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Wednesday, May 7, 2008

Paulson's Optimism and the Devil's Advocate

Henry Paulson said today that he believes the worst of the credit crisis is over.

Treasury Secretary Henry Paulson said Wednesday the worst of the credit crisis may have passed but acknowledged that rising gas prices will blunt the effect of 130 million economic stimulus checks. He ruled out a second stimulus package for now.


trio of crisis — housing, credit and financial — have pushed the economy to the edge of a recession. To help cushion the blow, the Bush administration and Congress speedily enacted a $168 billion stimulus package of tax rebates for people and tax breaks for businesses.

It is nearly impossible to know if the crisis is over, however there is another side of this story that says this crisis is only beginning and it will get much worse.

The extent of this credit crisis will come down to a reality that we will soon find out more about. There will be one of two scenarios that will play out. Either the mortgage crisis will be limited to sub prime or it will spread to prime loans. Keep in mind that ARM's (adjustable rate mortgages) weren't merely popular among sub prime borrowers. For several years, ARM rates were absolutely tantalizing for prime borrowers. I remember back in the summer of 2003, I once got a borrower a three year arm at 3.875% and I was able to pay for their costs.

Much through 2004 and into 2005, many ARM's could get rates below 5%. These tantalizing rates were way too much to resist and many prime borrowers took advantage. Many of these ARM's have already begun to adjust, but the bulk have yet to adjust. The key question remains whether or not these prime borrowers will face the fate of sub prime borrowers.

If they do, then we are only at the beginning of the credit crisis. There will still be two more years of ARM's adjusting en masse. If the nightmare scenario is upon us, then this will lead to even more foreclosures.

Furthermore, the real looming nightmare are Option ARM's. Those are gimmick loans where there is an artificially low payment for five years. Option arms' likely only garnered no more than two percent of the market. On the other hand, the danger of option arm's is the downward real estate market we are in now. Because borrowers almost always get them for their five year artificially low payment, they typically won't be able to make the payment once it resets in five years. Most of those will start to reset within two years. These option arms have what is called negative amortization payments. After the five years is up, the payments are adjusted over the remaining period. The bottom line is that when the payment adjusts it will adjust in an obscenely astronomical way.

If most of the folks that currently hold onto option arms are not able to refinance out of them, we will see a serious spike in foreclosures in the next two years. While Treasurer Paulson's view is optimistic, it is important to understand just what maybe in store for the market.

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