by John M. Curtis
(310) 204-8700

Copyright August 1, 2007
All Rights Reserved.

oaring foreclosure rates around the country spell trouble for the stock market and the economy, reeling from the meltdown in “subprime” lending. “Subprime” refers to “B-Paper” or “high risk” loans made to less qualified buyers with less stringent lending guidelines. Subprime loans, like “junk bonds,” typically come with higher interest rates, representing an attractive investment when sold into the “secondary market,” namely, as mortgage-backed securities. Investors, like pension and mutual funds, find investments appealing because they yield higher returns. When the economy weakens, more risky securities like “junk bonds” and subprime mortgages typically go into default, causing collateralized bonds to drop in value. Much of today's foreclosure activity is directly tied to defaults in subprime mortgages, where adjustable rate loans reset, strapping cash-crunched homeowners.

      When two Bear Stearns' hedge funds heavily invested in subprime mortgages showed trouble, investors realized that “B-Paper” loans were affecting Wall Street. While there's a strange disconnect between Wall Street and the housing market, defaults and foreclosures trigger a sell-off in mortgage-backed securities. Homebuilders stocks have been hammered because new federal lending guidelines make it more difficult to qualify marginal buyers, those with insufficient work-histories or income to qualify for conventional lending. When Irvine-based First Street Financial, the nation's biggest subprime loan underwriter, closed its doors in May, Standard and Poors downgraded bonds of “junk,” causing other subprime lenders, including Wells Fargo Bank, to call it quits. What fueled the housing boom, namely, cheap and ubiquitous money, now threatens the economy.

      While California defaults and foreclosures peaked in 1996, today's figures are especially ominous. In 1996, the California economy suffered a meltdown in the defense industry, causing high unemployment. Unlike today, defaults and foreclosures back then were attributed to unemployment, where borrowers could no longer afford mortgage payments. With unemployment at nearly record lows, today's defaults and foreclosures are tied to subprime lending practices, qualifying buyers for larger loans with teaser-rate adjustable rate mortgages. Unqualified buyers could afford whopping mortgages based on artificially low teaser-rates. In some cases, mortgage payments were based on 1% or or less, making monthly payments affordable. Now that adjustable rate mortgages have reset to “principal and interest” or “interest only,” borrowers can't make the payments and have no place to borrow.

      Over the past five years, new home sales rocketed across the country, largely driven by loose standards and practices by subprime lenders. Real estate agents, mortgage brokers and homebuilders made a killing, roping willing buyers into borrowing well-above their means. Most new buyers thought they'd eventually refinance adjustable rate mortgages once initial rates jumped. With new federal guidelines, these same borrowers can't refinance, now facing late payments, defaults and foreclosures. When the nation's largest mortgage lender, Calabasas-based Countrywide Funding, announced that 4.6% of its best borrowers were late on home equity lines, Wall Street started to sell off, realizing that without homeowners the economy would eventually go flat. Home equity spending represents a sizable portion of consumer spending fueling gross domestic product.

      Economists worry that without home equity spending the economy is likely to slow down, hurting corporate earnings and driving down share prices. Wall Street's biggest funds have already figured out that current stock values were exorbitant, prompting the latest “correction.” “So far, the foreclosures haven't affected the economy,” said economist John Husing, at Redlands-based Economics and Politics. “I absolutely don't think this is in any way a repeat of the early 1990s,” believing that today's low unemployment will save the market. Whether employment remains high doesn't affect the affordability of subprime mortgages now resetting and sending borrowers into default. When Bear Stearn's most lucrative hedge funds begin to disintegrate, it doesn't bode well for the housing market. Subprime mortgages, like junk bonds in the mid-‘80s, are going bust.

      Regardless of good or bad economic news, Wall Street knows when it's time to buy or sell. Since the market recovered from its historic meltdown in 2001-2003, Wall Street has enjoyed the longest bull market in history. Inflated share prices threaten a liquidity crunch by pushing prices beyond the range of average investors. Taking profits helps create new buying opportunities, spurring the market to new heights. With hedge funds going under and foreclosures on the rise, there's more room to discount current share prices. “People have stretched their finances to the breaking point,” said DataQuick analyst John Kerevoll, concerned that foreclosures have outpaced default notices. Most homeowners have burnt through their cash and have exhausted opportunities to squeeze more out of home equity lines. When that happens, it's going to hit the economy.

About the Author

John M. Curtis writes politically neutral commentary analyzing spin in national and global news. He's editor of OnlineColumnist.com and author of Dodging The Bullet and Operation Charisma.

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