The California Mortgage Crisis: No End in Sight

While the housing market might be picking up in a few parts of the U.S., the problems in California have only just begun.

Historically, California been one of the most expensive states to live in, but residents have been willing to put up with high real estate prices for the privilege of enjoying the California lifestyle. So, it’s not surprising that the Golden State is suffering particularly hard in the current mortgage crisis.

For many Californians, their dream home has now turned into a nightmare. Real estate prices have slumped by 40% to 60% since peaking in 2006 after a huge run-up that started in the late 1990s.

Meanwhile, some homeowners are seeing their monthly repayments rise to unaffordable levels – even though official interest rates are at an all-time low – and hundreds of thousands more will find themselves in the same boat over the next two or three years.

Mortgage Defaults

Almost one in ten Californians with a mortgage is now in default, i.e. they have missed several payments and are likely candidates for foreclosure. June 2009 figures show a 9.5% statewide default rate, up sharply from 6% a year earlier.

If the recent trend continues, 60% of these properties will enter foreclosure over the next several months. Industry observers say a commercial real estate crisis is looming too, with a large number of retail, office and industrial properties already in negative equity.

There are close to half a million foreclosed homes in the state at the moment, with around 80,000 to 90,000 new foreclosures being filed every month.

Many of the homeowners now under water are sub-prime borrowers, who typically took on so-called 2/28 mortgages. This is a 30-year loan, the first two years of which carry a low, “teaser” rate that has in most cases now reset to a higher level.

With California’s nearly 12% unemployment rate, soaring personal bankruptcies and cutbacks to government services, a large number of these sub-prime borrowers have had their homes foreclosed, or have simply handed back the keys and walked away.

Coming soon: the option ARM reset crisis

Hard as it might be to believe, we’ve so far only seen the beginning of California’s mortgage misery.

Brace yourself for the full blast of the option ARM reset crisis, which is starting to unfold now. In this state where (formerly) million-dollar homes are nothing special, option ARM mortgages were marketed enthusiastically to buyers of relatively pricy homes in “nice” neighborhoods.

Many of these buyers put down little or even no equity, which left them with no buffer when prices started to drop.

Also known as pick-a-pay loans, option ARMs allow borrowers to select their preferred monthly repayment level once the introductory low-rate period ends. You can choose how much to pay each month by switching between different mortgage types: interest-only, or fully amortizing over 15, 30 or 40 years. If, as many borrowers do, you make less than the standard payment, the difference gets added on to your mortgage debt.

Option ARM Mortgages

Option ARMs typically recast to a higher repayment level after five years, or once the loan balance reaches 110% to 125% of the initial mortgage. In other words, there are a lot of option ARM mortgagees out there with loans that have been growing in a market of sharply falling home values. And now these borrowers are looking at having their monthly mortgage bills bumped up by 40 to 80%.

To make matters even worse, a large proportion of these option ARM mortgages were issued to so-called alt-A borrowers with good credit but questionable or inconsistent payment capability. Since alt-A mortgages don’t require proof of income or assets they attracted a lot of self-employed people, but also droves of borrowers who overstated their incomes (hence the nickname “liar loans). It’s no wonder experts are warning of an impending disaster.

Aside from a good credit record and FICO score, an alt-A borrower needs to show a lower-then average LTV (loan-to-value) ratio on the property to convince the lender that they will be able to pay the mortgage. The result is that a large number of Californians with middling incomes were able to buy big, fancy houses they couldn’t actually afford, and are likely to lose over the next few years.

Nationally, about 40% of those who took out option ARM mortgages in 2006 and 2007 have already stopped making repayments, but less than 10% of these delinquent borrowers have had their loan terms modified by their lenders.

A Big Problem from 2010

The really big problem will come when the majority of California’s roughly 1 million option ARM loans recast higher in 2010, 2011 and 2012. At that point, or before, we will see homeowners throw in the towel and simply abandon their properties en masse. And they can usually do this without fear that their mortgage companies will come after them for the losses they will incur when they sell the houses for less than the outstanding loan.

Unlike the rest of the country, in California you’re not liable for any shortfall in the sales price if you walk away and hand the keys back to the lender. Officially this only applies to the first loan you took out on your home, but in practice it’s hard for them to pursue you even for a refinanced mortgage.

This has spawned a new trend in the state: an increasing number of homeowners with negative equity are now abandoning their homes even though they can still afford the repayments. Some of these people are even turning around and buying a more affordable foreclosed property instead.

So far the foreclosure problems have been worst in the Central Valley, with Riverside County the hardest hit. But once the number of option ARM resets starts to snowball in 2010, huge swathes of swanky neighborhoods in coastal locations like the west side of Los Angeles, Orange County and San Diego will turn into foreclosure-towns too.

Related Articles:

• Preventing a Catastrophe in the California Crisis
• 10 Tips on How to Avoid Foreclosure

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1. Alternative Options When You’re Facing Foreclosure