Should Money-Troubled Americans Just Walk Away From Their Homes?

It’s a radical suggestion that financially troubled American’s should just walk away from their homes. But what if that very suggestion might resolve the housing crisis faster than suggested interventions? Would it be worth it?

Financial institutions and politicians want you to believe that the housing market is solvable. Why would they do that? Well, financial firms really have little choice: the more homes that are foreclosed or deserted, the more billions they have to write-down.

This is causing serious upheaval in the financial industry. Countrywide has been bought by Bank of America and Washington Mutual may soon be bought by JPMorgan.

Other firms are selling themselves piecemeal to foreign investors and countries. Merrill Lynch, which is hinting at another $15-billion write-down, is trying to raise $4 billion from Asia, the Middle East or American firms. Citigroup has already sold $7.5 billion of itself to the Abu Dhabi Investment Authority.

It’s easy to understand why politicians want you to believe they can fix the problem: they’re trying to get elected or cover their collective asses. Solutions range from cutting the Federal Reserve Board’s borrowing rate to federal government bailouts that would cost taxpayers more than $100 billion.

Both ideas are kind of dumb: Cutting the borrowing rate just throws fuel into the fire. Making credit cheaper will just prolong the entire fiasco by encouraging lenders to repeat their mistakes. Worse, subsequent rising inflation will push the U.S. dollar ever lower, eventually making it a junk currency.

Government bailouts are even more ridiculous because we, the taxpayer, will someday pay. Consider what happens in a bailout: the federal government takes money out of its already overextended budget to help a homeowner keep his home. Because the government has to borrow money for this bailout, the U.S. immediately starts racking up interest charges. Someday, taxpayers MUST foot this bill.

Worse, the money given to the homeowner actually ends up with the investor or financial institution that made the loan. In effect, a homeowner bailout is also a business bailout. By the way, most homeowners will STILL be stuck with property he/she can’t afford.

But you may be asking yourself, isn’t the subprime crisis almost over? Ah, but if. In March and April, $200-billion worth of mortgages will reset. Heck, in January and February, $168 billion worth are resetting.

But the problem doesn’t stop there. Beyond the horizon, an entirely new problem – well at least to financial storytellers – is coming down the pike: pay-option adjustable-rate loans.

The best way to understand these things is to think of that much laughed at minimum payment amount listed on your credit card bill. If you make the minimum $15 or $20 payment month after month yet never buy another thing, your credit card debt will quickly grow to tens, if not hundreds, of thousands of dollars.

Pay-options, most of which went to prime borrowers, work the same way: homeowners can pay in less than the amount needed to keep the total debt from growing. The New York Times explains:

Only when the loan balloons to 15 percent larger than its original size – a nifty development that results from a multisyllabic quagmire known as “negative amortization” – do lenders demand that borrowers pay down principal. In many cases, this will cause borrowers’ monthly payments to double, according to analysts.

Negative amortization occurs even faster in an environment where home prices are falling. How much pay-option junk is out there? Look at the graphic I derived from the Los Angeles Times for an idea.

What are the likely failure rates? It’s hard to be sure, but 75 percent of Americans who hold of option ARMs are making only minimum payments. If 75 percent of these mortgages fail, that would implicate about half a trillion dollars worth of debt.

Are more toxic mortgage-types out there? Possibly. Consider this: the top 10 mortgage originators were making $495 billion in new loans the third quarter in 2006. The Top 10 made $532 billion in loans during the third quarter of 2005.

A quick extrapolation over 16 quarters brings the total of new loans to roughly $8 trillion for just the Top 10 originators. Keep in mind, a lot of these loans were made to Americans who refinanced their homes. Still, total U.S. mortgage debt is estimated around $20 trillion. New mortgages account for over a quarter of it.

Another problem are second liens, which are loans on top of mortgages. These were often use to avoid paying for Private Mortgage Insurance (long story,) or to avoid jumbo mortgage rates (longer story,) or to take money out of homes to buy boats, cars, pay medical bills or make home improvements (longest story.) The Top 5 loan originators were issuing about $60 billion a quarter of this kind of debt.

Financial institutions generally lose everything when these loans go bad for the simple reason the primary lien holder gets paid off first.

Anyway, I think you’re getting the idea. When looked at from afar, this housing market/economic mess is far larger than pundits tend to reveal. I’m not even getting into what has been happening with credit card debt and car loans.

With that in mind, here’s the solution that will never happen:

If Americans immediately walked away from negatively amortized mortgages, the crisis would end much faster. Here’s why:

1. Stressed homeowners who walk away from their properties can move into a rental and cut their monthly expenses, easing financial stress. Yes, their credit would be wrecked for a few years, but not as severely as if they foreclose or declare bankruptcy.

2. Financial institutions could unload properties more quickly because they would gain control faster than in foreclosure proceedings. By the way, this is already happening to some degree. The less time a home spends in limbo, the less likely it is to be damaged.

3. Here’s the really painful part: home prices would plummet, forcing additional homeowners to consider unloading properties. This was going to happen anyway, but bailouts and lower interest rates will just prolong the whole mess.

4. Financial institutions would be forced to come clean much faster than to date. Trust would be restored in surviving institutions once the carnage ended.

5. The economy will go into a full recession too fast for the Fed to lower rates and for politicians to enact wasteful bailouts.

6. Once home prices reach a low enough level, investors will snatch properties up and offer them as rentals.

7. This will stabilize the home market and offer a steady income source for property investors. (Currently, home prices are too high for leasing purposes.)

8. After the initial pain, the economy should begin its rebound.

Of course, few economists will ever make a suggestion such as this. Why? It sounds defeatist. It’s cruel to homeowners. It’s anti-American. Financial institutions would howl in protest.

Sigh, they’re probably right. Besides, there may be other unintended downsides, such as an economic death spiral or something. I am not an economist, just a daddy pundit. Still, I wish there was a way to test out the theory.

Stumble It!

Comments

[Summer]

"The economy will go into a full recession too fast"

Dude, any sentence with the word "recession" scary with "too fast" attached.

I know little about the economy, but living in Bank Town, USA I'm sensitive to the financial industries issues (their economy is my economy). If financial companies fail - and fast - a lot of people would lose jobs - and fast. (As many already have. I know more then one person that's carrying heavier work loads because co-workers got laid off.)

Bad house, no jobs, and a super delicate value to the dollar doesn't sound like a "recession" to me. It reminds me of The Depression.

[brettdl]

Sorry, didn't mean to scare.

A lot of the most extreme pundits, though, are predicting a Depression. I'm not sure it'll be that bad, but I do believe it may be the worst recession we see in our lifetimes.

[Nadine]

There's an article today in the Cleveland Plain Dealer about how home prices are being effected by banks selling homes at much less than market value.

[brettdl]

Oh boy, that doesn't bode well for the rest of the nation if banks start dumping properties on the market.

[Summer]

I'm not scared. Money's always been tight. I'm young, and I've never had a comfortable savings. I'm actually feeling really comfortable with no credit card or mortgage debt. Where most people are going to be hit, I'm safe.

It's just a scary sentence. I'm actually very intrigued by what'll happen as the economy changes. It's been a long time since a recession - especially a really bad one.

What I'm especially interested in is how this is going to effect government. To get this country out of recession in the past, we've started wars. That's how we GOT into this one... makes one wonder what the cure is for this particular pickle.

[brettdl]

I'm more than intrigued; I'm trying to figure out what will happen next so I can profit off it. When to buy property, what to invest in, etc.

[Jennifer]

I think this will mainly happen in the north. Just like the 1970s, when the economy was hard hit and gas prices went up, people were walking away from their houses then. My family moved us down south in 1980 and the economy was sound there compared to NY.

I think the same is happening again. Especially in places like Michigan. Of course everyone is affected, but some much worse than others, sadly.

[Todd]

I do computer work for a Mortgage Software company and we have felt the hit as well. However I have noticed a trend of smaller institutions working with the homeowner to make it much easier to stay in the home. While the large lenders and subprime lenders made major mistakes the one group that has been rather safe is Credit Unions. I am confident that with the gov't putting on band aids and other industry groups working with people the market will level out. It will not rebound, but level out to a manageable level. House prices went up too fast nearly 4 times the historical average for a few years and when the prices and the historical averages come closer things should improve. As for homeowners and property values. If you have no plans of moving for a while then those changes will not effect you.

My $.02

[EM]

I am in favor of your rational proposal but it would not result in a recession but a depression, though conventional economists do not recognize that word in the English language because the government has supposedly eradicated it just as modern medice has with smallpox.

[Rational expectations]

Excellent. One mistake, I think. The issue is not whether jingle mail will create a "death spiral" for the economy. This too exaggerates the ability of one set of actors (homeowners rather than the Fed or Congress) to change what is going to happen. Your point is that walking away changes WHEN things happen. This is better for the economy, better for homeowners in distress, but MUCH, MUCH, WORSE for the banks and investors.

If you are like most people, you did not own your home. The bank owns houses. Like a landlord, they very much want you to stay and pay rent. They want this enough that they are willing to let you have the place if you pay and live there for 30 years. If instead you leave, they have to find someone else to rent, er "buy".

Consider the next few years an IQ test for home debtors. The banks made a mistake and bought you a place to rent. Let them have it back. Those who "love their home" or think they are building equity somehow (how could this be the case when prices are declining and many people are not even scratching the equity? --- but why underestimate the ability of people to be foolish if they really try?) are going to get quite a bit poorer in the medium term. Those who cut their losses are going to survive... and a few of us --- those who saw this coming, sold their property and are now liquid --- will do very well indeed.

Rational expectations

[Brennie]

I'm puzzled as to how 'walking away' from a house saves someone from bankruptcy or foreclosure. . . 'walking away' does not make the mortgage obligation magically disappear.

[Random Bloke]

You can hold your hand over your ears and close your eyes but that won't stop the financial day of reckoning.

Far far better to make concrete moves NOW to protect your family.

[Random Bloke]

PS - try googling Ferfal and argentina and find out what life was like when the economy collapsed in Argentina. Ferfal has some tips on how to survive.

Summer - You cried about not wanting to be scared by the bad words. Here's two qoutes for you "Toughen up Princess" and "For my part, whatever anguish of spirit it may cost, I am willing to know the whole truth; know the worst and prepare for it" Patrick Henry

[brettdl]

R.E.: Fascinating analysis; I particularly like the lender/owner/renter analogy. My death spiral comment was a bit tongue-in-cheek but reading your comment, I'm glad you took it literally.

BTW, I sold my house summer of 2006.

R.B.: Summer is a regular reader of this site. I assure you, she is tougher than any of us.

[Summer]

Brett, Thank you.

Random Bloke, let me give you an explanation, because clearly my meaning didn't come across. Plus, you don't know me, so it's easy you could have taken my words without the proper tone.

It is a scary sentence. Depression, free fall into recession, frankly I think any sane person would find it to be a scary sentence. Equally scary sentences exist in other areas of the news.

The economy effects everyone as a whole. I, for my own reasons, feel reasonable safe (some noted in the above comment, others not) from a failing economy. In fact, I have a distinct feeling that I may be one of the people who will do well in the coming economic change. However, I feel a sense of concern for society as a whole. I have a family, friends, communities I care about and a sense of humanity that desires to see people, as a whole, do well.

Knowing there are monsters in the closet does sound scary. Just because I point that out doesn't mean I'm afraid of them.

[Justin]

I read about monetizing the bubble on clearpolitics.com: http://www.clearpolitics.com/index.php?itemid=690

It appears that we are all screwed over this thing.

[Rich]

"It's just a scary sentence. I'm actually very intrigued by what'll happen as the economy changes. It's been a long time since a recession - especially a really bad one."

You obviously did not own stock or work for a tech company between 2000 and 2003. Possibly the worst period for stocks since 1929-1932.

[TakeFive]

What???

"Stressed homeowners who walk away from their properties can move into a rental and cut their monthly expenses, easing financial stress. Yes, their credit would be wrecked for a few years, but not as severely as if they foreclose."

If you walk away, what do you think is going to happen? Can you clear this up, or was I right to stop reading after point #1?

[brettdl]

Beats me. Depends what you were looking for.

[Carl]

Walk Away - we need a huge supply on market if we ever expect homes to be affordable again. Nobody wins with overpriced housing markets, everyone needs a place to live and has to pay taxes and interest on that - better cheaper than expensive.

[Max]

Carl>we need a huge supply on market if we ever expect homes to be affordable again.

How come prices were half of what they are just a few years ago, in many markets? Nothing changed fundametally since then (did our wages double since then?), just the financial lending mania that gave huge no-doc loans for people who could never pay back, and who were speculating, buying up properties sight unseen. Once the economy gets a dose of reality, things will start to go back to normal. But it will be painful on the way there.

[the baglady]

If you walk away you will get foreclosed on. It's not like it's a magical pill for not having debt anymore. Unless you mean walk away as in killing yourself, then your debt obligations are gone.

[Max]

Regarding why don't the homeowners just walk away, and why the banks/lenders won't quickly discount the REO properties on books to quickly move the inventory. This is a particular instance of a general phenomenon call "price stickiness" - economic participants do not discount their prices in face of disappearing demand. As the result, the bid/ask spreads widen, and transactions disappear, causing a recession or a depression. The real reasons why humans behave this way, is not yet fully understood.

http://en.wikipedia.org/wiki/Price_stickiness

[Max]

In many cases walking away and leaving the keys on the kitchen counter is the best way to make the debt "disappear". Here is why:

1. In many states purchase loans are non-recourse. The lender cannot go after your other assets and income.

2. Even if the loan is a recourse loan, the lender still won't pursue the defaultee, since he/she is not wealthy to begin with. The bad thing that can happen is the IRS goes after the imputed income on the forgiven debt, but I think the government already passed (or will pass, if things get very bad on the national scale) a tax relief.

3. Since many of those who default did not have to put much of a downpayment, there is no incentive to keep paying for an expensive depreciating asset. They have no skin in the game, making the choice to simply walk away very attractive.

4. Credis score impact will be severe, but not fatal. Many people have lived through bankrupcies and recovered the credit status in a few years.

[Vinekeeper]

The idea that some of you are going to rush into that receeding ocean beach to pick up stranded fish and exposed bottom feeders is chilling. You are like the tourists who know the landscape so poorly as to miss the natural signs entirely. The resulting tsunami will wash you away.

An age is over. You must soon enough begin to think of shelter (warm and dry will be gold), food (much better than silver), and life sustaining water. Looking at the various bubble debacles misses the larger action. The housing scam is only the first car hitting the wall ... soon to be followed by food prices, climate disasters, disease, energy cost disaster, geo-political disaster, political disaster ...

Sorry ... the list can go on. But most of you already know that "civilization" is cooked. Its just too scary to really think about it?

You just want to know what the future looks like? If you already are, or can become a small farmer ... in a community of small farmers, you might have a ghost of a chance. When the seas went out to expose all those fresh pickings, the natives all headed for the hills.

Welcome to a piece of history none of us could anticipate when we were born and systematically acculturated. You will be witness to historic change none of us imagine ... because it is change than none of us CAN imagine.

Wake up!