Sunday, August 26, 2007

How big an impact are ARM resets going to have on the economy and financial markets?

Although there is no question that there are a significant number of ARM mortgages that are going to have interest rate "resets" over the coming months and next couple of years, there is no clear view on what the net impact on the overall economy and financial markets will be.

Bankrate.com has an article entitled Survivor's guide to ARM resets. I am not offering any recommendation on that article, but it is one point of view on "The ARM Reset Mess."

Nobody knows with clarity how many ARM resets will result in defaults, how many will result in foreclosures, how many personal bankruptcies will result, or what the net hit to consuming spending might be. I'm sure it will be relatively ugly, but I am also sure that it won't be anywhere near as disastrous as a number of commentators are asserting.

As painful as bankruptcy can be, it is actually quite liberating to finally get your onerous debts discharged and start over fresh. Suddenly you actually have money in your pocket (assuming you had a decent income to begin with) that was being sucked into that giant mortgage payment. I do not want to make light of bankruptcy, but I do know from personal experience that there really is a silver lining in that dark cloud.

As far as defaults, not all of them will lead to foreclosure. Workouts will be effective in some portion of the defaults.

As far as foreclosures, I think it will all depend on the actual numbers that play out. If the numbers turn out to be relatively low, the mortgage lenders or MBS bondholders will simply suck it up and take a modest to moderate haircut. No disaster there. The market values of housing related debt securities have already priced in a very heavy haircut, probably far greater than what may transpire.

If the number of pending defaults or foreclosures turns out to be huge, a bailout of some form will clearly be the order of the day. We have a election coming up in 2008, so even the Republicans will willingly go along with "providing aid to distraught homeowners" in such a scenario since to do otherwise would be suicidal in the election. The bright side of all of this is that it won't take a massive amount of money to bail out homeowners, but simply a piece of paper from Congress and or state legislatures that would either dramatically cap or defer the amount of the interest rate reset. Yes, the lenders holding those ARM mortgages or MBS bondholders would take a modest to moderate "haircut", but their alternative would be to have to deal with all of those foreclosures and the resulting hit to their capital and their income.

There are plenty of middle-ground alternatives. Countrywide Financial, which services the mortgages it originated, will be under a lot of pressure, especially due to some of its shadier practices, and in my opinion will be likely to voluntarily (and with the agreement of the MBS bondholders) agree to dramatically alter the terms of the ARM resets simply to protect their own financial situation. It will be a simple financial calculation, the net cost of dealing with a foreclosure versus the reduction of income from foregoing much if not all of the ARM reset.

As far as the hit to consumer spending for people who are able to eat the cost of their ARM resets, it is difficult to project. As I said, if the overall ARM reset impact is really huge, a bailout will dramatically mute its economic impact. I also suspect, once again with the 2008 election looming, that there will be a fair amount of government aid to homeowners who have difficulty coping with a big jump in their monthly payment. And even that aid will likely be limited since the big gain comes from simply capping or deferring the ARM reset amount.

Also, we do know now that one of the bigger scandals of the past couple of years was consumers who were pushed into expensive subprime mortgages or even ARM mortgages despite the fact that they had the documented income and cash reserves to qualify for more economical fixed or FHA mortgages. I suspect there will be a combination of class action law suites and government intervention to help get quite a few of these homeowners converted over to the more economical mortgages that they really do qualify for.

I certainly do not want to be too sanguine about the impact of ARM resets, but we do need to be cognizant that there really are any number of different scenarios that could play out. You can't simply look at the maximal worst case number of defaults and using simple arithmetic to definitively forecast how it will all play out.

Yes, I believe there will be a significant amount of pain, but I also strongly suspect that there will be far more irrational anxiety than actual pain.

The overall hit to the economy from the housing mess will probably continue to be in the 1% range. Maybe it will dip to 0.75% and maybe it might rise as high as 1.5% over the next year to year and a half. So, we are mostly talking about a continuation of the current hit and not a huge new additive hit. And certainly nothing indicative of a recession.

One last factor to keep in mind is that the total amount of money flowing in the economy does not decline simply because less is flowing into housing, but rather it simply flows elsewhere in the economy. Commercial construction is still quite strong and many businesses in the service sector are still quite strong. We may not be able to directly discern where the money flows have moved to in the short-term, but money does not simply vanish, especially when the Federal Reserve is showing that growth of the monetary base (M2) has been 3.5% (annualized) over the past three months, 5.5% over the past six months, and 6.1% over the past year. There really is plenty of money floating around seeking a home.

-- Jack Krupansky

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