An updated chart highlighting the option ARM and exotic mortgage loans made during the height of the bubble still shows us that many loans will go bad in the next couple of years.  We need to remember that the vast majority of troubled option ARMs were made from 2004 to 2007.  While analysts claim that there will be no reset problems, courtesy of low interest rates, the real problem stems from the recast of the mortgage.  Much of this is typically hidden until it explodes like a financial time bomb.  The reason this issue has somewhat lost steam in 2010 is that now, the really toxic loans are segregated into a handful of states including California, Florida, Arizona, and Nevada.  If you live in these states, be prepared for additional bumps in the housing road ahead.

Let us look at this new updated chart and try to figure out what is really going on with option ARMs but also with other toxic loans in states like California:

Source:  SNL, Credit Suisse

The data released only this month, highlights that between 2010 and 2012 some $253 billion of option ARMs will adjust and another $163 billion in Alt-A loans will reset.  This is extremely troubling because most of these loans were made in states that experienced the brunt of the subprime disaster.  You can imagine this hitting in a two wave fashion.  First, the subprime wave filtered through and now the option ARM and Alt-A wave will cast a shadow but only on a select number of states.  This older chart shows this two wave process:

Source:  Amherst Securities

For the last few months we have been in the eye of the hurricane.  While wave one has largely passed, wave two is only beginning to gear up.  One of the ideas being bandied about is that nothing will come from this second wave.  The assumption is all will be well.  We bought some time with the government loan modification programs known as HAMP but after almost one year of the program, only 168,000 permanent loan modifications have been made nationwide and many of the option ARMs don’t even qualify for this.  Banks have been trying to figure out what they can do with option ARMs but not much can be done because many of the borrowers do not or cannot continue to make payments on the loan.

Some staggering data from a Fitch report released late in 2009:

94% of borrowers made minimum payment only*

46% of all option ARMS were 30+ days late (with only 12% hitting recast)

Average loan-to-value ratios up to 126%

*With minimum payment loan balance increases through negative amortization

The above data was released back in September 2009 and most of the option ARMs are in California (roughly 50 to 60 percent).  Since that time housing prices in the state have not gone up.  So it is highly likely that more option ARMs are 30+ days late and LTV ratios are even worse as balances continue to grow while asset prices remain stagnant or retreat.  It is understandable that following nationwide coverage of the housing problem can ignore the option ARM issue because it is pinned on only a few states.  But these states will continue to face issues as these loans linger in financial limbo.  If we look at some of the option ARM lenders like WaMu (many are now gone) we can see how concentrated they were in only a handful of states:

The above is from the $52.9 billion option ARM portfolio of WaMu in 2008, at a point when the option ARM spigot had turned off.  WaMu had 50% of its option ARM loans in California.  If we add in Florida, that number jumps to 62%.  So this really is a problem that will hit a few states squarely.  But to understand the depth of this, let us first get an actual number of loans in California:

California Housing Units with a Mortgage:            5,290,276

Source:  Census, 2008 American Community Survey

We then have to figure out how many loans are currently in some form of distress or in foreclosure:

“(MBAA) The delinquency rate includes loans that are at least one payment past due but does not include loans in the process of foreclosure.  The percentage of loans in the foreclosure process at the end of the fourth quarter was 4.58 percent, an increase of 11 basis points from the third quarter of 2009 and 128 basis points from one year ago. The combined percentage of loans in foreclosure or at least one payment past due was 15.02 percent on a non-seasonally adjusted basis, the highest ever recorded in the MBA delinquency survey.”

The latest mortgage data shows us that 15.02 percent of all mortgages are 30+ days late or in the foreclosure process.  Now California has more troubles because of the option ARM concentration but we’ll be conservative and use the 15.02 percent figure:

5,290,276 * 15.02 percent = 794,599 properties 30+ days late or in foreclosure

I ran the numbers a few days back and found that only 154,000 properties are listed on the MLS in California.  So what is going on with those 600,000+ properties that are 30+ days late or in foreclosure?  Wells Fargo which acquired a large option ARM portfolio from failed Wachovia tried a few adjustments but they seem to be more extend and pretend methods of stalling the inevitable:

“(CNBC) Pay option ARMs are the new subprime, defaulting at high rates now thanks to adjustments as well as good ol’ unemployment. According to its Q3 earnings report, Wells Fargo, the fourth largest U.S. bank by assets, has $79.2 billion in debt on these loans alone, down from $101 billion a year ago, in addition to other ARMs and fixed-rate loans and full-term loan modifications. Wells didn’t make the Pick-a-Pay loans, they just inherited them when they bought Wachovia at the beginning of this year. Wachovia relished in selling these risky products in the most overheated housing markets. Suffice it to say, many many many of these borrowers are way way way underwater on their loans.

Enter the interest-only product, which will allow borrowers to defer their balances from 6 to 10 years. This keeps the borrowers in their homes, paying a little every month.  I called over to Wells Home Mortgage and spoke with CFO Franklin Codel. He told me that Wells has written down principal on the “vast majority of these loans.” Yep, just given that debt away, written down so far the tune of $2 billion, or about $46,000 per modified loan. So far Wells has turned about 43,500 Pick-A-Pays into interest-only ARMs.”

Since that time, mortgage distress has risen to a historic 15.02 percent and in California, there is little reason to believe the rate is any lower.  The above adjustment is yet to be seen as helping any sizeable number of borrowers.  It is also the case that banks have been reluctant to do any kind of principal reduction because this would force the bank to realize the actual loss on their balance sheet.  In other cases loans have been extended out to 40 years with lower rates but as HAMP has shown, even this isn’t enough to make a change if you have no job:

Source:  HAMP

Only 168,000 permanent loan modifications have occurred through HAMP.  What needs to be remembered that over the last decade, housing has shifted into a commodity where very little value is placed on the home as a place to set your roots and instead became a place to count your home equity.  With much of the equity stripped out, how many people will want to continue supporting a high mortgage when the home isn’t worth that value?  A handful of studies have shown that the number one predictor of foreclosure is negative home equity.  Virtually every option ARM in California is in a negative equity spot so that probably means 70 to 90 percent foreclosures on these places once we roll through the next wave.

What will banks do?  Well so far they have shown us that ignorance is bliss.  They have left the mortgages at face value and have no desire in pursuing a foreclosure (at least for now).  Why would they?  Say they have a $500,000 option ARM on a home now worth $250,000.  The loan has now grown to say $575,000 because of negative amortization but the borrower stopped paying once a recast was hit.  The bank can now claim an asset of $575,000 and lose $3,000 or $4,000 a month in missed monthly payments or realize a loss of $250,000 to $300,000 by foreclosing on the home.  So we may not see a big tsunami hitting us all at once but the wave will hit and it will be painful and drawn out.

In fact, if we pull data on some of the areas in California we will see entire blocks with massive amounts of distress:

Source:  Foreclosure Radar

Just look at the estimated equity column.  Most of these homes don’t even show up in the MLS.  But these are massive losses.  If we look at the loan data we find a few option ARMs and a few familiar names including IndyMac.

Yet that isn’t the only problem falling on a state like California.  There is also a number of jumbo loans:

California has 845,000 active jumbo loans.  And a large number are already in foreclosure or are now 30+ days late.  These loans carry big balances.  What is even more troubling is 55% of jumbo loans are adjustable rate mortgages.  With mortgage rates slated to increase this year, we can expect the foreclosure rate to zoom up.

The option ARMs, the Alt-A toxic loans, jumbo loan issues, and a 12.5 percent unemployment rate the highest in recorded history tells us the next wave will hit.  The mainstream media isn’t covering this because it really is a state specific problem.  But that is of little solace for those that live in sunny California.

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Rarely do we ever see an actual total inventory report for California because this would require a count of each county in the entire state.  I try to track all this data in a spreadsheet since obviously the most important item we have in measuring California real estate is the actual quantity of homes we have for sale on the market.  Last month, the amount of unsold inventory jumped from 3.8 to 5.8 months in January.  Part of this was because of the seasonal dip in home sales for December but also the elevated amount of homes for sale on the market.  Keep in mind that in the past the unsold inventory number would usually track down in the month as well as people would hold off on selling their homes.  Yet in this climate where a large number of home sales are distress properties, they are not pulled back during this typical seasonal fluctuation.

California still has many deep issues including a large amount of troubled loans in option ARMs and other mortgage products that have extremely high default rats.  Let us first look at the latest snapshot from the California Association of Realtors:

Aside from the seasonal fluctuation, the seasonal home sale rate has fallen by 10 percent from this time last year.  This can be from an exhaustion of home purchases and all the additional government programs set in place to spur home buying.  The median home price has been pushed up from this point last year but has fallen from last month.  The amount of unsold inventory did move up again last month.  Let us first crunch that number since this is such an important point in determining how many homes are for sale in California:

Source:  MLS

In total, California has over 154,000 homes listed on the MLS.  Yet this number in itself doesn’t tell us the actual amount of inventory on the market.  We then need to look at the number of homes sold statewide last month:

January 2010 CA Home Sales:                     27,858

After getting this number we merely divide by the amount of total inventory:

154,717 / 27,858 = 5.5 months

This number is fairly close to the 5.8 months reported by the CAR.  In a healthy housing market anything below 6 months of inventory is a good number.  Yet this market is anything but healthy.  In fact, we really need to get a better understanding of the market regarding negative home equity but also, how many homes are in distress that aren’t listed on the MLS.

A study from Arizona State University examines negative equity from MSAs (metropolitan statistical areas) and finds that the bulk of them are here in California:

Source:  ASU

Now this chart is crucial in determining the path ahead because it gives us a sense of how many more distressed properties we can expect in the year to come.  If we look at Merced California, 85 percent of mortgage holders are underwater.  Couple this with an unemployment rate of 17 percent and you can understand why some areas are going to see low home prices for a long period ahead.  And the study from ASU and other institutions shows that negative equity is the number one factor in predicting future foreclosure.  This makes sense.  If you are in trouble and have equity, all you need to do is sell.  But when you are in a position where you owe more than your home is worth, selling isn’t an option unless the bank approves a short sale and this seems to be a new path ahead.  How big of an impact this will have is yet to be seen.

So how many homes are in distress in California?  This is hard to say.  Yet even if we take nationwide statistics and apply them to the state, we know that the number of homes in trouble is extremely large:

“(Calculted Risk / MBA) The delinquency rate includes loans that are at least one payment past due but does not include loans in the process of foreclosure. The percentage of loans in the foreclosure process at the end of the fourth quarter was 4.58 percent, an increase of 11 basis points from the third quarter of 2009 and 128 basis points from one year ago. The combined percentage of loans in foreclosure or at least one payment past due was 15.02 percent on a non-seasonally adjusted basis, the highest ever recorded in the MBA delinquency survey.”

Now this is nationwide data.  So let us apply this number to the amount of California mortgages (the distress rate in California is much higher because of loans like option ARMs):

California

Housing Units with a mortgage:                 5,290,276

MBA Nationwide data on 1 payment behind and foreclosure (15%)

Total potential pool of current distress California homes:            793,541

Now take that above number and compare it to the 154,000 homes currently listed on the MLS.  In other words, the potential for distress inventory hitting the market for years to come is enormous.  It already appears that banks won’t flood the market but with this amount of people 1 payment behind or in foreclosure, California housing will be depressed for years to come.

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