What Lies Behind Higher US Negative Equity, Default Rates
With hindsight it is obvious that the explosion of new types of mortgages was a major cause of the US housing bust by increasing the likelihood of negative equity and subsequent loan defaults. New research published by the Bank for International Settlements gives that theory some underpinning and attempts to quantify its impact.
Author Luci Ellis of the Reserve bank of Australia writes that the relationships between the characteristics of mortgages and the incidence of negative equity in a housing bust help explain why US households have fallen into negative equity in greater numbers, and experienced more financial distress, than might have been expected from past experience in the United States and elsewhere.
“US households were more likely to take out high- Loan-to-Value loans, and loans with interest-only or negative amortization features, than seems to have been the case in other countries. The refinancing boom of 2003–04, as well as the frequent refinancing embedded in subprime mortgage contracts, meant that an unusually large fraction of US mortgages was quite young, and had built up little equity since origination. In
addition, the regional concentration of both the boom and the bust in prices probably added to the incidence of negative equity in the early stages of the bust.”
Ellis calculates that, for example, a 30% decline in housing prices over three years would result in almost 20% of negative amortization borrowers being in a negative equity situation, more than double the percentage for amortizing mortgages.
Households in negative equity might be more likely to actually default in the United States, for example, because unexpected health care cost shocks could disrupt their finances in ways that occur less often in countries with other health insurance arrangements, Ellis argues.”If a country has a greater rate of churn in its labour market than others, it might also imply that more households face the negative income shock of job loss, for any given unemployment rate. The availability of mortgage payment insurance or other resources to help households withstand income shocks could also affect the propensity for negative equity to translate into actual defaults.”
“The upsurge in arrears and default rates on US mortgages in recent years had many interrelated causes. Institutional factors that made households in negative equity more prone to default were clearly one set of
contributing factors.”
Perhaps more important, though, is that the types of mortgages on offer in the United States were more likely to have features conducive to pushing the borrower into negative equity if housing prices subsequently fell.
For details see: How many in negative equity? The role of mortgage contract characteristics
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