Subprime Suspect

By Daniel Gross
Sunday, July 29, 2007

Until recently, the long-simmering problems in the subprime mortgage market appeared to be localized -- contained to a few unfortunate housing markets and a few unfortunate companies whose fortunes were linked entirely to lending to individuals with poor credit. But this week, the subprime contagion spread rapidly. Countrywide Financial, a huge lender with little subprime business, reported that an unexpectedly large chunk of its prime loans were going sour. Homebuilders reported dismal results. Suddenly aware that loans don't always get repaid, the Wall Street credit machine, which has helped keep the stock market aloft, shifted into neutral. Investors reacted accordingly, repricing risk and driving stocks down with alacrity.

But the origins of the subprime mess can't be found in Lower Manhattan, or in Washington, where regulators generally snoozed as subprime emerged from a tiny niche to become a mainstream phenomenon. No, this trend, like so many others, started in Southern California.

Until recently, Orange County was New Jersey to Los Angeles's New York -- upscale but generally ignored, and not nearly so chic or happening as its urbane neighbor. Television helped change the image with glitzy offerings such as "The O.C.," "Laguna Beach" and "The Real Housewives of Orange County." These shows portray the county's glittering beach communities as the capital of plastic surgery and extreme consumption. But inland, just over the hills, the massive planned community of Irvine has become the nation's capital of real estate folly.

The transformation of the Irvine Ranch from a sparsely populated agricultural tract into a densely populated upscale edge city is astonishing. The Irvine Ranch's owners have amassed huge fortunes through their financial acumen. (Donald Bren is No. 27 on the Forbes 400.) Incorporated in 1971, Irvine boasts a diversified economy and superb university, is populated by many blue-chip companies and projects an image of suburban perfection, thanks to strict zoning laws that enforce design continuity.

As subprime lending grew into a substantial market presence in this decade, Irvine-based companies surged. Its corporate citizens include: Option One Mortgage, the subprime subsidiary of H&R Block, sold in April at a knock-down price to the private equity firm Cerberus; New Century Financial, which imploded in spectacular fashion in April; and the mammoth, still-solvent subprime outfits Ameriquest and Argent.

The subprime loans made by Irvine-based lenders were rapidly securitized -- sliced and diced into bonds, packaged together with other securities and molded into pools dubbed collateralized mortgage obligations. Leveraged investments in CMOs have caused a great deal of pain everywhere from Australia to Wall Street, where they helped sink two Bear Stearns hedge funds. But the locals also ate some of the toxic effluent produced by Irvine's debt factories. In June, Irvine-based Brookstreet Securities ran into trouble after it allowed customers to buy CMO obligations on margin. It shut down completely on June 30.

Brookstreet's rapid demise is an object lesson in how highly leveraged investments can turn sour quickly. Another Irvine-based operation, Irvine Housing Blog, brilliantly drives home the same point with daily dispatches about the seventh circle of real estate hell: people who buy houses on spec with no money down. A typical entry chronicles the purchase price, tracks down the amount of debt on the property and then calculates how much each party -- the buyer, the first mortgage holder, the second mortgage holder -- stands to lose, assuming the seller receives the asking price. My favorite thus far is the house for which somebody paid $1.29 million in May 2006, putting down only $91,000 in cash. Today it's listed for $850,000, a whopping 34 percent reduction in about a year.

It's not entirely surprising that Irvine is a center of reckless real estate lending and borrowing. It's a classic industry cluster of the type seen in areas that lack natural resources. Detroit's auto manufacturers encouraged the local growth of auto parts suppliers, companies that finance auto purchases and publications that cover the auto industry. In Silicon Valley in the 1990s, the people who created dot-com companies were co-located with the venture capitalists who funded them, the investment bankers and brokers who helped take them public and with many of the investors who got killed when the NASDAQ tanked. Irvine may have built up a diversified economy, but it remains a company town -- one whose fortunes are highly leveraged to the highly leveraged real estate industry.

Daniel Gross writes about business and finance for Slate, the online magazine at

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