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A Closer Look at Equity

Principles of Principal Reduction

Stuart Quinn    |    Housing Policy, Mortgage Performance

There has long been reluctance in establishing large scale principal reduction programs with robust government participation. As recently as February 2015, Federal Housing and Finance Agency (FHFA) director Mel Watt alluded to the agency’s continued analysis to determine the cost-benefit of implementing a targeted principal reduction campaign as an appropriate supplemental risk-mitigation technique for the government sponsored enterprises (GSEs). The assessment likely hinges on a few key questions and expands on a speech delivered by former FHFA director Ed DeMarco at the Brookings Institute in 2012. These considerations include, the difference between principal forbearance (or deferral) and principal forgiveness; the future of home prices and the general mission of FHFA. Properties that continue to remain underwater maintain higher levels of future default risk, while also diminishing the available tradable stock eligible for sale and purchase, directly impacting the number of existing owners participating in the marketplace (and available inventory). Our estimation is that if a policy decision does come from FHFA it will likely be targeted and may solely expand utilization of principal deferral as an option.

What is the Size of the Available Pool?

At the end of 2014, the rate of seriously delinquent loans (SDQ) held by the GSEs was 1.89 and 1.88 percent respectively for Fannie Mae and Freddie Mac.1 This is roughly the same percentage of SDQs they had in September of 2008, meaning the level is still elevated above the 0.5 percent pre-crisis levels, but has declined substantially from the peak. The SDQ metric for Fannie and Freddie also contains loans in foreclosure. Freddie disclosed that at year-end 2014, 2013 and 2012 approximately 53 percent, 61 percent and 68 percent of their SDQs were in foreclosure proceedings, respectively. Assuming that loans in foreclosure are unlikely to qualify for principal reduction due to their stage of distress, the remaining population of eligible loans becomes relatively small. However, the proper stage and requirements for eligibility would need to be determined by the FHFA. Taking a conservative approach and assuming 50 percent of the loans at the end of 2014 were in some state of foreclosure and applied across both Fannie and Freddie SDQ volumes, the net number of loans that were 90 days or more delinquent but not in foreclosure proceedings comes out to just under 265,000 loans. Given volume concentrations of SDQ in judicial states with lengthy timelines such as New York, Florida, Illinois and New Jersey, the number of addressable properties may be even lower than the 265,000 figure. Were a policy to be enacted, a net-present-value analysis would likely also be conducted on a loan-by-loan basis to determine eligibility.

Pace of Recovery in Different Jurisdictions

When CoreLogic began reporting on equity in the first quarter of 2010, three out of four properties in the Las Vegas-Henderson-Paradise Core Based Statistical Area (CBSA) were underwater, or worth less than the outstanding balance on their mortgage, the highest in the nation. That number has significantly decreased coming down nearly 50 percentage points and we further explored the change over time for a number of CBSAs. Figure one contains the top-ranked CBSAs in Q1-2010 based on share of underwater properties compared to the current share of underwater properties at the end of 2014. Three main features stand out:

  1. California CBSAs have made a remarkable recovery with Stockton, Modesto, Vallejo, Bakersfield and Fresno areas declining 48, 46, 44, and 34 percentage points respectively.
  2. The Midwest tells a different tale. In fact, the proportion of properties underwater as of Q4-2014 in Stockton, CA (16.3) is now less than Akron, OH (17.8); Cleveland, OH (19.1); Cincinnati, OH (16.9); Chicago, IL (18.5); Atlantic City, NJ (20.6); and Camden, NJ (17.1) despite Stockton’s negative equity being double those CBSAs in Q1-2010.
  3. Each CBSA from the top 35 list in Q1-2010 continues to have an elevated number of underwater properties, with at least 3 out of every 20 in negative equity.

If a policy of principal reduction is pursued, the agency will likely need to validate that they are targeting jurisdictions and individuals whose hardships are commensurate with the downturn, rather than reinforcing local policy decisions that could inhibit the rate of recovery. The Neighborhood Stabilization Initiative (NSI) under FHFA that targets the City of Detroit and Cook County, IL reinforces the approach of targeting slower recovering areas whose current home prices may not regain the market values reached during their peaks anytime soon.

How Far From Positive Equity?

To get a sense of how long an average underwater home would take to reach a positive equity position organically or without intervention, we took a look at a few key CBSAs and applied the CoreLogic Home Price Index (HPI) five-year forecast and amortized scheduled payments assuming a mortgage coupon of 5.22 percent based on national active mortgage rates.2 This analysis attempts to understand the average underwater borrower in specific localities, though, not all regions contain an equal proportion of properties in negative equity. For instance, the share of properties underwater in Dallas is less than 3 percent, while the proportion is over 18 percent in the Chicago area. However, our projections graphed in figure two indicate, the average amount of mortgage debt exceeding the market value of the home for that 3 percent of underwater properties will take longer to reach a positive position than the average of the 18 percent within Chicago. Our analysis indicates that the majority of the geographies forecasted will take nearly five to six years for the average underwater property to right side itself. When decomposed to determine if home price appreciation or principal pay down is a larger contribution to restoring equity in the first few years, there is variance between CBSAs, but the majority of the areas receive a larger contribution from the market recovery. For instance, in the first few years, Riverside, California’s home price appreciation contribution appears that it will outpace the scheduled principal payment, while the opposite is true in the Baltimore area.

<b>Figure 2: Recovering Equity in Select CBSAs</b>


The sensitivities and diversity of stakeholders impacted by principal reduction makes the policy decision particularly difficult to weigh and determine. The ramifications of strategic defaults, operational costs of implementing the program, incentive offsets within the principal reduction alternative program under Treasury and net-present-value calculations will all play a role in determining whether a change in policy makes sense.3 As the decision continues to remain under review, housing market appreciation and scheduled pay-down will continue to chip away at the 5.4 million existing homes in negative equity that continue to remain off-market, with the largest proportion of those homes residing in the lower value house price tier.

[1]Fannie Mae, p. 126; Freddie Mac, p. 101
[2] The data is sourced from CoreLogic True Standings Servicing data set and CoreLogic public records. The forecast uses the national average interest rate of 5.22 percent based on the weighted average interest rate of loans 90 plus days delinquent and in foreclosure, seasoned for four years and amortizes payments based on a fixed rate, 30-year schedule. The starting amount is the average mortgage debt outstanding less the average mortgage amount underwater. The CoreLogic HPI forecast is applied over the five-year horizon and then we use historical home price appreciation of 3 percent nominal growth (1 percent real with 2 percent inflation) for the remaining years.
[3] For further analysis on strategic default, see Bradley, et al., Strategic Mortgage Default: The Effect of Neighborhood Factors

The views, opinions, forecasts and estimates herein are those of the CoreLogic Office of the Chief Economist, are subject to change without notice and do not necessarily reflect the position of CoreLogic or its management. The Office of the Chief Economist makes every effort to provide accurate and reliable information, however, it does not guarantee accuracy, completeness, timeliness or suitability for any particular purpose.

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