“ARM”ageddon, Mortgage, Bank and consumer balance sheet bombshells

In the last edition of Tedbits I outlined how US Treasury secretary Hank Paulson guaranteed that the housing problem would not be a problem to the World economy.  Longtime readers also know I outlined the unfolding problems in the Adjustable Rate Mortgage markets beginning in September of last year.  I labeled the problems “ARM”ageddon.  Well a recent posting to the Orange county Register’s real estate BLOG by Joe Gagnon.  It outlines previous episodes of housing bubbles and reckless lending.  And how they can impact borrowers and lenders;

My comments are in italics.

Remember the S&L crisis of the late 1980s and early 1990s. In many ways the S&L crisis was a result of the interest rate crisis of the early 1980s. Recall that at one point in the early 1980s short-term interest rates approached 20% and long-term rates were a little lower. The S&Ls at the time were technically insolvent because most of their loan portfolio was in fixed rate product while their cost of funds was higher because of the inverted yield curve. They learned the lesson of borrowing short and lending long and the ARM was more or less born. Also, I think the government allowed S&Ls to make more speculative investments (higher yield to offset high funding costs) than ordinary mortgage loans. So they bought junk bonds (Columbia S&L was a virtual captive buyer of Milken's junk bond machine) and made construction loans and had equity investments in homebuilders, etc...

Well this worked for a while. But imagine the flood of money into these types of investments. Also, the tax code allowed for passive real estate losses to be deducted against active earned income (salaries, dividends, interest). Most of this passive loss was depreciation, a non-cash expense. What happened is that you had Doctors buying real estate to shelter their ordinary income, yet their cash flow was unaffected because the passive loss was a non-cash expense. Voila, massive overinvestment in real estate.

Now overinvestment often falls of its own weight. Oil prices crashed in the early 1980s and the pain spread through the Texas banking system. Coupled with real estate problems, virtually every major Texas bank failed. Next the Northeast was weakened by the stock market crash and the NY and Boston real estate markets peaked in 1987 coincident with the crash. California finally peaked in 1989 coincident with the peak in the Japanese stock and real estate markets. Folks forget that at one point the Japanese were major investors in California real estate. They bought many downtown L.A. hotels and office buildings. They bought Pebble Beach. They bought expensive homes in Palos Verdes and other high-end California communities. They also had a huge crash. For some reason, economists forget that it wasn't just aerospace problems that led to the Southern California housing slump of the early 1990s. Japanese overinvestment and disinvestment played a role. As did the fact that prices outstripped income and rents.

Balance sheet vaporization anyone, the banks are up to their gills in reserves backed by Mortgage backed securities and mortgages.  It is nation wide, not regional in nature? And think of all the credit default swaps (insurance against default) on these holdings.  The government cannot and will not allow these institution to fail!!!!

So with all these problems came the Financial Institutions, Reform and Recovery Act of 1989. FIRREA! Firrea created the RTC. Firrea also forced the liquidation of all these speculative investments from S&Ls. So now the troubled S&L industry had to dump these investments at fire-sale prices. This was like placing gasoline on an already burning fire. FIRE! FIRE! So the RTC went along and collected and sold off the debris at taxpayers' expense. Many more banks (and S&Ls) failed.

This dumping is on the horizon right now, car wreck dead ahead!!!

Homefed and Great American Savings were the two largest S&Ls in San Diego. Both failed. Bank of New England failed. Bank of Boston and Fleet were significantly wounded (now part of B of A). Wells Fargo was a huge target of short sellers and Buffett made a huge investment at the time. As a result of the mess, the government turned a blind eye and the banking industry underwent a huge consolidation. Wells bought First Interstate. B of A bought Security Pacific. Washington Mutual bought Great Western Financial and Home Savings of America (Ahmanson) and Coast Savings. All the New York money center banks merged into what are now Citicorp and JP Morgan.

So the 1990s went on and we got the tech bubble. I guess it's hard to tell what a bubble is if you work for the government, so the bubble went unchecked. In fact it was exasperated by the great Greenspan because the whole world was going to melt down because of Y2k problems. More money and tech investment was the answer. Poof! The bubble popped. Then the WTC came tumbling down. We can't let the US pay the price needed to correct any imbalances. Flood the world with more money!

Politicians and central bankers who avoid recession at any cost, but it is not avoided.  Only postponed with a far larger price tag for everybody.

So it worked. The tech mess was bailed out because we lowered rates to unprecedented lows. Everyone refinanced their mortgages and the interest rate drop made real estate seem cheap. I can buy a bigger house and a Hummer to boot all with the same payment. Wow, I've been renting and I can buy a house too. Great, I am on welfare but I can buy a house because my mortgage broker says I can just STATE my income. Awesome. Bush is all excited because the home ownership rate has hit an all-time high and homeowners all vote Republican. Fantastic.

Well, things got a tad carried away. Home price-income ratios got so high that real estate started to look expensive to some. Interest rates, after falling to 1%, started turning back up. Never mind said the lenders (and mortgage brokers). We can still get you in a home. We can give you an OPTION ARM loan and you only need to pay part of your payment. The bank pays the rest to itself. Cool! You don't have enough income or assets to buy. No problem. State your income! State your assets. Go No Doc. Go to Kaufman and Broad and triple your deposit money in a year!

So maybe if lending standards did not get completely abused and you actually needed a 20% down payment and could only borrow up to 28% of your gross income, home prices would have been checked by income. Instead they came untethered. So much so that the NAR said forget the old first time affordability rules. We will just change the rules. Now you only need a 10% down payment and can use 40% of your gross income to buy that charming house in Chula Vista.

Preying on the hopes and dreams of a generation, destroying their futures when their credit and futures are destroyed when the bubble popped.

Well now the bubble seems to have popped. Remember the Business Week Map of Misery Chart. California is the epicenter for Option ARM loans. Why? Because there is no land left in California and everyone wants to go to the OC and chicks with bikinis are hot and Countrywide is headquartered in Calabasas and USC has a great football team and everyone can be a movie star (or Realtor or Mortgage Broker or Flipper).

But something curious is happening. Borrowers in mass are starting to make the minimum payment on their Option ARM loans. So much so that the lending institutions are seeing huge increases in capitalized interest because they are essentially lending their borrowers their mortgage payment (look at the SEC filings for DSL, GDW, FED,WM...). Concerned and late to the party, the Interagenices issue new guidance to rein in the exotic loans. Ouch, says Countrywide, "Requiring lenders to qualify borrowers on the true cost of a loan, the company said, 'would tend to defeat the intended function of the loan and would significantly reduce the number of borrowers that could qualify.'" Whoa.

The rise in short-term rates would normally have checked the real estate markets a couple of years earlier if not for the Stated Income Option Arm. Imagine if you had used an interest-only ARM that adjusts annually to purchase a home in late 2003 or early 2004. Assume that there is no minimum payment feature. Your first year rate could have easily been 3.5%, and because that was the "real" rate for the ARM, you may have been qualified at that rate. A year goes by and short-term rates move up dramatically such that your new payment might be at 4.25%. Ouch! That's a 21% increase in my mortgage payment. Another year goes by and rates go up again. Double Ouch! My mortgage rate has gone up to 5.5% and my payment has increased 57% from inception. I barely qualified when I bought this house. How am I going to be able to make my mortgage payment?

Now if you live in Colorado you just have a hard time of it. There are not as many Option Arm loans available in Colorado as compared to California. So what do you do? Hand the bank the keys. That's why Colorado is currently seeing higher levels of foreclosure activity.

But if you live in California, what do you do? Well, when your first reset hit on your original ARM, you called your mortgage guy. No problem he says. We will refinance your IO loan into an Option ARM and your payment (minimum) will actually go down even though interest rates have risen. This is akin to Jesus walking across San Diego Bay. It's a miracle!

Of course, the problem is you just delayed the inevitable and made the problem worse. Your minimum payment rate can only last so long. The "real" rate has been rising with the up tick in mortgages tied to short-term rates. You can run your balance up to maybe 110-125% of the original balance, but that's it. The house has stopped appreciating, and maybe is starting to decline in value so you can't refinance. So you and everyone else make the MINIMUM PAYMENT. This means you don't need to worry about foreclosure just yet. You might be able to do this for a few more months.

So the bank is now in the position of contractually loaning a marginal borrower more money to make his payments. In past times this borrower may have already went into default, but the minimum payment gives him a chance for a short period of time. It's significantly worse for the bank because the LTV is rising into the eventual foreclosure. And it is rising because the bank is actually lending a troubled borrower more money just before the borrower hands the bank the keys.

This is why Downey, FirstFed, Golden West, Wamu and other lenders are seeing huge increases in their capitalized interest to loan interest income ratios. This is why their balance sheets are seeing huge increases in the amount of negative amortization included in loan balances. I don't believe this has ever happened.

Nope. These predators will be saved so they can continue to lend to the strong hands that will pick up the pieces of the wrecked lives they created with their reckless lending, aided and abetted by the Alan Greenspan, the Fed, and the treasury.  And of course those elected mandarins of Washington who are supposed to be providing oversight and regulation so these things are not allowed to happen.


Are falling rates going to bail out all these borrowers? How could it given that money was given away for free. You could lie about your income. You could make payments that were not reflective of the true cost and this was in an interest rate environment that gave borrowers the lowest true rates in a generation.

As this becomes more evident it will certainly cause repercussions in the MBS market. It will cause problems for the portfolio lenders. It will cause problems for the hedge funds that bought sub-prime MBSs and leveraged them up to enhance the return. It will cause problems for foreign central banks including China.

Certainly, these were not your Father's mortgage backed securities.
2007 should be really interesting with another $1,000,000,000,000 in resets.

Ponzi finance anyone? I predict, as I did in the last edition that the lending institutions and banks will have the bad paper moved off their balance sheets quietly by the US treasury, the fed, and the big investment banks.  Individual homeowners will go down in flames and their holdings will be purchased at rock bottom prices by the same reckless lending institutions and big investment funds that put them in the situation.  The new bankruptsy law will compound the woes of the marginal homeowner as he or she no longer has that option as the new law creates a sort of indentured servitude.  It’s like a used car lot where the buyer makes a foolish purchase of an automobile at sub prime rates of 20 to 28% interest and later defaults, allowing the lender to repossess the car and resell it over and over again.  The real criminals are the predatory lending institutions, which allow the buyers to purchase something he or she is not qualified for.  Sanctioned and approved by the US Government, your elected representatives and the Federal Reserve/US Treasury.

Technical Analysis of the S&P 500 and Gold by Garrett Jones

SPECIAL ALERT

         “New All Time Highs in the Dow – confirmed”

October 17, 2006

Garrett Jones

E-Mail: garrett111@comcast.net

  SPECIAL ALERT

“New All Time Highs in the Dow – confirmed”

"Financial genius is a short memory in a rising trend” - John Kenneth Galbraith

                                                                                    October 17, 2006

The picture of the bear hiding his head on the cover page is very likely the same expression most bears are feeling at this time.  We suggested that new highs in the Dow Jones Industrials were very likely and they are now a reality. The market has given us a first hand example of what “climbing a wall of worry” means in the real world.  So, the question is “What’s next?”  Frankly, that is always the question.

“Financial genius is a short memory in a rising trend” is a quote that may be very appropriate at this point in time.  We are dealing with a number of dynamics we have mentioned before -- debt, deficits, war, terrorism, derivatives time bomb, housing market crisis, and all of the other negatives that tend to spook investors on the market.  This market has done an excellent job of climbing a wall of worry.  Those investors with ‘short memories’ who have boldly participated in the market have been rewarded for their efforts. Those investors with longer memories (the ones who remember 2000-2002 and other such bear markets) have been penalized for their caution.  The implication of the quote, of course, is that the short memory folks view themselves as financial geniuses in a similar manner to the technology players leading into 2000.  They were geniuses …. and then they were broke (2000-2002 in technology stocks).

Many of the very experienced professionals of Wall Street are cautious and perplexed by this market.  You’ll recall that Warren Buffett did not participate in the technology craze.  Buffett wasn’t perplexed by it; he is simply a value player and didn’t see any real value.  The thing that has the old pros perplexed currently is that they can’t believe that the market has been able to rise this high and that the rally has extended this long without much of a correction.  After all, a four year cycle low is due and the market seems to be ignoring it.  This is perplexing because the four year “presidential” cycle has been remarkably consistent.  What is going on that seems to consistently drive this market higher and higher?

The answer to that is that there is an election coming up very shortly and the Administration is pulling out all of the stops in an effort to maintain power.  In addition, there is a very real fear that a collapse in real estate could cause the economy to go into a recession or worse.  The Fed has responded by seriously expanding money and credit – and that’s the answer to why the market has made new highs recently.

Let’s take a look at my long term indicator chart.  As long as the red line is above the yellow line, the

market is in a bullish mode.  The red line has been above the yellow line for 3½ years.  This indicator is designed to keep the investor in the market when he should be in it and out when he should be out.

Let’s check out the monthly chart.  This chart provides the long term perspective for the market.  As you can see, the market has broken out of the upper channel line which is bullish – at least at face value. The

reality is that I like to see two closing bars above the breakout line. You will not have that until the end of this month, so the jury is still out.  You also have what appears to be a five wave advance and a rising wedge pattern.  These two factors are potentially bearish. You have also moved into a .764 Fibonacci retracement line – which should provide resistance.  So, what you have at the moment is a bullish market that is on a buy signal combined with some things that may ultimately prove to be bearish.

Let’s check out the weekly chart and get closer look at the market.  The weekly chart is also still on a buy

signal.  In this case, it has moved to the upper channel where the market has reversed in the past. The sharper angled red channel lines show that price has entered a strong resistance area.  Nonetheless, there is no sell signal yet, so all we can say is that the market is currently extended.

The daily chart shows the incredible advance over the past three months.  It also shows that prices have moved into the upper price channel line as well as into a “price extension” channel from prior highs.  The

daily chart shows price running into a resistance line just like the weekly and monthly charts. This simply means that all three charts are extended and running into resistance.  Like the monthly and the weekly charts, the daily chart is still on a buy signal.  Caveat: that can change quickly.

In addition to the chart information, retail investor sentiment is at a multi year bullish extreme. The Volatility Index (VIX) has been at a low extreme of 11 or less for the past month.  Such readings have preceded every near term peak since 2005.  Low readings in the VIX equate to investor complacency.

The 26 week New High/New Low indicator is also at an extreme.  This indicator has coincided with virtually every high for the past couple of years.  The S&P 500 is also at a two year extreme percentage distance above its 200 day moving average.  This type of reading has also coincided with near term tops in the index over the past couple of years.

There are a number of other indicators that are extended as well.  One key area to watch is the NASDAQ Composite and the NASDAQ 100.  These indexes have taken a leadership role vs. the S&P 500. Until such time as the NASDAQ indexes underperform the S&P 500, the broad market advance is likely to continue.  A reversal in this leadership should be the first clue. Both of these indexes are currently challenging their recovery highs. 

This week is an option expiration week.  The tendency is for stock prices to hold up at least to the middle of the week and frequently throughout the entire week of expiration.  This coincides with my next expected cycle turn date which falls on the Friday (10/20) and Monday (10/23).  My last cycle turn date was August 31^st.  The market topped two trading days later and fell 25 S&P points from high to low.  That sounds timely and impressive, but I was looking for a much more significant decline.  In my view, it was a failure. Frequently, when a cycle date is a continuation as opposed to a reversal, the following cycle date has a higher probability of being a reversal.  This upcoming turn date falls into that category.

Gold

Gold is frequently called a barometer of anxiety.  Let’s see how we are doing (according to gold) as we enter the elections.  With respect to the general price direction of gold, it has been declining. That

implies that things are getting better.  That assessment would bode well with the recent directions of the stock market, the US dollar, the price of oil, the state of the US economy, etc.  The fact that elections are coming up also ‘coincidentally’ plays into the equation.  Seated presidents are notorious for priming the pump during mid term elections.  Gold is simply doing what it does best – it is reflecting what is going on at the moment.  Gold has recently fallen in price to 1) successfully test the June low and 2) bounce off the dashed white trendline that connects the lows of this rally and also is the bottom channel line off the top channel line that defined the recent high earlier this year.  It has also fallen back to test the major price channel that it broke out from late last year.  Remaining above that line will be the big test for gold.

My upcoming turn dates of October 20^th and 23^rd should be significant. I would expect a turn in the stock market to occur roughly in this time frame i.e. the turn is due in my opinion and could start at any time.  It would not be surprising to see such a turn accompanied by rising oil prices and rising gold prices.  The US dollar may be the only wrench in the works.  An argument can be made that the dollar has made a turn and should have a rally that lasts for many more months. The key on the dollar is a price breakout above 87.  Should that occur, gold may have a problem.  The main thing to keep in mind is that it is still the dollar – enough said.  This should be an interesting week.

All the best,

Garrett Jones

garrett111@comcast.net  

NOTE:  THIS E-MAIL REPRESENTS THE VIEWS OF THE AUTHOR AND IS INTENDED FOR EDUCATIONAL PURPOSES ONLY.  THERE IS RISK OF LOSS IN FUTURES TRADING.  PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS.

In conclusion:  The housing market has a long ways to go before the bottom, it will be on magazine covers before it is over.  Detailing the lives that have been wrecked.  The institutions that fostered the problem will be left unscathed courtesy of the Government and our elected representatives who will work to prevent any sort of slowdown and bail the lenders out so they can keep lending to the next guy or girl who can qualify.  The Stock market is bloated and overvalued; mutual funds have all time low cash, there are no bears anywhere, who are the next buyers as 92% of the public is bullish and have been for weeks and weeks.  Driven to these heights by what I believe is a GOP inspired government-buying spree.  This current run of quarterly double digit profit growth is only been seen once in the last 80 years, it has only one way to go.  The commodity boom is far from over just getting ready for the next bout of reflation and money and credit creation to hit the bricks.

Thank you for reading Tedbits, if you enjoyed it, send it to a friend.  Subscriptions are free at www.traderview.com.

 Tedbits is authored by Theodore "Ty" Andros, and is registered with TraderView, a registered CTA (Commodity Trading Advisor) and TraderVest Clearing LLC a GIB (Guaranteed Introducing Broker).  He currently is the principle of TraderView, a managed futures and alternative investment boutique.  Mr. Andros began his commodity career in the early 1980's and became a managed futures specialist beginning in 1985.  Mr. Andros duties include marketing, sales, and portfolio selection and monitoring, customer relations and all aspects required in building a successful managed futures and alternative investment brokerage service.   Mr. Andros attended the University of San Diego, and the University of Miami, majoring in Marketing, Economics and Business Administration.  He began his career as a broker in 1983, and has worked his way to the creation of TraderView of which he is the sole owner.  Mr. Andros is active in Economic analysis and brings this information and analysis to his clients on a regular basis.  Ty prides himself on his personal preparation for the markets as they unfold.  Developing a loyal clientele.

This report may include information obtained from sources believed to be reliable and accurate as of the date of this publication, but no independent verification has been made to ensure its accuracy or completeness.  Opinions expressed are subject to change without notice.  This report is not a request to engage in any transaction involving the purchase or sale of futures contracts or options on futures.  There is a substantial risk of loss associated with trading futures and options on futures.

-- Posted Thursday, 19 October 2006 | Digg This Article