In the States overnight everyone went gaga over the news that construction of new U.S. houses rose in February by 22% over the January rate. That’s an annual rate. So we’ll see how it goes. It had been down six months in a row.

Who knows why stocks really rally? But it probably wasn’t the housing news. Prices continue to decline in the U.S. market. Inventories are high. And there is still the matter of millions of Option ARM loans that are still nestled deep in the bowels of the global financial system. We’ll get to them in a moment. Oh yes we will, precious.

First, a bit of polly [politician—Ed.] bashing. –”Every single job loss in Australia is a human tragedy,” Wayne Swan has said. “It impacts on families and local communities, as well as the economy.”

Has the Treasurer never been fired? Job losses are indeed a cause for personal distress. We’ve been through a few. You have to regroup, gather your wits, tighten your belt, round up other useful clichés, and do what you can to survive?

But a human tragedy? That is utter nonsense. There are plenty of human tragedies that happen every day. Children die of cancer. Orphans are hit by trucks. Supermodels go hungry.

Job losses are a normal part of the economy. Hopefully you have an economy where new jobs replace the ones lost. This happens if you have a tax and regulatory system that rewards initiative, hard-work, and risk taking. The trouble with the emotional response to job losses, as much as it displays your sympathy and compassion, is that it encourages you to try and build a system where no one ever loses their job.

If you do this, you end up with a system that creates fewer jobs and less wealth. We won’t go into it in more depth. But if you’re keen on the subject, we recommend this essay by Charles Murray.

What about the Aussie housing market, you say? Glad you asked…

“The Australian housing market is facing the prospect of a ‘perfect storm’ of financial pressures, including high mortgage debt, overvalued homes and rising unemployment, which could see prices eventually fall by as much as 30 per cent, investors have been warned,” reads a story in today’s Age. Read it and weep.

It’s true the market has shown surprising resilience. The Canadian research group that the Age report cites says it can’t last.”The housing market is looking particularly vulnerable, with over-inflated prices, deteriorating affordability and slowing household income growth…There is an increasing possibility of a major housing bust in Australia.”

It does feel a bit like the eye of a hurricane, although we’ve never been in one. The sky is blue. The sun is out. The wind is down. Let’s have a picnic. We’ll bring the cricket bat and stumps, you bring the food and beer.

On a more serious note, as we’ve written in the introductory article to the March Diggers and Drillers, the only good news in all of this is that you have a pretty good idea of where all of this is headed (huge inflation) and one way to prepare for it (metals and energy shares).

If more bank losses are ahead (see below) then monetary expansion is on the cards to try and counter it. Deleveraging leads to lower asset prices. The Fed wants to fight it. We’re not saying it will be successful. But there’s no doubt Big Ben will try.

“Bernanke May Need `Massive’ Asset Purchases to Counter Deeper Contraction,” reports Bloomberg. “The Federal Open Market Committee, gathering today and tomorrow in Washington, needs to redouble its efforts after the central bank’s balance sheet shrank 17 percent from a $2.3 trillion December peak.”

Here’s a thought though. The Fed may choose to expand its balance sheet by buying Treasuries. But it may not prop up markets at all. As Peter Schiff noted in a pod-cast last week, the Fed may end up being the only large buyer of Treasuries while everyone else sells. U.S. interest rates will rise and the U.S. dollar will…not rise.

Peter suggests a much more rapid dollar crisis than seems possible at the moment, given the casual way through which officials are waltzing through the crisis. But this G20 meeting in London next month should be interesting. We expect there to be social unrest and violence. We also expect that the world’s investors may realise the markets overseers have no freakin’ clue what they’re doing. After that?

Well, your guess is as good as ours. But we’re looking to gold and oil. More on that next week.

Now about those mortgages…You remember the good old Option ARM don’t you? That’s the loan that allows you to choose the size of the payment you make on your monthly mortgage. Typically the loan begins with a twelve month introductory rate. After that, you can choose the minimum payment option.

If you choose the minimum payment option, you actually pay less each month that the interest on your loan. That interest is deferred, but it’s added to your principal. That means your principal is growing all the time. This is why these loans were also referred to as negative amortisation (or neg am) loans. You weren’t paying it off. You were actually growing it.

We hope you’ll bear with us for a moment as we go through this. The reason? There’s a slight sense of relief in markets right now. Everyone is throwing stones at AIG. And with the market putting a few good up days, people are losing the sense that our financial system faces serious problems. But they are trillions of dollars serious. And no amount of pleading by the U.S. Treasury Secretary for bankers to lend will change that. More losses are head.

But what size will the losses be? Another trillion? Another two trillion? Well let’s exclude commercial property and loans securitised with credit card receivables or auto loans. Let’s just look at Option ARMs.

Remember, an Option ARM loan “recasts” after five years to a new principal. The interest rate might even stay the same. But if the loan has been negatively amortising (growing as deferred interest payment are added to the principal), then the size of the loan is going to be much larger (an average of 30%, by some estimates).

Even if you’re paying the same interest rate, households at the margin are going to have a much harder time making minimum payments on loans that are 30% larger. And we’re not talking a small amount here. The Washington Post reports that between 2004 and 2007, over US$750 billion in Option ARM loans were originated. The scary part is that, as of late December last year, 28% of those loans were either delinquent or already in foreclosure.

And that’s before the “recasts” have even hit the borrowers. Most “recasts” don’t happen until five years down the track. That means mortgage holders wouldn’t confront the prospect of a higher monthly payment until 2011 or 2012. The chart below from Credit Suisse shows the pig in the python problem.

Bernanke has solved the interest rate problem for home buyers with adjustable rate mortgages by slashing short-term rates to zero, effectively. What’s more, he’s conducted purchases of mortgage backed securities by Fannie Mae and Freddie Mac in an attempt to bring down mortgage rates directly.

The looming trouble, however, is that negative amortisation ads to principal. It does so at a time when home prices continue to fall and unemployment is rising. Making a much higher payment is pretty shocking to begin with. It’s near impossible when you’re out of a job.

The trouble will hit sooner than the Credit Suisse chart suggests. Option ARMs automatically recast at the higher principal level once a predetermined loan to value ratio (LTV) is reached. For example, say you take out an Option ARM at an 80% (LTV) and immediately begin making the minimum payment. Your loan automatically recasts at an 85% LTV ratio. In other words, your loan recasts sooner than the five years you expected because of negative amortisation.

This is why the Credit Suisse chart shows a swelling amount of recasts beginning in April of 2009 and peaking in December of this year. It turns out many of those who took out Option ARMs chose the minimum payment. This led to much faster growth in the loan principal, thanks to neg am. And now, it’s going to lead to a much sooner recast of the loan.

As you may know, the current mortgage relief plans in the States, as feeble as they are, do not allow you to refinance your home if you already have negative equity. This means that in the coming months-starting next month-you have millions of home owners who will face much higher monthly payments on their mortgage.

Do you think they’ll pay them? Can they afford to? What will happen to house prices as this wave of neg am Option ARMs goes into default and foreclosure? There could be some real bargains in the housing market.

But for the banks, there will be some real pain. The banks, the insurance companies, the usual suspects, these are the institutions that stand the most to lose from losses on that $750 billion wave of Option ARM recasts. We’re not saying all those loans will go into default. But at the very least, the losses are certain to be taken, even though no one knows how big they will be.

Now maybe all this is “priced in” to bank shares and financial stocks. It’s pretty hard to price in what you don’t know, though. What seems certain is that banks would want to hoard capital in the coming months, not lend it. They face hundreds of billions more in losses, and that’s just from residential real estate (not commercial real estate or corporate bonds).

How will credit recover under those conditions? We reckon it won’t. In fact, the second contraction of the credit crisis could be worse than the first. You should consider that as you ponder your decision to get in our out of the stock market. Think of the number of companies that are already locked out of access to capital and credit. Will that improve in the coming months?

There’s a very real chance it could get much worse. Of course we hope that’s not true. But if it is, it means all those clowns holding press conferences about bailouts and recoveries are just whistling past the grave yard.

If they were smart, they’d be storing up cash and keeping their monkey yaps shut, or better yet, setting up a warehouse to settle all the CDS AIG has underwritten so it doesn’t continue to be a giant conduit between the American tax payer and AIGs counterparties (investment banks and commercial banks that bought CDS from AIG).

Regards,
Dan Denning
www.dailyreckoning.com.au

March 19, 2009