Monday, January 7, 2008

Negative Equity

The basic problem is that house price declines create large amounts of negative equity. Homeowners with negative equity lose their ability to respond to adverse financial events such as job loss or mortgage reset by refinancing or selling their home, and they therefore become much more likely to default. The importance of this problem is illustrated in Exhibit 16, which shows the distribution of home equity among US mortgage holders at the end of 2006 according to an analysis by First American CoreLogic, Inc. About 7% of US mortgage holders had negative equity at that point, and another 14% had equity of less than 15%. Thus, 21% of all mortgage holders—holding about $3 trillion in aggregate mortgage debt given the average mortgage debt held by the vulnerable borrowers—would be put into a negative-equity position if home prices fell by 15%. Source: Calculated Risk/Goldman Sachs/First American Core Logic
If real estate drops 30% the red sector will be upside down. If housing prices drop 50%, then include the yellow area in the total. Figure a worse case scenario of a 50 percent drop, one fourth of all housing has the potential to become "Jingle Mail."

People in the purple band have no equity to lose. Those foreclosures were the first to affect housing prices. Now the home owners in the red region are in trouble. Bank REO's are pricing into the yellow region right now. The red and yellow areas represent cash that was in the home owner's wallet. It's slowly disappearing. Figure about 25% of home owners in the United States have a good shot at losing their down payment and paid in equity. This will affect consumer spending for many years into the future. A drop like that could take the "hurry" aspect out of any future home purchase. Source