INTEREST BEARING NOTES

The Following Article is from the Spring 2007 Newsletter

Sub-Prime Spillover to A Paper Loans?

Within the last few weeks, the sub-prime mortgage lending industry has been at the center of the financial news presenting significant challenges for some firms in the industry. The troubles plaguing lenders of risky mortgages are not likely to spill over into the broader economy unless housing prices see another substantial dip.  As home prices have dipped nationwide, Subprime borrowers who are generally over leveraged have not been able to build up enough equity.  However, if home prices drop in a year, that could cause the problems to spill over into other areas.   At the moment, the spillover is just not there. 

Mounting concerns about risky mortgages by Subprime lenders who provide loans to people with poor credit histories have been making investors on Wall Street jittery which is resulting in lack of liquidity in the secondary markets.  Worried about defaults on the high-risk mortgages, federal bank regulators called on lenders to use caution in making Subprime loans and strictly evaluate borrowers’ ability to repay them.  Various Subprime lenders who did well in the housing bubble are closing.  We are experiencing the highest rate of delinquencies in almost four years.  How quickly we forget the early 1990s!  Many families potentially will be foreclosed on across the Country.  However, it is a mistake to apply the Subprime sector to the entire lending industry. 

Clearly abuses have taken place in the mortgage market.  As we look back at the incredible growth in housing prices, joined with a feeding frenzy of demand, the Subprime market leaped ahead in the volume of business they were doing to get more and more buyers into first time homes.  Many homebuilders and others anxious to continue feeding their sales volume jumped into this new market segment of Subprime lending in order to feed the conveyor belt of new construction gobbling up the farmlands. Exotic mortgages, no interest, option arms, etc were product of an industry that loosened its guidelines too much, and no doubt the consequences are being paid for the liberal underwriting.  Additionally, investors and speculators used these products to buy investment properties financed as owner occupied properties.  They are now bailing out on them, particularly inLas VegasandSouth Florida because they cannot sell the properties as in the past when they experienced liquidity problems.

Recent examples of the local problems emerging are in areas such as Riverside, California where in some neighborhoods, more than ten percent (10%) of newly constructed five bedroom homes that are only two years old are going through foreclosure because they are not reselling.  The buyers of those homes generally were paying purchase prices of $300,000 for the new homes and trading the lower purchase prices of new large homes for the long commutes to work inLos Angeles.  Combined with that relatively low purchase price byWest Los Angeles area standards, the borrowers had weak or bad credit and little, if any money for down payments.  Many homeowners took advantage of low interest rates and ‘exotic’ mortgage products such as adjustable rate mortgages, interest-only loans, payment option ARMs and other Subprime products to help finance their home-buying.

To join the ranks of homeowners in an era of skyrocketing prices, many buyers took “extraordinary risks” that sometimes led to a mismatch between a borrower and a mortgage product. As an example, the payment option ARMs were originally introduced for people whose monthly income fluctuated, such as salespeople. However, payment option ARMs often attracted borrowers who could only make the minimum payments, which increases the size of mortgage debts and the likelihood of defaults.  These types of loan products are not new or unique.  Instead, the borrowers assured themselves with statistics on real estate appreciation and lower interest rates since 9/11 to convince them that they could sell out quickly if there was a need to liquidate the property.  TheSouthern Californiareal estate market has generally not dropped significantly in price, but unit sales have dropped considerably.  Thus, the rapid run up in mortgage defaults and pending foreclosures when the distressed homeowner could not readily liquidate as in the past. 

While the use of these lending instruments could present a problem on par with what has been occurring nationally, there weren’t as many Subprime loans made in the West Los Angeles area as in other areas of Californiaand other States because of the relative unaffordability of Westside homes. California’s housing is expensive because of the restricted supply of new housing. The limited availability of land for development, shortages of water and electricity, lack of transportation infrastructure, environmental concerns and zoning regulations all mitigate against increasing the supply of new housing.  In January 2007, the median home price inCaliforniastood at $559,640, more than double the national median at $210,600.  The housing market correction started later in California than in other parts of the country. The coastal areas of California will recover from the correction first, while it may take longer for the Central Valley and Inland Empire of Southern California.

The troubles have caused comments that the economy could be sagging toward a possible recession, although most experts think that possibility is unlikely.  Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson have said they don’t expect the problems of the Subprime mortgage market to spread through the financial system and hurt the economy.  The Fed will likely hold on rates for much of 2007. 

Housing has led the country in and out of recessions.  Housing is important, and it important that our legislators do not overreact and cut off liquidity.  How hard a landing it will be is still open.  If we head to a hard landing, the Fed will have to cut rates which is good news for the housing market which will tend to soften the blow.  Thus, the 2007 year end outlook is that the economy could be impacted negatively which force a slight decrease in the interest rate environment and housing will will benefit in the long run.