Coping with the national mortgage: meltdown and the collapse of the shadow banking system.

NATIONAL FORECLOSURES jump 93%. More than 154 U.S. lenders have "imploded." Recent figures for defaults and foreclosures are evidence of a serious threat to the American dream of home ownership for subprime and, now, prime borrowers. When RealtyTrac, the leading online marketplace for foreclosure properties, released its U.S. Foreclosure Market Report a few months back, it showed 179,599 foreclosure filings for July (including default and auction sale notices and bank repossessions). Those figures were up just nine percent from the previous month, but a whopping 93% from July 2006. That amounts to a national foreclosure rate of one filing for every 693 households.

"While 43 states experienced year-over-year increases in foreclosure activity, just five states--California, Florida, Michigan, Ohio, and Georgia--accounted for more than half of the nation's total foreclosure filings," notes James J. Saccacio, chief executive officer of RealtyTrac.

From May to June, the National Association of Realtors reported the worst sales figures since November 2002. "Jumbos" (loans over $417,000) are being overpriced or not available as the secondary market dries up. The lenders that have imploded include all types--prime, subprime, and a mix of both; retail and wholesale; subsidiaries; and entire companies. According to Implode-O-Meter, lender implosion means bankruptcy filing, temporary but open-ended halting of major operations, or a "fire sale" acquisition.

Nevada came in with the nation's highest state foreclosure rate for the seventh consecutive month in July, points out RealtyTrac. That is one foreclosure filing for every 199 households, or more than three times the national average. In second place, Georgia's foreclosure rate exploded from the eighth highest in June to second highest in July with a 75% increase. That is one foreclosure filing for every 299 households, or 2.3 times the national average. In third place, Michigan stepped up from the seventh position, at one foreclosure filing for every 320 households. That is a 39% jump, month-over-month, and a 130% year-over-year increase. California, Florida, Ohio, Colorado, Arizona, Massachusetts, and Indiana also were among the nation's 10 highest.

The top 10 cities included Detroit--which is seven times over the national foreclosure average--Las Vegas, Atlanta, and Greeley, Colo. The top 10 metropolitan areas all are located in California, and include Stockton, Merced, Modesto, Vallejo-Fairfield, Riverside-San Bernardino, and Sacramento.

The markets are in the process of repricing risk. Mark Zandi, co-founder and chief economist of Moody's Economy.com Inc., predicts things will get worse before they get better. Defaults will rise to 2,500,000 over the next two years and 10% of subprime homeowners will be in foreclosure by mid 2008, up four percent. Countrywide confirmed that delinquencies have soared in the prime markets as well, from 1.8% to 4.6% at mid year. Bear Steams has filed for bankruptcy protection on at least two high-risk, high-yield, mortgage-backed funds and is bailing out another hedge fund with around $1,600,000,000.

The fallout from this lending debacle does not just affect individual borrowers. It already is taking a grave toll on the business, finance, real estate, and lending industries. Wall Street investors failed to fund $250,000,000,000 in high-risk corporate buyout or growth securities, causing junk bond yields to rise to a four-year high. The Federal Reserve injected $38,000,000,000 of liquidity (REPOS) into the markets, an amount not seen since Sept. 14, 2001. Employment has declined for the first time in years, and more than 45,000 (and counting) individuals have been laid off from mortgage lending jobs alone.

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The mortgage meltdown means that fewer subprime (and potentially prime) borrowers can buy a new home or refinance their current loan. There are three reasons: extreme credit tightening with more restrictive eligibility requirements; affordability now is tested at the fully indexed rate (not the lower teaser rate); and property values have fallen to the point where homeowners have insufficient equity to refinance or sell at a profit. In other words, most borrowers are locked into their property and loan as adjustable rate mortgages (ARMs) are resetting to higher rates, resulting in unaffordable monthly payments. Some 1.1 trillion dollars in loans are pending reset; in some cases, monthly payments will double. The 2006 so-called 2/28 ARMS will reset in 2008. Sen. Christopher Dodd (D.-Conn.) has speculated that payment-shock monthly increases could reach 300%.

Earlier this year, the debate on Wall Street was whether or not a secondary mortgage market, nonagency paper market, or commercial paper market actually existed during times of "no bids." This should be compelling evidence that the solutions, short and long term, must include private and public (government) safeguards that reduce market uncertainty. In addition to recent bankrupt Bear Steams funds, over 154 imploding lenders, a credit crunch, and a liquidity crisis, Real Estate Owned (REO) Packages held by Wall Street investment banks such as Bear Steams, Citigroup, JP Morgan Chase, Merrill Lynch, Morgan Stanley, and Lehman Brothers are rising at an alarming rate. In the last year, the rate of firms taking back ownership of property has, at times, jumped as high as 497%.

Since the dot.com bust of 2000, the flight to survival and profits went into real estate, and that market soared to all-time highs. In the process, the lending industry endured growing pains. The 80/20 "piggy back" jumped into high gear, followed by teaser adjustable rate mortgages (ARMs). In fact, the banking system has undergone primal and systemic changes. The mortgage lenders' model went from one of originating a mortgage with retained servicing to one of using warehouse lines to fund a loan often presold on forward contracts to Wall Street investment bankers waiting to deliver the "securitization" of a pool of loans to third-party investors.

From 2000-07, banks took in securitization products, including mortgages worth over one trillion dollars, and issued commercial paper. They created a great number of off-balance-sheet conduits and structures whose full liabilities they failed to report on their financial statements. This is known as RahC (Randomly Activated Hidden Contingency) and RahD (Randomly Activated Hidden Debt). In short, the industry created a Shadow Banking System, to use a phrase coined by Paul McCulley, managing director of PIMCO.

Does this sound familiar? Remember Enron? Apparently, through a series of related entities, Enron garnered a massive off-balance-sheet contingency that exposed the company to risks and liabilities in untold and unknown amounts. Now, with off-balance-sheet liability and exposure related to hedge funds, commercial paper, and derivatives, the formal banking system is trying to absorb assets burdened with unknown quantities and qualities of RahC and RahD losses and liabilities recently exposed in the Shadow Banking System. Literally untold exposure is etched in the fabric of off-balance-sheet contingencies. The economy must be safeguarded against this type of market destruction but, at the same time, laws and industry practices must emerge that create a steady and voracious growth across the board in new homeownership for decades to come.

Minimally, private-public solutions include government bailouts or foreclosure moratoriums; the Federal Reserve cutting interest rates; Freddie Mac and Fannie Mae approvals for loan buyouts (acting as a loan "warehouse"); and new bailout private equity rescue funds. With a 10 trillion dollar mortgage market, the subprime market is about 15%. Assuming a loss ratio of some 10%, a loss bailout would be in the area of $150,000,000,000. A $100-$300,000,000 bailout or rescue blanket will not be sufficient; $1,000,000,000 is a good start, but we need to start planning for much more.

It is obvious the rising threat of defaults and foreclosures is harming the economy, causing extreme asset devaluation and potentially creating a serious social problem. At this stage, society must decide a threshold question: Does it want to expand the American dream of homeownership and grow the economy at the same time or not? Increasing home ownership is a necessary component of success for the economy. Housing creates jobs and tax revenues. It also helps balance the budget, pay for Medicare, and stimulate growth. In fact, about 20% of gross domestic product and a like amount of consumer spending are related to housing. According to The State of the Nation's Housing report from Harvard University, every 1,000 homes built create 2,448 jobs, $79,400,000 in wages, and $42,500,000 in Federal, state, and local tax revenues and fees.

There is nothing wrong with a more profitable shadow mortgage banking model per se. In fact, the economy can benefit from more shadow banking, but it must be supported by at least minimum transparency in government and industry, liquidity, and credit safety belts. Moreover, homeowners must have access to new "affordability" models that pay for higher risk with noncash burdened insured investment from Wall Street, such as Foreclosure Mortgage Insurance Investment Funds (FMII) or Quarantined Built-In Origination Equity (QBIOE). When free markets allow 2,200,000 families to lose their homes and the broad economy is threatened with recession, capitalism falls to its knees begging for refinement. The fact that the Shadow Banking System's model neither is Federally insured nor able to use the Federal Discount Window makes it vulnerable to market extremes as well as to levels not yet known or understood.

Furthermore, since Japan and China have bought the majority share of the U.S. subprime high-risk, high-yield mortgages, international issues are sure to ensue that could result in weaker world markets or confidence. Refinements and safeguards should be in place to prevent extreme asset devaluations and ensure that society is protected, treated fairly, and participates in the success of the model. It no longer is just about profits. Capitalism must grow up like the rest of us and become more responsible. The greatest capitalists in the world can--and should--do better than they did in this last round of historic homeownership growth.

AVOIDING FORECLOSURE

Immediate loan workout solutions exist for homeowner defaults and foreclosures. The first step for those in distress is to con: tact the lender's loss mitigation department to obtain an affordability interview. Because homeowners often are hesitant to approach their lenders, approved consultants are offering to act as a neutral representative between the parties. These include HUD (U.S. Department of Housing and Urban Development), Neighbor Works, and select attorneys. In addition, a free public outreach education service, Help4ThePeople, provides information on viable solutions and avoiding foreclosure scams via its free booklet, 13 Homeowner Solutions to Defaults and Foreclosures. Solutions include:

* Preforeclosure loan refinance.

* Preforeclosure sale.

* Extension of adjustable loan reset dates.

* Cash payment loan reinstatement.

* Repayment installment plan.

* Loan modification.

* Loan forbearance.

* Federal Housing Authority HUD partial claim.

* Short sale for less than mortgage amount due.

* Deed in lieu of foreclosure.

* Short refinance.

* Reverse mortgage (for seniors).

* Defenses to foreclosure and bankruptcy.

Homeowners have fights, just as lenders do. Consulting a third-party organization or an attorney who specializes in this area of law can provide the help consumers need to select the most favorable option for their situation.

Richard L Rydstrom is an attorney with O'Connell & Rydstrom, Newport Beach, Calif.