They took out adjustable-rate mortgages at the peak of the housing bubble to buy homes they would otherwise not be able to afford. Or they refinanced existing mortgages to take cash out.
And now, two or three years later, the day of reckoning is here.
These are not lower- and middle-income borrowers, but more affluent consumers with annual incomes of $100,000 or more who are increasingly being ensnared in the home mortgage crisis.
People in all income categories “are facing the shock of new payments that can be twice as much as previous ones,” said Susan M. Wachter, professor of business and a real estate specialist at the Wharton School of the University of Pennsylvania.
Nor will falling interest rates help most of these homeowners, as their low initial payments skyrocket and the worth of their homes erodes, said Allen Fishbein, director of housing and credit policy at the Consumer Federation of America.
According to Loan Performance, a unit of First American CoreLogic, a real estate information company based in Santa Ana, Calif., about 870,000 borrowers took jumbo ARMs — mortgages of $417,000 or more — from 2005 to 2007.
In the fourth quarter of 2007, 8.10 percent were two or more payments late, it found, while 2.62 percent were in the foreclosure process and 1.35 percent had been foreclosed. All the numbers were up from the third quarter.
Mark Zandi, chief economist for Moody’s Economy.com, predicted that eventually 8 percent of these jumbo ARMs will be foreclosed. In the first quarter of 2008, “the delinquency and foreclosure rate will clearly be higher,” he said.
Today’s ARMs were “designed to fail, so you have to refinance,” Ms. Wachter said. “It shouldn’t be surprising that values go up and down in this kind of situation. And when you most need to refinance you can’t — the crux of the crunch.”
Jeffrey Conner, a San Francisco real estate lawyer, says he regularly hears from his clients “that lenders assured them they could always refinance.”
So what are these homeowners to do now?
Refinancing requires some equity. Even if homeowners put a substantial amount of money own, many have no equity because their homes are worth less than they owe. In real estate parlance, their mortgages are under water.
Richard Geller, founder of Mortgage Relief Formula, a for-profit venture based in Fairfax, Va., that counsels troubled ARM borrowers, said he received calls from affluent consumers in almost every major metropolitan area. At the moment, Manhattan appears to be the only exception in the weakening market, Mr. Geller said. “It’s really late in the schedule and will be the last place prices soften,” he added.
The first step for distressed homeowners, said Rhonda Porter, a certified mortgage planning specialist and broker in Seattle, is to pull out their loan documents and see what they say.
Sean O’Toole, founder of ForeclosureRadar.com, which tracks California foreclosures, divided borrowers into two camps. “If you have equity, you have choices,” he said. “If you don’t, you have to work on a loan modification with your lender.”
Consumers with substantial equity, high credit scores and documented income should be able to find conventional refinancing, he said.
Homeowners with at least 3 percent equity may qualify for refinancing through the Federal Housing Administration. On March 6, it began making loans up to $729,750, a new higher limit that expires Dec. 31 unless Congress extends it. Limits are 125 percent of median home prices, by county.
Loan modifications entail freezing or reducing interest rates and may also include balance reductions.
“But if your payments are still going to be more than half your gross income, the lenders won’t do it because they figure you’re going to default later,” Mr. Geller said. “It’s not rational to dedicate your life to making the next $5,000 monthly payment on an asset declining in value.”
Negotiating a loan modification means understanding that in most cases “the lenders really don’t want to force people into foreclosure because that virtually guarantees large losses in the market,” said Dean Baker, an economist with the Center for Economic and Policy Research in Washington.
“It’s a game of chicken,” Mr. Baker said. “And you can’t play it effectively unless you know what your risks are, including whether lenders can come after your other assets if you walk away.”
Borrowers should determine if they live in a state with nonrecourse laws. In general, lenders in those states cannot pursue borrowers for money owed. But these laws are complex and change often, so consulting with a lawyer may be necessary, Mr. Geller said.
Every affluent borrower who took an ARM has a different story.
In Oceanside, Calif., north of San Diego, people paid $650,000 to $750,000 in 2003 and 2004 for row houses on Cleveland Street, said Chris McBrearty, certified mortgage planning specialist, in Carlsbad, Calif., who wrote many mortgages there. When prices for the houses rose as high as $1.5 million in 2005, many of those people refinanced with ARMs to take out cash, he said.
But while the borrowers had the best intentions, life — job losses, divorces, deaths — changed their financial circumstances, Mr. McBrearty said. Now, with a most recent listing at $920,000, “nothing is selling on the street, and even for those with some equity, the products needed to refinance such large loans are not out there.”
One of those homeowners, a lawyer who spoke only on condition of anonymity for professional reasons, said he refinanced his mortgage with an ARM in January 2006 to take $510,000 out to invest in a hotel. “I planned to run the hotel with my lovely wife,” he said.
Their strategy was to sell the house after a couple of years, but when they put it on the market in April 2007, there were no buyers. The lawyer, now divorced, calculated that the mortgage payments, now $6,200 a month, plus taxes consume 96 percent of his net income, which includes occasional rent from vacationers who use the house. He lives with relatives and sleeps on the floor.
“I don’t regret what I did,” he said. But a foreclosure would hurt his career and finances, he said. “And I was raised to pay back what I borrow.”
His strategy now is to sell when prices revive. But that could take time, because a bank just sold a neighbor’s foreclosed home for $850,000.
Elizabeth Hamilton, the maiden name of a Los Angeles real estate consultant who did not want to be identified for professional reasons, said she turned to a nonprofit housing counseling agency when she was making no progress in persuading her lender to reduce the interest rate for the ARM she took on her $1.5 million home. The introductory rate was 7.9 percent for two years and payments were $6,541.
Now the interest rate is 10.25 percent and payments are $8,013. She cannot afford the payments, she said, because her husband has died and her income has fallen. “I need an interest rate reduction so I can get myself and children back on track,” she said.
A housing counselor, certified by the federal Department of Housing and Urban Development, quickly got through to her servicer’s loss mitigation department, where loan modifications are made. Now Ms. Hamilton needs to provide more personal financial information.
The best no- or low-cost housing advisers have contacts with lenders’ decision makers. “Our view is you need counselors who will negotiate for you,” said Bruce Dorpalen, director of counseling for Acorn Housing, a nonprofit counseling group.
Mr. Geller said he had heard of just one loan balance reduction won by a borrower.
That borrower, a real estate consultant in California who did not want to be identified because he feared angering his lender, said he used his understanding of state law to negotiate the refinancing. He bought a condominium two years ago for $450,000 and invested another $50,000 for improvements. His ARM had a 5.5 percent initial rate that was soon resetting to 7.25 percent. But his condo is now worth only about $350,000.
His lender agreed to give him a 6 percent fixed-rate mortgage and, he said, to knock $135,000 off the principal.
The agreement came only after he stopped paying his mortgage for two months. “I am very happy and grateful to the lender because what I owe on my condo now is in line with its worth,” he said. “I’m ecstatic.”