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As housing prices plummet in California, homeowners are increasingly finding that their mortgage debt is higher than the value of their homes. Faced with such a situation, some borrowers have simply stopped paying their loans.

This crisis of confidence is already hurting


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, which has a massive portfolio of mortgages in the state. But some analysts say the issues are about to get much worse for the bank as defaults increase.

Through its purchase of California-based savings and loan Golden West in 2006, Wachovia inherited a $120 billion adjustable-rate mortgage portfolio, which now amounts to 15% of the bank's total assets.

Specifically, the Golden West portfolio consisted of "option ARMs," otherwise known as negative amortization loans.

Option ARMs allow borrowers to make payments at less than the fully amortized rate. By not paying the full rate in a market where housing prices are falling, leverage ratios are ballooning for some borrowers.

Roughly 60% of these Golden West loans were written on homes in California, where price declines have outpaced the rest of the country.

The S&P Case-Shiller home price index for November -- the most recent month for which data is available -- shows housing prices fell 13% in San Diego, 12% in Los Angeles and 9% in San Francisco from a year earlier. That compares with an average 8% drop in the 20 national cities the index tracks.

Based on the home-price problems looming in California, Merrill Lynch analyst Edward Najarian downgraded Wachovia to sell earlier this month.

"Our increasingly bearish credit quality outlook is primarily driven by (Wachovia's) exposure to rapidly deteriorating residential real estate values in CA," he wrote, while also nothing that the company is "under-reserved" for future losses. He expects Wachovia's loan-loss provision to more than double this year from last year.


First Federal Bank of California

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Downey Financial

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, which offered similar negative amortization loans as Golden West, have reported very large loss provisions in their most recent quarters.

To date, most homeowner defaults and eventual foreclosures across California and the U.S. have come from subprime loans supplied to borrowers with poor credit. However, defaults have been increasing on loans to more creditworthy borrowers.

In some instances, the defaults are being caused by adjustable rate mortgages recasting from low initial teaser rates to higher rates. This process is known as "payment shock."

Wachovia, however, is facing a different issue. A growing number of analysts have been warning about how defaults in California are already rising in situations where borrowers' interest rates have not reset yet.

"You already have significant non-accruals at Wachovia with no payment shock," says Jefferson Harralson, an analyst with Keefe, Bruyette & Woods, who rates the stock market perform. "The market is weak enough where you see significant losses without payment shock. This shows the weakness in the loan category that the non-accruals are showing up before the recasts were being hit."

Non-accruals, or loans where homeowners have stopped paying the contracted rate, stood at 2.23% of Wachovia's option ARM portfolio in the fourth quarter, compared with just 0.55% a year earlier, Harralson says.

Throughout history, mortgage defaults have been primarily driven by three causes: divorce, a job loss or health issues. Now, another important factor is coming into play: the psychological drain that comes from owning a house worth less than the mortgage outstanding.

"When a borrower owes more than he owns, he is much less motivated to remain current on the loan," Oppenheimer analyst Meredith Whitney wrote in an influential December research note about how high loan-to-value ratios, and not credit scores, will be the ultimate driver of mortgage losses.

Don Truslow, Wachovia's chief risk officer, highlighted this problem on the company's fourth-quarter earnings call,

Many of Wachovia's mortgage losses (generally in California) "came from people that otherwise have the capacity to pay but have basically just decided not to, because of the selective loss on equity value in their properties," he told analysts.

Wachovia spokesman Don Vecchiarello says this phenomenon is not the primary driver of defaults, but it is popping up anecdotally. He says Wachovia does not track the percentage of loan defaults being driven by homeowners facing negative equity in their homes.

To get a feel for what's going on with Wachovia's option ARM borrowers, take the following hypothetical example.

Wachovia states that the average option ARM loan was written at 73% loan to value. For simplicity's sake, assume a borrower buys a house for $100,000 and takes out this average loan. That means the loan balance is $73,000 at inception.

Each month, Wachovia homeowners are given the option of four different payments (in order of least amount of money required): the minimum payment, the interest-only payment, the 30-year fully amortized rate, or the 15-year fully amortized rate.

Wachovia says about 60% of the borrowers in the Golden West option ARM portfolio are currently paying the minimum payment (but this can change in any given month).

The difference between the minimum payments and the 30-year amortization payments results in negative amortization, and the borrower's total loan balance increases.

Wachovia allows borrowers to let their balances run up to a maximum of 125% of the original loan balance, compared with 110% at First Federal and Downey. Thus resets are coming at a slower pace at Wachovia.

The borrower in our example who runs his mortgage to 125% of the $73,000 loan value now has a loan balance of roughly $91,000.

If the loan balance hits this 125% threshold through negative amortization, then the loan resets to a higher rate. And if the value of the house during this time frame fell 10% from $100,000 to $90,000, then the borrower is now facing negative equity in the home.

In many cases, housing prices have dropped more than 10%, putting the borrower further into negative equity. (Big enough housing-price drops create negative equity, even if the 125% negative amortization threshold hasn't been met.)

An important factor in the process is whether the Wachovia mortgage borrower also took out a second lien or home-equity loan against his house.

While Wachovia likes to cite the average 73% loan-to-value ratio on its option ARM portfolio, the bank does not provide information on how many of those loans are ones where the borrower also took out a second mortgage, or second lien, from another lender in order to finance the house as high as 100% loan to value.

In such situations, negative amortization on the first mortgage plus falling house prices is putting the highly leveraged borrower even further underwater.

"The second lien increases the probability of default," says an analyst at a hedge fund that is shorting Wachovia.

Vecchiarello, the Wachovia spokesman, says the company doesn't publicly disclose what percentage of the bank's option ARM borrowers also carried a second lien.

"It is impossible for us to say how many of our customers have gone and gotten a second mortgage externally," he said.

Vechiarello instead stressed that Golden West did not originate so-called piggyback loans on top of the option ARMs. Such piggyback loans allowed borrowers to take a second mortgage at inception in order to provide a down payment of less than 20% of the home price.

Vecchiarello also highlighted the ways in which Golden West was conservative in its underwriting of option ARM mortgages. He noted Golden West's 25-year track record with such loans, along with the fact that the bank underwrote mortgages based on the borrower's ability to pay the fully indexed rate and not the initial teaser rate.

While underwriting may very well have been solid at Golden West, a key variable from the default prediction models may have been missing.

No one at the lender appeared to place much probability on the current scenario occurring, where housing prices are falling and consumers are deciding to simply walk away from their homes.