ARM loan cost-benefit analysis

Boston real estate broker and InmanBlog reader John Keith comments that Countrywide Financial CEO Angelo Mozilo may be right when he says the media has put too much emphasis on resetting ARMs and subprime loans as the cause of troubles in mortgage lending, and not enough on pre-existing economic problems in places like the rustbelt.

Many experts agree that in many markets in states like Michigan, Ohio and Indiana, the economy is driving delinquencies and defaults. But in other places -- California, Florida, and Nevada -- it appears loose underwriting standards fueled unsustainable home price appreciation that's left many borrowers upside down (see recent post). 

Whatever the cause of the rise in delinquencies and foreclsoures, Keith laments that nobody has done a "thoughtful, concise, and exhaustive study of what we're actually facing" in the credit crunch that's ensued.

Not sure you can have it both ways -- concise and exhaustive -- but this Sept. 11 report by Danske Bank (the link is from Housing Wire via Bill Coppedge), is an easily digestible summary of what's happening and why.

If you want somebody to tell you what the magnitude of the credit crunch problem is, and when it will be resolved, be prepared to be disappointed. That's because it's about more than just losses in subprime mortgages or even mortgage lending as a whole.

Losses on subprime loans, it's often noted, will probably end up representing a tiny percentage of the U.S. mortgage market. It "would be strange if the entire global financial system should be in jeopardy because of losses corresponding to about 1 percent of the market cap of the US equity market," say Danske Bank's Carsten Valgreen and Allan von Mehren

But what we are experiencing is "not just a credit crisis within a small area of the credit market but has also developed into the biggest liquidity crisis in 20 years," they say. "This crisis is clearly most of all a crisis of mistrust and uncertainty among financial institutions. It is a modern version of a bank run."

What's driving it is a loss in faith in the complex securities that were created to fund mortgage lenders and the ratings agencies who evaluated these investments. Most of all, Valgreen and von Mehren say, it's about the costly process of "deleveraging" from these investments, with the use of derivatives and the uncertainty of the value of underlying assets magnifying the cost. 

Subprime losses "are more of a trigger than a final cause. Unfortunately this also makes predictions even harder. Even if we knew all about future losses in sub-prime or other US mortgage debt, we would only have sketchy ideas as to what is in store for the financial markets especially in the short run."

When it comes to ARM loans, Valgreen and von Mehren differ with Countrywide's Mozilo. The Danske Bank experts chart a rise in delinquencies and foreclosures among prime and subprime households with ARM loans.

"There is actually no major rise in delinquencies and foreclosures among subprime households with fixed-rate mortgages. Evidently this is an ARM crisis more than a subprime crisis," they conclude, demonstrating that the problem is tied to tightening of monetary policy, and not a "general household balance sheet problem."

If you agree with Valgreen and von Mehren, ARM loans -- and the Wall Street investment vehicles used to fund them -- should not only take the blame for the rise in U.S. delinquencies and foreclosures, but a global recession, if that's what is developing now. 

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