Monday, Jul. 28, 2008

Our View: Steps taken to deal with subprime mess will not suffice

The latest bad news factoid is that foreclosures in California are at a 20-year high. The scale is four times higher than peak levels in the 1990s.

And it is likely to get worse.

The timing of foreclosures is linked to the dates that adjustable rate mortgages (particularly the riskiest exotic loans) reset to higher monthly payments.

The 2008 resets peak in the early fall, especially for subprime loans (where resets peak in October).

Then we get a brief respite until another shoe drops. That will be the category of loans in between prime and sub-prime, known as the Alt-A market.

Californians have to resist the temptation to think that the crisis has plateaued.

These borrowers tend to have OK credit but little cash for a down payment. There will be a spike in Alt-A resets in 2010 and 2011.

As "Defaulting on the Dream," a study by the Pew Center on the States shows, Californians need to resist the temptation to think that the crisis has plateaued. Subprime borrowers have been concentrated in California, Rhode Island, Mississippi, Illinois and Texas, so it's not surprising that attention in California has been focused on subprime loans.

But too little attention has been paid to the Alt-A market. And California will again be at the epicenter when the Alt-A loan resets hit.

California-based IndyMac and Countrywide were the largest issuers of Alt-A loans. California, Nevada, Arizona, Florida and Virginia have the greatest share of Alt-A loans.

The prescient March 2007 Credit Suisse research note titled "Mortgage Liquidity du Jour: Underestimated No More" provides a nice summary of the Alt-A issue, and the numbers below come from that report.

In 2006 nationally, loans requiring low or no documentation of income were 81 percent of the Alt-A market. Interest-only and option ARMs (allowing a minimum payment that fails to cover even the interest due, like a minimum payment on a credit card) were 62 percent of the Alt-A market.

These exotic products were designed to reduce monthly payments at the beginning of a mortgage, for a limited time. But then comes the shock of the reset.

Worse, many of these borrowers not only took on what were risky mortgages to begin with, they also piled on piggyback loans (second mortgages at the time of purchase) to compensate for their lack of cash for a down payment: Fifty-five percent of Alt-A mortgages had simultaneous second mortgages attached to them.

In California, we've got miles to go before we sleep. The minimal steps the governor and Legislature have taken to deal with the subprime mess will not suffice to meet the looming Alt-A mess. Who's preparing for that?

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