The first thought that the above quote might provoke is - why would I begin a weekly comment by quoting an economic analysis that is nearly 5 years old? Two reasons. First, it should be evident that the recent credit crisis did not emerge as some unpredictable surprise, but was instead the very ordinary outcome of extraordinary recklessness. Though the mounting problems in 2005 were utterly ignored by the stock market for more than two years after this analysis was published, the fact is that even with the recent rebound, the S&P 500 remains below where it was in mid-2005. Overvaluation and reckless lending do not always translate into near-term market weakness, but they invariably haunt investors in the form of poor long-term returns.
Second, I've chosen a 5-year old analysis of mortgage lending specifically because the Alt-A (no documentation) and Option-ARM (negative amortization) loans discussed by the Economist commonly sported reset dates 5 years into the loan terms. So the observation that "payments surge as principal repayment kicks in" is not an event that was occurring then. Rather, it is an event that has just begun to occur with loans now hitting their resets. And while current ARM interest rates are only about 4.5%, these mortgages now demand a combination of interest plus principal repayment, on a loan balance that is most likely well above the current market value of the home. This is likely to be onerous relative to a previous payment that was less than the interest alone.