The Negative Equity Conundrum: Why Having Equity in a Home is Important. 1 out of 4 Mortgage Holders in a Negative Equity Position.

The post title should be obvious but something occurred during this decade that gave the impression that somehow, equity in a property was of little importance.  The last time in our history that we saw this massive amount of negative equity was during the Great Depression.  But even then, it was a poor comparison because mortgages were short-term falling under 10 years in length.  Most of those defaults came because of the employment situation and not the mortgage itself.  This decade however we entered into a new realm of housing economics.  What happens when 1 out of 4 Americans with a mortgage is in a negative equity position?

The first reason people find themselves in a negative equity position is because real estate values have fallen so precipitously over the last few years:

Source:  Zillow

The problem with the above is that you have almost two markets now.  You have one market with new buyers that are purchasing at much lower prices while there is still a significant portion of Americans living in homes with negative equity.  In other words, they are stuck.  They can’t sell because in order to sell, they would actually have to pay to move.   This provides less flexibility than say renting.  With 25 percent of mortgage holders in negative equity positions, a large portion of our population is now constrained.

The compounding of this problem is brought to light when you look at state data.  The top four states have these negative equity stats:

-1.  Nevada – 40% of mortgage holders underwater

-2.  Arizona – 37%

-3.  California – 33%

-4.  Colorado -31%

You would think that Florida would be up here (27%) but Colorado is an interesting pick.  Either way, a state like California with 12.2 percent unemployment has a large percentage of its population constrained to an asset that is worth less than the debt attached to it.  Think of someone that bought a $500,000 home that is now worth $300,000.  Let us assume this person is able to afford the mortgage payment.  What happens if a job promotion requires a move?  They can’t sell unless he wants to cover that $200,000 gap.  He can rent the place but surely he won’t cover the lost income.  In many of these cases, a person is likely to strategically default.  That is, stop payment on purpose.

That is why having equity is so important.  Even a 10 percent buffer allows someone to sell at any given point and take a little bit of money and move on.  When you push the lower bound of no down payment, any slight movements (and we had anything but slight movements) will shock values on the downside thus rendering the mobility of Americans.  We are now seeing FHA insured loans with massive problems since they only require a 3.5 percent down payment.

Equity is vital.  The government now making up 95 percent of the mortgage market must require 10 percent down.  Yet they realize putting this stipulation would stunt the housing market.  So they are now filling that role of subprime lender.  It is no surprise that recent FHA insured loans are defaulting.  Without equity, what can we expect?

Sales are virtually tracking with distress properties:

Source:  Zillow

In other words, housing sales are being quickly replaced with additional distress properties that will hold prices lower.  If sales pull back in the fall and winter, you can expect prices to come back down again.

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