FOOD FOR THOUGHT: Home Sweet Home (part 2)

Wednesday, February 17th, 2010

Another major problem for a housing recovery is the fact that there are a slew of adjustable-rate mortgages (ARMs) due to reset. According to Jim Nelson at the Daily Reckoning “The majority of these resets occurred between the summer of 2007 and the summer of 2008, which caused a massive amount of mortgage interest rate hikes, which caused millions of foreclosures. Things spiraled down from there, eventually freezing nearly all credit and causing the panic of 2008. Of course, that’s the 50-cent version of recent history. There were plenty of other financial calamities that went along with this, including the bundling of mortgage-backed securities and risky derivative products.”

What bothers me is how will we handle another round of re-sets on top of the other problems I touch on in part one, especially when they are the even more esoteric “Option Arms”?

Jim says “this second wave will come crashing even harder than the first. It’s made up of a type of mortgage called "Option ARMs." These give borrowers the option of how much they want to pay during the first five or 10 years of repayment. You can pay the full amortized rate, including interest and principal or Interest only, or, a token payment, well below the amount needed to cover the interest on the loan. This third option causes the mortgage balance to INCREASE instead of decrease. And usually, the borrower can continue to make minimum payments until the mortgage balance increases to 125% of the original amount. That’s when the trouble begins…especially if the interest rate increases at the same time. This is the exact situation in which many homeowners now find themselves.”

According to Whitney Tilson and Glenn Tongue of T2 Partners, who are experts on this subject, about 80% of option ARMs are negatively amortizing. Meaning these so-called top-tier borrowers are heading further into the hole. Once their rates reset, they could be in serious trouble.

Jim goes on to say “The chart above shows the two peaks in the mortgage-reset wave. The first peak is comprised of subprime ARM resets. And the second is mostly constructed of option ARM resets. We appear to be in the eye of the storm.

That fact alone shook our nerves when we first discovered it. But it was a different chart in Tilson and Tongue’s most recent presentation that really got us startled… It’s also the reason I’m predicting the dollar spike in 2010.

Instead of resetting as expected after the first five years, many option ARMs are so negatively amortized that they are hitting their automatic reset cap.

As you can see from the second chart, the expected reset peak was to occur in 2011. But the real peak is happening now. You can also see that the amount of mortgages resetting is spread over a longer period of time than originally thought, but is peaking much earlier. Unfortunately, it’s not the peaks that matter.

You see, those are just resets. But with unemployment reaching quarter- century highs every month, and the massive number of homeowners about to receive mortgage bills for two to three times what they are used to paying, we find ourselves in an even scarier environment than this time last year.

It takes anywhere between 3-12 months for most homeowners to actually go into foreclosure. Therefore, the wave of Option-ARMs that are now resetting could cause a major wave of foreclosures over the next 6 to 18 months. It’s tough to say exactly when the storm will come. But my guess is the second half of 2010. This second wave of foreclosures will not be good news for the economy or the stock market…At least that’s my guess.”

For those interested take a look at the ProShares, UltraShort Real Estate ETF (Symbol: SRS). This ETF seeks daily investment results that correspond to twice the inverse daily performance of the Dow Jones U.S. Real Estate Index. In other words this ETF would rise twice the amount that the Dow Jones Real Estate Index would fall.

When the real estate stocks were plummeting in November of 2008, SRS traded at over $200.00 per share. Now it trades at around $7.50 per share.

Who knows what will happen, the markets have an uncanny ability to fool us. That aside it’s good food for thought.

This is not a recommendation to buy, just an observation on my part. Check with your financial advisor

It appears to be a good speculation as these real estate stocks go through some kind of correction. If it’s not the bottom of our real estate problems, and turns out to be a bear market rally, it could turn out to have some real upside.

A good speculation, great leverage at 2x the index and low risk (maximum 8 points if it traded down to zero)

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