The Negative Equity Phantom Menace

by: Markham Lee

Month after month after month I read articles on how more and more of America's homeowners are underwater, and how negative equity is allegedly "driving" homeowners to walk away from their homes.

If you ask me this is a classic case of people who are confusing a cause with a symptom.

First off, homeowners don't exactly receive monthly financial statements that tell them how much their home is worth, so without monthly appraisals how would the typical homeowner even know they were underwater?

Furthermore recent homeowner confidence surveys indicate that many homeowners are unrealistically confident about the value of their homes. In Q2 a Zillow homeowner confidence survey indicated that 62% of homeowner's thought their home had either increased or maintained it's value, and 49% believed same in Q3 (despite the survey being taken during the market crash of October 7-9). This despite the fact that 77% of homes had last value over the trailing twelve months leading up to Q2, and 74% of homes had lost value over the same time period in Q3.

The above suggests that stating negative equity as a root cause of people going into foreclosure is more than spurious, as the data (and just daily reality) indicates that outside of people who are looking to sell or refinance, the majority of homeowners are rather unaware of the true value of their homes.

Second, let's ignore the above for a second and ask ourselves a rather simple question: would a solvent homeowner (one who can afford their monthly payments, meet their monthly expenses, etc) willing decide to destabilize their family, crush their credit, go through the humiliation of a foreclosure, etc, just because they're in a negative equity situation? Isn't it more likely that even if they're aware they would continue to make payments, keep their home and their financial stability whilst waiting for things to improve?

So if negative equity doesn’t cause foreclosures why is there a relationship between the two?

My suspicion?

It's that the people who are in negative equity situations are simply much more likely to be people who: bought with no money down, used exotic mortgages, overspent, bought within the last 2-3 years, new homeowners, etc. In other words they were people who either weren't especially financially solvent, or put themselves into a bad financial situation. After all let's not forget that the default rate for fixed rate traditional mortgages has barely budged despite the crisis.

I.e. negative equity isn't a cause it's actually a symptom of either bad market conditions, or of an individual who wasn't financially ready to buy a house.

Now the reason why this crosses various strata as defined by FICO scores, is because just because you have a high FICO doesn't mean you spend wisely on a house, have savings, job security, etc. Individual A could be someone with a 780 FICO, no money in the bank and a $50k/yr salary who decides to buy a $350k house with a Negative Amortization Option ARM, whilst individual B could have a 705 FICO $150k in savings, a $250k/yr salary and decide to buy a $400k house with $80k down and a fixed rate mortgage.

Whilst FICO is (generally speaking) a good measure of creditworthiness, when it comes to housing it's not necessarily a direct proxy for how solvent someone is, or the types of decisions they made during the housing boom.

This situation is another example of how people need to start viewing this crisis as it truly is, as opposed to this "thing" that just happened.


Zillow Blog: "Strangely, "Not My House" Sentiment Continues, Albeit a Smaller Group" -- Amy Bohutinsky, October 29, 2008.

Disclosure: at the time of publishing the author didn't own a position in any of the companies mentioned in this article; the ideas expressed are solely the opinions of the author and shouldn't be viewed as financial or investment advice.