Monday, April 12, 2010

Another painful mortgage crunch coming?

In 2007, Credit Suisse released an unusually frank and dismal report (PDF) on what the institution saw was a coming wave of adjustable rate mortgage resets.  Adjustable rate mortgages, or ARM's, "reset" when their terms call for a review of the mortgage terms and changes in the interest rates and payments are made, if necessary.  Factors influencing the magnitude of ARM term changes include the borrowers' credit histories, market interest rates and other effects. As we saw in 2008 and 2009, the report was as accurate as the ensuing meltdown was painful.

But as Credit Suisse continues to warn, it's not over, yet.  In the updated chart below, ARM resets are going to be a problem for several years to come.  While the percentage of sub-prime loans in the future waves of resets are smaller than those in the 2008-2009 crisis, there are large numbers of shaky mortgages left on the horizon, and the horizon is closing quickly. From 2010 through 2012, more than $1 trillion in ARM's will reset.  Pay particular attention to the proportion of unsecured and Option ARM's:

(Click the image for a larger view)

This does not mean that another trillion dollar meltdown is coming. At least not necessarily, based on the information available.  This is part of the uncertainty the financial markets face--there is no single clearinghouse for third-party data on the mortgage market like we have for stocks, bonds and Treasury securities.  Credit Suisse's estimate is a best guess calculation, based on its knowledge of the markets.  Their 2007 prescience is enough to convince me that, if they say a problem could be looming, there probably is.

What economists do know is this:

  1. The economy is not well situated to absorb the impacts of another financial crisis.  Unemployment remains high; business confidence levels remain low.
  2. Interest rates are likely headed higher over the next year or so, which means the ARM resets will be flying right into a period of higher interest rates, causing mortgage payments to increase and more homeowners to get squeezed.
  3. The Homeowners Affordable Refinance Program, designed to help borrowers refinance risky loans, has failed miserably.  It could have taken a lot of sting off of the coming round of resets.
  4. The Option and unsecuritized ARM's in the chart are major portions of the instruments that are resetting (these are the most likely to go into default, all other things being equal).
  5. There is not enough money for a TARP II.
The country is already trillions in debt.  Of the original $800 billion to $1 trillion in TARP I, there is only about $200 billion left, and President Obama wants to use some of it for job creation programs this year (something he can't do, but it won't stop him).  Obamacare's costs are just now becoming known, but will add billions more debt.

So, when will we know whether it's time to head for the hills?  Look for the first indications in late spring to early summer, 2010, but don't expect to wake up one morning to breaking news of an impending meltdown.  The process will take place over a nearly two year period, characterized by increasing personal debt levels, credit default rates and foreclosures.  If the economic activity improves dramatically between now and the end of the year, the next round of resets might only cause a minor second dip in the current recession (where a few quarters of growth are followed by a few quarters of anemic or negative growth).  But if the current economic conditions are still in place by January 2011, there could be blood in the streets.