photo by miyukiutada
Quote for the day:
"This is not a normal crisis but the end of an era."
Here is a chart on subprime delinquencies from the Dallas Fed. Subprime lenders started taking serious hits at the end of 2006. At that time, delinquencies were still at low historical levels. However, it was becoming apparent that the lenders had not eliminated risk from subprime lending; subprime reverted to acting like subprime. Wall Street somehow believed that they had sliced and diced risk out of the equation; unfortunately that was not the case. It is interesting that subprime is receiving all the blame, when subprime has mirrored the increase of delinquencies in prime.
Bear Stearns in a filing with the SEC gave insight into a typical Option ARM scenario. Their weighted average margin for their portfolio at that time was 3.375%. Their typical loan to value (LTV) was 78%. A typical CLTV was 90%. At one point, Bear Stearns was even offering 100% CLTV Stated Income Option ARMs.
For my example, I am using a margin of 3.375%, an 80% LTV, and 90% CLTV. I am using the median value of homes of $223,100 in January 2005 as the purchase price. I am assuming paying interest only on a HELOC.
This next spreadsheet compares the balances from the previous spreadsheet to home values (Updated on 1/29/08 to reflect November 2007 Home Prices).
A lot of borrowers didn’t mind going negative 2-3% a year when their properties were appreciating at a faster rate. More and more borrowers are going negative on their Option ARMs. In their SEC filings, Countrywide reports that "During the nine months ended September 30, 2007, 76% of borrowers elected to make less than full interest payments, an increase from 66% during the nine months ended September 30, 2006." As of September 30, 2007, 89% of the borrowers at Downey Savings were "utilizing negative amortization"; one year prior 86% were going negative. Indymac reported that as of September 30, 2007, "approximately 88% (based on loan count) of our pay option ARM loans had negatively amortized...This is an increase from 80% and 83% at September 30, 2006 and December 31, 2006."
If a borrower puts 10% down on a property ($22,310 in my example), and a property appreciates at 5%, then the equity would grow from $22,310 to $56,366 after 5 years. However, home values are not exactly cooperating. Declining values puts a lot of pressure on Option ARMs. Borrowers that use them are relying on values appreciating faster than they go negative. Looking at the non-performing asset chart (second chart from the top), values peaked in the second quarter of 2006. Since then values have come down and the non-performing loans have shot up rapidly.
According to the Case-Shiller index, homes appreciated at 15.9% in 2005, 0.2% in 2006. The Chicago Mercantile Exchange (CME) offers futures based on the Case Shiller index. The Case Shiller CME indexes are published on the last Tuesday of the month reflecting the data for two months prior. For example, this Tuesday, January 29, 2008, they published data for November 2007. One contract is $250 times the current value of each respective housing index value (if the index is at 200, then the contract would be $50,000). There are four quarterly contracts (February, May, August, and November). The February contract represents data from the previous October, November, December (2 month lag). As of data from Tuesday, January 29, the last trade on the November 2008 contract was at 189.80 compared to the current index of 205.09 (data for November 2007 that was released January 2008). This means that the futures are implying that the home sales in July, August, and September of 2008 will fall to 189.80 compared to the current value of 205.09.
Using the CME futures, we can get the projected values through September 2012. The CME futures are predicting that housing will go down in value by 9.3% in 2007 (December 2007 data will be released on (2/26/08)), down by 4.5% in 2008, and down by 6.7% in 2009. The futures are then implying that prices will float around that level until 2012. One caveat is that these futures are thinly traded.
I used the CME futures in my spreadsheet to estimate what values will do to calculate how much equity the borrowers will have with their Option ARMs. If the values continue as projected, then this month the borrower in my example would be at 96.5% CLTV. This is making it harder to refinance. Real estate markets vary considerably. Many will have more equity; some will owe more than their house is worth by now. The borrower in my example would have negative equity by the end of this year and would end up at a 110% CLTV after 5 years. After 5 years, Option ARMs will lose their minimum payment option. At that time they will have to pay their fully amortized payment. Option ARMs also recast when they hit their recast amount. These range from 110% to 125%. In 2005, Washington Mutual and World Savings normally were at 125%, Countrywide and Indymac were at 115%. Some other lenders had recasts at 110%.
One thing that is not being talked about on Wall Street and in the media, is that the Option ARMs with the 110% recasts that were originated in 2005 are starting to recast this year. In the example in the spreadsheet, a loan with a first payment in January of 2005 is recasting this month. Loans with a 115% recast will recast close to the 5 year mark.
The rise in delinquencies in Option ARMs is particularly alarming as most Option ARMs are still in the minimum payment phase. We already know how subprime borrowers have struggled when their payments recast. However the jump on a subprime loan is a lot less than the jump on an Option ARM. The Center for Responsible Lending did a case study on some subprime ARMs made by Option One Mortgage Corporation to borrowers in Charlotte, North Carolina in the first three quarters of 2004. The teaser rate for 2 years averaged 7.5% and had a margin of 5.4% over the 6 month LIBOR (currently at 4.6%). Using 90% of the $223,100 median price for a home in the U.S. on January 2005, a borrower with a first payment in January 2005 would have a payment of $1,403.95. On January 2007, the 2 year ARM would adjust to a fully indexed rate of 10.75% making the payment $1,857.07. This is an increase of $453.12 or a 32.3% increase in payment.
Using the same scenario, a borrower with an Option ARM would have initial payments of $574.06 for their first year on their first mortgage and perhaps a payment of $225 on a HELOC. Assuming the borrower made the minimum payment the whole time, the payment on the Option ARM would go to $617.12 in month 13, $663.40 in month 25, $713.16 in month 37. If the borrower had a 110% cap, then they would reach that point on the 37th month. They would then have to pay a fully amortized payment. Their payment would jump up to $1,468.43 in month 38. That is an increase of $755.27 over month 37 or an increase of 105.9% for the first mortgage.
One problem facing the Option ARMs is it will be difficult to restructure the loans. If a rate is restructured into a 30 year fixed rate at 7.5% in the subprime example, then there will be no change in payment (it goes from the teaser rate of 7.5% to a fixed rate of 7.5%). On the Option ARM, if the rate was restructured into a fixed rate at 6.00% in month 38, the payment would go from $713.16 to $1,228.95. This is still a large increase in payment even with a rate as low as 6.00%. Another problem is that with the low initial payments ($574.06 for the first mortgage in our example), many borrowers borrowed more than they could afford. Most borrowers are still in their teaser rate period. The rapid rise in non-performing Option ARMs is mainly comprised of borrowers still in their minimum payment period ($663.40 in our example). If borrowers are struggling with those payments, how are borrowers going to perform when the payment resets to over $1,400?
Credit Suisse has a chart shown right that shows what we are up against. Their chart shows 2010 as the start of the recasts. These are reflecting the influx of 2005 originations. However, if the borrower has made the minimum payment the whole time, then the 2005 originations with a 110% recast are already starting to recast this year.
Complicating the situation, Option ARMs were often sold with 3 year prepayment penalties to give higher compensation to the originators. This is unfortunate, because within those three years the situation changed dramatically. The fully indexed interest rate rose rapidly, home values started deteriorating, and lender guidelines changed.
One possible reason for the rise in delinquencies is that the borrowers are looking to refi out of the Option ARMs and are realizing that their equity has diminished and the underwriting guidelines have tightened. While they may have qualified with their original ltv and loan balance, they may not qualify at the new ltv, with their higher loan balance, and with the new tighter guidelines.
Subprime was the official word of the year for 2007. I suspect that in 2008, we will learn we were wrong to call it a subprime crisis. The mortgage crisis is too deep; there are too many factors. I think in 2008 the buzzword will change from a "subprime mortgage crisis" to just a "mortgage crisis."
photo by venkane
Quote for the day:
Information is not knowledge.
- Albert Einstein
The Big Picture took a look at Paul Kedrosky’s post on yesterday’s whiplash action. Paul looked at the number of times that the Dow opened the day down at least 1% and rallied to close positive from 1928 to now. He found that yesterday’s swing of 625 points from the low to the close was the second highest rally for the Dow ever (after opening down more than 1%).
I took a look at the S&P 500 from 1950 to yesterday. Yesterday was the biggest point swing in that period. It was 7th largest in percentage swings. For the Nasdaq Composite going back to 1971, it was the 27th largest in point swings and 19th largest in percentage swings.
You can use the scroll buttons on the spreadsheet to move down the spreadsheet.
Even though we have had 3 bouncebacks already this year, it is a relatively rare occurrence. From October 1938 to September 1958 it happened 22 times (about 1 time a year). From 2004 through 2006 it happened 17 times (about 6 times a year). Here is a chart showing how many times it has happened. You can click on the chart for a larger view. Notice the frequency during the Great Depression, the internet bubble, and now.
photo by Яick Harris
Quote for the day:
"Everyone has his day and some days last longer than others."
- Winston Churchill
On Tuesday, Bespoke Investment Group (B.I.G.), had a timely post on the largest down gaps in the S&P 500 tracking SPY ETF since 1994. They discovered that “when gapping down 2.5% or more, the ETF has traded higher 8 out of 9 times for an average gain of 2.69%.”
Since their post, the market has gapped down over 2.5% two days in a row and has closed over 3% higher than the open on both days.
I have updated a spreadsheet showing the gap downs going as far as -1.75%. When the market has opened up down 2.25% or more, SPY has closed higher 15 out of 16 times for an average gain of 2.99%.
The QQQQ ETF is much more volatile. When the market has opened up down 3.5% or more, QQQQ has closed higher 11 out of 13 times for an average gain of 2.48%.
When the market gaps up, there isn’t an apparent trend. Most of the gap ups were during the Internet Stock bubble.
You can use the scroll buttons on the spreadsheet to scroll down to the bottom of the spreadsheet.
I have also included the maximum loss the trade would have incurred (ETF open to low of the day). The stock market crash of 1987 illustrates the importance of stop losses. On October 19, 1987, the Dow Jones Industrial Average opened down 4.4% and finished the day down 22.6%. A lot of the NYSE stocks didn’t open as the sell orders swamped the buy orders.
I also included a study of the 30 current stocks that are in the Dow Industrial Average going back to 1980. Some of the 30 Stocks have been added since 1980. However, I used their stock data as if they were in the Dow the whole time. 8 stocks did not have data going back all the way to 1980 so I calculated an average with the remaining stocks (some of the companies that were in the Dow in 1980 have merged with other companies). Also I used a simple average giving each stock equal weight.
When looking at the Dow stocks, stocks that gapped down actually closed down from the open. The stock market crash in 1987 played a big part. But that was not the only reason. Prior to 1994, 12 out of 18 times stocks closed down from the open when they gapped down. However, even during 1994 - 2008, 7 out of 16 times stocks closed down from the open when they gapped down. The disparity between the SPY and the Dow components could be due to the fact that NYSE stocks don't always open promptly at 9:30am EST. Also the actual trading price of the SPY sometimes varies from the theoretical value of the index.
Here is a great interactive multimedia intraday chart of the 1987 stock market crash.
photo by ArtBrom
Quote for the day:
"I don't believe it. Prove it to me and I still won't believe it."
- Douglas Adams, "The Hitchhiker's Guide to the Galaxy"
It has been often said that when the U.S. sneezes, the rest of the world catches a cold. There was talk that with the growth in the emerging markets in Asia, that Europe and Asia have decoupled from the American business cycle.
The last two days have shown that the world still does fear a U.S. slowdown. With the American stock market closed on Martin Luther King day, the rest of the world had two days brew over recent developments. The results were not pretty.
photo by Joep R.
Quote for the day:
"We will be buying back on value shares later today since we don't want to get slapped on both sides of the face...selling more than we should and failing to catch up when the market recaptures momentum," said a Japanese fund manager.
On Friday, the Conference Board published the December 2007 numbers for the U.S. Leading Index, which is released monthly.
The Leading Index decreased 0.2%. Paul L. Kasriel, Senior Vice President & Director of Economic Research for The Northern Trust Company, wrote a good article on the Leading Index and furnished this chart.
The index is made up of 10 components. 2 of the components can be updated daily:
The Leading index does not carry too much weight with the stock market. A large part is due to the fact that most of the components are know ahead of time. The release of the index is old news when it hits. The Conference Board also heavily revises the weights to better forecast the business cycle.
This is not to say that the index or the components are not important indicators (just not breaking news).
Here are charts on 4 of the components that can be determined daily or weekly. You can click on them for a larger view.
The employment related charts mirror the official recession dates as declared by the NBER. The M2 and Interest spreads move a bit more independently and sometimes truely lead the recessions.
