Report Predicts Half of Mortgages Underwater by 2011

Nearly half of U.S. homeowners with mortgages could soon end up owing more on their loans than their property is worth, according to a new report from Deutsche Bank.

The report predicts that 25 million borrowers, or 48 percent of all U.S. residential mortgage holders, could be "underwater" - i.e., have negative equity - on their loans by the first quarter of 2011. That's nearly double the 14 million homeowners, or 27 percent of the market, the report says were underwater at the end of March.

"For many, the home has morphed from piggy bank to albatross," the report's authors wrote. "The questions now are, how will this wealth destruction drag on consumption and how will outsized mortgage burdens be resolved?

A continued decline in home prices will begin to have an increasing impact on prime borrowers, who have escaped the worst of the foreclosure crises so far, the report said. The report predicted that 41 percent of borrowers with prime conforming loans (meeting Fannie Mae/Freddie Mac guidelines) will find themselves underwater by early 2011, up from 16 percent at the end of March. For holders of prime jumbo loans, it predicts 46 percent will be underwater, up from 29 percent at the end of the first quarter of this year.

Defaults seen as more likely

With prime loans making up 80 percent of the overall market, this could have a significant impact on mortgage defaults, as homeowners with negative equity are far more likely to default on their mortgages. This is particularly true for homeowners experiencing a so-called "life event" such as unemployment, divorce or disability.

The increasing rate of negative equity also increases the likelihood that homeowners will choose to deliberately, or "strategically," default on their mortgages; that is, choose to cut their losses by giving up the property to foreclosure rather than continue making payments on a property that's worth less than they owe. The rate of mortgage holders severely underwater, defined as owning 25 percent or more over what the property is worth, was predicted to reach 28 percent by 2011, including 20 percent of those with prime conforming loans.

Nonprime borrowers already hit hard

Among subprime borrowers, the impacts were predicted to be more modest, primarily because so many of them are already underwater on their mortgages.

Approximately half of all subprime and Alt-A borrowers are currently underwater, according to the report, expected to increase to rough two-thirds by 2011. For holders of Option-ARMs, which include products like interest-only loans, almost none were predicted to have any remaining equity in their homes by 2011, with nearly 90 percent underwater, up from 77 percent currently.

Fortunately, Option-ARMs make up only a small slice of the market, about 3 percent of all mortgages, according to the report. Subprime and Alt-As make up about 9 percent apiece, with 66 percent in conforming prime loans and 13 percent prime jumbo loans.

Some critics have questioned the report's predictions, noting it is based on housing data collected earlier this year before the emergence of several positive trends suggesting the housing market is bottoming out. They say the actual declines in housing prices will be significantly less than Deutsche Bank is predicting.