More Borrowers Underwater: Why We Should Care

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Falling home prices at the turn of the year pushed more borrowers into a negative equity position, meaning they owe more on their mortgages than their homes are worth.

In Q4, 23 percent of borrowers nationwide, or 11.1 million, were holding "underwater" mortgages; that's a collective $750 billion of negative equity, according to the latest survey from CoreLogic. That's up from 22.5 percent, or 10.8 million, in Q3, again, thanks to falling home prices. To make matters worse, 2.4 million borrowers have less than 5 percent equity in their homes, deemed as "near-negative" equity.

Of course negative equity is concentrated in the hardest hit states: Nevada (65 percent), Arizona (51 percent), Florida (47 percent), Michigan (36 percent) and California (32 percent). This as the consensus among housing watchers is that home prices will fall another 5 to 10 percent this year before slowly climbing back. That means negative equity will climb another ten percentage points.

So why should we care if the bulk of these underwater borrowers can still make their monthly mortgage payments? "Negative equity holds millions of borrowers captive in their homes, unable to move or sell their properties," notes CoreLogic's chief economist Mark Fleming. "Until the high level of negative equity begins to recede, the housing and mortgage finance markets will remain very sluggish."

Negative equity will slow the pace of home sales, no question, but it will also provide more problems for policymakers and state and federal regulators. Right now the mortgage market is at the mercy of a huge potential settlement with the state attorneys general and a whole bunch of feds, part of which will be a push for principal write down on troubled loans. With negative equity continuing to rise, the principal write down argument gains strength. I spoke with Missouri state AG Chris Koster yesterday at a conference in DC:

"I think principal write-down is the right way to go. Twenty to 25 billion dollars is a significant amount of money. The big question is are we talking about five banks, 15 banks who chip in on that fund? We don't know the answer to that until we get through these negotiations, but we're at the beginning of something serious that could be successful."

But the head of the new Consumer Financial Protection Bureau, Elizabeth Warren, told a Reuters summit last week, with regards to punishing the banks with a monetary fund or fine, "I don't think this is about a pound of flesh. I think that's the wrong way to think about it." She seems more interested in repairing the market than giving borrowers back equity, the loss of which may or may not have been their own doing.

My concern is that the more borrowers in a negative equity position, the more may intentionally default on their loans in order to try for principal write down. Yes, it's the moral hazard, slippery slope argument, which I know appears to be losing some steam in Washington at least.

The negative equity issue also comes into play as regulators decide on risk retention rules and what exactly will qualify as a "Qualified Residential Mortgage." QRM's will be exempt from risk retention, so banks will not have to hold on to 5 percent of the risk on those loans before securitizing them. Rising negative equity bolsters the case for higher down payments for QRMs, especially as home prices continue to slide.

So yes, it's just another new number of how a lot of borrowers look on paper. It doesn't mean every underwater borrower will go delinquent on his or her mortgage. But it does add to risk, which this housing market does not like one bit.

Questions? Comments? RealtyCheck@cnbc.comAnd follow me on Twitter @Diana_Olick