Real Estate: The Worrying Numbers Behind Underwater Homeowners

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home for saleBy the end of the first quarter of 2010, the number of mortgaged residential properties with negative equity had declined slightly to 11.2 million, down from 11.3 million at the end of 2009, according to a report issued by real estate analytics firm CoreLogic. The report includes data through the first quarter, and is CoreLogic's most recent available study.

The bad news: Those 11.2 million loans make up roughly 24% of all U.S. mortgages. Add the 2.3 million borrowers who are close to slipping underwater (those with less than 5% equity), and the numbers rise to 13.5 million -- 28% of mortgages.

This aligns with other industry estimates. Earlier this year, Mark Zandi, chief economist at Moody's, estimated that roughly 15 million American homeowners owe the bank more than their home is worth. (Note: On Aug. 9, Zillow Real Estate Market Reports said the percentage of single-family homes with negative-equity mortgages fell to 21.5% in the second quarter, from 23.3% in the first quarter, due mostly to higher foreclosures in the period.)

Calculating how many households are underwater, how far underwater they are and how many others are at risk of sliding into negative equity should housing values decline further is critical to forecasting future foreclosures, a recovery in housing values and the financial health of U.S. households.

Negative Equity Boosts Foreclosure

The data confirms the common-sense expectation that there's a direct correlation between negative equity and foreclosures: As the number of homeowners who are underwater rises, so do foreclosures.

Many homes are worth only half of their mortgages. There are 4.1 million homeowners with more than 50% negative equity and another 5 million homeowners with 20% to 50% negative equity.

So the majority of the 11.2 million properties with negative equity (9.1 million) are deeply underwater and are thus unlikely to be made whole by modest increases in home prices. That makes further increases in foreclosures likely, and so it's unsurprising that expects that this year's foreclosures will swell to 2.4 million.

How Many Homes Could End Up Underwater?

If prices decline into 2011, as some analysts project, how many homes could slip into negative equity?

According to the U.S. Census Bureau, as of 2008, 51 million households had a mortgage, 24 million owned homes free and clear (no mortgage) and about 37 million households rented their homes.

In 2008 and 2009, foreclosures dissolved roughly 4 million mortgages, reducing the total number of outstanding mortgages to around 47 million. The total number of U.S. home-owning households stand at about 71 million.

The data presented by CoreLogic backs up these conclusions:
  • The highest percentage of homes with negative equity are concentrated in the states that experienced the most extreme price increases and the subsequent severe declines in valuations: Nevada, Arizona, Florida and California.

  • Though the media focuses on the "bubble" states, many other states also have high rates of negative equity: Over 20% of homeowners in Virginia, for example, are underwater, and an additional 5.7% are in near-negative equity territory.

  • Properties with more than one mortgage -- those with second mortgages or home equity lines of credit (HELOC) on top of first mortgages -- were twice as likely to be underwater than those with only a first mortgage (38% vs. 19%).
What is surprising is how few homes have conventional 30-year mortgages that require a down payment. An analysis I performed in 2007 found that only 12 million of the roughly 48 million homes with mortgages had only a conventional fixed 30 year mortgage and no additional liens.

So only 25% of all homes with mortgages had what was once the only loan available, the conventional 30 year fixed mortgage supported by a 20% cash down payment.

The other 75% of mortgaged homes had loans that greatly increased the risk of falling into negative equity or delinquency:
  • Low-down-payment mortgages -- as low as 3% for Federal Housing Administration (FHA)-backed loans. The FHA recently reported that fully 24% of its vast portfolio were "problem loans" -- seriously delinquent or in default.

  • "Exotic" subprime loans

  • Adjustable-rate mortgages that can reset to much higher payments after a few years

  • Two mortgages -- a first mortgage and a "junior lien" such as a second mortgage or a home equity line of credit (HELOC)
All this suggests that only 25% of mortgages -- those with 30 year fixed-rate mortgages -- are at low risk of negative equity. The remaining 75% -- mortgage holders at higher risk of negative equity or already underwater -- number about 35 million households and make up around half of total home-owning households (71 million). Of the 50% of homeowners with risky loans, some 11 million are already underwater.

The Equity Gap

According to the latest Federal Reserve Flow of Funds report, there was $10.24 trillion in U.S. residential mortgages and $16.5 trillion in total home equity.

Since there are about 47 million outstanding mortgages, and 24 millions homes owned free and clear (no mortgage), then we can calculate that free-and-clear owners hold about a third of the $16.5 trillion in home equity -- roughly $5.3 trillion. That leaves about $1.2 trillion in equity spread amongst the 47 million homes with mortgages.

Given the likelihood that those with a conventional fixed-rate mortgage are most likely to have substantial equity, then it follows that this $1.2 trillion in equity is concentrated in the 12 million homes with conventional mortgages.

Subtract the 11 million homeowners who are underwater and have no equity, and that suggests that the remaining 25 million homeowners with exotic, adjustable or multiple mortgages have relatively little equity.

A recent analysis of long-term U.S. real estate data concluded that over time, the nation's housing equity (collateral) can sustain a mortgage load of approximately 40% of total equity. Thus in 1990, $6 trillion of housing collateral supported $2.5 trillion of mortgages, and the $23 trillion of housing collateral in 2006 sustained $10 trillion of mortgages.

Since then, equity has fallen $7 trillion to $16.5 trillion, but mortgages have barely declined -- they remain at $10.24 trillion. To revert to the long-term trend, mortgages will have to decline by $4 trillion to about $6 trillion.

The conclusion: Never before have American homeowners with mortgages held such a thin slice of equity, and never before have so many homeowners been at risk of negative equity. Predicting accurately how many homeowners end up underwater is impossible, as the future of home prices is unknown. But anyone claiming that the number of underwater homes can't rise further is on thin ice.
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