COMMERCIAL MORTGAGES: Residential woes making their way to all sectors ANDREW LITTLE TIMES-DISPATCH COLUMNIST Mar 12, 2007 There is a crack in the rose-colored glasses real estate people have been wearing for the past four or five years. A small chip first appeared when home sales became sluggish last summer. The chip splintered as homebuilders reported significantly lower sales and shrunken pipelines for 2006. Now it is a widening crack, as lenders' aggressive underwriting practices have been caught in the back draft of flattening home prices. Borrowers who previously relied on home appreciation to finance their way out of overleveraging their homes have no place to go. The flow of capital, in effect, has been cut off. In the past two weeks, industry reports have indicated that at least 20 residential lenders have closed their doors or are looking to sell themselves. Most are sub-prime lenders, which deal with the more risky borrowers with less than prime credit. However, the woes have not been limited to small companies. Europe's largest bank, HSBC Holdings Plc, indicated last week that its North America profits fell 87 percent because two-thirds of its $10.6 billion in 2006 loan defaults occurred in the United States. Countrywide, the largest residential lender in the United States, disclosed last week that almost 20 percent of the sub-prime loans it services for third-parties are in default. More troubling, it indicated that delinquencies for its prime mortgages rose to 2.76 percent, while delinquencies for its prime home-equity loans rose to 2.93 percent from 1.57 percent. That is an 87 percent increase in default from last year. On the commercial mortgage side, we've looked at the slumping housing market as a temporary consumer problem that would make people feel less wealthy and perhaps effect retail properties as consumer spending abated. Unfortunately, we are more intimately intertwined with our residential brethren. For instance, Fremont (NYSE: FMT), a huge provider of residential and commercial construction loans, shuttered its sub-prime residential lending group and put 75 percent of the workforce on paid leave last week. The alarming losses in the residential mortgage market have had a sweeping and more dramatic impact on commercial mortgage rates than anyone anticipated. Now that sub-prime mortgages have been exposed as toxic waste and prime mortgages are starting to come into question, there has been a huge shift of money out of all real estate lending markets. Credit spreads for commercial properties have backed up significantly and can best be described as choppy. Translation; today, most commercial loan spreads are getting priced about .10 percent to .15 percent higher than two weeks ago. According to the John B. Levy and Company National Mortgage Survey, rates are now in the 5.6 percent to 5.7 percent range for five- and 10-year loans. What is scary about this widening crack is no one knows how bad it is going to get. The flow of capital to sub-prime borrowers is cut off. That means fewer home buyers and more pressure on home prices. According to the Mortgage Bankers Association, approximately 16 percent of the loans that were issued nationwide in the first half of 2006 were to sub-prime borrowers. Here in Richmond, the problems could be even dicier. According to information complied by First American Loan Performance, in the Richmond-Petersburg market, approximately one-third of the loans in the first half of 2006 were provided to sub-prime borrowers. Combine that statistic with rising tax assessments and higher tax and insurance escrows, and the area can expect its fair share of mortgage defaults. Defaults like those being reported are usually correlated to higher unemployment. So what would things look like with a little recession mixed in and higher unemployment?