There was much talk earlier this spring about so called “green shoots” in the economy by talking heads trying to coin a phrase that would stick. Unfortunately for us, they had very little evidence to back up such statements. Housing was still tanking, unemployment was still skyrocketing, and GM and Chrysler were swirling down the toilet of bankruptcy.

I’ve been rather pessimistic on the economy for a while now. As recently as April I was predicting a long drawn out recovery. I also predicted that a second wave of foreclosures coming from a type of mortgage called Option ARMs would start carpet bombing the economy all over again. Well, unlike a certain ex-President of ours, I’m willing to chart a new course when provided with new information.

Here is why I am cautiously optimistic for a near term recovery. I’ll go out on a limb and say that the bottom was sometime in June 2009.

Option ARMs

First, my biggest reason for originally predicting a long, drawn out, recovery was the Option ARMs. In a previous blog post, I explained how Option ARMs are one of the most dangerous mortgage types out there. The cliff notes version of this is: You can pay less than the amortised amount each month and whatever you don’t pay gets tacked onto the principle, up to 125% of loan value, and thus charged interest. After about 5 years or once the principle reaches 125% of loan value, the monthly payment “recasts” and now the owner has to pay the entire amortized payment on 125% of the loan value and now they only have 25 years amortization… just as sugar on top. A large batch of these mortgages were due to start recasting at the end of 2009.

My reason for course change? Many of these mortgages aren’t even making it that far. 42% of Option ARMs originated in 2006 and 35% of Option ARMs originated in 2007 are more than 60 days late today. These mortgages are never going to make it to the 5 year mark for recasting. Now, I’m not saying that these people aren’t going to be foreclosed on, they are. It’s unlikely that ANY of these mortgages will qualify for loan modification since one of the requirements is a principle balance lower than the value of the home.

Here is the good part, by going into foreclosure sooner, it softens the overall impact on the economy. So while it’s still bad, it hurts less. Would you rather be hit by 18 inches of snow over a period of 3 days or get hit by an 18 inch diameter snowball?

Ford posts profit

Ford Motor Company had two pieces of good news. First, Ford posted an overall profit for 2^nd quarter 2009. Their operating cash still took a $1 billion hit, but clearly progress is being made. The proof of that is in the next item.

Ford posts positive sales numbers

Ford posted their first sales gain in 19 months. Now I’m sure that a good portion of this can be attributed to the government’s Cash for Clunkers program, however Ford’s current model lineup easily stands on it’s own without help from the government. If their new Taurus had been in showrooms already, I’m sure they would have done even better.

This comes on the heals of Toyota’s statement that they are no longer profitable in North America.

Anecdotal

I do I.T. consulting work on the side. One of my clients is a real estate appraiser. Just three months ago he was talking about closing up shop. Now he’s having me refurbish older computers that haven’t been used in a while so he can bring in more help for all the work he has.

A guy who does painting and drywall work for me was talking about how he is closing on a house on Thursday but he doesn’t have time to work on it because of all the work he has coming in suddenly.

GDP only at -1%

This is where the caution part of “cautiously optimistic” comes in. That number, in a vacuum, doesn’t look too good. Taken with the numbers of the previous quarters it signals a huge turnaround. However, much of that regrowth has come from the government’s stimulus projects. Sure the bill was passed in the late winter, but it took till April and May before any sizeable amount of money was dispersed. In my area alone there are no less than four major bridge building/refurb projects that have started or resumed.

Unemployment

The unemployment numbers still don’t look too great but they tend to be a lagging indicator simply because they aren’t reported till after someone gets or loses a job. Watch the unemployment stats over the next few months.

Green Shoots?

Not really. But the seeds have been planted and watered.

Watch this space.

Here is the difference between what has happened and what is about to happen.

In the past 12 months, most of what has failed has been fairly standard, though sub-prime, adjustable rate mortgages. You get a $180k mortgage for a $200k home and get an adjustable interest rate that resets every year after 5 years or so. You paid the standard principle + interest + escrow. What has happened is the first bunch of homeowners who’s mortgages reset could no longer afford the new payments. Some refinanced, but a good many went into foreclosure. The foreclosures put downward pressure on home prices. When this happened, even fewer people could refinance their homes because the values of the home often fell below the amount of the first mortgage. The vicious cycle started and that’s how we got where we are today.

Keep in mind that 12 months of that have brought down the largest investment banks in the country, put Bank of America, CitiGroup, and Wells Fargo on the ropes, and forced mergers of banks that never would have happened in a normal climate.

Here is the fun part.

With an Option ARM loan you have the option to make partial principle and partial interest payments. What you don’t pay gets amortized back into the principle of the loan up to a maximum of 115% or 125% of the original loan value or once 5 years has been reached. Many people pick these types of loans because it was the only way they could afford the monthly payments on their McMansion. In the meantime, property values have fallen across the board making refinancing out of these loans virtually impossible. Once these loans are recast (similar to the resetting of the interest rate in an ARM), the home owner goes from making a minimum payment that doesn’t even cover interest to a fully amortizing payment that covers all interest AND principal. And remember, principal is 15-25% higher than the original loan balance. Most people with these types of loans also put no money down or got a second mortgage to pay for their money down. They owe 25% more than their home was valued at way back at peak housing prices. The payments jump to full amortization anywhere between 80% to 200% of the old house payment.

Now, with all that in mind. Lets look at the numbers.

The end of 2008 was the time period where the highest dollar value of standard ARM loans was due to reset. At the peak, about 36 billion dollars per month in loans reset. There is a lag with standard ARMs because the payment shock is anywhere between 0% and 20% increase in monthly payment. Many families can handle it for a short while before they start falling behind.

May/June 2009 is when the Option ARMs begin to reset. This wave has 3 small dips. The peak of the first wave hits us in December 2009 and reaches $25b per month in recasts. It drops off for a bit then shoots up to $30b a month in recasts around June 2010. Drops back to $20b per month in December 2010 and then surges to $40 billion per month in June 2011. Now when these loans recast, there will be a lot less lag time because the monthly payment will jump anywhere from 80% to 200% of what the homeowner is used to paying. With no way to pay and no ability to refinance, homeowners will throw in the towel much faster.

Are you ready for the punchline brought to us by Dr. Housing Bubble?

As of December of 2008, a stunning 28% of option ARMs were delinquent or in some stage of foreclosure. This is before any recasts have even kicked in!

Remember, the banks have already failed and consolidated from just the first mess. Bank of America, Wells Fargo, and Citigroup are already dangling on the cliff.

Who’s next?