Because this housing downturn ranks, by several measures, as the worst since the Great Depression, it’s quite likely we will see an unusually high number of foreclosures. It’s important to understand the magnitude of the defaults because that would provide color on the mortgage losses that banks will face.
I concede that it’s extremely difficult to estimate the number of future foreclosures, however I believe that by employing some thorough analysis one can at least come up with a ballpark figure that could be useful.
In my previous post I concluded that homes prices are likely to fall by around 30% from peak to trough which will be reached by early 2010 if not sooner. According to the following graph, that kind of price depreciation will lead to 20 million homeowners being underwater on their mortgages; that is, their mortgage balances will exceed the value of their homes.
Graphic by Calculated Risk, Data by First American
Since most mortgages are non-recourse, homeowners with negative equity have an enormous incentive to simply mail their keys to their lenders and abandon their homes. Of course, the majority of homeowners won’t do this for at least three reasons: first, they may believe their homes are worth more than what the statistics say; second they would not want to damage their credit rating which would hamper future borrowing; and third, they would want to avoid the social stigma of foreclosure.
That said those people who speculated in residential properties are likely to mail in their keys and accept an investment loss. Also, those people who suddenly need to move will realize that they can’t quickly sell their homes for a high enough price to pay off their mortgage balance and will instead simply default.
However, in most cases negative equity will only lead people to foreclosure when they are facing financial difficulties at the same time and are having trouble servicing their debt. Refinancing or selling their houses, options which in the past saved delinquent homeowners, are now off the table.
A major ticking time bomb is rate resetting mortgages which are widespread and, as the following graph shows, hundreds of billions of dollars worth of them are about to reset to much higher rates.
As a side note, this graph fails to convey that the majority of the option adjustable mortgages will begin to recast next year rather than 2011 as depicted because most borrowers have been paying only the minimum required resulting in negative amortization which has caused their mortgage balances to reach their principal caps much sooner.
Many of these homeowners will come to the realization that it doesn’t make sense for one to give up most of his income to service a mortgage with an 8% interest rate on a house that is worth less than the amount of the loan.
I believe it’s safe to assume that one-fifth of all homeowners with negative equity could ultimately default on their mortgages. So if home prices fall by 30%, 20 million homeowners will have negative equity and 4 million mortgage borrowers could default.
Plus another one million homeowners with positive equity could also face foreclosure due to an inability to maintain mortgage payments arising from resetting interest rates or loss of jobs (after all, we’re in an economic downturn with rising unemployment) with no option to refinance.
Thus, we are facing 5 million foreclosures or 10% of all owner occupied homes with some mortgage. Already the delinquency rate is spiking as the following graph shows:
Source: Federal Reserve
If lenders try salvage part of their investment by foreclosing on millions of homes and dumping them onto the market, the supply of existing homes for sale would surge from its current level of 4.5 million which is equivalent to 11 months of supply at the current sales pace. This would prevent a housing recovering from taking form for many years.
Now it is quite likely that major government intervention could significantly reduce the number of foreclosures — but the losses will then have to be absorbed by taxpayers as well as by lenders. In any case, the US economy will suffer.