Monday, May 12, 2008

Walking Away From the Mortgage

There has been some hysteria paired with some sober speculation (courtesy of esteemed minds like Marty Feldstein and Hal Varians) that what is driving home foreclosures, or what will drive the majority of home foreclosures is negative equity. I think this is both obviously correct and patently false. Where Feldstein and the like I think are wrong is they anticipate massive foreclosures brought on by negative equity for home owners who can afford their mortgage.

Background: Mortgages are Nonrecourse Loans
What makes a mortgage distinct from other loans is that it is non-recourse. What does this mean? Well, say I have a $500,000 mortgage and I default within six months of the loan's origination, the bank forecloses on my home and is only able to sell the home for $300,000. The bank can't come after me for the difference. They are stuck with the loss.

Two Scenarios:
Scenario One- the Foolish Speculator

A lot of folks got into mortgages that they couldn't reasonably afford but were banking on being able to take on a line of equity credit based on their home's appreciation. Thus, they're plan to pay for the mortgage was to take out more debt. This actually worked during the housing boom. However, when the bubble burst, homes ceased to appreciate, and thus there was no equity to tap. These folks went into to foreclosure and are going into foreclosure.

Scenario Two- the Solvent Homeowner who walks away

In Scenario two, the homeowner, while he can afford his mortgage, walks away from it because the bursting of the housing bubble has caused his mortgage to exceed the value of his house. I find this scenario unlikely for a number of reasons. The biggest reason, is if a homeowner simply walks away from his house which then goes into foreclosure, his credit will be wrecked. Your credit is vitally important. Landlords will look at your credit as a basis of whether or not to accept you as a tenant (an important consideration now that you don't hava a house). Banks look at your credit if you try to get a business loan from them. And the same applies to credit cards.

If the homeowner can afford the mortgage, he can ride out the housing downturn and wait till prices go up again, all the while, keeping his credit intact. There may be some regions where the downturn in real estate prices is more likely to be a permanent phenomenon (e.g. the rust belt) but for most areas prices are likely to rebound after awhile. Thus, it should come as no surprise that this second scenario, contra the emerging conventional wisdom, does not appear to be occuring.

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