Bloomberg reports today on Fed findings that state that (OMG!) piggyback mortgages are making it harder for homeowners to modify the terms of their existing first mortgages. No sh&$ Sherlock. Really? This is newsbreaking stuff here. 2nd lien holders who purchased piggyback 2nd mortgages are in a terrible position, althought it may be in their interest to get the first loan modification done, especially in bubble states where they’re basically holding air.

What are Piggyback 2nd Mortgages?

For those of you not overly familiar with the parlance of the early 2000’s housing boom, a piggyback mortgage is a 2nd mortgage used at the time of purchase (or refinancing) so that the first mortgage is kept below 80% of the value of the house to avoid mortgage insurance costs. The 2nd, piggyback mortgage makes up the difference of the financing, usually 100% to make it cheaper to buy (um, borrow) a home from the bank.

These loans were super-popular because it allowed you to either 1) by a home with no money down or 2) refinance and pull cash out of your existing home up to 100% of the property value.  Granted you’re now stuck with a huge loan and often with an adjustable rate first loan and a high-interest rate 2nd, but you got the cash and you were happy.

Until things started to get nasty.

Most Piggyback 2nds Aren’t Worth the Paper They’re Printed On

Nowadays, these piggyback 2nds are litterally unsecured debt.  Like a credit card.  The property values where this type of financing was popular (CA, FL, NV, AZ) have tanked more than 20% in most places rendering the 2nd lien completely unsecured.  Because the 2nd lien is subordinate to the first, they have no right to the devalued property ahead of the first lien holder in the event of a default.  So they just sit nervously chewing their nails and hoping the monthly payments continue to roll in until the tide starts to rise again.  That’s a long time to be biting your nails.

Companies like Wells Fargo, who hold millions of dollars in 2nd mortgages in states like California are very jumpy because these piggyback mortgages are starting to default at alarming rates.  More people are figuring out that they’d rather just not pay a loan that is $100,000 more than the value of the home and are walking away.

Piggyback Holders Make Loan Modifications Tough

There are several reasons that piggyback mortgages make loan modifications tough (and short sales for that matter).  First, is the overwhelming complexity of trying to get approvals lined up.  Most piggyback mortgages are not held by the originating party and therefore the servicing companies have to track down the final holder of the note and get approvals to allow the note to be subordinated to a new first mortgage (the one being modified).  If the 2nd mortgage is in some type of security that has been sliced and diced with many investors holding some interest it can be even tougher.  Second, as we’ve already covered, the 2nd lien holder is already in a precarious position due to the plummenting house values.  And a loan modification request is a sure sign of a borrower in distress which doesn’t bode well for the 2nd lien holder if the market keeps dropping.  The 2nd mortgage holder may decide that they’d rather take their chance with a foreclosure now and try to recoup something out of the deal instead of waiting as the housing market continues to tank.

Piggyback Holders May Want to Consider Approving Some Loan Modifications

2nd mortgage holders may consider allowing loan modifications in situations where either they have no options.  Such as a home that is completely underwater and they’re left in a position where the note is now basically an unsecured debt.  In this instance their only chance at recovering the debt is to give the homeowner the best chance at repaying it.  This chance can be improved by allowing the first mortgage to be modified to provide a more manageable monthly payment.  (But this is a bit of a pipe dream, since more than half of all modified mortgages are still defaulting.)

Alternatively, if they have a very good security position they may consider allowing a modification because they’d rather make the money on the interest and servicing while knowing that they’ll be compensated to one degree or another in a foreclosure proceeding.  (This, again is a bit of a pipe dream because I can’t think of too many areas where properties have appreciated to the point where original 100% financing is now, say, 85-90% of the home value.)

Piggyback Mortgage Holders are Going to Eat It – Big

Wells Fargo and other holders of millions of dollars of second mortgages are going to find themselves taking massive losses on these portfolios over the next several years.  With the housing market continuing to tank, the likelihood of cram-downs as a relief tactic increasing, and the job market crashing it is easy to make an argument that most of these 2nd mortgages aren’t worth 10 cents on the dollar.

Not that it won’t be deserved.  If you were out there buying up portfolios and pools of piggyback 2nd mortgages with 100% financing to people with 580 credit scores you deserve to eat it.  It’s just too bad that the taxpayers will end up paying for your bad decisions too.

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The current financial crisis affects everyone. No where, however, has the impact been more striking than on the middle-class.

“The gap between the ‘haves’ and the ‘have-nots’ is widening for families with children in the United States,” said Bruce Western, professor of sociology of the Multidisciplinary Program in Inequality and Social Policy at Harvard University. And primary author of a new study exploring income inequalities in the middle class during the past 30 years. “Inequality for these families has grown faster than the combined rates of inequality for all families and for men’s hourly wages.”

Results of the study, “Inequality Among American Families with children 1975-2005” indicate that several factors have contributed to the increasing stratification among the middle class. These factors include the growing income advantage of college graduates and rising number of single-parent households. The effects of these factors were somewhat offset by the the increasing rate of women’s employment and higher educational attainment among parents.

Current economic conditions may be slowing the rising tide of single parent families. A poll conducted by the American Academy of Matrimonial Lawyers (AAML) reveals that the number of divorces actually declines during periods of economic turbulence.

“The reason that the economy has such an enormous impact on divorces is that most people in the middle-income brackets are getting by on whatever income they have. They’re just getting by,” Bonnie Booden, a family law and divorce attorney in Phoenix, AZ told MarketWatch.

Circuit courts across the country are seeing notably fewer divorce and legal separation filings, MarketWatch reports. According to the AAML, more than one-third of members responding to the poll say they typically see a decrease in the number of divorce cases during economic downturns.

This is good news for families, children and the economy in general because the incomes varied the least among two-parent families according to the inequality study. Income inequality was greatest in single-parent families without a working mother. Unfortunately, the gap between high and low income families increased across all family groups during the 30-year period studied. The effect of the economic slowdown on the middle-class is important because it is a large and vibrant middle-class that purchases many of the products and services making up the bulk of the American economy. Without them, the economy continues to struggle and shrink.

“Our research suggests a broad increase in income insecurity that goes beyond low-skill workers and single parents and extends to families from every class,” Western states. “The polarization of family incomes among this generation has implications for the social and economic mobility of future generations and suggest the further erosion of the middle class in in years to come.”

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We have worried out loud that the policy remedies being pursued by the US amount to trying to restore the status quo ante to as great a degree as possible, particularly in trying to resturn US overconsumption to something approaching its former levels. Although it may be difficult to work two agendas, crisis response and addressing the root causes of our economic mess in parallel, focusing solely on the former runs the considerable risk of that we will see only a shallow recovery, with many of the elements of the crisis soon reasserting themselves in more virulent form.

Similarly, the Chinese, who at least in theory had accepted that they needed to let their currency rise (and presumably over time move to a more balanced, less export-dependent economy) have similarly gone into full reverse gear. The RMB has now been more or less re-pegged to the dollar, and China is moving in other ways to shore up exporters (such as pressuring banks to lend).

Michael Pettis points to a related, troubling development: other emerging economies are seeking to restore or increase trade surpluses. That in turn means SOMEONE has to import. But the US wants to increase exports (and the move by the Fed to quantitative easing will have the side benefit, from its perspective, of weakening the dollar). Euroland is neither keen nor able to step into the US role of importer of the last (and first) resort (boldface ours):

One consequence of the financial crisis will inevitably be capital outflows from developing countries. The necessary corollary of capital outflows is trade surpluses. Without running a trade surplus no country can consistently support capital outflows, and as obvious as this is, it also seems to be a source of tremendous mystery to many experts and policymakers. Keynes for example pointed this out in his fury at the way Germany was required to post war reparations in the 1920s while its ability to generate export surpluses was all but eliminated by the victorious powers. Capital exports by definition require trade surpluses.

This is just another way of saying that a lot of developing countries that had been running trade deficits will soon be, if they aren’t already, running trade surpluses. Instead of contributing their net demand to the world economy, as they had via their trade deficits, they will now be contributing their net supply.

This will not help the world imbalances. The biggest contributors of net demand are the US and non-Germany Europe, and both of these regions are seeing a rapid decline in their net demand contribution (i.e. their trade deficits are expected to shrink). To adjust to this decline the world needs new sources of net demand or else global production must contract sharply via factory closings and rising unemployment. But the largest net supply country, China, is increasing its export of net supply (its trade surplus has been rising) while several trade deficit countries in Asian and elsewhere are switching to trade surplus or otherwise trying to reduce their deficits.

This cannot be sustainable. We cannot expect production to rise while consumption declines except if it comes with a dangerous rise in forced investment (also known as inventory). The crisis cannot even begin to be considered in its final stages until this issue is resolved.

Pettis addresses another issue, namely, that China’s interest rate cuts will do little for consumers, and will instead exacerbate global imbalances:

For me, interest rate cuts in China will have very different effects than they might in the US. In the US, where a great deal of credit goes to consumption, lowering interest rates can be seen as boosting consumption as much as boosting production. At any rate the US, which contributes the largest amount of excess net consumption to the world and must bring it down, has every reason to focus on production-boosting measures as well as consumption-boosting measures.

But China is different. First of all there is little to no consumer credit in China, so cutting interest rates won’t do much to boost consumption. It might do so indirectly by reducing mortgage payments (Chinese mortgages are all floating-rate mortgages) and perhaps by slowing the decline in real estate prices, but it is not clear how big an effect that might have on increasing consumption, especially since even lower interest rates aren’t likely to create much buying interest for real estate. In fact there is some evidence in China that households may actually contract spending when deposit rates are cut since they need to save more to achieve their precautionary savings targets.

On the other hand with most credit going to investment, lowering interest rates definitely reduces further the cost of production. I know that the idea of lowering interest rates in an economic contraction is firmly entrenched in economic wisdom, and I am taking what may seem like an extremely opposite viewpoint, but I doubt that cutting interest rates is what China needs to do if it is expecting to adjust to the global payments adjustment. Every domestic policy must be aimed at boosting demand, and anything that increases China’s “competitiveness” is a dangerous detour since it can only exacerbate global imbalances and increase the likelihood of trade friction.

In down times, it’s every man for himself. The interesting question is whether these conflicts come to the fore in 2009 or take a bit longer to become acute.

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Only one thing is really clear about the Germany economy at the present time, and that is that it is shrinking rapidly. In fact it contracted far more than most analysts and observers expected in the third quarter (although I, for one, was not especially surprised), entering what now appears to be its worst recession in at least 12 years as both exports and domestic spending continue to fall. German gross domestic product in Q3 dropped by a seasonally adjusted 0.5 percent from the second quarter, when it fell by a quarterly 0.4 percent, according to revised data from the Federal Statistics Office. The Germany economy last had a two quarter contraction of this magnitude back in 1996.

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The IMF, which recently announced a $2.4 billion agreement with Latvia, has said the ailing Baltic country will not be required to give up its currency peg (the lat is currently pegged to the euro with a ±1% fluctuation band). This is quite an unusual move and is reportedly controversial even within the IMF.

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Chinese Yuan closed trading Wednesday in green at 6.8230 against the dollar on the over the counter market up from 6.8353 Tuesday.

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The Aussie closed trading flat against the greenback Wednesday with end of year transactions rather than economic data directing currency movements.

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The Bank of England on Wednesday set the fixed bid rate for its 7 day U.S. dollar repo at 1.16 percent.

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The euro gained strength in early European trade Wednesday as the 15 nation common European currency bought $1.4091 up from $1.4087 in late New York trading Tuesday.

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US equity markets and dollar are headed lower interest rates higher energy led commodities sector would climb up towards end of 2009 Asian markets will fall but bounce up later.

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