The Next Shoe to Drop

Ever since the subprime debacle lots of folks in the industry have been worried about commercial real estate mortgages (i.e. multi-million dollar mortgages for office buildings, apartments, malls etc). But the commercial crash never really materialized despite lots of vacancies. This author attributes that to bias at the banks, but I don't think that's the primary reason:

http://www.marketplace.org/topics/business/easy-street/one-financial-crash-we-avoided

The biggest reason in my mind is leverage. During the go-go years you could buy a house with 5% down or less! This causes two problems. First if you're only putting a few thousand dollars down instead of tens of thousands have you really thought this decision through? And second if you only put 5% down then a 20% drop in house prices puts you hella underwater - unable to move, unable to refinance. Worse still, after the crash in house prices banks face an incentive compatibility problem. Financially its in their best interest to reduce your principal and get as much as they can from you. But if they do this for one person then tons more people will stop paying their mortgages trying to get their principal reduced and the banks would be screwed.

But we don't have this problem with commercial mortgages. In the commercial world 40% down payment is the standard and almost no one is allowed to put less than 25% down. So even if commercial property prices drop 40% (as they have) the property securing the mortgage is still valuable enough to cover the mortgage! I feel this is the key difference, if borrowers stop paying the bank can seize the property and not lose any money. Consequently there is no need to reduce principal, no incentive compatibility problems. Instead the banks can work out extensions, lower rates etc and everyone is happy. What happened with residential mortgages is that people took out too much debt and consequently were too leveraged. No doubt a good portion of this was reckless speculation and runaway consumption, but soaring health care and education costs also played a big role. These consistently rank as two of the top uses for home equity withdrawals. The more I think about this the more I feel our economic issues are all interconnected.