Monday, October 29, 2007
9:35 AM - 10:35 AM

The Subprime-Market Ripple Effect

General Session

Speakers:

Ross DeVol, Director, Regional Economics, Milken Institute

Bill Lockyer, Treasurer, State of California

Jeffrey Mezger, President, CEO and Director of the Board, KB Home

Angelo Mozilo, Chairman and CEO, Countrywide Financial Corp.

Moderator:

Lewis Feldman, Partner, Los Angeles office, Goodwin Procter LLP

Summary:

It is a Rubik's Cube without colors. The collapse of the subprime mortgage market is indeed a many-sided aggravation. And like the cube, the collapse revolves around a single core: in this case, easy credit.

Thus did moderator Lou Feldman of Goodwin Procter take the audience through a subprime primer, noting first that a perfect storm was brewing for some years prior to 2007, when the mortgage industry and investment banks, not to mention tens of thousands of U.S. homeowners, began to reel from the tidal wave of defaults.

With lower interest rates running through in the early 2000s, Feldman said, the number of investors buying second homes more than doubled. By 2004, when the demand for houses was slowing and political pressure was building to make homeownership accessible to all consumers, loan originators -- who typically bundle and sell their loans, which may be resold again until they ultimately are held by a global network of investors -- began to ease lending standards and open the doors to borrowers with less attractive credit histories.

While subprime loans might have constituted just 2 percent of all loans in 1998, by 2007, they made up 14 percent of the mortgage market. In California that number is even higher for the year: 17 percent to 20 percent of all mortgages. And even though today's delinquency rates are the same as they were on Sept. 11, 2001, the magnitude is greater because there are seven times as many subprime mortgages now as existed then.

In just the period from second quarter 2005 to second quarter 2007, California delinquency rates have climbed more than 180 percent. But State Treasurer Bill Lockyear said that while he anticipates some economic ripple effect across the state, "it's still too early to measure." Next year, California’s deficit is expected to reach $9 billion, he noted, and while the subprime effect will be "significant," he anticipates that the state will be shielded by its strong and diverse economy.

Countrywide's Chairman and CEO, Angelo Mozilo, took pains to explain what precipitated the subprime problem. First, he said, easy money began to drive up home prices at the start of the decade. When the Fed began to raise interest rates -- after some six or seven times, in fact -- people suddenly began to scramble to get into houses before the next rate hike. In addition, lenders were facing pressure from minority advocates to help people purchase homes. Lenders felt pressure to lessen their loan standards.

But the ultimate cause of the current crisis is simple to explain, Mozilo said: Home prices are going down. And falling home values continue to be a problem. Recent homebuyers now owe more than their homes are worth.

"We must take steps to create liquidity," he warned.

So far, he said, the federal government has done little to help the industry. The Fed has lowered rates, which has brought some relief. But there has been no program, no effort, no legislative breakthrough yet, such as allowing Fannie Mae and Freddie Mac to raise their caps on mortgage holdings. All he has seen is pressure on the lenders, he said. "No one is helping (the lenders)," he said. "The ones who are putting out the intellectual assets, the financial assets are the lenders, and no one else."

Countrywide is in the process of modifying some of its loans, Mozilo said, though the process involves "separating the wheat from the chaff." Lots of the loans were taken by speculators. "They’ve run," he noted. "You can’t stop those foreclosures." His company is "focusing on families who may lose their homes and be relocated."

Jeffrey Mezger, President and CEO of KB Home, noted that California has the second-worst home affordability in the country, but that this "affordability crisis" existed long before the subprime loan crisis. New-home builders have reacted to the lending debacle by pulling back on inventory. KP, for example, which only builds homes once they've been sold, is moving into a new phase of building smaller, less expensive homes. The company is also reducing its investment in new communities and realigning overhead. "It’s going to stay tough for quite some time," he said of the economic effects on his industry and suggested that housing prices could drop up to 15 percent over the next year and a half.

Ross DeVol of the Milken Institute introduced the idea of "financial panic" as the culprit leading to the credit crunch, a term that met with general agreement. Examining what a 30 percent decline in housing sales, $90 oil prices and tightening credit could mean over the next year, DeVol cited a cut of approximately 3 percent in the state's GDP. On the bright side, he said, an optimist looks at the stimulus of higher exports due to a lower dollar. He also stated that by lowering interest rates, the Federal Reserve could lessen housing's fallout on the broader economy. But he was less than upbeat. "We're on the razor's edge of recession," he warned. "If anything else goes wrong, we probably have a recession." Treasurer Lockyear countered that he remained one of the optimists nonetheless. "Our economy is too strong," he stated. "I'm optimistic. I also see the growth trends."

Reaction to the lending crisis has been extreme, even "punitive," said Mozilo. It makes no sense to cut off credit to first-time buyers, since they constitute the most important segment of the homeownership cycle. "This is where it all starts," he said. Instead of punishing them, he said, people should look elsewhere for solutions. For example, the National Association of Realtors and the National Association of Home Builders -- which have made little effort to come together -- should work with lenders "to see if we can influence the process to create liquidity." Three, four or five years from now, he warned, "the gap between minorities and the majority will widen, leading to other social problems as well." Liquidity is the answer to ensure that homeowners can hold on to their properties.

In his history in mortgage lending, Mozilo said, he had seen only three reasons why people fall into delinquency: loss of a job, loss of a marriage or loss of health. When homeowners lose equity, he said, they leave their homes -- but for no other reason.

Mozilo also noted that one must be careful when looking at the current numbers. In order for loans to be modified, or "reset," he explained, they must go into foreclosure first. This is a regulatory issue. "We have a lot of latitude (in resetting loans)," he said, "but loans have to go into foreclosure." More important than that, however, he added: Loans going into foreclosure do not necessarily foreclose. The Countrywide average, he said, is a mere 1 percent.

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