August 18, 2007

Financial analysts should have seen the subprime bomb ticking

In fact, some did:
“All of the old-timers knew that subprime mortgages were what we called neutron loans — they killed the people and left the houses,” said Louis S. Barnes, 58, a partner at Boulder West, a mortgage banking firm in Lafayette, Colo. “The deals made in 2005 and 2006 were going to run into trouble because the credit pendulum at the time was stuck at easy.”

“I’m one guy in a research department, but many people in our mortgage team have been suggesting that there was froth within the market,” said Jack Malvey, the chief global fixed income strategist for Lehman Brothers. “This has really been progressing for quite some time.” …

“We’ve contended for a while that there was an issue in subprime debt,” said Neal Shear, global head of trading at Morgan Stanley. “A year ago, we were aware that delinquencies were going to rise.”

Meanwhile, since everybody who has followed this issue knows that the incestuous action of ratings agencies like Moody’s, touting subprime derivatives on which they stood to profit, is a fair part of the problem, the European Union is planning to investigate possible conflicts of interest. Where’s the SEC, on our side of the pond?

And, the anti-Cassandras also bear blame for being in denial still, primarily through their claim that this is a just a problem with subprime mortgages.

No, it also has affected a number of Alt-A mortgages, the next class above subprimes. Therefore, it has affected more collateralized debt obligations. It’s also caused other classes of mortgage to hike their interest rates.

And, with the peak in number of adjustable rate mortgages due to reset nearly a year off, we’re still not at the bottom of this.

Wal-Mart slumps; leading economic indicator of rocky times ahead?

Decades ago, General Motors’ Charlie Wilson said that what’s good for the country is good for General Motors, and vice versa.

No Sam Walton never made such a claim for Wal-Mart, nor has current CEO Lee Scott. Nonetheless, whether defending Wal-Mart’s pay scale or the “Wal-Martizing” of many small towns, there’s been plenty of economists who have, in essence, been ready to make that claim on behalf of the retailing behemoth.

Well, the flip side of that would be that what isn’t good for Wal-Mart isn’t good for the country. So, if Friday’s report on Wal-Mart sales means anything, it reinforces the likelihood of a recession, in my mind. Home Depot also reported problems, but its sales have been limping for several months. The Wal-Mart news is new and fresh:
Economists said the sluggish performance of the chains — Wal-Mart missed its profit forecast and Home Depot’s earnings dropped — could signal broader troubles in the economy.
“It’s a red flag,” said Jay Bryson, global economist at Wachovia. “If consumer spending starts to weaken, the overall outlook for economic growth will diminish.”
That, Wal-Mart executives said, is precisely what has begun to happen in its 4,000 United States stores over the last three months — even after the chain cut prices on 16,000 products this summer.
“Many customers are running out of money at the end of the month,” said H. Lee Scott Jr., the chief executive of Wal-Mart.

Home Depot started slumping some time back, once adjusted-rate mortgages began to rise, and its fortunes are more narrowly tied to housing. But, Wal-Mart’s problems would seem to reflect broader economic problems, in some cases, and broader economic worries about the future by people who have not been affected.

It is not horrible economic news if a company misses an earnings-per-share forecast by a penny. But, to be 3 cents off is a little more serious. I’m sure WallyWorld is already adjusting its third-quarter forecast. But, unless it outperforms that, rather than just hitting it on the mark, the Street might not be too impressed.

Plus, don’t forget those price cuts on 16,000 items. That forced dozens if not hundreds of Wal-Mart suppliers to do their own adjusting. And, if their products still aren’t selling well, some of them could be looking at layoffs in the future.

That makes it official in my mind; I’ll raise my 12-month recession odds from 2-5 to 1-2.

August 17, 2007

Iraq insurgents continue to think a step ahead of the American military

The latest twist? House bombs.
The 2nd Brigade, 3rd Infantry Division calls itself the "Send Me" brigade, and on Saturday, its soldiers were quick to send themselves to find the man who shot Pfc. William L. Edwards, a wide-eyed 23-year-old from Houston. They quickly identified the house where they believed the assailant was hiding and moved in, just as the sniper knew they would.

Inside the house, one soldier stepped on a pressure plate, detonating an estimated 30 pounds of explosives hidden under a stairwell. In an instant, four troops were killed; four others were injured. Edwards died later in the hospital. The sniper escaped.

The attack in Arab Jabour, southeast of Baghdad, was particularly savage, predicated on knowledge of the soldiers' sense of duty to a fallen comrade. Military commanders say the number of similar incidents — those in which soldiers are lured into a house rigged to explode — has risen dramatically across Iraq in recent months.

Especially for Marines, who are fanatic to the point of myth-making about refusing to leave a fallen comrade behind, these house bombs have to be like baited traps. The story notes this is all part of a pattern of emerging complexity in attacks, such as combining roadway IEDs with post-explosion ambushes, usually involving more insurgents at one site than previously was the case.

As for our top military PR? It’s a “spin” issue more than something to seriously address right now:
Officials attribute the increasingly sophisticated attacks to desperation on the insurgents' part after troops became too successful at finding roadside bombs and other explosives.

“It’s a clear sign that they could not get to us by other means, and that's a good sign,” said Lt. Col. Michael Donnelly, a spokesman for the American operation in northern Iraq, describing the pattern of house bombs in that area. “Obviously we're countering the improvised explosive devices, and force on force, they know that they can't fight us.”

This lying toady refuses to, or has orders to refuse to, credit insurgents for ever-rising tactical and technological ingenuity, even though he describes another example of such ingenuity in his very next breath:
But ambushes and rigged houses can cause many more casualties than smaller improvised explosive devices, which rarely kill more than one or two people at a time. Increasingly, Donnelly said, insurgents are creating a “daisy chain” of house bombs, in which an initial explosion can trigger blasts up and down a block.

Donnelly claims that the bombs leave tell-tale signs. Right.

If that really were the case all the time, why would the bombs be being used more and more? And, if it is starting to become true, the insurgency is probably already moving on to its next set of tactics.

In fact, Donnelly admits that, while keeping his BushCo happy face painted on.
Donnelly said that as U.S. troops become more skilled in identifying house bombs, al-Qaeda in Iraq will probably develop even more advanced techniques for attacking soldiers. But the American military’s counterinsurgency abilities, assisted by increased cooperation from Iraqi citizens, would prevail, he said.

Sure. Black is white, and the Red Queen loves Alice to death.

Smile at the airport, or the TSA will arrest you?

No, I’m not kidding:
“Specially trained security personnel” will be watching passengers for “micro-expressions” that will reveal treacherous agendas and insidious intentions at airports around the country. These agents, who may literally hold your fate in their hands have been given a lofty, Orwellian name: “Behavior Detection Officers.”

So, you’re supposed to smile while being told your flight has been cancelled? You’re supposed to smile while standing in an hour-long line trying to book a replacement flight? You’re supposed to smile while your plane sits on the tarmac, running late, and leaving you wondering if you’ll arrive at the next airport in time to make your second flight connection?

Here’s how a scenario could play out:
Apparently, these Behavior Detection Officers work in pairs. One scenario is that an officer might move in to “help” a passenger retrieve their belongings after they’ve been screened. And then the officer will ask where the passenger is headed. If the passenger’s reaction sets off alarm bells in the officer’s well-trained mind, another officer will move in and detain them. Let’s be really clear here. If a stranger moved in on me like that, I’d tell that person to go to hell, throw in a few other expletives for good measure and probably give them the finger as I stomped off. Of course, I wouldn’t be stomping very far.

Orwellian, indeed.

What next? Do we move beyond Orwell to Huxley and “Brave New World,” with the airport thought police passing out mind-control happy pills? Free Prozac with your in-flight pretzels and peanuts?

August 16, 2007

Tripartite Iraq? Bipartite? Or still unified, with new boundaries?

Abu Aardvark’s excellent article on what appears to be the final collapse of Sunni participation in the government of Iraq got me to thinking about what the longer-term results might be.

I know that a number of pundits, some historians and even a few American politicians have bandied about the idea of a tripartite Iraq, on Shi’a/Sunni Kurd lines. It’s usually presented as if this were the only realistic option (by politicians and pundits), or the most likely actual option (by historians).

In any case, a tripartite Iraq vs. current Iraq are presented as the only two outcomes, usually. But, the Sufi philosopher Idries Shah once said, “There are never just two sides to any situation,” and that is the case here.

For example, what if Sunnis, Shi’as, Iranians and Turks combine to do a partition of Poland move on the Kurdish state? Then, we’re down to a bipartite Iraq.

Or, what if Kurds and Shia’s stay together, with a Sunni area making a formal declaration of independence? Then we have a bipartite Iraq.

Or, what if the Saudis get so frustrated they issue an invitation to the Sunni area to let itself be taken under the Saudi wing? To appease Bush, they could make this as innocuous as possible, but then complete the annexation during the heat of the presidential election season or just after, confident they can then get away with it. Then, we have a still unified, but shrunken, Iraq, with an enlarged Saudia Arabia now having even more of both oil reserves and Falafist fundamentalists in its midst.

Hurricanes are incredible things — here’s an analogy

Looking at five-day forecasts of the inexorable intensification, and projected storm track, of a major hurricane like Dean — especially in light of Hurricane Katrina and the possibility that Dean will shoot the Cuba-Yucatan gap into the Gulf of Mexico with only moderate landfall diminution — leads me to an analogy.

When you were a kid, especially if you were a boy, did you ever hit a baseball in a street, or an open field next to houses, and watch its inexorable arc toward somebody’s window? Or did you throw a football indoors, hit a living room lamp or vase, and watch it tumble toward the floor in what seemed like slow motion?

Or, as an adult, have you accidentally bumped a glass off the counter and seen it tumble toward the inevitable crash on the linoleum-over-concrete kitchen floor, in what seemed like a freeze-frame progression?

In all those cases, you and I knew what was going to happen, but were powerless to change the trajectory of the baseball, lamp, or glass.

Well, that’s what a big hurricane is like. You have a pretty good idea where it’s going to be two-three days from now, and a decent probabilistic estimate of where it’s going to be four-five days down the road, but there ain’t a damn thing you can do about it (other than evacuate, of course).

Why Bernanke isn’t guaranteed to cut Fed funds rate to bail out housing market

The Federal Reserve chief still has inflation fears to worry about.

As the chart below shows, oranges, eggs, frozen juice, milk and apples — five of the most common family food purchases — are the five most inflated foodstuffs over the past year, with prices on all inflating at least 10 percent.

While the government leaves food, and energy, out of its core inflation forecasts due to “volatility” concerns, a 12-month time span is enough time for any “volatility” to drop out. This is real inflation.

And, W., like his daddy, just doesn’t seem to “get it” about inflation:
Meeting with economic writers last week, President Bush dismissed several polls that show Americans are down on the economy. He expressed surprise that inflation is one of the stated concerns.

“They cite inflation?” Bush asked, adding that, “I happen to believe the war has clouded a lot of people’s sense of optimism.”

Food prices and the folly of corn-based ethanol production are the main drivers of food inflation.

August 15, 2007

Wall Street: Giant Ponzi scheme? Giant poker game?

The combination of subprime mortgages, other mortgages and other items of debt into the complex collateralized debt obligations and credit default swaps invite both these comparisons, as Michael Panzner makes clear.

In essence, these forms of smashed, blended debt, sliced into tranches, are a Ponzi scheme because they have been relying on more and more people buying houses, buying bigger houses, refinancing for remodels and so forth.

These debt forms are like a giant poker game because the main bettors have been betting against the odds, especially the odds of subprime borrowers defaulting. (At the same time, as part of the incestuousness of these arrangements, creators of this debt have been depending on ratings agencies like Moody’s both to give the best possible rating on CDOs and to talk up the financial market in general, and housing market in particular, at the same time.

From Mish (whose blog on economic analysis is a highly recommended read), here’s what I mean by incestuousness:
Moody’s: “Moody’s has no obligation to perform, and does not perform, due diligence.”

S&P: “Any user of the information contained herein should not rely on any credit rating or other opinion contained herein in making any investment decision.”

Because of that bottom-line fact, Mish has a boatload of questions:
* How many billions of dollars will be lost because of absurd pricing models?
• How can it be that an entire system of investment decisions are based on ratings that the ratings companies tell everyone not to use for investment purposes?
• Were the ratings companies grossly incompetent or just foolish?
• Will the disclaimers of the ratings companies hold up in court?
• How long will it be before there be a court test of those disclaimers?
• Why has only a minuscule portion of subprime debt (2.1% or $12 billion of a massive $565.3 billion of subprime bonds) downgraded?
• Are the ratings companies under pressure by the banks and/or the Fed to not rerate this debt?
• Why is it that ratings companies are allowed to have outside business relationships with the companies whose debt they rate?
• Did banks realize how absurd those ratings were but look away because of greed and the ease in offloading he debt to pension plans, insurance companies, and hedge funds out of pure greed?
• Heck, did the upper echelons at the ratings companies themselves know their ratings model was flawed and look the other way out of greed?
• How long before there is a government sponsored bailout of this mess? Hint small ones are starting already. See Please - No More Help! for a discussion.
• How long before Bernanke starts cutting rates?
• How high will gold prices rise when Bernanke starts cutting?
Here's the big question: How big will the taxpayer bailout be?

But, Mish’s quote of Moody and S&P hand-washing, bad as it is, still isn’t the full story.

For one thing, these CDOs were backed not with money, but with insurance. And, just like people can “short” a stock, banks and other CDO creators could short their insurance.

Well, what’s happening right now is that a lot of bluffs are being called. Or, on the analogy above, a lot of banks and other lenders are facing the equivalent of margin calls. And, a lot of the people whose bluffs are being called are having to reveal they’ve been betting with IOUs or overrun bank drafts. And, unlike monetary deposits, these investments aren’t protected, even if made by banks. Plus, as Panzner points out, many of these types of loans were made by nonbanking entities.

Already three years ago, Warren Buffet was calling derivatives “financial weapons of mass destruction.” But Greenspan kept encouraging banks and other lending agencies to keep churning them out. Combine that with the Fed loosening the fractional money reserve requirement of banks, and you have the perfect storm.

This is why the Fed and the European Central Bank are injecting money into the system through buybacks. Banks already are thin enough on reserves that their power to fluff more credit into the system is running low. But, the Fed is actually using credit, not money, for these buybacks; banks, then, with their small reserve margins, can inflate this credit.

Stoneleigh at The Oil Drum goes into even more depth (warning, it’s about 5,000 words); if you still don’t understand too much about how much more than a “housing bubble” the subprime crisis is, and have a bit of reading time, I strongly recommend it.

One final note; our, and the world’s, Great Depression wasn’t caused by hyperinflation anywhere. Instead, the Roaring ’20s were a period of high credit inflation.

I think I’ve writeen enough on this to give you the general idea.

Money markets latest to catch the subprime bug

Even though money market accounts are supposed to be “safe” investments, it looks like at least one got tempted to dip its hand into the subprime cookie jar:
Sentinel Management Group asked the Commodity Futures Trading Commission to help it stop Sentinel's investors from withdrawing their money, according to CNBC. Sentinel doesn't manage money funds for retail investors. Rather, it helps commodity trading firms and hedge funds invest the cash they accumulate in short-term, interest-bearing vehicles, according to The Wall Street Journal.

Money funds, similarly, invest in short-term, high-quality obligations called commercial paper. But in an effort to gain a competitive edge, some companies that run the funds stretch a little further out on the risk spectrum. Though it's not clear yet what securities Sentinel holds, there has been speculation in the market in recent days that some money funds owned short-term paper — including mortgage-backed securities — issued by banks with exposure to problems in the subprime-mortgage market.

The problem is twofold. One, Sentinel doesn’t have the type of liquid capital to pay off many investors. Two, the commodities commission said it has no power to do what Sentinel wants.

And, the problem has its own shockwaves
Sentinel is not a mutual fund company, and should not be confused with Sentinel Funds of Vermont, which today posted at its website that it is “in no way affiliated with the Sentinel Management Group (of Illinois).” …

Spokesmen for Fidelity Investments, Vanguard Group and T. Rowe Price said their firms have no significant exposure to commercial paper backed by subprime mortgages.

If other money-market funds are exposed, watch out. Calls on money could become stampedes, which will only further tighten business liquidity and cut the availability of business credit.

Housing woes continue

Year-to-year sales off 11 percent for second quarter, despite price drop of 1.5 percent. In Southern California, sales are their worst since 1995.

My latest recession odds are 2-5 within a year and 5-4 in favor by the start of 2009.

Those 110,000 U.S. weapons missing from Iraq?

A notorious Russian arms dealer is behind those missing AK-47s:
Consider the case of one particular bad guy, Viktor Bout — a stout, canny Russian air transporter who also happens to be the world's most notorious arms dealer.

When the U.S. government needed to fly four planeloads of seized weapons from an American base in Bosnia to Iraqi security forces in Baghdad in August 2004, they used a Moldovan air cargo firm tied to Bout's aviation empire. The problem is that the planes apparently never arrived.

The missing Bosnian weapons could simply be a paperwork problem (and it's not certain that they are among the missing weapons the GAO discovered; they may be an additional loss). But Bout's involvement raises bleak possibilities … that the arms were diverted to another country or to Iraqi insurgents killing American troops.

For more than a decade before he landed on U.S. payrolls, Bout's air cargo operations delivered tons of contraband weapons … to some of the world's most dangerous misfits.

He stoked wars across Africa, supplying Charles Taylor, the deposed Liberian president now on trial for war crimes. He ferried $50 million in guns and other cargo, and he even sold air freighters to the Taliban. …

Bout also has a well-known record for working both sides of the fence. His planes armed both the Angolan government in Africa and rebel forces arrayed against it. He cut weapons deals with Afghanistan's Northern Alliance government before betraying it by arming the Taliban.

One thing about the Bout affair is certain. As of mid-2006, his firms were no longer flying for the U.S. in Iraq. But now he poses a new problem: "blowback," the blunt term espionage writers like to use for the deadly consequences of poor spycraft.

When the U.S. turned to the Bout network to mount its Iraq supply flights, it was already clear that Bout's network had aided the Taliban's extremist mullahs. How could the U.S. be absolutely certain he wouldn't fly for our enemies once he had left the payroll?

We couldn't and, apparently, he is.

Last summer, a jumbo Il-76 flying the Khazakh flag swooped down to a landing in Mogadishu to unload arms for radical Islamic leaders who briefly seized control of Somalia. It was one of Bout's planes, concluded U.S. military intelligence officials.

With arms-dealer friends like this, who needs enemies, eh?

August 14, 2007

More FISA follies

Crazy Uncle Larry’s Lancaster ISD teacher bribery plan

So, Lancaster (Texas) ISD Superintendent Larry Lewis wants to bribe reward teachers for perfect teaching attendance by giving them shiny Cadillac CTS cars?

Let’s say 100 teachers meet this goal.

Let’s say the CTS is the promised prize.

Let’s price a CTS at 40 grand.

Let me see — $40,000 times 100 teachers?

That’s $4 million freaking semollians!

And this from a school district with less than half a million in reserve funds.

In other words, the ONLY way Larry could pay for this would be to hike property taxes well past the rollback rate. And, I’m sure Lancaster voters would swat that idea down by a bigger margin than they did with Larry’s last bond issue. They surely will not vote to give teachers something extra for what is expected of people at work.

First, Larry apparently can’t do math on a 30-day advance notice calculation on his calendar to get a four-day school week approved by the state.

Now, he can’t do math on district funds and budgeting.

Your friendly, next door NSA


Who could oppose giving these folks a little bit more, or a whole lot more, FISA powers?

THIS is why “free trade” with China is a bum steer

Oh, sure, all the Democratic presidential candidates will bleat like angry sheep right now about slaves in Chinese factories, but what will they do about this:
China is still freeing people including children forced to work as slaves in illegal brick factories, two months after the scandal involving the brick yards was exposed, officials said Monday.

The scandal erupted in early June after Chinese media reported that children as young as 8 were abducted or recruited from bus and train stations with false promises of well-paying jobs and sold to kilns for about $65.

after Jan. 20, 2009?

August 13, 2007

Housing bubble-caused credit problems too big for feds to fix?

That’s the take from Bill Fleckenstein First, he takes on the hypocrisy of Wall Street:
The whole notion that Fannie (Mae) and Freddie (Mac) should bail out the mortgage sector — because of foolish behavior on the part of (a) the financial institutions that lent money to folks who could never pay it back if home prices didn't rise 6% annually and (b) the folks who bought a house they couldn't afford, because it just had to go up in value — is anathema to capitalism.

Now, here’s the latest wrinkle that could further dry up credit:
Turning to losses abroad — caused by investments here — when the German bank IKB imploded two weeks ago, it was revealed that they had about $17 billion in subprime exposure and had lost $3 billion. IKB held these structured-credit assets in a conduit, which is a version of a special-purpose entity that banks use to own structured credit. More importantly, conduits are funded in the commercial-paper market. So, in addition to credit risk, it sounds to me like they are borrowing short and lending long, which is always dangerous when your assets are illiquid.

Soon, most conduits will be updating their net asset values and rolling their commercial paper. In addition to those two potential data points, it's important to understand that in all likelihood, IKB won't be the last entity in trouble. As my "lord of the dark matter" friend notes, most of these European banks all pursued similar strategies. And I would say that if European banks were involved, U.S. banks probably were, too. …

The moral of the story? As we get further down the road, I think we'll discover that some money-market funds owned commercial paper issued by a conduit whose assets may not be up to snuff. So folks with a lot of assets in money-market funds might want to double-check that they know what's in them.

Bottom line: The upcoming weeks should be pregnant with indications of more trouble throughout the whole financial-engineering world. More than a few outfits may discover that the triple-A pieces of paper they thought were worth 100 cents on the dollar are worth only, say, something in the 70s. That will make for a lot of heartache.

In other words, we’ve probably just seen the start of problems. By the end of this month, the one piece of good news is that we should know just how bad the problem is.

August 12, 2007

Just how worn out is the Army?

It’s pretty bad, according to the Observer:
The anecdotal evidence on the ground confirms what others - prominent among them General Colin Powell, the former US Secretary of State - have been insisting for months now: that the US army is 'about broken'. Only a third of the regular army's brigades now qualify as combat-ready. Officers educated at the elite West Point academy are leaving at a rate not seen in 30 years, with the consequence that the US army has a shortfall of 3,000 commissioned officers - and the problem is expected to worsen.

And it is not only the soldiers that are worn out. The wars in Iraq and Afghanistan have led to the destruction, or wearing out, of 40 per cent of the US army's equipment, totalling at a recent count $212bn (£105bn).

But it is in the soldiers themselves — and in the ordinary stories they tell — that the exhaustion of the US military is most obvious, coming amid warnings that soldiers serving multiple Iraq deployments, now amounting to several years, are 50 per cent more likely than those with one tour to suffer from acute combat stress.

The army's exhaustion is reflected in problems such as the rate of desertion and unauthorised absences — a problem, it was revealed earlier this year, that had increased threefold on the period before the war in Afghanistan and had resulted in thousands of negative discharges.

This is why Lt. Gen. Lute has brought up the idea of a draft. Of course, as Vietnam showed, if you want a desertion problem, all you have to do is draft people to fight an unpopular war.

More bad housing news — defaults getting repoed faster than they can be resold

The result will likely be a downward push in the price of existing homes:
Major lenders are repossessing homes in Southern California much faster than they can sell them, a development that could set off a downward spiral of price cuts and more foreclosures.

At some point — maybe this fall, maybe in 2008 — the lenders’ inventories will grow so large that they will have no choice but to start aggressively cutting prices, many agents and analysts predict.

That, in turn, will put more pressure on individual sellers, who will have to reduce their own prices if they want to find a buyer.

As values fall, more people could lose their homes, which would swell the lenders’ inventories anew.

One thing the LAT story misses is that, if house prices slide enough, all of a sudden, local school districts, cities and counties face budget crunches. That’s the story that hasn’t yet been covered; at some point, local elected officials will have to start making some tough budget decisions.

Aren’t buyers somewhat to blame for the housing bubble, too?

Well, yes, in some cases, though most of the writing we’ve seen on the subject either commiserates with them or is straight financial analysis of what this means for the economy.

But, plenty of people who bought homes on 2/28 mortgages, other interest-only mortgages negative amortization mortgages, or other creative financing, were not working poor families buying their first home with a subprime mortgage they didn’t understand fully.

Instead, they —

A: Knew exactly what mortgage they had and what risks it might entail, and/or

B: Were buying second or third homes as either rental or resale investments, and therefore should be no more commiserated with than people who similarly overextended themselves in the stock market, and/or

C. Were solidly middle-class to somewhat upper middle-class couples trying not just to keep up with the Joneses but be pacesetters buy buying more house than they really needed, except for show; therefore

D: They’re smart enough, or were investing enough money to pay a lawyer to be “smart enough” for them.

In essence, this is what much of the housing bubble derives from — a mortgage world treated by brokers just like a stock market.

Read on to get more of the picture:
When Linda Martin refinanced the mortgages on three different houses nearly three years ago, she thought the lower monthly payments would help her save more money for retirement.

Instead, the Lakewood, Colo. skin-care specialist is sinking in financial quicksand amid a widening mortgage morass that's pulling down home prices and threatening to drag the U.S. economy into a recession.

“I’m hanging on by a thread, not knowing whether I am going to be living in a car in six months,” said Martin, who declined to reveal her age.

Martin is among the hundreds of thousands of borrowers saddled with “option” adjustable rate mortgages, risky loans that dangled bargain-basement introductory payments and also let borrowers defer a portion of interest payments until later years.

But, the piper is now demanding to be paid.
Here’s why: When borrowers pay the minimum monthly amount on an option-ARM, they aren't covering the amount of interest accruing on the loan. To compensate, lenders add the amount of unpaid interest to the mortgage's outstanding debt.

Option-ARMs also allow for a higher monthly payment to reduce the loan's principal, but most borrowers only make the minimum installment. At some lenders, 80 to 90 percent of the option-ARM borrowers are paying the minimum amount.

So, a homeowner who originally borrowed $250,000 under an option-ARM could end up owing an additional $5,000 to $10,000 after making the minimum monthly payment for a year, depending on the terms. …

Martin doesn't think she is upside down on her loans yet, but knows she is getting uncomfortably close as home prices around her neighborhood continue to sag.

When Martin refinanced the mortgages on her home and two rental properties in October 2004, she said she owed a total of $735,000. The combined debt now stands at $777,000 and is growing by more than $2,000 each month.

Martin says she would have never refinanced if a mortgage broker hadn't misled her about how the new loans worked - a frequent complaint among borrowers with option-ARMs.

This gets to point D above. If you’re buying two additional houses for rental property, and you aren’t 110 percent sure about mortgage details, why in the hell aren’t you hiring either a lawyer or a financial analyst or accountant?

Anyway, getting to the economic analysis after all, here’s more of just how bad the problem is.
Last year, negative amortization loans accounted for 9.9 percent, or $350 billion, of all mortgages nationwide, up from just 0.4 percent as recently as 2003, according to LoanPerformance.

The mortgages were particularly popular in high-priced real estate markets like California or areas like Nevada, Arizona and Florida, where speculators were buying homes as investments instead of places to live.

Option-ARMs accounted for nearly 22 percent of the mortgages made in California during 2006, according to LoanPerformance. Other hot spots included: Nevada (15 percent), Hawaii (13.3 percent), Florida (12.2 percent), Washington (10.9 percent) and Arizona (10.6 percent).

If many of those loans go bad, major option-ARM lenders will likely be forced to erase some of the profits that they have already booked from the exotic mortgages. Under an accrual accounting method allowed by regulators, option-ARM lenders routinely record the uncollected interest as income even though the money may never be paid.

This phantom income has swelled along with the use of option-ARMs. For instance, Washington Mutual recognized $706 million in uncollected interest from negative amortization loans during the first half of this year, a 61 percent increase from the same time last year.

Investors already appear to be seeking shelter from the possible financial storm ahead.

Washington Mutual's stock price has dropped by 21 percent so far this year while Countrywide's shares have shed 34 percent. Another major option-ARM lender, IndyMac Bancorp Inc., has been even harder hit, with its stock plunging by 55 percent since the end of last year. The sharp downturn in those three stocks alone have wiped out a combined $24 billion in shareholder wealth.

No, I don’t feel sorry for mortgage brokers engaging in technically legal but duplicitous accounting. And, I hope that Congress does NOT consider an equivalent of the 1980s S&L bailout should things get that bad.