Why the next mortgage crisis may be worse.

Commentary about business and finance.
April 15 2008 8:12 AM

Here Comes the Next Mortgage Crisis

Subprime was just the beginning. Wait until California's prime borrowers start handing their keys to the bank.

Forclosure
Foreclosures are soaring out West

California is to mortgage lending what Chicago is to pork bellies. For years, that meant it was a place with soaring house values; today, the foreclosure rate across the state is twice the national average and going up fast. Riverside County, outside Los Angeles, may be the foreclosure capital of the country, with a rate close to six times the national average. And housing prices are in freefall.

California should be the poster child for a mortgage-loan bailout. In few other places have so many taken on such onerous debts with so little equity. Unfortunately, the crisis in California is going to get much worse, and there is no bailout that will solve it. Why? Because if the first stage of the foreclosure crisis was about people who could not afford their mortgages, the next stage will be about people who have every reason not even to try to pay their mortgages.

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Over the next several months, we're going to be subjected to a chorus of hand-wringing about the moral turpitude of people who walk away from their mortgages and pronouncements like last month's warning from Treasury Secretary Henry Paulson that people should honor their mortgage obligations. The problem with finger-wagging on what you "should" or "ought" to do is that, when it comes to money, you're usually given the lecture only when it's in your interest to do the opposite. Certainly, that's the case for all the California homeowners who in the next year or two are going to find themselves with the choice of whether, faced with a huge new wave of interest resets and a historic decline in the value of their homes, they will simply walk away.

First, those home prices: For a weird few months of the mortgage crisis, statisticians came up with peculiar numbers about home values, rolling out comforting stats showing single-digit declines. Well, that's over.

Last month, the California Realtors' association (folks who in October managed to "project" that prices would fall 4 percent in 2008) reported that, actually, California house prices in February fell 26 percent from a year ago. In the places where the foreclosure boom has hit hardest, it's worse.

A quick, almost random survey of some foreclosure prices in Southern and Central California:

  • In San Bernardino, a house bought for $310,000 in 2005 is now being offered by the bank for $199,900.
  • A 2,000-square-foot ranch house in Rancho Santa Margarita is down from $775,000 to $565,000.
  • A starter home in Sacramento, sold for $215,000 in 2004, is now down to $129,900.

These are not sale prices. They are asking prices. Don't doubt that they are negotiable.

Unfortunately, when it comes to the California crash, these striking numbers are not the end. They are the beginning. (To give Paulson his due, he said that, too.) Which brings us to the other scary part of the California story: a coming wave of interest-rate resets in prime loans given to people with good credit that are just as bad, or worse, than we've seen in subprime.

The most common subprime loans were known as "2/28" in the industry: 30 years, including a two-year teaser rate before the interest rate rose. Now these loans have reset, and we're seeing the fallout.

But prime borrowers, too, got loans that started out with low payments; if you bought or refinanced your house in the last few years, it's not unlikely that you have one. With an "option ARM" loan you have the "option" (which most borrowers happily take) of paying less than the interest; the magic of "negative amortization." The loan grows until you hit a specified point—the exact point varies with the lender; with Countrywide, it'll come after about four and a half years—when the payment resets to close to twice where it was on Day 1.

Just two banks, Washington Mutual and Countrywide, wrote more than $300 billion worth of option ARMs in the three years from 2005 to 2007, concentrated in California. Others—IndyMac, Golden West (the creator of the option ARM, and now a part of Wachovia)—wrote many billions more.  The really amazing thing is that the meltdown in California is already happening and virtually none of these loans have yet reset.

Option ARM loans were heavily marketed to upper-tier home buyers in California. It's hard to know how bad the option ARM crisis will be before it actually happens, but Moe Bedard, an advocate in Southern California who advises homeowners on foreclosure and blogs about the crisis at Loansafe.org says that the difference in the time until the rate rises is the main reason that upper-middle-class Orange County (now facing foreclosures at a rate merely twice the national average) hasn't yet been hit as badly as places like Riverside.

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