Just when you thought the real estate market was going to settle down, a new and bigger wave of foreclosures is headed our way! The first wave came from the sub-prime loans; the second wave is from Alt-A loans. A fairly ominous report from the New York Times Is here.

In case you don’t know how all of this began, let me give you a brief overview. Subprime loans have been around since the early 90’s. Sometimes the loans were made to credit card holders but most of the money was lent to home buyers. Sub-prime loans are made to borrowers who are not considered “prime” because they lack one or more of the usual qualifications which lenders require. So, if a borrower has insufficient employment history, poor credit, or too little money they become candidates for those riskier sub-prime loans. To compound matters, many of these borrowers take out Adjustable Rate Mortgages (ARM’s) to keep their payments lower; at least in the beginning.

Prior to 2004, lenders had fairly strict lending practices; but then, in an attempt to help more people become homeowners, they were urged to loosen up their requirements for subprime borrowers. Most lenders are happy to make such loans provided they can transfer the risk in the event that the borrower defaults; but they need a secondary market to sell their loans to. Enter Freddie Mac (They buy the loans from the lenders) Fannie Mae (They get the money) and AIG (They insure the loans).

Around 2007, the interest rates on those sub-prime ARM loans began to adjust higher. Since so many of the borrowers were marginal in the first place, they could not support the higher payments and an avalanche of foreclosures ensued. After two years, we are just starting to see some of the numbers improving, suggesting the worst is behind us. But wait! Another wave is on the way.

In addition to making all of those sub-prime loans, the lenders were also making loans in another somewhat risky category called “Alt-A” loans. These borrowers had better credit scores and other qualifications than the sub-prime borrowers did, but they were not “A” borrowers either; hence they were called “Alternative A” borrowers, shortened to Alt- A. The most common allowance which was granted this group was they were not required to verify their income. So, many people referred to them as “Stated Income” loans.

The underlying problem with so many of these loans was that the borrowers were allowed to make payments that did not even cover all of the interest that was due. The shortfall was simply added to the unpaid balance of the loan. That creative twist seemed appealing to lots of borrowers because home prices were on the rise throughout that time and most of them just assumed that the home value would continue to rise and eventually they would have new equity which they could get to, one way or the other.

But a villain was hiding in the shadows; namely there was a 3-year window on the payment arrangements. Now, the windows are beginning to close on all of those loans. The borrowers can no longer make payments that are less than the interest which is due. Furthermore, they have to also start making principal payments. In the mean time, the market prices did not continue to climb as they expected. On the contrary, most homes have fallen in value. In many cases, that means these borrowers owe more for their homes than they are worth; and that means they cannot refinance them with some less-painful loans.

As a result, a lot of additional homeowners are going to lose their properties; some because they must sell (divorce, corporate transfers, estate sales, etc.) and others because they cannot handle the higher payments. To add more fuel to the fire, there are a lot more Alt-A loans than sub-prime loans. Here is a recent article by our friends at the Money Game. Four states are especially vulnerable: California, Florida, Nevada and Arizona.

There are also lots and lots of commercial loans in the same predicament.

The only silver lining in this gray cloud is that interest rates are very low again so some of those people may be able to get good replacement loans, if they can act soon enough.

If I had to guess, I would say we are in for another two years of foreclosures on every block, but all is not lost. There are three categories of people who can benefit from a climate like this: Real estate investors, Brokers who specialize in working the foreclosure market and First Time home-buyers. Most of us can get in on the bandwagon somewhere, if we just know what to do.

Ain't that a bummer?

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