Monday, August 29, 2011

21st Century Indentured Servitude

In Orange County 1 in 6 homes is worth less than the mortgage outstanding on the home. That's 1 in 6 families who can't move, can't refinance and are throwing good money after bad. For folks who bought in 2005-2007 it will take decades for house prices to recover. These people aren't building equity in their homes, they made a bad decision at the peak of the bubble, took on too much leverage and ran into some bad luck. That seems to be a common theme these days.

How can the economy recover when so many people are held hostage by their homes, their student loans or their credit cards? Yes, as a country we took on too much but that happens. The US has always been a debtor friendly place, bankruptcy laws are very forgiving compare to other countries - just look at all the abandoned cars in Dubai:

But in recent years the US has become far less debtor friendly - at least for consumers. Student loans cannot be discharged in bankruptcy, they will garnish your wages, your Social Security, whatever they can get their hands on. Mortgage balances cannot be reduced in bankruptcy either - you either pay off the full balance or you walk away from the whole thing and lose your house. Imagine if corporations were subject to the same laws? It would be a disaster! Why do we subject families to such hardship but exempt corporations? We screwed up, give us a chance to fix it. This guy theorizes that we're actually in the middle of a super-crisis that started in the '70s. I'm not sure I buy it but he raises a lot of good points:


  1. To your point that borrowers can only pay their full debt or walk away and lose all their equity in the home, foreclosure is almost always a losing proposition for the bank and to that end banks try to avoid foreclosure. Considering:

    1. The cost of paying someone to go physically evict tenants,
    2. The people leaving the home are probably not going to go out of their way to leave it in good condition,
    3. The bank has to find someone to sell the house and pay them a commission, and
    4. The bank has to try to sell now, with prices depressed, versus waiting for the market to go back up,
    foreclosure is a suck for the bank. They will almost always try to work with the borrower to refinance, short sell, restructure their payments, etc rather than try to kick them out. Foreclosure typically only happens after several months of delinquency, after all other avenues have been exhausted..


  2. And that's exactly why there are millions of homeowners lingering in foreclosure/REO for 2 years or more. I didn't believe it when I saw in the NAPALM data, but its all there. People who haven't paid a cent but are still living there.

    Securitization messes up all the incentives, if the bank owns the note I'm sure they're much more willing to work with the homeowner. However when the loan is part of some security owned by potentially dozens of investors, there's no mechanism to negotiate. The investor takes the loss, someone else is servicing, someone else is trustee and don't even get me started on MERS. Its not even clear who (if anyone) has the right to foreclose! The whole thing is a giant giant mess.

    The only middle ground I see is if courts have the power to reduce principal balances. Now that creates a whole host of moral hazard problems of its own - but it may be better than what we're currently going through.

  3. Reduce principals? Can these courts increase principals when prices start going up again?

  4. Here's a neat article:
    Executive summary: bank makes loan. Borrower doesn't pay. Foreclosure goes to court and judge cancels the debt (?). Free house!
    I don't know how this turned out as I couldn't find more recent articles, so it may have been overturned at a higher level.

  5. No doubt there have been a number of people who have gotten mortgage debt canceled. But the problem is the millions who aren't so lucky. Plus these decisions are entirely one sided and questionable constitutionally. We need something more mutual - we (both the borrower and bank) screwed up, lets work it out.

  6. Living rent-free for two years or more sounds like a nice consolation prize for the borrower. How much do you value your credit score? There's a price for everything...

    Another thing to consider: realistically, how much equity in the home are borrowers sacrificing when they default? Many borrowers who, all of a sudden, found themselves unable to pay the note on their mortgages had interest-only (IO) payments for the first year or so of their mortgages' lives. IO borrowers pay less per month during the beginning of a loan's life (the interest-only period) because they don't pay down the principal, and when the IO period ends their monthly payment goes up because they're starting to make principal payments as well. Until principal payments are made, no equity is built up. So if a borrower walks away during or immediately after the IO period, they lose zero equity.

    Even non-IO, fixed conforming loans apply only a small percentage of the first few monthly payments to principal. So borrowers whose payments don't jump up after an IO period don't lose that much equity either by defaulting within the first two years... certainly less than two years' rent.

  7. Michael, I'm not exactly sure what you're arguing. People don't default if they have any equity at all, if you're $100k underwater on your house then you start thinking about how much your credit score is worth.