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Negative Equity: Not Good But Improving

Back in October, we posted that falling home prices would drive more homeowners into a negative equity situation where their home was worth less than the amount of their mortgage (also known as the house being ‘under water’ or ‘upside down’). If a homeowner falls further into negative equity, it increases the chances that they will walk away from their mortgage obligation. This is known in the industry as a strategic default. This could dramatically increase the number of foreclosures coming to market and cause house values to fall further.

The Wall Street Journal reported on the impact of negative equity on strategic default:

Most defaults are typically driven by a combination of income shock and negative equity, or what’s known as the “double-trigger” hypothesis. While borrowers who lose their jobs but have equity in their homes can sell and avoid default, those without any equity are left with fewer options.

The most recent Fannie Mae National Housing Survey looked at how people viewed walking away from their mortgage obligation. Here are some of their findings:

  • Underwater delinquent borrowers are the most likely to have considered stopping their mortgage payments.
  • Delinquent borrowers are almost three times as likely to have considered stopping their mortgage payments if they know someone who has defaulted on their mortgage.
  • 17% of all people who are delinquent believe the amount they owe on their mortgage is 5-20% more than the value of their home. That number jumps to 29% when they believe the amount they owe on their mortgage is at least 20% more than the value of their home.

The CoreLogic 3rd Quarter Negative Equity Report released Monday showed

 … equity data indicating a third consecutive quarterly decline in negative equity for residential properties. CoreLogic reports that 10.8 million, or 22.5 percent, of all residential properties with mortgages were in negative equity at the end of the third quarter of 2010, down from 11.0 million and 23 percent in the second quarter. This is due primarily to foreclosures of severely negative equity properties rather than an increase in home values.

Obviously, the fact that the number is declining is good news for the housing market. However, with prices again falling there is concern that the current situation could worsen. Mark Fleming, chief economist with CoreLogic said

“Negative equity is a primary factor holding back the housing market and broader economy. The good news is that negative equity is slowly declining, but the bad news is that price declines are accelerating, which may put a stop to or reverse the recent improvement in negative equity.”

Radar Logic addressed the CoreLogic report yesterday in an opinion piece:

According to research by CoreLogic, borrowers become more likely to default the further underwater they become in their mortgages. Thus, falling home prices could increase defaults, foreclosures and, as a result, the inventory of bank-owned properties. Based on our analysis, homes sold by financial firms sold for 38 percent less, on average, than homes sold by other sellers as of September 30, 2010. As such, foreclosed homes represent a low-priced alternative to homes for sale by owner/occupants, and as sales of foreclosed homes become a larger percentage of total sales, owner/occupants face increasing pressure to reduce their asking prices in order to compete. So falling prices could create a self-perpetuating cycle of negative equity, foreclosures, and further price declines.

Bottom Line

If people fall into negative equity, the chances they will strategically default increases. This would lead to more foreclosures which will mean more downward pressure on home values. More homeowners will see themselves in negative equity as prices fall. And round and round we would go. Let’s hope prices hold thus preventing this from happening.

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