This will only apply to owner occupied properties with at least a 36 month ARM reset period or less.

Loans must be originated between 1/1/2005 and 7/31/07. These loans must have reset dates between 1/1/08 and 7/31/10.

The loan must be current.

LTV must be greater than 97 percent

The borrower must have a FICO score less than 660

The borrower’s FICO score cannot be higher than 10% since the loans origination date.

Each servicer must determine the owner cannot afford higher payments.

Should you fall within this if-then statement of complexity, you will qualify for the 5-year rate freeze. So instead of a 2/28 mortgage we now have a 7/23 mortgage. In this post we will analyze our hypothetical case study of Johnny Subprime who meets all the above contingencies and has a scheduled rate reset on 1/1/2008. Just to show my due diligence in this, I decided to call up the Hope Now Alliance program. I called at a late hour as everyone was hitting their slumber since I know they are extremely busy. After a brief summary of what they are about, I am led to the omnipresent “press 1 for English, press 2 for Spanish.” From what it appears, they are being an advocate and are running a quick triage report to see if you even qualify. Early estimates from various sources state that this plan will currently help anywhere from 125,000 to 240,000 people. This plan doesn’t even begin to address the potentially more dangerous mortgage bubble of Option ARM mortgages that are set to hit in 2010 through 2011. According to Fitch Ratings, 80 percent of Option ARM borrowers only make the minimum payment. What this means is these folks are going negative amortization in a time where across the country every large metro area is seeing real estate depreciation. This is a guaranteed recipe for being underwater at a time when analyst are predicting the bottom of the housing market will be hit. It is literally the second tidal wave of this housing credit explosion.

Let us deal with one thing at a time. Let us run some assumptions just to show how this Hope Now Alliance will play out for Johnny Subprime:

Mortgage Type: 2/28 Mortgage

Origination Data: 1/1/2006

Home Purchase Price: $250,000

Mortgage Amount: $250,000

Mortgage Rate: 7 percent with expected rate at reset of 10

Current Principal and Interest: $1,663

Expected Principal and Interest at Reset: $2,173 *2/28

Taxes and Insurance: $260

Yearly Income: $50,000

Monthly Net Take Home Pay: $3,080

Car Payment: $300

Car Insurance:$100

Auto Fuel: $120

Food: $400

We’ll leave out other factors like cell phones, healthcare, utilities, and credit cards which many borrowers have. With the current payment Johnny Subprime has disposable monthly income of $237. After talking with a counselor on the phone, Johnny hasn’t missed a payment and falls within the guidelines and demonstrates that a rate reset will suddenly put his $237 monthly surplus into a monthly deficit of $273. Since most subprime borrowers already start out at a higher rate, it is very common to see a starting rate of 7 percent especially if the note originated in 2005 or 2006 when rates were very low and the secondary market was buying them up like hotcakes. So instead of his rate resetting in 1/1/2008 it will now reset in 1/1/2013. Without the rate freeze the rate payoff curve looks as follows:

For simplicity, we will only assume that there is a rate cap of 10 percent and doesn’t go higher which is a very high probability given the current economic circumstances and the structure of many subprime loans. Interest rates cannot remain at multi decade lows forever. So the freeze is on and Johnny lives to fight another day. Does this freeze really help long-term? Johnny goes on living his life, paying his bills, and doing the things of daily life. Let us assume that Johnny has received a 4 percent pay raise each year and now we are in 1/1/2013. How does our scenario variables change?

Current Principal and Interest: $1,663

Expected Principal and Interest at Reset: $2,112 *7/23

Taxes and Insurance: $260

Yearly Income: $60,800

Monthly Net Take Home Pay: $3,597

First you’ll notice that the difference between the 2/28 reset payment and the 7/23 reset payment is only off by $61. So how is Johnny Subprime now doing in 2013? With the new rate reset he is now with a monthly surplus of $305. On the surface, it looks like the rate freeze has saved Mr. Subprime from losing his home. But there are many assumptions that we are assuming here.

Three Assumptions of the Hope Now Alliance

This seems all well and good for our hypothetical case. But as you can see from the tiny payment difference, all we are doing here is buying extra time in hope of a few things. First, there is no reason for Johnny Subprime’s salary to go up in the next 5 years. In fact, wages have recently been stagnating. If and when the economy goes into recession, there is even less of a reason to assume wages will increase as the economy contracts. This puts one major dent into this freeze plan.

The second assumption is that housing prices will stabilize over this timeframe. Who is to say prices will stay the same? In fact, we have another major mortgage debacle awaiting us in 2010 and 2011 just when this one is getting cleansed from the system. We are already seeing that yes, real estate does go down and in fact can go down on a national scale. Estimates abound that home prices can fall anywhere from 10 to 30 percent depending on the area. Many analyst predict the bottom somewhere in 2010 but of course the dormant giant of Option ARMs hasn’t even been tackled. So assuming Johnny Subprime’s property falls by 10 percent nominally, he will still owe $227,868 on the new 7/23 mortgage and the property will be worth $225,000. He will have zero appreciation and will lock himself into a place for 7 years. As you can see, sometimes renting is better than buying. After all, having a roof over your head and building up no equity is the simplistic definition of renting.

The final assumption here is that Johnny will in fact want to stay in his home. We’ve heard countless times from the industry how no one ever stays in one place anymore. Well in this case, Johnny will not have much of a choice in the first few years since he doesn’t have the equity to sell especially in a declining market. What if he gets a new job somewhere else and needs to move? Is he going to be compelled enough to stay in the place? What if he realizes that the only true winner here is the lender and he in fact may be coming out with no equity in the end? Will he want to continue making payments to keep the lenders afloat?

You can see that it is much too early to determine how this thing will go. Will people in foreclosure that don’t qualify for this plan call for equality? Why should they be punished because they didn’t fall within the given timeline of the current proposal? What about prime borrowers that are underwater? Why shouldn’t they be able to freeze their rates as well? Again these are philosophical questions more than economic but I assure you they will come up in the coming years. Even though this isn’t a bailout per se, it does open the door slightly for more government meddling. We already know that Paulson said this isn’t a “Federal bailout” but the wording giving tax-exempt status to states should be watched. Another major thing that would be a bailout is what Angelo Mozilo, CEO of Countrywide mortgage is pushing. He is calling for caps to be raised to $625,000 so the FHA, Freddie Mac, and Fannie Mae can purchase larger mortgages. Mozilo had actually called for raises of as much as $850,000. Since Countrywide and WaMu have nearly 45 to 50 percent of their mortgages in California, I wonder why he is pushing this so hard?

What are your thoughts? Is this a bailout or is this something more benign?

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This article is a culmination of years of looking at data and tying many things into the current economy. We will first look a the exponential growth of mortgage debt. Next we will examine the looming issue of trade deficits and how a falling dollar is something that the Fed is silently hoping for. Then we will look at the DOW and show that in real terms, it is now in a very negative territory. Finally we will look at the data and try to examine what path we are heading down.

The Growth of Mortgage Debt

As it stands, the current mortgage debt outstanding is $13.3 trillion. In 2000, mortgage debt was at $6.5 trillion. That means in 7 years we have doubled the national mortgage debt outstanding which is simply amazing. You can see from the above chart, grey areas showing recessions, that each slowdown in the economy had a net effect of flattening the curve down for a few years. Not this time. You’ll notice that during the previous recession, mortgage debt suddenly sky rocketed into an exponential dimension. The amount of mortgage debt outstanding is incredible. Let us take a look at another chart:

For comparison sake, this chart shows the total public debt outstanding. In 2000, total public debt outstanding stood at approximately $6 trillion, almost on par with the total mortgage debt of $6.5 trillion. Fast forward to 2007 and total public debt is at $9.1 trillion and mortgage debt is at $13.3 trillion. A difference of $4.2 trillion. You may get a better understanding of what I was talking about in July of this year about a severe housing crash slashing $5 trillion in wealth. Dean Baker, co-director of the Center for Economic and Policy Research estimates that a housing slump may lead to $8 trillion in wealth lost because of the impact of a negative wealth effect and our reliance on debt as money. What seemed far fetched during a feverish housing market is starting to seem more realistic. If we were to divide the total public debt to each woman, man, and child in America your piece of the debt pie would be $30,000+. If we ran these numbers back in 2000, the piece of the pie would be $20,900+ adjusted for population figures and debt figures at that time. Now imagine if we added mortgage debt into the equation and revolving credit as well. We as an entire society are spending more than we earn! So how is this possible?

Importing Goods and Exporting Debt

Don’t be shocked by the chart above. Both Republicans and Democrats are guilty of running massive trade deficits. As you can see, during the Reagan 80s we started dabbling in the art of running serious trade deficits. Clinton continued this legacy during the 90s and now you can see with Bush that this seems to be the trend for the past 30 years. You may notice a short spike but don’t get too excited. This is in large part not by us exporting more goods or services, it is largely impacted by our declining dollar. If you have any doubts about the massive imbalance just ask one of the millions of Black Friday shoppers to show you one of their multiple items that they purchased. Take the item and see where it is made. Do you want to take a wild guess where the product was manufactured? There is no question that we do export certain goods and services but nothing to the extent of what is brought in. Take a look at the port of Long Beach incoming and outgoing container trade numbers:

These are measured as TEUs or 20-foot equivalent units. Think of your common 18 wheeler and you’ll get an idea of the magnitude of goods coming into one of the single busiest ports of our nation. You’ll notice that for the past month, we brought in 323,131 while sending out 144,839. Once you realize how tilted the scale is you start to understand the extent of our growing trade deficits. Some have argued that this is the reason that the Fed is actually happy to see a declining dollar. The short-term spike would suggest that a falling dollar is doing something to our trade deficit but at the same time it is hitting you straight in your pockets. We have been exporting our dollars to foreign nations and they have been allowing not only Americans, but also Europeans and Australians to live beyond their means. No country can run deficits indefinitely. All these things are tied in the now global marketplace. Why do you think OPEC was jawboning about the drop in the dollar? Not sure if they can do much since they get paid a large portion in dollars so it benefits them to have a strong dollar but you understand that one winner equals another loser in a different part of the world. This has become a zero sum game because debt has become money. When the numbers are broken down we see that consumers are merely reflecting the lead of their nation; that is spending more than they earn. This unsustainable policy cannot go on forever and we will have tough decisions to make.

The U.S. Dollar Faces Major Challenges

As previously mentioned the US Dollar is facing a steady decline. It is now facing steep competition for the title of world’s reserve currency. As you can see from the chart above, the Euro had a tough few years starting out. The Euro is the currency of the Eurozone which includes 13 states. These include Germany, France, and Austria to name a few. The dollar was held by 70.9 percent as the official exchange reserve in 1999 by nations while the Euro was held by 17.9 percent. As of 2007, the US dollar is now held by 65.7 percent while the Euro has steadily gone up to 25.2 percent. Clearly the dollar still dominates the world reserve markets but the lead is slowly dwindling. The attractiveness recently of the Euro is that countries have to meet strict requirements to enter the “zone” and a small percentage is actually backed by physical commodities. This love may be short lived since credit bubbles are also looming in Europe. The master of Irrational Exuberance, Alan Greenspan has talked about diversifying into foreign currencies in a recent 60 Minutes interview:

“Greenspan says it doesn’t matter what currency he is paid in. “Key question, basically, is, in what currency do you wish to hold your assets,” he explains.”And what I’ve done is I diversify.”

I wonder if consumers paid with Euros during the holiday rush? Do you think consumer spending was influenced by a psychological urge to unload dollars that are becoming worth less and less each day? Hard to believe the amount of money “aka debt” being spent out there. Now we realize why globally, other countries are starting to worry. Many are starting to realize that something has to give in this global Ponzi credit scheme.

Dow Jones, Meet Negative Returns

The week starts off on an interesting note. Not because we saw another triple digit loss but because we are now technically in a correction. If you look at the above chart, the DOW is up only 2.25 percent for the year. Given that the US Dollar index has fallen from 85 to the current 75, and inflation is running around 3 percent (so says the ministry of truth), you are actually in negative territory. I heard someone talking about it that it “isn’t so bad with a 2.25 percent increase considering all the problems going on.” Well, it is much worse than that if you are paid in dollars (which I’m guessing most of you are) and the under reported inflation numbers make it seem like nothing is really going on. It is a two hit combo; first you’re currency is debased to make up for the massive deficits while the government skimps on inflation numbers to hold back on fixed payments. Take a look at the below oil chart:

Do you notice something? Given that energy is a large part of our consumption, it is hard to believe the data that is being dished out. And what of housing? Incredibly the government uses owners equivalent of rent to factor in housing prices. Well we all should know by now with the often quoted 70 percent of Americans own their home figure that we should examine mortgage payments as a true indicator of true cost of housing since the majority own. But of course these two things would show inflation running at a much higher rate so we don’t want to do that. Inflation is a silent tax. For some reason politically people are happier being told that no taxes will be raised while the green dollars in their wallet (if they still carry any) are slowly shrinking in purchasing power. No wonder why monetary policy isn’t taught in high schools. The public would understand the slight of hand the government is dishing out and they would demand restraint on spending. Given the spending binge this past weekend it is becoming more apparent that many Americans are using shopping as a sedative to facing the brutal facts. Like Social Security, the time is running out to right this ship before it is too late. Either way we will have some tough decisions ahead of us.

Where we are Going

Knowing a little bit of history can give you an idea of where we are heading. Human behavior has common patterns. With common patterns we can predict to a certain extent what will happen in the future. The complexities of the global market are large and I’m reminded of the adages that if a butterfly flaps its wings in Brazil there can be a chain reaction causing a thundering wave in another part of the world. Everything is interlinked in a symphony of cause and effect.

A good starting point is to look at the US consumer:

Where the consumer goes so goes the economy. Our trading partners are watching just as closely because a slow down here means a larger slow down in their respective regions (and less dollars). It’ll be important to keep an eye on incoming cargo from various ports to monitor the flow of goods since this typically will react very quickly. We are already seeing a minor slow down but it is hard to say with us being in full holiday swing. We will have better numbers to work with in January and February of 2008. The above chart shows consumer sentiment. As you can see we are now reaching lows only seen in the last recession earlier in the decade. What is fascinating here is that employment numbers are still healthy, GDP is still humming along, and people are still spending. So why is this trending downward? It should be rather obvious that most previous downturns were led by falling industries. That is, the technology boom and bust (look at the 90s) led to increase in sentiment followed by a decrease with loss of jobs and sentiment. This bust will be led by credit which I believe gives the title “credit crunch” a new meaning. Even with the booming housing market consumer sentiment never reached the high that was reached in 2000.

Let us take a look at an ominous sign for predicting the future of housing. Housing starts are a very crucial leading indicator of the health of the future housing market. Home prices are lagging indicators, telling you how good it was; housing starts tell you how good or bad it is going to get:

Housing starts are now reaching lows not seen since the early 90s. A fascinating thing to note is that for each previous recession, housing starts trended downward and then increased as the economy improved. You’ll notice that housing never skipped a beat in the previous recession. We went from a technology bubble to a credit bubble driven in large part by the housing industry. The stops in the chart make sense because who is thinking of buying a house in a downward economy? But the rather unusual thing of our current economy is a large part of our decade long prosperity was based on trading, financing, decorating, and flipping homes. Take a look at the construction numbers and again pay careful attention to the gray areas:

Never in the history of this country has so much relied on housing and credit. Just to demonstrate this even further consumers to compensate for stagnant wages are using a larger portion of their income to pay for the servicing of debt:

You notice that over 30 years the chart hovered around 11 to 12 percent. We are now solidly over 14 percent. This may not be a big difference but considering that the consumer powers 70 percent of the economy, this small increase can mean the difference between a growing economy and one on the brink of a recession.

I hope that we can now realize that this housing fiasco is more than a “subprime” issue. If we define subprime as giving loans to borrowers that are high risk and have a high likelihood of defaulting, we need to look in the mirror and ask some hard questions to our leaders. Amazingly none of the leading candidates are talking about this. Some see nothing wrong with this. Most seem to stick to multiple issues on a superficial level while never addressing a comprehensive solution. As I think about it, maybe it isn’t politically wise to tell your prospective voters that they should reign in their spending and be more prudent with their finances. Clearly the majority of the public doesn’t want to concern themselves with all this financial mumbo jumbo. The only time they will open their eyes is when calamity is too close to change course. I am hopeful that as a society we will come out better because of this challenge. It may encourage people to take a more active role in managing their own finances and questioning authority. It will also show how globally we can rise and fall because of the common ties of economics. There isn’t anything wrong with being prudent and financially responsible. We are in an unsustainable course and our goal should be to find a sustainable long-term solution to the problem. If nothing is learned from this debt bubble, the greatest heist in American history will go unpunished.

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John McCain has just given the US public a crash course on why debt is not a good thing. McCain raised $11.2 million this past quarter but spent most of it and has very little cash on hand. Seems rather commonplace for many Americans to spend more than they earn. Not only that, the major issues that we should be discussing such as the credit bubble, declining dollar, Social Security, and international conflicts are nowhere to be found in the mainstream political debate. Why isn’t any politician tackling any of these problems head on and discussing them? The only person I’ve heard mention “inflation” is Ron Paul, who by the way is financially better off than Mccain. Maybe basic finance does help those in politics. Either way, I think most Americans are realizing that being able to purchase something on cheap credit does not equal financial independence. On the contrary, many are realizing crippling debt is like jumping into the ocean with an albatross around your neck.

So we close off the first two quarters of the year with the fuse inching along to the dynamite box full of funky credit and Wall Street collateralized debt obligations that are so complicated, even the people that created them have no idea how to untangle them. The big bang is here and the world is realizing and watching morbidly, that we spent way beyond our means. In this article I will discuss three main issues that will impact the entire country. From young professionals starting their career to those in retirement. This credit bubble discriminated against no one. If you wanted a home equity line of credit, you were welcomed. If you wanted a no money down interest only loan, come on in. This bubble is one for the ages and we are starting to see that the public is starting to get the memo that massive credit is not a solid solution for sustainable growth.

Social Security – Shhh! Please be Quite

It has been argued that Social Security is the third rail of politics. We remember Al Gore and his lock box talk. Or Bush and his goal of privatizing Social Security. Both went down in mad Ghostrider flames. Yet the issue still looms. Even Clinton recognized the issue with Social Security but no political will was willing to attack the problem. The buck has now passed from three presidents onto another one that will inherit the problem in 2008. Every expert acknowledges that we have a looming problem with Social Security. But anytime a politician brings up the issue, it gets shot down. Typical of the housing bubble, Social Security is a ponzi scheme heading down a slow but sure road of insolvency.

For one, 44 million Americans depend on Social Security (so guess how they’ll vote). Two thirds of senior citizens depend on Social Security as their main source of income. 18 percent of senior citizens rely on Social Security as their only source of income. Income that pays for food and housing cost. Keep in mind, even if you have your home paid off you will still get yearly tax bills. You will also need housing insurance and maintenance costs factored in. Why do you think many senior citizens are victims to reverse mortgage loans that are so financially egregious, you would think that you were dealing with a local bookie or turf accountant.

In 1960, there were 5.1 workers putting in money to the system for each person drawing on benefits. In 2005, the number dwindled to 3.3 workers. The projected number for 2031 is 2.1 workers for each person drawing on Social Security benefits. Why the sudden shift? Well we can thank a population boom phenomenon otherwise known as the baby boomers.

Baby boomers are considered to be folks born from 1945 – 1964. The total number of births during this time is somewhere in the ballpark of 76 million. Currently they are 20 percent of the adult population. An incredibly large number. The term is normally given to those in the age bracket of 44 to 62. The major shift will start occurring in 2008 when we start seeing baby boomers go into full retirement. The system is solvent until 2018, which at the time more will be paid out than paid into the system. By 2042 the system will be dry. So anyone in the 20 to 39 age range needs to start planning for another venue of retirement benefits since the last three presidents didn’t do squat regarding the issue.

With a high cost of living, mounting credit card debt, ridiculous college costs, and entry level salaries how is it possible for young professionals to realize the dream of their parents? Hard work and savings are paramount. But the way mom and dad did it is not going to apply to this generation since the Social Security safety net won’t be there for many and housing costs are much larger in proportion to those a generation ago.

Savings and Debt – How does it Break Down?

I’ve been clipping a few charts from the previous LA Times with fascinating data. After reading how Kobe is still up to his antics with the LA Lakers and David Beckham’s Galaxy salary is larger than many third world country’s gross domestic product, I enjoy heading over to the business section. The numbers are startling and the picture that is painted is that young folks of today consume at a high pace and save very little for retirement. It could be a generational thing where many of us are more comfortable paying with a credit card rather than cold hard cash. This debt mentality is also a contributing factor for the housing bubble. After all, a generation raised at the teat of debt is easily coerced into further spending. Large mortgages didn’t phase many young professionals. I’ve had a close friend purchase a Real Home of Genius condo with his wife for half a million dollars in a regular suburb of Orange County. The condo is slightly over 1,000 square feet and as cookie cutter as they come. Their combined income barely allows them to cover the mortgage, taxes, and association fees but they are following the lead of mom and dad. The only caveat is, mom and dad bought with 10, 15, or 20 percent down and went 30 year fixed. But the need to own a home is so psychologically ingrained that folks are willing to live on Cup-o-Noodles to pay the mortgage.

Let us take a look below at some raw numbers:

This first table looks at average amounts in bank accounts per household. Keep in mind that with averages, a person with $200,000 in the bank will skew the chart higher. But even with that considered, the amount of money in accounts isn’t that high. You may say, “well of course not, these people have them in 401(k)s and retirement accounts.” I’ll get to that in the next section but suffice it to say that folks aren’t really saving elsewhere.

The next chart looks at household debt from the same sample in the survey of 158,000 US households:

This chart should put a major hole in many housing pundit theories of Americans being okay with large mortgage debt. The above chart includes revolving debt and mortgage debt. The highest average is in the 30 to 39 category and it tops out at $107,525. Now think about a young professional couple buying a starter home of $500,000 with 20 percent down. They’ve taken on $400,000 in debt. Or 4 times the average overall debt of those in the 30 to 39 and 40 to 49 group range.

Another scary factor is many of those hitting retirement are still in debt. As we’ve mentioned, if you are relying solely on Social Security as your main retirement income or a large part of it, $50,000 in debt is a large chunk of change.

Retirement

It is pretty clear that anyone in the 20 to 39 age bracket will need to fund their own retirement and not depend on Social Security. So how are folks doing?

Well there goes the argument that the majority of people are funding their 401(k). The 20 to 29 year olds are the one’s who need to fund their 401(k) accounts most aggressively. Those in the 30 to 39 age range seem to be getting the message that Social Security will not be there for them. Is fear of no Social Security the only reason for this shift? We have another reason:

Pension plans are going the way of the Dodo bird. Anyone under the age of 40 is most likely to be at the tail end of a generational ending of pension plans. You can see from the numbers above that only 8 percent of household in the 20 to 29 range have pension plans and 14 percent of those in the 30 to 39 age range. If anything, these charts should show you that we are not in the world of our parents.

Let us not even dive into the declining dollar, massive deficits, and the ridiculous shadow government tactics used to calculate inflation. This all ties into the housing bubble because with such a high cost of living and lack of future planning, many young professionals seem to indicate by their buying habits a “screw the future” and live a carpe diem type lifestyle. To keep up with the dream of being equally as successful as their parents, they are mortgaging their present lifestyle to meet a dream that is no longer available. They chase this dream by diving into credit and hyping the monthly payments. Yet this is unsustainable. At which point will folks in the 20 to 39 age range become furious about paying into a system that they will not benefit from? At what point will they realize that inflation numbers are cooked and demand better accounting practices?

Sometimes it seems that the media is trying to create a generation of zombies that will stay away from picking up a book and educating themselves about the true state of affairs. According to A.C. Nielsen Co., Americans watch an average of 4 hours of television a day! Mortgage ads spouting crack pot numbers. Flip this House. Extreme Home Makeover. And all the other housing related shows seem to be the number one source for where people get their housing information. In addition we get this mantra of easy monthly payments and the advent of gorilla marketing making it seem like using cash is for old folks. The credit card commercials tell you two things; the faster you spend the better and don’t be uncool and use cash. God help us if people are using the television to educate themselves regarding the credit bubble, savings, debt, and retirement.

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