Homeowners in the US are defaulting on their mortgages at record rates, and commentators are increasingly casting the blame on “negative equity”.
The term applies to those borrowers whose loans are now worth more than the value of their homes, largely due to those precipitous declines in house prices we keep hearing about.
More than half of the people who purchased houses in 2006 now owe more on their mortgage than their house is worth, according to data from real estate website Zillow.com (Hat tip, Carlomagno.)
Of those who purchased a house in 2005 and 2007, 42 and 45 per cent respectively face negative equity, Zillow said.
One theory is that such borrowers are more likely to default, by exercising a put option to escape this situation. In the jargon, this is known as a “Ruthless Default” and more popularly, as “walking away.”
But negative equity alone does not account for the unprecedented levels of mortgage delinquencies and foreclosures in the US.
Or, as Fitch puts it in its latest report on Alt-A delinquencies,
The interaction of declining home price declines with high risk mortgages has caused delinquencies to rise rapidly. As in the subprime market, loans with high risk attributes such as simultaneous second liens (SSLs, aka piggyback mortgages) are defaulting at very high rates relative to other loans and to history.
In other words, while negative equity caused by falling home prices plays a part, the fact that many borrowers were given high loan-to-value mortgages and then piggyback loans is also significant, because it is this complete lack of equity in the home that tips the balance.
Per Fitch:
Borrowers that have perceived equity in the home, including those underwritten to a low doc program, are exhibiting significantly lower delinquency rates than their SSL counterparts.
Meanwhile, analysts at CreditSights have taken a slightly different line:
Cities with high levels of weak documentation mortgages and adjustable rate mortgages, especially those that have already reset, have higher levels of defaulted and delinquent mortgages…this suggests that homeowners are being forced to default by payment shocks rather than deciding to default as a result of negative equity.
For CreditSights’ David Watts, “defaults are a product of necessity, not of design.”
Mr Watts cites research by Peter Chinloy of the American University, who analysed the state of the UK residential property and mortgage market at the start of the 1990s. UK borrowers experienced both payment shocks - due to mortgages resetting to higher interest rates - and negative equity.
Between 1988 and 1993, the UK-wide Halifax house price index declined by 24 per cent in nominal terms and 40 per cent in real terms, and 20 per cent of mortgages or 2m homeowners experienced negative equity.
But repossessions at their peak in 1991 and 1992 averaged just 75,000.
Mr Chinloy’s conclusion is that borrowers generally continue to make their mortgage payments even when facing negative equity; they tend not to walk away.
Consequently, Mr Watts maintains that payment shocks - in the form of rising interest rate payments - is they key driver of mortgage defaults, for both subprime and Alt-A borrowers.
Not everyone agrees, however.
BarCap analysts Ajay Rajadhyaksha and Derek Chen think the negative equity phenomenon is under-rated, and puts $800bn of mortgage debt at greater risk of default.
“If they have home equity left, borrowers are hesitant to default, even if in trouble,'’ they wrote in an April report. “If the house is worth more than the loan, why default and leave money for the bank? Better to sell the house instead.'’
And Credit Suisse data suggests that borrowers who have never been delinquent on a subprime mortgage are three times more likely to miss a payment if they have less than 20 percent equity in their homes, compared with similar borrowers with more equity.
At least no one is predicting prime borrowers will start defaulting at the same rate. Oh, wait, never mind…
