February 1, 2010
Last week I penned an article, "Why Are Homeowners Idiots?", that engendered a lot of heated debate.
The basis of the article was a paper by University of Arizona law professor Brent White. As White's paper pointed out, many severely underwater homeowners are staying put because of a perceived moral obligation to continue paying. Many readers of the article felt very strongly about this obligation, and suggested that there's no good reason to walk away -- particularly if you can still afford the monthly payments.
But let's try to step away from morals and simple truisms for a moment, and look at why the case of this subsegment of homeowners is so important to consider.
Adding fuel to the flames
There are certainly broader repercussions from homeowners who walk. Though there have been some signs of stabilization in the housing market, it's far too early to say that the market has truly recovered. Additional defaults only serve to exacerbate this problem, since they put downward pressure on housing prices and create even more inventory for the market to absorb.
This dynamic would create problems for homeowners in the areas where so-called "strategic defaults" take place, because they'd likely see the value of their homes decline further. It also causes problems for homebuilders like KB Home and Toll Brothers (NYSE: TOL), as they're forced to compete with the bargain-basement prices of foreclosures.
The situation would also put increased pressure on banks like Bank of America (NYSE: BAC), Citigroup (NYSE: C), and JPMorgan Chase (NYSE: JPM), not to mention wards of the state Fannie Mae (NYSE: FNM) and Freddie Mac, who would have to deal with the foreclosure losses.
But it's not that simple
There's a flipside to this coin, though. I believe that what we'd all like to see at the end of this mess is a housing market that is once again fully functional. While strategic defaulters may force us to deal with increased foreclosures now, they save us from having to swallow the problem over a longer period of time.
One of the key reasons that it may make sense for some severely underwater homeowners to default is because they can't rationally hope to have equity in their home for many years to come. If circumstances dictate that these homeowners need to move, or no longer have the means to pay for their mortgage a few years down the road, they will likely still be in a position where they will have to foreclose or short-sell, rather than sell their house on the open market through the normal process.
Even if these homeowners remain in a position to pay their mortgage for years to come, the lack of equity in their home will keep them out of the homebuyer pool, even if, under normal circumstances, they'd like to move up to a larger home. These factors could help keep the housing market stumbling along for some years.
Additionally, for the housing market to truly find itself on a sustainable path, we'd need to see home prices fall back into line with historical norms. One widely used gauge of home prices involves comparing housing prices with prevailing rental rates. Between 1988 and 2000, the average home in the U.S. sold for 14.6 times the average annual rental rate. Though this multiple has fallen significantly since its high of 25 in mid-2007, it was still at 18 during the third quarter of 2009. Strategic foreclosures could help bring this multiple down further, allowing more potential buyers to be able to afford a home, and putting the market back on a sustainable path.
And though my colleagues and I have poked some fun at the extraordinarily low interest rates that the Fed has been providing for banks, this highly accommodative stance from the Fed gives the banks additional ability to absorb hits from their mortgage portfolios now. Prolonging the process risks the possibility that the banks will have to keep limping along when interest rates are not there to cushion the blow.
Finally, as one reader pointed out to me in an email, homeowners who walk away from a hefty mortgage in favor of a lower rent payment suddenly end up with more money in their pockets at the end of every month. This money can be pumped back into the economy if they decide to spend it at Wal-Mart (NYSE: WMT) or Costco (Nasdaq: COST), for instance, or it can be pumped back into the stock markets as these folks rebuild their retirement nest egg.
A touch of gray
Considering many of the comments from my previous article, it is clear that there are many out there who believe that paying a mortgage is a very black-and-white issue. That is, if you can continue to do it, you have the unyielding obligation to do so.
Looked at from a broader perspective, though, the picture may not be quite so crystal clear. The mere fact that we have a good number of homeowners living in houses that are vastly underwater is a problem for the housing market, and it's a problem that we'll have to digest one way or another. As I've argued above, swallowing the bitter pill now may be preferable to letting the issue linger for years to come.
Of course, suggesting that homeowners walk isn't the only possible outcome from all of this. If banks start to get the sense that there is an increased willingness among this group to walk, the banks may decide that it is in their best interest to find a middle ground -- one that would potentially leave both the banks and the homeowners better off.
Last week I penned an article, "Why Are Homeowners Idiots?", that engendered a lot of heated debate.
The basis of the article was a paper by University of Arizona law professor Brent White. As White's paper pointed out, many severely underwater homeowners are staying put because of a perceived moral obligation to continue paying. Many readers of the article felt very strongly about this obligation, and suggested that there's no good reason to walk away -- particularly if you can still afford the monthly payments.
But let's try to step away from morals and simple truisms for a moment, and look at why the case of this subsegment of homeowners is so important to consider.
Adding fuel to the flames
There are certainly broader repercussions from homeowners who walk. Though there have been some signs of stabilization in the housing market, it's far too early to say that the market has truly recovered. Additional defaults only serve to exacerbate this problem, since they put downward pressure on housing prices and create even more inventory for the market to absorb.
This dynamic would create problems for homeowners in the areas where so-called "strategic defaults" take place, because they'd likely see the value of their homes decline further. It also causes problems for homebuilders like KB Home and Toll Brothers (NYSE: TOL), as they're forced to compete with the bargain-basement prices of foreclosures.
The situation would also put increased pressure on banks like Bank of America (NYSE: BAC), Citigroup (NYSE: C), and JPMorgan Chase (NYSE: JPM), not to mention wards of the state Fannie Mae (NYSE: FNM) and Freddie Mac, who would have to deal with the foreclosure losses.
But it's not that simple
There's a flipside to this coin, though. I believe that what we'd all like to see at the end of this mess is a housing market that is once again fully functional. While strategic defaulters may force us to deal with increased foreclosures now, they save us from having to swallow the problem over a longer period of time.
One of the key reasons that it may make sense for some severely underwater homeowners to default is because they can't rationally hope to have equity in their home for many years to come. If circumstances dictate that these homeowners need to move, or no longer have the means to pay for their mortgage a few years down the road, they will likely still be in a position where they will have to foreclose or short-sell, rather than sell their house on the open market through the normal process.
Even if these homeowners remain in a position to pay their mortgage for years to come, the lack of equity in their home will keep them out of the homebuyer pool, even if, under normal circumstances, they'd like to move up to a larger home. These factors could help keep the housing market stumbling along for some years.
Additionally, for the housing market to truly find itself on a sustainable path, we'd need to see home prices fall back into line with historical norms. One widely used gauge of home prices involves comparing housing prices with prevailing rental rates. Between 1988 and 2000, the average home in the U.S. sold for 14.6 times the average annual rental rate. Though this multiple has fallen significantly since its high of 25 in mid-2007, it was still at 18 during the third quarter of 2009. Strategic foreclosures could help bring this multiple down further, allowing more potential buyers to be able to afford a home, and putting the market back on a sustainable path.
And though my colleagues and I have poked some fun at the extraordinarily low interest rates that the Fed has been providing for banks, this highly accommodative stance from the Fed gives the banks additional ability to absorb hits from their mortgage portfolios now. Prolonging the process risks the possibility that the banks will have to keep limping along when interest rates are not there to cushion the blow.
Finally, as one reader pointed out to me in an email, homeowners who walk away from a hefty mortgage in favor of a lower rent payment suddenly end up with more money in their pockets at the end of every month. This money can be pumped back into the economy if they decide to spend it at Wal-Mart (NYSE: WMT) or Costco (Nasdaq: COST), for instance, or it can be pumped back into the stock markets as these folks rebuild their retirement nest egg.
A touch of gray
Considering many of the comments from my previous article, it is clear that there are many out there who believe that paying a mortgage is a very black-and-white issue. That is, if you can continue to do it, you have the unyielding obligation to do so.
Looked at from a broader perspective, though, the picture may not be quite so crystal clear. The mere fact that we have a good number of homeowners living in houses that are vastly underwater is a problem for the housing market, and it's a problem that we'll have to digest one way or another. As I've argued above, swallowing the bitter pill now may be preferable to letting the issue linger for years to come.
Of course, suggesting that homeowners walk isn't the only possible outcome from all of this. If banks start to get the sense that there is an increased willingness among this group to walk, the banks may decide that it is in their best interest to find a middle ground -- one that would potentially leave both the banks and the homeowners better off.
