Homeowners Walk Away

There is an article in the New York Times about a growing group of homeowners choosing strategic default.

New research suggests that when a home’s value falls below 75 percent of the amount owed on the mortgage, the owner starts to think hard about walking away, even if he or she has the money to keep paying.

Source: New York Times

My problem with the financial industry is that all of this is 100% foreseeable. Here is a quote from an executive at Wachovia:

An executive with Wachovia, one of the country’s biggest and most aggressive lenders, said during a conference call in January 2008 that the bank was bewildered by customers who had “the capacity to pay, but have basically just decided not to.”

Bewildered? On the front end, lenders couldn’t figure out that if a borrower had negative equity they might not walk away? Come on. Why would anyone sink money into a property that is worth substantially less than you paid if you can walk away and get a fresh start?

It makes sense to do so. The current regime permits borrowers to shift their losses to the bank. The stakeholders in the bank don’t feel the pain either since it is ultimately backstopped by the government. So ultimately, the current regime permits borrowers to keep the upside and externalize losses on society (ie., the taxpayer).

In places such as California where loans are non-recourse, the only incentive not to walk away is harming your credit score. If your credit is already in the dumps, then there is literally no incentive to keep paying.

Strategic default is always a worry in commercial lending and precautions are taken on the front end to prevent it. Similar precautions should be taken with residential mortgages and we would not be in this mess. Two simple fixes:

1. Full Recourse. Residential loans should be full recourse loans in all states. In many states, residential loans are fully recourse. So even if the borrower sends “jingle mail” to the lender, the lender can still pursue the borrower personally for the total amount of the indebtedness less the amount of proceeds received at a foreclosure sale.

Keep in mind that even if the lender does not want to deal with suing the borrower, there are vultures out there that  do. There are companies out there buying these notes for pennies on the dollar and pursuing borrowers. My point is that a full recourse loan would provide a tremendous disincentive to simply walk away. It would also force home buyers on the front end to carefully analyze taking out a loan for hundreds of thousands of dollars.

Imagine if borrower’s had to carry this risk during the bubble years? If an “investor” knew they might have their wages garnished or other assets seized if the house lost value and the investor defaulted (either on a voluntary or involuntary basis), many of these investors would not be lining up to enter the house flipping business. The investors would have to carry the risk of loss rather than the federal government.

This may sound a bit harsh, but it should be a big deal to take out a loan for hundreds of thousands of dollars. In this country, there are people that cannot afford a $1,000 LCD TV yet are able to “afford” a $250,000 house because of the government’s intervention in the housing industry.

2. Equity. Homebuyers need to come up with a 20% down payment. The homeowner must have a skin in the game. If the home declines in value, the homeowner needs to take the hit first. Not the bank (or the FHA, Fannie or Freddie). It is not that I care about banks, but the problem is banks (and GSEs) are ultimately supported by the government meaning if the bank picks up the bill than it means there is a high probability that the loss of value is being externalized on society rather than on the homeowner.

I’ll end my rant by saying that it a joke that many are bewildered by how this housing mess occurred. Besides the obvious structural problems with home loans I have mentioned above, the government’s intervention in residential lending will continue to cause bubbles and financial instability.  Two other changes we need:

1. Abolish the FHA. Loans with 3-5% down breaks the equity requirement I mentioned. The FHA cannot exist because the risk of borrower default is carried by the government (and externalized on society) rather than the borrower. We then end up with the strategic default problem when the loans go into default.

2. Retool Fannie and Freddie. The original mandate for the GSEs was to package mortgages into a pool and sell them to investors. Under no circumstances should a GSE be allowed to hold mortgages for their own account. Because of scumbags like Barney Frank (the guy should be in jail), the government owns by some estimates over 50% of the residential mortgages in this country. So the losses are taken on by the government rather than by the originating lender and the borrower. Put another way, how do we have a system where the government takes the risk on a home loan? Shouldn’t 100% of the risk be allocated between the lender and the borrower? Why should society pay?