The negative home equity nightmare: Housing won't stabilize until 2011

Aggressive lending practices fueled the housing boom, and the availability of generous sums of mortgage and home equity money left borrowers with more debt and less equity than ever before. The Federal Reserve reported that home mortgage debt grew at a double-digit rate every year from 2002 to 2006. But as real estate markets across the country have seen price declines between 10 percent (Dallas) and 54 percent (Phoenix), an estimated 11 to 15 million households are now "underwater" on their mortgages, owing more than their house could be sold for today. This overhang, already being blamed for exacerbating the decline in residential real estate, likely won't peak until 2011, according to a research note from Deutsche Bank obtained by DailyFinance.

Deutsche Bank says that nearly $6 trillion in home equity has been vaporized since the peak in housing prices, and any quick recovery would be dependent on repeating the same lending mistakes that led to the boom -- an unlikely proposition. As housing prices continue to fall, the firm estimates that 25 million homeowners, or 48 percent of all mortgages, will eventually wind up being underwater.

The concentration of underwater borrowers is somewhat dependent on geography and the mortgage products that were used in the latter stages of the housing bubble. Deutsche Bank believes that about two-thirds of Alt-A and Subprime loans and almost 90 percent of Option ARM loans will be underwater in 2011. Option ARMs had higher initial balances relative to the home's price (loan-to-value, or LTV), and had negative amortization features that made the principal balance grow for a set amount of time. Additionally, the use of alternative mortgages were more heavily favored in areas that had registered large gains in housing prices -- the same areas that have since been hit hardest by the bursting of the bubble.

Deutsche Bank's future pricing declines divide the worst housing markets into the "sand states" of Arizona, California, Florida, and Nevada, as well as states like Ohio, Michigan, Illinois, Wisconsin, Massachusetts and West Virginia that are struggling due to their manufacturing base. While the current list of areas where more than 50 percent of borrowers are underwater is dominated almost exclusively by the sand states, Deutsche Bank sees the number more than doubling to include parts of the aforementioned states in addition to places like Lousiana, Maryland, Oregon, and Utah. In other words, the "sand state" housing crisis is going nationwide.

Borrowers who are underwater on their mortgages act differently than borrowers with equity, because any number of events -- such as a job loss or divorce -- can lead to a default. The foreclosure process is costly to banks, and a foreclosed home on the market makes selling a home under regular circumstances more difficult. Using a previous study by the Federal Reserve, Deutsche Bank suggested that "an absolute floor" of seven percent of underwater borrowers will go on to default on their mortgages in the next three years. The Financial Times says that 1.265 million homes were lost to foreclosure in 2007 and 2008, and using the most conservative figure given by Deutsche Bank, 1.75 million defaults will occur -- meaning that a large majority of defaults could be in the past.

The numbers, however, reveal just how conservative Deutsche Bank's numbers may be. The already-foreclosed-upon houses represent nine percent of current underwater borrowers, meaning that the current loss rate has already far exceeded the previous case study in much less time. Doing a simple extrapolation to the borrowers who will soon be facing negative home equity suggests that losses might not have reached their halfway point yet, meaning more pain is in store for homeowners, the mortgage lenders who finance them, and the taxpayers who bail out the lenders.

James Cullen edits and writes at He has no personal position in the stocks mentioned above.

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