A Congressional Oversight Panel report on the "continued risk of troubled assets," issued Aug. 11, expressed concern about the solvency of small banks whose balance sheets were clogged with "troubled assets" consisting of toxic mortgages, and about the securities based on them.

The panel may have foreseen the small-bank failures to come as these toxic mortgages default and become nonperforming assets. In fact, the alternative-A and option adjustable-rate mortgages are to begin resetting in 2009 through 2012, and the FDIC "problem list" of banks that run a higher risk of failure grew to 416 in the second quarter, from 305 in the first quarter.

During the housing bubble of 2004 to 2007, many homeowners refinanced their homes when housing prices boomed. The alt-A and option ARMs were the most popular, but there would be a nasty surprise when these mortgages reset after the initial five years. As these mortgages reset and the monthly payments skyrocket, homeowners will be at risk of default and foreclosure. These resets will usher in the second wave of foreclosures in 2009 through 2012 — the worst possible time for our economy.

Among these homeowners are a significant number of small-business owners who were drawn into these mortgages by the ease with which they could refinance and access cash with low teaser rates and little or no proof of income. Refinancing to cash out the equity in their homes was the easiest way to meet the small businesses' cash-flow needs, instead of the traditional sources of funding provided by the SBA, commercial banks or other financing sources that required cumbersome financial statements, income documentation and credit history.

For small-business owners, the scheduled resets during 2009 through 2012 and the spike in the monthly mortgage payments will cause additional stress, which may prompt job loss for their employees. The loss of jobs related to mortgage default and the resulting financial distress will further weaken our economy and prolong the recession.

My company recently completed surveys on small businesses and toxic mortgages. The results offer compelling evidence that a significant number of small-business owners fell prey to these toxic mortgages and are at risk as these mortgages reset. The studies are an outgrowth of the small-business research I have been conducting with my partner Jung I. Song since 2000.

There were three surveys. The national survey was completed in November 2008, the California survey in April 2009 and the California Hispanic survey in June

We found that among small-business owners:

  • More than one-third (33.9%) cashed out the equity in their homes as home values spiked during the 2004-to-2007 housing bubble.
  • Respondents have toxic mortgages: U.S. 31.9%; California 51.8%; California Hispanic 52.6%.
  • Respondents are expecting resets between 2009 and 2012: U.S. 22.9%; California 34.9%; California Hispanic 44.7%.
  • Respondents are "very worried" about their monthly mortgage payment at reset: U.S. 18.4%; California 29.9%; California Hispanic 49.3%.

A significant number of small businesses with these risky mortgages could be at risk of foreclosure.
For small-business owners, the resulting spike in the monthly mortgage payment will lead to financial distress and default and will be a contributing factor for unemployment and mortgage failure. The small-business owner is keenly aware of the importance of a good credit rating. The prospect of default will prompt cost-cutting measures that will mean job loss and closed shops and offices, in turn causing a loss of rental income for commercial real estate owners who have loans originated with small banks.

The link between the financial distress of small-business owners with the resetting toxic mortgages may have contributed to the 81% increase in small-business bankruptcy filings in June 2009 versus June 2008, according to Equifax, and the sharp increase in delinquencies, notices of default, and foreclosures especially in the California, Nevada, Arizona and Florida, where the housing bubble was centered and 75% of these alt-A and option ARMs were issued from 2004 to 2007. Small-business distress and failure has the potential to exert a devastating impact on our economic system by contributing to the surge in bankruptcies, the high level of credit card debt and delinquencies, and bank failures.

The link between small-business failure and small-bank failure may be evidenced by a study of small-bank failures during the last great episode in 1982 to 1989. A September 1990 study commissioned by the Federal Reserve Bank of Cleveland, "Underlying Causes of Commercial Bank Failure in the 1980s," concluded that banks that failed between 1982 and 1989 tended to be in states with higher small-business failure rates than those of the nonfailed banks. This study shows a correlation between small-business failure and bank failure.

These various findings indicate a link between small-business owners with alt-A and option ARMs that are resetting and spiking — to double and triple their initial mortgage payments — and the financial distress and loan defaults precipitating the small-bank failures that the Congressional Oversight Panel warned about.

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