Is the sky falling?

Implications: The fallout from the subprime mortgage market has been continually underplayed by the Federal Reserve Chairman. However, as the hangover from the mortgage origination party begins to settle in, the long-term impact is being felt across the financial sectors, and not just exclusively within the Mortgage Industry.

Analysis:  

As many economists have foreseen, the fallout from the deteriorating subprime market is having a greater impact that originally anticipated by the Federal Reserve Chairman. The most recent headline reflecting this potential disaster is closure of several hedge funds who were scrambling to cover their bets placed against (and for the ABX), and now trying to meet the margin calls by their respective investors through liquidation of their collateral. While the ABX is simply an index of the subprime mortgage market as a trading instrument, the historic lows it has reached is a subtle reminder that the worse might be yet to come for the mortgage lenders and investment professionals who have bought and sold these debt products.

An underlying theme of the many stories of lenders who are having difficulties managing the rising delinquencies and foreclosures is a credit issue that has never been experienced in the US economy: the combination of rising rates, declining or stagnant home values with little or no equity available – thereby giving a seller of the home an upside-down-look as to mortgage balance v. equity, and an amount of household credit debt that is near biblical proportions. Finally, add the more stringent bankruptcy laws, which would relieve much of the underperforming consumers of their debt, along with the required minimum payment for bank-issued credit cards doubling from their previous 1.5% of the principal balance to 3%, and you have what could be the makings of a “Perfect Storm”. Fortunately, many of the lenders are now offering a restructuring package of those who have ARM’s to convert their personal mortgage into a fixed-rate product, in order to forestall foreclosure. This reactive approach will help reduce some of the credit problems facing the average consumer: however, with little or no equity available in their homes to pay down the installment and revolving debt, the day of reckoning for repayment of this debt is only delayed, not abated.

Finally, many of the ARM products that were used to qualify lower- to marginal credit clients were the Pay-Option ARMs: for the prudent and/or disciplined consumer, this product affords some flexibility in repayment if their cash-flows are erratic or temporarily placed outside of their households (e.g. costs for taking care of an elderly family member, non-reimbursed moving expenses, etc…). However, in many instances, the product was used by brokers and banks alike to place people in homes that either should not have been given the mortgage, or at least not one of that size: many have had their “American Dream” become a living nightmare, and could eventually lose their homes. The immediate impact on the banks will be a stable of vacant properties, but the long-term affect could have a greater impact: many banks will not provide mortgage financing for people with prior foreclosures within the last 7 to 10 years. As such, the ‘One-and-Done’ group this circumstance applies to, will not be able to get another home loan unless the underwriting standards are relaxed enough to allow this credit transgression, which they might due to the fact that this will be a large enough portion of their target market base, to warrant such a credit risk.

Aside from the obvious impact to the lending institutions involved, the continued deterioration of the mortgage industry is indicative of a greater, more macro-level credit situation and could further lead to a ‘critical mass’ of credit performance and debt leverage scenario that might not be averted.