John M. Lee: Subprime Loans

The topic of subprime loans hit the real estate stage front and center this year without much warning. In fact, most people are not even sure what subprime loans are and how these potential problem loans can affect real estate.

The definition of subprime loans is a little fuzzy. But in general, these are loans made to people purchasing or refinancing real property, and whose credit is not as pristine as lenders would like to see. They generally include borrowers whose credit score is 620 or lower. Thus, there was a niche market for selected lenders who want to develop business in this area.

Because these loans are riskier, the lenders charge a slightly higher interest rate and points to accommodate these types of loans. Typically interest rates are one to two percent higher, and loan fees are one-half to two points higher than normal.

However, because these loans are riskier and more prone to foreclosure, the banks diversify away their risk by selling them in the secondary market. That way, they recover their principal, keep the points as their profit and walk away from the liability in the event of foreclosure. Also, they can originate more loans and make more money from charging up-front fees.

Some banks also keep the servicing portion of the loans and charge the investors a continual fee for following the account. The secondary market usually packages the loans and sells them as mortgage back securities. There are also insurance companies involved, which can protect the investors if a homeowner were to default on the loan. The insurers often obtain re-insurance to further offset their risk. That is how the risk and liabilities are spread out throughout the financial industry.

When the news broke earlier this year that subprime lenders were in trouble, the whole stock market dropped and we suffered one of the largest losses in the stock market. How will the demise of the subprime loan market affect real estate?

Because of the high delinquencies of the subprime loans, 13.3 percent versus 2.6 percent for regular loans, lenders are tightening up on their underwriting criteria, making it more difficult for borrowers to obtain these loans. The effect will be fewer buyers and less demand for the current inventory on the market.

Thus, the basic economic theory of less demand and same supply leads to lower prices for real estate.

The latest statistics indicate that 20 percent of the new mortgages originated during the last two years were subprime. However, they were more prevalent in other parts of California, but not so much in the Bay Area. So I do not expect us to feel it much in San Francisco.

We are starting to see more bank-owned properties coming onto the market. However, they are nowhere close to what we saw in the early '90s. We will not be facing the same amount of foreclosed properties as we saw in the past.

In the Bay Area, we will be able to work our way past the subprime loan problem without too much trouble. However, because foreclosure rates are up, there might be some upcoming opportunities for buyers and investors.

John M. Lee has an MBA from UCLA and is a top-selling broker with Pacific Union. If you have any questions regarding real estate, call him at (415) 447-6231 or e-mail johnlee@isellsf.com.