Subprime Borrowers Face ‘Reset Problem’: Barrons
Barron’s Online has a report on subprime loans. Highlights, “The red hot US housing market may be fast approaching its date with destiny. Indeed, inside the mortgage trade, much anxiety is being focused on a looming ‘reset problem.’ Over the next two years, monthly payments on an estimated $600 billion of mortgages to borrowers with checkered or no credit histories, the ’sub-prime’ market, may zoom as much as 50% higher, as the two-year teaser rates on hybrid adjustable-rate loans expire and interest payments hit their fully indexed levels.”
“In the past, such resets caused little disruption. For one thing, the sub-prime market was strikingly smaller. Only $97 billion of such mortgages were originated in 1996, compared with a mammoth $628 billion last year and $540 billion in 2004. Sub-prime loans outstanding now account for more than 10% of the total U.S. mortgage debt of $8.4 trillion.”
“Moreover, the reset triggers on sub-prime mortgages have dramatically shortened, with the loosening in underwriting standards. During the past two years, ‘affordability’ products, as the industry has dubbed them, have migrated from prime to sub-prime borrowers.”
“Significant sticker shock impends for sub-prime borrowers. The shock will be even greater for the sub-prime borrowers who are facing not only a jump from a fixed to a floating rate, but also the burden of amortizing principal after two years of interest-only payments. And for many, the interest- rate reset and IO expiration will occur on the same day, a reflection of the ‘risk layering’ prevalent in the sub-prime market over the past two years.”
“Glenn Costello of Fitch Ratings estimates that at least a quarter of all sub-prime borrowers facing resets may have precious little equity left, even with the huge surge in home prices in the past two years. Many piggy-backed loans to borrow the down payment on their homes, in addition to taking on a conventional mortgage. ‘For some borrowers, there will just be no loan-to-value gap left,’ Costello contends.”
“Even more ominous for the sub-prime borrowers with more than $600 billion or mortgages resetting in the next two years would be new standards for ‘nontraditional’ mortgage products that have been jointly proposed by a number of federal regulators.”
“Obviously, any smash-up in the sub-prime market would hurt lenders. Some such as New Century Financial (NEW) are set up as real-estate investment trusts and, as such, retain some of their securitizations and those of other players. In a bad market, most of the blood would spilled in the lower-ranking tranches of sub-prime mortgage-backed securities, bonds rated triple-B minus and below.”
“(A) New York hedge-fund manager is busily shorting triple-B and triple-B-minus tranches in sub-prime securitizations. The fund is also short various collateralized debt obligations, an estimated $50 billion or so invested mostly in the junior tranches of sub-prime securitizations. ‘These CDOs…could get completely wiped,’ the manager says. The liquidity of the sub-prime market depends on continued purchases by CDOs of the randier tranches of sub-prime securitizations. Should this funding dry up, the sector’s financing structure could seize up. And that would spell big trouble not only for sub-prime borrowers, but for the entire U.S. housing market.”
Thanks to the readers who sent this in.
“The liquidity of the sub-prime market depends on continued purchases by CDOs of the randier tranches of sub-prime securitizations. Should this funding dry up, the sector’s financing structure could seize up.”
This cold reality will change lending practices in the U.S. more than any new lending “standards” bearing the Fed’s imprimatur.
Mad Tiger,
Good point. That always follows a credit bubble. The Fed takes comfort in the idea that the risk is widely spread. But when they visited several derivative houses last year, the books were a mess. Could take years to sort out, like Fannie Maes accounting.
The CDOs and Derivatives are mostly sold overseas well beyond the control of our regulators.
A friend of mine who was in real estate until recently said that the first IO loans should start resetting this March. Does anybody know anything about this? Will these first resetters just be able to sell if they can’t pay? I wonder if anybody knows the timing of how the IO reset wave will hit, and when can we foresee that the first waves of resetters who will not be able to refinance without losing money will start?
They will start resetting and some have reset. In the case where the individuals credit has improved (and the price of the subject property has not declined in value) the borrowers can refi into another IO product 3,5,7 or 10 Yr IO ARM and if the credit has not improved then into another 2yr IO.
They will reset in regular waves, month after month, already have and already are.
http://www.idorfman.com/Charts/InterestOnlyLoans.gif
http://www.idorfman.com/Charts/MortgageRateReset.gif
This story is probably the primary reason I’m sitting on the sidelines. When I first moved to LA, the first question I asked myself was; How are these people going to make payments on these loans based on their incomes? Am I missing something here? Is money in high cost of living areas different then money in low cost of living areas? My conclusion, they can’t make their payments. Thats why this bubble is so stupid!
“(A) New York hedge-fund manager is busily shorting triple-B and triple-B-minus tranches in sub-prime securitizations. The fund is also short various collateralized debt obligations, an estimated $50 billion or so invested mostly in the junior tranches of sub-prime securitizations. ‘These CDOs…could get completely wiped,’ the manager says. The liquidity of the sub-prime market depends on continued purchases by CDOs of the randier tranches of sub-prime securitizations. Should this funding dry up, the sector’s financing structure could seize up. And that would spell big trouble not only for sub-prime borrowers, but for the entire U.S. housing market.”
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Many have commented upon the soaring inventory in many local markets. Part of the new selling is by speculators who are now scared that house prices will drop instead of rise. This is a double whammy because speculators were an important part of the demand pool that was driving prices ever higher. Now they aren’t and instead they are selling.
We can’t escape the cold reality of the age old law of economics…Supply and Demand. Soaring supply and shrinking demand will be the recipe for a most memorable housing bust. And not the least of the problem will be the double whammy of the toxic loans. Many of the buyers who stretched to buy using loony loans….Oooops, I forgot…”affordability products,” are going to be forced into the supply pool. At the same time, the subprime lenders are going to be squeezed by inability to sell the loony loans they originate as this article so clearly explains. So fewer buyers will be there due to lack of “affordability product.”
There is no way that the housing crash will not be historic. Fasten your seatbelts.
anyone know the amount spent in 1999 on cap ex- supposedly RE meltdown is “no big deal “because companies are going to spend so much on biz equipment
2 things we know- mort equity extraction over the last two years was huge and cap ex ain’t likely to be as high as 1999
It was recently posted that business borrowing is up, and that this investment would help power the economy over any real-estate road bumps.
I’m not sure I by it. It seems unreasonable to assume that capital expenditures would rapidly expand in the face real-estate collapse. Which is to say, if a wave of panic selling hit the housing sector, I think a lot of business spending would be quickly shelved.
Glenn Sheldon,
Business borrowing is up, but that won’t stop our economy from taking a bruising. However, expecting the economy to slip into a protracted recession, possibly recession is probably not correct.
Remember that we still have excess liquidity due to the Fed printing too much money to keep rates low. That money must go somewhere. Also, other nations (particularly China) still believe in the dollar and pump even more liquidity into our economy by buying our debt (government bonds and friends).
Remember that the dotcom crash was a relatively painless recession because the housing bubble was waiting in its wings. Excess liquidity caused the dotcom bubble, it caused the housing bubble, and after a recession (possibly a mild one) it will cause the next bubble. This may be in business, gold, or something else. I dont’ know.
What I do know is that there will be more and more bubbles until the credit bubble (excess liquidity) pops. If you really want to understand this dynamic read “The Dollar Crisis”
The excess liquidity will be mopped up by defaults. People think that the money will move from housing to stocks without thinking about how the money will get out of housing first. This is a liquidity trap. You can’t get your money out of housing when there are no buyers at the price that will cover your debt. Unlike stocks, housing is an illiquid and highly leveraged asset class. The money will not move to another asset class, it just simply disappears by default. Hence we have a credit deflation and the money supply shrinks.
Comment by Glenn Sheldon
2006-02-11 14:01:02
It was recently posted that business borrowing is up, and that this investment would help power the economy over any real-estate road bumps.
I’m not sure I by it. It seems unreasonable to assume that capital expenditures would rapidly expand in the face real-estate collapse. Which is to say, if a wave of panic selling hit the housing sector, I think a lot of business spending would be quickly shelved.
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Housing panic means the ATM shuts down means consumer spending drops means we go into a recession that will become a depression.
Dawnal, I don’t know about depression, but I agree that consumer spending will drop a lot now that the home ATM is kaput. Business CAP EX has no hope of making up for any kind of significant drop in consumer spending since it’s a much smaller percent of the economy.
People buy stuff because they feel wealthy because their home has increased in value.
Companies produce more because people buy stuff because people feel wealthy because their homes have increased in value.
Companies purchase capital equipment to produce more stuff to sell to people because they are buying because their homes have increased in value.
Remove the homes increasing in value part and I see no capital expenditures, simply a period where a bunch of groups will have large sums of cash and will buy up the lesser fish at impressive discounts because they’ve run out of cash and can’t borrow and then they’ll wait it out until the next expansion.
MazNJ,
Actually, companies have not been doing much capital spending in the last few years. Instead, they have been saving much of their money.
This is part of the reason for the housing bubble. Since companies are saving rather than borrowing, interest rates are lower than they otherwise would be.
If we are lucky, increased corporate capital expenditures will prevent us from experiencing too great of a recession when housing bubble bursts. Interestingly, this is probably the worse case scenario for the housing bulls. If the economy manages to do OK during the housing bust, then the Fed will have little pretext for adopting an accommodative monetary stance. In addition, long-term interest rates would remain high because of increased corporate borrowing. Finally, if voters think that the economy is doing OK, politicians might be hard pressed to perform a bail-out of people who are underwater on their mortgages.
Well said Montie,
I would only ad that capital expenditure creates jobs, which boosts consumer spending, which creates inflation (devalues the dollar), which raises interest rates, which hampers housing.
Remember, job creation is a much more powerful economic stimulant than the home equity ATM. The home refi boom created demand for expensive items. More jobs, possibly low paying, will create demand for lower priced items.
The conclusion is that a housing bust may be acompanied by a small recession and subsequent economic growth. However, the days of Hummers in the ghetto will probably be over by then.
This is from Barron’s Online as well.
http://www.smartmoney.com/barrons/index.cfm?story=20060210
“IF THERE’S A place in the world to make money, leave it to Grantham to find it. A founder and investment strategist of the Boston-based GMO, which manages $115 billion — mostly for institutions and well-heeled individuals, Grantham has made an art of discerning the relative values of various asset classes — everything from timber to emerging-country debt — and drawing on historical patterns to forecast market trends.
. . .
“Based on our data, housing is a classic bubble. It is well over a 40-year breakout, or a two-standard-deviation event. So this feels like the end of a cycle, the end of a delicious 23-year run from 1982 to 2005. The forces that went into it cannot be repeated. That’s what is so interesting. If you go from 13% inflation to 2%, you pretty well know that game is over. The long bond goes from 15% to 4% and something, and that hardly allows for any inflation, so you know that game is finished.
In Boston, housing costs are at 6.3 times family income, while the long-term average is below 4; that’s a huge difference, and it means young people can’t afford houses. That can keep going for a while and the fat cats can afford to buy second homes, but in the end you need the kids to come along and be able to afford a house, and they cannot.
There are signs things are beginning to turn. Interest rates have turned and gone up a bit, although the longer rates have hardly moved. House prices look as if they are peaking now. Two of the last three months have been down in price, seasonally adjusted.”
Many of these overextended subprime borrowers will simply turn in their keys when the reset hits. They could barely afford the teaser rate, much less the reset rate.
There is a misperception that the borrowers can just turn in their keys as happened in Texas in the ’80s. As has been reported on this site and others, 80/20 loans have recourse. The loss to the banking institution will be reported as income to the borrower and taxes will be due. Bankruptcy does not eliminate IRS bills.
My favorite quote from the article:
“many sub-prime borrowers who took out loans in recent years may not be able to refinance unless their income increases or interest rates drop significantly,” he observes dryly. In other words, the American Dream of home ownership could turn into a Roach Motel nightmare.”
I think looney loans is an appropriate term. Or suicide loan is even better. That American Dream will become the financial tomb for many people (or Roach Motel as Brad says). It should be interesting to watch. I am waiting for California to blow up big time. Also, an article in yahoo news showed 7 California cities ranking in the top twelve for worst traffic. Maybe that will change as more people leave California. I am glad I finally got out of the unGolden State to the Land of Enchantment. Much better family environment that the looney Bay. Ciao folks in CA
Short term thinkers are excited by the European “fix”. Wait until they realise this will be the same “fix” for Spain, Italy, England…..
Wow. Strange trip down memory lane:
Comment by diogenes
2006-08-13 19:15:33
Muggy,
concerning this thought:
“I believe that some of the towns won’t get hit as hard because of the tourist value and coastal location, but when it comes to places like Largo, I think it’s going to get really bad. The truth is is that most of those home should be in the 100-200 range.”
You are right that the Coasts always have a higher price per comparable unit, but take a drive next weekend, or some weekday.
Start down at St. Pete Beach and drive up Gulf Blvd. to North end of Sand Key.
Do you remember 2 years ago? You could hardly find a place for sale. If you did, their were 5 vultures standing in line with contracts.
Now? Multiple signs “for sale” “for rent” for miles and miles.
They have paid too much. They need to unload.
I looked at a small wood frame bungalow in Madeira Beach in 2001.
It was about 135k. Two blocks off the beach. By late 2003, the same place was asking $498k. I laughed at the listing agent when she told me the price. She said they would only go up and i had better buy now or “I WOULD BE PRICED OUT OF THE MARKET FOREVER”> We all know the story.
I was accosted by a street peddler leaving my office on Friday as I attempted to get onto Ulmerton Rd. Condos for Sale.. Newly refurbished…..All the usual crap. He was handing out flyers from the street median at 66th and Ulmerton. Not a good sign of a strong market.
The coasts won’t go down as far, but I will wager good odds (you pick them) that they will show the first signs of resistance. I believe we are already seeing that…………..and all the NEW LUXURY CONDOS…………………..fuggid aboudit.
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5 years, man. Geez…