Slate: Coming 'Jingle Mail' Wave
Toomre Capital Markets LLC ("TCM") wrote yesterday in the post 'Moment of Truth' for Wachovia about Wachovia's surprise first quarter earnings loss and how much of the loss was due to their approximately $130 billion portfolio in pay option ARMs. On Tuesday April 15th 2008, Slate has followed up with the sobering article entitled Here Comes the Next Mortgage Crisis. The subtitle to the article is Subprime was just the beginning. Wait until California's prime borrowers start handing their keys to the bank. For those who are more optimistic that the Capital Markets are nearing the end of the mortgage crisis, they would do well to read this very sobering article written by Mark Gimein.
The main thesis behind this article is that with the California residential real estate prices in a free fall, the phenomena of walking away from a home will sharply increase, even for those with strong credit ratings in the so-called "prime" mortgage category. TCM refers to this walk-away phenomena as "jingle mail" and sadly thinks that this phrase will become part of the national lexicon in the coming two years. The article states "Unfortunately, the crisis in California is going to get much worse, and there is no bailout that will solve it. Why? Because if the first stage of the foreclosure crisis was about people who could not afford their mortgages, the next stage will be about people who have every reason not even to try to pay their mortgages." [TCM emphasis added]
Later the article continues. "… for all the California homeowners who in the next year or two are going to find themselves with the choice of whether, faced with a huge new wave of interest resets and a historic decline in the value of their homes, they will simply walk away. First, those home prices: For a weird few months of the mortgage crisis, statisticians came up with peculiar numbers about home values, rolling out comforting stats showing single-digit declines. Well, that's over. Last month, the California Realtors' association (folks who in October managed to "project" that prices would fall 4 percent in 2008) reported that, actually, California house prices in February fell 26 percent from a year ago. In the places where the foreclosure boom has hit hardest, it's worse."
This sharp decline in California real estate prices is causing many of the mortgage products originated in the 2005-2007 to have current LTV's near or in excess of 100 percent. The article then continues to explain how the decline in real estate prices when coupled with coming "prime" option ARM resets is likely to leave many homeowners with the economic quandary of whether they should remain in "homedebtor" hell servcing more debt than the home is worth or in a nonrecourse state like California simply walk away. The article explains:
The most common subprime loans were known as "2/28" in the industry: 30 years, including a two-year teaser rate before the interest rate rose. Now these loans have reset, and we're seeing the fallout.
But prime borrowers, too, got loans that started out with low payments; if you bought or refinanced your house in the last few years, it's not unlikely that you have one. With an "option ARM" loan you have the "option" (which most borrowers happily take) of paying less than the interest; the magic of "negative amortization." The loan grows until you hit a specified point—the exact point varies with the lender; with Countrywide, it'll come after about four and a half years—when the payment resets to close to twice where it was on Day 1.
Just two banks, Washington Mutual and Countrywide, wrote more than $300 billion worth of option ARMs in the three years from 2005 to 2007, concentrated in California. Others—IndyMac, Golden West (the creator of the option ARM, and now a part of Wachovia)—wrote many billions more. The really amazing thing is that the meltdown in California is already happening and virtually none of these loans have yet reset. [TCM emphasis added]
Option ARM loans were heavily marketed to upper-tier home buyers in California. It's hard to know how bad the option ARM crisis will be before it actually happens, but Moe Bedard, an advocate in Southern California who advises homeowners on foreclosure and blogs about the crisis at Loansafe.org says that the difference in the time until the rate rises is the main reason that upper-middle-class Orange County (now facing foreclosures at a rate merely twice the national average) hasn't yet been hit as badly as places like Riverside.
When those dominoes start falling next year, we may or may not have a subprime bailout plan, and the discussion will start about how to bail out this next tranche of borrowers. The bailout plans on the table now, such as the one put forward by Barney Frank (one of Congress' genuinely cogent financial minds), are reasonably based on the principle of bringing payments down to a point that homeowners can afford.
But where prices fall 40 percent to 60 percent, all that goes out the window. Why? Because in expensive locales like San Diego, tens of thousands of people with 100 percent loan-to-value mortgages and option ARMs are living in homes in which they have no equity and on which they owe a lot more than the house is worth.
In these places, accepting a government "bailout" that pays them, say, 90 percent of the value of the house to keep from foreclosing will be very tough for lenders, who (if the appraisers don't fudge the numbers) could be forced to take 36 cents or 45 cents on the dollar for their loans. On the other hand, any plan that makes them pay more if they can afford it is hugely disadvantageous for the borrowers, who have option ARMs about to reset and are much better off handing the keys to bank—and maybe even scooping up the foreclosed house down the street.
The article ends with the very sobering thought: "Of course, all those people stuck between rising mortgages and falling prices are free to follow Paulson's advice: Keep making payments on an outsized mortgage, and take a bullet for the greater economic good. Fortunately for them, and perhaps unfortunately for the economy, a lot of them will come to the realization that they just don't have to." TCM strongly feels that the realization that even "prime" borrowers will not meet their obligations is going to severely impact the mortgage-backed securities and securitization markets for at least the next several years.
We are entering a scary period where one will have to seriously question what a legal real estate contract is really worth. The American thrift industry has largely disappeared and with it their large mortgage portfolio holdings. For the last couple of decades, institutional investors (both domestic and globally of all stripes) increased their allocation to mortgages. Certainly now, these fixed-income institutional investors (who are primarily focused on investment grade portfolios) are not going to buy the MBS securities if they get stuck with the large losses if and when real estate prices go down. Commercial and investment banks are loathe to put more such MBS securities or mortgage whole loans on their balance sheets. FNMA and FHMLC are capital constrained and there is some doubt about whether the Federal government in fact will guarantee their obligations.
Hence, perhaps one of the most challenging questions for policy makers is in this age of "jingle mail", who will own the mortgages and fund the "American dream of home ownership"? There has been considerable political capital getting voters across all spectra into becoming homeowners. Will there be the same effort in figuring out where this mortgage finance funding is going to come from? One thing is clear though to TCM. More "real" equity is going to be required in most real estate transactions to satisfy the concerns of the mortgage finance debt holders. Without factoring in any impact from the economic cycle, this higher equity requirement implies that there will be fewer eligible buyers of residential real estate and that downward price pressure on real estate prices is likely to continue for at least several years.