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Cascade: No. 80, Spring/Summer 2012

Spotlight on Research: The Distributional Impact of Negative Equity*

The fallout from the recent meltdown in the housing market continues to afflict many homeowners today. A great deal of attention has been focused on the debilitating effects of a rise in foreclosures and falling house prices that accompanied the market downturn. The depressing effect of foreclosures on house prices has presented several challenges to homeowners. Declining home values have resulted in a number of homeowners owing more on their mortgage than their home is worth. Thus, the homeowners are saddled with negative equity, which is commonly referred to as “being under water.” Accordingly, negative equity might make it difficult for some homeowners to sell their house or lead to defaulting on their mortgage, resulting in foreclosure. Another consequence is that homeowners lose a valuable source of wealth — equity in their house.

The prevalence of homeowners with negative equity coupled with the incidence of foreclosures adversely affects the stability of communities. In assessing the viability of communities, it is instructive to know if some communities have a disproportionate number of homeowners with negative equity. A recent study by Spencer Cowan and Katie Buitrago sheds some light on this concern.1


Marvin M. Smith, Ph.D., Community Development Research AdvisorMarvin M. Smith, Ph.D., Community Development Economic Advisor

Cowan and Buitrago pointed out that the large drop in house prices nationwide is due, in part, to a large number of foreclosed properties listed for sale at auction at discounted prices. Moreover, foreclosed homes, especially vacant properties, can lead to blight and higher levels of crime that further reduce property values, which result in more homeowners with negative equity. According to the authors, more than 11 million homes nationwide have negative equity totaling $717 billion.

The presence of homes with negative equity in a community can be a destabilizing force. Cowan and Buitrago maintained that “negative equity is a significant driver of foreclosure.” As such, negative equity can create a cycle in which more concentrated foreclosures exacerbate the decrease in property values of neighboring homeowners, thus leading to additional foreclosures. The authors also discussed some of the characteristics of mortgages that tend to have negative equity and their detrimental effects. They noted “one study found that 80 percent of nonprime borrowers with payment-option Adjustable Rate Mortgages (ARMS) and 75 percent of nonprime borrowers with short-term hybrid ARMS had negative equity in their homes, compared to 39 percent of nonprime borrowers with fixed-rate mortgages.”

Cowan and Buitrago hastened to add that not all homeowners with underwater mortgages will default — particularly those who are able to make their monthly payments. However, those with a loan-to-value (LTV) ratio exceeding 110 percent are more likely to default. They cited a report that found that “homeowners with LTV ratios exceeding 150 percent were seven times as likely to go into foreclosure than homeowners with some equity in their homes.”

The authors also pointed out that the presence of negative equity can exert an adverse influence on homeowners seeking relief from foreclosure prevention programs. They noted that “one study examining subprime mortgagees who received loan modifications estimated that a homeowner with negative equity is one-quarter as likely to re-default on his or her loan modification if the modification includes a reduction of mortgage principal.”

Cowan and Buitrago further indicated that foreclosure is not the only deleterious outcome of negative equity. They observed that “even when negative equity does not result in default and foreclosure, it can reduce neighborhood wealth and stability and limit opportunities for homeowners to use home equity to finance retirement, higher education, or entrepreneurship.” Furthermore, research has shown that those with underwater mortgages are less likely to devote the necessary resources to maintain their property, which, in turn, can lead to neighborhood deterioration.

As mentioned earlier, negative equity represents a loss of wealth. This is noteworthy since “more than half of the net worth of Latinos and African Americans in 2009 was attributable to home equity, compared to 38 percent for whites.” Consequently, Cowan and Buitrago suggested that the manner in which negative home equity is distributed across different segments of the population can have profound effects on their economic security, especially those least able to offset the blow from the loss in wealth. Similarly, communities with a disproportionate level of homeowners with negative equity and its related consequences might be subject to destabilization. The authors investigated these possibilities.

Data and Area of Study

Cowan and Buitrago focused their analysis on “patterns of negative equity in communities of different racial and ethnic compositions in the Chicago six county region.” The authors used “proprietary data on home equity, property values, and outstanding mortgage debt on residential properties in the Chicago six county region as of the end of 2011. The data classify properties with mortgages based on the LTV ratio, aggregated by ZIP code. Within each zip code and LTV range, the data include the number of parcels with mortgages, total home value, total dollar amount of outstanding mortgage debt, total number of mortgages, and total amount of equity.” They merged these data with Zip Code Tabulation Areas data on racial and ethnic composition from the 2010 U.S. census. This allowed them to examine the impact of negative equity in communities of color in the study area.


Cowan and Buitrago’s analysis yielded the following key findings:2

  • Nearly one in four residential properties in the Chicago six county region is underwater, with just under $25 billion of negative equity.
  • Almost half of the properties in communities of color are underwater or nearly underwater.
  • Almost one-third of the loans in communities of color are severely underwater.
  • Only about one-third of homeowners in communities of color have significant equity in their homes.

Policy Recommendations

The main outcome of the authors’ analysis was that “negative equity and its associated impacts are highly concentrated in the Chicago region’s communities of color.” They further demonstrated that the “destabilizing effects of negative equity include increased likelihood of foreclosure, property disinvestment, diminished returns from foreclosure prevention programs, and decreased family and neighborhood wealth.” Cowan and Buitrago voiced concern that communities of color with a concentration of these factors would face difficult challenges to achieve economic recovery and neighborhood stabilization. They offered the following recommendations to address this issue:

  • More use should be made of principal reduction by mortgage servicers as a foreclosure prevention instrument. The authors noted that servicers typically modify troubled mortgages by lowering payments through reducing interest rates or extending the loan terms. Cowan and Buitrago pointed out that these measures might be appropriate for borrowers with issues of affordability, but they may not provide adequate relief to underwater homeowners trying to avoid foreclosure. These homeowners might be better served with a principal reduction loan modification.
  • The Federal Housing Finance Agency should allow the use of principal reductions on loans backed by Fannie Mae and Freddie Mac. The authors noted that Fannie and Freddie manage “60 percent of all loans serviced.” However, since the conservator of these two institutions does not allow principal reduction on loans that they back, many underwater borrowers are denied a principal reduction modification, even if it could avert foreclosure.
  • The process for short sales should be streamlined. While short sales can be beneficial to underwater homeowners and servicers (by avoiding the cost of a foreclosure), the authors observed that these sales take a long time to complete, which can serve as a deterrent to prospective buyers.
  • * The views expressed here are those of the author and do not necessarily represent the views of the Federal Reserve Bank of Philadelphia or the Federal Reserve System.
  • 1 Spencer Cowan and Katie Buitrago, “Struggling to Stay Afloat: Negative Equity in Communities of Color in the Chicago Six County Region,” Woodstock Institute, March 2012.
  • 2 The key findings are taken from the Cowan and Buitrago article. For more on these findings, see the article.