In the second part of our series on the subprime crisis, we focus on how Los Angeles has been affected. Need to read the first installment explaining the crisis? Read The Subprime Crisis: A Beginner’s Guide.

The City of Los Angeles has avoided the effects of the subprime rampage many parts of the country have seen. While major media sources including The Los Angeles Times have been quick to correctly point to Southern California as an epicenter of the subprime debacle, those same news sources have been slow to point out that Los Angeles and its Westside neighbors have been spared from the foreclosures seen in other parts of the Southland.

Yes, areas of the San Fernando Valley, Los Angeles County, and many areas of the Inland Empire—San Bernardino County and Riverside County—have been hit hard by the subprime situation, but the real estate market in the City of Los Angeles and other parts of the Westside area has remained strong.

The local media has been criticized in recent weeks by many real estate professionals for failing to report on the distinction between the Southland as a whole and Los Angeles in particular. The difference is stark and deserves to be identified.

They could just as easily have included facts—even just a sentence or two—about the strength of the real estate market in the Westside instead of their uniformly ‘doom-and-gloom’ outlook.

"I understand that the [Los Angeles] Times needs to make a buck, just like everybody else, and sensationalistic headlines certainly sell papers," says one colleague who’s definitely taken umbrage with the one-sided reporting on the subprime situation.

"But they could just as easily have included facts—even just a sentence or two—about the strength of the real estate market in the Westside instead of their uniformly ‘doom-and-gloom’ outlook. That would have given their readers a more complete picture of local conditions."

This juxtaposition of fortunes may be due to the fact that as home prices increased in the popular Westside area, many homebuyers were forced out of the market and bought homes in the Inland Empire instead. Many of these same buyers used subprime loans to finance their purchase and are now seeing their mortgage payments grow beyond their ability to pay.

According to RETRAN data, there were only 8 total foreclosures for the third quarter of 2007 for the following areas of the Westside:

• Brentwood
• Bel Air
• Beverly Hills
• Malibu
• Marina Del Rey
• Pacific Palisades
• Santa Monica
• West Hollywood
• Westwood (90024)
• West Los Angeles (90025).

In fact, according to DataQuick, of the 13,583 total Notices of Default issued (this is before foreclosure actually begins) for either single-family residences or condominiums in the Los Angeles area for Q3 of 2007, less than one-half of one percent were from the Westside.

Given that affluent and not-so-affluent areas of the San Fernando Valley, San Gabriel Valley and the Westside are still experiencing brisk sales activity, especially on well-priced homes, the broad strokes painted by The Los Angeles Times and other media outlets have given many potential homebuyers a false impression of current market conditions.

2007 has been kind to the Los Angeles real estate market. Buyers who are waiting for a potential glut of foreclosures to flood the market may be better-advised to set their sights on areas other than the resilient Westside of Los Angeles.

Will this resilience continue in 2008? We’re about to find out.

But do you really know what subprime means? What effect has it had in Los Angeles? What challenges does it present, even to those with excellent credit? What opportunities does it reveal?

To answer these questions, let’s start at the beginning…

Understanding Mortgage Lending

Traditionally, mortgages were financed by banks. This meant that a bank was limited in its lending based on the deposits they received from their customers.

Recent changes to this model, however, paved the way for the current situation to arise. Banks moved to a new lending model in which the mortgages they held were sold to the bond markets. This freed banks from lending based solely on their customer deposits.

The boon to this new model was that more money was available to help people buy homes. The downside, unfortunately, was that banks no longer had as much pressure to verify that the mortgages they issued were solid. Knowing that the mortgages they created would eventually be sold, banks took on riskier loans than would have been prudent in the more traditional lending era.

The Mortgage Bond Market

Until recently, the mortgage bond market was heavily dominated by government-sponsored agencies such as Freddie Mac. Since 2002, however, the private sector asserted itself in this market with a vengeance.

With new mortgage vehicles such as jumbo loans, and sub-prime loans to borrowers with poor credit histories and/or weak documentation of income who were rejected by prime lenders like Freddie Mac, the private sector significantly increased its role in the mortgage bond market.

The rise of private sector participation catapulted the mortgage bond market to a worth of $6 trillion, making it the largest part of the $27 trillion bond market. The mortgage bond market is now even bigger than the Treasury bond market.

Foreclosures Emerge

Many homeowners were lured by brokers selling subprime mortgages who explained that the equity in homes could be turned into cash by refinancing. What brokers failed to explain in many cases was that the mortgage interest rates would double after 2 years.

A wave of foreclosures began appearing, first in inner-city areas, then across the entire country, starting in 2005.

By that point, 20% of all mortgages were subprime. They were especially popular among recent immigrants in the competitive housing markets in New York City, Arizona, Nevada, Washington, D.C. suburbs, and Southern California.

Consequences

Foreclosures are predicted to rise over the next two years as many sub-prime mortgages fall outside of their initial 2-year period, causing interest rates to become variable and, in many cases, double. It is estimated that as many as 2.4 million homeowners are in danger of foreclosure because of subprime loans.

The dramatic rise in foreclosures has had such a strong impact on the price of homes that we now see the first national decline in housing prices since the 1930s. A glut of 4 million unsold homes is depressing prices, forcing builders to lower prices to rid themselves of remaining inventory.

The building industry, comprising 15% of the economy, is expected to halve its output, causing a loss of over one million jobs. Related industries such as manufacturers of durable goods, e.g. washing machines, home improvement stores, furniture makers, may also take a hit.

Banks and the bond market are also feeling the crunch. Banks have already lost $60 billion, and bondholders (such as pension funds) who have bought subprime mortgage bonds have seen a sharp fall in value of those instruments. Estimates of the total financial loss for these institutions run as high as $450 billion.

Since lenders have suffered badly, they are more stringent with any new loans they make, resulting in a tightening credit supply for consumers. Mortgages, especially non-traditional ones such as subprime and jumbo loans, are now more difficult to obtain.

Now that the basics are covered, in subsequent posts, let’s answer the questions we originally asked:

• What effect has it had in Los Angeles?
• What challenges does it present, even to those with excellent credit?
• What opportunities does it reveal?

To read more about the subprime situation, check out the following links:

• The Subprime Crisis In Graphics
• Subprime Crisis Timeline
• Wikipedia’s Page on the Subprime Mortgage Crisis