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Now Comes the Real Crash

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Here's the good news: The worst of the subprime mortgage carnage is behind us.

Here's the bad news: That was just the tip of the iceberg. There's probably much worse ahead.

Fool retirement guru Robert Brokamp recently sat down with noted value investor (and former Fool writer) Whitney Tilson to talk about his thoughts on the continuing mortgage crisis. In the interview -- which appears in the new issue of the Fool's Rule Your Retirement newsletter, available online at 4 p.m. EDT today -- Tilson talks about where we currently stand in the mortgage crisis.

I thought this was a subprime problem!
It was, at first.

Many subprime mortgages started out with a low "teaser" interest rate that then increased to a market-level subprime rate after a set period of time. When that happened, the payments would go up -- often by a lot -- and the hapless overleveraged borrower would go, "Oh fiddlesticks, I can't afford to pay the mortgage anymore."

(Except that most of them probably didn't say "fiddlesticks." But I digress.)

Tilson notes that the number of loans facing payment shock started climbing in early 2006, reached a very high level in early 2007, and stayed high until about the end of last year, at which point they started falling off sharply. Likewise, the massive wave of defaults and foreclosures triggered by these higher payments is abating. That wave is behind us.

But subprime mortgages weren't the only ones with teaser rates.

Now, it's mostly not a "subprime" problem
The emerging problem is with prime mortgages, those issued to people with good credit. The crash in housing prices has left many of those folks "underwater" -- owing more than their house is now worth. And the crash in the global economy has left many of those folks unemployed -- and many who are still employed are making less money now than they were a year or two ago.

Tilson cites figures that about a quarter of all prime U.S. mortgages are underwater at the moment, and that number is likely to grow if housing prices continue to fall. Despite some beliefs that home prices are bottoming, unemployment is still a big problem -- Deere (NYSE: DE  ) , among others, just announced new rounds of layoffs. And now mortgage interest rates are suddenly rising -- the average 30-year mortgage is up to 5.32% this week, up from 4.91% just last week, according to the most recent Freddie Mac (NYSE: FRE  ) survey.

Nobody knows quite how all these factors will play out, but clearly the potential for a huge wave of defaults in the near future is growing.

What, you thought things were stabilizing?
Tilson recently argued that the appearance of stabilization in the housing market is a "head fake," caused by the usual spring surge in homebuying and a temporary reduction in the inventory of foreclosed homes sitting on the market. The crisis, Tilson says, is actually getting worse.

As Tilson sees it, although the worst of the losses suffered by speculators and subprime borrowers are over, problems with prime loans are just now starting to pick up steam. Many conforming prime loans are owned by Fannie Mae (NYSE: FNM  ) and Freddie Mac. But other mortgages will likely also prove problematic, including home equity lines and prime "jumbo" mortgages, as well as the scarier Alt-A and Option ARM loans.

Eeeek?
Why scarier? According to Tilson, nearly half of Alt-As and over 70% of Option ARMs are underwater. Alt-A resets are just starting to take off -- they won't peak until 2012 or 2013. And Option ARMs don't just reset, they recast -- borrowers go from making just interest payments, in many cases, to making full proper 30-year-amortized mortgage payments. Some could see their monthly payments increase by 60% or more.

And after that, commercial real estate could be the next problem area. That won't just hit the property owners -- REITs like mall giant Simon Property Group (NYSE: SPG  ) and New York-based heavyweight Vornado Realty (NYSE: VNO  ) -- but will also impact regional banks such as Fifth Third (Nasdaq: FITB  ) and Regions Financial (NYSE: RF  ) that have heavy exposure to commercial real estate loans.

Protecting your portfolio
In the Rule Your Retirement interview, Tilson explains how he expects all of this to unfold. He also offers some thoughts on positioning your portfolio in the months and years ahead -- including some ideas that may surprise you.

If you're not a Rule Your Retirement member and you'd like to read the interview, help yourself to a free 30-day trial. Sign-up takes just seconds and there's no obligation to subscribe.

Fool contributor John Rosevear has no position in the companies mentioned. You can try any of our Foolish newsletters free for 30 days. The Motley Fool has a disclosure policy.


Read/Post Comments (12) | Recommend This Article (54)

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 04, 2009, at 1:49 PM, tshk1221 wrote:

    The residential mortgage market got completely screwed up because of the following:

    - Residential real estate acquisition costs were extremely outrageous from 2005 - 2007 because of lenders' blind faith in and dependence on appraisals which were solely based on outrageous sales comparables.

    - A very substantial portion of buyers during this period purchased houses primarily for investment purposes, rather than for basic living purpose, expecting unreasonable price appreciation in a very short period of time.

    - Payment schedules of some of the mortgage loans were horrendous. Especially, interest-only ones can be simply called Deadly Poison to all the parties related such as borrowers, banks, GSEs and MBS investors.

    I don't think anyone in the US can come up with a good solution for these loans with freaky payment schedules that were already made. However, the following must be really done to prevent a greater future credit / real estate crisis in the future:

    - Lenders' blind dependence on sales comparables must be significantly reduced. Income approach must also be adopted and used even for primary house purchase. Income approach should be a must for investment purchase of houses. Outrageous sales comparables are one of the true culprits of this mortgage / real estate crisis. If not fixed not, lenders' blind dependence on sales comparables will create another bigger credit / real estate boom and bust within 15 - 20 years.

    - Regulators must eradicate the freaky payment schedules of mortgage loans such as interest only. Mortgage loans must always be structured with principal & interest for a fixed term. If borrowers' personal cash flow do not quality for principal & interest, mortgage loans should not be allowed.

  • Report this Comment On June 04, 2009, at 1:59 PM, PSU69 wrote:

    As nibble near 9000, I hear the wannabe bears developing their dooms-day stories. Many homes are being purchased now for the right reason....people will live in them rather than FLIP. Certainly, pockets of price depression willl exist where basic industry illness goes forward with the evolution. "NOW COMES THE REAL CRASH" Silly headline.

  • Report this Comment On June 04, 2009, at 2:01 PM, TMFHousel wrote:

    Great article, John.

  • Report this Comment On June 04, 2009, at 3:32 PM, greenvillewolf wrote:

    More doom and gloom. Quelle surprise!

  • Report this Comment On June 04, 2009, at 6:11 PM, CatWhisperer wrote:

    To recap:

    25% of prime mortgages are 'underwater'

    50% of Alt-A mortgages are 'underwater'

    70% of Option Arm mortgages are 'underwater'

    Deere recently announced layoffs

    Average 30 year mortgage rate is up 0.4% in a week

    And this indicates the immanence of a 'Real Crash' why?

    Do not for an instant mistake me for a bull in this climate, but I don't necessarily read 'gathering thunder' in the supporting evidence cited in this argument. Of course, being 'underwater is not necessarily a problem in and of itself (outside the ego) for the homeowner that intends and is able to 'hold.' It takes a second event, such as a desired or forced sale or the desire to re-finance to make the 'underwater' condition a problem. I see no specific and compelling evidence in this discussion that the aggregate all occurances of both conditions will definitely manifest with sufficient magnitude and swiftness to result in a 'real crash' in the next 3 to 4 years. Not to suggest a real crash will not occur, I simply didn't find the evidence presented to be in support of this conclusion.

  • Report this Comment On June 04, 2009, at 7:35 PM, jbrt wrote:

    whos kidding who ? you sound like Art Cashen more and more each day , sounds like you're sorry you were too cheap to invest back on March 10th . .... He who hesitates ! you know the rest . What did you think the DOW was goin' to go to 2,000 ? sounds as if you wanted it to . Some of these articles are beyond depressing to say the least . FOUR MORE YEARS ! FOUR MORE YEARS !

  • Report this Comment On June 04, 2009, at 7:47 PM, pmhuskey wrote:

    I'm not so convinced of the impending crash either. Credit Suisse has touted the infamous recast schedule chart for various mortgage types, which shows a wave of Alt-A/Option ARM recasts late this year. However, it turns out some lenders are redefining the conditions for recast, which is delaying the event for up to a few years. I would not be surprised if most of the major lenders do something along these lines, as it much easier to deal with a sustained swell rather than a crash wave of defaults.

  • Report this Comment On June 05, 2009, at 11:40 AM, geraldjones wrote:

    Far to many bonus driven lenders in our banks, looked to document files with appraisals to satisfy the examiners. The paper was sufficient to justify a loan. My bank loaned a business partner of mine who had NO income on a house that had been vacant for 3 years.The loan officerf NEVER saw the property. He ran to bankruptcy court when he couldn't sell the place and left me to eat a $100K loan. The loan officer got her bonus.

  • Report this Comment On June 05, 2009, at 3:42 PM, MAcDScientist wrote:

    Another factor I have not heard considered is real estate taxes. Many taxing bodies have lost significant income from investments. This particularly effects a library or school to fund pension funds. The taxing bodies are already raising property taxes. My real estate tax went up the most this year than any of the past 20 years! I expect more of the same next year. It won't be long before I have to sell and move because I can't afford the tax - not the payments. My annual real estate tax now is higher than my annual mortgage payments. I live in Illinois.

  • Report this Comment On June 08, 2009, at 1:54 PM, BMFPitt wrote:

    Wow! 30% of option ARMs aren't underwater? I would have guessed closer to 5%.

  • Report this Comment On June 12, 2009, at 8:40 PM, eurekalogic wrote:

    This as simple as a Kondratiave wave winter that started in 2000 and the Elliot wave five is finally here. Everyone who makes comments like high school tards are making me sick. I know where I am in the time line and ready. To bad everyone ekse is thinking that Bush or Obama have done any greater affect than a blip on the grand scheme..

  • Report this Comment On June 22, 2009, at 5:53 PM, AustinAndy wrote:

    As our unemployment rate continues higher, it will impact the home ownership market significantly. In addition, with the wave of baby boomers starting to retire in the next five years or so, and with the drawdown in value of houses, there is further pressure in real estate. And if you think that the subprime problem has no further impact, you do not understand that the unprofitable housing assets are still on the books of the banks and will continue to depress the market for homes. This problem has a long ways to go.

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John Rosevear
TMFMarlowe

John Rosevear is the senior auto specialist for Fool.com. John has been writing about the auto business and investing for over 20 years, and for The Motley Fool since 2007.

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