9.7 million loanowners hold out-of-the-money options gambling on bubble reflation
Negative equity is making ordinary homeowners into speculators in the options market, each betting on the continued reflation of the old housing bubble.
An option contract provides the contract holder the option to force the contract writer to either buy or sell a particular asset at a given price. A typical option contract has an expiration date, and if the contract holder does not exercise their contract rights by a given date, they lose their contractual right to do so. An option giving the holder the right to buy is a “call” option, and the option giving the holder the right to sell is a “put” option. The writer of an options contract is typically paid a fee or a premium for taking on the risk that prices may move against their position and the contract holder may exercise their right. The holder of an options contract willingly pays this premium to limit their losses to the premium paid if the investment does not go as planned. Most options expire worthless.
Mortgages exhibit the characteristics of options contracts. The current batch of underwater borrowers pay their option premiums with loan modification payments. If the various market manipulations cause prices to go up, lenders keep all the gains from appreciation up to the outstanding balance of the loan. If prices go up beyond the loan balance, the borrower keeps the overage.
The potential for rising prices making lenders whole is the main reason the federal reserve is complicit in efforts to reflate the housing bubble; State and local governments aren’t complaining either. Further, the potential to sell without a loss and perhaps make a few dollars compels most underwater borrowers to agree to often onerous loan modification terms, avoid short sales, and keep their homes off the market. Underwater borrowers are largely responsible for our gilded age of low housing inventory.
A total of 9.7 million American households still have “underwater” mortgages, meaning they owe more on the home than it is currently worth. Homes in the lowest price tier are most affected, according to data released today from Zillow.
Thirty percent of homes in the bottom price tier are in negative equity, while only 18.1% of homes in the middle tier and 10.7% in top tier are underwater, according to Zillow’s Negative Equity Report. Homes are defined as top, middle, or bottom tier based on their estimated value compared to the median home price for that area. (Nationally, the median price in the top tier is $306,700; middle tier, $163,400; bottom, $98,400.)
Overall, 18.8% of homeowners were underwater during the first quarter of 2014. And more than one-third of all homeowners with a mortgage were “effectively” underwater, meaning they have less than 20% equity in their home.
It’s no coincidence that low housing inventory is an indicator of residual mortgage distress. The higher the concentration of underwater borrowers, the lower the available MLS inventory is, an effect particularly evident at the low-end of the housing market.
What’s particularly significant about the Zillow report is that it underscores a reason for the low prevalence of first-time homebuyers in the market: many owners of less expensive homes can’t afford to sell.
“The unfortunate reality is that housing markets look to be swimming with underwater borrowers for years to come,” said Zillow Chief Economist Dr. Stan Humphries via a release. “It’s hard to overstate just how much of a drag on the housing market negative equity really is, especially at the lower end of the market, which represents those homes typically most affordable for first-time buyers. Negative equity constrains inventory, which helps drive home values higher, which in turn makes those homes that are available that much less affordable.”
That’s exactly how it works.
If prices keep rising, and if lenders return to their foolish HELOC lending of days past — or worse yet, 100% financing — then we have one more option-like feature of mortgages to contend with: the “put” option refinance. Late in the bubble when prices were near their peak, many homeowners refinanced their properties and took out 100% of the equity in their homes. In the process, they were buying a “put” from the lender: if prices went down (which they did,) they already had the sales proceeds as if they had actually sold the property at the peak; if prices went up, they got to keep those profits as well. The only price for this “put” option was the small increase in monthly payments they had to make on the large sum they refinanced. If fact, on a relative cost basis, the premium charged to these speculators and homeowners was a small fraction of the premiums similar options cost on stocks.
Of course, mortgages are not option contracts, and lenders did not view themselves as selling option premiums to profit from the premium payments; however, speculators certainly did view mortgages in this manner and treated them accordingly.