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2007-04-01 14:59 by Karl Denninger , 61 references Ignore this thread
Wall Street Manipulation - and what you can do about it *
What a wild ride the last week or so in the markets.

Up 100, down 100. Up 200, down 200. 300 point swings in a day.

This is all blamed on the "Subprime" mortgage market. And that, my friends, is a lie.

Quick education here - "Subprime" loans are made to people who have spotty credit. If you made a few late payments on your credit cards, have a lot of debt on them and little assets, or simply have next to nothing on your credit report, you're "Subprime." These folks have over representation in the minorities and the working poor, but this isn't really about race.

Its about credit quality, and with risk comes higher potential rewards.

But here's the 900lb gorilla in the room. Its what is called "Alt-A" mortgages, and you know what they are. They're advertised on the radio every day. "Quicken Loans, a rate around 5%" (as just one example.) You listen to the radio, you've heard 'em. And at the end is the disclaimer (APR 7.5%) - buried in the quick speak.

The underlying problem here is that starting with the 00/01 crash in the tech stocks the Fed got very aggressive in cutting rates - down to levels that had never been seen before. 1% Fed Funds. Unheard of. This created an explosion of liquidity, because bankers could borrow money short-term for 1%, lend it to you at 4 or 5%, and make an incredible amount of money.

And lend it they did - but they didn't take any long-term bets at that price. Why not? Because the Fed Funds rate is an overnight deal - it can change any time.

So what mortgage bankers do is write your loan, hold the loan for a short period of time, package up those loans into what are called "tranches" and sell them on the marketplace. Hedge funds and big investment banks - Goldman, Morgan Stanley, Merrill Lynch - they're the buyers. This is how the mortgage originators manage THEIR risk - that of a big hike in interest rates that puts their investment underwater.

Now here's the problem.

The ALT-A market is in fact more risky than the Subprime! Why? Because the percentage of these loans is huge compared to the Subprime. Countrywide Mortgage, widely thought of as a "prime" mortgage lender, in fact did nearly half of their business in these "Alt-A" products last year. They push these products hard because they're very, very profitable - when things work out.

What's worse is that these products have been pushed as "debt consolidation" loans. "Pay off those high-priced credit cards" scream the ads. Yeah, right, and risk your house!

But now we've got a problem. House prices are stagnant or actually declining in many places in this country. And these "Option ARMs" have a bomb built into them - they capitalize the unpaid interest back into the loan, raising its principle value. When the interest rate resets, and this is just starting to happen, the effective rate (when computed on the original loan balance) of many of these loans will reach 12%!

TWELVE percent guys. Interest rates last seen when Jimmy Carter was President.

You remember those days, don't you? I sure do. The market - and the economy - were in the TANK! Why? Because borrowing money was insanely expensive and inflation was high too.

Now here's the REALLY bad news. All of these mortgage companies book profits when you carry back "option interest" as additional principle! How's that, you ask?

Well, its actually quite legal, even if tricky. See, your balance went up, and they expect you'll pay it. Since you originally borrowed $X, but now owe $Y in principle, they book that as "free money" - profit - on the deal.

This of course assumes you actually pay it back! If you don't.......

There is no good news here folks. In fact, its all bad news.

And what do the "Talking Heads" say on CNBC and the other "news" outlets? The same thing they said as the Tech Crash was about to get underway, but the first companies were just starting to get in trouble.

"Its contained."
"There is no underlying problem."
"This is just a short-term correction (in the housing market)."
"We are 'untroubled' by our exposure to subprime."

Yeah. Anyone remember 1999?

Here's the deal folks.

All those folks who took out HELOCs (home equity lines of credit) did not cut up their credit cards. They just paid them off using the HELOC, but kept spending. This was ok when your house value went up faster than the interest that you imputed back into the loan using those "option loans".

But now the price appreciation in the house has gone to zero, and that imputed principle is actually additional debt!

In many places these loans are actually underwater right now. That is, you owe more on your house, all up, than its worth. And some of those states are "zero recourse" - that is, you can walk off and hand the mortgage company the keys, and while they will trash your credit rating they can't sue you.

People know this, and they're exploiting it. How? Well that's cute too. Many folks, facing a crushing blow of debt via an impending reset they KNOW is coming, are doing the following:

Let's say you have a $750,000 house. You took a first mortgage as a "2/1 10%" ARM, which is a common ALT-A product. Its cheap because the interest rate is only locked for two years, then it floats at LIBOR (a commonly used interest rate benchmark) plus some percentage. You then took an "option interest" loan for the rest (down payment, what's that?) or even better, you borrowed the downstroke somewhere, then paid it back using a "silent second" - a Home Equity line (HELOC) that had an "option interest" feature.

Well, now the chickens are coming home. Your house has actually depreciated in value by 10% because, well, nobody's buying right now. So you have a $750,000 house with a $750,000 mortgage but the house is only worth $675,000! What's worse is that the interest rate is about to reset 2% up from your "teaser rate", and you know you can't make the payments three months from now.

So you shop for a $500,000 house (remember, its a down market!) You qual for that mortgage (your FICO score is still quite good, as you haven't blown a payment yet) on the basis of selling the OTHER house. You get the loan on THAT house, but its an ALT-A product too; you simply lie about your income, and since its a no-DOC loan and your FICO is in the 650 range, it goes right through.

You move in, then default on the original $750,000 loan!

This is happening all over California, and the bank is left holding the bag!

Note that NONE of this is happening in the Subprime space - its all in ALT-A!

And virtually ALL of the lenders are exposed to the ALT-A mess.

This hasn't gotten any press at all, but it will in the coming months. Mark my words. The resets from 2005's "peak of the bubble" are just starting on these loans - close to 20 percent of all mortgages out there are ALT-A products right now, and 50% of those written in the last two years! Essentially ALL Home Equity lines fall into this category!

Now sure, not all of the HELOCs are going to default. But historically, less than 1% of all mortgages ever go into default. Right now we have the highest rate of defaults in history, and we haven't even started with the ALT-A products yet.

This is the story that hasn't been covered folks.

Come back here in six months - I'll remind you right here - when the true pain begins. This fall and especially this coming winter, its going to be a big story, and the REAL risk to the economy is going to come from this angle, with no real way for the Fed - or anyone else - to bail it out.

Mark my words.

What can you do about it? Be careful. If you're invested, you need to be paying attention. If your time horizon is 20 years or more, then none of this matters much to you, because this, like all other business cycles, will work its way out.

But if you're within 5 years of retirement I'd be thinking about a very strong bias towards fixed income. There is a serious risk of a 20% to 30% decline in the market - similar to what happened in 2000-2003 - and once it starts it will accelerate in a huge hurry. When the losses begin to be realized you're going to have a lot of people who will suddenly get religion, and the selloff is likely to be extreme and protracted.

Now of course I could be completely full of it.

But I don't think so.

Statistics supporting the above:

1. Conbined "loan to value" on ALT-A purchases in 2006 was 88% on average, with 55% of buyers taking out a second at the same time as the purchase.
2. Low or no-documentation (stated income) loans were 81% of total originations.
3. Interest only and option ARMs were 62% of purchase originations in 2006.
4. 1-year hybrid ARMs were 28% of ALT-A originations in 2006 (these loans reset in just one year!)
5. Investors and second home buyers were 22% of ALT-A purchase originations in the last year.
6. Approximately 40% of purchases in 2006 involved second mortgages taken at the same time as the purchase. This is important because these "piggybacks" are how you get around loan-to-value restrictions! While the industry has tried to say that this is primarily a subprime thing, THAT IS A LIE - 55% of ALT-As had piggypacks in 2006!
7. TWENTY FOUR PERCENT OF ALL NEW ALT-A ORIGINATIONS WERE INTEREST ONLY OR NEGATIVE AMORTIZATION IN 2006!