"Is it subprime?" or is "It Californian?"
Some analysts predicting top to bottom falls in prices of as much as 40 percent, California looks headed for a recession. Don't be surprised too, if in six months the question angry bond holders ask is not "Is it subprime?" but "Is it Californian?"
Make no mistake: California matters. It's the world's 10th biggest economy, it generates 13 percent of U.S. GDP and its homes are collateral for billions of bonds held by investors around the world.
The situation has worsened dramatically since a freeze in global capital markets in August made it much tougher and more expensive to get a subprime or large loan.
And with unemployment rising in the state, in part because of job losses in construction, finance and real estate, things could get a lot worse.
"We are heading into a state recession and that will take an already horrendous mortgage problem and take it over the top," said Christopher Thornberg, of Beacon Economics.
"Prime loans will be in trouble too. We've got a giant mess on our hands."
Essentially, the same factors that drove housing prices upward in California are now conspiring to take them back down again.
Prices in the state have tripled in the last decade, but most of the gains have come since 2003, when subprime and adjustable-rate lending took off. That allowed people to buy homes with debt they really were not able to repay. As long as prices went up, no problem: borrowers were able to refinance when the introductory rate rose or even sell for a new higher price that more than paid off the debt.
But when prices begin to fall - by 6-9 percent in the major metropolitan areas so far - that logic no longer held. What's worse, the investors who had been buying the debt got wise and cut off the tap. Market rates have gone up, lending criteria have gotten tighter and a bunch of borrowers have handed the keys back to the lenders, who then try and sell into a plunging market.
In Sacramento County in September, 27 percent of all sales were by lenders who had repossessed homes.
Alex Barron says if you really want to see how far prices will fall, look at auctions of bank-owned real estate and at some of the fire sales now being held by developers.
"The builders are already pricing their homes 30-40 percent lower than they were at peak," he said.
"(Bank-owned) prices have come down 30 percent or so from where those loans used to trade at, as well. If the last clearing price is that much lower, everything is going to get there sooner or later."
A report released by Goldman Sachs last week called Californian house prices 35-40 percent over-valued in a note to clients.
Gains up through 2003 were largely driven by good fundamentals, rising disposable income and falling interest rates, according to the note. But in 2004, as "affordability" loans such as subprime took off, so did house prices. As of the last quarter of 2006, 41 percent of all loans in California were subprime.
Barron sees top-to-bottom falls of 50 percent, while Thornberg is looking something on the order of 25 percent.
While these are far worse than consensus, falls of those magnitudes in California house prices would have far-reaching effects.
California would tumble into recession, raising the risks of a national recession. The rate of default by prime borrowers would also spike upwards, putting further pressure on bank balance sheets and deepening and hardening the credit crunch.
Those types of house price falls are almost certainly a lot higher than the assumptions used by the ratings agencies, so expect to see another round of shock and losses by holders of so-called safe bonds.
If the bailout fund for bank-affiliated structured investment vehicles (SIVs) is going to be $80 billion, how big a fund will we need for California?
From: Patrick.net news