The JUMBO Problem - Manhattan Wont Help Banks

A: Wave 1 of the credit crisis brought a lot of pain but seems to be behind us now leaving the residual damage to the real economy. Of course I am referring to the carnage brought on by subprime, near prime, and option ARMs to the banking system. The first wave took some of our biggest banks, insurers and IBs, and took the markets for a roller coaster ride. This wave is behind us because most of the damage done to the banks is in the past - writedowns were taken, capital was raised/injected, and fed facilities help to keep the financial system functioning. The efforts by the fed to bring down the indexes tied to ARM resets will help us avoid another wave of defaults that would have come this year and next - potential wave averted. But for the ARMs, don't forget that its the recast that will negate any savings from a rate reset downwards. A recast is when the loan is re-amortized to the higher principal amount for the remaining loan term, raising the minimum monthly payments as the payment cap no longer applies - lots of recasts lie ahead. Lets keep it real here folks. But the real problem that seems to be largely ignored is what is going on in the jumbo market and prime market! Delinquencies are rising, fast. We must ask ourselves, is it right to ignore this or is it right to be cognizant of what could be the next wave of this crisis; especially when the high end in Manhattan is struggling like it is.

Bear rallies have a tendency of re-installing hope and euphoria that all the bad news is behind us and so called green shoots will blossom into a full gear bull market. In my trading days, we called this the 'sucking in' phase - pace of decline slowed, bad news sent shares surging, shorts got murdered, and retail investors get sucked into the rally as the move nears maturity. I don't care what the VIX says, expect plenty of volatility moving forward if this crisis does indeed prove to be of the tsunami kind. The stock market is a pricing mechanism and is currently discounting ('re-pricing') the removal of the 'world is over' scenario and pricing in rosier times ahead. That is why even bad news sends shares soaring leaving many baffled. But what if rosier times are farther out than what stocks are currently pricing in - making stocks more and more expensive? That's the million dollar question and the argument I bring forth. After what we have been through, it pays to at least be aware of what is going on out there for what could be what Bernanke calls another, 'credit market relapse'.

I want to re-introduce this chart (a bit outdated right now in regards to JUMBO & PRIME delinquencies) by T2 Partners on Page 16 showing us the rise in delinquencies by loan type/class - notice the 3 problem areas (subprime, alt-a, option ARM) and the 2 higher quality areas hiding at the bottom (jumbo & prime):

Looking at this chart, you can see the types of loans that sparked this credit crisis in 2007 and caused such problems for those holding securitized mortgage bonds; they included subprime, alt-a, and option ARMs. Then you see prime & jumbo way underneath, holding firm but showing the initial trend of distress. Its as if we could view this in waves:

WAVE 1 - sparked by subprime, alt-a, option ARMs. Fed facilities, rate cuts, and Treasury capital injections handled this wave. Option ARMs will reset lower, bringing payment relief to many of these homeowners. Loan recasts will ultimately come and negate some of this relief. Those with 3YR ARMs will have 2 years of rate relief before seeing their first loan recast if they have not refinanced into a new loan product. Subprime/Alt-a/Option ARM etc., recognized losses so far have been about $684Bln with this first wave, and banks both privately and publicly raised about $690Bln as of the 4th quarter of 2008 (view image)! I'm generalizing here as there were other factors contributing to losses during the crisis, but the point is that the bulk of losses were from these three areas of credit.

WAVE 2 (yet to come) - perhaps sparked by commercial, prime, jumbo, HELOCs, lbos, credit card writedowns. How quickly we forget that the IMF recently upped their total global credit writedowns estimate to $4.1Trln - this assumes total US writedowns of $2.7Trln, up $500Bln from previous estimate (view image).

Some math: $684Bln in global losses taken so far as of Q4 2008 compared to $4.1Trln in total IMF expected losses for global institutions. That leaves some room for more stuff I think.

Now some of the writedowns have been taken towards the 2.7Trln estimate already, so its a matter of where we are now and what may be left ahead of us - I don't know who has access to that kind of transparency right now; not even the federal regulators. Clearly the issue is not the stuff that already was dealt with, but the stuff that is marked as performing yet the actual pace of deterioration is accelerating - in other words, a performing loan book / bond is starting to non-perform. What are the marks on these guys and how does the recent accounting change cushion the possible blow that lies ahead?

I can't find any up to date data on delinquency rates for jumbo and prime, but I did see this latest article noting a report out of Barclays Capital about a "disturbing trend" among so called jumbo loans:

Loans to borrowers who bought pricey homes are going bad at a faster clip. Barclays Capital notes the “disturbing trend”–worsening delinquencies among so-called jumbo loans that are too large for government backing. The investment bank tracks the share of loans that roll into delinquency every month, and nearly 0.88% of jumbo loans made in the first half of 2007, for example, went delinquent in March from February, up from 0.77% in the previous month.

Some of those delinquencies will become foreclosures. Foreclosure starts have jumped by 221% among jumbo loans made to prime borrowers, or those with good credit, according to March mortgage report from LPS Applied Analytics. That’s more than among any other loan type.

If the trend continues these higher quality and larger debt classes could produce losses that will have to be absorbed by the banking system - which is why banks seem to be hoarding cash in reserves to the tune of 1.1Trln to deal with the upcoming losses expected from business and household loans. Banks are preparing, are we? It's safe to say that Manhattan's high end / commercial sector blues won't help matters in the near term - unless people think the high end and commercial sector in this great city is unaffected by this slowdown and will continue to perform. Tomorrow we get the stress test results, and I just don't see how the gov't will collapse the markets at this stage of the game. But who knows. After the stress test Broadway show passes, its back to reality and that is why caution is still warranted as to the wavey nature of this crisis.

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