On the front lines of the U.S. meltdown

SPECIAL REPORT: A road trip in California, the state hit hardest by the recession

090413_caliIt’s just before 11 a.m., and a small group of men in scuffed sneakers and blue jeans have assembled on the courthouse steps in Stockton, Calif. They’re here for what’s become a familiar ritual in U.S. cities hit hard by falling house prices: the foreclosure auction. At the peak of the housing bubble, Stockton was one of the most frenzied real estate markets in the country. Now, with many of those homes in foreclosure, the bidding wars have turned surreal.

An auctioneer steps out of the courthouse, and with little fanfare starts to read out the details of several foreclosed homes. For a while there are no takers. Then he gets to a house in the nearby town of Manteca—opening price: $99,870.08. “Two more pennies,” says one bidder in a muscle shirt. Another man steps forward: “Plus a penny.” It goes on like this, the two bidders anteing up copper Lincolns for a home that, four years ago, might easily have fetched $40,000 above the asking price. “Going once, twice, third and final time. Property is sold at $99,870 and 13 cents.”

ALSO AT MACLEANS.CA: Photo Gallery—What a recession looks like

In a country that’s always done things bigger—bigger booms, bigger bubbles, bigger busts—California stands apart. Few other places saw real estate mania reach such feverish heights. Fewer still have seen their fortunes plunge to such abject lows that the decision over whether to buy a house comes down to five cents. With the world’s eighth-largest economy brought to its knees, Maclean’s took a road trip through one of the hardest-hit parts of California: the region encircling the San Francisco Bay Area. It’s a ring of misery, where unemployment is nearing 20 per cent in some counties. In cities like Stockton, one in 60 houses are in some state of foreclosure. With shopaholic Californians hunkering down, retailers are shutting their doors, from exclusive boutiques to outlet malls in soccer mom enclaves like Elk Grove. One city, Vallejo, unable to pay its bills, has given up and declared bankruptcy. More are expected to follow. Even Silicon Valley, California’s most resilient region and its best hope to lead a recovery, is struggling.

California has always been a barometer for the rest of the country. As the Golden State goes, so goes the United States. Now everyone is waiting to see whether the California dream can be resurrected. “People are watching California closely because what happens here is seen as an indicator of what will happen elsewhere,” says Alex Whalley, an economist who teaches at the University of California-Merced. “California is the leading edge of what’s to come.”

The city of Merced sits some 200 km southeast of San Francisco, and a lifetime away from the glitter and restlessness of coastal California. But those two worlds have come together in this dusty corner of a farmer’s fleld in mid-March. The Governator is here, and he’s brought cash to upgrade a nearby freeway overpass. It’s been six years since Arnold Schwarzenegger gave up acting to take top billing in the state legislature. And as he speaks, a trucker passing by on the highway spots him and honks. “We will be pumping in as much money and pumping out as much money as we can,” he says, punching the air with his giant fist and sounding not unlike Hans and Franz from that old Saturday Night Live sketch. “We will rebuild this area and create as many infrastructure projects as possible.” That’s because, like everywhere else in this recession, “infrastructure” is a code word for jobs, and jobs are something Merced desperately needs.

The latest figures released last week are startling. In February, unemployment in Merced (pop. 80,000) hit 19.9 per cent, double the national average and well above California’s already high rate of 10.5 per cent (only Michigan has been harder hit). During the housing boom, half of all new jobs in California were tied to real estate, and Merced was no different. With the housing collapse, thousands of construction jobs have dried up. The region relies heavily on agriculture, but a three-year drought has crippled the sector—in February, Schwarzenegger declared a state of emergency because of the water shortage. Several retailers in the city, such as Linens N’ Things and Circuit City, but also local building supply stores, have closed. Quebecor World, the Montreal-based printing company that sought bankruptcy protection last year, operates a plant here that has laid off staff. Ellie Wooten, the 75-year-old mayor of Merced, recently warned it might close altogether. “Merced was a sleepy little town that nobody had ever heard of,” says Whalley, a Canadian from London, Ont., who moved to Merced at the peak of the boom to work at the university. “Now everybody knows it as the centre of the bust.”

The first thing that’s striking upon arriving is that this doesn’t look like a city in the grips of a crisis. You expect to see rows of boarded-up stores and despondent souls roaming the streets. Instead, downtown Merced is quite charming. There’s a lineup at the Starbucks on Main Street. And the streets are full of cars. But head north of Yosemite Avenue, which once served as the outer limits for the town, and the full scale of America’s woes hits you head-on.

Large signs that advertise housing developments with names like Windsong and Riverstone point instead to overgrown grassy fields. Roads have been built and light standards put in place, but most of the lots are empty. Where you’d expect to see rows of cookie-cutter homes, there are just small clusters of houses scattered awkwardly across the landscape. Sometimes work crews simply put down their hammers and walked away, leaving behind wood-frame skeletons to bleach in the sun. In the evening you can stand on the divider of a freshly paved four-lane road for 15 minutes and not see a soul. When a woman finally does come along with her dog, she says that some people have walked away from their homes and left town. She and her husband are still holding on, but “it’s scary.” They owe $135,000 more than their house is worth.

Every mania has a foundation, and in Merced it was anticipation over the new university, which opened its doors in 2005. While crews worked on the campus eight kilometres north of town, developers scrambled to fill in the cow pastures in between with homes. Many believed that overnight, Merced would be transformed into a thriving university town. The city was also touted as an emerging commuter city for the Bay Area. Speculators, mostly from San Francisco, snapped up the new homes, driving prices up 50 per cent between 2002 and 2004. But eventually, reality set in, even as new developments were being mapped out. With just 2,500 students, the university is not much larger than a high school at this point, though it’s expected to grow. What’s more, it’s a daunting three-hour drive past grain elevators to get to San Fran. Whalley recalls the mood as the bubble began to burst. “Sales started to slow down but the line was, ‘It’s only temporary, there won’t be a decline, at worst prices will just flat-line,’ ” he says. “It’s kind of what you hear in Canada right now.” At the peak in 2005 the median house price in Merced was $382,000. Today it’s just $105,500.

There was another glaring flaw built into Merced’s real estate equation that no one seemed to ask about. Who in this town could possibly afford these McMansions? At the peak of the market it took an income of $120,000 to buy a home in Merced, according to the Center for Housing Policy. Yet, Merced has always had a problem with high unemployment. The median income is barely $35,000 a year. That suggests the majority of people who were buying then were out-of-town speculators or locals who had no hope of actually repaying their mortgages.

A few blocks up the road from where Schwarzenegger held his press conference, Michelle Allison, program manager at the county employment office, spreads half a dozen menial job postings out on a table in front of her—much of what’s on offer at the moment. An increasing number of the people coming in for help are flight attendants, teachers and business owners. Yet the going rate for the few jobs available is just US$8 an hour. “It’s frustrating because we’re getting them all trained and ready to work, but for what?” she says. “There’s nothing out there.”

Anthony Jones, an army veteran who’d worked steadily for two decades, has hit a wall. It’s been a year since he lost his $31,000-a-year job at a struggling grocery chain, and in that time he’s applied to dozens of employers, with no success. “I feel like I’m starting all over again at 50,” he says. He remains optimistic that the government’s stimulus programs will jump-start the local economy. But the fact is, it could take months for that to take effect, leaving few options for those who can’t find work in the meantime.

Allison herself is all too aware of that. Her job ends next month. “I’m looking for work outside of California,” she says.

Michael Blower never quite knows what to expect when he enters a foreclosed home in Stockton. The real estate agent is often the first person into a house after the bank has seized it. In one home he found an abandoned antique piano. In another house all the walls had been kicked in, possibly by vandals but more likely by the previous owners before they left. And when he opened a dishwasher recently, it was crawling with cockroaches and rats. So when he walks into a two-storey house on the edge of Stockton and sees shattered glass everywhere, he’s not particularly surprised. A football-sized rock sits in the middle of the kitchen floor. Blower will have to call a contractor to replace the glass, but he knows it will probably just get smashed again. “We’ve got at least another couple of years of this,” he says.

The title of Foreclosure Capital of America tends to shift with each month of new data, but Stockton is almost always in one of the top five spots. Starting in 2003, people began to flee rising house prices in the Bay Area for bedroom communities like Stockton, but that only served to drive up property values here, too. As buyers got squeezed out of the market, banks peddled more and more subprime loans to entice them back in. At the height of the bubble, when the average house price reached $358,000, the vast majority of home sales in the city were bought with subprime mortgages. This explains why homeowners here have been hit so hard by the wave of foreclosures. Stockton house prices have plunged by about 62 per cent to an average of just $137,000. This has left whole neighbourhoods “underwater”—meaning homeowners owe more than their houses are worth. According to Zillow, a market research firm, an estimated 96 per cent of all homes in Stockton bought in 2006 are underwater.

As a result of all this, Stockton’s real estate market has a zoo-like quality to it. It was here, after all, that the phenomenon of the foreclosure tour first emerged. On weekdays, minibuses prowl the streets, shuttling buyers from foreclosed property to foreclosed property. The world of real estate reality TV, which whipped buyers into a frenzy during the bubble, has tuned in to the trend. When a new show called Deals on the Bus was launched in January, naturally Stockton was the first stop. Prettying up neighbourhoods so they look enticing to passersby has become an industry unto itself. Nothing screams empty home like a sunburned front lawn, so landscapers spray dead lawns with green biodegradable paint to give properties that lived-in look.

Watching all this from their rental house are Daniel and Dorothy Martin. He’s 91. She’s 77. But their age didn’t help them avoid being evicted from their home in February. If anything, it made matters worse.

Dorothy is deeply religious. Before sitting down for an interview, she first requests that everyone join hands while she leads a prayer, asking that peoples’ eyes be opened to the troubles so many homeowners are facing. But she quickly admits to having less than charitable thoughts toward the mortgage brokers who forced her out of her home. “I’m a Christian woman, but I felt like breaking the windows and splattering the walls with paint before we left,” she says. “I kept asking ‘Why us?’ We didn’t do anything. Why should we be thrown out on the street?”

Over the years the Martins have owned seven homes from Ohio to California. When they moved to Stockton four years ago to be close to their grandchildren, they bought a home with an $85,000 down payment. Both of them are retired, but their fixed income of $3,700 a month more than covered the $1,600 monthly payments. Then last year the Martins were notified that their payments, like those of so many other Americans who took out adjustable-rate mortgages, were about to skyrocket and would gobble up almost their entire income. They tried to renegotiate, but were told that until they defaulted, the bank couldn’t help. When they did stop making payments, they learned that the bank they’d been speaking with no longer owned their mortgage. (Their daughter, Gail Sullivan, later learned the Martins’ mortgage had been sold and resold five times.) In February, the Martins received a “notice to quit.” The sheriff’s office posted it to their front door. But by then they’d already moved out. “We left a lot of love in that house,” she says.

Despite all that’s happened, Dorothy remains hopeful everything will work out for them. She’s also thankful the couple have a roof over their heads and food on the table, unlike so many others. A quick visit to the Stockton food bank shows the extent of the problem. A long line of people coils up to the door. According to Kristine Gibson, a manager at the food bank, demand is up 25 per cent over last year, and rising. She says the people coming in today for food baskets include a lot more middle-class families. She can tell by their nicer cars.

If there’s a silver lining in Stockton’s housing crisis, it’s that affordability has meant a return to some semblance of normalcy in the housing market. Blower says half of the people he sees buying homes today are investors, while the other half are first-timers who wisely sat out the bubble and saved their money. “There are a lot of couples who thought they’d never be able to buy a house three years ago who suddenly can today,” he says. “I’m seeing a lot of all-cash offers from them.”

Still, the damage has been done, and the repercussions will continue to be felt for a long time. In recent months many banks have abided by a moratorium on foreclosures, but that is about to end. The result, says Blower, will be hundreds of additional properties dumped onto the market.

But as everyone knows now, America’s recession has spread far beyond the world of residential real estate. As Wiley Chandler, who anted up the winning penny at the Stockton courthouse, puts it, “Everybody had money, everybody was refinancing their houses. Little guys, big guys, they were all spending it on everything. And now nobody is spending nothing.”

Nowhere is that more apparent than the commercial wastelands forming around Sacramento.

When Oprah Winfrey aired a segment on a tent city full of homeless people in Sacramento in late February, it touched off an international media storm. Here, in the capital of California, was one of the most glaring symbols of the recession. Since then, reporters from every continent have flocked to the sprawling site, set beneath power lines and next to an almond factory. The fact is, though, most of the residents here, like Rico Morales, the self-proclaimed mayor of the tent city, have been homeless for years. “This is my home, it’s not a mansion, but it’s organized,” he says, adding that he’s been homeless since he was 13. “When the mayor [of Sacramento, former top NBA-player Kevin Johnson] gets off work, he wants to go home, have a coffee, watch some TV. We’d like the same thing, but unfortunately we can’t.”

But while the sudden media attention given to Sacramento’s tent city has shone a much-needed light on the long-term problems of homelessness in America, there’s another U.S. crisis playing out that could prove far more crippling to the global economy. And signs of it are evident 20 km south of Sacramento, in the city of Elk Grove.

In 2005, the U.S. Census Bureau crowned Elk Grove the fastest-growing city in America—although, astonishingly, until 2000 it didn’t even officially exist. In just one year, the population exploded by 12 per cent to 112,000. With home builders racing to erect whole new subdivisions overnight, their counterparts in the world of commercial real estate launched a tidal wave of new strip mall and office building projects for the growing population to shop and work in.

Today, if you drive a few minutes into the countryside, you can see where that wave broke. A skeleton of steel beams and aluminum roofing rises out of the weeds, the remnant of a highly touted 130-acre shopping mall (the owner of the project, General Growth Properties, is one of America’s largest developers, but is struggling to stave off bankruptcy). Several car dealerships have gone bust, luring gangs who tag them with graffiti. Whole strip malls sit empty. A cook at a Chinese restaurant sits outside smoking a cigarette during lunch hour because there are no customers to feed. “People aren’t going out to eat anymore,” he says. Several restaurants, such as Chili’s, have closed. The commercial vacancy rate in Elk Grove and other cities around Sacramento has topped 30 per cent. Analysts expect it to rise further.

It is, of course, a similar story all across the state. In Silicon Valley, the area to the south of San Francisco dominated by the technology sector, offices within blocks of the massive Google campus are crying for tenants. Even the most exclusive shopping districts in California are struggling. From Rodeo Drive to Melrose Place, luxury boutiques that just a year ago were considered “recession-proof” have closed. Tracey Ross, whose eponymous boutique in West Hollywood served celebrities like Kate Hudson, shut down her store in January. “When wealthy customers who can afford to pay retail are getting 80 per cent off at Saks, it makes it impossible for smaller boutiques to compete,” she said at the time.

What does it matter if the world has a few less J.Crews or Bed, Bath & Beyonds? Many experts say commercial real estate is the next domino to fall as a result of the U.S. recession. If it does, those banks and institutional investors that managed to dodge the housing crash, including those based in Canada, could face even more staggering losses.

Consider the nondescript three-storey red brick office building a half-hour up the highway from Elk Grove in the city of Roseville. It’s the kind of structure that crowds most business parks. But, said one mortgage banker in Sacramento who asked not to be named, the giant Quebec pension fund, Caisse de dépôt et placement du Québec, could face millions of dollars in losses on this one building alone. Through its real estate financing subsidiary CWCapital, which manages US$11 billion in assets, the caisse is exposed to the high-risk portions of a US$10.5-million securitized loan on the property. But the banker says a third of the building sits empty and the developer has stopped making loan payments. Given the tumbling value of commercial property in the region, he estimates the building is worth half the loan amount. “They [the caisse] don’t know what’s coming,” says the banker.

For a while it looked like the California dream had turned into a permanent nightmare. For months this past winter, legislators grappled with how to plug a massive US$42-billion hole in the state’s finances for the year. Some 20,000 public sector jobs were on the chopping block. Billions in personal income-tax refunds, welfare payments and student grants were put on hold. In short, California was going broke. Last December, Gov. Schwarzenegger did what he’s had to do a lot of lately. He declared a state of emergency, this one fiscal. In the end, the state passed a budget involving US$13 billion in new taxes and US$15 billion in spending cuts. Schwarzenegger, meanwhile, may be popular in the rest of the country, but in California his approval rating is in free fall.

But if the state managed to temporarily plug its fiscal hole, in Vallejo the dam has broken wide open. Last year, this scenic city 53 km north of San Francisco declared bankruptcy. “We’re out of money,” says Stephanie Gomes, a city council member.

Since the late 1970s, when anti-tax advocates introduced a state ballot measure called Proposition 13 that capped property taxes, cities in California have increasingly relied on new home construction and commercial development fees to feed their revenue needs. Now, with the foreclosure crisis and businesses closing, that money has dried up.

But even as cities like Vallejo are having a hard time finding new revenue, they are also suffering the after-effects of a massive spending spree. Spending on public sector salaries in particular has skyrocketed. According to Gomes, a leader in the fight to fix Vallejo’s financial mess, 26 employees each earned more than US$250,000 last year, most of them firefighters. The city’s unfunded liabilities, meaning the money it must eventually pay out to cover employees’ health and retirement benefits, total more than US$200 million. As a result, Vallejo has had to slash services. The number of police positions has been cut to 116 from 150, while two fire stations have been closed and another two are at risk. “People are hurting, they’re losing their jobs, losing their homes, yet we’re looking at a US$13-million shortfall,” says Gomes. “We can’t go and ask people for more money until we get our own house in order.”

Some fear other cities may tumble into the bankruptcy pit. Several small towns outside the Bay Area, such as Rio Vista and Isleton, are said to be at risk. “There’s not much else cities can do,” says Lynn LoPucki, a professor of bankruptcy law at UCLA School of Law, “other than sell off city hall to pay down their debts.”

If Vallejo represents the worst-case scenario for California, then Silicon Valley remains its greatest hope. If the state can regain its past glory, the bets are that the turnaround will start here.

No one’s saying the tech hub has escaped the recession unscathed. The foreclosure crisis has touched cities like San Jose and Palo Alto. Unemployment in the region has also hit 9.4 per cent. Giants like Hewlett-Packard, Microsoft and even Google have announced layoffs. At a Starbucks near the Google campus in Mountain View, several customers update their resumés on laptops. One of them, Michelle, moved to the area three years ago from back east and quickly landed a job as an office administrator at a small tech start-up. The company recently shut down. “Anyone who tells you Silicon Valley will avoid the recession doesn’t know what they’re talking about,” she says.

Still, the region is proving more resilient than other parts of the state. A big reason for that was the carnage of the dot-com crash in 2000, which left the tech sector much leaner. “There are microcosms of economic viability in California, and Silicon Valley is one of them, because we already had our crash and depression,” says Patti Wilson, a career adviser. While companies have been laying off workers, they’re still hiring new ones, replacing poor performers with better talent. And Silicon Valley continues to attract the lion’s share of the world’s venture capital.

Yet even Wilson is hedging her bets. She was born in Canada but has lived and worked in the Bay Area’s tech sector most of her life. Her plan is to move back to Canada part-time. She says that decision is driven partly by the economic crisis, but also her unhappiness with the state of politics in the U.S. “This is a very troubled time,” she says. “There’s no early remedy for the challenges facing the United States. This will be long-term, pervasive and debilitating.”

Back in Merced, there are signs of hope. Wal-Mart plans to open a distribution centre in the city, which would bring hundreds of jobs. The housing market, meanwhile, seems to be slowly regaining its footing.

It’s early evening and Roberta Flanagan, an 84-year-old real estate agent in the business since the 1960s, has thrown a party for her clients, complete with 100 lb. of corned beef. Standing in the crowded room, you wouldn’t know there’s a recession going on outside. A steady stream of people comes in through the door. Many have taken the opportunity of the housing crash to buy homes they couldn’t afford before. “A whole generation just got a hard lesson in life,” says Flanagan. “Good old common sense is going to come out of this. Is there a future? You bet.”

Such optimism in itself is not going to be enough to fuel a recovery, even if it were shared by the rest of state. But when the economy does turn around, California will likely be at the forefront of the rebound. It’s just that, with unemployment rising and damage from the foreclosure crisis still unfolding, it could be some time before that happens.