This article analyzes the causes of California’s current foreclosure crisis, dissects the toxic results of negative equity on the real estate market and proposes local and federal action to remedy widespread insolvency.


Diagnosing the symptoms

Although the Great Recession is officially over, California continues to groan beneath the recessionary weight of a devastating profusion of households displaced by foreclosure. The Golden State is ranked fourth in the nation for the percentage of mortgages considered seriously delinquent (90 or more days late). More critically, over 25% of single family residence (SFR) homes in California are plagued by illiquidity, meaning the owner cannot be cashed out. Illiquidity is the direct result of a negative equity and, with the passage of time, leads to insolvency.

With little hope of any relief from negative equity by price increases or principal reductions in this decade, the effects of foreclosures will continue to decimate the real estate market as an untreated plague. Even positive equity homes will decrease in value — a crippling symptom of their proximity to delinquent neighbors.

The statewide devastation is solely the product of over-indulgent lending practices during the Millennium Boom. As home prices climbed from 2002 to 2006, lenders indulged their borrowers’ thirst for instant gratification in the form of adjustable rate mortgages (ARMs). They doled out mortgages to homeowners who had no realistic ability to meet their impending graduated payments — resets — on loans secured by collateral and appraised as having increased value.

These irresponsible mortgage transactions became the financial accelerator dynamic that inevitably lead to the collapse of real estate prices. During this lush period of hot money and steaming prices, most borrowers had no problem refinancing well before their ARM payments reset to higher amounts, and lenders provided that liquidity loophole to minimize delinquencies.

These excessive lending practices screeched to a halt when the Great Recession swept across California in 2007 and 2008. Homeowners were left unemployed or otherwise unable to meet reset payments. Lenders feigned ignorance of their hand in the fallout of increased real estate owned (REO) inventory, negative equity homeowner imprisonment and widespread insolvency among everyone involved in real estate. The effects have been both direct and indirect, involving all California property owners on some level and crippling California’s economic recovery for years to come.

Direct and indirect distress

The nearly one million California homeowners who have or who will soon experience foreclosure firsthand are burdened by displacement and financial instability. 40% of school districts nationwide cite foreclosure as the primary reason for increased student homelessness. Homeowners who are forced out of their homes, many of whom will be forced to move away from their jobs, will be hard pressed to find employment elsewhere which will further perpetuate the risk of another default. [For more information regarding children affected by foreclosure, see the November 2010 first tuesday article, Children devastated by the foreclosure crisis.]

Even if homeowners are able to avoid unemployment and stay current on their mortgage payments, their homes have decreased in value as a result of neighbors who have not been so fortunate. REOs speckle the urban and suburban landscape like dead trees in a withering forest, leaving the broader community depreciated in value with a tendency towards widely vacant, unkempt neighborhoods. [For more information regarding vacancy rates, see the November 2010 first tuesday article, Nobody’s home: California residential vacancy rates.]

MLS brokers must now focus their efforts on helping those million homeowners who have or will soon face foreclosure.

Multiple listing service (MLS) brokers must now focus their efforts on helping those million homeowners who have or will soon face foreclosure. Most will be unwilling (if not unable) to re-enter the homeownership market for years after their negative experience. With resulting low credit scores, the households displaced by foreclosures will find friendly respite in renting, which can provide them with commodious homes for lower monthly payments than their previous mortgage lenders permitted.

However, the wholesale conversion of SFR neighborhoods from homeownership to buy-to-let investors and tenants has a negative impact on the broader community. Renters (and their investor-landlords) are often uninterested in the upkeep of a home they don’t own and the improvement of a community from which they’re disconnected. It will take more than a decade for these more transient type neighborhoods to rejuvenate by returning to a greater percentage of homeownership — as seen in the Moreno Valley and Lancaster fallout of the early 1990s. [For more information regarding rentals, see the December 2010 first tuesday article, Increasing renter populations drag neighborhoods down.]

Neighborhoods with no neighbors

California’s Central Valley and Inland Empire, comprised primarily of the state’s least expensive housing, have the highest densities of foreclosures in the state — roughly 15% of all housing units in those regions. Located outside of the Bay Area and Los Angeles, these commuter bedroom towns have experienced heavy growth in new SFR construction in the past decade, as homebuyers seized opportunities to finance their dream homes with subprime or Alt-A ARMs and raise their children in suburban communities beyond the border of their urban workplace. Consequently, the majority of the mortgages for Central Valley and Inland Empire homes in foreclosure were originated during this time of loose lending, between 2002 and 2007.

The greatest number of total foreclosures occurred in the major cities of California. The impact in sheer numbers has been most severe in Los Angeles (nearly one quarter of the state’s population), with 206,048 foreclosures from 2006 to 2009. While exurban communities are experiencing a heavier concentration of foreclosures as a proportion of all housing units, the total impact of foreclosures in large cities is more widespread. Since housing units in urban areas are more densely concentrated than in their exurban counterparts, the closer proximity of foreclosed properties to non-distressed properties in these urban areas has a more pronounced negative effect on the non-distressed properties’ values.