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Is It Contained?
by David Stanowski
16 April 2007

While the Federal Reserve, the Treasury Department, and most mainstream Wall-Street analysts assure us that the Sub-Prime Meltdown is "contained"; many other financial analysts, without their obvious conflicts of interest, do not agree! There is certainly plenty of evidence to indicate that there are additional problems looming in the mortgage market, which will probably impact residential real estate in a negative way.

Charles Hugh Smith recently used three sources of data to put the actual scope of the current mortgage problems into better focus. The U.S. Census Bureau's "American Housing Survey", the "Financial Service Factbook", and "Stresses in the U.S. Mortgage Credit Markets" reveal that there are 74.9 million housing units in this country, and 65% of them (48.4 million) are mortgaged in some way.

This leaves 26.5 million housing units with no mortgages, which would seem to be without any kind of risk, within the present discussion, but even this overlooks the fact that you can never actually own real estate "free and clear". Such owners must still pay rent, in the form of property tax, to the County, or they will eventually lose their property just as surely as a renter who does not pay their landlord!

The author goes on to analyze the 48.4 million properties with mortgages on them, in terms of risk of default and foreclosure. He found that ONLY 12 million of these mortgages are of the conventional fixed-rate variety, where the owner was required to make a down payment of 20%, or more! The remaining 36.4 million mortgages are made riskier due to one or more of the following factors: balloon payments due, home-equity loans as liens, second or third mortgages, low down payments through FHA or VA, adjustable interest rates (ARMS), origination through sub-prime or Alt-A lenders!

Any factor that makes a mortgage deviate from the standard conventional mortgage makes it a higher risk. The precise amount of higher risk depends on the specific circumstances of each loan.

Based on this data, we can assume that, during a recession, or falling real estate market, the 26.5 million owners without mortgages should have little risk of losing their property, unless they can not pay their property taxes. Another 12 million households, with conventional fixed-rate mortgages should also be considered to be in a low-risk category. However, this also means that 36.4 million owners have higher, to much higher risk mortgages than has ever been the case in prior economic cycles!

Therefore, far from being "contained" in the sub-
prime sector, the higher risk of defaults, and foreclosures has spread to 75% of all mortgaged properties (36.4 million out of 48.4 million); and 49% of all housing units (36.4 million out of 74.9 million)!! It won't take many of these potential dominoes to start falling to put a lot of pressure on the market.

When you trade futures and options, you have a daily reminder of the pros and cons of leveraged positions. You can't ride out falling prices for years pretending that you're not losing money, because your positions are re-priced daily, and you get a margin call if your losses mount. This is not the case in the real estate market.

As long as a market is moving your way, leverage is your friend, but when it reverses, it multiplies your losses very, very quickly. The 36.4 million outstanding non-conventional mortgages have greatly increased the amount of leverage in the residential real estate market, and most of those properties are held by inexperienced and uninformed buyers, who have no clue about the down side of leverage!

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