March 12, 2008 (Housing Market Monitor)

Housing Market Monitor

Ratio of Home Equity to Value Plunges to Record Low

March 12, 2008

By Dean Baker

"Many existing homeowners lack the equity for a down payment on a new house." 

As predicted here in prior weeks, the ratio of homeowners’ equity to the value of their homes fell below 50 percent in the Federal Reserve Board’s release of Flow of Funds data for the fourth quarter. The release also included revisions to prior quarters’ data, so the ratio is shown as falling below 50 percent for the first time in the second quarter. By the fourth quarter it was down to 47.9 percent.

This ratio, which had been consistently in the high sixties until the late 80s, has plunged in recent quarters, dropping by 2.6 percentage points, from a 50.5 percent level in the fourth quarter of 2006. The decline stems from the fact that people continue to borrow from their homes (mortgage debt rose by $655 billion in 2007) even as the value of their homes is collapsing.

The current ratio would not be a problem if equity was distributed evenly, but of course it is not. According to the consumer expenditure survey, 35.8 percent of the population owned their home outright in 2006. Adjusting for differences in home values, the average ratio of equity to value for the 64.2 percent of homeowners with mortgages is now just 25.7 percent. Even within this group there are enormous differences, with some homeowners having nearly paid off their mortgages, while tens of millions have little or no equity.

This loss of equity is extremely important for the current state of the housing market. Banks in many distressed markets now require non-borrowed down payments of 20 percent. If a seller has to pay a 6 percent realtors’ fee, then an average homeowner with a mortgage would not have enough equity in their home to cover the down payment for a similar house in the same area. Since the median ratio of equity to value is far below the average, the vast majority of current homeowners who still have mortgages do not have enough equity to meet down payment requirements for comparable homes in the areas where they live.

Historically, down payments have primarily been a problem for first-time homebuyers. In the current market, down payment requirements are likely to be a serious obstacle to purchasing a new home even for many families who have already owned a home.

The loss of home equity is also a huge issue for older homeowners approaching retirement. For the vast majority of older workers, home equity is the main source of non-Social Security wealth. The destruction of home equity wealth seen in just the last year is enormous. The 9.1 percent nominal decline shown in the Case-Shiller index implies a 12.4 percent real decline in house prices over the course of 2007. This translates into a loss of $2.7 trillion in home equity in a single year, or an average of almost $40,000 per homeowner.

The amount of home equity lost last year is more than half the size of the $5.1 trillion shortfall projected for the Social Security program over its entire 75-year planning horizon. While the Social Security shortfall has received enormous attention from politicians, the media and the economics profession, the plunge in housing equity has gone almost unnoticed. This shows the tendency of the not just politicians and the media to be driven by fads, but also the economics profession.

USA Today reported yesterday on the sharp growth in the numbers of people who are tapping into or fully liquidating 401(k) accounts in order to prevent foreclosures. Since it is extremely unlikely that house prices are going to turn around any time soon, many of these people are likely to find themselves with neither a home nor retirement savings.

While it is too early to assess the effectiveness of the Fed’s latest bailout efforts, the basic intent should be clear. It allows banks in financial trouble more time to try to find less informed investors who will buy their devalued assets. This benefits the banks’ managers and stockholders; it is less clear how it benefits the economy as a whole. 

Dean Baker is Co-Director of the Center for Economic and Policy Research, in Washington, D.C. (www.cepr.net). CEPR's Housing Market Monitor is published weekly and provides an incisive breakdown of the latest indicators and developments in the housing sector.

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