Some 8% of all mortgages originated in the first nine months of 2022 were already underwater by year’s end, an eyebrow-raising statistic reported this past December by Black Knight. To put it another way, one in every 12 new homebuyers, or about 270,000 borrowers, owed more than their home was worth.
Oftentimes, buyers who take out Federal Housing Administration loans will walk away owing more than their home’s value due to the low downpayment requirements and the fact that closing costs can be rolled into the loan. Still, such a sizable number of new borrowers with negative equity in their homes is worrisome.
Every one of those borrowers is a family that risks being put through the hell of a foreclosure.
– Mark Calabria, senior adviser, Cato Institute
Questions are being asked about what could happen if home price appreciation stalls or declines with an accompanying recession leads to job losses. The average borrower will likely be fine even in a downturn, says Mark Calabria, a Cato Institute senior adviser. He’s primarily worried about more vulnerable borrowers, “the 10% to 15% tail risk,” or those on the lower economic rung who don’t have a lot of equity in their homes.
“That is enough borrowers that we should be concerned,” says Calabria, the former head of the Federal Housing Finance Agency (FHFA). “Of course, every one of those borrowers is a family that risks being put through the hell of a foreclosure.”
With existing mortgages, he points to debt-to-income (DTI) ratios as a troubling trend. As of September 2022, 30% of borrowers had mortgage payments that ate up more than 45% of their total monthly income. That’s the highest share in the past decade, according to the American Enterprise Institute. If these homeowners lose their jobs, it would be difficult for them to repay their mortgages on unemployment insurance.
“Now I recognize there’s some in the industry who feel that DTI is not a big deal,” Calabria says. “I’ll tell you what really kind of changed my mind on it in a big way was, the No. 1 predictor that we saw internally (at FHFA) in 2020 over who took Fannie and Freddie forbearance was DTI.”
Credit scores are another concern. Last year, the average FICO score on a conventional loan was 749, according to ICE Mortgage Technology. Calabria believes there has been a FICO score inflation due to negative credit events not being reported during the COVID-19 pandemic. He also points to a 2003 change in law that allowed people to challenge negative credit-score entries. “Nobody calls and complains that there was a mistake that made their FICO score too high,” he says.
Others are less pessimistic about how the housing market would fare in a recession. Homeowners are in a much better position now than during the Great Recession, says Selma Hepp, CoreLogic’s interim chief economist and executive of research and insights. Strong underwriting conditions going into the pandemic make defaults less likely, she says.
With recent price appreciation, many homeowners have a great deal of equity in their homes. The average loan-to-value (LTV) ratio in third-quarter 2022 was 43.6%, significantly lower than the 71.3% LTV seen in Q1 2010. “Most folks, if they do have some equity, will just go and sell their home (if they sustain a job loss),” Hepp says. “I think that all this home price growth that we’ve had has helped create a financial cushion for folks.”
Mortgage delinquencies reached a record low in Q3 2022, according to an email from Mike Fratantoni, chief economist for the Mortgage Bankers Association. Foreclosure starts and inventory rates also remain low even after the lifting of the federal foreclosure moratoriums, he says.
“That said, both the delinquency and foreclosure numbers are likely to increase in 2023 and 2024 as the unemployment rate rises and the housing market continues to cool,” Fratantoni says.
Daren Blomquist of Auction.com believes that there will be a recession in 2023, pointing to the investors who use his company’s website. “They’re on the front lines of local housing markets,” Blomquist says. “So, their bidding behavior on Auction.com actually tells us a lot about what they expect to be happening in the next six to 12 months.”
Foreclosure-auction buyers typically bid less than a home’s value since an interior inspection cannot be conducted prior to the sale. Early in the pandemic, investors were underbidding by about 9% to 10%. But after March 2022, there was a dramatic shift as investors started bidding nearly 25% below value. This shows that investors are worried about market conditions, Blomquist says.
Still, his company has modeled the worst-case scenario if a recession were to occur. In this scenario, foreclosures could more than double in 2023 compared to 2022. But these numbers wouldn’t be much higher than in 2019, and they’d be far lower than in the worst years after the Great Recession. Blomquist says there’s been a lot of talk about “home equity as the savior of this housing market.” He’s not sure this will necessarily be the case.
“Equity alone, either positive equity or negative equity, does not make or break a mortgage — what makes or breaks it is income,” Blomquist says. “Home prices going down is not going to be a huge threat, but if that is combined with a recession with job loss, that’s where I think you could see the increase in defaults.” ●
