In California, foreclosure's next wave?

California's Central Valley already sits at the center of the housing crisis, but high prices and contracting incomes are now compounding the foreclosure problem.

Investors and subprime borrowers took the brunt of the first and second wave of foreclosures. Now, the broader economic stagflation here imperils another batch of borrowers.

These homeowners have mortgages higher than their home's value, and the payments have gotten beyond their reach, not necessarily because interest rates have risen, but because their budgets have tightened.

That's what happened to Bob Scarpitto. He used to donate his time installing pools for needy families on the TV show "Extreme Makeover: Home Edition."

Now, he's the one down and out.

Mr. Scarpitto's pool business dried up last year when banks tightened home equity lending. He went from a $300,000 salary to zero trying to keep the business afloat. With no income and a higher cost of living, he lost his modest home to foreclosure. He sold everything, except a prized boat, which he just put on craigslist.

"My guess is the majority of foreclosures that will take place are for families whose homes are underwater or whose current income is not sufficient – thanks to a burst of inflation and [stagnation] of real incomes," says Andrés Carbacho-Burgos, housing economist at Moody's Economy.com.

Over the past year, the Central Valley communities of Stockton, Merced, and Modesto have been passing around the dismal distinction of No. 1 foreclosure city in America. Scarpitto's hometown, Merced, now tops the charts with 9.3 percent of first mortgages in delinquency, according to figures from economy.com. Stockton sits at 8.6 percent and Modesto at 8.3 percent.

Meanwhile, incomes in the three cities fell by around 4 percent over the past year in terms of purchasing power, according to estimates from Mr. Carbacho-Burgos.

"That doesn't sound like much, but it can make the difference between being able to comfortably service the mortgage and significant tightening of the belt in order to make the payments – especially if you have a long commute," he says.

For Scarpitto, the high prices hastened the depletion of his savings and the day in April when he had to hand back the keys of his home. He took out a $320,000 mortgage in 2005, but a neighbor short-sold his house recently for $180,000.

"I've lost everything. I had more when I started the business in late 2000 and I thought [then] I was taking a huge risk," says Scarpitto. "I've been slowly selling it off to keep afloat and try to find gainful employment."

His girlfriend has given him a place to stay, and he's taken up motorcycling to save on gas. But there's not much he can do about a grocery bill he says has jumped 30 percent from last year.

His greatest problem is the tough job market here for anyone connected to the housing sector. "No one wants to hire a contractor," he says.

The tough economy and inflation are piling onto the housing market's woes, says Merced Mayor Ellie Wooten, who is also a real estate agent. "There are so many elements involved in this that realistically it's terrifying."

In Modesto, city housing official Barbara Kauss worries about a coming "third wave" of foreclosures. The first wave washed over investor properties, the second – peaking in early July – wiped out recent adjustable mortgages whose rates ratcheted up.

A third wave, she worries, "will be people who just truly can't afford the mortgage payment."

Even for those who could have afforded it before if they had a fixed rate, "that'll be the last straw: the economy," she adds. "If someone earning wages in your family was laid off, and food has gone up, and gas has gone up, there's no more way to reach."

At this point, the data isn't current enough for real estate economists to know if higher prices and weak employment are causing a fresh batch of foreclosures, cautions Cynthia Kroll, a regional economist at the University of California at Berkeley. Historically, however, recessions drive up foreclosures.

"Usually the foreclosures start after the recession starts. So it would not be surprising to get more foreclosures that were spurred by those kind of problems, since the ones we've seen so far were generated by other factors," says Dr. Kroll.

One factor was higher payments due on adjustable rate mortgages once the rates "reset" to higher levels. While more resets are around the corner, several factors have helped mitigate that problem, including low interest rates, fewer such loans in the pipeline, and a greater willingness by banks to move borrowers into fixed-rate mortgages.

Officials are trying to get the word out that banks might cut deals. "If you are in trouble, ask your bank," implores Ms. Kauss. "A lot more homes probably could have been saved [but] people walked away and never talked to their bank."

That message is everywhere in the Valley. At a Modesto gas station, the pump-side video screens play an advertisement for foreclosure advice, offering a hotline at 1-888-995-HOPE, and the tag line, "because nothing is worse than doing nothing."

For Scarpitto, the focus now is finding a job – and finding sources of strength. Asked how he perseveres, he pauses.

"It's partly my kids – the opportunity to show them that no matter how bad things are, you'll be able to get through it," he says. "And my girlfriend Leslie. She's got enough faith for both of us."