THE MORNING AFTER

The morning after an all night party is just never quite as enjoyable as the festivities that preceded it. Those who overindulged in the easy cheap and cheerful credit of the last decade are now waking to the reality of those excesses. This fallout has only begun to take its toll on credit markets and the economy as a whole.

Remember the saying “it’s just too good to be true?” Borrowers just loaded up on debt with all the easy money that was readily available. Borrowers are now waking up the morning after leveraged beyond their own capacities. Debt expanded with loans on credit cards, real estate, cars and of course subprime residential mortgages. While the booming housing market continued, lenders lowered their credit standards enabling people with poor credit history to purchase property they could not afford.

This fed the continued rise in home prices while borrowers and lenders became even more complacent while increasing the debt. There were billions of dollars in complex securities tied to these loans that were packaged and then sold to investors who were betting on the boom to continue. Additionally, several aggressive hedge funds and other financial institutions borrowed large amounts of easily available short-term debt to fund the purchase of even higher-yielding, long-term securities in an effort to boost even greater returns.

This concept was working for several years while the economy and housing values continued to rise. Alas, the tides changed, housing prices began to come down and the dynamics began to shift into reverse. Now leverage, which is defined as “the use of credit to enhance one’s speculative capacity,” shifts to deleveraging and slows down the real estate appreciation and overall economic growth. This deleveraging began last summer as lenders recognized a higher volume of subprime mortgage loans that were just not going to be paid back. Lenders were forced to apply tougher credit requirements, which inevitably is followed by a decline in housing prices.

When housing prices were rising, lenders were not using caution in extending credit. And now with the decline, lenders are extremely cautious. I’m sure you know what I’m talking about if you’ve applied for a loan recently. Banking institutions and other holders of subprime mortgage securities have been forced to take large write-downs on the value of their holdings. Again, I’m sure you know what I’m talking about if you’ve received an appraisal recently. While trying to protect themselves from further possible write-downs and remain in compliance with their capital ratio requirements, banks are pulling back and reducing the amount of lending. This has housing prices fall even further, leading to a reduction in the value of mortgage-backed securities, which serve as collateral for a majority of loans that lenders made to hedge funds and other investors. This cycle has forced investors to sell assets to raise money to meet margin calls from lenders, creating an even further reduction in asset prices contributing to a deleveraging spiral. The result of this spiral is more than $200 billion in write-downs on securities tied to subprime mortgages. Additionally, the mortgage-backed securities market has become extremely illiquid as demand for these securities has dried up due to fears of further declines in price. Naturally, this illiquidity and fear also spread throughout the credit markets.

The collapse of the fifth largest investment bank in the United States, Bear Stearns, demonstrates the gravity of the current credit crunch followed by IndyMac and others on the watch list. This downfall culminated with the government-assisted fire sale to J.P. Morgan for a small fraction of its value. Bear Stearns was far more reliant on mortgage-backed securities and less diversified than its Wall Street peers, leaving it more exposed when the credit markets began to freeze. Bear Sterns was also insufficiently capitalized to withstand this crisis although they did have a cash emergency reserve of $17 billion it was less than adequate as they had 102 billion in collateralized borrowing. While the value of the collateral fell, Bear began to receive margin calls from its lenders. It was not possible for Bear to sell the mortgage-backed assets in the current environment; thus the firm’s liquidity was questionable. The problem escalated with speculation and rumors, which is typical when fear is rampant. Bear was not successful in reassuring the lenders and customers of its financial stability losing confidence, leaving customers rushing to withdraw assets and lenders refusing to provide the short-term funds that Bear had relied upon ultimately leading to its downfall.

The Federal Reserve has taken aggressive action to prop up mortgage-backed securities and provide liquidity to the credit markets. The Fed slashed short-term interest rates by a full three percentage points since September, which is the fastest reaction of this amount in decades. Other measures to infuse liquidity into the credit markets have been taken, such as agreeing to take billions of dollars of mortgage-backed securities as collateral from financial firms in exchange for short-term loans. The Fed is also allowing investment banks to borrow at a discount, which is a benefit previously reserved for commercial banks. Fannie Mae and Freddie Mac created by Congress to provide funding to mortgage securities and government sponsored enterprises now appears to be shattering the American Dream it helped to create.

The apartment market has always followed the housing market and naturally the economic tide affects us all. I feel that it’s safe to say that housing providers will not be going out of business in the near or distant future. People will always need a place to live and the demand for rental housing in Santa Monica still remains very strong. Naturally, it’s taking a bit longer to rent larger units at higher rental rates although we still see the strongest appreciation in Singles. They always have more turn over than the larger units, and still remain to be the most affordable to a larger majority of renters and can usually be rented at a higher rate upon turnover. A lot of buyers are waiting in the wings for prices to fall and this is just not going to happen in Santa Monica unless of course the price was simply to high to begin with. It’s still a good time to sell if you’re realistic and although your return may not be what it was a year ago, the internal rate of return is still very strong. We recently closed escrow on a building that was on the market 2 years ago when then seller changed her mind about selling.Now being ready to sell, she was concerned that she was going to make so much less than she would have if she sold 2 years ago. I’m happy to say that the sales price was only around 2% less than it would have been 2 years ago. Once again, it’s about being realistic. So if you’ll listening to the news and starting to experiencing the doom and gloom, please remember that the glass is still half full.