders to tighten their standards.
But the lenders had gotten used to living high on the hog. So, when rates started rising, they didn’t pull back. Instead, they offered up plenty of exotic ways for people to get in over their heads.
Historically, these products had specific uses before the bubble …
Take option Adjustable Rate Mortgages (ARMs), also called “pick your payment†loans. These loans let you choose one of several payment options each month. You can:
- Make a full principal and interest payment.
- Pay only the interest due.
- Choose not to pay even all the interest that’s due. The unpaid interest will get tacked onto your loan. This is called negative amortization because, over time, your principal balance will go up, not down.
Option ARMs used to be extremely rare. They were mostly used by sophisticated, higher-income borrowers who wanted to maximize their tax deduction on mortgage interest. Workers who relied heavily on commissions also liked the option arrangement because it allowed them to make a minimum payment during lean months and a much higher payment during good times.
Heck, even “stated income†or “low documentation†mortgages were designed with a real purpose. See, self-employed borrowers sometimes have a tougher time proving how much they earn. So, for a slightly higher interest rate, banks would agree to give these people mortgages with less — or virtually no — documentation proving income, assets, or savings.
But in the midst of the bubble, the industry perverted option ARMs and stated-income loans into something else entirely. They called them “affordability†products, and doled them out like candy to anyone. It didn’t matter if the borrower could even balance a checkbook, much less understand how these complicated loans worked.
Brokers and lenders pushed option ARMs by focusing on the 1% “start rates†these loans feature. They also highlighted how low the minimum payments would be. They played down the fact that the start rates last for only a few months before adjusting higher. And they swept the whole negative amortization catch under the rug.
Meanwhile, abuse of stated-income mortgages spread like wildfire. Mortgage brokers even coached borrowers on how to take them out — by making up any old income figure that would qualify them for the mortgage they needed.
Save for a down payment? Pay off principal? These ideas were called “old fashioned.†Instead, the industry put borrowers into interest-only loans with no money down. They promised buyers that home values always go up, that paying off principal was a waste of money.
I try to stay dispassionate in this business. That’s what you’re supposed to do when you analyze the financial markets day in and day out. But the kind of crap that went on over the past few years really gets my blood boiling! The worst part …
The Hangover Ain’t Pretty.
And It Ain’t Over, Either!
In and of itself, all this risky lending would likely drive delinquencies, foreclosures, and loan losses higher. But to make matters worse, existing home prices are falling at the fastest rate in recorded history … the inventory of homes for sale is hovering around its highest level in history … and economic growth is slowing.
The industry wasn’t prepared for this. The ratings agencies on Wall Street weren’t expecting it. And naïve borrowers certainly aren’t in a position to handle it. That’s why we’re suffering a brutal hangover …
- A stunning 3.9% of the subprime borrowers who got loans in 2006 are already at least two months behind on payments. That’s the fastest a yearly “vintage†of subprime mortgages has gone bad in recorded history. It’s also almost twice last year’s delinquency rate.
- It’s not just subprime loans going bad, either. Every quarter, the Fed releases data on loan delinquencies and charge-offs for all financial institutions (many of which specialize in plain-vanilla prime loans). Delinquencies jumped to 1.72% in the third quarter of this year from 1.38% in a quarter earlier. This is the highest since late 2003. The worst it’s going to get? Not by a long shot. I’m expecting the delinquency rate to climb toward 2.5% or higher in 2007.
- Bankruptcy filings skyrocketed late last year after the federal government passed new legislation making it tougher for debtors to go broke. That led to a big dip in filings in the first quarter of 2006. But now, they’re rising all over again — to 156,000 in the second quarter and 170,000 in the third. It’s yet another troubling trend on the credit front.
- As you can see from my chart, mortgage payments are now consuming the biggest chunk of disposable income in U.S. history — 11.6% in the third quarter. And many lenders have been writing mortgages that represent 40%, 50%, even 60% of a borrower’s income.
The bottom line: More and more average Americans are struggling to pay back record levels of debt. Many are just giving up. This will drive loan losses up throughout the mortgage and banking industries — it’s just a question of magnitude.
My guess is you’re going to see weaker lenders and home builders fold. Heck, it’s already happening in a few places. A company called Ownit Mortgage Solutions — the 11th largest subprime lender — just closed its doors and fired 800 employees this week. It made more than $8 billion in mortgages last year and basically shut down overnight when it ran out of cash because of a surge in bad loans.
I also expect earnings warnings from some of the big subprime lenders. We’ve already heard bad news from firms like H&R Block. And if the economy slips into recession, even bigger diversified banks could get whacked.
Last but not least, the mortgage meltdown is just one of the triggers that could bring the recent market party to a close. As I’ve been telling you, easy money has kept asset prices inflated, but that can’t last forever.
My suggestion: If you’re going to play this rally, do so in select sectors and stocks only. Use stop loss orders to control risk. And always keep a generous reserve of cash in short-term Treasuries or Treasury-only money funds.
Until next time,
Mike
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