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Negative equity--a novel solution: a growing number of homeowners are underwater on their mortgages. An idea to credit a greater share of monthly mortgage payments early on to principal, rather than to interest, could offer a solution.

One of the problems with the American housing market today is that hundreds of thousands of subprime and non-sub-prime borrowers are in a negative-equity position. Equity, as we all know, is the difference between the market value of the property and the amount of the mortgage's outstanding principal balance. To be in a negative-equity position means that more is owed on the property than the property is worth. (Other colloquial expressions for this situation are "being upside-down" with respect to the loan and "being underwater").


The new danger is the fraction of alternative-A and prime borrowers who are upside-down on their mortgages. This is estimated by Moody's, West Chester, Pennsylvania, to be about 10 percent and increasing. This current situation is the outcome of the severe residential real estate price declines of the last two years.

Were even 15 percent of these 10 percent negative-equity homeowners to default and be foreclosed upon, the effects on the rest of us would be calamitous. If I use as an example my estimate of a 15 percent foreclosure rate for otherwise good, but underwater, borrowers, I estimate that would mean another 750,000-plus housing units on the market---almost doubling the coming deluge from subprime borrower foreclosures.

This is just part of today's deteriorating house-price tale. Home builders, apparently still believing in both Santa Claus and the Tooth Fairy, were continuing to start construction at the rate of at least 500,000 housing units per month in late 2008. Using four months as an average completion time, this will lead to at least another 2 million unsellable homes by this summer. The excess residential real estate supply is now 2-million-plus over normal times (4.5 million in total), according to Inside Mortgage Finance. And as we all know, these times are not normal. The situation is deteriorating as the latter number grows by 10,000 per day.

In my view, none of the proposals for redress discussed so far has a chance of keeping even a small fraction of subprime borrowers in their homes. Minor variations, borrower by borrower, of standard workout procedures will not work. Non-subprime, nonconforming borrowers, who now find themselves in an upside-down position, have been left out of President Obama's $75 billion plan.

What is desperately needed is a rapidly acting, relatively inexpensive, non-inflation-producing method of significantly limiting the forthcoming flood of housing stock from regularly paying homeowners in a negative-equity position. I believe the idea described in this article can materially help hundreds of thousands of families underwater on their loans. I estimate this would prevent, or at least forestall, some hundreds of thousands of unnecessary foreclosures. Doing so, in turn, would also slow the so-far neverending decline in housing prices. Implementing this approach would also preserve the residual equity in our homes.

What is this breakthrough concept? The idea is to reverse the customary accounting of the principal and interest components of the monthly mortgage payment until a zero-equity position is reached. It is that simple. If this is done, then it can succeed in speedily changing many upside-down borrowers to right-side-up borrowers.

The cost to taxpayers of helping current non-subprime borrowers who are in a negative-equity position? Assume that if this proposal is enacted, there will be an average $20,000 interest loss per loan spread over 750,000 liens. If so, then the federal government can make the lenders whole for only $15 billion. This is less than 20 percent of the $75 billion in the Obama foreclosure-prevention plan, it will assist hundreds of thousands more families and is nowhere near the much higher numbers sometimes bandied about.

The arithmetic of negative equity

A typical family

Let's go back two years. Then, the financial resources of the average American family totalled about $85,000. Half of this was the equity in their homes. The median home price was about $220,000.

Confounding the mean with the median, these figures imply that the typical loan-to-value (LTV) ratio was about 80 percent. This conforming level of equity, i.e., 20 percent, is very important. One reason is that once a homeowner's equity drops even a few percentage points below 20 percent, the probability of default rapidly escalates. This statement is based on decades of borrower payment behavior on tens of millions of home loans.

Suppose that two years ago a house was purchased, or a home loan refinanced, for the median amount of $220,000. Imagine that this family made the then-median annual household income of $55,000. Further envision the buyers made a down payment or had residual equity equal to the prudent level of 20 percent of the new mortgage amount--in this instance, $44,000. Then, the face value of their new lien would be $176,000 (=$220,000 - $44,000).

Finally, assume that they obtained a then-conforming interest rate of 5.75 percent per year. The other aspects of the lien were that it had a 30-year term; was fully amortizing; had a level, monthly payment; and was at a fixed rate (i.e., the traditional kind). The corresponding monthly payment is $1,030. (All numbers have been rounded in a numerically appropriate fashion, and the traditional version of a mortgage is assumed from now on.)

Today the situation is different. At present, housing prices in this family's neighborhood are down by 25 percent, so the market value of their property is $165,000 (= 0.75 x $220,000). Two years after origination, their unpaid principal balance is $171,300. Their equity at this point is equal to $165,000 -$171,300, or -$6,300--the family is in a negative-equity position.

Their situation could have been much worse. Had just 10 percent been put down, then the face value of the mortgage would have been $198,000 (= 0.9 x $220,000). The monthly payment for this amount, at 5.75 percent per year, is $1,160. The remaining principal balance after two years would be $192,800. With a steeper housing price decline of 30 percent, the market value of the property would only be $154,000 (= 0.7 x $220,000). The revised equity position is equal to $154,000 - $192,800, or -$38,800.

A low-income, subprime borrower family

If a typical low-income, subprime borrower family bought a house two years ago, their current situation is truly dire. The purchase price of their house would have been less than the typical family's--say, 80 percent of the median amount, or $176,000. I also assume that their annual household income was also 80 percent of the median amount, i.e., $44,000.

Moreover, a low-income, subprime credit-risk individual rarely has any savings, so there was probably no cash down payment. Similarly, there was no cash to provide the initial funding for the escrow account. These normally out-of-pocket expenses would have been rolled into the mortgage amount. Let's assume further that the 5 percent closing costs were added in, too. This puts the face amount of the lien at $184,800 (= $ 176,000 + $8,800; $8,800 = 0.05 x $176,000). At a subprime mortgage interest rate of 10 percent per year, the resulting monthly payment comes to $1,620.

At the end of the second year, the unpaid principal balance is $182,600. If the housing market price decrease in the family's locale was 25 percent, then the property would only be worth $132,000 (= 0.75 x $176,000). As a consequence, the borrower's equity position is $132,000 - $182,600, or -$50,600. No life preserver has enough buoyancy to prevent someone who makes $44,000 per year, and who is this far underwater, from drowning. (Sorry.)

A higher interest rate, larger closing costs or a steeper price decline would each further reduce the equity level. For instance, a 12 percent per year interest rate combined with 7.5 percent closing costs (a mortgage amount of $189,200 with a monthly payment of $1,950), and a 35 percent housing-price decline (a current market value of $114,400) puts the net negative equity at $73,300. (The unpaid principal balance was $187,700.)

A high-income, subprime borrower family

Being a subprime credit risk means a higher interest rate is needed to compensate for the more likely chance of delinquency followed by default, with the subsequent losses to the lender. So, a high-income, subprime borrower is not going to get a lower interest rate than a low-income, subprime borrower. Moreover, if these subprime borrowers sought a larger home loan to buy a more expensive house, an even higher interest rate would be demanded because of the increased potential loss severity.

Suppose they bought a $450,000 house with no money down, 7.5 percent closing costs and the initial funding of the escrow account all rolled in. The latter two features represent 11 percent of the purchase price, bringing the total amount borrowed to $500,000. Let's assume an interest rate of 12 percent per year, which means the monthly payment would be $5,140. If the fraction of the gross income devoted to mortgage payments is 40 percent, then the annual household income would have to have been $155,000.

After two years, the outstanding principal balance is $496,100. If the price decline in the family's neighborhood has been 25 percent, then their negative-equity amount would be $158,600.

An upper-middle-class family

Consider a different case--that of a family who bought a $700,000 home with an 80-10-10 mortgage. The 80 refers to the 80 percent LTV of the first mortgage. Eighty percent of $700,000 is $560,000. One of the 10s refers to the cash down payment ($70,000) and the other 10 refers to the second mortgage ($70,000) they are simultaneously taking out to cover their cash deficit. Using this approach, many families have purchased homes they couldn't quite afford. As a result, they spent a year or two or three being "house poor."

With the same 5.75 percent per year interest rate, the first mortgage's monthly payment comes to $3,270. The monthly payment for a $70,000, 8 percent per year, 10-year second lien is $850. Note that applying 33 percent of the family's gross annual household income to mortgage expenses implies an income of $150,000 per year was necessary. If they have an automobile loan, a student loan or any other long-term debt obligation, then they are likely to be beyond prudent underwriting standards.

It is now two years later, local housing prices have declined by 30 percent (i.e., the property is now worth $490,000) and the remaining principal balances on the family's mortgages are $545,200 and $60,100, respectively. Their net negative-equity amount is equal to $115,300 (= 0.7 x $700,000 - $545,200 - $60,100).

Note the family is in this fix because of the second mortgage. Had they saved for a rainy day and managed a 20 percent down payment, their negative-equity position would be a less-daunting $55,200 (unpaid principal balance = $545,200.) In any case, as they owe more on their real estate than it is worth, one might be tempted to conclude the rational thing to do is to stop paying. This is a result they--and more importantly, we--do not want.

Keeping us from paying any more than we have to

Instead of going into the computational details of how the amortization of a fully amortizing mortgage works, look at Figure 1. It illustrates the slowly declining part of the constant monthly mortgage payment going toward interest. It also illustrates the slowly rising part of the monthly remittance going toward the reduction of the outstanding principal balance.


The graph was constructed for a traditional lien with a face value of $100,000 and an interest rate of 6 percent per year. (Everything in the figure scales with the par amount, so the absolute value is irrelevant to the form and timing of the curves.)

Knowing this, how can we--income-tax-paying Americans--invent something that can keep families from defaulting who are on the edge of defaulting (due to their negative-equity position)? Appreciating the accounting details of a monthly mortgage payment, there is a simple way to make an upside-down borrower right-side-up, and in a reasonable amount of time: It is to reverse the attribution of the interest and principal components of the monthly remittance. In other words, in the early life of a mortgage instead of the larger portion of the monthly payment going to pay interest on the remaining principal balance, devote it to the reduction of principal and vice versa.

Even better is to devote the entire monthly payment to principal reduction. This will speed things up by about 20 percent because, two years after origination, the ratio of principal to interest components is about 0.25 on the base case home loan. An even faster mechanism to rectify the situation is to vigorously suggest to the homeowner that he or she make significant curtailments. (A curtailment is an early repayment of part of the outstanding principal balance.) In some circumstances, such additional partial principal payments can be quite high without further increasing the probability of a delinquency. Also, since the supplementary principal amount is not an obligation, it can be minimized if default threatens.

The typical family reconsidered

Return to the typical family case. For the 5.75 percent per year, $176,000 home loan, the monthly remittance was $1,030. At the end of the second year of occupancy, $820 of the $1,030 is going to pay interest and $210 goes toward reducing the outstanding principal balance. My proposal is to transpose the accounting--credit the $820 to abatement of the remaining principal amount and the $210 to interest.

The family's equity position after two years was a negative $6,300. How long will it take, if we reverse the ordinary accounting of interest and principal, for the negative-equity position to become a positive-equity one? Merely eight months. Within this eight months' turnaround of payment structure, a total of $6,600 will have been transferred to principal reduction.

With a short eight-month time horizon to an equilibrium state, our struggling borrower would be greatly motivated to hang on, thereby keeping his or family in the home, diminishing their financial stress level, maintaining their credit rating and staying out of bankruptcy court. The latter is an outcome we want, too.

Even the investor wants it, although the investor has to pay for it. Why? Compared with a now-typical 45 percent loss severity on a foreclosure, forgoing $10,000 of interest is much better than a loss severity of $77,100 (= 0.45 x $171,300). If you think a 45 percent loss is too high, then use last year's value of 30 percent: 30 percent of $171,300 is $51,400.

(The reader should be aware that the interest computation is complicated by two factors: one is a small time value of money aspect that is being ignored. The second is known as negative amortization--when a borrower's monthly payment is insufficient to cover the interest due, then the shortfall is added to the unpaid principal balance. As a result of this augmentation, the interest component of next month's fixed payment would be higher yet. Were there to be another deficit, then the missing interest due would again be added to the unpaid principal balance, and so on. As a result, the investor is losing out on more interest, say $10,000, than the straightforward calculation of $6,600 would indicate.)

In the 10 percent down-payment situation, the equity position was -$38,800. Now it will take 3.5 years to become right-side-up. (The monthly expenditure is $1,160, of which $925 is credited to interest two years after origination.) What else can be done? As suggested earlier, have the homeowner make reasonable curtailments.

In this illustration, the annual household income was assumed to be $55,000. This value, plus the amount of the mortgage payment, means that only 25 percent of the family's gross income is going to mortgage payments. If curtailments are added to stretch this to 38 percent, then an additional $580 per month is available to quicken the reduction of the unpaid principal balance.

If this course of action were diligently followed, then 42 months become 26 months. Without losing overtime pay, the disappearance of a spouse's part-time job, a large medical bill or the need for a new (used) car, this family can reach a positive-equity position in the foreseeable future via the combination of accounting reversal and curtailments.

An upper-middle-class family reconsidered

Now let us review the situation of the upper-middle-class family. With 20 percent down, the family's negative-equity amount was $55,200. The monthly payment was $3,300. At the end of two years, the amount dedicated to interest is $2,620. It would require 21 months for this family to become right-side-up using my proposal.

Assuming that their mortgage payment to income ratio could be stretched from 33 percent to 38 percent, then their monthly curtailment could safely be $460. Devoting the amortization schedule's monthly interest plus a $460 curtailment per month to principal reduction puts their heads above water after just 18 months.

So, what about the lender this time? In exchange for not having a loss severity in foreclosure of $164,000 (= 0.30 x $545,200), the lender gives up almost $50,000 in interest. Which option would you choose? Plus, if the investor takes the deal, he or she gets this problem off the books and off his or her mind.

The real world No. 1

The real-world problem with this or any other good idea is the dispersion of the ownership of mortgage-backed securities (MBS). Identifying and locating these people would be an onerous undertaking. Moreover, the covenants of a mortgage-backed security frequently require that at least half, and sometimes two-thirds or more, of the owners have to agree in order to alter some aspect of the underlying home loans.

Permitting a standard workout--which won't work sub-prime borrowers out of their financial difficulties--is one example. Implementing a novel idea like this en masse would be another.

So, in practice, the only method to provide any kind of significant assistance to underwater borrowers appears to be for some entity to purchase the entire mortgage-backed security(ies)--e.g., the federal government. In other words, "the bad bank" solution.

Lastly, if you or I wanted to invest in mortgages per se, there are many mutual funds in which we could have placed our funds. Similarly, if we wanted to invest in residential real estate, there are many real estate investment trusts (REITs) where we could have placed our funds. Making mortgage or real estate investments via the U.S. Treasury is not my preferred option. Nonetheless, in our own self-interest, I believe we have to do so. For the underwater homeowners, it can be accomplished with a low cost to those who will have to bear the burden.

The real world No. 2

There is another, much simpler, way this unique workout technique could be implemented: Leave it up to the servicer. The firm providing the servicing and loan administration function knows the payment behavior of the homeowner best. The servicing company can also easily make a determination of the homeowner's equity position.

With this information, let the servicer decide which alternative-A and prime borrowers in a negative-equity position could be fairly quickly turned around by a combination of the reversal of the principal and interest accounting plus curtailments. The servicer can contact these homeowners and forcefully suggest cooperating with the modifications. It does so without notifying the investor. No notification of the lender is necessary because the federal government picks up the tab for the full amount of forgone interest. Doing so means there is no true negative amortization, for the investor has been made whole. Lastly, succeeding with this plan will do a social good while preserving most of the remaining equity in peoples' homes.

I believe this idea will go far toward preventing unnecessary negative-equity-based foreclosures, slowing the decline in housing prices and keeping our costs to a minimum. Nothing I have seen or heard comes close to delivering these benefits in the real world. Neither standard workouts nor minor variations of a standard workout can so significantly diminish the looming, very large, negative-equity-based problem our housing system faces.

Laurence G. Taff worked at Fannie Mae for seven years. where he served as an internal and external consultant and as the firm's principal international consultant. He is the author of investing in Mortgage Securities (American Management Association. 2003) and Mortgage Banking Technology (Mortgage Bankers Association. 2004). This article is a condensation of part of his forthcoming book. The Sub-Prime Mortgage Mess. The Credit Crunch, and 2010+.
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Title Annotation:Housing Economics
Comment:Negative equity--a novel solution: a growing number of homeowners are underwater on their mortgages.
Author:Taff, Laurence G.
Publication:Mortgage Banking
Geographic Code:1USA
Date:May 1, 2009
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