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2007-03-07 14:50:00

Part One: Subprime Lending Contagion



Steve Dexter, author of "Rich in Debt"

con·ta·gion  // Pronuncia[kuh n-tey-juh n] –noun
 
Contagion? Now what in the world is a contagion and what does this have to do with real estate lending?
 
Contagion is the root word of contagious which is the process of an infection spreading to unaffected areas. If you have a cold, when you sneeze, the cold virus that spreads the cold and infects others is the contagion. We will see how this applies to the world of finance, because there was a world financial crisis that roiled the financial markets in the 1990's and now we face a looming financial contagion across mortgage markets.
 
Epidemiology of Financial Crisis
 
The root of present lending dilemmas can be traced to the Southeastern Asian financial crisis of 1997. Thailand's economy was in trouble in 1996 as their currency, the Bhat, rose in value against the dollar. American and international banks had just bailed out Mexico because nobody wanted to see their economy melt down and the Mexican peso become severely devalued. The bailout restored the value of the peso which began to rise in value against the American dollar.
 
The Thai Bhat also rose in value, but at precisely the wrong time. Their exports became more expensive, foreign currency reserves began to drain away to pay for the deficits, and seeds of a crisis were sown. The Bhat was allowed to float, and since its value was no longer pegged to the U.S. dollar, it progressively became worth less.
 
As money poured out of the country, Thailand's deep structural problems suddenly became apparent to investors. After 10 years of unsurpassed growth and money flooding into Asia, Western banks became leery about lending more money there.
 
Liquidity evaporated in Thailand as well as in the stronger economies of Indonesia, South Korea, and Japan. Bankers’ anxieties became self-fulfilling, particularly as Thailand's economy began to self-destruct. Speculators, stock investors, and local businessmen wanted the safety of dollars. The fall of 1997 saw currencies fall in the Philippines, Malaysia, Indonesia, Taiwan, and South Korea.

The stack of Dominoes began to fall. The Dow dropped 554 points -- the biggest one-day point decline -- on October 17th, 1997. The Hong Kong stock market declined 24% over the previous four days.
 
That was the Asian financial contagion of 1997. Now let's talk about the American subprime contagion of 2007 where danger, perceived or real, will infect the secondary mortgage market with the contagion of risk.
 
Risk Erodes Lender Confidence, Spurs Regulation
 
Subprime credit loans are scaring Wall Street. J.P.Morgan, one of the chief buyers of this loan genre, estimates that 35% of all new loans originated in the last quarter of 2005 and all of 2006, will have difficulty making their payments when their adjustable rate mortgages hit their first adjustment period.
 
There were not enough buyers last Friday of subprime risk to cover loans recently closed or in process. In panicky conditions, no buyers at any price. Nada.
 
Alt-A loans are closer to junk than trash, but high loan-to-value-ratio Alt-A loans are still trash. By next week there will be few buyers of Alt-A risk, and that market may lock up just like subprime. Even if unaffected lenders like Countrywide and Bank United have to increase their reserve requirements because of increased investor scrutiny and regulatory oversight, they will have less money to lend and their earnings don't look as good.
 
Here is the danger: All the trouble rolls down hill-- Wall Street investor makes packager/securitizer buy back bad paper. The packager throws those nonperforming loans back to the lender. The lender makes broker who originated loan take back the bad loans. And here is the scary part –- the broker will have to go after the borrower to collect back payments and file judgments. To write off losses, 1099s will be issued to borrowers for  portions of “loan forgiveness,” adding tax bills to the borrowers' overall indebtedness.
 
Here are other reports in recent weeks about the “Great Mortgage Market Meltdown:"
 
At least 20 subprime lenders have scaled back, closed or sold themselves in the last five months.
 
  • New Century lost one third of its share price in one day last week. They announced that they would re-state past earnings, make fewer loans this year and take a fourth quarter loss.
  • Novastar's share price declined 50% in the last 10 days.
  • Lenders on the auction block:
      1.  Option One Mortgage, an Irvine based subprime lender, will be sold for 103 million dollars by parent company H and R Block at the end of March.
      2. Ameriquest, an Irvine top tier lender will be sold this year, say investment bankers at Bear Sterns.
      3.  Argent Mortgage, a lender that is on the market for sale now, is now requiring new sales reps to give back their commissions if loans they originate fall into foreclosure.
 
  • San Diego Tribune reported one in five subprime mortgages made in the last tw years are going into foreclosure.
Late payments for all residential mortgages shot up 15.6% the last quarter of 2006 according to the FDIC, the highest since 2003.
 
  • But only 20% of FDIC insured banks' loan portfolio are subprime securities. That is good -- big banks seem to have low exposure to subprime risk.
  • Freddie Mac, the second largest provider of funds for home loans will no longer buy what it deems to be high risk mortgages vulnerable to foreclosure.
  • Now Congress will get into the act. Several proposals are on the table to restrict people from qualifying at an artificially low teaser rate and who get into trouble when that loan readjusts. Legislators want to protect unsophisticated borrowers from being preyed on by mortgage salesmen of “low ethics”. Unfortunately, it will have the opposite effect and lock more people out of the market.  
Will this cancer of default spread? Will late payments infect mortgage markets up and down the credit spectrum and will a reverse speculative bubble pull the real estate market down with it?
 
What can you do to protect yourself and to take advantage?
 
Part Two of Subprime Contagion will be published in RealTown next week.

(Steve Dexter is the author of Real Estate Debt Can Make You Rich. He is also a loan officer licensed in AZ, CA, CO, CT, DC, FL, HI, ID, MD, MI, MN, NV, OR, UT, VA, WA.)



Steve Dexter, author of "Rich in Debt"

con·ta·gion  // Pronuncia[kuh n-tey-juh n] –noun
 
Contagion? Now what in the world is a contagion and what does this have to do with real estate lending?
 
Contagion is the root word of contagious which is the process of an infection spreading to unaffected areas. If you have a cold, when you sneeze, the cold virus that spreads the cold and infects others is the contagion. We will see how this applies to the world of finance, because there was a world financial crisis that roiled the financial markets in the 1990's and now we face a looming financial contagion across mortgage markets.
 
Epidemiology of Financial Crisis
 
The root of present lending dilemmas can be traced to the Southeastern Asian financial crisis of 1997. Thailand's economy was in trouble in 1996 as their currency, the Bhat, rose in value against the dollar. American and international banks had just bailed out Mexico because nobody wanted to see their economy melt down and the Mexican peso become severely devalued. The bailout restored the value of the peso which began to rise in value against the American dollar.
 
The Thai Bhat also rose in value, but at precisely the wrong time. Their exports became more expensive, foreign currency reserves began to drain away to pay for the deficits, and seeds of a crisis were sown. The Bhat was allowed to float, and since its value was no longer pegged to the U.S. dollar, it progressively became worth less.
 
As money poured out of the country, Thailand's deep structural problems suddenly became apparent to investors. After 10 years of unsurpassed growth and money flooding into Asia, Western banks became leery about lending more money there.
 
Liquidity evaporated in Thailand as well as in the stronger economies of Indonesia, South Korea, and Japan. Bankers’ anxieties became self-fulfilling, particularly as Thailand's economy began to self-destruct. Speculators, stock investors, and local businessmen wanted the safety of dollars. The fall of 1997 saw currencies fall in the Philippines, Malaysia, Indonesia, Taiwan, and South Korea.

The stack of Dominoes began to fall. The Dow dropped 554 points -- the biggest one-day point decline -- on October 17th, 1997. The Hong Kong stock market declined 24% over the previous four days.
 
That was the Asian financial contagion of 1997. Now let's talk about the American subprime contagion of 2007 where danger, perceived or real, will infect the secondary mortgage market with the contagion of risk.
 
Risk Erodes Lender Confidence, Spurs Regulation
 
Subprime credit loans are scaring Wall Street. J.P.Morgan, one of the chief buyers of this loan genre, estimates that 35% of all new loans originated in the last quarter of 2005 and all of 2006, will have difficulty making their payments when their adjustable rate mortgages hit their first adjustment period.
 
There were not enough buyers last Friday of subprime risk to cover loans recently closed or in process. In panicky conditions, no buyers at any price. Nada.
 
Alt-A loans are closer to junk than trash, but high loan-to-value-ratio Alt-A loans are still trash. By next week there will be few buyers of Alt-A risk, and that market may lock up just like subprime. Even if unaffected lenders like Countrywide and Bank United have to increase their reserve requirements because of increased investor scrutiny and regulatory oversight, they will have less money to lend and their earnings don't look as good.
 
Here is the danger: All the trouble rolls down hill-- Wall Street investor makes packager/securitizer buy back bad paper. The packager throws those nonperforming loans back to the lender. The lender makes broker who originated loan take back the bad loans. And here is the scary part –- the broker will have to go after the borrower to collect back payments and file judgments. To write off losses, 1099s will be issued to borrowers for  portions of “loan forgiveness,” adding tax bills to the borrowers' overall indebtedness.
 
Here are other reports in recent weeks about the “Great Mortgage Market Meltdown:"
 
At least 20 subprime lenders have scaled back, closed or sold themselves in the last five months.
 
  • New Century lost one third of its share price in one day last week. They announced that they would re-state past earnings, make fewer loans this year and take a fourth quarter loss.
  • Novastar's share price declined 50% in the last 10 days.
  • Lenders on the auction block:
      1.  Option One Mortgage, an Irvine based subprime lender, will be sold for 103 million dollars by parent company H and R Block at the end of March.
      2. Ameriquest, an Irvine top tier lender will be sold this year, say investment bankers at Bear Sterns.
      3.  Argent Mortgage, a lender that is on the market for sale now, is now requiring new sales reps to give back their commissions if loans they originate fall into foreclosure.
 
  • San Diego Tribune reported one in five subprime mortgages made in the last tw years are going into foreclosure.
Late payments for all residential mortgages shot up 15.6% the last quarter of 2006 according to the FDIC, the highest since 2003.
 
  • But only 20% of FDIC insured banks' loan portfolio are subprime securities. That is good -- big banks seem to have low exposure to subprime risk.
  • Freddie Mac, the second largest provider of funds for home loans will no longer buy what it deems to be high risk mortgages vulnerable to foreclosure.
  • Now Congress will get into the act. Several proposals are on the table to restrict people from qualifying at an artificially low teaser rate and who get into trouble when that loan readjusts. Legislators want to protect unsophisticated borrowers from being preyed on by mortgage salesmen of “low ethics”. Unfortunately, it will have the opposite effect and lock more people out of the market.  
Will this cancer of default spread? Will late payments infect mortgage markets up and down the credit spectrum and will a reverse speculative bubble pull the real estate market down with it?
 
What can you do to protect yourself and to take advantage?
 
Part Two of Subprime Contagion will be published in RealTown next week.

(Steve Dexter is the author of Real Estate Debt Can Make You Rich. He is also a loan officer licensed in AZ, CA, CO, CT, DC, FL, HI, ID, MD, MI, MN, NV, OR, UT, VA, WA.)

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