Subprime or Prime, That is the Question

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It is amazing to me how I keep reading, over and over again, about the 'subprime' problem. Starting a couple of years ago, and back then, justifiably so, the term stuck.

Not only were people with low credit scores given fixed rate loans, as time went on, the guidelines and terms got better and better for the subprime borrowers. Soon it was 100% financing, then 102 and 103% financing, then no doc/stated income, meaning they could claim whatever income they wanted, with little worry the LO or lender would check. Yes, even those loans were 100% financing.

Next, the 'smart' people that run Wall street were so hungry for more loans to securitize, they began to offer adjustable rate, 100% loans. These loans could start out with a small rate, then reset to a larger rate. More often than not, these resets are proving to be more than these people could afford.

As could be predicted, it was the loans given to people with a proven track record of not paying bills on time that blew up first. But how big a percentage of overall loans over the last few years was this 'subprime' group?

By 2005, subprime loans had become 20% of all mortgage originations. In 2006, subprime loans became 24% of loans originated. It was in 2006 most of the subprime companies began to realize major problems, mostly with their buyback agreements. A clause in most of the agreements would force the originating lender to buy back the loan if it went into default. By 2007, subprime originations had fallen as a percentage of total loans to less than 10%.

The rise in adjustable rate loans has been more dramatic, and more encompassing, than the subprime arena. Washington Mutual became famous within lending circles for its Option ARM programs long before awareness of a 'subprime' problem. Countrywide followed suit, and took it to the next level with its "Fast and Easy' program. Fast and Easy became known as 'fast and sleazy', mainly because they were not verifying incomes, even though they had the borrower sign a piece of paper allowing Countrywide to pull past tax records to verify income.

Countrywide then sold these unverified loans to FNMA and FHLMC as prime loans. These loans are now defaulting at a rate greater than subprime. The fate of FNMA and FHLMC are in great peril because of the 'prime' loans Countrywide sold them, that now look to be 'not so prime'.

I still read in newspapers only about the 'subprime' problem. I still hear on CNBC, FOX and CNN about the 'subprime' problem. The majority of loans now defaulting were not subprime at the time of origination. They were 'prime'. The one thing they all have in common is they were, and are, adjustable rate loans.

The reason for most of the defaults is this simple fact - at the time of origination, the borrowers could afford the initial rate. Whether they bought for speculation or not, almost every borrower anticipated that when they took the loan the value of their property would go up. If they could not afford the reset, conventional wisdom was they would be able to refinance, get another low initial rate, and get a little extra cash, because, of course, the property would be worth more.

Because of this thinking, the idea if someone could actually afford the new, higher rate at reset was rarely factored in when considering ability to repay the loan.

Well, for the last 18 months, property values have not gone up. In fact, nationwide, property values have decreased more than 20% since January 2007. As each month goes by, a new phenomena rises in frequency, that of "Jingle Mail". Jingle Mail is the term assigned to homeowners who are walking away from houses because they are upside down in their mortgages, implying they are mailing their keys to the bank. Their reasoning is "why pay 25% more for my house than it is now worth, plus interest, when the same house across the street I can rent for 1/3 the monthly payment?"

This type of action from homeowners, unfortunately, is just starting.

Consider this; Mish at Global Economic Trend Analysis has been tracking one 2007 MBS bond issue from Wamu.
* The original pool size adding up all the tranches is $519.159M.
* 92.6% of the entire bond was rated AAA by both Moodys and S&P.
* 22.89% of the whole pool is in foreclosure or REO status after 1 year.
* 31.17% of the pool is 60 days delinquent or worse
* The top 5 tranches constitute $476.069M out of an original pool size of 519.159M. In other words, 91.7% of this entire mess is still rated AAA.

Folks, these are not subprime loans. They are prime and Alt-A. These were given to people with good credit scores. What's worse, is this entire MBS issue is heading for a complete rating downgrade.

These are all adjustable rate loans.

This is one of thousands of derivatives not yet downgraded. This particular MBS is actually better off than many others that have yet to be downgraded. Most of the MBS yet to be downgraded consist of 'prime' loans.

Because these loans are considered 'prime', the market, the ratings agencies, the banks have all been reluctant to mark these down. Many investment programs such as IRA funds, pension funds, retirement funds, both public and private, hold derivatives just like this one. All of these investment programs, plus many more, can only buy AAA rated investments. As these MBS issues lose their AAA rating, these investment programs must sell them.

This is one HUGE problem. Once they lose the AAA rating, they are not worth anywhere near what was originally paid for them. Everybody who has money in any mutual fund, IRA account, retirement fund, money market account etc. which bought any mortgage backed paper (which almost all of them have some) is going to lose money. Guaranteed. How much you will lose depends on how many derivatives your fund purchased. Do you know how to find these in your fund? It would be wise to find out, today.

A big part of the problem is how the media reports this. they continue to call it a 'subprime' problem. This creates the perception that less than credit worthy borrowers were given loans, and of course, the lowlifes are now defaulting.

By the end of this mortgage mess, many more 'prime' loans will default than subprime. Most resets for adjustable rate prime loans originated in 2005, 2006 and 2007 are still in front of us. Most of the loans originated in those years are adjustable rate. They will reset at a ratio based on what the prime rate is at the time of reset. The Fed has just sent a message to Wall Street that rate cuts are over, and rate hikes are likely.

The only way for people to realize this a huge problem is to stop labeling it a 'subprime' problem and call it what it is, an 'adjustable rate' problem.

Gotta Love the Activists

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Life is interesting because of people like this. We need more of them.

I read Market Ticker almost everyday. Karl Denninger, who's opinions can be a little salty at times, is a genius. Karl has been an options trader for quite some time, and follows the markets with a sense of wit, wisdom and old fashioned honesty rarely seen in today's society. His ability to pick apart the actions of some of the biggest movers and shakers of the corporate world enlightens us to a view we cannot get in the mainstream media.

Do yourself a favor, as you find the time, to read what he has to say for the day. You may disagree with a few of his ideas, but you will always be entertained and informed.

The following is the whole excerpt from his most recent post. The subjects of my previous posts are an important part of why these people are protesting. I enthusiastically support them. Therefore:


“FED UP USA” STAGES FRIDAY PROTEST IN WASHINGTON, D.C.
Angry Citizens To Protest Federal Reserve and Government Fiscal Policies that have resulted in commodity price inflation, devaluation of the US dollar, and now threaten to destabilize the bond market.

Niceville, FLA (June 27th, 2008) – A group of Americans who met on an internet forum are converging on Washington D.C. from across the nation on June 27th to protest federal financial irresponsibility. The group, “Fed Up USA”, met for the first time last April to stage a protest outside Bear Stearns Headquarters after the Treasury announced $29 billion in guarantees to an LLC to entice JPMorgan to purchase the failed investment bank. This time, in Washington D.C., the group will continue to push for an end to government bailouts and the Federal Reserve’s acceptance of questionably-valued, unmarketable mortgage collateral in exchange for treasury paper. The group is also seeking greater transparency in financial reporting, elimination of SIVs and other off-balance sheet Enron-like accounting practices. The protest will begin at 8:00 a.m. at the Federal Reserve building. “Fed Up USA” plans to take the protest to the US Capitol later in the day.
The Federal Reserve’s acceptance of illiquid mortgages, car loans, boat loans, student loans, credit card receivables and foreign debt as collateral is unprecedented, even during the Great Depression. The Fed has already accepted so much questionable debt as collateral that it only has $25 billion of treasury bills left to exchange, representing 3% of its balance sheet at the time it bailed out BSC creditors. Karl Denninger, spokesman for “Fed Up USA”, explained the problem, “The Fed is in no position to orchestrate another bailout of a financial institution without calling into question the credit rating of the United States, the dollar’s status as reserve currency and the viability of the US bond market. But the Fed will do just that unless taxpayers demand that they stop. That is the reason it is so important to protest.”
“Meanwhile”, added Stephanie Jasky, “the Fed policy reliquifies banks to continue to lend to speculators without fear of risk as the Fed, in essence, has their back. That excess liquidity has found a profitable home in commodities, perpetuating the risky behavior that caused the problem in the first place. Furthermore, our elected officials appear to be encouraging fraud and financial irresponsibility by allowing banks to hide their bad assets. Instead, we are here to demand from congress and the senate that the speculators accept the consequences of their risky bets, not the taxpayers.”
If you’d like more information about FedUpUSA or to schedule an interview, please call Karl Denninger at 850-897-4854. Email is info@duxnro.com. Website is http://fedupusa.org.

Don't Open the Door

The Wall Street Journal gave a scathing editorial. It is unusual. The reason I say this is because, the WSJ has mostly been a cheerleader over the last two years, despite tremendous writedowns among major corporations. These writedowns have occurred in one area, the investments with anything involving housing. More specifically, the debt associated with housing. Already passed by the House, a new bill will raise the loan limits, and reduce downpayments, on loans issued by the FHA that would classify for subprime.

Congress, in its place of eminence, certainly believes it can defy logic, gravity and the sun rising in the east if it passes this bill.

The WSJ begins "Well, this certainly is embarrassing. The Federal Housing Administration – the very agency the Bush Administration and Congress trumpet as the solution to the mortgage crisis – has announced that it suffered a $4.6 billion loss last year." The bill, quickly making it's way through the house and senate, will increase the loan limits, and bring upwards of $300 Billion new subprime and Alt-A loans into the FHA portfolio.

GNMA, widely known as Ginnie Mae, is the conduit for all FHA and VA financing. It is the only GSE to have explicit backing of the US Government. If there are any losses, taxpayer money is used to replace those losses.

I believe there will be significant losses with this new batch of loans. So does the WSJ.

The larger question is this - Why should the banks that originate these loans, and make the profit on them, be allowed to unload them, and leave the American taxpayer to pay the bill?

From WSJ-

"The Government Accountability Office finds that default rates among low or zero downpayment FHA loans are about three times higher than on conventional loans. They go Bust." " Mr. Frank's House bill would allow the FHA to guarantee a loan up to 125% of the average home price in any area."

What??? Into a declining market?

Believe this; if this $300 Billion gets in the door, there is a lot more coming up the sidewalk, wanting to come in for the party; From WSJ -

"The most reckless provision now on the Senate floor would allow the FHA to take over risky subprime loans from private banks. When FHA Commissioner Brian Montgomery announced the agency's losses last week, he warned that Congress's subprime loan bailout could plunge FHA deeper into the red. Senate Banking staffers tell us that lenders have all but admitted that, if the bailout becomes law, they will dump their worst loans onto the FHA."

How high do you want your taxes to be? How low do you want your property value to drop? It is inevitable that your children, and probably grandchildren will pay for this. Wanna make it your great-grandchildren?

The only way this can work is if property values come back up to where they were in Jan. 2006, and come back very soon.

I don't think that can happen in the next few months, do you?

In fact, commercial property is just beginning to follow the residential slide. The drag on our economy this creates will spell the end for many regional banks. This is not my opinion, it is the FDIC's opinion.

More taxpayer money to cover the losses of the speculative real estate boom. Congress should not use taxpayer money to back the excesses of speculation. Keeping people in their houses currently paying something every month is wise. To increase the number of people who will go underwater with their mortgages.... well, that is another thing.