Michael Williams - Community Development Financial Analyst
Published October 1, 2012 | October 2012 issue
Despite promising signs that home prices have stabilized or even inched upward, many homeowners remain mired in negative equity. Having negative equity, or being “underwater,” occurs when a borrower owes more on a mortgage than the current value of the property securing the loan.
Being underwater reduces a homeowner’s net worth and has additional, often ongoing, consequences for both the homeowner and his or her neighborhood. Despite historically low interest rates, underwater homeowners who opt to remain in their homes are typically unable to refinance into lower monthly mortgage payments. Furthermore, they may have to delay home repairs and improvements due to a lack of home equity. Those looking to move also face real barriers as additional out-of-pocket funds are required to pay off the loan at the time of sale. Ultimately, a borrower who is severely underwater may choose to strategically default on the mortgage, adding the property to the pool of homes in foreclosure. These consequences ensure that underwater mortgages remain a drag on the greater economy.
According to a report released in July 2012 by CoreLogic, a national financial, property, and consumer data analytics firm, 24 percent of residential properties in the U.S. with a mortgage were in a negative equity position at the end of the first quarter of 2012.1/ This rate, though exceptionally high by historical standards,2/ actually represents a 2 percent decrease from the end of the fourth quarter of 2011.
The Ninth Federal Reserve District has not dodged the negative equity problem, though it has fared better than the nation as a whole. According to the CoreLogic report, statewide negative equity rates in the Ninth District range from 6 percent of mortgages in North Dakota to 36 percent in Michigan. However, the Michigan figure is largely driven by the housing market in and around Detroit, which lies outside the Ninth District. Excluding Michigan, the state in the Ninth District with the highest rate of negative equity is Minnesota, at 18 percent.
While the underwater mortgage data CoreLogic released publicly in July are useful, they do not contain enough geographic detail to provide a sense of what’s happening at the community level. To better understand the distribution of underwater mortgages in the region we serve, the Community Development Department of the Federal Reserve Bank of Minneapolis developed a ZIP Code area indicator that shows the percentage of first-lien mortgages that are underwater in the Ninth District. Our analysis reveals that the greater Twin Cities area of Minnesota is the epicenter of the District’s underwater mortgage problem.
To create our indicator of underwater mortgages, we combined data from two purchased datasets: the CoreLogic Home Price Index, which measures the change in home prices throughout the country; and home value and loan balance data from the Applied Analytics Residential Mortgage Servicing Database, a dataset from a mortgage-tracking firm called Loan Processing Services (LPS). The home value from LPS represents the sale or appraised value of the home when the mortgage was originated, dates that range from 1976 to 2012. We estimated the current value of the property by multiplying its value at loan origination by the subsequent percentage change in the CoreLogic Home Price Index for the property’s ZIP Code area. The resulting estimate of current value was then compared to the current loan balance available from LPS.
Our approach presented a number of measurement issues. First, only first-lien mortgages were used in the comparison to home values. Thus, the actual negative equity rate is likely higher than our calculations indicate, since first mortgages issued prior to 2007 were frequently bundled with second mortgages (so-called “piggyback” mortgages). Also, because home values are seasonal, in that they tend to decline in the winter months and peak in summer, measurements of negative equity fluctuate significantly throughout the year.
An analysis based on our indicator shows that 16 percent of first-lien mortgages in the Twin Cities area are underwater, the highest rate for any specific area of the Ninth District. These mortgages are clustered primarily in exurban parts of the Twin Cities metro, but pockets also exist in the inner city and in inner- and outer-ring suburbs.
The District-high rate of underwater mortgages in the Twin Cities area stems from a steep rise in home values that preceded the recent economic downturn. According to the CoreLogic Home Price Index, home values in the Twin Cities metropolitan area increased at an average annual rate of 11 percent from January 2000 until reaching their peak in April 2006. As home values declined, homeowners sank deeper underwater, beginning with mortgages originated in 2006 and spreading to older and then newer originations. Due largely to the high levels of sales activity during the run up in home prices, 47 percent of currently underwater mortgages in the Twin Cities area were originated prior to 2007.
The map below, which is drawn from the results of our indicator-based analysis, illustrates the distribution of underwater first-lien mortgages within the Twin Cities market. It shows that areas especially hard hit include the East Side of St. Paul, Brooklyn Park, Brooklyn Center, Farmington, Woodbury, and several suburban and exurban areas in Wisconsin and the northwest metro.
It follows that areas where a large proportion of mortgage originations occurred at or near the height of the housing bubble would be hit particularly hard. The 55040 ZIP Code area of the city of Isanti fits this description. The population of this exurban city boomed during the first half of the 2000–2010 decade, more than doubling from 2,324 residents in 2000 to 5,206 in 2006. Many of these new residents were first-time home buyers seeking more affordable lots farther from the central cities. Forty-three percent of first-lien mortgages in Isanti were originated prior to 2007, and 57 percent of first-lien mortgages in Isanti’s 55040 ZIP Code are now underwater.
In the core of the metro area, the 55130 ZIP Code, which makes up a large portion of St. Paul’s East Side, also has one of the highest rates of negative equity. Here home buying continued at relatively high levels into 2009 and 2010. Nearly 80 percent of outstanding first-lien mortgages that are currently underwater on the East Side were originated after 2007. Despite the continuing market activity, home values have steadily declined and negative equity has become entrenched.
In addition to examining the geographic distribution of first-lien mortgages that are underwater, we looked into the “depth” of the underwater problem, in terms of determining which vintage of mortgages has the highest underwater rate. Not surprisingly, we found that first-lien mortgages from 2006—the height of the housing bubble—that are still outstanding are the furthest underwater. Fifty-three percent of this cohort is estimated to be underwater in the Twin Cities area. An additional 10 percent of borrowers with first-lien mortgages originated in 2006 are estimated to have less than 5 percent equity in their homes.
As the map indicates, many areas of the Twin Cities are contending with high rates of negative equity. Pockets in other regions of the Ninth District are seeing high rates as well, although not as high as those in the Twin Cities metro. In an effort to monitor mortgage conditions and their effects on the broader economy, we are conducting ongoing analyses of mortgages in the Minneapolis-St. Paul area and other parts of the Ninth District. The results will be posted on the Minneapolis Fed’s web site at www.minneapolisfed.org as we produce them. Our hope is that ZIP Code-level calculations of current housing market conditions, including but not limited to analyses of negative equity, will provide policymakers and community organizations with an additional tool for engaging in their foreclosure prevention and outreach efforts.
2/ Many housing experts argue that a healthy housing market should have fewer than 5 percent of mortgages underwater.