Sunday Musings: The Next Mortgage Shock

Wall Street, along with many investors, seems to long have forgotten Subprime mortgages, which ignited the economic crisis we’re currently in.

However, there are other dangers lurking which most people are not aware of. I am talking about the upcoming recasts of Alt-A (liar loans) and Pay-Option ARM mortgages (less than interest only loans).

The more recent focus has been on lower interest rates, and how they will actually help home owners lower their payments as their mortgages get reset. While this is true, the more important fact that has not been mentioned is what happens when their mortgages get recast.

So what’s the difference between reset and recast?

Most mortgage of the past are of the adjustable kind where the interest rates are adjusted (reset) once a year. With lower rates, that has benefited many homeowners. The problem is that just about all mortgages have a 5-year term, after which they are recast. It simply means that any negative amortization is added to the loan balance, which is then amortized over the remaining 25 years.

In that case, low interest rates won’t help much, because an amortized loan has higher payments than an interest only loan.

How much higher?

One reader wrote in and said that his payment went from $2,137 to $3,730 per month, which is an increase of almost 75%. It’s pretty clear that most people with these types of loans have not gotten a similar raise recently to absorb the difference in payments. This now has become no longer a matter of lower interest rates, but a matter of cash flow.

There are over $600 billions of these types of mortgage in the market with the majority having been placed in California and Florida.

CBS featured a video on the subject titled “A Second Mortgage Disaster On The Horizon.” It pretty much explains the upcoming mortgage resets over the next 2 years.

Why bring it up?

I am not trying to focus on the negatives here, but I am trying to realistically assess what is on the economic menu for the next couple of years. These mortgage recasts will certainly not contribute anything positive, so be prepared that there will be some kind of a fallout effect on the stock market as well.

Just because we are seeing a rebound rally off the lows right now does not mean all is well. To protect yourself, if you invest in the markets, always have an exit strategy, because it will save your bacon if you’re wrong or if unforeseen events suddenly reverse market direction.

This year has confirmed that simply holding on to investments no matter what is nothing more than gambling and/or unnecessary risk taking. If you lost because of it, don’t make the same mistake in the future again.

About Ulli Niemann

Ulli Niemann is the publisher of "The ETF Bully" and is a Registered Investment Advisor. Learn more
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