One in Four Homeowners Is Underwater

Written by Chris Titus, CFA

Language: English (business)
Level: Intermediate and above

Vocabulary:

• Underwater - when a borrower owes more than the home is worth because the home fell in value.
• Home equity = (Home Value minus Home Loan)
• ‘hardest hit' - experiencing the worst of something
• ‘the second shoe to drop' - means more bad news will come making the current situation worse.
• to land - to fall onto
• to saturate - cannot hold anymore. Image: a sponge full of water. The sponge is saturated.
• bloated - at or beyond capacity
• Leverage - Purchase something with debt. You own more assets working for or against you. Leverage can be very good or very bad...very quickly!
• ‘to bottom out' - to reach a bottom and move sideways.

Warm Up Questions:

• Has housing been a good investment over the long-term? Why?
• Is now a good time to buy into housing? Why?
• If you could buy a home today, where would you buy it and what kind of home would you buy?

Article

The amount of U.S. homeowners underwater has risen to 23%, jeopardizing the outlook for a sustained recovery in housing.  According to First American CoreLogic, a real-estate information company based in Santa Ana, CA, roughly 10.7 million households had negative home equity balances in the third quarter. The hardest hit states were Nevada, Arizona, and Florida. Underwater mortgages as a percentage of total mortgages ranged between 45% and 65%.  The high proportion of underwater mortgages is likely to be the second shoe to drop in the financial crisis. Many of these mortgages will land in bank foreclosure and the homes will further saturate an already bloated housing market. Economists don't expect U.S. home prices to bottom out until early 2011 due to a saturated market.

Questions:

• Why is the housing recovery in jeopardy?
• Why is having a mortgage that is underwater a bad thing?
• Which were the hardest hit states? Do you think the amount of borrowers underwater was very high? 
• Valuation is often a relative measure. What should the proportion of underwater borrowers be in a healthy market? Take a guess and explain your rationale. 
• What was the first shoe to drop? Describe the second shoe to drop. Will the second shoe have more of an impact than the first, or just delay a recovery? 
• If you live in Massachusetts, how much of an impact will you feel by a second round of real estate foreclosures in Nevada, Arizona, or Florida?

Activity

You are an investor who believes a second shoe is about to drop. How can you take advantage of this situation? Name different ways you could you profit. Name different ways you could protect your current investments.

Possible Answers:

• Cash: Have cash ready to make purchases after prices fall again. However, it would be best to wait until the market has bottomed out and begins rising again.
• Knowledge: Become familiar with the geographic areas that have high proportions of underwater borrowers. Learn whether your area will suffer the same problems. 
• Protect: Sell any properties ahead of the next fall in prices
• Rental Properties: Lock tenants into longer-term leases (at lower prices if necessary)
• Derivatives: Purchase credit default swaps that bet mortgages fail. This is for more sophisticated investors - typically institutional investors. Yes, these are the securities that got us into this financial mess.

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