Correcting a Misconception about Home Equity

Note: We had hoped to deliver a FDIC Bank Closure Report today, but no banks were closed since last Friday.

We have been hammering on the shocking lack of home equity that most owners with mortgages in the USA actually have. This short article explains the situation mostly very well (and has a nifty chart to boot), but overlooks one critical point: about one-third of homeowners own their homes free-and-clear, that is, having no mortgage. We will explain why this is so important.

First, a brief quote from the article (bold added):

"When value falls and debt stays the same, equity gets crushed (See The Problem With Debt). If house prices end up falling more than 40% peak to trough, which seems likely, U.S. homeowner equity will drop more than 70% and as many as half of American mortgage holders will be underwater."

This is not correct. If homeowner equity drops more than 70%, virtually every mortgage holder will be underwater. Using figures from the article, at present the value of all houses is about $18 trillion and the amount of mortgages is $11 trillion, which leaves $7 trillion of equity. If you take into account that about one-third of homeowners do not have a mortgage, this means that about $6 trillion of houses is owned free and clear, and $11 trillion of mortgages is on $12 trillion of houses.

All that it would take to put the group of homeowners with a mortgage under water is just another drop of $1 trillion, or a little over 5% of the current value. Of course some would be very underwater, and some not at all, but the overall situation is quite precarious. This is very bad for the homeowners who can't sell if they want to, and can't refinance because there isn't enough equity.

It is even worse for the banks, and the Federal Government. Once that 5% additional drop happens, even prime mortgage portfolios are truly junk investments since the collateral no longer covers the principal amounts. A peak to trough 40% devaluation as suggested by the quoted article will bring many trillions in losses to the Federal Government, and ultimately the taxpayer. Underwater homeowners - either unable to make mortgage payments, or having little incentive to do so even if they can afford them - will 'walk away' en masse.