SEPTEMBER 2007 :: COVER STORY : ECONOMICS

'A Disaster on Our Hands'
What Happens When You Owe More Than Your House Is Worth? One Family Is About to Find Out.

BY JAMES R. HAGERTY AND KEN GEPFERT
The Wall Street Journal

Nearly two years ago, Mario and Leticia Montes found a home they loved, a gray stucco bungalow in a middle-class neighborhood of Orange County, Calif.

The price was a major stretch at $567,000. But the couple, who had sold a home a few years earlier to move to a better area, was tired of renting. "We agreed we wanted to be homeowners again," says Mr. Montes, "even if it meant the end of vacations and not eating out as often."

Like many people who jumped into the rising housing market in recent years, they had little money for a down payment and chose a riskier loan option that would hold their monthly payments down for the first two years, then "reset" to a much higher level. Such loans were a popular option for people whose weak credit history or small savings would ordinarily make it difficult to get a home loan. Mr. and Mrs. Montes say their mortgage broker assured them they would be able to refinance-or take out a new loan with more-friendly terms to replace the old one-in a couple of years to keep their payments affordable over the long term.

But with the "reset" on the loan just a few months away, the refinancing option now looks impossible. Similar homes in their area have been selling for $535,000 to $565,000 recently, less than what the Monteses paid. That means the Monteses may owe more than the market value of their house. In other words, they have no "equity" in their home.

CAUGHT IN A TRAP

The Monteses, in effect, bet that housing prices would continue to rise, and that their equity in their home would grow as a result. At the time they decided to buy, it was more important for them to hop onto the escalator than to wait until they could afford to make the leap according to traditional lending criteria. Now, with home values flat or falling in their area, they are caught in a trap that hundreds of thousands of other homeowners could face as housing prices weaken and the easy borrowing terms of recent years dry up. Lenders that embraced all kinds of risky loans two years ago are refusing even to consider extending new credit to people like the Monteses who lack any equity in their homes.

"We have a disaster on our hands," says Mr. Montes, a 48-year-old warehouse manager. He fears he won't be able to handle the payments after the December reset and wonders whether the family can avert foreclosure. "At this point," he says, "we really don't have a plan."

Until recently, the Montes family didn't seem like the type that would find itself faced with foreclosure. They live in a solid neighborhood and are both employed and in good health. "My wife and I make pretty good money," says Mr. Montes. Mrs. Montes works as a school secretary. Together, they earned nearly $90,000 last year.

But they already pay about $38,400 a year on their home loans, even before taxes and insurance. In December, when their primary loan "resets" to a higher interest rate, that cost will rise to about $50,000 a year, Mr. Montes says.

"It's getting worse and worse," says Jeff Lazerson, a mortgage broker who tried to help the Montes family last spring but concluded even then that they couldn't qualify for a new loan. Many people who have been counting on a refinancing to ease their debt burdens will find that's now impossible, he says: "It's either work 24 hours a day to make ends meet [with the existing loan] or mail the keys back to the bank."

Being stuck with little or no home equity is no longer a rare situation. Christopher Cagan, a mortgage researcher, recently found that nearly 7% of 32 million U.S. households studied as of last December owed more than their homes were worth, based on computer estimates of the property values. An additional 4% had home equity of 5% or less, meaning that the value of their homes exceeded the loan amount by no more than 5%. Since then, house prices have edged down in much of the country, erasing more home equity.

Without a cushion of equity, homeowners are vulnerable to losing their homes to foreclosure if they suddenly are out of work, suffer a serious illness or, like the Montes family, face a jump in mortgage payments.

Partly as a result, foreclosures are surging. Economy.com, a research firm, projects that lenders will acquire about 760,000 homes through foreclosure this year and 935,000 in 2008, up from an average of about 440,000 a year from 2000 through 2006.

'SUBPRIME' LOAN

When the Monteses decided to buy the bungalow in 2005, they had only a so-so credit record and little savings. So they settled for a "subprime" loan, with costlier terms than those available in the "prime" market.

The Monteses' primary loan is the type that became the dominant subprime mortgage during the housing boom of the first half of this decade-and now has become a symbol of misguided lending. These loans are known in the business as "2/28" mortgages. The interest rate is fixed at a relatively low rate for the first two years (5.45% in the Monteses' case), then floats within certain limits for the next 28 years. In many cases, that "reset" of the interest rate after two years leads to a monthly-payment increase of 30% or more.

Lenders promoted the 2/28 loans as "affordability" mortgages, because they helped people buy houses that wouldn't have been affordable with the higher immediate payments on 30-year fixed-interest-rate mortgages. To make the loans even more affordable in the early years, they were often structured as "interest only," meaning that borrowers paid only interest in the beginning; principal payments were deferred until later.

Lenders sometimes described these loans as "credit-repair tools." The idea was that people with blemished credit records could take out a 2/28 subprime loan and keep up with the payments long enough to improve their credit records, then qualify for a less-costly prime loan to refinance with.

Earlier this year, regulators ordered subprime lenders to make such loans based on the borrower's ability to afford the loan after the reset, not just for the initial two years, as was the common practice. That change, along with other trends, has caused major subprime lenders to stop making 2/28 loans. Instead, they are making more subprime loans that carry a fixed rate for at least five years, as well as ones that hold down payments by stretching the payments over 40 years instead of 30.

The Montes family got their loan through a mortgage broker who offered to arrange for two loans, one to cover about 80% of the home price and the other, a so-called piggyback loan, for the rest. For the first two years, their total monthly mortgage payments are about $3,200. The loans are initially interest-only.

Mr. Montes recalls feeling edgy about whether he could afford the higher costs-about $900 more a month-due to take effect after two years. But he says the broker assured him he could refinance with a new loan before those costs kicked in.

Mrs. Montes says she was apprehensive about the broker's assurances. "But I blame that on that I don't understand the lingo they were talking," she says. "It's a scary experience. ... All I could see was all these numbers flash before me."

'EMERGENCY MODE'

Within months of moving in, things started going wrong. The Monteses received notice that their house had been reassessed based on the $567,000 purchase price. That raised their taxes to $6,000 a year, from $2,900 and would have increased their monthly payments (including the mortgages and taxes) to $3,931. "Whoa!" Mr. Montes recalls saying. "I can't afford this. I went into emergency mode."

He was able to successfully challenge part of the tax increase, but another shock came early this year when he began looking at refinancing possibilities. Mr. Montes says four brokers-including the one who arranged the original loan-turned him away, saying it wouldn't be possible to refinance because, with home prices flat at best, the family had little or no equity in the home. Worse for the Monteses, they learned that they faced a $12,000 prepayment penalty if they refinanced within three years of the original mortgages-something that Mr. Montes says wasn't made clear to him when he took out those loans.

Another broker told him that his home had gained enough in value for him to qualify for a more affordable loan. The Monteses paid for an appraisal and were told their home was worth $620,000, or about $53,000 more than they paid in 2005. But more than three months later, the broker outlined a package that would have involved payments far higher than indicated in earlier meetings.

Next, Mr. Montes sought the help of Laurie Arnold, a former neighbor who is a loan officer for a big mortgage lender. In another blow, Mr. Montes learned that the appraisal he had done in March-at a cost of $375-was no longer valid. Ms. Arnold sounded out appraisers and concluded that there was no hope the house could appraise for enough to allow the family to qualify for a refinancing.

LITTLE WIGGLE ROOM

The Monteses hoped for help from the company that services their loans, but an employee of the servicing company said that wouldn't be possible if the family has no home equity, Mr. Montes says.

Mr. Montes says the family may try to sell the house, but that would be tricky in today's weak market. Or they could try to trim other expenses and keep meeting the higher monthly home payments that are due to take effect in December.

There is very little wiggle room. Mr. and Mrs. Montes also have two car loans, with payments totaling about $700 a month, and are borrowing more to help put their elder daughter through college. They recently had to tell their younger daughter they couldn't afford $70 a month for her to take piano lessons.

The couple now eat out once or twice a month, instead of once or twice a week before they bought the house. The trips they used to take to Lake Tahoe now are out of the question.

To bring in a bit more income, Mr. Montes recently found a weekend job as a bartender. He says he might be able to take on a third job.

"Bottom line, it's our little home," Mrs. Montes says. "We're going to keep it. Hopefully, we won't go down and if we do, we're going to go down with a fight."