More Mortgage Timebombs?

Benjamin Tal, one of the pre-eminent economists in Canada, explained in a presentation that I attended why Alt-A and Option-ARM mortgages won’t be timebombs the way sub-prime mortgages were. He described being in New York as the credit crisis unfolded and he gave his opinion that the entire American financial system was teetering on the edge of total collapse. It was apparently a big mistake to allow Lehman Brothers to fail, since the big banks are the oxygen that keeps the financial system alive.

The problems with the sub-prime mortgages are well-known. They were offered to people with inadequate credit, bearing teaser rates that would reset in two years. This allowed people to buy houses much larger than they could afford. Then, between 2004 and 2007, interest rates rose by about 4.0%. When the interest rates reset, not only were they higher than the teaser rates, but they had also increased, making the payments unaffordable. Homeowners (in the loosest sense of the term) walked away as values fell, and foreclosures jumped.  Because 95% of sub-prime mortgages had been securitised, anyone who held the securitised loans took an immediate write-down (due to mark-to-market rules) and banks found their capital impaired. Could the same vicious cycle be repeated as interest rates reset and payments come due on Alt-A and Option-ARM mortgages?

Alt-A mortgages also offered teaser rates, generally with a reset period after five years. After the crisis that was precipitated by loan defaults in the sub-prime mortgages, there is one major difference. In order to save our financial system from collapse, the US Federal Reserve has pushed interest rates to 0.25%. As the interest rates on Alt-A mortgages reset, they will be based on the new rate of 0.25% and payments will remain essentially unchanged from the teaser rates.

Option-ARM mortgages offered borrowers a choice of three payment plans: principal + interest, interest-only or minimum payment. The last option, minimum payment, was below the level of interest-only and thus resulted in negative amortisation. Put another way, borrowers who opted for minimum payment would see the balance of their loan grow and the interest cost was added to their loan. Whether or not we believe it’s irresponsible to take a negative-amortisation loan, about 85% of borrowers chose that option. These loans also generally had a reset period of five years, but there are a couple reasons Mr. Tal doesn’t see them as a ticking timebomb. The first is that only about 50% were securitised, while 50% remained on the banks’ balance sheets. This means that future earnings will be negatively affected, but defaults won’t necessarily result in an immediate write-down and the related capital impairment. Of the 50% that remain on banks’ balance sheets, roughly half is owned by Wells-Fargo (from the purchase of Wachovia). Those loans had a special feature: they don’t reset for 10 years.

After these explanations, Mr. Tal said that he was confident that Alt-A and Option-ARM mortgages are not timebombs and will not endanger the equilibrium of our financial system the way the sub-prime mortgage meltdown did. Having said that, he is not optimistic about the future profitability of US banks.

Another common concern is commercial real estate loans. Commercial real estate tends to lag residential real estate and I have heard anecdotes of falling values and reduced loan-to-value ratios. Together, these can make it impossible to refinance. Combine that with securitisation, and forced selling results. Mr. Tal predicted that commercial real estate mortgage defaults will cause 500 regional banks to fail. To put the number in perspective, he referenced the 900 banks that failed in the Savings & Loan crises, and around 2000 banks failed during the Great Depression.

His conclusion was that the US administration is doing the right thing. They are buying time and buying jobs. In fact, he believes the Chinese administration is also buying time and buying jobs. That should give the private sector time to find its footing and recover from the present deleveraging.

This gets me excited about buying US real estate. There has been a phenomenal opportunity to buy US real estate cheap, and it’s not over yet. On the other hand, I’m not optimistic about the Canadian manufacturing sector, or anyone looking to export to the US. American consumers are simply not purchasing like in the past and the American government will definitely not buy from foreigners, when there’s a choice. At the same time, given the government spending and the industrialisation of China and India, as well as other emerging markets, the commodity and natural resource story seems to remain intact.