One of the biggest questions overhanging the housing market right now concerns the behavior of underwater mortgage borrowers. If the mortgage is non-recourse – and let’s assume for the moment that it is – does it always make sense for such a borrower to walk away from the house? If you listen to the likes of Nouriel Roubini, the answer seems to be yes – he expects as many as half such borrowers to walk away. But many other people, including myself, think that the incidence of "jingle mail" will be much, much lower.
The key concept in this debate is the idea of equity. If you’re in a "negative equity" situation, then on a purely economic level there is a strong case to be made for leaving your house and its associated mortgage. But how do you value equity? A blog entry by Buce got me thinking today: when people talk about "equity" in the context of residential housing, they’re actually talking about book value. And as any stock-market investor knows, there can be a world of difference between equity valuations and book value.
If your outstanding mortgage is larger than the value of your home, then you’re in a situation where liabilities (the mortgage) exceed assets (the house), and book value is negative. But it’s entirely possible for a company with negative book value still to have positive equity: look at General Motors, which is trading at $20 per share even as its book value is -$65.
If you sell your house, you’re essentially liquidating: you’re selling off the assets and paying off the liabilities, to the extent that they can be covered with the proceeds of the asset sale. But most companies are worth more than their book/liquidation value, and there’s no reason why home equity shouldn’t be thought of in the same way.
Buce points out that the equity can be valued as an out-of-the-money call option: it might not be worth much, but such options are generally worth something. And more generally, just as there’s value in operating a company as a going concern, there’s value in owning and living in your house, even if your mortgage payments are higher than they would be if you bought the house today.
Why do houses generally cost more to buy than they do to rent? Because there’s a speculative component to the price: buyers pay extra for the possibility that they might be able to make a large capital gain when they come to sell. Nowadays, of course, they’re likely to do the opposite, and force a discount to compensate for the possibility that they might have to suffer a large capital loss when they come to sell. But if you bought your home to live in it, and if you expected to make the mortgage payments you signed up for, and if you’re able to make those mortgage payments, then owning a house does still give you that possibility of future capital gains. And walking away will probably mean you can’t buy another house for at least two years, so you lose that option. (Theoretically, of course, you could buy your new house before you walk away from your old one, but I haven’t yet heard of anybody doing that.)
So where does that leave us? I suspect that prime fixed-rate mortgage borrowers are not going to walk away in significant numbers. Prime ARM borrowers expected to be able to refinance before their reset, and they might find that impossible if they’re underwater, so jingle mail is a possibility there, depending on whether the reset rate is significantly higher than their initial rate or not. Subprime ARM borrowers, of course, are already defaulting in record numbers. Which leaves just subprime fixed-rate borrowers: they’ll probably continue to make their payments unless or until they can’t.
But the willful jingle mail – can pay, won’t pay – I think is still going to be a very rare thing.