We’ve only just begun

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I’ve had a cou­ple of very enjoy­able chats this week with Red Symons, on the ABC Break­fast Show in Mel­bourne, and some friends have been try­ing to get me to throw some old Sky­hooks song lines into the conversation–such as “Hor­ror Movie” and the like (for any non-Aus­tralian and/or non-“Living in the Sev­en­ties” read­ers, Red was a guitarist–and played drums on the one occa­sion I saw them live, at Syd­ney Uni­ver­si­ty’s Union Build­ing in the ear­ly ’70s–and lyri­cist; here is a link for the lyrics).

Though they’re def­i­nite­ly apt, the piece of 70’s music that most came to mind when I spot­ted this new fea­ture on the US Fed­er­al Reserve’s web­site this morn­ing was from The Car­pen­ters (which in con­trast to The Sky­hooks, was not one of my favourite bands): “We’ve only just begun”.

It’s an inter­ac­tive map of the sub­prime and alt‑A mort­gage cat­a­stro­phe in the Unit­ed States. The num­bers, which are also avail­able for down­load as Excel spread­sheets, are sim­ply stag­ger­ing.

The scari­est part of the data relates to what are known as ARMs (“Adjustable Rate Mortgages”)–fixed rate mort­gages that began with a “teas­er” low rate, and then reset after a num­ber of years to a high­er rate (the stan­dard US mort­gage is a fixed rater, unlike Aus­tralia where vari­able rate mort­gages are the norm).

Of the almost 3 mil­lion sub­prime loans (the pre­cise num­ber is 2,919,604, rep­re­sent­ing 2.5% of Amer­i­ca’s 115,904,641 hous­ing units), almost 2/3rds are ARMs (the nation­al aver­age is 62.9%), and just over 30% of them will reset to the high­er rate in the next 12 months (with anoth­er 10% to fol­low over the next two years).

That’s why this cri­sis has “only just begun”. There are two sides to this cat­a­stro­phe, and what­ev­er is done about it, one side or the oth­er is bank­rupt.

IF the ARMs go ahead, then the num­ber of Amer­i­can house­holds that will go bank­rupt is at the min­i­mum 1 million–because there’s no way these bor­row­ers can pay the high­er rate. At the sim­plest scale, this is because the rates will rise from an already high aver­age rate of 8.8% to a usu­ri­ous 14.8%. But on top of this, the effec­tive rate for the loans through­out has been the high­er rate–and the gap between this and the ini­tial teas­er rate was cap­i­talised onto the debt.

So a bor­row­er who took out a loan in 2006 of $183,900 (the aver­age sub­prime loan size–note by the way how small this is com­pared to medi­an Aus­tralian hous­ing loans), and whose loan resets to the high­er rate next year, will go from pay­ing 8.8% on 183,900 to pay­ing 14.8% on $219,200–a dou­bling of annu­al inter­est pay­ment com­mit­ments, from $16,180 to $32,440.

This for a cohort of bor­row­ers who are already mas­sive­ly behind on their payments–though not as mas­sive as it will get (cur­rent­ly 10% are behind 30–60 days, 5% 60–90 days, 10% 90 days plus, and 11% are in fore­clo­sure). There’s no way they can man­age this: they are, as the Amer­i­cans put it, “toast”.

But what if they are freed from this obvi­ous­ly oner­ous bur­den by leg­isla­tive fiat? Then the peo­ple and insti­tu­tions who bought the res­i­den­tial mort­gage-backed secu­ri­ties (RMB­Ss) that these mort­gages finance are “toast”: the bonds will be next to worth­less.

And it won’t end there. After the sub­primes come the “Alt‑A” mortgages–ones not high enough grade to qual­i­fy as prime, but above sub­prime in past cred­it his­to­ry. There are rough­ly 2 1/4 mil­lion of them, with much high­er debt lev­els (aver­age of US$321,000), low­er aver­age inter­est rates (6.6%), cur­rent­ly low­er default rates (5.6%–half as many in fore­clo­sure as the sub­primes), and low­er lev­els of arrears (just over 10% behind, ver­sus 25% of the sub­primes).

But just over half of them also have ARMs, and about half of them are sched­uled to reset to a 3% high­er rate in 2010 or lat­er. By then, eco­nom­ic con­di­tions will have dete­ri­o­rat­ed so much that their own finances will be “sub­prime” at the time, and the snow­ball  will con­tin­ue rolling down the High­way to Hell.

So We’ve Only Just Begun. And it is a Hor­ror Movie, though not “right there on your TV”–if you’re Amer­i­can, you’re liv­ing in it.

And if you’re not Amer­i­can, then it’s still almost guar­an­teed that some of your invest­ments will suffer–whether indi­rect­ly if you own shares or prop­er­ty, or direct­ly if you or an agency that affects you pur­chased the RMB­Ss that fund­ed the sub­prime scam. You may well wish that you were still “Liv­ing in the Sev­en­ties”.