Second Mortgage Default Wave

60 minutes on Sunday a couple of weeks back shared with us the problem with the second wave of mortgage defaults been precipitated by mortgages with built in resets. It is ugly and the scale of the problem is easily as large as the subprime portfolio we have just digested. My own thoughts on this matter are that this portfolio will turn out to be a lot more financeable than anyone expects.

The reason for this is that the interest rates have sunk so low that the monthly payment should still be affordable to most borrowers. Of course, outright speculators who have no hope of a profit remaining and are certainly underwater will be walking. That is why some high rise condo buildings are empty.

The question now is how do we ensure that this possibility is fully exploited? A federal guarantee is one option for say ninety percent of the face of the mortgage. All this ensures that a large percentage of current homeowners remain homeowners and prevents this fresh inventory from entering the market.

That leaves the nasty problem of what to do with the inventory now underwater. We are still left with the option of going to a mark to market program that accepts a prices point anniversary date and refinances fifty percent of the property at going rates while exchanging the balance of the old mortgage for a fifty percent equity stake in the property.

This method still has the potential of resolving all the bad paper and can be also used as a tool to resell the entire property inventory that the banks are now stuck with. More critically it places a floor on the housing market and eliminates the entire overhang as quickly as possible. Otherwise this overhang will be squeezing the market for several years and I am been optimistic.

The necessary money is already largely in place and certainly more can be added. I would also expect that this drastic move would be swiftly rewarded by rising housing prices and a swift recovery of homeowner equity resulting in profitable buyouts of the remaining bank owned equity. In fact, I would expect that this procedure would become standard in the industry as a preferred alternative to foreclosure.

The problem with all this is that it needs to be mandated through legislation and carefully overseen. It cannot happen otherwise because of various conflicting rules.

The current scenario is unfolding in slow motion, one foreclosure at a time. This means that the end buyers are monitoring capital deterioration that they now expect to continue for at least two years. By going to a mark to market strategy, this is ended and the capital shortfall is recognized and made up. The institution is making money and rebuilding capital the next day. I think this is very doable once the complexities are fully understood and clarified.