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Are You Ready for Round II of the Mortgage Meltdown?

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If you've adopted the notion that the worst of the financial crisis is behind us, please think again.

I consider it the height of irony that a sobering wake-up call should come from a ratings agency. After all, I lambasted these agencies repeatedly on my CAPS blog a year ago for failing to warn investors about the risks inherent in mortgage-backed securities and other derivative instruments. Perhaps cognizant of the need to restore credibility, Fitch Ratings delivered a report last Tuesday that -- in the context of the ongoing equity rally -- may represent an uncharacteristically proactive warning to investors about the challenges ahead. If these projections prove correct, then looming mortgage defaults risk sweeping ramifications for the financial system.

Looking at subprime, jumbo, and low-doc home loans that were bundled into mortgage-backed securities between 2005 and 2007, the report focuses on the subset of those loans that have been renegotiated since their origination. While excluding loans backed by Fannie Mae (NYSE: FNM  ) and Freddie Mac (NYSE: FRE  ) , the report examined mortgages of types that represent about one-fifth of the $10 trillion American mortgage pie. Mortgage servicing firms have ramped-up loan renegotiations, lowering rates or even reducing principal, but are finding many borrowers still walking away from severely devalued properties.

Fitch Ratings projects that a stunning 55% to 65% of those reworked loans will nevertheless reach the 60-day delinquency stage within 12 months of the loan's alteration. For the subprime mortgages in that group, that expected delinquency rate climbs to 65% to 75%! Echoing the concerns of fellow Fool Alyce Lomax, the report points to falling income and rising unemployment as contributing factors. Even Moody's chief economist Mark Zandi, who believes that "the bottom of the housing downturn is within sight," expects a further 11% decline in home prices nationwide.

Pondering the potential consequences
In the scenario implied by this report, however, I believe that both of Zandi's projections would prove overly optimistic. The same conditions seen placing existing loans at risk should also lower the number of able buyers, leading to falling demand and further oversupply concerns. That would significantly prolong the pain for homebuilders like Toll Brothers (NYSE: TOL  ) , and could domino onto the bottom lines of related material makers like USG (NYSE: USG  ) , further challenge related freight volumes for railroads like Norfolk Southern (NYSE: NSC  ) , and so on.

This Fool sees a potential link between the report's release and the horrific performance of mortgage-backed securities (MBS) last Wednesday, which drew plenty of comments from CAPS members. Making matters worse, S&P also warned last Tuesday that it may reduce ratings on large portions of commercial MBS. The reverberations from renewed crisis in mortgage-backed securities would further reduce the flow of credit, lead to another spate of asset write-downs, and ultimately herald the unwelcome return of systemic risk to the national lexicon.

As over-extended borrowers default on increasing numbers of credit cards, auto loans, and student loans, overall loan losses for banks like Citigroup (NYSE: C  ) and Bank of America (NYSE: BAC  ) could mount considerably. I kid you not, Fools. The potential ramifications of this mortgage meltdown scenario are that far-reaching ... and then some.

The last domino to fall
The U.S. Treasury and the Federal Reserve have been crystal clear with their actions to date, so their responses to mortgage defaults of a previously unanticipated scale are fairly predictable. Simply stated, I believe that the Fed will absorb additional distressed debt assets onto its balance sheet, offering more crisp dollars in return. While the TALF program presently reports a loan balance of just $15.4 billion, we may yet discover the full range of motivations for the program's expansion from $200 billion to $1 trillion.

Faced with a growing list of insolvent banks, and a stress test process revealed as a joke, I could see Treasury seeking additional TARP-like funds from Congress, and perhaps advocating yet another stimulus package while finding ways to commit capital alongside the Fed in their well-entrenched strategy of countering the deleveraging process with an ever-increasing supply of fiscal intervention. Given the profound discomfort with the U.S. fiscal response already communicated by foreign holders of U.S. debt, like China, I see a failed fiscal response strategy leading this nation's currency down a road to ruin.  

I truly hope this report is just as mistaken as the ratings agencies were during the lead-up to this crisis in their investment-grade ratings on what proved to be toxic junk. If, however, this report reflects a ratings industry that is grappling with reality in the aftermath of that failure, then the ultimate stress tests may yet lie ahead.

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Fool contributor Christopher Barker thinks derivatives are a dirty word. He can be found blogging actively and acting Foolishly within the CAPS community under the username TMFSinchiruna. He owns no shares in any of the companies mentioned. The Motley Fool's disclosure policy has zero exposure to derivatives.

Read/Post Comments (3) | Recommend This Article (25)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 02, 2009, at 11:05 PM, RWR5438 wrote:

    This beginner investor needs help. Is there a expected timeline on this Round II of the Mortgage meltdown? Should an investor continue to make gains in the market until a certain point? When should be the exit point? And what should an investor move into? Sorry for all the questions.

  • Report this Comment On June 04, 2009, at 10:34 PM, vmh104 wrote:

    RWR5438, That's the million dollar question. Currently people are foreclosing with good mortgages.... but as for the ones with bad mortgages.... here is the old subprime problem

    and here is the up and coming alt-a arm

    You can also check out this video explaining how the alt-a option arm is going to be worse than the sub prime problem:

  • Report this Comment On June 05, 2009, at 6:09 PM, dbbfool63 wrote:

    I guess it's true when they say the really smart people with all the college degree's on their office walls do not have any common sense.

    In 2001, I bought a house in a community of about 700 houses at most and paid just below the so called market value because my Realtor told me how houses were appreciating at a good pace.

    A couple years later, 2003, my father had a stroke and needed someone to live with him, so I decided to sell my house and at least get my money back out of it. What a shock I got, now my Realtor tells me the housing market was getting bad and that in my 700 house addition, there were 132 of them for sell because of bankruptcy's and others who bought a bigger house in a new addition they had built.

    It took 2 1/2 years to sell it while sitting empty loosing my but from high interest payments only to sell it for $8K less than I paid and with the other cost in selling it, I paid all interest the whole time and came out with $2300. from a down payment of $14,600 not including all the fee's associated with buying it.

    The biggest problem I see, is all the banks giving people a loan for a bigger more expensive house while still owing most of a first mortgage on a house they needed to sell. Then turn around and file bankruptcy using loop holes to keep the bigger house and getting out of other major debts and loan companies will still give them more money against the the house they got to keep.

    I could go on and on, but when you look around and see a population of 80K people and there are 200K homes in that same area because builders just keep on building with people buying them, common sense tells me that would leave 120K houses empty and run down.

    Was I the only one who seen this going on from 2000 to 2005 and started praying after that. Detroit should have been an early clue. I don't think they just up and lost half there population and abandon houses in a few months. You sure would think so.

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