Loading the player...

What is 'Underwater'

Underwater is the term for a financial contract or asset that is worth less than its notional value. This item could be an out-of-the-money call option where the stock currently trades above the option's strike price. Underwater is also a term for a home, or other substantial assets, which has an outstanding mortgage or loan with a higher amount due than the value of the asset could bring in the open market. 

In either case, the holder has an asset without actual value.

BREAKING DOWN 'Underwater'

In options trading, an out-of-the-money (OTM) call has a strike price above the current price of the underlying stock or commodity. An OTM put has a stroke below the current price of the underlying. If the underlying asset cannot move above the call strike or below the put strike, the option will expire worthlessly. This occurrence is because all of the value of OTM options derives from its time value and the potential for the underlying to move in price. However, unless it moves, all of that time value decays, leaving the options holder with a worthless asset.

Traders use OTM options when they believe the underlying asset will eventually move in the desired direction.

Another usage of the term underwater has to do with solvency. When notional, or book value, is higher than market value, the holder of the assets cannot meet financial obligations. For securities trading, this can lead to margin calls.

Underwater Real Estate

In real estate, underwater refers to the situation where a house or other property is worthless if sold right now than the money owed on loan. This poor value presents problems for both the homeowner and the holder of the mortgage. If the homeowner needs to move, the sale of the home will not produce sufficient monies to pay the mortgage holder, even before any transaction fees. In this case, the homeowner must find additional funds or enter into a short sale with a third party. These types of problems, in turn, lead to legal battles and possible difficulties down the road for both the original homeowner and the third party lender.

While a short sale does complicate the process by which the original lender recovers their money, a more significant problem with underwater mortgages emerged after the housing bubble in 2006 and bust in 2007. Homeowners with owing more than their home's value quietly walked away from their investments. This resulted in mortgage defaults, leaving the lending banks with losses and the added expenses of liquidating their acquired homes.

The problem turned into a crisis when collateralized mortgage obligations (CMO), a type of mortgage-backed security (MBS) issued by a third party dealing in residential mortgages, failed. The issuer of the CMO collects residential mortgages and repackages them into a loan pool. The pool then becomes the basis of collateral for issuing a new set of securities.

RELATED TERMS
  1. Negative Equity

    Negative equity occurs when the value of real estate property ...
  2. Debt Deflation

    Debt deflation is a concept that pertains to debt’s effects on ...
  3. Second Mortgage

    A second mortgage is a type of subordinate mortgage made while ...
  4. Piggyback Mortgage

    A piggyback mortgage can include any additional mortgage loan ...
  5. Strike Price

    The price at which a specific derivative contract can be exercised. ...
  6. Term Payment Plan

    A term payment plan is an option for receiving reverse mortgage ...
Related Articles
  1. Personal Finance

    HARP Loan Program: Help for Underwater Mortgages

    If you are underwater on your mortgage, this program may be just what you need to help build up equity in your home.
  2. Personal Finance

    7 Mortgage Trends To Expect In 2011

    How will the year compare to 2010? What's likely to be different?
  3. Personal Finance

    How Do Mortgage Lenders Get Paid and Make Money?

    When homebuyers educate themselves on how mortgage lenders get paid and make money, they are more likely to save thousands of dollars on their mortgages.
  4. Trading

    The Dangerous Lure Of Cheap Out Of The Money Options

    Betting on a big price move with cheap out of the money options can be profitable, but understand the risks and alternatives before doing it.
  5. Personal Finance

    Shopping for a Mortgage in 2017? Use This Tool First

    As home-buying technology has progressed, the process of finding the best mortgages rates for 2017 can all be done online.
  6. Personal Finance

    How Interest Rates Affect the Housing Market

    Understand how rate changes can affect home prices and learn how you can keep up.
  7. Retirement

    Reverse Mortgages Really Can Help

    Discover another way to fund your retirement without having to make payments on a loan.
  8. Personal Finance

    Reduce Interest With An All-In-One Mortgage

    "Offset" mortgages combine a checking account, home-equity loan and mortgage into one account.
  9. IPF - Mortgage

    9 Things to Know Before You Refinance Your Mortgage

    Whether or not a mortgage refinance is right for you depends more on individual circumstances than on this week's mortgage interest rates.
  10. Personal Finance

    The Reverse Mortgage: Lifesaver or Albatross?

    How to decide if a reverse mortgage will help fund your retirement – or undermine it.
Hot Definitions
  1. Working Capital

    Working capital, also known as net working capital is a measure of a company's liquidity and operational efficiency.
  2. Bond

    A bond is a fixed income investment in which an investor loans money to an entity (corporate or governmental) that borrows ...
  3. Compound Annual Growth Rate - CAGR

    The Compound Annual Growth Rate (CAGR) is the mean annual growth rate of an investment over a specified period of time longer ...
  4. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows ...
  5. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing a company that measures its current share price relative ...
  6. Internal Rate of Return - IRR

    Internal Rate of Return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments.
Trading Center