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Canada and US subprime mortgages

Harry Koza is senior Canadian markets analyst at Thomson Financial and a columnist for GlobeinvestorGOLD.com.

August 10, 2007

You've got to admire U.S. Federal Reserve Board chairman Ben Bernanke. What a master of the understatement. While his predecessor, Alan Greenspan, used to specialize in impenetrable Delphic utterances that required interpretation by legions of market hierophants, Mr. Bernanke keeps it simple and almost innocuous:

"Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing."

I'll say. I see that foreclosures in Southern California were up 725 per cent in the second quarter: 9,504 houses repossessed by the bank, compared with 1,152 in the same period in 2006. In L.A. County, foreclosures were up 799 per cent in the same period. Okay, so that's not a lot of houses in itself, but multiply that by all the other jurisdictions where subprime mania took hold, and pretty soon, you've got, well, you've got a lot of underwater real estate. I've seen forecasts that as many as half of all subprime mortgages will go bad - that's 1.7 million houses.

That's a much more serious number. I figure it's giving Mr. Bernanke and his Fed minions some sleepless nights. By way of comparison, the foreclosure rate on Canadian residential mortgages is less than a quarter of 1 per cent a year.

Anyway, as Gentle Ben says, the correction is "ongoing." The Online Dictionary's definition of "ongoing" is, "currently taking place, in progress, or evolving." Incidentally, the example the Online Dictionary uses to illustrate that definition is, aptly enough, "an ongoing economic crisis."

There's been a lot of carnage already. So far this year, $240-billion (U.S.) in option-ARM (adjustable rate) mortgages have reset at higher rates, and borrowers have seen their monthly payments go through the roof. That's caused a lot of delinquencies, and is starting to cause all those foreclosures. But the big reset upset is still to come. John Mauldin of Millennium Advisors, in his e-letter this week, had a handy schedule of what's ahead. Option-ARMs really peaked in popularity in 2006, and most of them had low "teaser" rates for the first two years. So while there will be around $50-billion (U.S.) worth of resets this month and a roughly similar amount each month through the rest of this year, in January, 2008, the figure shoots up to $80-billion, peaking next March at $110-billion before starting to taper off again.

In just the first three months of next year, more option-ARMs will reset at higher rates than did in the first seven months of this year. By this time next year, there will have been $1.125-trillion worth of resets since Jan. 1, 2007. Let's assume that half of them do go into foreclosure. Call it an even $500-billion: That's still a serious haircut, even for the $11-trillion U.S. economy.

So, how many more hedge funds, collateralized debt obligations (CDOs), mortgage-backed securities and mortgage lenders will have gone belly up by then? I'd hazard that there will be plenty more before things stabilize.

That's why debt markets are so nervous. The bond market knows that real estate "corrections" take years to unwind. When the United States had its savings and loan crisis in the late eighties, it took until the mid-nineties to work out the bad assets. Mind you, the Savings & Loans had good loan books; they'd just been funding 30-year mortgages at 8 per cent with one-year term deposits at 12 per cent. I guess they'd planned to make it up on the volume.

The fast-money crowd nowadays would call this "negative carry." Actually, that's a phrase that hedgies and CDO investors and leveraged buyout (LBO) geckos are getting unfortunately accustomed to hearing a lot of these days, along with such other time-tested phrases as "margin call," "mark-to-market," and the scariest of them all, "offered without" (trader argot for, "Show you a bid? That CDO is so ugly, if it was your kid you'd have to tie a pork chop around its neck to get the dog to play with it.")

Okay, so let's take a quick and dirty stab at predicting the future. So far this year there have been $240-billion in subprime mortgage resets, which has generated, according to the Mortgage Lender Implode-o-Meter (ml-implode.com), 114 belly-up mortgage lenders and, in just the past two months, 17 big global hedge funds that have halted redemptions, of which 10 have gone blooie.

Based on Mr. Mauldin's schedule of resets, there will be about $840-billion of resets by the end of July, 2008. That's 3.5 times the amount that's reset so far this year. Making the presumptuous assumption that foreclosures, bankruptcies, CDO failures and hedge fund implosions continue at the same rate, we could see another 400 mortgage lenders buy the farm and another 360 hedgies get trimmed by this time next year.

It all reminds me of the old Eagles' tune, Hotel California, as if done by Led Zeppelin: "If there's a bustle in your hedge fund, don't be alarmed now. You can check out any time you like, but you can never leave."

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