HOME SECURITY
One Family's Journey
Into a Subprime Trap

By JAMES R. HAGERTY and KEN GEPFERT
August 16, 2007 - Wall Street Journal

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

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. Mr. and Mrs. Montes convened a meeting with their two teenage daughters around the kitchen table to hash out the implications. "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."

With a December "reset" on their loan looming, however, the refinancing option now looks impossible. A friend who works as a loan officer called with some bad news this week: Similar homes in their area have been selling for $535,000 to $565,000 recently. That means the Monteses' loan balance may exceed the value of their home.

The Monteses are caught in a trap -- one that hundreds of thousands of people could face as the housing market totters and the easy credit of recent years dries up. They in effect bet that the boom in housing prices would continue. It was more important to hop onto the escalator than to wait until they could afford to make the leap according to traditional measures.

And with thousands of mortgage banks and brokers threatened with extinction, lenders that embraced all kinds of risky loans two years ago are enforcing increasingly strict standards. They are refusing even to consider extending new credit to people like the Monteses who lack any equity in their homes.

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 rate, that cost will rise to about $50,000 a year, Mr. Montes says.

Tightening Standards

Lenders have been tightening their standards for the past year in the face of rising defaults and growing jitters among the investors who provide funding for loans. That tightening has accelerated in the past two weeks as many lenders -- uncertain at what price they might be able to sell loans -- have stopped making all but the safest ones.

"It's getting worse and worse," says Jeff Lazerson, chief executive of Mortgage Grader, a mortgage broker in Laguna Niguel, 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, director of research at First American CoreLogic, a housing and mortgage data supplier in Santa Ana, recently found that nearly 7% of 32 million U.S. households studied as of 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. Since then, house prices have edged down in much of the country, erasing more home equity.

Partly as a result, foreclosures are surging. Moody's Economy.com, a research firm in West Chester, Pa., 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.

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, swept away by regulatory fiat and investors' flight from mortgages deemed too risky. These loans are known in the trade 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 at a predetermined margin above an interest-rate index 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.

U.S. lenders originated about $600 billion of subprime home loans in 2006, or 20% of all home mortgages, according to Inside Mortgage Finance, a trade publication. About 56% of those subprime loans were 2/28 mortgages, says Keith Ernst, senior policy counsel at the Center for Responsible Lending, a nonprofit research and lobbying group in Durham, N.C.

Mario and Leticia Montes and daughter, Christina, in front of their house in Fullerton, Calif.
The lending industry touted 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-rate mortgages. To make the loans even more affordable in the early years, they were often structured as "interest-only," meaning that 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 and qualify for a less-costly prime loan.

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 tighter guidelines from rating agencies and risk-aversion among investors, has recently prompted 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 in Rancho Cucamonga. Using what was then a common formula, the broker 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 would be able to afford the higher costs -- about $900 more per month -- due to take effect after two years. But he says the broker assured him he could refinance before those costs kicked in.

Mr. Montes preferred not to name the broker publicly because the broker has a business connection with a relative of the Monteses. The broker declined to comment.

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.... I said, 'Mario, I hope you don't get into something that is going to hurt us.'"

They moved into their home and hung a sign on the front door reading, "Life is a daily celebration of love." Within months, things started going wrong. The Monteses received a letter informing them their property taxes had been reassessed based on the $567,000 sale price instead of its previous $389,000 value. That raised their taxes to $6,000 from $2,900 a year 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 in late February of 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.

Then another broker told him in March that his home had gained enough in value for him to qualify for a more affordable loan. They paid for an appraisal and were told their home was worth $620,000, or about $53,000 more than they paid in 2005. The Monteses were jubilant, thinking their home was saved. 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 at IndyMac Bancorp, a large lender based in Pasadena. In another blow, Mr. Montes learned that the appraisal he had done in March -- at a cost of $375 -- is 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. Based on recent sale prices and other data, Zillow.com, an online service that provides home-value information, estimates that the price of a typical home in Fullerton is down 6.7% from a year ago.

The Monteses now hope for help from the company that services their loan, America's Servicing Co., a unit of Wells Fargo & Co. Mr. Montes telephoned America's Servicing Tuesday to ask whether it might consider a modification in the terms of the loans to help him keep the payments affordable beyond the reset date. An employee of the servicing company said that wouldn't be possible if the family has no home equity, Mr. Montes says.

A Wells spokesman declined to comment on the Monteses' loan but said the bank reviews requests for loan modifications "on a case-by-case basis and works with customers on solutions that address their individual financial needs."

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.

Borrowing for College

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 money 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. They have yet to visit a nearby jazz club they had hoped to frequent. The trips they used to take to Lake Tahoe now are out of the question.

To bring in a bit more income, Mr. Montes two weeks ago found a weekend job as a bartender for a catering company. He says he might be able to take on a third job.

"Bottom line, it's our little home," Mrs. Montes told a visitor one evening in April as tears welled in her eyes. "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."

Write to James R. Hagerty at bob.hagerty@wsj.com5 and Ken Gepfert at Ken.Gepfert@wsj.com6