A lot is being written about the current "credit crunch" which seems to be a daily topic of interest in the media, and is adding further fuel to the fire in the housing downturn. But just what is this "credit crunch"?

In a nutshell, the aggressive lending practices of the past five years are starting to come back and bite lenders in the rear.  One of the prime factors was adjustable rate mortgages with "teaser" rates, which allowed borrowers to purchase more home that they could afford. These rates were several points below prime for a year, and then they adjusted upwards from there.

This was all well and good while the housing market was hot, but once things slowed down, and sellers far outnumbered buyers, these "sub-prime" borrowers no longer had the option of selling their homes to escape from payment escalations.  The upshot here is that people are now getting saddled with payments they can't afford on houses they can't sell.

The result?  A dramatic increase in foreclosure rates all over the U.S. People are losing their houses left and right, and in many cases, they are simply walking away.

But, let's take a step back here, to really understand the credit crunch.  What happens to many mortgages once someone closes on their home?  Their mortgages are packaged with other similar mortgages and sold to investors such as pension funds.  Many investors were attracted to sub-prime mortgages because they were backed by the collarteral of the homes, and they provided higher rates of return because of the higher risk.  But now, with the housing market cooling off, and in some areas, declining, in combination with a huge escalation in defaults, has caused these investors to run for the hills.  No one is buying subprime mortgages,  which means the people who underwrite them have to hold them and thus, they can't get the capital to make any new loans.  Many large subprime lenders have folded up shop and other larger lenders are laying off personnel. 

Really, the problem harkens back to the massive influx of capital into real estate.  Several years ago everyone was investing in real estate, and the prices were driven up artificially.  Lenders, too, jumped on the bandwagon and made money easier to get. 

What is the solution and how long will it take?  The answer is unclear.  Right now there is 9+ months of inventory for sale, and more coming online as foreclosures increase.  Builders, too, were caught up in the frenzy and overbuilt during the boom, which means there is both a surplus of new homes and resale inventory.

The first thing that has to happen is for the mortgage industry to stabilize.  Some people will have to take their lumps in the process.  The Fed could help by lowering interest rates to make real estate more attractive and more affordable.  The next thing that needs to happen is that supply and demand need to come into better equilibrium so that sellers won't have such a difficult time selling.  Builders need to back off of new development and owners need to hold off on selling.  Easier said than done, perhaps.  

Additionally, states need to take measures to help local conditions.  The State of Florida has passed fairly large property tax rollbacks which makes properties more affordable.  Insurance, however, is still an issue, but reforms are in the works. 

Mother nature would be kind to do her part this year and spare us from any catastrophic natural disasters. 

So, it will be a waiting game to see how long this "correction" will take.  Just like the stock market, when things get artificially inflated, reality must set in. 

Our best guess is that things will stabilize in the latter half of 2008.

Todd Smith, Managing Director

Blue Horizon Venture Consulting (www.bluehorizonvc.com)