One of the central reasons for the recession -- and for the anemic recovery from it so far -- has been the issue of the popping housing bubble. Housing is, for most homeowners, a highly leveraged investment. Even the old conservative rule of a 20% down payment is a far more leveraged position than is allowed when buying stocks, where at least 50% down is required. During the housing bubble, almost no one was putting 20% down anymore, and down payments of under 5% were common.
Even long-time owners were encouraged by the banks to treat their houses as if there was an ATM in the kitchen next to the toaster oven. Cash-out refinancing and homeowners lines of credit were common. In fact, even during the huge run-up in housing prices, the percentage of equity people had in their houses did not rise significantly on average nationwide. People assumed that housing prices would never fall and so it was safe to spend the equity gains that occurred as housing prices rose.
Then, as prices fell, the equity in houses fell even more sharply as a result, wiping out trillions of dollars of wealth. It also resulted in huge numbers of people being “underwater” on their mortgages, owing more than the house is worth.
Being underwater is a necessary condition for a foreclosure to happen. If the homeowner has positive equity in a house, he will always be better off simply selling the house rather than let it slip into foreclosure. It is, of course, not a sufficient condition.
There are lots of people who are underwater on their houses who are still paying the mortgage. The depth of the water matters. There are also non-economic factors to consider -- for most people a house is a home, and they have strong attachments to it and the community it is in. People don’t want to have to uproot their families and pull kids out of the schools they are going to.
Letting a house go into foreclosure is not exactly good for your credit rating, either. Thus if a homeowner still has solid cash flow and is only a little bit underwater, the odds are that he or she will keep on paying the mortgage. However, if one or both of the breadwinners in the family become unemployed, the odds of the house going into foreclosure rise significantly. If the house has a mortgage of $250,000 on it, the house is more likely to go back to the bank if it is worth $200,000 than if it is worth $245,000.
Still an Enormous Problem
Over the weekend I saw some graphs that were part of a Congressional briefing on the subject by Mark Zandi of Moody’s Economics and Robert Schiller, the Yale professor and the co-creator of the Case-Schiller housing price index. The graphs below come by way of http://www.calculatedriskblog.com/2010/07/negative-equity-breakdown.html. They show that while the situation has stabilized recently, we still have an enormous problem on our hands.
The recent small uptick in housing prices is mostly due to the homebuyer tax credit. In a subsidized transaction, and the tax credit is a textbook example of a third party (Uncle Sam) subsidizing a transaction, both the buyer and seller will benefit. The buyer sees it come April 15th, the seller in the form of a higher price for the house.
By arresting the decline of housing prices, the tax credit did prevent more homeowners from slipping below the waves. Of course, after someone actually loses the house to foreclosure, or if he or she can arrange a short sale where the bank agrees to let the homeowner sell the house for less than the amount of the mortgage and not have to show up at closing with a big check, the house is no longer underwater.
The first graph (all the graphs are from this site) shows the percentage of homes with mortgages that are underwater (solid blue line, left scale). It doesn’t matter if the house with the $250,000 mortgage is worth $249,000 or $49,000, as long as it is worth less than the amount of the mortgage it is included.
At one time, it was common for people to have mortgage-burning parties where people celebrated the last payment to the bank on the house. That has not died out, and about one third of houses in the country actually have no mortgage on them at all. Some of those are all-cash investors, but mostly it is older people who have lived in the house for a long time and finally paid it off. Thus the percentage of homes in the country that are underwater is significantly less, just under 20% rather than over 30%, as is shown by the dashed blue line.
The red line shows the total value of the underwater mortgages to be about $2.4 trillion, down from a peak of about $2.6 trillion in the second quarter of 2009, but up from under $500 billion in 2006. Of course, there have been a lot of foreclosures over the past few years, and homes that have already been foreclosed on are not under water.
The $2.4 trillion number is the total amount of the mortgage, not the amount that is underwater. It is the underwater portion that is the potential loss to the big banks that made the mortgages, like Bank of America (BAC) and J.P. Morgan (JPM). However, mostly the risk is to the taxpayer, since the biggest holders of mortgages are Fannie Mae and Freddie Mac and more recently, the Fed.
The underwater portion is estimated to be $771 billion as of the first quarter of 2010. The depth of the water counts. Since the likelihood of foreclosure is related to the depth of the water, the distribution of how far people are underwater also matters.
People just a little bit under are not that likely to let the house go back to the bank. It simply is not worth it in terms of family disruptions, credit ratings and the personal sense of honor in paying your debts even if you are not legally obligated to do so (most mortgages are non-recourse, meaning if you don’t pay, you lose the house, but that’s as far as your legal obligations go). People who are deeply under are downright stupid if they don’t.
The second graph shows the breakdown. There are a total of 14.75 million homeowners who are underwater. Of those, over 4 million are sitting deeper than the wreck of Transocean’s (RIG) Deepwater Horizon. That big first bar is homeowners with more than 50% negative equity.
In other words, for that $250,000 mortgage, the house is worth less than $125,000...OUCH! With the end of the tax credit, it is highly likely that we will see a renewed decline in existing home prices. If housing prices fall by 5%, then each bar on the graph -- with the exception of the first one -- will move one spot to the left, and the first one will grow by approximately the size of the second bar (offset by the actual number of foreclosures or short sales).
So where is the flood? The final graph shows the breakdown by state, in those states for which the data was available. The worst “flooding” by far is in the desert of Nevada. It is a pretty good bet that the 18% of homeowners (red portion of the bar) there that are more than 50% underwater will go into foreclosure. Right now, by paying the mortgage each month, they are acting like gamblers who are deep in the hole and increase their bets in the hope of breaking even. Even the yellow portion of the bar makes it a bit of a long shot for the probability of the house price rebounding enough to eventually have positive equity again.
Combined, those two groups are more than half the homeowners with mortgages in the state! Then consider that Nevada now has the highest unemployment rate in the country, and it looks like the whole state is rolling snake eyes. The other two poster children for the housing bubble -- Florida and Arizona -- are not in quite as bad shape; to get to half of all homeowners underwater, you need to include even those that are just “damp” on their mortgages. Still, that is a lot of people who are underwater.
Housing wealth is -- or at least was, before it all evaporated -- far more widespread and “democratic” than stock market wealth. For many people, the equity in their houses was a form of “forced” savings that was going to be a big part of retirement plans, or the way they were going to put their kids through college. Now either they have to abandon those plans ("Sorry Billy, I know you worked hard in high school and got into the Ivy league like you always dreamed, but you will just have to go to community college instead,") or people are going to have to save a lot more out of current income.
As the savings rate rises, it means people will spend less at the stores, particularly on discretionary items. It means fewer meals out, and when people go out, it means it is more likely to be at McDonald's (MCD) than it is at Red Lobster (part of Darden, DRI).
Of course, it is hard to save when you are out of work. It is only the 90% of the workforce that does have jobs that have any real hope of saving. As they scramble to do so, the lower demand is likely to cause more unemployment. If people are not going out the Red Lobsters of the world, then there will not be as many people working as waiters. busboys and cooks.
Since people have a greater tendency to view housing equity as “permanent” wealth relative to stock market wealth (where people know a correction can come along at any point), the negative wealth effect from a decline in housing prices is greater than a similar decline in stock prices. It is estimated to be between 5 and 7%.
In other words, if the value of your house goes down by $10,000, you are going to spend between $500 and $700 less in the subsequent year. It is not just those that are underwater who have lost housing wealth, and if you multiply that $500 to $700 across tens of millions of homeowners, you have a very big dent in consumer demand.
The future course of housing prices -- and with it the savings rate -- and consumer spending are a far bigger source of uncertainty than anything surrounding future regulations or taxes. If businesses don’t think the consumer demand will be there, they are not going to invest, particularly at a time when there is lots of excess capacity, as there is now.
Corporate profits are doing extremely well; so far the earnings of the S&P 500 are up 44% year over year with 2/3rds of results in. However, if the demand is not going to be there in the future, corporations will simply sit on the cash, or perhaps use it for dividends and share repurchases. The only investment that will be desired will be investments that raise productivity and cut costs (and jobs). This is the key reason why we have such slow growth right now.
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Then, as prices fell, the equity in houses fell even more sharply as a result, wiping out trillions of dollars of wealth. It also resulted in huge numbers of people being “underwater” on their mortgages, owing more than the house is worth.
Being underwater is a necessary condition for a foreclosure to happen. If the homeowner has positive equity in a house, he will always be better off simply selling the house rather than let it slip into foreclosure. It is, of course, not a sufficient condition.
There are lots of people who are underwater on their houses who are still paying the mortgage. The depth of the water matters. There are also non-economic factors to consider -- for most people a house is a home, and they have strong attachments to it and the community it is in. People don’t want to have to uproot their families and pull kids out of the schools they are going to.
Letting a house go into foreclosure is not exactly good for your credit rating, either. Thus if a homeowner still has solid cash flow and is only a little bit underwater, the odds are that he or she will keep on paying the mortgage. However, if one or both of the breadwinners in the family become unemployed, the odds of the house going into foreclosure rise significantly. If the house has a mortgage of $250,000 on it, the house is more likely to go back to the bank if it is worth $200,000 than if it is worth $245,000.
Still an Enormous Problem
Over the weekend I saw some graphs that were part of a Congressional briefing on the subject by Mark Zandi of Moody’s Economics and Robert Schiller, the Yale professor and the co-creator of the Case-Schiller housing price index. The graphs below come by way of http://www.calculatedriskblog.com/2010/07/negative-equity-breakdown.html. They show that while the situation has stabilized recently, we still have an enormous problem on our hands.
The recent small uptick in housing prices is mostly due to the homebuyer tax credit. In a subsidized transaction, and the tax credit is a textbook example of a third party (Uncle Sam) subsidizing a transaction, both the buyer and seller will benefit. The buyer sees it come April 15th, the seller in the form of a higher price for the house.
By arresting the decline of housing prices, the tax credit did prevent more homeowners from slipping below the waves. Of course, after someone actually loses the house to foreclosure, or if he or she can arrange a short sale where the bank agrees to let the homeowner sell the house for less than the amount of the mortgage and not have to show up at closing with a big check, the house is no longer underwater.
The first graph (all the graphs are from this site) shows the percentage of homes with mortgages that are underwater (solid blue line, left scale). It doesn’t matter if the house with the $250,000 mortgage is worth $249,000 or $49,000, as long as it is worth less than the amount of the mortgage it is included.
At one time, it was common for people to have mortgage-burning parties where people celebrated the last payment to the bank on the house. That has not died out, and about one third of houses in the country actually have no mortgage on them at all. Some of those are all-cash investors, but mostly it is older people who have lived in the house for a long time and finally paid it off. Thus the percentage of homes in the country that are underwater is significantly less, just under 20% rather than over 30%, as is shown by the dashed blue line.
The red line shows the total value of the underwater mortgages to be about $2.4 trillion, down from a peak of about $2.6 trillion in the second quarter of 2009, but up from under $500 billion in 2006. Of course, there have been a lot of foreclosures over the past few years, and homes that have already been foreclosed on are not under water.
The $2.4 trillion number is the total amount of the mortgage, not the amount that is underwater. It is the underwater portion that is the potential loss to the big banks that made the mortgages, like Bank of America (BAC) and J.P. Morgan (JPM). However, mostly the risk is to the taxpayer, since the biggest holders of mortgages are Fannie Mae and Freddie Mac and more recently, the Fed.
The underwater portion is estimated to be $771 billion as of the first quarter of 2010. The depth of the water counts. Since the likelihood of foreclosure is related to the depth of the water, the distribution of how far people are underwater also matters.
People just a little bit under are not that likely to let the house go back to the bank. It simply is not worth it in terms of family disruptions, credit ratings and the personal sense of honor in paying your debts even if you are not legally obligated to do so (most mortgages are non-recourse, meaning if you don’t pay, you lose the house, but that’s as far as your legal obligations go). People who are deeply under are downright stupid if they don’t.
The second graph shows the breakdown. There are a total of 14.75 million homeowners who are underwater. Of those, over 4 million are sitting deeper than the wreck of Transocean’s (RIG) Deepwater Horizon. That big first bar is homeowners with more than 50% negative equity.
In other words, for that $250,000 mortgage, the house is worth less than $125,000...OUCH! With the end of the tax credit, it is highly likely that we will see a renewed decline in existing home prices. If housing prices fall by 5%, then each bar on the graph -- with the exception of the first one -- will move one spot to the left, and the first one will grow by approximately the size of the second bar (offset by the actual number of foreclosures or short sales).
So where is the flood? The final graph shows the breakdown by state, in those states for which the data was available. The worst “flooding” by far is in the desert of Nevada. It is a pretty good bet that the 18% of homeowners (red portion of the bar) there that are more than 50% underwater will go into foreclosure. Right now, by paying the mortgage each month, they are acting like gamblers who are deep in the hole and increase their bets in the hope of breaking even. Even the yellow portion of the bar makes it a bit of a long shot for the probability of the house price rebounding enough to eventually have positive equity again.
Combined, those two groups are more than half the homeowners with mortgages in the state! Then consider that Nevada now has the highest unemployment rate in the country, and it looks like the whole state is rolling snake eyes. The other two poster children for the housing bubble -- Florida and Arizona -- are not in quite as bad shape; to get to half of all homeowners underwater, you need to include even those that are just “damp” on their mortgages. Still, that is a lot of people who are underwater.
Housing wealth is -- or at least was, before it all evaporated -- far more widespread and “democratic” than stock market wealth. For many people, the equity in their houses was a form of “forced” savings that was going to be a big part of retirement plans, or the way they were going to put their kids through college. Now either they have to abandon those plans ("Sorry Billy, I know you worked hard in high school and got into the Ivy league like you always dreamed, but you will just have to go to community college instead,") or people are going to have to save a lot more out of current income.
As the savings rate rises, it means people will spend less at the stores, particularly on discretionary items. It means fewer meals out, and when people go out, it means it is more likely to be at McDonald's (MCD) than it is at Red Lobster (part of Darden, DRI).
Of course, it is hard to save when you are out of work. It is only the 90% of the workforce that does have jobs that have any real hope of saving. As they scramble to do so, the lower demand is likely to cause more unemployment. If people are not going out the Red Lobsters of the world, then there will not be as many people working as waiters. busboys and cooks.
Since people have a greater tendency to view housing equity as “permanent” wealth relative to stock market wealth (where people know a correction can come along at any point), the negative wealth effect from a decline in housing prices is greater than a similar decline in stock prices. It is estimated to be between 5 and 7%.
In other words, if the value of your house goes down by $10,000, you are going to spend between $500 and $700 less in the subsequent year. It is not just those that are underwater who have lost housing wealth, and if you multiply that $500 to $700 across tens of millions of homeowners, you have a very big dent in consumer demand.
The future course of housing prices -- and with it the savings rate -- and consumer spending are a far bigger source of uncertainty than anything surrounding future regulations or taxes. If businesses don’t think the consumer demand will be there, they are not going to invest, particularly at a time when there is lots of excess capacity, as there is now.
Corporate profits are doing extremely well; so far the earnings of the S&P 500 are up 44% year over year with 2/3rds of results in. However, if the demand is not going to be there in the future, corporations will simply sit on the cash, or perhaps use it for dividends and share repurchases. The only investment that will be desired will be investments that raise productivity and cut costs (and jobs). This is the key reason why we have such slow growth right now.
Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market beating Zacks Strategic Investor service.
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