Affordable Housing Institute : US

By: David A. Smith

 

Just as the new decade’s dawn has added to our lexicon one new term – sovereign bankruptcy – it’s time now to add another – ‘strategic’ mortgage default.

 

Time to knock over the financial bombs?

 

[I put 'strategic' in quotes because, as we shall see, it's an unproven and questionable conclusion as to motive. – Ed.]

 

Will this phenomenon be limited to sporadic outbreaks, or is it the beginning of a nationwide epidemic?

 

 

I’m still afloat, and you’re not …

 

The subject is explored in a lengthy City Journal article University of Chicago business school professor Luigi Zingales, whose bio opens:

 

As you might expect from one of the Chicago Boys, he’s market-oriented

 

Born in Italy, a country with high inflation and unemployment that has inspired his professional interests as an economist, Zingales carries with him a political passion and the belief that economists should not just interpret the world, they should change it for the better.

 

Professor Zingales opens with a personal story:

 

Eighteen years ago, when I bought my first apartment in Chicago, I asked my broker whether, if I defaulted on my mortgage, the lender could come after my income after repossessing the house. I had heard that some states didn’t allow that, and I wondered if Illinois was among them. To my surprise, the broker didn’t know, either, but she promised to find out. It clearly wasn’t a burning question for her, since she still wasn’t able to answer it the next time we met. Our ignorance wasn’t unique. Confident that house prices would never stop rising, most Americans never bothered to check what would happen if they defaulted. After all, who would walk away from a house worth more than the mortgage?

 

As Professor Zingales knows now, and most people knew back then, most single-family home mortgages are recourse – meaning the lender can not only take your property, it can also sue you for the shortfall. 

 

Today, the matter is far from theoretical for the 15.2 million American households holding mortgages that exceed the value of their homes.

 

Time out!

 

Hold your water while I explain something.

 

For any borrowing, we have to distinguish two types of default risk:

 

1. Payment risk.  The borrower cannot afford to make the payments as they come due.

2. Collateral risk.  The property is worth less than the remaining loan unpaid principal balance (UPB).

 

Most people default because they have payment problems, not because they theoretically believe their home to be worth less than its value.  Fear of dispossession is one of the many rational reasons why homes are resistant to price drops:

 

From my blog, July 30, 2006

 

It will help determine how many of them choose to “default strategically”—that is, walk away from their mortgages –

 

Again, ‘walk away’ is a casual and misleading term, and I fear indicative of a mindset that, if it takes hold, could be very problematic for the nation.

 

“If you keep going, you’ll never own a house in this town again!”

 

– even when they can afford them, because they’ve determined that it’s no longer worth it to keep paying.  And that, in turn, will help determine the future health of the American housing market—and thus of the U.S. economy.

 

Professor Zingales rightly sets the stakes – not just the millions of households, but the entire economy, would be further destabilized if what we will accept as ‘strategic’ mortgage default because the norm.

 

How much of a risk is it?

 

Many people think that we don’t have to worry about widespread strategic defaults.

 

Count me among them – at least pending further evidence.

 

When I discussed the problem with a board member of one of the top four American banks, he categorically denied its existence: “The idea that people would walk away from their homes when they can still afford to pay the mortgage is unfounded.” A study from the Federal Reserve of Boston seems to confirm his skepticism. Evaluating Massachusetts homeowners during the 1990–91 recession, it found that only 6.4% of “underwater” borrowers—that is, those burdened with mortgages that exceeded the value of their homes—ended up in foreclosure.

 

Don’t forget, even if a home has collateral risk, the borrower may well be able to make the payments, and will want to do so.  The determination of collateral risk is predicated on an appraisal, and we know those have a substantial margin of uncertainty, so – adding the element of hope – what an appraiser thinks is home below mortgage balance, the owner may know is well above mortgage balance.

 

Not all of those households were defaulting ‘strategically’; many, presumably, were actually unable to pay their mortgages.

 

Once again, I added quotations around that ‘strategically,’ simply because the definition is so squishy.  We always chose what to pay and what not to pay.

 

 

Strategic default is hard to define, of course, and presents difficulties for researchers. What exactly does it mean to be able to pay a mortgage? If I default because I’m unwilling to work extra hours to pay my mortgage, is that a strategic default or a necessary one?

 

That’s why it’s dangerous to slap a judgmental label (‘strategically’) on a condition that could have – probably does have – multiple causes.

 

During the 1990–91 recession in Massachusetts, home prices fell just 22.7% from peak to trough, and most borrowers had made 20% down payments—so few owed much more than their houses were worth. Even people who had bought at the peak owed, on average, just 3% more than the value of the house. Over the last few years, by contrast, home prices have fallen by 40 to 50% in several areas, and many borrowers had put very little or nothing down when they bought their houses.

 

Certainly the current situation is so much more dangerous – but many of these borrowers have long since defaulted, as chronicled in endless sympathetic (borrower perspective) or scare-mongering (lender perspective) stories.  Still, the severity is much greater now.

 

Furthermore, during the current recession, the problem affects not only those who bought houses at the peak but also those who took advantage of rising house prices to take some money out in a refinancing. This wasn’t the case in 1990–91, when home-equity lines of credit were extremely rare.

 

From what I remember of that pre-email era, I wouldn’t have said ‘extremely rare.’  Less frequent, surely.

 

Survey-based evidence also suggests that strategic default has become widespread. A survey conducted by the Chicago Booth/Kellogg School Financial Trust Index, which I helped design –

 

Fighting with Congress for last place: trust in financial institutions

 

– asked a representative sample of 1,000 Americans how many people they knew who had defaulted and how many of those people had defaulted even if they could still afford to pay their mortgages.  According to the respondents in March 2009, 23% of their acquaintances’ defaults were strategic.

 

A bit of a bizarre statistic, asking if your friends’ default were ‘strategic,’ a definition that allows the respondent to feel superior to the unnamed defaulter.

 

By September, that fraction had increased to 36%.

 

So even if the statistic is flawed, the flaws should have been the same both times, so at least the perception of casual defaults is rising dramatically.

 

How much risk? If the underwater homeowners who currently refuse to default –

 

Yes, he’s making a rhetorical point, but this is a loaded phraseology.

 

 

– changed their minds and decided to abandon their mortgage commitments, the results could be catastrophic.

 

Here’s the real point.  That many mortgage defaults would be a tidal wave.

 

Bad for resale values …

 

The more people walk away, the more houses get auctioned off, further depressing real-estate prices. This additional decline would push more homeowners into negative territory, leading to still more defaults.

 

All our financial boats sink together

 

Every time a borrower defaults, moreover, he makes future mortgages more expensive (because lenders have to cover the cost) and the mortgage market more inefficient (because many potential borrowers are shut out). This higher cost and reduced availability of credit would depress house prices even more, jeopardizing the possibility of an economic recovery.

 

Correct on all counts.

 

Such a continued collapse is already a distinct possibility in several states: Nevada (where two-thirds of all homeowners are underwater), Arizona (51%), Florida (49%), Michigan (48%), and California (42%).

 

Throughout this recession, those five states have consistently been the epicenter of trouble. 

 

Adding to the deadliness of this cycle would be the fact that as more strategic defaults occurred, the social stigma associated with them would lessen.

 

Probably.  People have an enormous capacity to conclude that anything goes if “it’s not my fault, and the observant herd will rapidly notice if defaulters are not dismembered.

 

Not only did the real-estate crisis shove millions of homeowners underwater; it also jeopardized the very social norms that it rests upon.

 

A bout of dismembering will get people’s attention

 

Should we be scared?

 

[Continued tomorrow in Part 2.]