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Five Reasons Why Negative Equity Could Kill GDP Growth

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It may not be necessary for market timing, but it's essential for economic forecasts.

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Negative equity on a residential mortgage means the owner of the residence owes more on the mortgage loan than the property is worth. This has become a big problem in the US and it's an issue that needs to be taken into account as one forecasts the prospects for a recovery in consumer spending and overall GDP growth in the next few years.

How Big Is the Negative-Equity Problem?

According to data released by First American CoreLogic, as of June 30, about 15 million US residential properties were worth less than the mortgages owed on the properties. This represents about 32% of all mortgaged residential properties. The report also estimated that there are an additional 2.5 million mortgaged properties that were approaching negative equity. This means that negative equity and near negative equity mortgages represent almost 38% of all residential properties with a mortgage in the US.

Three states account for roughly half of all mortgage borrowers in a negative-equity position. Nevada at 66% had the highest percentage, followed by Arizona at 51% and Florida at 49%. Michigan at 48% and California at 42% were fourth and fifth in the rankings.

According to the same report, the aggregate property value for loans in a negative-equity position was $3.4 trillion. This figure can be thought of as the value of a subset of properties that are at high risk of default. In California, the aggregate value of homes that are in negative equity was $969 billion, followed by Florida at $432 billion, New Jersey at $146 billion, Illinois at $146 billion, and Arizona at $140 billion.

In a recent report, Deutsche Bank estimated that the number of US mortgage holders facing negative equity would approach 48% within 2 years. Others have offered estimates of around 30%.

Approximately two-thirds of owner-occupied housing in the US has a mortgage. This implies that currently, roughly 24% of US households are in a negative equity or near negative-equity position with respect to their home. If Deutsche Bank's estimates were to prove accurate, this figure could rise to about 33% within 2 years.

The Consequences of the Negative-Equity Problem

1. The financial system faces grave risks.

According to the Mortgage Bankers Association, as of June 30, more than 13% of mortgage owners are either in default or behind in their payments. According to the report, approximately 4% are in foreclosure and 9% have missed at least one payment. The fact that somewhere between 25% and 50% of all residential mortgages will be in or near negative equity in the next couple of years implies that default rates will remain very high for an extended period of time in the US. Indeed, the fact that foreclosures in the US increased by 7% in July relative to June despite an uptick in economic activity is a potentially ominous sign.

Certainly, it must be recognized that not all mortgage holders with negative equity will default. In addition, even if home prices decline another 20% as some analysts are suggesting, a significant portion of the face value of the defaulted loans will be covered by the collateral value of the homes. Still, the phenomenon of negative equity is a problem of monumental proportions for the US financial system.

2. Negative equity could cripple consumer spending.

Being underwater on their mortgage makes people feel poor. This should significantly affect their propensity to consume. The Permanent Income Hypothesis (PIH) developed by Milton Friedman (the most prominent model of consumer behavior within the economics profession) posits that individuals take into account not only their current income, but their total wealth when making consumption decisions. And behavioral research suggests that wealth effects -- particularly large fluctuations in a short period of time -- may impact consumption far beyond what's predicted by the PIH.

The increase in perceived wealth created by the housing boom fueled accelerated consumption on the part of consumers from the mid 1990s through 2006, well beyond what the standard PIH theory would predict. Keeping this in mind, it seems probable that the enormous damage done to the household balance sheets of vast numbers of Americans as a result of the housing crisis may similarly cause dramatic downward adjustments in household consumption.
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