Location, Location, Location and Underwater Homes

Includes: IYR, RWR, RWX, XHB
by: John Lounsbury

The latest data from First America CoreLogic for the first quarter of 2010 has been graphed by Calculated Risk:

For large image click here or on the image itself.

Note: Data for Louisiana, Maine, Mississippi, South Dakota, Vermont, West Virginia and Wyoming were not available for the graph above.

A total of 11.2 million homes are underwater, owing more mortgage principal than current market value. An additional 2.3 million mortgages had less than 5% equity. When you recognize that closing costs for the seller are often 6% or more (mainly realty commission and home inspection and code violation correction expenses), these 2.3 million "near" properties also actually need self-contained breathing apparatus.

Underwater Does Not Necessarily Equal Eventual Default

The total of negative equity properties, if sold, is 13.5 million homes. That is 28% of all mortgages. But this doesn't mean that most will default. A lot depends on the economy. If the economy strengthens and the recovery becomes even modestly robust (2% to 3% GDP growth for at least 6-8 quarters), employment will improve by several million, downward pressure on personal incomes will ease and both the psychology and reality of mortgagors will improve, reducing the number who will default. These factors will impact the rates of both forced and strategic defaults.

My Personal Story

I draw on my personal experience in regard to the previous discussion. We built our dream home in the early 1970s, right in front of the two worst recessions (until 2007) since the Great Depression. We built right in front of the terrible energy driven inflation of the Arab oil crises which saw the price of gasoline and home heating rise 500%.

We built what was then a very large home (a McMansion of its day) of 3,000 square feet and located it on a 21 acre estate property which required 50 miles a day commutation by private auto (no public transportation available). The commonly desired homes of that time were 2,000 square feet or less and within five miles of work. We had built a white elephant for the economic conditions that ensued. And we mortgaged it to the fullest extent possible at the time: 80% first mortgage and 10% second mortgage. We moved in with three pre-school aged children and virtually no cash reserve savings.

We didn't try to sell, but I doubt that, if we could even have gotten an offer, it wouldn't have been enough to cover the two mortgages for the first 7-8 years. I believe that we were 25-30% underwater for at least 2-3 years.

We made it through this difficulty because:

  1. I had a secure job.
  2. We heated our home as much as possible by burning firewood, of which I had a surplus on the property. We reduced our heat and electric bills by more than 80%.
  3. We drove old cars until they dropped and then bought another old car.
  4. I car-pooled to work during the worst of the oil crisis.
  5. We cut down our food expenses dramatically by harvesting game and growing vegetables.
  6. We had a sense of obligation to ourselves and the children to see our personal financial crisis through to a successful conclusion.

During the 1970s we seriously doubted several times that we could actually hold our financial position together. I can only imagine how people feel today when they get in a similar situation without the favorable collateral support factors that I enumerated above.

The Doomsday Scenario

If there is another recessionary dip, we could see more than 50% of the underwater properties default. (Note: This my rough estimate. I have not seen an estimate by anyone else.) And home prices would probably drop significantly further adding to the 13.5 million problem mortgages we already have. That is what I call the doomsday scenario. These foreclosures would come at a time when renewed recession would dry up the weak demand for housing that exists currently.

A credible source, Prof. Robert Shiller, Yale University, postulated last week in The New York Times that fear of a new recession could actually produce one. I guess I would equate his proposition to the concept that the biggest handicap one can have is self doubt. The American consumer certainly has had his self confidence challenged.

Location, Location, Location

Making a glass half full statement, almost half of the states above have less than 20% underwater or nearly underwater. This cutoff number (20%) is significantly less than the 28% for the nation as a whole. But only two states have less than 10% in that category.

The disaster is especially concentrated in six states, each of which have more than 30% of mortgages near or completely underwater. Three are over 50%. These are not states with small populations, except for Nevada with 2.6 million people in 2008 for a 35th ranking. Arizona ranks 16 and the other four are all in the top ten.

Location is always a primary factor in real estate considerations. Five of the six basket cases on the underwater mortgage list are in the far west and the southeast. Only Michigan is in the other 80% of the land mass of the lower 48. However, even though the worst cases are concentrated geographically, the problem is still distributed over most of the nation. Only two states have less than 10% of mortgages being problematic.


We have a national mortgage problem, in spite of the headlines concentrating on a few states. For most of the nation, satisfactory resolution of the underwater mortgage problem will be achieved with continued economic recovery. For the six basket cases, though, there is likely to be a longer workout process.

The workout could be very expensive for mortgagees (lenders). Over 10% of mortgagors (borrowers) are 25% or more underwater. That is 4.9 million mortgages. The total valuation shortfall is $656 billion. Calculated Risk has a nice graphic which emphasizes the magnitude of this deeply underwater problem.

Finally, some local markets with big problems are still not recognizing reality. David Streitfeld writes in The New York Times that building is booming in Las Vegas. There are currently 1,100 new homes under construction and builders are scrambling for lots to start more. This is in a market where there are more than 9,500 brand new homes sitting empty and 5,600 new foreclosures coming to market in the coming months. Streitfeld reports that there are similar booms in new construction in many of the other hardest hit markets.

Streifield quotes a builder:

“We’re building them because we’re selling them,” Mr. Anderson said. “Our customers wouldn’t care if there were 50 homes in an established neighborhood of 1980 or 1990 vintage, all foreclosed, empty and for sale at $10,000 less. They want new. And what are we going to do, let someone else build it?”

If what Mr. Anderson says is generally true, existing home prices will continue to fall, pushing default rates higher, and creating even greater lender write-offs, while purchasers pay up by ever increasing amounts to get new construction.

Disclosure: No stocks mentioned.