Definition
“Underwater” is a term used to describe a financial condition where an asset, loan, or portfolio is worth less than its related debt or purchase price. This scenario can occur in various financial contexts:
- Mortgages: A mortgage loan balance that exceeds the value of the property securing the loan, often referred to in the context of “upside-down mortgages.”
- Options: Financial options (both calls and puts) where the exercise price is higher than the market price of the underlying security, rendering the options worthless if exercised.
- Portfolios: A collection of stocks or bonds that has depreciated in value, causing the current market value to be lower than the purchase price or the book value.
Examples
Underwater Mortgage
During the financial crisis of 2007-2008, many homeowners found themselves in a situation where their home values had plummeted, while their mortgage debts remained high, resulting in underwater mortgages.
Underwater Stock Options
An employee might receive stock options as part of their compensation package with an exercise price of $50 per share. If the market price of the stock falls to $30 per share, these options are considered underwater, as exercising them would result in a loss.
Underwater Investment Portfolio
If an investor purchases a portfolio of technology stocks for $1 million, and due to a market downturn the portfolio’s value decreases to $700,000, the portfolio is considered underwater.
Frequently Asked Questions
What does it mean to be “underwater” on a mortgage?
Being underwater on a mortgage means that the outstanding loan balance on the mortgage exceeds the current market value of the home. This can cause significant financial strain as selling the home would not cover the mortgage debt.
Can underwater options still be profitable?
Underwater options are not profitable at the current market price. However, if the market price of the underlying asset rises above the exercise price before the expiration date, they can become profitable.
How can one recover from an underwater portfolio?
Recovery from an underwater portfolio involves patience and strategic financial planning. Diversifying investments, reducing expenses, and possibly infusing the portfolio with additional funds when market conditions are favorable can help mitigate losses over time.
What steps can be taken if a mortgage is underwater?
Homeowners can consider several options such as refinancing, mortgage modification, short sale, or even opting for government assistance programs to alleviate the burden if their mortgage is underwater.
Are there any programs to help with underwater mortgages?
Yes, various government programs like the Home Affordable Refinance Program (HARP) have been designed to help homeowners refinance their underwater mortgages into more manageable terms.
Why do options become underwater?
Options become underwater when market conditions fluctuate and the price of the underlying asset moves unfavorably beyond the exercise price of the option contracts, making it unprofitable to exercise them.
Related Terms
- Upside-Down Mortgage: A situation where the loan balance exceeds the home’s market value.
- Call Option: A financial contract giving the holder the right, but not the obligation, to buy an asset at a set price within a specific period.
- Put Option: A financial contract giving the holder the right, but not the obligation, to sell an asset at a set price within a specific period.
- Negative Equity: The condition of owing more on an asset (like property) than its current market value.
Online References
Suggested Books for Further Studies
- “The Four Pillars of Investing” by William J. Bernstein
- “Options Trading for Dummies” by Joe Duarte
- “The Intelligent Investor” by Benjamin Graham
- “Real Estate Investing for Dummies” by Eric Tyson and Robert S. Griswold
Fundamentals of “Underwater”: Finance Basics Quiz
Thank you for exploring the financial nuances of being underwater in various contexts. Dive deep into your study and continue expanding your financial knowledge!
