The Edge Annual Question this year asks a group of (mostly) scientists what they have changed their mind about and why. I’m no scientist, but this is as good an opportunity as any to make explicit two things, both mortgage-related, on which I changed my mind in 2007. Both of them fall under the general rubric of "a little knowledge is a dangerous thing": I would have been much better off with a completely naive view than I was with a very basic grounding in mortgage finance.
The first is relatively narrow: it’s the question of the effect of default rates on the prices of mortgage-backed securities. At the end of 2006, a lot of people started getting rather alarmed at a spike in mortgage default rates, especially among subprime borrowers. Obviously, if you package up mortgages into securities, and then those mortgages start defaulting at historically unprecedented rates, those securities are going to fall in value.
But I wanted more detail: I was interested in how much mortgage-backed securities would fall in value when default rates rose. So I did some paddling around in the shallow end of the theory of mortgage bonds, and what I found surprised me: no one seemed to be the slightest bit interested in default rates. The prices of mortgage bonds were entirely a function of prepayment rates, and default rates simply didn’t enter into the equation.
That fact – and it was a fact, until recently – informed my thinking on mortgages for far longer than it ought to have done. In reality, there were two considerations which trumped the defaults-don’t-matter-only-prepayments-do paradigm. The first was that we were at the start of an unprecedentedly nationwide housing slump, which meant that the geographical diversification built into most mortgage portfolios was of little if any help. And the second was that the underlying mortgages were very, very different animals to the kind of things for which there was a lot of price-and-default-rate history. Subprime mortgages of the 2005-6 vintage simply don’t behave like other mortages, because the underwriting standards used when they were issued were probably as lax as mortgage underwriting standards have ever been. And the originators didn’t care, since they made their money by flipping their mortgages via investment banks to investors in CMOs and CDOs.
My mistake was that I failed to appreciate how much a change in underwriting standards could and would effect the very dynamics of the entire asset class. Default rates had historically been dwarfed by prepayment rates; now, however, when default rates started getting up to the same order of magnitude as prepayment rates, the whole calculus of valuing mortgage-backed securities changed, and I was too blithe to notice for much of the year.
The second thing I changed my mind on is far broader: it relates to the whole concept of homeownership, and who exactly really owns a home which has been mortgaged.
Once again, the naive view is simple: the bank pays for your house, which means that the bank owns your house, unless or until you pay it off. Legally, however, that’s not the case at all. The owner of the home is the homeowner, and the bank is just a (secured) lender to the homeowner.
That’s why I’ve been so concerned with the whole issue of recourse vs non-recourse mortgages. People seem to think that they can just walk away from their house – and their mortgage – if they find themselves stuck in a negative-equity situation. In theory, that’s not true: the bank gets back whatever it can from the sale of the house, and then the borrower still owes the bank the balance.
In practice, however, as my commenters have pointed out – thanks especially to James Moore, P Jackson, and Uncle Festus – things can be very different, and it turns out that most mortgages are de facto non-recourse no matter what the letter of the contract says, even if the borrower does not declare bankruptcy. In order to chase its borrower for the remainder of what is owed, a lender has to go to court and get something known as a deficiency judgment. And it turns out that lenders, for many reasons*, are decidedly loathe to do that.
How this will affect the ongoing housing slump no one knows. It’s possible that it could exacerbate things quite nastily. Many borrowers can go from insolvency to solvency by simply mailing in their house keys to their bank: their assets would decrease by the value of their house, but their liabilities would decrease by the value of their mortgage, which could be substantially greater. People who bought speculatively, hoping to flip at a profit, might find such a course of action especially attractive: they not only have negative financial equity in their house, but they also have very little emotional equity in it. They were playing a game of "heads I win, tails the bank loses", and now Plan B is coming to pass.
The downside to such an action – bad credit – is relatively low, especially if the borrower lines up a nice rental before defaulting on his mortgage. After all, we live in a country where even bankrupts are bombarded with offers of secured and unsecured credit.
The other big downside to "jingle mail" is the tax bill which arrives when a lender forgives a large chunk of your loan. But guess what – the government has now decided to waive those taxes, at least for 2008. So if you think you might find yourself losing your negative-equity home at some point, it really makes quite a bit of sense to walk away from it this year, just as soon as you’ve found somewhere else to live.
I’ve changed my mind on this only in the past week or so, and I might change it back if stories start trickling out about individuals who have lost their homes but not their mortgage debts. But for the time being I no longer subscribe believe in this, which I wrote as recently as December 19:
As for the homeowners, of course their houses are assets: it’s their mortgages which are liabilities. Losing their houses only means getting out of debt in certain limited circumstances: (a) when the loan is non-recourse — which is rare in the subprime world, especially since most subprime mortgages were refinances; (b) when the servicer accepts a short sale; (c) when the homeowner declares bankruptcy as part of the foreclosure process.
In reality, and especially in California, I now think that losing one’s house to foreclosure does, to all intents and purposes, mean wiping out all your mortgage debt. When a mortgage is hundreds of thousands of dollars greater than the value of one’s house, that can be a very attractive bargain indeed.
*Here’s four reasons why lenders are loathe to go to court to get a deficiency judgment:
- The borrower hasn’t got any money or much in the way of income, and it will cost a lot more to get a court judgment than the lender can reasonably hope to retrieve from the borrower as a result of it.
- There’s a wave of foreclosures, and servicers are already overburdened by the number of defaults and delinquencies they’re dealing with: they simply don’t have the time or the staff to start chasing borrowers in court.
- A deficiency judgment is not a slam-dunk: as commenter PJ says, "judicial foreclosures give the borrower a chance to highlight any fraud, real or imagined, that may have taken place at origination."
- The servicer doesn’t own the loan, and I doubt that servicers have any contractual obligation to get deficiency judgments against borrowers. Even if they did, the owners of the loan – the CMOs and CDOs – aren’t going to sue the servicers for failing to apply for a deficiency judgment. While securitization hurts borrowers by making loan modification more difficult, it also I think helps borrowers by making lenders less likely to take things to court.