Economic Rebalancing

The global economy is horribly out of balance, with the United States going deeper into debt each year as a result of a huge trade gap. This blog describes the process of global economic rebalancing. If you have any comments or questions about the posts here, please don't hesitate to use the comments section.

Saturday, February 24, 2007

The Subprime Timebomb Explosion Continues

The meltdown of Subprime stocks continues to get attention, and the problem will get much worse from here. To Recap:

In 2003, rates hit historic lows and 3 year-ARMs were popular as an especially low rate option that provided 3 years of stable payments.
In 2004, rates began rising and 2-year ARMs became more popular due to lower initial interest rates.
In 2005, low APRs were gone but ultra-low teaser rates for 1-year ARMs sucked in many new borrowers.
In early 2006, all three of the above mortgage classes began resetting in large numbers, but emergency refis were available for many distressed borrowers.
In late 2006, subprime lenders began tightening up because they were forced to repurchase too many of their new loans due to early defaults.
In 2007, credit is tightening severely in the subprime market because the market for subprime securitizations has been crashing. Meanwhile record numbers of ARMs are resetting as loans facing their first reset in 2007 are added to the surviving loans that reset for the first time in 2006 and now must reset again.

As credit tightens, default rates are escalating. The game is finally over for buyers who bought more than they could afford. With home prices stagnating and declining, the cash-out refinancing game is also coming to an end. All this will put much greater pressure on the housing market in 2007.

Credit hasn't tightened as much in the Alt-A and prime spaces, but the markets for those securitizations has begun to fall as well. Given that the main difference between subprime and prime is just a credit score, the numbers of overextended prime borrowers is probably very large.

The following chart is based on data from Novastar Financial's securitizations over the past 3 years:

The vertical axis shows the percentage of loans that are contractually delinquent or defaulted on by 60 days or more, including foreclosures and real estate owned.
The horizontal axis shows how old the securitizations are in months.

The chart shows a few things, including:
1. Recent loans are going bad much faster and at a higher rate than loans made earlier in the cycle.
2. There has been a rapid increase in delinquencies and defaults in the past year, since ARM resets took off.
3. The increase has been accelerating in the past 4 months, since credit began tightening.

This was all before the market for subprime securitizations crumbled. Now things will really get ugly for distressed borrowers.

Meanwhile the execs at major subprime lenders are giving the same sort of surprised and bewildered responses that homebuilders gave when their industry began to stall. There are plenty of market commentators and biased industry economists arguing that this is just temporary, but we're really just in the early stages of the housing and mortgage market implosions. It was all very predictable, just as the path forward is predictable given the factors I've discussed. Industry execs can't possibly be as clueless as they sound, can they? Regardless, they are sure to fare much better than their shareholders as they already pocketed huge salaries and bonuses based on the years of overstated profits they enjoyed before the bubble burst. Unfortunately the millions of overextended borrowers who are watching all of their previously imagined wealth evaporate aren't going to fare nearly as well.

There's a whole lot of pain being felt on Main Street.

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