The subprime mortgage issue is falling on the global credit scene like a cluster of napalm bombs, exploding not just locally in the U.S. but setting financial conflagrations around the world.

It ought to come as no surprise to observers of the scene that the peak of the subprime fallout still lies ahead. The greatest number of adjustable rate mortgages were scheduled to reset a month ago, in October ’07, although the total number scheduled to reset through 1Q08 remains very high. If we assume that it takes about 90 days for a mortgage in default to enter into the foreclosure process, and 3-4 months to complete, then we can expect the money center banks, some hedge funds and other investors to continue to post substantial losses on loan portfolios and affiliated Scheduled Investment Vehicles (SIVs) through 1Q08 -2Q08.

Jan Hatzius, Chief Economist at Goldman Sachs, estimates that total subprime losses will be close to $400B. To put that in perspective, $400B is about 2x the loss experienced by the Resolution Trust Corporation in cleaning up the S&L crisis of the 80’s.

That problem can be regarded as the near-term issue. The more immediate problem is the credit crunch which makes rolling over the SIVs’ short-term (270 day) loans very difficult. The nub of that problem is the uncertain quality of the collateral held by the SIVs and other holders of interests in these derivatives. Some collateral may indeed be rated AAA, but others may be CDOs that contain less than investment-grade obligations. Many institutional investors and pension funds are barred from investing in less than AAA investment-rated situations.

Until that collateral can be picked apart, analyzed and evaluated, many investors prefer to stand down. As well they should, since the rating agencies whose job it is to perform those tasks, have lost substantial credibility.

Meanwhile, the Fed, under Dr. Bernanke’s leadership, continues to follow its Keynesian nose by lowering interest rates and adding liquidity to stimulate the economy. The Fed added $41B in new funds (read: fiat money) during the first week of November and an additional $49B in funny money just last week. The value of the US dollar continued its decline [35% since 2001 (thank you Mr. Greenspan) and 6.7% since 1-01-07 (thank you Mr. Bernanke)]. In light of a flagging US economy expect that – despite all protestations by the Fed and by Secretary Paulson’s jawboning to have China allow the Renimbi to float (fat chance) – the Fed will again lower the Fed Funds Rate in December by 0.25%. Expect, also, the predictable result: a continued slide in the US dollar and a continuing rise in prices due to inflation.

Quo Vadis, Commercial Real Estate in CA?

There is an important distinction between loans secured by residential (single-family) real estate and those secured by commercial properties. The former loans, originated by local lenders – have been readily salable to Fannie Mae/Freddie Mac which returned proceeds for additional lending. But commercial loans – until a few years ago – had no such secondary market until Wall Street dreamed up the securitization of these loans using REMICs (real estate mortgage investments conduits).

There were many loose loans issued by commercial lenders during the 2006-2007 hay-day of easy financing, but the total is nowhere near the volume and value of residential subprimes. Nevertheless, investors seem to make little distinction between the two since many SIVs, hedge finds and other entities hold loans securitized by an assortment of collateral types: residential loans, commercial loans, auto loans, credit card loans etc. As a result, the dollar value of CMBS (collateralized mortgage-backed securities) has declined 40% in 3Q07.

Commercial loans are now available under tighter underwriting criteria: lower Loan-to-Value (LTV) ratios, higher debt-coverage ratios (DCR) and higher interest rates. Buyers in this market must pony-up larger down payments and demonstrate the stability of the property’s future income stream.

This reality has not yet settled in with some sellers and some buyers of investment real estate. This is especially true in California (and on the East coast) where capitalization rates for commercial properties remain in the low 5-6% range while interest rates have climbed to 6-7% range. The only rationale for buying a low cap-rate property ( in light of real inflation rates substantially above those reported by the gov’t’s CPI) is the reasonable expectation that rents can be raised sufficiently to deliver an acceptable yield on the investment over the entire holding period. This expectation is called “risk.”

Although California is forecasted to enjoy a substantial increase in population, we do not believe that the demographic profile of this increase presages increased per capita net spending power. We believe that better real estate investment opportunities lie beyond California’s borders, in so-called “secondary markets,” and even in foreign countries.