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“Millions of Borrowers Will Be Trapped” – 11/9/2005

“No one could have foreseen this.” That’s the explanation we are hearing from The Street and industry insiders about the mortgage market meltdown. But as the title quote shows, it’s not true. A number of analysts and commentators were paying attention and had been sounding warnings for years. I began ringing the alarm bells in 2004 and continued to do so in every mortgage market report I posted in the Wall Street Examiner Professional Edition over the past 3 years. The data was unequivocal that we were headed for big trouble.

Here’s what I wrote on November 9, 2005, much of which I had been repeating throughout much of 2005. I have highlighted where I at that time discussed some of the easily foreseeable events transpiring today.

Through the March-June recovery, the overall level of applications remained well below the levels of the 2003 bubble and the 2004 echo bubble, in spite of the fact that rates were as low as they were at the peak of mortgage activity in 2004. Lower rates were less stimulative in 2005 than in 2004 because most of the latent demand has been met and because price increases have outstripped any drop in interest rates in most major markets. Housing affordability has plummeted. A sustained rise in mortgage rates now would crush demand, especially for refis, and housing affordability would continue to diminish.

Data from the Federal Housing Finance Board showed that prices were up again in September as they retested the June high. A trend blowoff in residential real estate prices in June was followed by a two-month pullback before September’s rally. The price peak in September coincides with the mortgage application peak in June. The drop-off in applications volume since then could portend a fall in housing prices. The annual rate of increase has been holding near 16%.

The percentage of ARMs has been holding near 30% in spite of the rise in ARM rates, and narrowing spreads versus fixed rates. ARMs were 31.6% of total applications in the week ended November 4. That was the highest reading since early June. A 26.5% reading in early September was the lowest level since February 2004. The record high was 36.6% of total applications in the week ended March 25, 2005. It is surprising that the use of ARMs has not fallen more given the narrowing spread. Affordability is clearly the issue. The least affordable (i.e. most expensive) markets in the country have the highest percentage of ARM borrowers. The Federal Housing Finance board reported that in the second quarter of 2005 in the San Francisco MSA, over 70% of borrowers used ARMs. In the San Diego market over 60% of borrowers used ARMs. With interest rates rising, this is a ticking time bomb.

ARM borrowers are betting on a rate decline. History shows that when a high percentage of borrowers choose ARMs, rates rise over the following year. That is exactly what has happened since March of 2004. Millions of borrowers will be trapped and stuck with rising payments from a level at which they are already stretched.

The real problems will begin when borrowers can no longer make the rising payments on variable rate mortgages. This year most borrowers on one year ARMs will see their interest rates increase by 2% or more. Their real estate taxes and insurance will also be going up, and to add insult to injury, skyrocketing energy costs will squeeze them further.

In places like Florida, and other states where property assessments are capped until a property is sold, buyers will see their taxes go up by 50% to 100%. Some borrowers will simply stop making payments. Others will put their homes on the market and become renters. This process has already begun. Housing market inventory is increasing. That will slow the appreciation rate. The foreclosure rate will go up, supply will continue to increase while there are fewer and fewer buyers. House prices will begin to come down. The wheels have been set in motion, and by 2006, a wave of foreclosures should begin to pressure real estate prices even more.

Both purchase mortgage and refi activity have been gradually downtrending since June. When rates rise, first, transaction volume declines. Then if the rate rise continues, the market begins to recognize that with falling prices. Sellers are usually the last to get the news. Prices may appear to stay high, or even go higher months after the bubble actually ends, but the truth is that fewer sellers can get their price. By the time the point of recognition arrives, it is too late. As rates rise, refi activity also dries up. Stalling prices will also end the refi cash out game that has been propping up the US economy. This will further pressure systemic liquidity.

With Fannie Mae under government mandate to reduce its size, this in itself could crimp the market’s ability to meet liquidity demands. This too would manifest itself in rising longer-term interest rates. Foreign central banks have stepped in to absorb the paper being liquidated by the GSE’s including Fannie Mae, in an orderly process. Data from the commercial banking sector, and the Fed’s primary dealers indicates that these key players are no longer willing or able to absorb allof the MBS paper being created, as FNM continues heavy liquidation. That has left FCBs as the buyers of last resort, a role which they have been fulfilling over the last several months, in what I have called a prevent defense. They know well that a meltdown in the US mortgage market would take their own economies down with it.

We’ll need to keep our eye on weekly data from the Fed on custodial holdings of Agencies, as well as MBS levels in the banking system, along with the delayed monthly portfolio reports from Fannie and Freddie. Weekly reports from the primary dealers showing changes in their holdings of MBS will also need to be watched. In the last couple of months, not only FNM, but also the commercial banks have been reducing their holdings, while large mortgage banks are being forced to increase their portfolio holdings. That’s not a good sign. The mortgage banks need to be able to package and sell the loans they originate in order to be able to continue to originate more loans. If they can’t do that, it means the market is tightening, and will tighten more.

I will continue to keep you informed of developments in the all important housing and residential mortgage markets as they occur in the Wall Street Examiner Professional Edition. One thing is certain. In spite of the fact that the mainstream media has finally taken up coverage of this story, and many pundits are claiming to see a stabilization in the housing markets, the end of the contraction is really nowhere in sight. If you would like to follow my analysis of this area, as well as analysis of broader measures of liquidity, and technical analysis of the markets, I invite you to try the Wall Street Examiner Professional Edition on a risk free basis for 30 days.

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