Negative Equity Will Increase Unless Home Prices Surge

The number of properties "under water" remains at record levels while there is little hope for a positive turnaround anytime soon. A First American CoreLogic report shows nearly 10.7 million, equal to 23% of all residential properties with mortgages, were in negative equity or had less than 5% equity as of September 2009. Another 2.3 million mortgages were approaching negative equity bringing the total to nearly 28% of all residential properties with a mortgage nationwide.

"Negative equity continues to be pervasive and to impact almost every segment of the housing market. The recent improvement in home prices this past spring and summer has slowed the increase in negative equity, but it will take a significant rebound in home prices, which we are not expecting, to offset the dampening effects of negative equity in the most depressed states," said Mark Fleming, chief economist with First American CoreLogic, Santa Ana, Calif. The national-, state- and city-level negative equity report based on third-quarter data uses a proprietary model that factors in loan amortization and utilization rates for home equity lines of credit to ensure "a more precise view" of borrowers who owe more on their mortgage than their homes are worth, First American CoreLogic said. If the previous methodology - which did not account for amortization or HELOC utilization - were used, the negative equity rate would have been 33.8%.

Report highlights show the distribution of negative equity is heavily concentrated in the same five states that are suffering from higher levels of foreclosure. Nevada had the highest percentage of negative equity at 65%, followed by Arizona with 48%, Florida 45%, Michigan 37% and California 35%. Among the top five states, the average negative equity share was 40% compared to 14% for the remaining states. California and Florida had the largest number of negative equity mortgages accounting for 4.4 million or 42% of all negative equity loans. Negative equity can occur because of a decline in value, an increase in mortgage debt, or a combination of both. Not coincidentally Nevada also features the highest loan-to-value ratio in the country at 114%, followed by Arizona at 91%, Florida 87% and Michigan 84%.

The report shows that the average mortgage debt for properties in negative equity was $280,000, with underwater borrowers in a negative equity position facing an average loss of $70,000. The problem remains present even for 2009 originations, which have a share of 11% in negative equity and another 5% in near negative equity.

According to First American CoreLogic data the third-quarter aggregate property value for loans in a negative equity position was $2.2 trillion, which is the total property value at risk of default, against a total of $2.9 trillion of mortgage debt outstanding. A higher number of such at risk of default borrowers underwater was among homeowners who financed their properties between 2005 and 2008 peaking in 2006 when 40% of borrowers were in negative equity.

The risk of default increases along with the amount of loss borrowers and investors face. And that brings about the risk for strategic defaults, which also are difficult to predict.

The report found that while investors default at rates typically 2% to 3% higher than owner-occupied homeowners with similar negative equity both behave similarly when negative equity is very high.

Earlier this year Experian and Oliver Wyman researched strategic defaulters, or borrowers who default on their mortgages only because the value of their home declined well below their mortgage balance.

Experian said its researchers have developed a way to estimate the number of strategic defaulters and uncover trends that can help improve loan modification programs.

They found that there are striking behavioral differences between prime borrowers and borrowers in distress. Analysis revealed that those in the super-prime and prime credit score categories are 50% more likely to engage in strategic default than those with lower credit scores. Furthermore, according to Experian, lenders and servicers need to detect "cash-flow managers," or a segment of distressed borrowers who closely mimic strategic defaulters but could turn into favorable candidates for a loan modification. Unlike strategic defaulters, these borrowers continue to make occasional payments on their mortgage, which indicates intention to get out of delinquency.

“While 60% of strategic defaulters are charged-off within six months after serious delinquency, one-third of cash-flow managers cure on their mortgage within six months after serious delinquency and another third remain less than 90 days past due,” said Piyush Tantia, a partner in the Retail and Business Banking Practice of Oliver Wyman.“Therefore, cash-flow managers represent the borrowers who would make the best candidates for loan modification offers. The impact to businesses that successfully identify and address the two segments can be significant.”