San Diego Real Estate … The Coming Next Wave of Foreclosures

The first wave of foreclosures occurred due to the re-setting of some "sub-prime" loans. These loans were predominantly the 80/20 loans that were used to assist buyers to obtain property with no down payment. Later in the cycle of the origination of these loans, the documentation requirements were lessened considerably, so that by 2005, buyers were able to obtain 80/20 loans to purchase property with little- to no-income documentation. Buyers speculated on properties increasing in value and had little regard for the payments. As the loans re-set (usually 2-3 years later), the buyers found themselves unable to make the payments or unable to refinance, and the properties ended up in foreclosure.

Here's what we need to understand about these loans:

1. Is that they were spread across the United States (demographic and geographic distribution) and

2. There were a lot of them done for buyers buying new homes. In San Diego, we are seeing the results of these loans as properties in newly constructed developments (Eastlake, San Marcos, Condo conversions, etc.) are defaulting in high numbers. However, the buyers of these properties generally DID understand that the loan would convert or "adjust" after an initial 2-3 (in some cases 5) year period. Further research suggests, however, that these buyers were not necessarily defaulting due to rising payments (the Fed has reduced short term rates significantly, thereby reducing the impact of the adjustment) but rather were defaulting to rid themselves of a negative equity position.

Many buyers in San Diego County who purchased properties in the $500k range and borrowed the entire $500k, and now find the property worth a current estimate of $400k are choosing to walk away from the negative equity position, regardless of ability to handle the payments. Research by the Federal Reserve has deemed these "unpreventable" foreclosures in that the property cannot be refinanced and the borrower is not compelled to keep the property with no hope of any short term appreciation.

However, the impact of these resets is nothing compared to the upcoming impact of the "option ARMs" that are going to reset in 2009 – 2011 (peaking in 2010).

During the housing heyday, borrowers quit even asking about rate, and asked instead "what are the lowest payments you can get me for this home." Lenders responded by offering the option arms with a 1% (or other similarly low) start rates but with a "real" rate tied to the LIBOR or to US Treasuries or other indexes. The use of these loans peaked in 2005. These loans were predominantly used in Southern California and other high cost housing areas and were used with a much greater frequency than in more "affordable" areas in middle America (not near the geographic diversity as the sub prime loans). Here's where it gets tricky. While folks with the 2/28 loans knew an adjustment was coming, many option arm borrowers are NOT aware that an adjustment is coming. Almost ALL option arms are structured in a similar fashion. They have a feature where they "re-cast" every 5 years. This means that at the end of the initial 5 year period, the initial start rate (often called the "teaser" rate) goes away. The loan will then reset or re-cast and the payments will be based on a full amortizing loan amount for the remaining 25 years of the loan. Many of the people with this type of loan simply do not know or understand that this will happen.

Here's an example. Let's say that a buyer purchased a property in 2005 for $550,000. If they put 10% down, they would have a loan amount of $495,000. With an initial "teaser" rate of 1%, they would have minimum payments for the 1st year of $1592 per month. If the "fully amortized" or "real" payment was based at say, 6.5%, the loan balance would go up by over $1500 per month. So, where would the buyer be at the end of the first year? Assuming that the buyer made only the minimum payment (which most do), the minimum payment can only increase by 7.5% of the PAYMENT AMOUNT. So, the $1592 payment become a $1711 payment. However, the buyer owed an additional $18,000 more than the $495,000 because of the negative amortization. What happens next? 

In the 5th year, the minimum payment will be just over $2100 per month. Assuming that the "real" rate is in the 6.5% range over the initial 5 yrs (which looks pretty realistic based on current rates), the loan balance would have increased to approximately $550,000. What happens now?

This is the interesting part because even many savvy and educated buyers and borrowers simply do not know. What happens is this: The loan at that point "re-casts" and becomes amortized over the remaining 25 years at the current rate. If we continue to use the 6.5% as a reference point, the payment will go from $2100 to over $3700 a month!! Thats right, a $1500 per month increase ($550,000 at 6.5% for $25 yrs yields a pmt of $3713).

Meanwhile, the median value of a home that was worth $550,000 in 2005 might only be $400,000 in 2010 (assuming a decline of 25% in value. Per today's San Diego Union Tribune, the value of the average SD home lost 25% in the last year alone, so the $400k estimated value figure might be generous). Now, imagine how many people with a $400,000 property and a $550,000 loan are going to hang in there after finding out that their payment is going up $1500 per month?

This will be the next wave of foreclosures. These loans and properties are in all areas of San Diego, not just the newly constructed properties on the outskirts of town. The fallout of these foreclosures in San Diego will hit higher end and coastal areas and everywhere in between. YIKES!   Many thanks to our guest author, Mr.Greg Brooks Southwest area manager San Diego Mortgage Network for this enlightening post. *Ed notes: The next bank with possible trouble??… I've been told Downey Savings & Loan was a major player in the option arm business and about a year ago their non-performing loans were at appx. 1.3%. In June 2008, it's said that Downey's non-performing loans are now appx. 15%!                                      San Diego real estate blog