….hardly anyone in Merced planned very far ahead. Not the city, which enthusiastically approved the creation of dozens of new neighborhoods without pausing to wonder if it could absorb the growth.

Certainly not the developers. They built 4,397 new homes in those neighborhoods, some costing half a million dollars, without asking who in a city of only 80,000 could afford to buy them all.

Obviously not the speculators turned landlords, who thought that they could get San Francisco rents in a working-class agricultural city ranked by the American Lung Association as having some of the worst air in the nation.

And, sadly, not the local folk who moved up and took on more debt than they could afford. They believed — because who was telling them differently? — that the good times would be endless.

“Owning a home is the American dream,” says Jamie Schrole, a Merced real estate agent. “Everybody was just trying to live out their dream.” The belief that this dream could be achieved with no risk, no worry and no money down was at the center of the American romance with real estate in the early years of this decade, and not just in Merced.

How long will the economy have to pay the price for that illusion? The experience of Merced, which rose higher and fell faster than nearly anywhere else, suggests that recovery from the national real estate debacle will be painful and protracted.

In the three years since housing peaked here, the median sales price has fallen by 50 percent. There are thousands of foreclosures on the market. The asking prices on those properties are so low that competitive bidding, a hallmark of the boom, is back.

But almost no homeowner can afford to sell. If you cannot go as low as “the foreclosure price” — the cost of a comparable bank-owned house — real estate agents say you might as well not even bother listing your home. And so most people do not: three out of four existing-home sales in Merced County are now foreclosures, the highest percentage in the state…

Foreclosures and default notices skyrocketed to record peaks in California and the Bay Area in the fourth quarter of 2007, according to a report released Tuesday. The information was a fresh reminder that the slumping real estate market is continuing to have a serious impact on homeowners, particularly those with risky subprime mortgages.

Lenders repossessed 31,676 residences in California in the October-November-December period, according to DataQuick Information Systems, a La Jolla research firm. That was a dramatic 421.2 percent increase from 6,078 in the year-ago quarter. In the Bay Area, foreclosures rose an equally stunning 482.5 percent to 4,573 in the fourth quarter, compared with 785 a year ago. Contra Costa County, with 1,558 foreclosures, up 533.3 percent from a year ago, had the most, followed by Alameda County with 1,026 (a 514.4 percent increase) and Solano County with 704 (up 528.6 percent).

“Foreclosure activity is closely tied to a decline in home values,” DataQuick President Marshall Prentice said in a statement. “With today’s depreciation, an increasing number of homeowners find themselves owing more on a property than its market value, setting the stage for default if there is mortgage payment shock, a job loss or the owner needs to move.” It was the most foreclosures since DataQuick began tracking them in 1988 and more than double the previous peak of 15,418 foreclosures in the third quarter of 1996. The fewest foreclosures recorded were in the second quarter of 2005, when 637 homes were repossessed.

Mortgage default notices, sent by lenders when homeowners are several months behind on payments, also hit record highs. Default notices are the first step of the foreclosure process. Statewide, lenders sent 81,550 default notices, up 114.6 percent from 37,994 in the fourth quarter of 2006. It was up 12.4 percent from 72,571 in the third quarter of 2007. It was the most defaults since DataQuick began tracking them in 1992.

Bay Area home sales limped along at a decades-low pace in October, as buyers continued to find few mortgage options. A total of 5,486 new and existing houses and condos changed hands last month, down 35.7 percent from October 2006 and the lowest sales count since at least 1988 Sales of existing, single-family homes in the nine counties that touch the bay slid 41.3 percent, from 5,761 last year to 3,384 in October, the firm reported Thursday. Although it was the 33rd month in a row of year-to-year sales declines, the market has been slammed in recent months by a tightening in the mortgage market, which is making home loans harder to come by and more expensive.

Of particular concern in the high-priced Bay Area housing market is that the number of jumbo loans, or those over $417,000, has slowed to a trickle. This summer, after higher defaults in the subprime sector – where mortgages were given to people with iffy credit – investors stopped buying jumbo mortgages, leading buyers to walk away from deals or avoid the market altogether. “We don’t have liquidity in the marketplace, and that’s creating a drop in market value because people can’t close on a purchase,” said San Francisco mortgage broker Leon Huntting.

The median price for resale homes was almost steady at $670,000, a scant 0.4 percent more than $667,500 last September. The median price declined in five counties – Alameda, Marin, Napa, Solano and Sonoma. The Bay Area median price has been propped up by a tilt in the mixture of sales – more high-end homes have changed hands, boosting the median. But with the credit crunch making it harder and more expensive to get a larger mortgage, the buoying effect of expensive-home sales was reduced in September. “When you combine the price difference (for jumbos) with the restrictions in underwriting guidelines, that was a double whammy,” said Rob Chrisman, director of capital markets at NL Inc., a mortgage bank in Walnut Creek. “To compound it, buyers were possibly thinking that prices were stagnant or coming down in other parts of the nation and California, so maybe prices in the Bay Area would come down, so let’s wait. So you had three strikes against the jumbo market.” … The rising rate of foreclosures and defaults also hurts sales. When a lender forecloses, it puts the property on the market, often at a slight discount. Before a bank forecloses, desperate homeowners who are behind in their payments often try to unload the property as a “short sale” for less than they owe on the mortgage. Both types of sales further depress prices…. Rising inventory levels are another factor that impact sales. The number of for-sale homes in September rose in seven Bay Area counties compared with a year ago, according to MLS data compiled by ZipRealty…. “This is a cyclical downturn fueled by a lot of really dumb loans made from 2004 to 2005, the so-called subprime loans,” (real estate broker Betsy) Karevoll said. “We’re not in a recession. We’ve got a fairly stable economy. It’s an entirely different correction than it was back in the mid ’90s, for example, when jobs were being lost, people were leaving California, people were making less money. This is somewhat uncharted territory.”

Bad news came in threes for the real estate industry Tuesday as two nationwide economic reports and one from California showed the housing slump is accelerating. California home sales plunged nearly 30 percent last month compared with August 2006 and median prices dropped by almost 14 percent in the High Desert area and part of Santa Barbara County, the California Association of Realtors said Tuesday.

In the Bay Area, sales of existing homes dropped 26.5 percent in the same time period, but, because of more sales at the higher end of the market, the median price of a single-family home actually rose 9.9 percent from August 2006, to $832,760. That was down about 1.1 percent from July’s median of $841,660. For the entire state, the median price edged up 2 percent to $588,970. But analysts at the trade group pointed out that prices were weak in nine geographic regions and at the lower end of the market. The median price of an entry-level home – anything less $500,000 in California – dropped 5.1 percent in August to $349,360.

In addition, the inventory of unsold homes was 11.8 months in August, compared with 5.9 months in August 2006. The figure represents the number of months it would take to sell all the homes currently on the market. “The credit crunch emerged as uncertainty about the extent of the subprime problem drove investors across the globe to turn off the tap of funds to lenders in mortgage and other credit market segments. With credit drying up, even qualified buyers were unable to receive funding for home purchases,” Leslie Appleton-Young, the trade group’s chief economist, said in a news release…

Some economists warned that even worse news could be ahead because of the financial market turbulence in August. “August’s sales do not reflect the full impact of the credit crunch, which hit financial markets in mid-month, since most sales were financed with loans approved weeks beforehand,” said Patrick Newport, an economist at Global Insight.

The number of homes entering the foreclosure process hit a record high in the second quarter, but things are going to get even worse over the next 12 months, when millions of borrowers see the interest rate on their adjustable-rate mortgages reset for the first time. ARMs are tied to short-term interest rates but are typically fixed for a few years before they begin adjusting. Because short-term rates have increased dramatically, many homeowners will face payment shock when their rates adjust. In a meeting with mortgage servicers Wednesday, Treasury Secretary Henry Paulson said, “We’ve been experiencing market turbulence, and as I’ve said for a while, this will take some time to work its way out.” …

About $1.1 trillion of adjustable-rate mortgages were scheduled to reset for the first time in 2007 and 2008, according to First American LoanPerformance. These represent about 10 percent of all mortgages outstanding. Virtually all these ARMs will reset at higher rates – in many cases much higher – resulting in bigger payments for homeowners. Reset activity is likely to peak in the fourth quarter of this year and the first quarter of next year… Well over half of the resetting loans were made to subprime borrowers with low credit scores. “The subprime resets will create more difficulty for households and the economy because many subprimes qualified based on a low teaser rate,” not on the post-adjustment rate, says Steve Cochrane, senior managing director of Economy.com. With tighter lending standards and no investor appetite for risky mortgages, refinancing “might not be possible,” Cochrane says. And with home prices lower in most areas, borrowers who put little or nothing down now owe more than their homes are worth, so selling the home to pay off the loan is no longer an option. The brunt of the reset problem has yet to hit.

“I think we’re very near recession, and California is on the leading edge of the downturn,” said chief economist Mark Zandi of Moody’s Economy.com. “The housing market is the economy’s most significant problem, and California’s housing market is among the worst in the country.”

The U.S. Labor Department said nationwide payrolls shrank by 4,000 in August, the first monthly decline since August 2003. Although the unemployment rate was unchanged at 4.6 percent, the payroll loss jolted Wall Street, which had expected jobs to grow. The Dow Jones average fell 249.97 points, to 13,113.38. Economists said the job loss was evidence the housing market’s problems are seeping into the overall economy. They believe the Federal Reserve, in an effort to boost the economy, will almost surely lower interest rates at its next meeting Sept. 18…

Yet the national slowdown in jobs mirrors what’s been occurring lately in California, where payrolls are in decline and unemployment is inching up. The state lost 8,600 jobs in July as unemployment rose to 5.3 percent. Sacramento-area unemployment is up to 5.4 percent, as the region lost 5,200 jobs in July. State and local job numbers for August will be released Sept. 21.

“We are leading in terms of this whole correction, or whatever you want to call it, in the housing sector,” said Howard Roth, chief economist at the California Department of Finance. “Where it ends, I’m not sure.” On the national level, 22,000 construction jobs disappeared in August, as did 46,000 factory jobs and 6,000 in the lending industry.

In addition, the government revised downward its estimates of job creation in June and July, from a combined 218,000 jobs to 137,000. Analysts believe some of the losses in manufacturing are tied to housing as anxious consumers, no longer tapping their home equity for cash, cut back on spending. Auto industry officials, for instance, say most of the downturn in U.S. auto sales is in California and Florida, where the housing market is the weakest. Car sales in California fell 7.7 percent in the first half of the year. “The problems in housing and mortgage markets are now affecting confidence, and thus activity, in other parts of the economy,” said Zandi of Moody’s Economy.com.

And, of course, industries directly tied to housing are continuing to shed workers. A host of mortgage lenders suspended operations in recent weeks, eliminating jobs in the Sacramento area. The construction industry is still weakening. Christopherson Homes of Santa Rosa has laid off 22 of its 30 employees in south Placer in the past year, while Folsom-based Elliott Homes cut 15 jobs in the past two weeks. “We laid some people off,” said Elliott Vice President Russ Davis. “I think every company in the region has laid people off.”

Chris Thornberg, head of Beacon Economics consulting in Los Angeles, said California will feel the effects of a recession worse than most states because it was such a hotbed of subprime mortgage lending. “We will bear the brunt of this primarily because of the mortgage issue,” Thornberg said.