Bankrupties: The Worst Is Yet To Come

Sub-prime mortgage defaults and bankruptcies have peaked. But in all likelihood our twisted economy still has a long way to go before the recession fully unwinds and slightly happier days are here again.

The next big economic smack-down will be from millions of Alternate-A and Option ARM loans. Dubbed “toxic” mortgages, they portend to be justly named. We’re talking a whole lot more bankruptcies.

Alt-A mortgages are offered to borrowers who pose less risk than sub-prime loans but don’t qualify for an A-paper, or "prime" loan, which requires a FICO credit score greater than 680, verifiable income and, among other criteria, a debt-to-income ratio less than 35%.

Just as a large number of subprime mortgages (40%) were approved through an automated loan process whereby the customary review and documentation of assets and income bred applicant falsification of information and lender fraud, so too went these toxic mortgages.

With a low, introductory interest rate, many buyers were enticed (coerced?) to purchase homes beyond their means. When the introductory rate ends, monthly payments balloon by 50% or more.

The amount of outstanding Alt-A mortgages is over $2-trillion. Add another $750-billion in Option ARM loans that will reset between now and 2013. Keep in mind that sub-prime loans totaled approximately $1.3-trillion. We’re set up for double the trouble.

Now, close your eyes, take the deepest of breaths, and hold it for forty (the number of months until the majority of toxic mortgages have defaulted) seconds. Red-faced and woozy, you’ll be floored. However long it takes before you can stand up straight – no grabbing a-hold of something for stability – that’s a pretty good estimate of how many years before the economy has begun to get back on its feet. Let’s say five minutes/five years.

Option ARM loans give the borrower the flexibility of a repayment schedule that starts with a “teaser” interest rate as low as 1%. The worst of all options are interest-only payments. Intended as an investment vehicle for people whose income can vary (commission jobs or those with regular bonuses), the borrower has the “option” to pay down the principal of the loan. Otherwise, the loan balance increases, resulting in negative amortization. You end up owing more on the house than the value. The value has already plummeted due to the number of foreclosures over the past two years.

Although there’s an Annual Payment Change cap of 7.5%, on the fifth year a built-in recalculation can increase the monthly payment well over 100%. Option ARM loans were popular with property investors when home values were expected to follow an upward climb.

Fitch Ratings, a global agency that analyzes credit markets in more than 80 countries, estimates 80% of all Option ARM holders make the minimum monthly payment. With more than 55% of these borrowers owing more than the value of their properties, with payments about to go sky high, expect many to simply walk away from their investments.

More alarming than what I imagined, in response to my July 1st column “Setting aside common sense for feel-good consumerism”, reader Alex Charles e-mailed what had first appeared to give me a scolding for suggesting everybody who took out a home loan during the boom years made foolish decisions.

Instead, Alex told a frightening tale of what is happening to responsible mortgage holders. Alex has 30 years in Information Technology with Project Management Certification (BA degree plus 4,500 hours experience required – two years). With a FICO score of 820+, he relocated from the north and took out a fixed-rate conventional loan in 2000, never having been late on mortgage and other credit obligations.

That was before he became unemployed on September 17 – a year ago (his job vanished somewhere off-shore). He remains unemployed, over three months behind on mortgage payments and amazed “that Governor Crist has not made any regular press appearances to even ‘sugar coat’ the dire situation of unemployment and small businesses tanking”.

What could possibly be more devastating than an ever-growing number of Americans losing their homes through bankruptcy?

A National Association for the Self-Employed (NASE) survey shows that 3.7-million small businesses (10 employees and less) have toxic mortgages that will come due in the next three years, of which more than a third are already delinquent by one to three months.

With the looming number of small business bankruptcies, the ranks of the unemployed will multiply. Owners don’t qualify for unemployment benefits. Workers have limited benefits that are but a fraction of their previous earnings. With few prospects of rejoining the workforce anytime soon, even at lower pay, their savings become depleted as has already happened to millions of Americans. More bankruptcies.

The toxicity of home and small business ARMs will lead to more bank closings, more foreclosures, more taxpayer funding of bailouts to keep big banks – still too many for the good of taxpayers – from failing.

Of the 8,195 banks and savings associations FDIC insured, 414 were on the “problem list” at the end of June, up from 305 in March and approaching the record 434 institutions in June 1994

Instead, hundreds of small and medium-size banks will fail. Sheila Bair, chairwoman of the FDIC, acknowledges the “looming problem” of commercial real estate loans that saw a doubling of defaults from 2Q of 2008 (1.18%) to 2Q of 2009 (2.88%) with a projected rate of 4.1% by year-end then level off at about 5% through 2012 before a modest decline to 4.5% in 2013.

Bair is hopeful (fingers crossed?) the FDIC will be able to avoid opening an interest-accruing line of credit with the Treasury Department, which has pre-approved a $500-billion loan. The FDIC receives no federal tax dollars – insured financial institutions fund its operations. But, one way or another, don’t taxpayers always gets stuck with the bill?

Taxpayer Alex says, “We certainly don't want a hand-out, just a chance to earn a decent paycheck with health insurance.” Washington is working on it. Or is it?