Walking Away from Negative Equity

Today let’s look at negative equity and attempt to determine what impact it will have on a housing recovery in 2010. Negative equity, often referred to as “underwater” or “upside down,” means that borrowers owe more on their mortgage than their homes are worth. Negative equity can occur because of a decline in value, an increase in mortgage debt, or a combination of both.

Because of falling prices over the last few years, more and more homes are now in this situation. First American Core Logic, in a study this past November reported:

Nearly 10.7 million, or 23 percent, of all residential properties with mortgages were in negative equity as of September, 2009. An additional 2.3 million mortgages were approaching negative equity, meaning they had less than five percent equity. Together negative equity and near negative equity mortgages account for nearly 28 percent of all residential properties with a mortgage nationwide.

Why is this data important? The number one indicator of foreclosure is negative equity. Let’s look at a chart for First American Core Logic’s report:

As we can see, the further a homeowner falls into negative equity the more likely they will wind up in foreclosure. Why? It breaks down into two reasons:

1.) Negative equity is making people question whether making payments on a depreciating asset makes sense.

Many people are beginning to look at their house solely as a financial investment and that investment is turning sour. They are questioning whether it any longer makes sense to make payments on an investment which continues to lose value.

An article in the Los Angeles times addresses this issue:

But research by three academics suggests that the willingness of people to default depends largely on just how far underwater they are. Or, as the study’s authors put it, “People default because of the size of their negative equity, not just because they cannot afford to pay.”

2.) People are questioning if there is an ethical, or moral, imperative to pay back a debt you have entered into.

The ‘stigma’ for not paying your debts isn’t as strong as it was even a decade ago. As more and more families are forced into foreclosure, it makes it easier for others to accept that fate.

Earlier this year, a research paper on homeowners with negative equity walking away, entitled Moral and Social Constraints to Strategic Default on Mortgages, stated:

We find that people who have been exposed more to defaults are more willing to strategically default. Holding morality constant, people who know someone who defaulted strategically are 82% more likely to declare their intention to do so.

Couple that with the fact that financial institutions such as Morgan Stanley are now walking away from their mortgage obligations on commercial properties, the moral imperative has almost become obsolete.

So we can see that negative equity will cause millions of foreclosures. How will it impact your state or region?

Click below for state and local charts:

First American Core Logic Report