Tracing the Trail of Relief
Negative equity, valuation methods play key roles in determining which troubled borrowers gain from assistance plan
By James R. Follain, Ph.D., and Barbara A. Follain, Cyberhomes Contributors
Published: May 16, 2008
The remedies being proposed to address the subprime mortgage mess focus upon a subset of those affected by the housing slump: certain distressed borrowers in areas in which the risk and reality of foreclosure are most prominent, and the lenders and investors who own the original loans of the distressed borrowers. The borrowers would have an opportunity to obtain a new loan that is more affordable and less prone to foreclosure. The lenders would also receive some payments in return for a commitment not to foreclose and seek additional payments from the borrowers. Let’s take a look at how some foreclosure relief funds might be distributed.
Example of a relief plan
One example of this type of remedy is a bill proposed by U.S. Rep. Barney Frank (D-Mass.). Distressed borrowers would be those with “negative equity,” the scenario when the outstanding mortgage balance owed by a borrower exceeds the current value of his or her home. For example, if a household owes $250,000 on its mortgage and the house is worth $200,000, negative equity is -$50,000. There may be other criteria to qualify for assistance, such as a requirement that the borrower lives in the home, is not seriously delinquent and has the income to support a new loan, but the key requirement is negative equity.
Why the focus on negative equity? Borrowers with negative equity are the most likely to default on a mortgage and trigger foreclosure proceedings by the lender. The evidence on this point is overwhelming and has been widely known for years. The exact amount of negative equity that leads a borrower to “walk away” or “turn in the keys” to the lender does vary among borrowers. A typical pattern is a sharp increase as soon as equity becomes negative, then rises more and more steeply as equity becomes more and more negative. If negative equity is -40 percent, the probability of default is in excess of 75 percent.
There’s also a belief, though it is less documented, that the current surge in foreclosure will be highly concentrated and lead to a damaging ripple effect upon property values of other homes in those neighborhoods. Hence, the proposed relief offers an opportunity to reduce the number of foreclosures and avoid additional house price declines that would affect a much wider set of homeowners.
A potential downside of this program is the uncertainty surrounding it. We have not had a program like this before, so it is quite difficult to estimate its total cost or to know how many people foreclosures would actually be prevented. It is even harder to know where the relief would be provided. We look at Los Angeles County to get a sense of how much the program might cost and how many people would be served. Implementing the Frank proposal.
Although details of the Frank proposal and others are still being developed and debated within Congress, here is our sense of how this proposal and similar ones would work:
- Borrowers with negative equity would be allowed to obtain a new FHA (Federal Housing Administration) mortgage equal to 90 percent of the current market value of the house. The borrowers would need to come up with the 10 percent down payment, which may be a challenge for some. The new loans would be no more than $729,750. The borrowers would also have to satisfy other underwriting criteria related to their ability to pay, credit score and loan size.
- The negative equity would be largely forgiven. However, there may be some provision that requires that the borrower make an additional payment to FHA in the future if the property appreciates and the borrower sells the house.
- The original lender would receive payment for a portion of the outstanding debt via the new loan and a payment from FHA. The lender must then promise not to pursue the borrower for any additional funds.
We apply this program to a group of purchase transactions of single-family houses in Los Angeles County in the fourth quarter of 2006 and who obtained a mortgage at the time of purchase. The average sales price of these 13,818 single-family homes was about $655,000.
This area seems like a logical area for assistance. House prices among all tiers of the market have declined by 18 percent. Price declines in the bottom tier of the market have been particularly hard hit. Since late 2006 house prices in the lowest tier (under about $500,000) declined by 21 percent, whereas prices in the top tier (above about $700,000) declined by 11 percent. Also, this is an area in which the current foreclosure rate is about 25 percent higher than the national average and more than 113,000 subprime mortgages are outstanding.
Estimating current property values
The last and most critical set of information needed to estimate how relief funds will be distributed are current valuations of the 13,818 properties purchased in the fourth quarter of 2006. This is necessary to identify those borrowers who have negative equity in early 2008 and, as a result, qualify for the relief funds.
There are many options to obtain such information. We use the value estimates generated by Cyberhomes. These are based upon state-of-the-art automated valuation models, which provide sound information in most cases and during most time periods. However, the range of these estimates can vary substantially depending upon a variety of factors, especially the availability of good comparable sales. When these are less available, the range of estimates can be substantial. For this reason, we also incorporate an alternative option: the Case-Shiller house price indexes. If the range of the estimates from Cyberhomes is judged to be large or unreliable, the current value estimate is generated using the Case-Shiller tiered price indexes for LA County. It turns out that this particular approach has quite a substantial impact on the results.
Here are some of the key findings of the analysis:
- Sixteen percent of the LA borrowers now have negative equity. The distributions at the time of purchase and as of February 2008 (given our assumptions) have made a substantial downward move, which indicates a much larger fraction of the population with lower equity. Most borrowers with negative equity have relatively small percentages, but more than 1,300 have negative equity of at least 10 percent and 150 have negative equity in excess of 20 percent. This is after just 15 months of ownership.
- Ten percent, or 1,362 households, are identified as eligible for the program. The total volume of new loans to these borrowers would be about $550 million. The average borrower would receive a loan reduction of about $13,000.
- Lenders will receive benefits. Lenders would receive an additional $17 million in payments to settle the original first loans if they are fully compensated for the outstanding debt, and $13 million if lenders received 75 percent of the outstanding loan balances due them.
Several distinctive characteristics of those eligible for the program can also be identified:
- They tend to be those who lost the largest amounts of house value in the past 15 months. They lost, on average, about $100,000 per property whereas the other 90 percent of the buyers lost about $17,000. Obviously, the distribution of property value reductions is quite dispersed around the average.
- They tend to be those with relatively high original loan-to-value ratios. For example, the average original loan-to-value ratio among those eligible for the new program was 84 percent, versus 71 percent for all others. About one third of the eligible borrowers had original loan-to-value ratios in excess of 90 percent.
- They were more likely to have obtained an adjustable-rate mortgage. About two-thirds of those eligible for the program held an adjustable-rate mortgage, versus about half of those who are ineligible. Some of these borrowers may have chosen loans with the potential for negative amortization and large interest rate resets, which may lead to even greater amounts of negative equity and more distress than our data can capture.
We find that the distribution of eligible loans within LA County is quite concentrated. More than a third of the borrowers are in the far eastern portion of Los Angeles County in ZIP codes 93534-93536 and 93550-93552. ZIP codes 93535 and 93552 contain the most eligible loans. Cyberhomes provides excellent information to help locate and summarize these areas. That median income is just below $50,000 and the average age of homes is about 20 years. You’ll also see the recent downward trend in house prices in this part of the county.
Implications for the policymakers
Cases can be made both for and against plans such as the Frank proposal. The ultimate success of any particular plan, however, will benefit from careful attention to implementation details and transparency regarding the rules used to allocate the funds. Otherwise, we can imagine a scenario in which the funds accomplish much less than promised — and substantial taxpayer discontent.
Our guess is that the outcomes generated by our analysis would be consistent with what policymakers and taxpayers have in mind from this program. The program focuses benefits toward those who own homes in the lower end of the house price distribution (at least in California), suffered disproportionate price declines, and likely suffer from the prospect of payment shock because of their disproportionate reliance upon adjustable-rate mortgages. Also, and importantly, the funds are geographically targeted to a half dozen ZIP codes in which the fallout from foreclosures may affect the property values of borrowers who still have positive equity and an incentive to continue their mortgage payments.
Though the estimates generated by this process seem reasonable, they clearly rest upon one critical assumption — the way in which current values were determined. It turns out that our choice of what constitutes a reliable house price estimate makes quite a difference. If we considerably widen the acceptable range of value estimates and reduce reliance upon the Case-Shiller index, the size of the program shrinks considerably to just 2.5 percent of the sample (332 households). The sensitivity of the results to this choice of valuation method highlights an important concern of any relief program — different valuation methods will generate different outcomes. The complexity will be acute in those areas in which the number of foreclosures is large and growing because under such circumstances it will be more difficult to obtain good “comps” not adversely affected by nearby foreclosure activity.
Our hope is that government regulators are hard at work doing similar kinds of calculations all over the country, and trying different parameters of the program. We would encourage them to focus upon two particular issues.
First, they will want to experiment with various measures of current value and invest considerable resources into the valuation of properties in areas in which foreclosures are large and growing. Second, we hope they will provide even more information about the distribution of the program benefits than we did. Our sense is that the larger population of non-recipients who have also been hurt by declining house prices will want to be reassured that the taxpayer-financed programs for distressed borrowers are being directed to areas in which the fallout of the foreclosure problem is most pronounced, and where the eligible borrowers have the capacity to meet their new obligations.