Housing Woes Move Up the Ladder

• Middle and high-end housing markets are deteriorating, while the worst may be over at the bottom of the ladder.
• Negative equity and job losses, problems formerly concentrated at lower end of the market, are spreading to upper tiers.
• Policies designed to help stabilize housing have failed to directly address the drag from job losses.

The housing market's woes are moving up the food chain, with negative implications for policies designed to stave off mortgage foreclosures. The current housing crisis had its roots in subprime mortgages, which dominated the lower end of the market; for a time the middle and upper tiers of the market performed better. In the last quarter or two, however, these higher tiers have appeared increasingly troubled.

Overly leveraged subprime borrowers initiated the housing crisis in 2007, which gathered momentum amid a downward spiral of defaults, foreclosures and negative equity. Now the combination of negative equity and job losses has affected wealthier markets, as seen in the erosion of mortgage credit quality among prime and jumbo mortgage borrowers. The highest tier is particularly exposed, as these homeowners are unlikely to receive the same government support offered to lower- and middle-income homeowners.

The top also rises

Although higher-end markets were somewhat insulated from the housing downturn in its early phases, the drivers of the subprime crisis have also weighed on more expensive homes. Imbalances were not as severe in higher-end housing markets, but they too grew highly overvalued during the boom, setting the stage for a large correction. Based on the average of house price indices in 16 metro areas covered by S&P/Case-Shiller, prices in the top third of the market rose by nearly 50% between 2003 and the peak in 2006.

(S&P/Case-Shiller house price tier indices are available as three-month moving averages for 16 metro areas across the nation. The indices are disaggregated so that the low-tier index represents the bottom third of sales transactions, the middle-tier index represents the middle third, and the high-tier index reflects the top third. Cutoff points for the tiers vary over time as well as across regions. In August, the cutoff for the high tier ranged from $542,200 in San Francisco to $176,330 in Phoenix.)

Negative equity spreads

Negative equity is a growing phenomenon at the high end of the housing market, where prices have fallen by 27% from their peak. Job losses—which affected manufacturing and construction industries hardest early in the recession—have spread to white-collar fields, dampening demand and raising delinquencies among owners of more expensive homes. Mortgage credit has also grown more restrictive for the highest-tier borrowers who rely on jumbo loans: Lenders currently require downpayments of 20% to 30%, and typically charge interest rates higher than for prime loans. Although high net worth households may not need mortgages, those who do find it more difficult to get them.

In addition, weaker demand at the low end of the housing market has negative implications higher up the ladder. Sales of lower priced homes help homeowners trade up to the middle tier, whereas those looking to trade up higher can do so more readily if demand is strong for their own houses. The collapse of the housing market's lower end in the wake of the subprime mortgage crisis thus undercut demand for more expensive homes. Policymakers are focusing attention on the lower end of the market, offering tax credits to first-time homebuyers as well as mortgage modification and refi programs for conforming loans. These efforts should eventually trickle up, but in the meantime, pricing trends look worse at the high end. Finally, a shift in consumer preferences is curtailing demand for high end housing. Burned by plummeting prices in the past several years, buyers are thinking twice before purchasing expensive homes.

Waiting out the market

With greater financial resources, high-end homeowners were able to wait out the market, forestalling price declines as severe as those that affected the low end. As more high-end homeowners find it necessary to sell, however, they are being forced to accept lower prices. Case-Shiller data provide some evidence of the weakening in the middle and high tiers. In markets covered by this index, house price trends in the high and middle tiers were just beginning to weaken in August relative to the low tier index; the trend continued in September.

The shift is slight but significant, in that it reverses a trend that persisted through the recession. The high tier is performing worse than the low tier in 12 of the 16 metro areas covered by the S&P/CSI indices. Tier indices based on a household weighted average of the 16 metro areas summarize these trends. While all three tiers are rising on a month-ago basis, gains in the low and middle tiers are stronger than in the high tier, while the low tier is outpacing the middle tier for the first time since house prices started falling broadly in 2007.

The implications for mortgage markets of falling house prices in the middle and upper tiers are evident in recent data from the Mortgage Bankers Association for the third quarter. The 30-day delinquency rate among prime borrowers rose by more than 33 basis points, compared with a decline of 42 basis points in delinquencies among subprime borrowers. The rate at which prime foreclosures were started rose by 51 basis points; by contrast, the rate at which subprime foreclosures were started fell by 43 basis points.

To be sure, delinquency and foreclosure rates for prime borrowers are still lower than for subprime borrowers, but measures of credit quality are deteriorating faster within the prime category. Problems are evident in the highest tier of the housing market as well. Moody's Investor Services reports that the proportion of loans delinquent 60 days or more among those who owe $1 million or more on their homes is nearly as high as the rate for borrowers with lower-balance loans. Further, the delinquency rate on million-dollar mortgages is rising quickly. In October, about 25% of these borrowers were 60 or more days behind in their payments, up from 15% a year ago.

This mounting supply of properties that may end up in foreclosure will further depress house prices over the next two quarters, particularly as job growth remains absent. The middle market for conforming loans will garner some support from the Home Affordable Mortgage Program and the expansion of the homebuyer tax credit. However, HAMP helps lower monthly mortgage payments for households that were overleveraged to begin with. It does not aid the many homeowners who formerly were good credit risks but have now lost jobs and lost equity. Similarly, the homebuyer tax credit does not help the unemployed. Continued job losses hamper the effectiveness of HAMP. The high end of the market will receive little support from policymakers; its only hope is a turnaround in the job market and a trickle-up effect from the now more stable lower and middle tiers.