ARM Resets: Clear and Present Danger to Global Financial Markets

``The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved." Ludwig von Mises Human Action

Now as we have earlier noted, we believe that the credit markets will continue to reflect pressures from the persisting angst over the losses of illiquid structured finance/derivatives products which includes packages of subprime instruments now spilling over to the rest of the global financial markets.

Even high quality AAA instruments have now been marked down! According to one of our favorite author, Mr. John Maudlin (emphasis mine), ``Some BBB tranches of subprime paper are down by 60%. That is not surprising, given the quality of the loans that were made. What is very disturbing to investors is to watch what they thought was AAA credit already marked down by 10% or more. Some AA credits are down by as much as 25%. If you bought recent A rated mortgage paper you could be down by over 50%! That is ugly.”

So what was initially thought to be an insulated or “contained” event seems to be spreading towards the credit markets in general. As a result, rates of junk bonds, commercial real estate loans, and leveraged buyout financing have all tightened up. And tightening up means fewer activities or diminishing access to funding.

According to Mark Larson of Moneyandmarkets.com (highlights mine), ``As a result, we've seen activity in these markets drop dramatically. Compared to June, the total amount of corporate debt issued in July plunged 66%. The amount of sold junk bonds plummeted by a shocking 89%. And those Collateralized Debt Obligations (CDOs) that used to be so popular? JPMorgan Chase recently said sales of CDOs sank to just $9.1 billion in July from $43 billion in June.” For this week junk bond issuances have totally evaporated!

If mergers and acquisitions, corporate share buybacks and private equity deals had been previously the key drivers for the US equity markets then the sudden contraction of liquidity or access to funding combined with rising risk aversion by investors could have possibly resulted to a credit squeeze for the global financial markets addicted to leverage.

Quoting at length Mr. Doug Noland of the Credit Bubble Bulletin who aptly describes the present conditions (highlights mine),

``While the subprime implosion was a major marketplace development, in reality only a small segment of the mortgage marketplace was actually impacted by significantly tighter Credit conditions. Today, we are in the throes of a dramatic, broad-based and momentous tightening of mortgage Credit. Importantly, key players and sectors throughout the mortgage risk intermediation process are increasingly impaired and now in full retreat. This includes entities such the mortgage insurers, MGIC’s and Radian’s faltering C-BASS securitization unit, REITs such as failed American Home Mortgage and others, hedge funds such those that failed at Bears Stearns and many more, the broker/dealer community and the mortgage derivatives market generally. There is also the issue of exposed mutual funds, money market funds, pension funds and the banking system in general. Just like NASDAQ went to unimaginable extremes than then doubled during the final “blow-off” – total mortgage Credit doubled subsequent to the Greenspan Fed’s reckless post-tech Bubble “reflation.” Mortgage exposure now permeates the (global) system and is highly susceptible to “Ponzi Finance” dynamics.

``The process of transforming risky mortgage loans into coveted perceived safe and liquid (“money”-like) Credit instruments has broken down on several fronts. Not only is the intermediation community impaired, marketplace confidence and trust in the quality, safety, and liquidity of mortgage (and mortgage-related) securities is being shattered. There are apparently serious problems developing throughout the massive marketplace for (“repo”) financing MBS. And it is precisely the market for financing the top-rated mortgage securitizations – where the perceived risk was minimal – where I suspect the greatest abuses of leverage occurred. The marketplace is now experiencing forced de-leveraging and a liquidity Dislocation - with major systemic ramifications.”

If the impairment proves to be systemic as Mr. Noland avers, then the likelihood is that we could be witnessing more downside volatilities for the financial markets in general. A disadvantage which used to be a widely touted advantage is that as risk instruments got to be widely distributed (spread risks), however, attempts to identify areas of concern has now become opaque even to regulators.

At present the financial markets could be at a denial stage, where the bulls will fight with its fullest intensity to restore or recapture its lost ground. If fundamental problems remain unresolved, the bulls will then likely encounter repeated failed attempts. This essentially leads into fear and desperation and eventually to panic and capitulation.

How good the chances of a recovery?

For Mr. William Gross, the Warren Buffett of bonds, Managing Director for PIMCO, it looks like this would be a protracted attrition like engagement. He says which we quote (emphasis mine), ``The right places to look for contagion are therefore not in the white-washed Bear Stearns hedge funds, but in the subprime resets to come and the ultimate effect they will have on the prices of homes – the collateral that’s so critical in this asset-backed, and therefore interest-sensitive financed-based economy of 2007 and beyond.”

Figure 4: Mortgage Resets.com: ARM Resets as of January 2007

Those who bought into the peak of the US real estate cycle using teaser rates will end up paying amortizations of about 30% or more as rates adjust to reflect on their contracts (reset for every six months for 28 years after two years of low introductory rates), where some homeowners may be unable to cope with the higher payments (whose original intent was to earn by flipping “short-term” trading houses!).

With the present tightening trends in the lending standards by the surviving institutions and insufficient home equity shares as an offshoot to the declining real estate values, refinancing becomes less of an option for some homeowners while the threat of foreclosure looms.

Remember these household mortgages have been securitized, packaged and repackaged into different forms of highly levered instruments alongside other classes of debts, received improvised ratings from credit agencies as a consequence to the financial alchemy and sold to investors worldwide.

Now as foreclosures mount, investors or institutions holding on to these papers have been feeling the heat of the losses. Many of them will be forced to hold houses which they cannot liquidate in a market short of buyers. Credit lines to institutions with significant exposures are then cut and/or portfolio holdings significantly re-rated. Such losses subsequently eat up on their capital, which leads to their insolvency. Some of them go bankrupt; the others sell on the remaining liquid assets to settle on their outstanding liabilities and keep the company afloat. The general decline in collateral values (real estate, credit instruments and equities) essentially diminishes the ability to intermediate financing which then becomes a systemic risk.

If the credit markets today are feeling the unintended effects of $300 billion worth of resets in 2006 then we should expect more jitters to hit the credit markets as a tidal wave of more than $2 trillion of these loans (see Figure 4) or about a quarter of all mortgage loans outstanding are undergoing or will come up for interest rate adjustment in 2007 to 2008, according to mortgageresets.com.

For some, this imploding credit bubble is seen to have a potential widespread impact. Bear Stearns Chief Financial Officer Sam Molinaro was quoted by Reuters on Friday saying that ``Bond market turmoil sending investors fleeing from risk may be a worse predicament (highlight mine) than the 1980s stock market fall and Internet bubble burst.”

``These times are pretty significant in the fixed income market," Molinaro said on a conference call with analysts. "It's as been as bad as I've seen it in 22 years. The fixed income market environment we've seen in the last eight weeks has been pretty extreme."