More than 2.3 million homeowners in the U.S. faced foreclosure in 2008; an 80 percent increase over 2007. A massive number of ARM (Adjustable Rate Mortgage) interest rate resets started this year, and will continue through 2012, with a big spike in the fourth quarter of 2010 and lasting through the second quarter of 2012. Further, option ARM mortgages will see a big spike in resets, starting in April of 2010, and lasting through the first quarter of 2012. While historical data and analysis has not conclusively shown a direct correlation between rate resets and foreclosures, I believe there is a combination of factors at work that will drive another, large wave of foreclosures.
First, the good news. If we look at the overall economy, we have had some signs of improvement, especially with regard to third quarter GDP (Gross Domestic Product), which grew at an estimated 3.5 percent growth rate (annualized). We have also seen that consumers, given a good deal such as the cash-for-clunkers program, are willing to spend money, and personal savings has increased this year. There is also a lot of pent-up demand, as consumers have not purchased many items that they will eventually need to buy. Finally, according to the California Association of Realtors, home prices have begun to stabilize, and in our local market, the supply of single family homes has dropped from about 11 or 12 months a year or so ago, to about 5 months today, and to only about two months for those properties priced below $500,000.
Here’s the bad news – although home prices are stabilizing, the reason inventories are coming down is because prices have fallen dramatically, offering attractive pricing for buyers looking for a good deal. This is great if you are a buyer, but not so great if you own a home at a higher price, especially if you have an adjustable-rate mortgage that is going to reset soon. The problem is that, when homeowners with adjustables go to refinance, if their equity has fallen to a point where they have less than 20 percent equity, unless they can shore-up their equity, banks will not refinance their loan, even if they have the income to support the new loan payment. Banks are following much more stringent lending policies today, and it is unlikely they will soften their policies during a declining real estate market environment.
Foreclosures are estimated to reach 3.5 million in 2009, up over 50 percent from the 2.3 million last year. Despite the more than 500,000 homeowners that have taken advantage of loan modifications, more people are falling into default than are getting this help. Furthermore, a high percentage of those receiving loan modifications, end-up in foreclosure anyway, within a few months.
The first wave of foreclosures was driven by sub-prime mortgages—low-quality mortgages extended to homeowners with poor credit and less ability to pay. The new wave of foreclosures we are seeing now, and that I believe will continue and accelerate into next year and through 2012 is being driven by high unemployment and exotic Alt-A option ARMs—mortgages with the option to pay interest-only or some interest and some principal, but with reset features that will cause payments to begin adjusting up.
Twenty of the top fifty cities and six of the top ten in terms of foreclosures are in California. Santa Barbara-Santa Maria-Goleta is number 38 with 1,790 foreclosures during the third quarter, which represents 1.18 percent of homes in the area, or 1 for every 85 homes. Foreclosures in our area are up 11.39 percent from the second quarter of this year, and are up 5.85 percent from the third quarter of last year.
We have a large number of Alt-A loans in our local market, leaving us particularly vulnerable to foreclosures. Since we have experienced significant price declines in local property values—from the peak median price of $1,275,000 in October of 2007, to the current $740,000, or by 42 percent—we can expect foreclosures in our local area to continue, especially with so many resets coming over the next three years. The reduction of equity values for local homeowners, in my opinion, raises the risk of foreclosures, more so than in many other markets, since the 42 percent decline we have experienced is a much larger amount in dollars. What I mean is that 42 percent of $1.275 million ($535,500) is a lot more money than 42 percent of a $400,000 peak price in some other community (only $168,000).
Another way to look at the problem is to think about refinancings. Let’s say that a homeowner here in town owns the median home, for which they paid $1 million a few years ago, that hit a peak value of $1.275 million, and is now worth $740,000. If they put 20 percent down ($200,000), that means they borrowed $800,000. Now their home is worth $60,000 less than the original loan (assuming they haven’t paid down the loan much, which would be accurate with a loan that is only a few years old). In order to refinance, the homeowner would need to have the $60,000 to bring the loan balance down to the current value of the property, plus another 20 percent (the minimum required by lenders at present—of the $740,000 current value; another $168,000; for a total of $228,000.
This assumes that the lender would refi with only 20 percent equity, which many will not do right now, since they fear the real estate market may continue to decline. Additionally, the homeowner would have to show income sufficient to justify the new, higher loan payments at the higher rate (this assumes the homeowner is refinancing out of an adjustable into a fixed-rate loan, which would have a higher rate).
Mark Schniepp, PhD, Principal of the California Economic Forecast, (www.californiaforecast.com) is more optimistic, stating that, “there is no empirical evidence that resets and recasts cause foreclosures,” and that the bulk of the option ARM resets will occur in 2011 and 2012, after, he believes, the economy will have already entered a recovery phase.
Steve Epstein of Coldwell Banker (805.689.9339) states that in May and June local real estate professionals were told to expect a new wave of foreclosures in the local market in July and August, but they did not come. “The REO (foreclosure) market remains very soft, meaning there are not many foreclosed properties available. Our sub-$800,000 market is selling very well, so if a homeowner is facing a reset and knows they cannot refinance, they should look to sell the property before it goes into foreclosure.”
Regardless of what happens with the overall economy and our local economy, and the national and local real estate market, there will certainly be some residents of Santa Barbara that will face the possibility of a foreclosure. For these homeowners, it is best to be proactive. Even with a short sale, the negative impact on one’s credit is typically only 24 months versus five years or more for a foreclosure. Contact a good real estate broker who can provide you with all of the options available to you. Understand all of those options and develop a plan of action. Even if it means waiting things out for the market to recover, at a minimum, knowing what you can and cannot do will help you to make the best decision.