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It is easy to conceptualize the Home Equity of an individual homeowner falling to zero. A buyer overpays for a house, does not invest a sufficient down payment and ends up with mortgage debt in excess of the market value of the home.  In fact one-in-three U.S. homeowners with a mortgage current find themselves in this predicament.  Record foreclosures have resulted.

It is far more difficult to imagine the total net Home Equity of the United States falling to zero.

Clarification:  "Net National Home Equity of Zero" does not mean that everyone loses the equity in their house.  There are plenty of cities and states untouched by the Housing Bubble or its collapse.  Tens-of-millions of people will retain large sums of Home Equity no matter what happens.  But those homeowners with negative Home Equity directly off-set others with positive balances.

Home prices continue to decline at a record pace rapidly eroding leveraged equity.  Yesterday I analyzed the prospect of further price declines destroying all of those gains accumulated during the Housing Bubble.  (Link to Article)

The possibility of the nation’s Home Equity approaching zero may be a challenge to conceptualize, but the same laws of accounting, finance and reality apply to the entire housing stock as do to individual homeowners.  

What if the fair value of houses in the U.S. is less than the total amount of existing mortgage debt?  What if the value of the housing stock falls below this mortgage total?

In the interest of fair disclosure, it is functionally unlikely that this scenario would be entirely realized due to the inevitability of foreclosures.  When the prices of individual properties fall below the mortgage balance, negative equity does not necessarily persist.  Many times foreclosures result, mortgage debt is written down and replaced by a lower balance when a new buyer purchases the distressed property.  Mortgage debt is reduced and the negative equity is transformed into a positive balance depending on the use of a down payment by the new buyer.  This is one of many reasons why foreclosures are vitally important.

That the possibility of national Home Equity falling to zero is even considerable, though, is a frightening prospect.  But it makes for a fascinating analysis. 

As of year-end 2008 there was $10.5 trillion of mortgage debt on residential housing.  This figure is higher than the entire value of the U.S. housing stock in 1999.  Were the price of America’s housing to fall to $10.5 trillion without a reduction in mortgage debt Home Equity would be reduced to zero.

This scenario seems highly unlikely today given that the value of the housing stock at year-end 2008 was $18.3 trillion.  There was a $7.9 trillion Home Equity cushion that would need to disappear. 


But house prices are declining at record rates, Home Equity is disappearing at a pace in excess of $2 trillion per year and today the Federal Reserve will announce a first quarter decline in equity of approximately $600 billion.

A Perspective on Fair Housing Value

For the Doomsday Scenario to be approachable the value of the U.S. housing stock would have to fall to $10.5 trillion.  The question becomes what is the fair value of housing and will prices approach this figure?

TheAMD.com has advocated a methodology for estimating the fair value of housing based on an historical understanding of:

• When the Housing Bubble began 
• What caused it 
• How those catalysts distorted prices
• When housing prices began to rise unsustainably

The Housing Bubble began in 1995 when Government initiatives designed to realize a social agenda triggered an historic and sustained increase in Homeownership rates to record levels.



Record high Homeownership triggered an unsustainable and accelerating increase in national home prices which began in 1997. 

 

Home prices decoupled from the sustainable rate of appreciation consistent with inflation and income growth because of Government intervention and the proliferation of wildly distortive Affordable Mortgages. 

Now that the Bubble has collapsed and the market conditions which determine value have reverted to a pre-bubble dynamic, it is reasonable to expect that prices will return to sustainable levels which existed prior to the national distortion. 

It is difficult to quantify the current justifiable price of the U.S. housing stock using 1997 valuations because homes, neighborhoods, cities and states are dynamic.  The following analysis is admittedly limited but conceptually valid and makes for an interesting study.

Methodology for Calculating the Fair Value of the U.S. Housing Stock

• The value of the U.S. housing stock was $8.4 trillion at year-end 1996
• Housing units have expanded from 114,555 at year-end 1996 to 130,840 at year-end 2008; an increase of 14.2%
• Assumption made that newly constructed homes are 20% more valuable than existing stock (this is similar to the valuation premium seen in historical and current median transactions, but admittedly could vary in either direction for a variety of reasons)
• The rate of inflation from 1996 through 2008 was 32.6%

Estimated Fair Housing Value = 8,363 * (1 + (cumulative housing stock growth * (1 + new house premium)) * (1 + cumulative inflation))

Based on this simplified calculation the U.S. housing stock today is fairly valued at a 55.2% premium to the 1997 figure of $8.4 trillion.  This equates to a sustainable price of $13.0 trillion. 





Should the price of the U.S. housing stock return to the sustainable, inflation-adjusted valuation of year-end 1996, Home Equity would decline to $2.5 trillion. 

Could Home Equity Fall Below the $2.5 Trillion Level Consistent with Sustainable Value?

Prices during bubble-cycles tend to rise above fundamentally justifiable valuations during the boom-time and overshoot fair value to the downside during the bust.  Traditionally, the higher the boom valuation the more the trough falls below fair value.  It is entirely possible given the centrality of falling house prices to the economic downturn that prices could overshoot 1997 levels.

Furthermore, the market conditions which determine the price of houses have not reverted to 1997 levels, they are much worse.  These include:

• Credit availability is reduced  
• Credit terms are more stringent
• Hybrid mortgages are no longer prevalent (ARMs, Option-ARMs, Alt-As, Interest-Only)
• Demand for homes has decreased
• Supply of houses has increased (Inventories are at record highs and total units have increased by 14.2%)
• The perceived risk of owning a home has increased
• Expectation for future home price performance has diminished
• Unemployment is much higher and rising
• Foreclosures are at record highs and will persist
• Marginal mortgage interest rates are much higher (relative to bubble hybrid alternatives)

Given that the market conditions that determine prices are substantially worse than that which existed in 1997, it is entirely possible that the housing market could stabilize at a valuation that is less than this historical level.

Background Noise that Inhibits Analysis

I find this conceptual analysis to be interesting but I do recognize its limitations.  The value of the housing stock is affected by a huge number of factors.  A non-exhaustive list of these difficult to capture value-influencing characteristics includes:

• Cultural and social perception of housing changes over time.  It was rising, now it is falling
• Some homes depreciate in value; we see this clearly with foreclosed and abandoned properties
• Other homes increase in value due to capital investments such as expansions or pool installations
• Some neighborhoods improve in value and others decline
• The median price premium of new homes (used in the calculation) may not fully capture the incremental value of these assets relative to existing houses
  • Many large homes or high-end properties are dramatically more valuable than the median
  • Other new homes were poorly constructed, built with Chinese dry-wall or are no longer worth their replacement value

Many factors not captured could influence fair price of the U.S. housing stock relative to that calculated in this analysis using 1997 valuations.  

Dismal Reality

It is certainly possible that housing prices will stabilize above 1997 valuation levels.  This would be consistent with the perspective of many analysts, economists and politicians who failed to predict the Housing Collapse or the Economic Depression.  But it is also possible that prices will fall to this level or beyond based on the market fundamentals which determine value. 

The calculated fair value, Home Equity figure of $2.5 trillion is a big number relative to zero.  Regardless, a decline of this order of magnitude would have a disastrous, persistent impact on a consumer-based economy that has profoundly restructured itself for more than a decade to operate in an environment characterized by high and rising levels of Home Equity.  The Affordable Mortgage Depression is unlikely to end for years. 


Tomorrow’s Home Equity Week (HEW) Article:  What Needs to Happen to Owner’s Home Equity for Housing to Stabilize Before 2014

Monday’s HEW Article:  Historical Home Equity Percentages Since 1945

Tuesday’s HEW Article:  A Focus on Home Equity Since the Housing Bubble’s Inception

Wednesday's HEW Article:  The Impact of Falling Prices on Housing Bubble Home Equity 

Weekend HEW Article:  What Needs to Happen to Owner’s Home Equity for Housing to Stabilize Before 2014