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Monday, May 8, 2006 | The rate at which borrowers are foreclosing on their mortgages has doubled since last year, as high-risk financing has become the norm for home buyers in San Diego County. Local experts wonder whether the recent spike in foreclosures is a harbinger of horrors to come or of the much-hyped “soft landing” for the local real estate market.

In the month of January 2005 there were 374 mortgage defaults – that’s when a borrower hasn’t kept up their payments and a lender has the option to start the foreclosure process. In January of this year, that number rose to 536, according to County Records Service, a firm that tracks foreclosures in the county.

Perhaps even more indicative of the state of the housing market, in January 2005 no properties were seized by lenders through the foreclosure process in San Diego County. Every one of the homeowners who had defaulted on their loans managed to offload their property without the bank closing in on them. But last month, lenders seized 66 properties through foreclosure processes. That’s almost as many as in the whole of 2005.

Foreclosure occurs when a borrower fails to meet the terms of their mortgage, usually resulting from a borrower being unable to make the monthly payments on their mortgage, and the home is repossessed by the owner’s lending institution.

Though there’s no doubt that default and foreclosure rates have been climbing in San Diego, there’s considerable debate going on in the real estate world about what those rate increases mean and what effect they might have on property values.

Most analysts agree that foreclosure rates have been extraordinarily low for the past few years, and that an increase in the number of people who are unable to keep up their payments is a natural result of the cooling real estate market. The upward trend in foreclosure rates is likely to continue, they said.

“I anticipate that we’re going to have substantially more foreclosures in the future, that’s going to continue for a couple of years,” said Erik Weichelt, owner of San Diego REO Realtors, who specialize in buying and selling foreclosed and distressed properties.

Experts also agree that intrinsic to the rising foreclosure rates is the preponderance of non-traditional loans being used to finance home purchases in San Diego County.

In 2005, more than 70 percent of home loans in the county were interest-only or negative-amortization loans, according to Loan Performance LLC, a San Francisco-based firm that analyzes lending statistics. With interest-only loans, a borrower only pays off the interest on their loan every month for an initial time period. With negative-amortization loans, the borrower actually pays less than their interest payment each month, meaning that the amount they are borrowing grows over time.

Loan Performance reported that in 2005, 26.7 percent of loans made to homebuyers and those refinancing their mortgages were negative-amortization loans. In 2004, that number was 9.9 percent. In 2003, it was 1.1 percent.

In addition, the vast majority of loans issued in San Diego County in recent years have been adjustable-rate mortgages. The interest rates for these loans are indirectly tied to short-term federal interest rates. Those rates have been rising recently, which means many people’s mortgage payments have been increasing, leading to an increased chance that they will succumb to foreclosure.

Generally, buyers are attracted to interest-only and negative-amortization loans because these loans offer much lower initial monthly payments than a fixed-rate mortgage, where the payments typically stay the same for the duration of the loan. These “exotic” loans also require much smaller down-payments or even no initial down-payment at all.

For the last few years, property values have been soaring and many people have been able to buy property with a very low down-payment and low monthly payments for the first few years. Many homebuyers have then chosen to tap the equity that has built in their property and refinance their purchase after a year or two, thus giving them a lump sum that often eases the burden of the increased monthly payments they end up having to make.

But without substantial value increases, many homeowners will not have much equity to take out of their homes once the initial period of low monthly payments ends, and will therefore be unable to refinance. Instead, they may find their monthly payments substantially increasing while the value of their home remains the same or even drops. For some, that will inevitably mean foreclosure.

Because the wide use of interest-only loans and negative-amortization loans is a new phenomenon, nobody really knows what will happen to all those loans if the real estate market continues to cool off.

The vast majority of these loans include a starting-off period of lower rates and consequently lower monthly payments, but at some point those rates and monthly payments increase substantially, which some experts said will result in more and more foreclosures and more and more properties on the market. Having more properties on the market generally means that home values decrease.

Edward E. Leamer, director of the University of California, Los Angeles, Anderson Forecast, said the real estate market’s in uncharted waters. In the past, he said, real estate prices have only dropped catastrophically as the result of severe economic shocks hitting the local economy. For example, the last real estate slowdown, in the late 1980s and early 1990s came on the back of enormous job losses in Southern California.

The question is whether an increase in foreclosures as a result of San Diego home buyers’ reliance on non-traditional and riskier loan products could, in itself, constitute an economic shock. Leamer said the popularity of such loans is “very troubling,” but that he’s not sure what will be the effect of so many people relying on them to finance their home purchases.

“History isn’t very informative about that, because we haven’t been through this sort of a cycle,” Leamer said.

Most people are likely to keep up their payments some way or another, Leamer said, no matter what’s happening to their home values. Those are quite cautious words from someone who’s been notoriously pessimistic about the housing market.

Charles Jolly, president of the San Diego Association of Realtors, said most foreclosures are likely to result from the high number of speculators who invested in the real estate market. Even if foreclosures rise, he said, the number of homes being bought and sold on the market each year pales in comparison to the broader stock of housing and home loans that are out there. Only about two percent of all the homes in San Diego are bought and sold each year, he said, and increased numbers of foreclosures will only affect the small minority of people who have to sell their homes.

Gary Painter, director of research at the University of Southern California’s Lusk Center for Real Estate, said a reasonable number of foreclosures plays into the “soft landing” theory for the housing market. Gradually, some people will be knocked out of the game, he said, but that’s only to be expected as the market softens and as some people cannot keep up their payments.

The recent rise in foreclosure rates could simply be a return to “normal” rates, Painter said. Indeed, Phyllis Ingram, president of County Records Service, said rates are still way below where they were during the last major slowdown in real estate.

“When we went into the recession, the figures zoomed up, they were much higher than they are now,” Ingram said.

Nevertheless, the recent spike in foreclosure rates troubles Ingram and certainly has a lot of local analysts holding their breath to see what happens over the next few months. There’s little question that if the number of foreclosures continues to rise exponentially there will be an impact on local housing prices, the question is, then, how much the rates will rise and therefore how much prices will be impacted.

Those are questions nobody can answer just yet, and the next few months in San Diego real estate will be the time for experts to watch what happens very closely.

Please contact Will Carless directly at will.carless@voiceofsandiego.org with your thoughts, ideas, personal stories or tips.

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