17 NOV 2009, Tuesday (Part 4)

1. More from cyclepro.com...mortgage default peaks yet to come:
2. US banks were hit hard by the subprime default meltdown. But an even bigger default opportunity awaits during summer-fall of 2010 and another larger wave in 2011. These are the Option-ARM and Alt-A rate resets. Combined, these are as big (in dollar volume) as subprime was last year. 2009 is simply the mortgage default scenario taking a breather. This is a lull while the news media is scrambling to find evidence of a non-existent recovery. The 2010 and 2011 reset waves should have a much bigger impact on banks than the subprime bomb.
3. The subprime event hit when banks were weak, but not yet crippled. Now many are crippled from it. FDIC bank failures are increasing. As we go through the 2010 wave with option ARM and Alt-A resets the banks will be hit while they are weak and undercapitalized. With almost no time to recover, the 2011 wave will hit and an even weaker banking system will be hit harder yet. It could result in a knockout. The Alt-A mortgage holders may not be as weak as sub-prime, but the option ARMs are just as weak. It does not matter, the dollar amount of these mortgages are similar to subprime in overall magnitude and much larger on a per-mortgage basis.
4. If residential mortgage defaults were not potentially damaging enough, there is also the commerical real estate loan defaults looming large. By analogy, the Option-ARM/Alt-A events are like large waves on an open sea -- the commercial event is like a rogue swell that is substantially larger than the two residential events. However, we can see and forecast the timing for the residential events, the commercial event is a little more difficult, and like a rogue wave, it can happen at any time and last for quite a while. Already, the water level is rising, suggesting the swell may be entering the bay.
5. Also using the same analogy, a wave that occurs at the same time as a swell intensifies the height of that wave. As such, if the larger commercial event occurs in tandem with the residential events, the impact to the US banking system is likely to be dramatically amplified. If you have ever been to the ocean and tried to stop a wave, you know it is a futile exercise.
6. Folks, this is scary stuff!
7. This timeframe could shift outward if the Fed pardons defaulting mortgage holders or forces banks to provide more leniency against formal foreclosure. But that will also undermine bank profits (or magnify losses) and merely postpone systemic breakdown. I am not saying the entire financial system will disintegrate, but it is going to lose a few apendages, and that will certainly be painful.
8. The budget deficit and other Fed bailout strategies may stoke nasty and threatening inflationary storm clouds on the horizon, but the deflationary threat here and now is stronger well into 2012 and the shrapnel cleanup period that immediately follows.
9. 2012 will plumb the depths of deflation (likely a full blown depression!) and then slowly transition into a nasty stagflationary era. Sometime well after 2012 is when I think the inflationary pressure will have its first chance of manifesting into real substance. If I am correct, around 2016-2017 is the timeframe when inflation should be at its maximum bloom.
10. It will be up to the Fed at that time to see if they can mop up to keep inflation at bay. It is one thing to drop dollar-bombs from a helicopter, it is an entirely different matter to recollect them afterwards. More of a classic view, inflation cannot occur as long as unemployment is high. The Fed can monitize debt, bailout Wall Street, and Obama can run higher budget deficits... these events do not cause inflation unless Main Street has the cash with which to spend and is comfortable doing so. As long as the blizzard of Bernanke Dollars remains isolated to Wall Street and DC, there will be no inflation... and the government spending $400 on hammers or toilet seats does not count... inflation requires happily employed consumers to spend money.
11. August, 2011 is the last and largest major reset peak for residential Option-ARMs and Alt-A's so formal foreclosures should occur about 6-9 months following. By spring, 2012 the worst of the residential reset storm passes. This cleanup, however, will probably have to work itself out on its own because the Feds stimulus gun will probably be out of bullets by then. Americans are likely to be financially exhausted and too fearful of spending money on anything they don't have an immediate need for. There is likely to be a rather long stretch of survivalism that dampens consumer spending.
12. It is very, very difficult for me to even consider inflation at this time while all of these heavy and vulnerable mortgage rate resets remain queued up to execute. You can mark it on your calendar because, baring major Fed intervention, it's gonna happen.
13. Real estate investors may have to wait until 2012 for the opportunity of a lifetime to pick up obscene bargains for pennies. But to do so you will have to have the cash. I have no doubt that an RTC-like agency will be created by then to provide home buyers with terrific foreclosure bargains and excellent new mortgage terms, which essentially means 20% down and very low fixed rates for 15 or 30 year terms. Between now and then, the only viable residential real estate opportunity for anxious home buyers that I can see is with assumable FHA mortgages that already have low fixed rates.