The worst is not over in the housing market. To date, problems and media attention have centered upon flimsy underwriting standards and weak housing prices within the $1 trillion subprime market. However, even prime loans are experiencing an increase in late payments and defaults. Therefore, as both subprime and prime loans worsen, expect continued deterioration in prime and subprime loan prices and performance well into next year and expect further weakening of housing related loans and mortgage investments. Unfortunately, many home owners will not be able to modify their loans in order to prevent economic hardship or default.

Within Orange County, over 17,300 homes are for sale – an estimated ten month supply – and 26% of those homes are vacant. Prices in many areas have not receded appreciably, however, because many sellers lack the financial pressure to drop their prices and procure a swift sale. On the other hand, lower priced housing areas, areas with lower average incomes, and areas saturated with condominiums have been especially hard hit because of the subprime effect.

Nationally, home prices are softening slightly as “For Sale” signs sprout and additional people walk away from new home orders. The supply of unsold homes is at nearly nine months. The buildup of homes on the market is like water pooling against a dam; eventually, something has to relieve the pressure. If home sales don’t pick up, prices will probably break down. Meanwhile, homebuilders are stuck in a production debacle, continuing to manufacture new housing while simultaneously writing off billions of dollars in land purchases. Increasing delinquencies and defaults in prime and subprime mortgages will be negative for many industries, including consumer retailers, homebuilders, mortgage brokers and bankers.

Increased consumer delinquencies and defaults will also be noticed in credit card and vehicle loans. This will lead to a double negative effect on the manufacturers of high priced toys: sports cars, power lawn mowers, ATVs, motorcycles, jet-skis and boats. The effect will be double negative because it will come from both the demand and supply side. On the demand side, credit woes will mean that less people will be able to afford new machinery. From the supply side, consumer financial pressures will lead to a flood of used toys for sale that will put further pressure on new equipment transactions.

In both high yield and investment grade bonds, prices are likely to decline (and spreads are likely to increase) over the next several months. A sizeable supply backlog, recently created by several large leveraged corporate buyouts (LBO), will pressure high yield prices. Continued LBO activity and recapitalizations will also stress the investment grade market. In addition, mortgage market turmoil will cause investors to reevaluate all assets and thereby further weaken all corporate and high yield bonds.   Just how far mortgage market woes will seep into the broad credit markets remains unclear.

Michael Ashley Schulman, CFA
Hollencrest Capital Management