The current financial crisis has its root in the mortgage issuance boom that began in 2001 and peaked, with the net issuance of USD 1.1 trillion of household mortgages, in the first half of 2006. For much of the post-war period, net new mortgage origination by households averaged about 3% of GDP but peaked close to 9% in the second quarter of 2006. It is reasonable to assume that the borrowers early in the cycle represented the comparably high quality part of the borrower spectrum (hard as it seems to describe “subprime borrowers” in that way), with the credit quality of borrowers deteriorating markedly as the boom approached its peak.

At the peak in 2006, a record 50% of total mortgage applications were for Adjustable Rate Mortgages (so called, ARMs, with very low teaser rates that would generally reset 5 years forward). The upper chart shows the huge wave of subprime ARM resets in 2007/08: the resets cycle for the sub prime mortgage genre peaked in late 2008 and accounts for the sharp decline in overall resets in 2009 that has given respite to banks and a degree of relief to borrowers. Unfortunately, as the chart shows, the lull in ARM resets hits its low point now, before the surge of a second wave of resets in 2010/11. In fact, the lower chart shows almost USD 750 bn of resets in the next two years, concentrated this time in the Option ARM and Alt-A genre of mortgages. Option ARMs are mortgages that required little or no documentation, where borrowers had the option of making monthly payments (with the interest rate generally negatively amortizing on the mortgage) and, given the shocking borrower quality, the hope was that house prices would continue to rise and homeowners could simply “flip” the property when the mortgage came to reset. There are almost USD 200 bn of Option ARMs to reset in the years ahead (Fitch estimate that 90% of those have yet to reset) and, given that delinquency rates are already running near 40%, the scale of this reset time-bomb is equal in magnitude to that of subprime in 2007/08. Alt-A mortgages sit somewhere in quality between prime and subprime.

Looking at the lower chart, in excess of USD 1 trillion in mortgages reset in the next 3 years: resets in the next 3 years are equal in magnitude to those of the last 3 years. Whoever said the credit crisis was over is severely misguided!

Whilst taxpayers will remain in their wrongful place in the capital structure of banks, the much needed debt for equity swap process absent, the consequence of “subprime the sequel” is that further substantial losses will be taken by the government purse and the financial sector is a long way from being able to function normally. It may, also, be premature to allow banks to escape TARP constraints, simply to pay staff bonuses.