December 13, 2010

Blast From the Past

This blog was originally posted on March 17, 2008. Not much has changed in the almost three years since then, huh??? I've inserted some December 2010 comments in parentheses.

CREDIT IS THE KEY

Precipitated by the subprime mortgage mess, major Wall Street firms are starting to fall. (Actually, a bunch of them fell.) Let's take a look at one of the biggest contributing factors...credit.

You've probably heard about credit scoring by now. Your credit score is calculated by a bunch of complicated formulae by the three national credit repositories...TransUnion, Experian, and Equifax. Although your score is likely a different number depending upon the reporting bureau, it likely falls within a range that allows most creditors to identify your credit risk instantaneously. How is this possible?

Credit scores range from a low of approximately 350 to a high of 850. In all my years of reviewing credit reports (and I've reviewed thousands), the lowest score I've ever encountered was 386 (this still holds true three years later), and the highest was 820. According to Experian, the national average credit score is 692 (it is now closer to 680). Your credit score determines whether you receive the lowest possible interest rates on home loans, car loans, credit cards, etc., or whether you will suffer through life paying higher than market rates for everything. And though it takes years to attain the highest credit scores, it only takes a missed payment or two to drop you into "undesirable" status.

Getting back to my opening line: JP Morgan (which is now JP Morgan Chase) has announced its intent to acquire troubled Wall Street broker Bear Stearns for $2/share. Bear simply got sucked in too deep in mortgage-backed securities loaded with subprime mortgages. Subprime mortgages are, of course, loans make to uncreditworthy (or credit-challenged, if I'm being politically correct) borrowers. Anyone with any credit background could have told you the day these subprime loans were made that many, if not most of them would eventually default. Even the subprime loans that haven't gone delinquent or defaulted have essentially been 'blackballed' - they are essentially worthless in the secondary market. And so explains why Bear Stearns is in the pickle they're in...their banks realize the assets are worth pennies on the dollar, so they ask for more money to protect the bank against losses. Without the ability to sell them in the secondary market and regain liquidity...well, I think you see where that will lead. (in technical terms, this is called "the crapper")

Back when real estate prices were going through the roof, there was a veritable credit orgy, where anyone who could fog a mirror could get a loan. Today we're all paying the price for this free-for-all. I know I'm not the only one with declining values in my stock portfolio and IRA. Nor am I the only one watching my house depreciate month after month. (This situation actually improved, but the fall was pretty steep when it happened.)

So how does this affect you? Chances are if you're reading this, you are collecting payments on a real estate note. Do you know anything about the credit quality of your payor? If not, what you don't know may hurt you. The market is currently seeing a "flight to quality" - many loans with poor-credit borrowers simply aren't marketable. (This is even truer today than in 2008 - bad credit equals unacceptable risk.)

I spoke with a noteholder this morning. When I asked her about the credit quality of her payor, she said "I don't really care - they pay me and that's good enough for me." Unfortunately for her, she needed to sell her note so she could generate a cash down payment for her primary residence. It turns out her payor's credit score is 541, which is considered very poor. How did it affect her pricing? Let's just say she received an offer about $15,000 less (on a $60,000 balance) than she would have if her payor had good credit. (She probably wouldn't have even gotten a quote for her note in today's market.)

I feel like I could write a book on the subject of credit, but I doubt you came here to read a novel. Just know that somebody else's credit CAN hurt you, whether it's the payor on your note, or tens of thousands of subprime borrowers defaulting at breakneck speed nationwide. Protect yourself, and just as importantly, protect your credit!

Make it a great week.

Clint

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