Do underwater homeowners have a zero cost option on future movement of home prices?

That seems to be the conclusion of the SF Fed, who note that for the upside-down borrower, there is merit in staying put. “Given the importance of falling house prices as a factor in defaults, it is natural to ask how far they must drop before it serves the borrower’s rational interest to strategically default, that is, to walk away from a mortgage even in the absence of a life event.

The SF Fed has left out one other important factor that determines whether the “owner” will strategically default: Alternative rental costs of similar or identical housing.

To this borrower, the ability to go down the block to rent a similar home at half the monthly price is a powerful incentive. One can hypothesize an entire neighborhood of post foreclosure rentals with each former owner renting the house to the immediate left of their prior home. Everyone (except the lender) wins!

If the Fed wants to determine whether someone might strategically default, I suggest looking at the state of the local rental market. If it provides competitive housing a much lower price points, you have the financial incentive to offset free option on home price directions.

Regardless of that omission, the charts are still powerful. Though we have seen these previously, they still have the power to astonish:

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What a difference a decade makes:

Underwater Homes, Q4 2000

Underwater Homes, Q4 2009

Excerpt:

Given the importance of falling house prices as a factor in defaults, it is natural to ask how far they must drop before it serves the borrower’s rational interest to strategically default, that is, to walk away from a mortgage even in the absence of a life event. A common answer is that house prices must fall to a point where the value of the house is less than the remaining loan balance, or when the house is “underwater” (see Thaler 2010, for example). The map in Figure 1 estimates the incidence of underwater first-lien mortgages in 2000. We do not know the actual values of the underlying properties backing these mortgages, but we can estimate the loan-to-value ratios by applying regional house price indexes to the appraised values of the houses at mortgage origination. In 2000, underwater borrowers were a rarity. The share of such borrowers exceeded 2% in just one state—Hawaii. The actual default rate, defined as the incidence of mortgages 60 days past due or in foreclosure, was about 2%.

The 2010 underwater mortgage map in Figure 2 looks very different. Over the intervening period, underwriting standards had shifted and lenders had become more willing to extend mortgages to borrowers who made small down payments. House prices also fell dramatically. The combination of small initial equity stakes and falling house prices produced a sharp jump in the proportion of underwater mortgages. In California, Florida, and Nevada, more than 20% of mortgages presently have principal balances that are greater than the estimated home values.

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Source:
Underwater Mortgages
John Krainer and Stephen LeRoy
FRBSF Economic Letter 2010-31
October 18, 2010
http://www.frbsf.org/publications/economics/letter/2010/el2010-31.html

Category: Credit, Options, Real Estate

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

19 Responses to “Do Underwater Homeowners Have Zero Cost Option on Home Prices?”

  1. Petey Wheatstraw says:

    (Tangentially related) back-to-back headlines at Calculated Risk:

    “Housing Starts increase in September”

    followed by:

    “Fed’s Dudley: 3 million excess vacant housing units”

    Somewhere in there, somebody’s Ox is getting gored.

  2. Arequipa01 says:

    Bloomberg Pimco, Blackrock, NY Fed requesting BoA buy back….hmmm.

    Will Au bounce at 1290?

  3. Marcus says:

    One observation from the second chart, why are Texas and Louisiana doing so well? We understand the forces at work in California and Florida. How did two populous, developed States duck the problem?

  4. Arequipa01 says:

    http://bestcities.milkeninstitute.org/bestcities2010.taf?rankyear=2010&type=rank200

    Are there clues embedded in this ranking exercise that could suggest the regions or cities which will likely experience soonest a recovery in res housing?

  5. Why walk away? Strategically default and then just stay there. Spend the money you save on rent to hire a lawyer to fight the foreclosure process tooth and nail. Demand that the bank “show the note” as ZH, et al, advise is a great strategy for fucking a bank out of its interest in the repayment of money you borrowed from them. With all this fraudclosure talk, you’d have to be a fool to allow a mortgage against you to proceed unabated. Forget “don’t pay, don’t stay”. Now it’s “don’t pay and stay”. Life’s good.

    But your tax bill’s gonna go up. To fund Tarp II to bail out the deadbeat banks again. There really is no such that as a free lunch, or house.

  6. bergsten says:

    Wouldn’t it be simpler all around for the bank to just rent the home to the foreclosed owner? The property would be kept up, there wouldn’t be moving expenses, no change-of-address forms, and nobody would have to come around, change the locks and steal the parrot.

  7. Perrin Clemenceau says:

    Re: The Curmudgeon

    I’m paying mortgages on five properties. One commercial, three residential four-plexes, and my own personal home. I’ve never missed a payment, been late, etc…

    If you think for one second that I will continue to make payments on these notes without hard documented proof of title/ownership, then I say you are; certifiably insane, a bank branch manager, or you don’t own any property. The rule of law cuts both ways, and its there to protect both parties of a contract.

    I’ve hired counsel to verify that the $3.86 million in mortgage payments I’ve made over the past six years has been made to the correct party. If my current servicers can’t (or refuse) to produce the required documentation, then I will file suit and seek to recover past payments as well as have the liens removed from my affected properties. Then, I will negotiate a settlement on this newly unsecured debt.

    I applaud all others who are seeking remedies through the courts as well. I’m on the cusp of putting your “no free house” statement to the test, and I couldn’t be any happier about it.

  8. beaufou says:

    Holy cow, I just googled rentals in my area and renting is the new buying.

    “But your tax bill’s gonna go up…”
    Our tax bills are going to go through the roof anyway, but it’s ok, because if you fall behind on your taxes, our banking friends are always there to help and take your burdensome house away:
    http://www.youtube.com/watch?v=g2bju39fTTI&feature=player_embedded

    This is the boomerang effect of cheating your way to prosperity.

  9. beaufou says:

    Actually, after reflection, don’t pay your mortgage and your taxes.
    Maybe, with the fantastic job Banks have done with paperwork etc… they’ll actually be able to buy your debt and foreclose on themselves. ( :

  10. Fred C Dobbs says:

    Here we go again, stirring up people without disclosing the facts. This is not new. In California, it has been ‘heads’ I win and ‘tails’ you lose in betting on the direction of real estate values, since the Depression. If I buy a house and pay 20% down, and borrow the rest, I can walk at any time, because California prohibits personal judgments against the borrower for the difference between the loan balance and the foreclosure sales price. Excepted are commercial loans, and refinanced loans on residences. However, the process of getting a personal judgment in such case makes getting them impractical. As a consequence, very few judgments are ever obtained against any real estate borrower in California. If the value goes up, the borrower wins but if it goes down, the lender loses. This is why, among other reasons, it never made sense for lenders to not require substantial equities when borrowing in California.

  11. louis says:

    This all goes back to BR and his observation that the banks are operating under a failed buisness model, They do not know what to do with these underwater homes. Many intelligent proposals have been floated. Their current model is to play chicken and dare the owner to default. In states like California walking is the logical decision.

  12. Fritz1234 says:

    We looked at this in 2008: http://housingderivatives.typepad.com/housing_derivatives/2008/02/the-free-option.html#tp.

    Many homeowners were grantyed an almost free option on the home, the biggest expense being the negative change in FICO score down the road. Underwriting free (or nearly-free) options is a real killer.

  13. dasht says:

    In a lot cases, I bet, it will work like unsecured debt:

    There are firms where if you are over your head in unsecured debt, they will act as “negotiators” with the creditors. The implicit discussion with the creditors is basically: “Settle on our terms or else we make it very expensive for you to collect even pennies on the dollar from this guy.” Debtor gets massive forgiveness and the mouthpiece firm takes a cut.

    On homes: there already are “short sale” brokers and it is a similar deal. They say to the banks “You wanna do this the easy way, or the hard way?” The banks then pay these brokers to get the homeowner to leave and (where the short sales broker is competent) with clear forgiveness of the note.

    If “foreclosuregate” raises the legal costs of foreclosure just a bit…. I predict that a lot of homeowners will eventually be paid by their lender to leave, free and clear, or else will get very sweet refi deals with some professional fees to the middle-man broker that raised the credible legal threat.

    Oddly, if foreclosuregate is really that bad? Then (with a little help from Congress for some liability protection) the net result could very well be a more efficient liquidation of under-water properties (with the courts bypassed by some professional fees and wheel-greasing).

  14. curbyourrisk says:

    Living in Nassau County, not near BR…..I have decided a value fo what is my walk away price. If houses in my area reach a certain level I am giving a BIG FU to the bank. I have already informed them of this and what my price is. They kindly reminded me of my moral obligation to pay the loan. To which I promptly fell on the floor laughing.

    FU Bank of America…….

  15. Lyle says:

    To answer Marcus, Texas does not restrict the use of land for development. Around Houston the development limit in the se is the swamps, elsewhere 100+ miles. Around Dallas Fort Worth 100+ miles of miles and miles. Austin, San Antonio to the east at least 100+ miles of miles and miles before they run into the miles and miles from Houston. So as a result prices did not run up as much. Secondly Texas had its own mini version of the crash from 1985 to 1993 or so. My house in Houston went down 50% in price. There is still memory of this in the bank population of Texas since all but one bank in the state got bailed out at the time, and Texas Commerce got bought by the Chemical Bank of NY. This is how BofA got into Texas when one of the big banks failed.
    So both house prices did not go wild and bankers remembered the crash during their career in Tx. For La at least avoiding NO again little limits to development.

  16. Julia Chestnut says:

    We rent a house for half of what the mortgage would be on the house. Of course, the price of houses in this area is INSANE – like, half a million for a 1500 square foot house. I can’t afford to buy here, even remotely, and my rental is across the house from three brand new, $2 million homes. I’m sorry, that’s crazy. If I could buy here, I wouldn’t. I’d rent.

    I’m with you: why would anyone on earth pay twice what they could be paying for a house for the pleasure of being responsible for upkeep?

  17. “I’m paying mortgages on five properties. One commercial, three residential four-plexes, and my own personal home. I’ve never missed a payment, been late, etc…

    If you think for one second that I will continue to make payments on these notes without hard documented proof of title/ownership, then I say you are; certifiably insane, a bank branch manager, or you don’t own any property. The rule of law cuts both ways, and its there to protect both parties of a contract.

    I’ve hired counsel to verify that the $3.86 million in mortgage payments I’ve made over the past six years has been made to the correct party. If my current servicers can’t (or refuse) to produce the required documentation, then I will file suit and seek to recover past payments as well as have the liens removed from my affected properties. Then, I will negotiate a settlement on this newly unsecured debt.

    I applaud all others who are seeking remedies through the courts as well. I’m on the cusp of putting your “no free house” statement to the test, and I couldn’t be any happier about it.”

    For the record, I own my home and a small farm, free and clear. Of your real estate portfolio, best of luck to you in getting those pesky banks that lent you money for it off your back. Don’t walk away. Just push them away. It won’t be free, however, if you are successful in turning “owership” into ownership. For one, the banks won’t be likely to ever lend you another dime. For two, the “free” property you receive will be paid for in higher taxes for those of us that actually saved and invested and bought things with cash and didn’t get out of paying for them because of a legal technicality. Of course, you’ll be paying higher taxes, too, but I suspect not to the tune of nearly $4.0 million. So, good luck with your strategy of fucking over the banks on obligations that you admit to having made, while still getting the property in the end. That’s better even than Donald Trump does. He either pays the loan or walks away and forfeits the property. This really is no country for honest men.

  18. ashpelham2 says:

    I think all of these southeast states, with the exception of Florida, which isn’t really like the southeast in any way, just have less gambling take place by banks and the residents, as the states so deep in trouble right now. There are generally lower incomes in those states in better shape right now, GENERALLY SPEAKING. I worked in credit analysis for a large southeastern bank in the time period of 2004-2006, and we monitored these credits very personally, especially in the aftermath of the Hurricanes of 2005, to manage any debts that might be at risk. My financial institution generally was not in on the packaging of loans deal.

    Alabama, my state, probably is in a little worse shape because we had a presence by some of the biggest risk taking banks. Wachovia specifically, and their cavalier attitude toward lending out money on houses. And no one can argue that they didn’t have their place in this mess, as their purchase of Golden West in 2004 was one of the stinkiest bank acquisitions to occur until the entire crisis began.

    I’m not expert on banking in the southeast, but states like TX and LA were just managed more diligently than CA and FL by the lenders, and the borrowers. AL and TN can be grouped that way too, but GEORGIA had aspects to it similar to western or Northeastern states, primarily because of the demographics of Atlanta. I can speak for Mississippi, as I work for a company HQ’d there…..MS is just not a very well off state, in any way. There is inherent risk in doing any large transaction there. Commercial, residential, or otherwise.

  19. ashpelham2 says:

    The Curmudgeon@8:33

    I see your point and it’s valid. Sure, it appears that the OP is trying to walk on his obligations. But his lenders didn’t follow through on their obligation to maintain minimal records for him either. I bet once he pays off the properties through the course of making payments, when he’s done, it’d take those lenders forever to finally present the borrower with the title, due to their own fumbling, over-sized idiocy.

    So, while I understand the social obligation you are illustrating to that OP, let’s not think for one minute that this is “Hands Across America” all over again. It’s every man, woman, borrower, or lender, for themselves. If you can get an advantage financially, you have to take it. It’s too hard to live in this world without wealth and possession, no matter how it is obtained.