The current state of the Los Angeles real estate market has many causes.  One major contributor was the option arm.

The option arm was an adjustable rate loan with the option of making one of several monthly payments. The minimum payment option kept monthly payments dangerously affordable. But the catch was that the payment was not sufficient to pay down the mortgage and each month the mortgage balance increased.

Assume that my current mortgage payment is $2000 a month, but this payment is not sufficient to pay down my loan balance.  Making this $2000 monthly payment will never pay off my loan and the difference between my payment and the payment that I should be making is added to the amount I borrowed.

Option arms are adjustable rate loans with negative amortization; they have the provision that the loan is recast (the payment is reset) after a set period of time.  Let’s explain in English:

I am making the $2000 a month payment, but in order to pay off my loan, my payment should be $3200. Each month the $1200 (which I am not paying) is added to the amount of my original loan. Each month after my $2000 payment, I owe $1200 more on my loan than I owed the previous month (plus compounded interest).

After a predetermined period it is time to pay the piper.  What we are now seeing is that borrowers simply can not afford their new recast payment.  AND in the meantime, home values have dropped; perhaps they owe more than their home is worth.  Even if prices had not dropped they would still be in trouble because their loan balance has increased each month – they owe more than they originally borrowed. And this is only one aspect of the subprime crisis.  Another aspect is the homeowners who have refinanced and spent their home’s equity; many of them now owe more than their home is worth.

Want a more detailed explanation?  Read Dr. Housing Bubble’s article