When I posted Part 1 of this series there were several skeptics who doubted the impact that the RE Bust would have on pensions. The reasoning given is that most pensions funds are forbidden to invest in non-investment grade bonds (only BBB-/Baa1 or higher).

That sounds like good reasoning, but is it?

The fact is that risk has been "badly mispriced" in the bond market for many years now, as the Economist puts it.

The basic point to note here is that most bonds are just too expensive - investors are too complacent about the risks of holding them.

Those skeptics don't acknowledge that many of those subprime Mortgage Backed Securities (MBS) are rated higher than junk grade. And that doesn't even address the fact that as the default rate rises, those MBSs will be downgraded. Investment grade bonds don't always stay that way.

Another mistake made by the skeptics is that the Real Estate Implosion will be limited to just the subprime market, and therefore won't effect most of the bond market. Nothing could be further from the truth.

"To define the problem as a subprime problem is short-sighted," Rosner said. "It's really seeing the tip of the iceberg as the iceberg."

The latest foreclosure data also may spell trouble for Wall Street, where pools of bonds may be susceptible to nonperforming loans that underpin debt vehicles known as collateralized debt obligations.

Just as more expensive homes are beginning to fall through the cracks, the fear is higher-rated bonds within CDO structures may be vulnerable.

UBS Securities said in a report last month that rising delinquencies may cause losses within some subprime mortgage bonds rated as high as the "A" category.

The skeptics also point out that credit spreads for junk bonds are so low today because we've had several years of historically low bond default rates. But anyone who's ever opened up a book on economic history will tell you that most bad loans are made when times are good and the markets are complacent, not when times are bad and Wall Street is full of fear.





In Part 1 I made a case that the subprime mortgage market was saturated with debt and ready to implode. Credit Suisse summed up the subprime mortgage situation this way: "In 2006, Wells Fargo, HSBC and New Century were the three largest subprime originators, representing 29% of the total market. Since year-end, Wells Fargo has announced tightening credit standards, HSBC has recorded bad loan provisions in excess of $10 billion, and New Century's fate lies in the balance of its warehouse lenders."

The 2-year ARM represented 78% of all subprime MBS's sold in 2006.
In this edition I want to focus on one level up from subprime - Alt-A's. And in particular, I want to focus on a report released a few weeks ago by Credit Suisse called Mortgage Liquidity du Jour: Underestimated No More.



The chart above is the most important chart you will see concerning the immediate future of the real estate market. As you can see, the peak of subprime mortgages created with opening "teaser' rates will reset to much higher market rates around the holidays late this year. It generally takes 6 to 12 months for a home to move through the entire foreclosure process and finally end up as a unit of inventory. Adding in at least three months between the resetting of the rates until the foreclosure process begins, we aren't looking at a peak in the subprime implosion until probably some time in 2009. In other words, we haven't seen anything yet. The subprime implosions is going to get much worse before it gets better.



The other thing to notice is the secondary peak that comes more than two years later. It's this segment that I want to focus on, mostly because Alt-A's encompass such a large amount of these loans.

Alt-A loans, also known as alternative-documentation loans, are not new to the industry. In the past few years, however, their definition has become something of a moving target. The reason that defining Alt-A is so important is that flexibility in its definition leads to variability, and the underwriting and credit quality of Alt-A pools can vary. This can become an issue, particularly as the loan moves into the secondary market. The lack of a standard lender definition of Alt-A, combined with the prevalence of government-sponsored enterprises (GSEs) in this market, have blurred the line between Alt-A and prime collateral.
The Alt-A product is primarily credit-score driven, as its borrowers don't have proof of income from traditional employment. The Alt-A loan alleviates the challenges associated with due diligence, such as providing income verification and documentation of assets.

As Credit Suisse describes the Alt-A market: "More recently, the Alt-A segment of the mortgage market has evolved to include many of the most risky, "exotic" mortgage products such as option ARMs and limited documentation mortgages.

"Although the rapid expansion of the subprime market has been highly publicized and scrutinized, its growth is rivaled by the Alt-A mortgage market, which has expanded from just 5% of total originations in 2002 to approximately 20% in 2006."

The report goes on to say that Alt-A's not only increased in market share, but also changed into the most risky of loans: "Negative amortizing loans accounted for roughly 26% of all Alt-A purchase mortgages in 2006, compared to just 2% in 2003. That percentage would be even greater (46%) when throwing refinances into the mix as well.

"As shown in Exhibit 9, low/no documentation loans (stated income loans) represented a staggering 81% of total Alt-A purchase originations in 2006, up significantly from 64% just two years earlier. These loans are also sheepishly referred to as "liar loans" by many in the industry due to the propensity for borrowers to exaggerate their income on loan applications. [my note: A 2006 study by the Mortgage Asset Research Institute sampling 100 stated income loans found that 60% of borrowers had "exaggerated" their income by more than 50%.] In addition, the combined loan to value on Alt-A purchase originations was 88% in 2006, with 55% of homebuyers taking out simultaneous seconds (piggybacks) at the time of purchase. [my note: "piggyback loans" are typically done by borrowers in order to avoid having to put down any deposit at all. They usually take out a typical ARM mortgage on 80% of the value of the home, and then take out a home equity loan of 20% to cover the remaining cost. The 2nd mortgage carries a higher interest rate, but saves the borrower from having to pay for mortgage insurance. At least that is how it was first designed. It is now used to purchase homes far beyond the borrower's means.] Investors and second home buyers represented approximately 22% of Alt-A purchase originations last year, which is the largest non-owner occupied share among the various segments of the mortgage market. Adding to the risk is the fact that 1-year hybrid ARMs represented approximately 28% of Alt-A purchase originations in 2006, setting the stage for considerable reset risk."

Some people have the false perception that the epicenter of all this risky lending was in the subprime area. But in fact Alt-A was the epicenter. For instance, in 2005 interest-only and negative-amortization loans constituted 37% of subprime lending, but 65% of Alt-A lending. In 2006 the ratio was even larger (23% for subprime and 62% for Alt-A). Jumbo loans also dwarfed the subprime sector when it came to creative financing over the last four years.

So why all the lying and risky mortgage loans in this segment? Because Alt-A's are the area for real estate speculators: "These datapoints suggest that the Alt-A market, in recent years, has been a haven for homebuyers and investors looking for exotic mortgage products intended to mitigate the lack of affordability caused by surging home prices.

"In our opinion, markets that have become significantly exposed to these exotic mortgag products in the past three years, and the mortgage originators/builders that use them to finance their new construction homebuyers will be hit especially hard as underwriting standards begin to tighten, as the incremental demand created by the added liquidity in recent years would likely diminish. Not surprisingly, many of the states that had the greatest share of Alt-A mortgages in 2005 have also served as the primary growth engines for the major homebuilders in recent years. We estimate that Nevada, California, Arizona, Florida and Virginia had the greatest share of Alt-A originations in 2006."

So how bad can things get? Look overseas and you will see.

I point out the proliferation of real estate speculators in high-risk/high-leverage/low-documentation loans because historically these will be the first people to walk away from their properties when the market turns down. And instead of throwing a single house onto the market, like the subprime borrowers will do, the speculators will throw several houses on the market at a time, all of them at a discounted auction price.

While a typical homeowner is going to continue to pay the mortgage on the home they live in no matter how "underwater" their equity value is, a speculator will walk away from a house in which he owes tens of thousands of dollars more than he could possibly sell it for. And as all these empty houses hit the market at distressed prices, it pushes all other houses down in value as well. Unless you don't plan on selling your house, it is only worth whatever someone is willing to pay for it.

Credit Suisse has this to say on the future: "Analyzed another way, we take each piece of the general mortgage market and use conversations with industry contacts, recent tightening announced by lenders and expected legislative and regulatory actions to estimate the proportion of each segment that could be eliminated by tighter lending standards. In our base case, we assume that 50% of the subprime market is at risk, taking originations back to 2003 levels, which would impact total purchase volume by 10%. Similarly, we estimate that 25% of Alt-A and 10% of prime loans would not be approved under tighter restrictions for various combinations of investor purchases, piggybacks, low down payments and low documentation. In aggregate, the total impact to originations would be 21%."

In other words, 21% of the all the loans since 2003 would never have happened given future lending standards. How this effects the future is more vague, but it has direct effect on mortgages that will be resetting in the coming years. 21% of the borrowers who can't meet the reset interest payments on his mortgage will be unable to take out a new mortgage, which means a quick trip to foreclosure.

The reports continues: "Related to speculation, investors' share of the market climbed to roughly 18% in 2005 and 2006 from an average of 7% from 1998-2001, implying that a return to the mean would remove 11% of housing demand. On top of that, we expect that mortgage tightening could eliminate approximately 15-25% of buyers, implying a 25-35% reduction in peak housing production. This would likely be exacerbated by declining consumer confidence, investor demand falling below historical norms and the risk of a softening economy (all of which seem present today), suggesting at least a further 10% drop."

Bringing this back to the point I was making in Part 1, pensions (along with insurance companies and hedge funds) are one of the largest buyers of of MBS's. Most protect themselves by buying derivatives from each. thereby spreading around the risk but not diminishing it in any way. All evidence points to these MBS not being properly priced or rated for risk. The pension system in America is broken and we all know it. A significant ripple from the RE implosion, even not a direct hit, could easily be enough to push it over the edge.









Historically debt has always been associated with slavery. Peonage took the place of outright slavery in the South after the Civil War in the form of sharecropping. Yet, for some reason, the middle class seems to show absolutely no fear of debt today.

Peonage is a word we should all get more familiar with. It's exactly the term that Paul Krugman used to describe the 2005 Bankruptcy Bill.



Increasingly the non-wealthy of this country view borrowing money as a ticket to a better life, despite the fact all evidence points in the other direction.






It appears that once again, people have forgotten the lessons of the past.

Maybe its just me, but I think people should stop thinking of politics in a horizontal, left-to-right spectrum, and should start thinking of politics in a vertical, top-to-bottom spectrum.