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Don't sell California short.

Now, actually, may be a good time to buy California servicing. The thinking here is that prepayments have slowed, servicing prices have dropped and the state's economy may be on the brink of recovery.

California no longer leads the nation in mortgage prepayment rates. Today servicing portfolios from the state prepay just around 10 percent faster than the national average. Washington, Michigan, Vermont, Wisconsin, Illinois and North Carolina all are experiencing faster prepayment rates. Because prepayments affect servicing portfolio returns more than any other factor, this development should be considered a positive one for servicers with California loans in their portfolios.

But for many servicers who had taken California's fast prepayments for granted, a change in the status quo has led to increased concerns about the state's economy.

Pricing on California servicing now is significantly lower than for servicing from other areas. In fact, the difference can be as much as 25 to 50 basis points. Some industry observers think this might be due more to perception than to fact. All things considered, California servicing should be selling at a premium because of its improved prepayment picture.

Some potential buyers of this servicing may be overreacting by questioning whether this time California's once-booming housing market actually may be poised to take a tumble. In doing so, they are missing an opportunity to enjoy some attractive prices available today on well-performing servicing portfolios.

Slower housing appreciation and weak economic growth have caused this drop in prepayments. Obviously, homeowners who are concerned about job security are slower to move up to a bigger house or to do a cash-out refinancing. But while today the state is moving back toward stability and growth, much of what is still being reported focuses on the factors prevalent a year or two ago, which were quite depressing for those who follow the state's economy.

The job loss picture

Both aerospace and construction jobs have dropped by about 25 percent from 1987 to 1990 peaks. About a third of a million jobs were lost in 1991, and roughly 200,000 last year--but California job growth should be positive in 1993, according to The Center for the Continuing Study of the California Economy in Palo Alto. And although defense spending has declined, it still is sizable. Prime defense contracts for work in the United States reached a high of almost $140 billion in 1985, according to the Department of Defense. But in 1991 they still amounted to more than $125 billion. Twenty percent of that amount--more than $24 billion--came to California companies in 1990. Military payrolls brought almost $14 billion more into the state that year.

Despite employment dropoffs, total aerospace sales rose from $118 billion in 1989 to $143 billion last year, according to the Aerospace Industries Association of America. Yet cutbacks in aerospace employment put many highly skilled workers out of a job. A slowdown in computer sales also hurt Silicon Valley firms, while falling real estate sales put the construction industry in a tailspin. Mergers and liquidations of banks and thrifts have drastically reduced financial services employment. Let's consider two specific examples to see how these economic strengths and weaknesses could affect servicers of California loans.

No hurry to move

In the full parking lot outside a private dining club in Newport Beach, Lexus and BMW seem to be the cars of choice. Members inside look over their menus as the conversation turns to real estate. One diner remarks that his house is worth 20 percent less than it was a few years ago.

Yet his payments also are lower because he refinanced last year. In addition, many of the state's homeowners have plenty of built-up equity, since the median

price of a California home rose from $168,560 in 1988 to $197,900 in 1992, according to the California Association of Realtors (CAR).

Our Newport Beach diner has no need to move now, and so he will wait until the market recovers before selling his home. In fact, he is even thinking of taking advantage of today's attractive home prices to purchase a vacation property in a small town a few hours' drive away.

But in Fullerton, California, a suburban bedroom community of Los Angeles, another homeowner gets ready to mail his keys back to the lender. Two years ago, he used a $180,000 ARM with negative amortization to purchase a $200,000 home. After being laid off, he discovered his home is now worth $175,000--while his mortgage balance is $190,000. Because he would lose money by selling his home and paying off the mortgage, he simply defaults instead.

In between these two extreme pictures of today's California servicing market are millions of homeowners who make up a diverse state with mortgage delinquencies that are below the national average. During the third quarter of 1992, the percentage of conventional loans past due for 60 or more days was 0.79 percent in California, compared to 0.94 percent nationally. For all loans, the rate was 1.31 percent in the state, versus 1.59 percent for the country, according to the Mortgage Bankers Association of America's National Delinquency Survey.

According to the survey, the foreclosure rate in California was 0.84 percent during that period, which was 0.2 percent below the overall U.S. foreclosure rate. More than half of all states had a foreclosure rate higher than California's in last year's third quarter.

A revival in real estate

Signs that the real estate market is turning around are appearing. The CAR expects 1993 home sales to increase 2 percent in number of sales, compared with the 1992 total sales pace.

Additionally, the National Association of Home Builders (NAHB) projects that total starts for single-family homes in California will be 247,600, which is more than 18 percent higher than last year's estimated figures. The NAHB forecasts California new home sales in 1993 to be 184,500, nearly 17 percent higher than 1992 levels.

What happened?

During the 1980s, there were some California lenders who had the reputation of providing mortgage funds to anyone "who could cloud up a mirror." Portfolio lenders, and those who specialized in "no-income verification" mortgages, at times provided buyers with an opportunity to purchase the home they really wanted--but didn't necessarily qualify for.

Given this relatively easy extension of credit, California home prices skyrocketed--rising by more than 18 percent in 1988, and then another 16 percent in 1989. A real estate agent at that time might be placing a "for sale" sign in a front yard, only to have someone stop and immediately make an offer above the asking price.

Such activity obviously was unsustainable. The Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) reined in the S&Ls and no-income verification loans disappeared soon after. With less available capital for mortgage lending and tougher credit standards, home prices could not continue rising faster than California incomes.

But what made the ensuing real estate "down" cycle more severe was the timing of our nation's recent recession. Just as the California home market started to sour on a cyclical basis, the entire national economy also staggered.

Consumer confidence then plummeted. As more layoffs were announced, the public's desire to buy what now appeared to be overpriced homes was sharply reduced. In 1989, sales fell 4 percent from the previous year. Further drops of 16 percent and 6 percent ensued during the next two years. Finally, a small rise in sales transactions came in 1992, according to the CAR.

Lenders also are seeing delinquencies level off, as some life comes back into both the economy and the housing markets.

Market dynamics

Unlike Texas or the Northeast, the nature of California's housing market almost ensures that demand will exceed supply. Numerous factors account for this. One of the most important is Proposition 13. Until the mid-1970s, California home prices tracked the nation's median price. But the 1978 passage of Proposition 13 helped increase California's appreciation rate. Proposition 13 imposed a cap on annual property tax increases, permitting them to rise at no more than 2 percent annually.

By effectively reducing homeowner payments, these artificially low property taxes then provided the breathing room for housing prices to rise. They have done so steadily since that time and now are approximately twice the median national price.

As a result of having low property taxes, California cities encourage commercial rather than residential development. Sales tax revenue is more significant to them than capped property taxes. Additionally, residential builders have been very sensitive to the market. When sales began dropping in 1989, builders quickly stopped putting new homes on the market. During the last several years, the rate of building has not been enough to keep up with the state's population increases.

California's growing population also ensures high housing demand--and, that provides support for prices. Environmental concerns and the natural boundaries of ocean, farmland, desert and mountains can't accommodate the overbuilding that Texas and New England experienced in the past. Many California cities also have "growth controls" that actually stipulate how many homes can be built each year.

The real estate slump of the past few years has been a good test of the California housing market's underlying strength. While the bottom has dropped out of demand, the median price of a home has stayed stable. Annual sales fell by 25 percent from 1988 to 1991, yet median prices have not fallen, notes the CAR.

California has recovered from worse sales slumps: from 1980 to 1982, sales dropped by 50 percent, only to increase by almost that amount the next year.

What's the servicing worth?

Nevertheless, several reports came out during the second half of 1992 that were pessimistic about California's future. Quite a few dismal elements were in place at that time: a real estate slump and general economic recession, the state's budget shortfall and a continuing drought.

But now developments have changed, as they inevitably do, and it's somewhat easier to be optimistic: consumer confidence is up after the election, real estate seems to be staging a comeback and the rains have returned. But the lingering presence of competing signs has left servicers asking which trend is more dominant--a rebounding California or a still-stagnant state?

It's my view that firms buying California servicing rights today are getting a better deal than they would have two years ago. Both the real estate market and general economy are stronger than they've been. In addition, many borrowers refinanced into fixed-rate loans during 1992. Mortgage delinquencies, thus, are less likely because monthly payments are less. In addition, the possibility of prepayments coming from future mortgage refinancing has diminished.

Today's forces

No one knows for sure how any portfolio will perform, and a sense of healthy skepticism probably favors buyers of servicing rights. Yet to see the full picture, we need to be aware of the current trends that are painting a brighter outlook for California servicing.

Measures are being taken within the industry to reduce fraud. Lenders are sharing information with each other, data bases are being developed and regulatory bodies are becoming more active in detecting fraud.

Today, lenders are helping their loan officers spot problems before a mortgage is on the books, by providing training and "fraud checklists" showing them what to watch out for. Because the vast majority of loans are sold into the secondary market, the need to adhere to strict standards is universally accepted.

Tax forms are being double-checked with the IRS to confirm income and assets. Field review appraisals are ordered on loans considered riskier. Parties in a transaction are at times contacted by the lender, to make sure there are no "straw buyers."

What are the positives?

Prepayment rates are falling. One advantage of having slower appreciation in California is that homeowners are not able to profitably sell a few years after buying and trade up, as was done so frequently in the past. This is what spiked the state's prepayment rate up so high.

In addition, slower equity growth means fewer cash-out refinances are being done. People become more conservative when the economy is soft--as can be seen in the slow pace of real estate sales in recent years.

Housing affordability also is increasing in the state. Slower appreciation and low mortgage rates are combining to help make homes more affordable. Whereas last year only 25 percent of all California households could buy a median-priced home, today 30 percent can.

First-time homebuyers are the most-active buyers now. Many who had given up hope of owning a home in the late 1980s are taking advantage of today's rates and prices to buy. Currently more than half of California's purchases are attributed to first-time buyers, up from less than a third in 1987 according to the CAR.

Also, according to the CAR, the percentage of families in Los Angeles that can now afford a median-priced home has tripled over the last three years.

Legislative changes also are making it more affordable for Californians to purchase a home. Last December, a 21 percent increase in FHA's loan limit for high-cost areas went into effect. CAR estimates that with this change, 39 percent of all homebuyers in Los Angeles can now use an FHA loan.

In addition, Fannie Mae and Freddie Mac's loan limit is now higher than the cost of a median-priced home in California, making their attractive rates available to more borrowers. Loan programs such as Fannie Mae's Community Home Buyer's Program, which allows borrowers to get 5 percent down payment loans, with only 3 percent coming out of their own pocket, also are helping first-time buyers.

First-time homebuyers even with lower incomes now are entering the market. The median household income of first-time California homebuyers last year was $50,000, down from $55,000 in 1991. The significance of first-time buyers is that they start the move-up cycle that allows sellers to purchase more expensive properties.

Increased home sales will further help the California economy because many additional products and services-from real estate sales to carpets--are initiated by a home purchase.

Jumbo loan concerns

Prices on starter homes have remained steady due to demand, while more expensive houses are harder to sell now. According to the CAR, a two-year supply of homes worth more than $500,000 was on the market as of mid-March.

But sluggish demand for higher-priced homes poses no significant risk to California servicing. As a rule, jumbo servicing rarely changes hands and thus is not a factor in the overall market. It generally is either retained or sold by a conduit on a loan-by-loan basis. Nearly 99 percent of all bulk servicing purchased is made up of conforming loans, according to an industry source.

Future prospects

The size of California's economy still would rank the state among the 10 largest nations in the world in any reckoning of economic superpowers. It has certain underlying strengths that will continue to buoy the state.

For instance, Los Angeles is the major port connecting the United States with Japan and the emerging Pacific Rim nations such as Singapore, Taiwan and Korea. Financial services, marketing support and warehousing and distribution are some of the goods and services then sold in California to both import and export firms. In addition, the prospects of free trade with Mexico open up new possibilities for cross-border business.

Tourism and convention business also add to the economy by bringing jobs to transportation firms, resorts and restaurants. San Diego has become a popular destination point, in addition to California's wine country, San Francisco, Hollywood and Disneyland.

Continued in-migration both from other states and foreign lands ensures that demand for housing will grow. In fact, for the past several years California has not been adding enough units to match population growth.

Housing demand creates construction jobs, as well as a need for home furnishings. It also helps keep home prices from dropping.

While California's unemployment level has been a major area of concern, the state's job picture actually brightened in the third quarter of 1992.

Consumer confidence showed a corresponding increase soon afterward. The Consumer Confidence Index for the Pacific Region--which includes the states of California, Oregon, Hawaii, Washington and Alaska--was at 64.4 percent in January 1993, up from 54 percent in January 1992.

California lagged the rest of the country going into an economic stall. It is expected, therefore, that it will pull out after the national economy's rebound is underway. Encouraging economic figures nationally should help stimulate the West Coast.

Know your product

California's economy is about twice the size of any other state's, so no generalizations hold across-the-board. Certain specific geographic regions, loan types and origination time frames tend to present increased risks to servicers. Knowing what you're buying has never been more important.

Mortgages originated in California make up about a quarter of the nation's dollar volume of home loans. It is almost impossible to build a large servicing portfolio, then, without finding California product that fits your needs. Careful buyers today can find portfolios that should perform well.

Both loan prepayments and prices for California servicing have dropped, making this an ideal opportunity for contrarian buyers. On new conventional product, California servicing is currently capturing returns ranging from 11 percent to 15 percent, compared with returns of 10 percent to 12 percent on servicing from the Northeast.

In addition, plenty of servicing will come on the market this year as thrifts try to raise capital, small lenders attempt to leverage their warehouse credit lines and public companies seek to establish good earnings. This product availability means that prices won't shoot up due to excessive demand.

Stanford Kurland is chief operating officer and senior managing director at Countrywide Funding Corporation, Pasadena.

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Title Annotation:house buying in California
Author:Kurland, Stanford
Publication:Mortgage Banking
Article Type:Industry Overview
Date:Apr 1, 1993
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