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Negative equity still an issue

(Published by South China Morning Post, 20 Aug 2008)

On the eve of the first anniversary of the global credit crisis which continues to dominate news headlines, two words which Hong Kong people understand very well – negative equity – is becoming more of a reality in the US housing market.

According to the S&P/Case-Shiller home price index, prices in several of what were the most attractive housing markets such as San Diego, Los Angeles, Phoenix, Las Vegas and Miami have declined in the past year by 25 to 35 per cent, whereas the national average has declined 10 to 15 per cent.

Based on our analysis, the steep home price declines have resulted in nearly 6 per cent of the US$12 trillion in outstanding mortgages or some US$700 billion of residential home loans being upside down or in negative equity (a situation in which the outstanding mortgage amount is larger than the value of the property).

This growing problem has been exacerbated by recent mortgage product innovations such as Option ARMs (adjustable-rate mortgages) with negative amortisation features. As defaults on subprime and Alt-A mortgages begin to show signs of peaking, mortgage delinquencies and defaults of prime borrowers (which comprise nearly 85 per cent of the market) are increasing at an alarming rate.
The US Federal Reserve, the Treasury, and banking regulators are carefully monitoring the exponential increase in mortgage loan defaults as a result of negative equity. Mortgage loan agreements in most US states are non-recourse to the borrower. In other words, the lender’s only recourse on the mortgage is the property.

The large US government-sponsored enterprises – Fannie Mae and Freddie Mac – have recently introduced disincentives such as prohibiting foreclosed borrowers from getting another mortgage through them for five years, unless there are documented extenuating circumstances.

In theory, these new measures may prevent some homeowners from walking away and avoiding paying-up their mortgage and to think twice before mailing in the keys to the lender (known as jingle mail). However, from a practical viewpoint, if the level of negative equity becomes so large that the homeowner believes it would take more than five years to get back to parity (property value equal to the mortgage amount), no amount of penalties will be able to stop the flood of jingle mail.

In the aftermath of the Asian financial crisis, Hong Kong homeowners remember too well the stinging pain of negative equity which affected nearly one in two homeowners. From 1997 to 2003, residential property prices fell nearly 70 per cent.

At the end of last year, several prominent Hong Kong property experts were predicting robust increases (up to 50 per cent) for the residential market this year. At the halfway point, according to the Ratings and Valuation Department, residential property prices have only shown nominal increases for the mass market (Class A and B), whereas the overall market is up slightly more, skewed somewhat by the luxury market (Class D and E).

Despite the sluggishness in property prices, mortgage transactions up to the end of the first half have been extremely robust, running at a year-on-year increase of over 60 per cent (HK$117 billion versus HK$72 billion). In fact, this level of activity is nearly 90 per cent of the transaction value (HK$130 billion) over the same period in 1997.

While the transaction volume/value has been extremely promising, a declining trend in the second quarter is a worrying sign. Since 2003, nearly 20 per cent of all mortgage transactions have been originated with an average loan-to-value of 90 per cent. Therefore, even a small property price correction of 10 to 15 per cent would place nearly HK$80 billion of mortgages in negative equity. A 25 per cent property price decline would put HK$140 billion of mortgages in negative equity.

The negative equity crisis which caused great financial and social distress to thousands of Hong Kong homeowners is actually quite positive – mortgage default rates during the crisis were quite small by international standards.

This is because Hong Kong borrowers generally honour their mortgage agreements due to the full recourse nature of the mortgage – in other words a bank can chase after a borrower for more than their property is worth even after it forecloses and sells the property without fully recovering the loan.

Hong Kong’s property market will not be directly affected by the rising cases of negative equity in the US. Instead, the recent sharp housing price declines across the border and in many of the major cities on the mainland caused by the tightening of bank credit by the People’s Bank of China may have a more profound impact here.

As Hong Kong becomes more integrated with the Pearl River Delta, the pricing for housing, food and other goods and services will become more fungible or more readily interchangeable. Although the Hong Kong dollar is pegged to the US dollar and, indisputably therefore, property (asset) prices are forced to overshoot on the upside (mid-1990s) and the downside (1997-2003), it seems inevitable that Hong Kong’s property market will become ever more linked to the macroeconomic policies of China, rather than those of the US.

Leland L.Sun

Leland L.Sun
Director and Founder of Pan Asian