Does negative equity cause foreclosures?

For years folks have been wondering what caused the mortgage meltdown and many people have pointed to subprime loans. But it turns out that borrowers with weak credit and toxic loans were not the problem, at least according to the Wall Street Journal. It offers a headline which says there’s New Evidence on the Foreclosure Crisis. And what does this new evidence show? “Zero money down, not subprime loans, led to the mortgage meltdown.”

According to author Stan Liebowitz, “by far, the most important factor related to foreclosures is the extent to which the homeowner now has or ever had positive equity in a home.”

Liebowitz says in the second half of 2008 that ‘although only 12 percent of homes had negative equity, they comprised 47 percent of all foreclosures.”

Only 47 percent? That little? Here’s a reality: A huge majority of homes purchased during the past five years have never had any equity. None.

This is not just an academic matter. If you’re thinking of buying real estate at this time then negative equity can be your pal, your buddy and your best friend.

No Equity, Not Ever

Figures from the National Association of Realtors show that in 2008 the typical home was bought with 9 percent down, meaning 91 percent of the purchase was financed. So if the typical home was bought with 9 percent down and 91 percent financing, how much equity was held by the purchaser? Answer: Zero.

A huge percentage of all buyers have negative equity up front and don’t know it because they define “equity” as the market value of a home less its mortgage debt. If a sample home was bought for $500,000 and has a $455,000 mortgage (91 percent) then with such thinking it would appear that the owner has equity worth $45,000.

In theory this sounds about right but in reality it costs money to sell a home, say 8 percent for marketing costs and closing or $40,000 in this case, assuming the property can be re-sold for $500,000.

The mythical equity number shrinks even further when you look at real-life marketplace conditions. NAR says “the national median existing-home price for all housing types was $173,000 in May 2009, down 16.8 percent from a year earlier.”

Let’s try that equity calculation again: $500,000 less 16.8 percent = $416,000. $416,000 minus 8 percent = $382,720.

These numbers lead us toward two facts: First, a huge percentage of recent home purchases are vast pits of negative equity. Second, the overwhelming majority of homes with negative equity are not being foreclosed.

No Wrong From Lenders

Adds Liebowitz: “liar loans and loans with initial teaser rates had virtually no impact on foreclosures, in spite of the dubious nature of these financial instruments.”

If “liar loans and loans with initial teaser rates had virtually no impact on foreclosures” then why would lenders stop offering such financing? Why would lenders write-off huge portions of such portfolios?

The best example is Washington Mutual, a firm taken over by JP Morgan Chase in 2008. In a September 2008 presentation to shareholders JP Morgan Chase discussed the loan portfolio it was getting with Washington Mutual, at one point the nation’s largest savings and loan company. WAMU held option ARMs with a face value of $50.3 billion when it folded — but Chase expected to write off 20 percent of those loans. That’s $10 billion down the drain.

Liebowitz is looking at financing from the second half of 2008 so of course “liar loans and loans with initial teaser rate had virtually no impact’ on foreclosures. This sounds like news that will elate various lenders, but why would anyone expect a different result? Most toxic loans have teaser periods that last from three to five years, meaning that by the second half of 2008 the financial fangs for most “nontraditional” loans originated in 2007, 2006 and some of 2005 would not yet be showing. No less important, by the end of 2008 a number of temporary foreclosure moratoriums had kicked in, distorting marketplace data.

The Investor Opportunity

"Today the issue with negative equity is not that it exists, but rather who will eat the loss if necessary," says James J. Saccacio, chief executive officer of, the nation's largest source of foreclosure listings and data. "Owners with no equity, no assets and no savings cannot absorb the shortfall from a sale while lenders are effectively being forced to take losses through short sales and the foreclosure process. For many foreclosure buyers today the key issue concerns how much of a loss can lenders tolerate."

Vast numbers of homes are today underwater but not facing foreclosure. As long as loan payments are made then lenders are happy and courthouse steps are empty.

The real problem is not that borrowers have negative equity, the issue is that borrowers cannot make their payments.

We now have armies of owners who are about to be foreclosed. They cannot afford the new and higher monthly payments which are required once teaser periods end. Their loan balances are likely to be larger than the original cost of the property, meaning they cannot sell and pay off the debt. In addition, many have little or no savings and growing numbers are unemployed.

For homeowners, negative equity is only a problem if they can’t make their monthly payments and must sell. For lenders the issue is different: If they hold onto foreclosed homes in the hope of higher prices they then have the cash cost of maintaining such properties but no income in the form of offsetting monthly mortgage payments. Alternatively, if they must sell then they will be forced to sell at a discount in most markets — if they can sell at all. Either choice for lenders is lousy, so the question for lenders is which option is least awful.

As the expression goes, you can’t cross a chasm in two jumps. The choice for lenders is black or white, up or down, either hold or sell.

If you’re in the market for property then negative equity tilts the playing field in your favor. Negative equity forces owners who can’t make their payments to sell at discount and it pressures lenders to short-sell or to dump properties that have been foreclosed. Either way, as a real estate buyer the wind is toward your back.

But one has to ask: Are today’s lower prices enough? In many cases the discounts we’re now seeing are extremely attractive but as always there’s no such thing as a sure bet. For instance, prices may be low today but could they be still-lower tomorrow? Are the dismal prices we see now only a false bottom? Imagine that prices went down further — but interest rates rose. At what point in such a situation would lower prices offset higher rates and put you ahead?


Peter G. Miller is syndicated in more than 100 newspapers and operates the consumer real estate site,