Deutsche Bank (DB) believes continued declines in home values will increase the number of US mortgagors with negative equity from 14m in Q109 to 25m in Q111. According to a report Deutsche released this week, the 25m represents a projected 48% of all US mortgages. While subprime and option adjustable-rate mortgages (ARM) are the biggest source of underwater borrowers in the current market, Deutsche said a larger percentage of prime conforming and prime jumbo borrowers will join the fray. Prime conforming and prime jumbo will make up 79% of all US mortgages and Deutsche estimates 41% of conforming and 47% of jumbo will be underwater, up from current levels of 16% and 29%, respectively. This rapid influx of underwater borrowers will have a significant impact on default rates. In addition to future underwater borrowers being forced into default from a “life event” — unemployment, divorce, disability, etc. — Deutsche warned others may “ruthlessly” or strategically default. Increased defaults in the middle class will suppress consumption, added Deutsche, further slowing housing recovery. It’s hard to predict exactly how high the default rates will go. The current housing recession is unique in that it was brought on and perpetuated by a number of factors — unstable loan products, crashing housing prices, and unemployment, among others. Deutsche cited a study of the Massachusetts housing decline of the late 1980s and early 1990s that showed less than 7% of underwater borrowers defaulted as perspective on the default rate for underwater borrowers. But in the early 1990s, borrower and loan product quality were significantly better, the home price decline wasn’t as severe, and unemployment was lower. Deutsche said the 7% experienced in Massachusetts should be the floor — a best-case scenario — for the surge of underwater borrowers it expects in 2011. Borrowers with loan products with already high underwater rates will only get worse. By 2011, Deutsche predicts 89% of option ARM borrowers will be underwater, up from 77% in 2009. The rate of underwater subprime borrowers will increase from 50% to 69%, and underwater Alt-A borrowers will increase from 49% to 66%. An important factor to consider is how deep underwater borrowers will be, and it depends on their loan type. For prime conforming borrowers, Deutsche predicts the number of borrowers with negative equity — loan to value (LTV) between 105% and 125% — will virtually equal the number of borrowers with what it calls “severe negative equity” — LTV over 125%. But Deutsche expects the 89% of option ARM borrowers underwater to be split with most — 77% of total option ARM borrowers — holding severe negative equity. For underwater prime jumbo loans, more borrowers will have severe negative equity — 29% of the combined 47%. The split for underwater Alt-A borrowers is expected to take an opposite proportion, with 49% of all Alt-A borrowers in negative equity and only 18% in severe negative equity. Underwater subprime borrowers will face a similar breakdown. Write to Austin Kilgore.

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