ARM Reset Payshock Could Be Next Crisis

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Many home loans in the last 10 years have had “teaser” rates, and low qualifying requirements. After a defined period of time however, the loans “reset” to have a large balloon payment or greatly increased monthly payments. This increase is called a “payshock”. The large number of subprime loan payshocks and resulting defaults (and their flowdown into packaged loans and derivatives based on those packages), were the proximate cause of the economic meltdown in 2008.

You can see in this chart that subprime loan resets were huge leading up to the 08 crash. These loans had been given to large numbers of people who could not handle the payshock as the housing bubble burst, and thus defaulted on their loans.

Click on the image for a larger version

Unfortunately, the next big problem is adjustable rate mortgages (ARM). The area under that curve is about as big as the subprime hump was – and the economy is weaker, with more people out of work and just managing to get by. More people are under water on their loans too, since the real estate market has continued to decline. This new ARM-related payshock wave has the potential to cause more havoc than the subprime crisis did, although new limits on derivatives could help to mitigate it somewhat.

The real estate market is getting worse every month, with values dropping, and more and more mortgages going underwater.  Take a look at this:

First American CoreLogic, the research firm that monitors housing equity, reported Tuesday [February 23, 2010] that 11.3 million homeowners -- or 24% of all homes with mortgages -- were underwater as of the end of 2009. That's up from 23% and 10.7 million borrowers three month earlier.

Nevada was the state with the worst record at 70% of all mortgaged properties underwater. That was followed by Arizona (51%), Florida (48%), Michigan (39%) and California (35%).

I can think of four ways that the crisis could be avoided:

1. The economy is performing so well by then that most people have no trouble with the payshock.
2. The housing market is so good that people can take equity out of their house.
3. The government takes over private banking and pays off the loans with printing-press money, promising that no one will be thrown out of their home by the evil bankers.
4. Inflation takes off so much that an extra thousand a month or a balloon payment of $50k simply isn’t very much money.

I am betting on number 3, since that was pretty much the response to the 2008 crisis, and I really don’t see a wonderful economy magically appearing in the next year or two. Number 4 is possible, but unlikely in this short timeframe.

Note that if this all occurs as planned, housing prices could drop again in a big way.

Deflation, inflation, stagflation -- who knows which way it will go? At this point, your investment decisions are dependent almost entirely on government policy, not company fundamentals, so it is a real guessing game. I am not even sure gold is safe. Cash probably is not.  A couple of months ago, Nouriel Roubini said "Investors would be better off stockpiling canned foods and other commodities like oil if the recession suffered a double dip" Can anyone say Cloward-Piven?
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