First American Core logic just released its report on the number of homeowners who are underwater on their mortgages. The storm waters continue to rise.

In all, more than 11.3 million, or 24 percent, of all residential properties with mortgages, were underwater at the end of the fourth quarter of 2009, up from 10.7 million or 23 percent at the end of the third quarter of 2009.

An additional 2.3 million mortgages were approaching negative equity at the end of last year, meaning they had less than five percent equity. Thus even though the Case Schiller indexes have been showing a slight rise in housing prices during the fourth quarter, an additional 600,000 homeowners slipped below the waves during the quarter.

Here are the highlights of the report:

“Negative equity continues to be concentrated in five states: Nevada , which had the highest percentage negative equity with 70 percent of all of its mortgaged properties underwater, followed by Arizona (51 percent), Florida (48 percent), Michigan (39 percent) and California (35 percent).

“Among the top five states, the average negative equity share was 42 percent, compared to 15 percent for the remaining 45 states. In numerical terms, California (2.4 million) and Florida (2.2 million) had the largest number of negative equity mortgages accounting for 4.6 million, or 41 percent, of all negative equity loans.

“The net increase in the number of negative equity borrowers in Q4 2009 was 620,000, with the largest percentage increases occurring in Nevada, Georgia and Arizona. Among the states with the highest negative equity shares, California had the smallest increase in the negative equity share, which only rose 0.4 percent to 35.1 percent.

“In numerical terms, Florida had the largest increase in the number of negative equity borrowers rising by more than 141,000, followed by Georgia (65,000) and Illinois (55,000).

“The rise in negative equity is closely tied to increases in pre‐foreclosure activity and is a major factor in changing homeowners’ default behavior. Once negative equity exceeds 25 percent, or the mortgage balance is $70,000 higher than the current property values, owners begin to default with the same propensity as investors.

“The aggregate dollar value of negative equity was $801 billion, up $55 billion from $746 billion in Q3 2009. The average negative equity for an underwater borrower in Q4 was ‐$70,700, up from ‐$69,700 in Q3 2009. The segment of borrowers that are 25 percent or more in negative equity account for over $660 billion in aggregate negative equity.

“Of the over 47 million homeowners with a mortgage, the average loan to value ratio (LTV) is 70 percent. More than 23 million, or 49 percent of all homeowners with a mortgage, have at least 25 percent equity in their home and over 12 million have at least 50 percent equity in their home.”

While not everyone who is underwater on their mortgage is going to default, the expected rate of foreclosure among people with positive equity (above water) in their homes should be zero.  After all, it’s better to sell the house and have some cash in your pocket (but not have the house) than to just let the bank take it and have no cash.

If someone lives in the house and has kids in school, they are not going to pull them out of the school for just a few thousand bucks.  A house is more than just an investment, it is a home.

However, those non-economic considerations are not unlimited. If they did not exist, then the economically rational thing to do would be to default almost as soon as the value of the house fell below the value of the mortgage. Investor-owned properties tend to behave that way because investors don’t have the psychological attachments to the property.

The real danger point (from the point of view of the mortgage holders) tends to be when people are underwater by more than 25%. At that point, the value of the little marks on the wall at each kid’s birthday or Christmas simply gets overwhelmed by the fact that continuing to pay on a $300,000 mortgage on a house that is only worth $200,000 is just a waste of money.

The following graph comes from the report (via Calculated Risk). To the left of the line, people are above water, and to the right of the line they are above water.
 

 
Generally the people to the left of the line will cure their delinquencies before the home is actually taken over by the sheriff, by selling if need be. Notice that investors are more “ruthless” about defaulting than are owners who live in the houses at all depths of water, but at around the 25% underwater point (Loan to Value of 120-125%) there is a real inflection point in the behavior of owner occupiers.

Since the deep underwater houses are very concentrated geographically , look for foreclosure activity (or short sales) to soar in the hardest hit states. Nevada just simply looks like a basket case, with more than half of the homes with mortgages having mortgages that are at least 25% higher than the current value of the house.

Note that the first four states on the graph were the poster children for the housing bubble. Michigan is a different story; there the state is losing population and as a result has too few people for the existing stock of houses, rather than having too many houses built for the population during the bubble.
 

 
However it is worth noting that there are many areas of the country where housing prices are still comfortably higher than most people’s mortgages. The final graph (from http://www.calculatedriskblog.com/) shows the number of houses with mortgages that are either underwater (blue), or just have their nose above the waves (less than 5% positive equity, in red). It is also a good answer to a trivia question, what does New York have in common with Oklahoma?

Note that there are several states for which the data was not available. The houses that are underwater are the houses that are in the shadow inventory of houses that are likely to come on the market. That means that housing prices will be under more pressure in places like Nevada and Arizona than they will be in New York or Montana. This is despite the fact — indeed, in part because of the fact — that housing prices have already fallen far more in Las Vegas than in Tulsa.

There is a self-reinforcing downward spiral to housing prices. When the extraordinary government support to the housing market ends this spring — the first-time buyer tax credit and the Fed buying up $1.25 Trillion of mortgage backed securities, mostly those backed by Fannie Mae (FNM) and Freddie Mac (FRE) are the two most important — we will probably see another down-leg in housing prices, and the worst of it is likely to be in those areas that are already hard hit.

There is a relationship between the unemployment rate and the percentage of underwater homes, but it is far from exact. Montana and North Dakota have some of the lowest unemployment rates, while the rates in Nevada, Florida and Michigan are well above the national average.

However, there are several high unemployment states such are South Carolina and Rhode Island that are squarely in the middle of the pack, while Idaho and Utah have below average unemployment rates yet have relatively high numbers of underwater mortgages. When someone is underwater on their home, and also becomes unemployed, the risk of foreclosure really shoots up.

Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market beating Zacks Strategic Investor service.

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