Underwater Mortgages and Strategic Defaults
This post represents a follow-up on last week’s report, Underwater Mortgages Increase, but No Break for Borrowers, in which I described the growth in underwater mortgages, a term that describes borrowers whose mortgages exceed the value of their homes. This week witnessed the release of a report with a similar theme: “Almost one-quarter of U.S. mortgage holders owed more than their homes were worth in the second quarter and that figure may rise to as much as 30 percent by mid-2010 as job losses and foreclosures climb, Zillow.com said.
It seems that this phenomenon is destined to turn into a major issue, as two research organizations have now sounded alarm bells within the span of one week. (The seminal report was authored by Deutsche Bank, which warned that, “The percentage of people owing more than their properties are worth may increase to almost half of U.S. mortgage holders before the housing recession ends.”)
This trend could have significant consequences for both the housing market and the economy in general. As unemployment rises, more homeowners are falling behind on their mortgages. One analyst points out, “If you look at prime jumbo, the highest quality mortgages, 6.2% are seriously delinquent. That sounds like a low number. But two years ago that number was 1%. It’s a very straight trajectory from September 2007, pretty closely mimicking unemployment.” Consider also that “In June, foreclosures accounted for 22 percent of total U.S. home sales.”
This will inevitably cause housing prices to trend lower, exacerbating the problem of negative equity. In the same month, “29 percent of homes sold were purchased for less than what the owner originally paid.” In turn, this feeds back into the housing market: “The negative-equity rate will rise and spin off more foreclosures. I see a substantial downside risk to prices and don’t think we’ll see a bottom until the middle of next year.” And the cycle repeats itself.
The main unknown is not whether negative-equity mortgages will become more prevalent (this seems inevitable), but rather the proportion of underwater loans that will result in foreclosure. It is especially difficult to forecast strategic foreclosure [deliberately defaulting on a (underwater) mortgage]: “People say, “I bought my house for $500,000, it’s worth $250,000, there are 10 available for sale in my neighborhood. It makes no economic sense to spend the rest of my life trying to pay off a $500,000 debt when there’s no reasonable likelihood to expect this house to go back up to $500,000.”
Thus, strategic defaults are best estimated/understood as a function of underwater loans. As for the most accurate way to make such an estimation, there are a couple approaches. In an earlier post on this topic, we reported that “26% of the record numbers of home mortgage defaults across the country are strategic.” According to a recent study by The Federal Reserve of Boston, meanwhile, 7% of underwater borrowers in one sample size defaulted. Deutsche Bank, however, believes this is an underestimation: “We do know that most people try to maintain their home. They try to keep their mortgage current. But to expect it to be as low as 7% is very wishful thinking.”