Monday, June 1, 2009

Option Arm Tsunami!

Before I begin:

A big hat tip to Mish for the charts, and please check out his excellent post on the mortgage meltdown.

I wanted to dig a little deeper into one area of the research report from T2 partners that Mish discusses in his post.

I will get to the bipolar markets in my Bottom Line section that I always finish with. However, I thought it was critical that I begin with the oncoming Option Arm Tsunami that we are all about to face.

T2's research report was absolutely phenomenal. As you all know, the subprime reset fiasco is just about over. Most of these life long renters are now back where they belong: In their apartments. Lets be honest, just about all of the subprime buyers had no business buying a house in the first place. They would have gotten a 30 year loan if they actually had the ability to pay it back.

Shame on Wall St for creating fraudulent faulty lending products like subprime that allowed unqualified buyers to get into these houses in the first place.

I asked everyone earlier this week: Is Prime the new Subprime?

The answer is an overwhelming yes, and the data out of T2 overwhelmingly supports this thesis. As the housing bubble turned into a speculative mania, Alt-A/Option Arms soared in popularity as they became a very convenient way for Wall St to keep the bubble going. Many of these were "liar loans" where no income verification was done. The bankers at the peak of this mania were basically handing out $1 million Alt-A loans like candy. $2.4 trillion dollars of Option ARMS were done overall, and $750 billion of them were done at the peak from 2005-2007.

These loans were created by Wall St for one reason only: They were a way keep the game going at the end when NO ONE could afford to buy a house.

The banksters didn't care if the borrower could ever pay the loan back because they passed on all the risk by securitizing the loans, and then proceeded sell them to the first sucker they could find in the form of an "AAA" shit sandwhich.

Well guess what folks. Now that the game is over: Its time to pay the piper. As you can see below, the Option Arm resets just got started and doesn't peak until 2013:

As I explained before, these loans were mainly given to higher income buyers and speculator's that couldn't afford to qualify for a 30 year mortgage. As you can see below(especially during the peak), people were using these loans because they obviously couldn't afford the house. If they could it would have made much more sense to go with a conventional mortgage because the rates were much lower:

So what happens when you lend to people using practically no lending standards and don't even bother to verify their income? THEY DON'T PAY YOU BACK. As you can see below, the delinquency rates on these loans are soaring:

My Take:

30+% delinquencies! Yikes! What a damn fiasco! Does everyone still think the banks are now well capitalized after their puny $60-70 billion in capital raising's? Over the next 5 years they are about to be slammed by a $2.4 trillion Tsunami of Option Loans that will once again bring them to their knees. Ummm...Something tells me they are going to need just a bit more money. Anyone got a few trillion they can borrow?

The scary thing here is this crisis hasn't even started yet. The period over which these loans reset ins much longer than subprime. Another thing to point out here is this was the speculator's favorite loan because he didn't have to have his income verified. These greedy specs just went to the bank, bought 10 houses on a $100,000 a year salary, and then screamed "Let's Flip Some Houses and Get Rich!".

These loans were often used by the prime buyers as well. As I have explained before. The prime and the subprime buyers both made the exact same mistake: They bought houses they couldn't afford.

How Will This Effect The Housing Market?

T2 nailed it in their report. Let me echo their sentiments. the $500,000 and up market is TOTALLY SCREWED. We already have 40 MONTHS of inventory here and its growing by the day.

The low end of the housing market has been moving strongly as home buyers gobble up foreclosures in the bubble areas. These foreclosures are nothing to write home about. Many of them are small and below McMansion standards, but buyers jumped all over them because they were affordable! I mean you feel like you gotta steal if you were able to buy a $350k house for $180-200k!

The problem here is as the prime borrower's and speculator's begin to roll over in the $500k-750k "mid to upper end" part of the housing market, its going to result in an explosion of new foreclosures.

The massive glut of new inventory combined with much tighter lending standards will force the prices of these homes to crash which in turn will then push them from the "mid to upper end" of the housing market down to the "lower end" of the market.

This will deal a crushing blow to the current suckers that picked off the first big wave of foreclosures. Why? Because new buyers will be able to pick up a 500-700k McMansion at around the same price level as the first round of foreclosures which aren't nearly as nice.

This will push the values of the "Round 1" foreclosures down because they won't be able to compete with the new flood of higher quality inventory.

Anyone that jumped in early on the first set of foreclosures will then end up taking another beatdown as the housing crisis continues to snowball. The 180k "steals" that home buyers gobbled up in droves after the first wave of foreclosures may only be worth 100k once the Alt A McMansions get down into their price range.

This will deal another very painful blow to the psychology and sentiment in the housing market. I still believe that no one will want to own a home when this all is said and done.

Anyone remember how burned you felt after buying Amazon at $300/share at the peak of the tech bubble? Home buyers will eventually feel the same way. The housing bubble may end up being the grandest of them all.

Bottom Line:

Patience is a virtue. This next Tsunami will take several years to play out. Do not be in a rush to buy a home. The next round of foreclosures will be much nicer than the first round that was basically comprised of below standard subprime crap boxes.

Could a McMansion sell for 200k or less 5 years from now? Wouldn't surprise me in the least.

As for the markets:

Bonds collapsed as money went back into stocks. This game can't go on forever folks. There simply isn't enough money to prop up both. Expect to see mortgage rates and gas soar as everyone begins to price in the economic recovery thats never going to happen this year.

This rally has speculation written all over it. I am still short treasuries, long metals, and short the S&P. The dollar continues to get trashed as we spend ourselves into oblivion.

I found it funny when it was reported today that the government spent $30 billion on GM to save 40,000 jobs. This equates to spending $1.25 million per worker. And you wonder why the bond market is nervous? I have no words to desribe how ridiculous this is.

If I was a GM worker, I would have asked Obama if I could dump my job and take the $1.25 million in the form of a severance package.

The insanity continues! Stay tuned!


Johan said...

Greetings from across the Atlantic! :)

Just want to say that i really enjoy your blog Jeff! It is nice too know there are som realists out there. People here in Sweden (and in europe in general) have gone absolutely crazy, and are bying stocks and houses again like there is no tomorrow...
Everyone here seems to think this market downturn is over and forgotten and now everyone THROWS their last money into the stock and housingmarket cause they don´t want to miss the big giant bull market that every moron seems to think is going to continue forever...
It´s truly entertaining.

Keep up the good work!

/Johan, Sweden

Anders said...

30 billion and 40000 jobs equal 750000 dollars/job, not 1.25 million-but that is of course extreme as well

Jeff said...



Its great to here from the Swedes!

You guys need to come over here and show us how you nationalized your banks.

I agree. The market is getting so seculative based on zero fundementals.

That scenario never ends well. I don't know why we haven't leanred our investing lessons after getting burned twice in the last 10 years with the tech and housing bubbles.

It appears the speculators need to get burned a third time after this recovery doesn't happen and we retest or break the lows.

GL up there in Sweden and stay warm!

Jeff said...


Don't forget the $20 billion we already gave them.

Its actually probably more than $1.25.


flipdippy said...

Jeff - did you read this in the USA Today?

I wonder how it all will play out in Baltimore. Long-term I'm bullish on Baltimore metro, but short term, dunno. Still seeing inventory move quickly in the 21093 zip code when priced correctly. Identical homes in developments have wide range for sale prices, leading me to assume buyers are paying premiums for updated and well maintained homes.

Could be a lot of fools rushing in.

Jeff said...


I am bearish on every housing market because interest rates are going to go through the roof.

No one will be able to afford housing at the current pricing levels.

That being said, I am less bearish on Baltimore becuase of all of the federal workers.

I still think Baltimore is way way too bubbly though.

I wouldn't touch any house until we know where interest rates end up.

It will be 2-3 years before I seriously take a look at the MLS.

Perfectly happy renting.

Anonymous said...

"Over the next 5 years they are about to be slammed by a $2.4 trillion Tsunami of Option Loans that will once again bring them to their knees."

Jeff - arent you overstating things? Slide 23 indicates there is approx 750B of Option Arms left, not 2.4T

Jeff said...


I here ya. Let me add.

$750 billion of loans were done at the peak.

Many of the $2.4 trillion are just starting to reset. Will the owners of these loans contnue to pay as job losses mount?

Don't forget this is on top of further subprime, credit card, and commercial losses.

I think the ARM reset will be the KO punch.

Lets see what happens

Anonymous said...

Many of the $2.4 trillion are just starting to reset. Will the owners of these loans contnue to pay as job losses mount?

Don't forget this is on top of further subprime, credit card, and commercial losses."

I agree Jeff. I just wanted to make sure I understood correctly, you said "2.4T" of "Option Arms". I think you meant to say

750B of Option Arms


2.4T of Alt A.

My guess is you meant the latter.

Jeff said...



Sorry. I tend to lump all of this crap together at times. Its all crap but the alt a's are probably worse.

Its not going to end well that's for sure!