WALNUT CREEK, Calif. – When it comes to mortgage lending, seven of the top 10 riskiest metropolitan areas are in California, according to the PMI Spring Risk Index. According to the report, the Oakland area has a 49% chance of property values decreasing. San Jose follows with 48%, and San Diego is at 47%. Orange County and Los Angeles have risk values of 43% and 40%, respectively. What does it mean for a metro area to rank high on the index? The rankings are comprised of a variety of factors, according to Marco Van Akkeren, Director of Mortgage Analytics for PMI. "First we take a look at recent home price appreciation trends, local labor market conditions, compare the increase in home prices to the increase in rent prices, and calculate an affordability index," Van Akkeren said. "After taking all these variables into consideration, our model calculates the likelihood of prices decreasing during the next two years." Compared to Boston or Detroit, also high on the list due to weak employment conditions, the economy in California is relatively strong. Instead, affordability is creating the risk. "Affordability is very important because if there were an economic shock in a California community, the demand could not absorb the extra supply of high-priced homes," Van Akkeren explained. The PMI economist gave examples of previous economic shocks, such as the oil bust in Texas, and the more recent dot-com bust in San Jose. Last month's announcement of military base closures, he said, would certainly affect home values in those areas. Making matters worse, Van Akkeren noted an article in the May 17 issue of the Wall Street Journal, which reported that during the first two months of 2005, 61% of all mortgages in California were interest-only loans. The national average, he said, was only 33%. "Borrowers are leveraging themselves more for affordability, we know that with interest-only loans, there's the possibility of payment shock after the reset period," Van Akkeren said. Additionally, institutions have been offering 80/20 or 80/10/10 financing to borrowers to get them into homes while avoiding mortgage insurance. While this type of financing is attractive to borrowers in the short term, it creates risk for both the lien holder and the borrower in the long term. "The nice thing about MI is that you don't exposure yourself to interest rate risk," Van Akkeren said. "But with an 80/10/10 or an 80/20, the second tends to be tied to a loan which is variable, and borrowers don't fully understand the risk that is associated with this type of product." Van Akkeren noted that rates will likely raise rates higher in the future, and borrowers who are already stretching to afford current payments on a variable rate loan won't be able to afford increases in their mortgage payment. With all this doom and gloom predicted for the future, should California credit unions be concerned? In San Diego County, where median home prices have more than doubled in the past five years, affordability is a hot topic. According to the California Association of Realtors, as of March 2005, only 10% of San Diego residents earn enough to afford a median priced $588,800 home. Despite such bleak statistics, Scott Norris, SVP of real estate at San Diego County Credit Union, isn't worried that a lack of affordability will spell disaster. Norris said the most of his real estate borrowers are repeat homebuyers, and the majority of the institution's loans are 50% loan to value or less. The $2.8 billion institution manages a mortgage loan portfolio of $1.2 billion, and retains all of its funded mortgages in house. San Diego County CU introduced 100% financing and other products in late 2004 to attract first-time homebuyers. While he acknowledges that those who have little or nothing to put down create more risk, Norris said owner-occupied properties are still a good bet. "We don't do a lot of speculative lending," Norris said, "for our members, it's their homes we're talking about, and they're going to make that payment through good times or bad." Norris has seen projections forecasting increased demand for Southern California real estate during the next few decades. "When the Boomers retire, they're not going to want to live in the snow," he said, "and that generation has money – they can afford to move here." PMI's Van Akkeren admitted that intangible considerations like climate, which aren't considered in his economic model, do contribute to the stability of a region. "In a place like California, demand is always going to be high, perhaps not a volatile as certain regions, but there's both a positive and negative that goes with that," he said, adding that in high demand areas, affordability will always be an issue. Affordability is also extremely low in desirable Northern California, where only 12% of residents in the San Francisco Bay area can afford to purchase a median-priced $689,240 home. At San Francisco-based Patelco Credit Union, decreases in property values seem unlikely due to a limited amount of space, according to Chris Oldag, Senior Vice President of Lending. "There's always been tremendous demand for property in San Francisco, and if people need to get out, they can at least recover their sales The $3.6 billion Patelco has $851 million worth of real estate loans on its books, about one-third of its total loan portfolio. The institution sells all long-term fixed loans, and retains the adjustable rate products. Like San Diego County CU, the majority of Patelco's homebuyers are repeat homebuyers who bring with them a large amount of equity from their previous home. While Patelco does offer 80/20 financing and is preparing to launch an interest-only loan program, qualifications for those riskier loans are high. "We're delighted to put people into homes, but we're not going to create the potential for economic disaster at Patelco," Oldag said, adding, "We're not talking about making loans to 22-year-olds here." Affordability is slightly better in Los Angeles, where 17% of households can afford a median-priced $466,250 home. Rick Jarrar, first vice resident of lending for Lockheed Federal Credit Union, feels LA's strong economy and desirable location make it a strong real estate market. "There's nothing we see that might suggest a decrease in employment or big increase in rates, which gives us a level of comfort in the short term," Jarrar said. The $2 billion, Burbank-based Lockheed does offer an expanded approval program for less qualified borrowers through Fannie Mae. By selling the riskier loans to the secondary market, Jarrar said, he minimizes risk for his credit union. Lockheed does, however, keep all other real estate loans on their books. Real estate loans make up $1.2 billion of the institution's $1.8 billion loan portfolio. First-time homebuyers are purchasing in less expensive suburbs and commuting into the city, Jarrar said. "We're seeing a migration of folks who can't afford the Burbank market, but can afford a brand new home in Palmdale, for instance," he said. "They're having to commute, but at least it's an opportunity for them to buy a home." How seriously should institutions take PMI's risk forecasting? Because the index has only been produced for two years, Van Akkeren said he is only beginning to see how accurately the index predicts risk. However, it appears the model works. "Last summer, we published some model validation results, and found that it's been very good in predicting previous downturns," he said. "We feel, at least, there's a significant chance of home prices declining in the areas we've identified," he summarized. -

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