Deconstructing the Deutsche Bank Underwater Scare

A report put out by Deutsche Bank is creating all sorts of business buzz. That's because the report predicts that 48% of all mortgages will be "underwater" by the end of the first quarter of 2011. A mortgage that is "underwater" is one where the mortgage is larger than the value of the house. These sorts of mortgages have a significantly higher incident of defaults. Currently, the number of properties that are underwater is estimated to be at 26% by Deutche Bank. That's bad enough but their estimation is just down right scary at 48%. All mortgage types will see increases in "underwater" mortgages and even prime loans will have 41% of their mortgages under water. (currently on 16% of prime loans are underwater)

Here's the important numbers to know. There are 110 million households in this country. 75.5 million of these are property owners. About 68% of these, or 51.6 million, have a mortgage. Of that, about 14 million, or 26%, are currently under water. Deutche Bank has analyzed that the single worst loan is the Option Arm. Deutsche Bank estimates that an astonishing 99% of Option Arms will be under water. It's currently estimated to have 77% of their mortgages underwater. That makes sense since Option Arms feature a negative equity payment option. Fortunately, Option Arms do NOT account for that much of the overall pool. They did, however, become quite a fad for several years during the boom.

Most scary, Deutshce estimates that 69% of mortgages will be valued over 90% of the value of the home by the end of the first quarter of 2011. California, Florida, and Arizona all feature a majority of area that has at least 30% underwater mortgages. The city of Chicago also has more than 30% of its mortgages that are underwater. All those states will get even worse. Washington state will also become a state with a majority of its area having 30% of their mortgages or more underwater. Also, Detroit is estimated to cross over 30% by then as well. The worst performing city in the nation is currently Merced, California where 95% of the mortgages are currently underwater.

Deutsche also referenced another study done by Economy.com which concluded that only 19 million mortgage,or 36%, will be underwater by the end of the first quarter of 2011. Deutsche Bank believes the increase in underwater mortgages will be due to several different factors. First, Deutsche believes that the value of properties will drop another 14% over the next two years. Second, Deutche predicts that prices will continue to decline because 1)increasing joblessness 2) excess supply of properties over demand, and 3)continued unaffordability in some areas.

The most important variable that is difficult to predict is how many of these mortgages that are underwater will go into default. Deutsche referenced a study on underwater foreclosures during a downturn in Massachusetts in 1991. In that case, only about 7% of those mortgages went into default. There are, however, a plethora of factors that indicate that in the current climate we are going to see a much larger percentage. The loans are much more frequently adjustable rates, there is a much greater percentage of sub prime borrowers, and the home deprectiation wasn't nearly as acute then. Furthermore, total defaults at the time was only about 1%. It's headed toward 10% now. That indicates that 25-30% of all underwater loans will likely go bad. All of this means that as many as ten million more homes are likely to get foreclosed on in the next two years.

Not surprisingly, the conclusion of the report is that these added underwater mortgages will have downward pressure on consumption and it will hit the middle class the worst. In other words, there is still plenty of pain. You should all be able to see then why this report is getting so much business publicity.