Negative equity and foreclosure

This article discusses the factors which cause strategic default to make financial sense for a negative equity homeowner.

A crisis squandered by an inactive government

Conventional wisdom holds that foreclosures are triggered when homeowners owe more on their mortgages than the fair market value (FMV) of their homes. This is a financial condition called negative equity.

Experienced by a debilitating one-third of California’s homeowner population in the years immediately following the Millennium Boom, negative equity is universally feared by homeowners, lenders and policymakers alike. Consistent with this wisdom, negative equity is often blamed as the primary cause for the rise in foreclosures that invariably accompanies a bust in real estate pricing which cyclically occur.

In response to the increase in negative equity and the corresponding foreclosure frenzy in 2008-2011, the government unleashed a series of policies attempting to induce lenders to offer a mortgage modification in lieu of foreclosure.

If negative equity is the problem, mortgage modifications, most effectively in the form of reduced mortgage debt (also known as a cramdown), are the preferred solution. Yet government efforts to generate mortgage modifications were largely unsuccessful.

The lending industry historically disregards government incentives to modify mortgages. However, lenders are less able to ignore the lawsuits of state attorneys general, which do induce action. Without modifications, marginally insolvent homeowners with negative equity default and go into foreclosure, a drag on the state’s economy.

When lenders do choose to modify a mortgage, they tend to leave the mortgage balance intact, limiting the modification to a mere reduction of the dollar amount of scheduled payments in exchange for an elongated term.

That lender perspective is best encapsulated in a 2008 study from the Federal Reserve Bank of Boston (FRBB).

Contrary to popular belief, the FRBB study found negative equity on its own is rarely sufficient to induce foreclosure. By examining historic foreclosure rates in Massachusetts over a 20-year period, the report’s authors discovered that over 90% of homeowners with negative equity continued to pay their mortgages.

What then would compel a negative equity owner to strategically default?

A 2016 paper by the FRBB identified the main culprit for strategic default — job loss or other financial shock. Negative equity status was revealed to rarely play a primary role. This fact is not lost on mortgage lenders.

Further, the 2016 report demonstrates that strategic default almost always remains a seldom-used option for homeowners. The homeowner is faced with many economic disincentives that accompany the foreclosure process. These drive negative equity owners to hold on to their homes, in spite of the personal and financial costs. As a result, they become prisoners in their own homes, policed by lenders.

Negative equity — plus a shock — spells default

Even when the outstanding mortgage balance exceeds the home’s market value, it is almost always a more fiscally sound decision for homeowners to continue making payments on their mortgages when they are able, according to the FRBB report.

This is due to:

• the costs of relocating;
• the damage done to credit; and
• the emotional distress associated with failing to keep their home.

Combined, these factors keep homeowners in their residences — imprisoned — unless some additional external factor tips the scale of their judgment.

Homeowners generally do not default and go into foreclosure on their homes unless negative equity is combined with a household income shock (e.g., loss of job, divorce, loss of health, death, mortgage resetting, etc.) that places the mortgage payment beyond their reach.

The FRBB article concludes that if the preponderance of underwater homeowners is not in fact at risk of default due to their inability to pay, then mortgage modifications that reduce the mortgage balance or interest rate are an unnecessary loss for lenders.

Why would lenders effectively offer discounts to owners who would never have defaulted in the first place?

This logic also applies to the approval of a short sale.

Short sale approval involves a discount given to owners who will not default and force a foreclosure sale, but are actively seeking a way out from under their mortgage debt. They force the issue by selling at current prices, contingent on the lender discounting for a final payoff.

Forbearance agreements temporarily reduce monthly mortgage payments but do not alter the original terms of the mortgage. These are far more frequently considered by lenders. Unlike other assistance measures, forbearance agreements are economically beneficial only to homeowners at serious risk of foreclosure. Lenders who use forbearance agreements can thus direct their resources where they will be most effective — foreclosing on the insolvent homeowners.

During 2020-2021, heightened numbers of homeowners entered forbearance programs under the Coronavirus Aid, Relief and Economic Security (CARES) Act — it was a time consisting of record-low foreclosures, despite high levels of job loss.

The share of mortgages in forbearance peaked at 8.5% in May 2020 and steadily declined as homeowners regained jobs lost during the 2020 recession. Homeowners were further buoyed by multiple rounds of government-sponsored stimulus, in the form of direct checks to taxpayers and extra cash to businesses willing to hire during the recession.

Without the need to sell, homeowners who would have completed a forced sale instead kept their home off the market, shielded by forbearance while their incomes caught up. This contributed to record-low levels of inventory during 2021.

Looking back at the short 2020 recession, government forbearance programs and stimulus payments were the cure to keep homeowners housed while employment numbers caught up. Without a return of government-backed housing relief, the only cure available to mortgaged homeowners who slip underwater will be strategic default.

Related article:

California’s for sale inventory: a symptom of seller reluctance in 2023

 

Negative equity in the years ahead

The share of mortgaged homes with negative equity in California increased slightly to 0.7% in the fourth quarter (Q4) of 2023. However, watch for this number to rise through 2024, as the price decline resumes following Spring 2024’s brief price bounce. For perspective, a whopping 37% of mortgaged homeowners were underwater at the height of the foreclosure crisis, in 2010.

As home prices continue to contract over the next two-to-three years, watch for the share of underwater homes to rise rapidly, plunging anyone who purchased with a minimal down payment during 2020-2021 deep underwater.

Real estate professionals can get ahead by learning to assist underwater homeowners. Gathering options for homeowners facing negative equity on top of an inability to pay or a need to move will prepare agents to work with a larger share of clients in the down years ahead.

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Plunging home values and few savings leave recent homebuyers unprepared to combat negative equity; Monthly Statistical Update (December 2022)