by Jerome a Paris
Sat Feb 7th, 2009 at 06:27:18 AM EST
Option ARMs See Rising Defaults
As of December, 28% of option ARMs were delinquent or in foreclosure, according to LPS Applied Analytics, a data firm that analyzes mortgage performance. That compares with 23% in September. An additional 7% involve properties that have already been taken back by the lenders. By comparison, 6% of prime loans have problems. Problems with subprime are still the worst. Just over half of subprime loans were delinquent, in foreclosure, or related to bank-owned properties as of December. The nearly $750 billion of option ARMs issued from 2004 to 2007 compares with roughly $1.9 trillion each of subprime and jumbo mortgages in that period.
Nearly 61% of option ARMs originated in 2007 will eventually default, according to a recent analysis by Goldman Sachs, which assumed a further 10% decline in home prices. That compares with a 63% default rate for subprime loans originated in 2007. Goldman estimates more than half of all option ARMs outstanding will default.
These numbers give an idea of the size of the financial woes we are facing: more than a trillion dollars of net losses just in the US real estate market, before taking into account knock-on effects on the economy and the recession.
But more than anything else, they underline the dismal failure of the banking world: a 50% loss rate in retail banking is absolutely stunning. Remember that banks will make roughly, to keep it simple, a couple percent margin on the money they lend towards home purchases. The banks do not get any upside if prices rise: at best they get paid back their loan, plus some interest income. Which means that they make money only if default rates are significantly below that couple percent figure. Which, in turn, means that loans have to be provided to creditworthy clients, with acceptable collateral, and conservatively sized, ie that risks have to be properly assessed over the period of the loan, in order for banks to be reasonably confident that loans can almost always be repaid.
A 50% default rate demonstrates an absolute failure by lenders to do their only job, their most basic trade: risk analysis. If there ever was an indictment of the banking industry as it was structured lately (under the "originate, bundle and distribute" model, ie agents selling loans, passing them on to investment banks which repackaged them into vast arrays of securities that they got rated and sold to bond investors), this is it. It did not do its job, and, quite frankly, that part of the industry should be closed down and all people involved forbidden from ever touching a financial instrument again.
Any cursory look at what was happening in that market since at least 2004 made it obvious that the people involved were betting vast amounts of money on the real estate market continuing to go up - and, more importantly, that they knew it. That the underlying products were called "liar loans" and the clients "ninjas" (no income, no job or assets) shows beyond any doubt that everybody was aware that this was not traditional banking, but pure gambling on the party continuing.
Those bankers that did not relax their lending practices (including the majority of local banks in the US) can understandably feel a little miffed, or even betrayed, by the practices of their brethren, especially when they were told along the way that they were obsolete, stodgy losers and relative pay moved accordingly. Even if their moral and professional compasses can be described as lacking, those that took advantage of this situation can be understood, given the rich reward they could get with almost no downside; but the full risk and management apparatus of the banks and investment houses that employed them or financed their products has to be blamed for not doing its job properly. Where were the credit committees? where were the risk officers? What was management thinking?
And the very worst is that it is the very same risk & management people that are now turning the screws on the economy in order to try to save their skins - presumably, displays of absolute risk 'virtue' today will help interested bystanders (ie shareholders and regulators) that they are competent at their jobs and should keep them. In fact, they are compounding their initial mistakes and making things yet worse - including for their own institutions, showing once more than they don't actually understand risk...
Thus - why are these people still in charge? They are absolute failures, and are taking down the economy with them by their incompetence.
