The Story Without a Happy Ending

By understanding the markets and the underlying factors, it will allow us to make better decisions.

We’re about to be in for another shock.

Not too long ago, we wrote a story on the Crash of 2010. In that issue, we predicted the markets will correct itself later this year, with debt being the catalyst for our next economic and stock market decline.

That was a very bold statement considering the bull run we’ve been on. The market numbers continue to look good. Hedge funds continue to buy stocks. The markets continue to climb.

But as the old saying goes…

The bigger they are, the harder they fall

Sooner or later, this bull run has to end. And we’re not the only ones who think so. It’s no shock that the markets are gaining momentum after such a dramatic death spiral. But what has been overlooked by investors is that its advancing without much help from the institutions…who, aside from gold-related plays, are keeping most of their cash on the sidelines.

That’s right. It’s the mom and pops (and the government, according to Trimtabs) who are the major driving force behind this recent run and when it ends, it’s going to be the retail investor who pays.

Debt the catalyst

The US government has been trying tirelessly to hide the truth about its economic recovery (see The Hidden Agenda). Over the last year, they have been slowly releasing information on unemployment numbers and another mortgage-foreclosure crisis, yet covering it up with other topics such as health care reform, China-related matters, etc…

But they’re not fooling us. They can’t. Because the headlines are just baffling. Take a look:

“The share of borrowers who are falling seriously behind on loans backed by the Federal Housing Administration jumped by more than a third in the past year, foreshadowing a crush of foreclosures that could further buffet an agency vital to the housing market’s recovery… For now, just about every major measure of the agency’s (Federal Housing Administration) financial health is worsening. “Washington Post

“It’s devastating,” says Mr Dan Claggett. “We helped an 85-year-old woman who couldn’t get a loan modification. She lost the home that she lived in for 35 years”.Financial Times

“The federal government and states are girding themselves for the next foreclosure crisis in the country’s housing downturn: payment option adjustable rate mortgages that are beginning to reset.”

“We can’t lose sight of what remains our biggest collective challenge — the recovery is by no means fully assured. Too many citizens in all of our countries are still feeling the recession’s impacts…We must continue with our stimulus measures. At the same time, it also behooves us to put our minds to how these will be balanced with exit strategies.”Stephen Harper

  • One analyst recently argued that the only major problem still existing in the U.S. economy is the U.S. housing market. A Deutschebank study recently reported that by the first quarter of 2011, 48% of U.S. homes are expected to be under water, i.e., owing more on the mortgages than the market value of the home.
  • Fannie Mae announced Friday a net loss of 74.7 billion dollars in 2009. That’s even worse than in 2008, when the mortgage finance giant posted a loss of 59.8 billion dollars. This time Fannie Mae said it would tap an additional 15.3 billion taxpayer dollars from the US Treasury by March 31.
  • According to the Mortgage Bankers Association, more than one in 10 mortgage holders is behind on payments and, adding those in the process of foreclosure, more than 15 percent of borrowers are delinquent – the highest level ever recorded since its survey began more than 40 years ago.
  • The Federal Deposit Insurance Corporation, the agency that guarantees up bank deposits, said that more than 700 banks are in trouble.

But those points alone are far from being the problem. Those we can handle.

The problem on the horizon, if not immediately fixed by the Government, may make the subprime mortgage crisis that helped send the Dow below 7000 look like a walk in the park.

What’s about to happen could very well be the debt catalyst that we anticipated would be the trigger for our next stock market decline…

The second wave of foreclosures

Foreclosure Troubles

Overall foreclosures are expected to hit an all-time high of 3 million units this year – despite ramped-up efforts by the Obama administration to bolster loan modifications.

Mortgage foreclosures due to option ARM defaults are expected to begin this spring and peak late this summer. It will surpass the number of foreclosures resulting from the recent subprime mortgage mess.

The Story Without a Happy Ending

For budget-tight homeowners, it was an offer they couldn’t refuse: Refinance your mortgage at a discounted rate and cut your payments in half. No down payment needed, no document required, just sign on the dotted line. In a hot real estate market where prices had gone far beyond anyone’s wildest imagination, new home buyers were jumping at the chance to own their new homes – without realising what they were really doing.

For the many who got suckered, they are in for a rude awakening. While many Americans are worrying about dramatically declining home prices, borrowers who jumped at the sweet sound of option ARM loans have another, more immediate problem: payments that are about to skyrocket far beyond what they are capable of paying.

For those of us in Canada who have not heard of the Option Adjustable Rate Mortgages (ARMS), you are going to be shocked.

It’s one of the few mortgages that can actually have “negative amortization,” meaning the unpaid portion of the accruing interest is added to the outstanding principal balance. So even if you make payments on time, you may end up owing more than you initially invested and thus, your payments could rise substantially.

Any mortgage that is allowed to generate negative amortization means that the borrower is reducing his equity in his home, which increases the chance that he won’t be able to sell it for enough to repay the loan. When you combine that with the substantial decrease in US properties values, you can see how big this problem has become. (see a brief explanation of Option ARMS here)

As we mentioned in “Another Shot At Glory,” as much as 81% of the option ARMs originating in 2007 are expected to default, with many ending in foreclosure. About $750 billion worth of option ARMs were issued between 2004 and 2007. . . and will begin resetting in the next few months. Most of these loans will be underwater – not to mention the negative amortization factor. So although these foreclosures will spread over the next few years, it will take a long time (over two-three years) before things settle.

Assuming the above sentiment, rising foreclosures will undoubtedly add to the unemployment figures, or vice versa, which will ultimately lead to another sell-off in the markets. When you combine this with the threat of either inflation or stagflation (see We’re Back and It’s Time to Prepare and The Crash of 2010) and the possible bubble in China, you can see why our stance remains firm that the market will correct itself in 2010, or early 2011 before finally settling down in 2012 and 2013.

We don’t mean to sound pessimistic. Nor do we want to. We just want to expose the facts that the US government doesn’t.

By understanding the markets and the underlying factors, it will allow us to make better decisions. We will be looking at shorting the US financial sector soon if the stars align and unless we hear any different from China, we will continue to remain bullish on precious metals.

While we are on that topic, something happened this past Friday which may not only send the markets and the US economy down much further, but could send gold flying through the stratosphere.

More on this story next week…

Stay tuned.

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A Brief Explanation of Option Adjustable Rate Mortgages (ARMS)

A Brief Explanation of Option Adjustable Rate Mortgages (ARMS)

A Brief Explanation of Option Adjustable Rate Mortgages (ARMS)

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