Negative Equity Nation for 1 out of 5 Homeowners: The Psychology of the 10 Million American Homeowners with Zero Equity.

Recent data suggests that the number one factor for walking away from a home is negative equity.  For us to understand this dynamic, it is important to understand why someone would leave a home with a mortgage.  According to the U.S. Census Bureau some 51.6 million owner occupied homes have a mortgage.  This is data from late 2007 so we should be getting the updated data in the ACS that comes out in September of 2009.  Another third of homeowners have paid off their mortgage.  But with 26,000,000 unemployed and underemployed Americans, paying the mortgage has become more challenging.

We recently discussed the rise in bankruptcies which comes even with the stricter guidelines put in place in 2005.  A recent Freddie Mac report found that 17 percent of the mortgages in their portfolio had negative equity while another 11 percent had equity of 10 percent or less.  Now if you think about it, selling costs can be 6 percent so even those with 10 percent or less equity stand to lose money in a home sale.  If we put this together, some 28 percent of Freddie Mac loans if they were sold today may yield the borrower zero or will cost them thousands.  This is a recipe for disaster.

First let us take a look at the Freddie Mac world:

freddie mac us mortgage debt

At the end of 2008 some $11.9 trillion in mortgage debt was outstanding.  Between Fannie Mae and Freddie Mac, a total of $5.3 trillion was in their portfolios.  The massive rise in debt followed in line with the multi-decade long housing bubble.  Now Freddie Mac and Fannie Mae serve virtually the same role in the mortgage market.  They provide so-called liquidity in the secondary arena.  What this means is no one else would buy these mortgages now that they know Wall Street virtually turned many loans into casino like instruments.  Now, the two giant government agencies are virtually the only game in town.  But what is in the report should be of concern.  Let us pull out the Freddie Mac data by itself:

mortgage portfolio

Freddie Mac has a mortgage portfolio worth $1.96 trillion.  Of this portfolio 13 percent is made up of option ARMs, ARMs, and interest only products.  These are toxic loans.  This may not seem like much but this is equivalent to $254 billion in toxic loans.  Keep in mind those 30-year fixed mortgage are also seeing rises in defaults.  Assuming 17 percent of the borrowers are underwater, some $333 billion in mortgages are severely at risk.

Yet the risk is much deeper since the unemployment situation is causing even those with 30-year fixed mortgages to default.  The problem with being underwater is that the owner has little motivation to keep paying the mortgage.  For most people, they buy homes to live in but also to build up a steady stream of equity.  Yet in this decade, we have seen something that hasn’t occurred since the Great Depression.  We have seen a nationwide housing market decline.  And now, with websites like Zillow and also, local county assessors offices going online many people can check the “value” of their property with very little hassle.  So what this creates is an obsessive real estate culture.  Let us take a look at what occurred in this decade:

us housing market

Since the 1980s for nearly 30 years housing prices have been on a tear.  Now that the bubble has burst equity levels are now back to 2001.  The peak was reached with zany valuation while the debt still exists.  That is why on the chart above you’ll notice housing prices declining while mortgage debt levels are still near their peak.  It is interesting to note that Freddie Mac assumes booming mortgage debt again:

freddie mac us mortgage debt

Yet the losses are going to continue mounting as home prices continue to decline.  Freddie Mac figures some 1 out of 5 homeowners with mortgages are underwater.  Yet we know that there are still many more Alt-A loans that will have much higher default rates.  Freddie Mac is probably as conservative of a portfolio as we will get.

Here is some of the data on walking away:

“(WSJ) The researchers found that homeowners start to default once their negative equity passes 10% of the home’s value. After that, they “walk away massively” after decreases of 15%. About 17% of households would default – even if they could pay the mortgage – when the equity shortfall hits 50% of the house’s value, they found.

“Our research showed there is a multiplication effect, where the social pressure not to default is weakened when homeowners live in areas of high frequency of foreclosures or know others who defaulted strategically,” Zingales said. “The predisposition to default increases with the number of foreclosures in the same ZIP code.”

And here is another point.  If you live in area with high defaults the stigma may not be there for a strategic default.  Take a look at the rising losses in certain states:

credit-losses-by-state

In California the negative equity rate is much higher.  So losses are starting to mount and virtually all Alt-A and option ARM holders in the state are underwater.  This is going to increase the walking away phenomenon.  Even a map of the U.S. will tell us where most of the foreclosures will occur:

state-map

With 1 out of 5 homeowners with negative equity, we have a fleet of 10 million Americans being tempted to walk away from their mortgage.  With unemployment rising, the default may occur because of necessity.  Keep in mind these are people who are still current on their mortgages and not in a stage of default.  Unfortunately housing prices still have a way to go on the downside thus pushing more homeowners underwater.

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