Felix Salmon

A textbook case of jingle mail:

I got an agreement of sale today from a realtor looking for a prequal on a shortsale , the buyer lives next door , he has a current mortgage for $800,000 on a home he purchase in 2005 with no money down , the home he has under contact is right across the street from his present home , the offer is for $500,000 and it looks like the bank will accept it

The borrower plans to buy it as a primary , once he moves in , they will stop making payments on the $800,000 loan that they have with CW

He qualifies full doc and has a 770 FICO , he figues letting his credit tank is not a big deal when he is lowering his mortgage debt by $300,000 .

In English, I live in an $800,000 house I bought with no money down. I can buy an identical house across the street for $500,000. My credit’s great, since I’ve never missed a mortgage payment. But as soon as I buy the house across the street, I have every intention of never making a mortgage payment on my present place again. Since my mortgage is de facto non-recourse, and since I don’t need to pay taxes on forgiven debt, the cost of default is basically zero, while the benefit of default is $300,000 in lower total indebtedness.

The loser here is Countrywide (CW), which lent $800,000 to a man with good credit and will now have to sell his house, out of foreclosure, for maybe $500,000 if they’re lucky. After costs, they could easily be sitting on a loss of $400,000.

Alternatively, the loser is whomever ultimately bought Countrywide’s loan.

I don’t know whether this is fraudulent or not, and frankly it doesn’t really matter. Note that this has absolutely nothing to do with subprime: everything in this scenario is a prime loan. There are a lot of people who would be more than happy to wreck their prime credit in return for hundreds of thousands of dollars. Credit score simply doesn’t appear in the formula:

Negative equity + Non-recourse debt = Very nasty price dynamics and mortgage losses.

(Via Tanta)

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:

1. 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.
2. 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.
3. 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."
4. 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.

Have I mentioned of late how much I love my commenters? Many

thanks to James

Moore, who adds a very interesting twist to my obsession over

the proportion of mortgages which are non-recourse.

Moore gets straight to the heart of the matter: the key

question isn’t how many mortgages are non-recourse, but rather how many

mortgage lenders would go after their borrowers for unpaid mortgage

debts even after the property in question is sold at foreclosure.

Moore’s insight is that just because a lender can

pursue a borrower, doesn’t mean it will. And the

key distinction to be made here is between judicial and non-judicial

foreclosure.

I’ll let Tanta

explain the difference:

Foreclosures can be

“judicial” or “non-judicial.”

Some states require judicial foreclosure; most states allow one or the

other at the lender’s election or in certain other

circumstances. A judicial foreclosure requires the lender to sue the

borrower in court for satisfaction of the debt. A non-judicial

foreclosure allows the lender to use the “power of sale

clause” in the mortgage document to force sale of the

property without a court order.
Because

the non-judicial foreclosure uses powers granted to the lender in the

mortgage document, which is executed by the borrower at the time the

loan is made, the property sale is, in essence, already

“authorized” by the borrower. When you sign a

mortgage document, you are agreeing in advance to sell your property at

public auction if you do not pay the debt as agreed in the note.
Non-judicial foreclosure is

almost always faster and cheaper for the lender than a judicial

foreclosure. Most of the time, when there is a choice, the lender

chooses the non-judicial option for that reason. The big benefit to the

lender of a judicial foreclosure is that the lender can ask the court,

when appropriate, to enter a “deficiency judgment”

against the borrower; this makes the borrower liable for any difference

between the proceeds of the sale and the debt owed when the borrower is

upside-down. Practically speaking, a lender who chooses non-judicial

foreclosure generally waives its right to seek a deficiency judgment.

The lender’s calculation, obviously, comes down to weighing

the benefit of quick sale and reduced expenses against the cost of

(potentially) writing off part of the debt.

If a mortgage lender wants to sue a borrower for repayment

over and above the sale proceeds from the property, then, it basically

needs to go to court and get a deficiency judgment. If you’re going to

go to court anyway, you might as well get a judicial foreclosure: if

you opt for a non-judicial foreclosure, then the chances of your going

back to court for a deficiency judgment are essentially nil.

Now Moore says that in California, at least (all this is

complicated greatly by the fact that foreclosure law is made by the

states, not the federal government), “you just don’t see judicial

foreclosures” – they’re simply too expensive for the lenders,

and the extra money the lender might be able to squeeze out of the

borrower simply can’t compensate for the cost of getting that

deficiency judgment in the first place.

This surprises me, I must say. After all, California was

ground zero when it came to mortgage innovations like 125% LTV

mortgages, where the bank lent the borrower more money than the

property was worth. Clearly, no one is going to do that unless you have

a reasonable expectation that you can go after the borrower

individually for any monies not received in foreclosure. The credit

markets might have gone a bit crazy over the past few years, but they

didn’t go that crazy. (Please

tell me they didn’t go that crazy.)

But it’s also obvious that in these stressed times when

lenders can’t even service their loans properly because they’re

overwhelmed by the volume of defaults, they’re going to be extremely

hesitant to go through the hassle of a judicial foreclosure, if they

have a much easier alternative in non-judicial foreclosure.

So maybe even recourse borrowers might be able to walk away

from their homes without declaring bankruptcy – “jingle

mail”, it’s called – with the reasonable expectation that

their bank won’t pursue them for any extra money. If that’s the case,

it adds a whole new and rather unpleasant twist to the dynamics of the

property market. Suddenly, it becomes economically idiotic for many

prime borrowers to continue to make their mortgage payments, even if

they can quite comfortably afford them. And the implications of that

for properety prices are nasty indeed.

John Berry dedicates his

Bloomberg column today to debunking exaggerated estimates of

the magnitude of the subprime crisis. $300 billion, he asks? $400

billion? Pshaw.

A more realistic amount

is probably half or less than those exaggerated projections — say $150

billion. That’s hardly chicken feed, though not nearly enough to sink

the U.S. economy.

A loss of $150 billion would

be less than 12 percent of the approximately $1.3 trillion in subprime

mortgages outstanding.

Now Berry admits that the markets are valuing subprime

securities as though total losses will exceed $300 billion, so he’s

basically saying that he’s right and the markets are wrong. I’m

generally suspicious when people say that, but Berry’s math does make a

certain amount of sense:

Most subprime borrowers aren’t going to default. Suppose

even one in four does and lenders recover somewhat more than half the

mortgage amount. A fourth of $1.3 trillion in subprime mortgages is

$325 billion, and a 55 percent recovery would mean a loss of about $145

billion.

Once you remember that a good $500 billion of that $1.3

trillion is in fixed-rate subprime mortgages with relatively low

default rates, these kind of numbers do seem reasonable.

On the other hand, Berry assiduously avoids trying to tot up

total losses from Alt-A and prime mortgages, not to mention the

resulting losses in industries ranging from homebuilders to diswasher

manufacturers. So while Tyler Cowen points

to Berry’s column as a reason why he’s “not yet convinced by the

economic pessimists,” I don’t find it nearly as compelling. The fact is

that a lot of the USA’s biggest and most important banks are

in serious trouble, and when banks are in trouble, lending

and growth invariably suffer.

And at the risk of sounding like a broken record, I’ll repeat:

no one is going to have a real handle on mortgage losses unless and

until someone manages to get a handle on the percentage of mortgage

loans which are non-recourse. If your house falls in value and you have

a non-recourse mortgage, then it makes perfect economic sense for

someone in a negative-equity situation to simply walk away –

something known as “jingle

mail“. But given the amount of refinancing going on during

the last few years of the mortgage boom, I suspect that the vast

majority of mortgages are not non-recourse.

(Refis are never non-recourse.)

If there are lots of middle-class homeowners out there

suffering under the burden of enormous non-recourse mortgages which are

worth more than their houses, we could easily find ourselves in a

situation where total losses moved up into the $400 billion range. But

that’s a really big if.