March 2007

Sub-Prime Loans and Foreclosures in California
By Robert Kleinhenz and Sara Sutachan


The California housing market held steady at the start of 2007 with a slight decline in sales, while the median price continued to edge up. Statewide sales of existing detached homes fell 3.2 percent from 452,060 homes in December to 437,580 homes in January. However, the 12.6 percent decline from January 2006 was the smallest year-to-year decline in over a year. The median price rose 1.9 percent from $549,460 in January 2006 to $559,640 in January of this year, while the median fell slightly compared to the revised December median of $569,560. By comparison, most regions and counties posted year-to-year decreases in their median prices in January 2007.

While the market is showing signs of stability, attention has turned toward potential problems with sub-prime loans and other alternative loan products that have gained in use in recent years. (Briefly defined, sub-prime loans generally are loans to qualified individuals with credit scores below 620). Indeed, the use of sub-prime loans in California has climbed dramatically in recent years, accounting for less than five percent of loans outstanding for several years before climbing to roughly 14 percent of the total by 2003, based on data from the Mortgage Bankers Association (figures reported are not seasonally adjusted). Concerns center mainly on how many sub-prime borrowers will face foreclosure in the next couple of years, as their loans reset from lower teaser rates to fully indexed mortgage rates.

Delinquency rates provide an approximate measure of the potential downside risk in the months and years ahead. The delinquency rate for all loans in California as of the 4th Quarter of last year stood at 3.25 percent, compared to 5.31 percent for the US as a whole. California has fared better than other states around the country because its economy has continued to grow and add jobs in recent years. Moreover, it experienced much larger price gains in the first half of this decade compared to many other parts of the country.

Of all the sub-prime borrowers, the most threatened group consists of households who have sub-prime adjustable rate mortgages (ARMs). In the 4th Quarter of 2006, sub-prime ARMs made up 8.6 percent of the total number of loans outstanding in California. Of all sub-prime ARMs in California, 12.1 percent were delinquent as of the 4th Quarter, and accounted for 1.04 percent of total loans outstanding. Only a fraction of all delinquent loans will actually go into foreclosure because of measures taken by lenders to prevent costly foreclosures. For borrowers who face temporary problems, these include delaying payments for a short period of time or scheduling a lump sum payment in the near future. For borrowers with more severe problems, alternatives include short salesor mortgage forgiveness. At present, it is anticipated that the proportion of foreclosures in California should be near the long-run average of just under one percent.

The loans posing the greatest risk of delinquency and/or foreclosure were underwrittenin 2005 and 2006, with many of these loans facing resets in 2007 and 2008. Numerically, there were many more loans in 2005 -- the record year for California home sales than in 2006, so the 2005 cohort of loans is most worrisome. Given the timing of the resets, the greatest stress on the market and the economy should be in 2007 and 2008.

The negative impact of sub-prime loans in California is likely to be limited to sub-prime borrowers  mainly those holding sub-prime ARMs -- and to lenders who relied heavily on the sub-prime market segment for their business in recent years. Risks loom largest for marginally qualified households in newer developments with a concentration of borrowers holding sub-prime loans. If payment resets force a few of these households into foreclosure, property appraisals may suffer, and may have a potentially adverse impact on others in the development when they seek to refinance their homes. Spillovers to well-qualified borrowers or other neighborhoods should be minimal. Also, assuming the foreclosure rate remains near the long-run average and the economy avoids recession, the risk to the overall housing market and the general economy should be manageable. That said, the market has not dealt with this type of situation in the past, so the likely outcome is difficult to gauge.

To learn more about our Trends Newsletter, please contact the Research & Economics Department at  research@car.org or (213) 739-8352.