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Easier money

Sub-prime mortgages favored by borrowers with weak credit and little cash may prolong the housing slump.

March 12, 2007

CALIFORNIA'S HOUSING bubble and housing slump share a root cause: easy money. And the particular category of easy money that sustained the bubble for so long -- so-called sub-prime mortgages, which are designed for borrowers with weak credit and little cash on hand -- may also prolong the slump.

Generally, sub-prime mortgages carry higher fees and interest rates than prime loans. Often they feature adjustable rates and other options that keep payments low in the first few years of the loan. They make it easier for buyers to break into expensive markets such as Southern California; since 2003, 15% to 25% of the mortgages originated in California have been sub-prime.

But these loans have a dark side: The size of their payments can increase, sometimes steeply. When home prices are on the rise and credit is easily available, such spikes aren't as problematic; if the payments are too much, a homeowner can always refinance or sell (at a profit).

Or at least a homeowner could during the bubble. In a downturn, those options evaporate -- and many borrowers default.

In the fourth quarter of 2006, default notices rose to almost 40,000 -- their highest level in eight years. The pain could spread if rising defaults beget stricter lending practices and demand for housing slips, driving prices still lower.

Whether the sub-prime mess will initiate such a downward spiral -- or infect the real estate market more broadly -- remains to be seen.

Freddie Mac, which owns about $184 billion in bonds backed by sub-prime mortgages, recently announced that it was raising qualification requirements for the loans in which it invests. And five federal financial regulatory agencies have urged lenders to better explain the risks of adjustable-rate loans.

Economists from industry groups say the sub-prime crisis doesn't necessarily spell doom. Another view is that the housing market was in need of a correction and that a tightening of credit is just what the broker ordered. Either way, wobbles from large sub-prime lenders -- which include Irvine-based New Century Financial Corp. and Santa Monica-based Fremont General Corp. -- could put a damper on the local economy.

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