Other than Andrew and Pete, it's not often that I disagree publicly with an economic icon, especially when it's Martin Feldstein.
But Feldstein's article from The Wall Street Journal about homeowner's who are underwater, that is, whose mortgage is greater than the value of their home, has troubled me greatly since it was published last Tuesday.
The article is based on the premise that homeowners who who are underwater have a strong incentive to walk away from their home and instead rent a place to live. That only makes sense if the homeowner bought the home to sell it and make a profit and now wants to cut his or her losses by getting out from what was a very bad investment.
As I've said before and continue to believe, at least in relatively recent times when home values were soaring, the real American Dream isn't owning your own home, it's selling it for far more than you paid. If the opportunity to do that no longer exists, and if some would be profit seekers got into the market too late to make any money, walking away from that investment before it loses any more seems to be rational.
But that's not what Feldstein is saying. He is assuming that the old version of the American dream -- buying and living in a home you own -- is still what motivates people. These are the folks Feldstein says have an incentive to walk away from their home and instead become renters. The reason, he says, is that the only thing these homeowners will lose if they walk away is the home. All of their other assets are protected.
That doesn't make sense.
First, if the goal is to have a place to live, then the underwater homeowner is already in a home of her or his choosing. It makes no sense for them to incur the additional out-of-pocket expenses, not to mention the time and hassle, that comes with moving.
This is more than just paying for a U-Haul van, notifying your friends about your new address, changing your information on yor driver's license and bills, and changing your landline number and cable tv and internet service. It could also involve far more difficult problems such as new schools and friends for your kids.
By contrast, there's no additional expense in continuing to make your mortgage payments. In effect, you're already renting, that is, you're paying to live somewhere without building any equity. So why incur any additional costs by walking away to rent somewhere else?
Second, in addition to the moving and other expenses involves in walking away from your home and renting, you also lose the big tax deduction you're getting for the mortgage interest you're paying. You may not be building any equity. and your loan-to-value ratio may be getting worse, but you're still paying deductible interest when you make mortgage payments.
That means that walking away from your mortgage likely makes your immediate financial situation much worse. By contrast, staying in your underwater mortgage probably means that it barely changes.
Third, walking away from a home and mortgage almost always negatively affects your credit rating and decreases your value as a renter to a prospective landlord. At a time when the demand for rental housing is increasing because of the mortgage and credit crises, why would a landlord take a risk on someone who has just abandoned a housing-related financial obligation?
Fourth, even if you did buy the property to make a killing when you sold it, walking away from an existing mortgage to rent means that you lock in your losses and have no opportunity whatsoever to make any money on your currently bad investment. The far better strategy, especially at this point, is to stay in rather than abandon your home and then wait while (hopefully) the market recovers.
Finally, suppose you want to trade your current bad investment for something you think will be better by getting rid of the existing underwater mortgage and buying a new house at the low prices that currently exist. Presumably that new house will appreciate from its current depressed price and you'll make some money. But that trade will work well only if you can get a new loan, something that you just made much more difficult.
Renting?
"Third, walking away from a home and mortgage almost always negatively affects your credit rating and decreases your value as a renter to a prospective landlord. "
Renting? They are walking away and moving in with parents, siblings, kids, etc. They can't afford rent. They've lost their jobs, or hours have been cut. You talk about it as if foreclosure is an investment decision. For many it is a survival decision . . . they don't have a choice.
The best insurance against more foreclosures is creating jobs. Obama says he'll try to create 2.5 million new jobs, and I believe that is the correct approach. If people can pay the mortgage they'll stay in their homes for the reasons you mention (disclocation, cost of moving, keeping kids in their schools, maintaining a good credit rating, etc.)
Blinders
Your perspective is informative. I have wondered how the financial industry could possibly overlook the housing bubble and not foresee that the collapse of a housing bubble would result in foreclosure. You are making assumptions about the costs of staying in an underwater mortgage versus renting that are just not consistent with reality. What you assume MAY have been true at one time but is no longer operative in today's market.
Start by comparing the monthly cost of making mortgage payments at the current rate to the monthly cost of renting. Consider that people who make $50K per year are paying less than the top income tax rate so their tax savings due to mortgage is much less. Also consider that deducting the total interest may put them into AMT territory. This is a less good incentive than you might imagine. After you go through a budget, it becomes painfully obvious that the best economic move is to walk away.
When people wake up to the fact that the banks are nothing more than loan sharks that have screwed them royally, why would they feel the need to hold up their end of a really bad deal? Loan sharks keep poor people hooked by threats of personal violence. Professional loan sharks (which is what Big US finance has become) cannot threaten bodily harm so there is no reason for borrowers to NOT stiff them. Walking away from bad deals is nothing more than economic self-interest and economists should not try to deny it and should NOT have assumed otherwise.
back-of-the-envelope fun
Let's say you bought a modest $600,000 house at the peak in San Francisco (May 2006 per Case-Shiller) with 5% down. With a 5% 30-year loan you've paid off nearly $20,000 principal, so you owe $550,000. If your house followed the Case-Shiller repeat-sales index precisely, its value was $416,000 as of August. Since home loans are non-recourse, the market currently is offering you $134,000 to walk away.
Now, I hate moving, but $134,000 seems like an awful lot of motivation to bite the bullet and move. The loss of the interest deduction doesn't impress when I can rent for less than the after-tax cost of my mortgage, and despite the correction in the housing market, I still can. Your analysis will start to gain traction only when the market has corrected enough that the subsidized cost of owning is comparable to the unsubsidized cost of renting. In many parts of the country that may now hold true again, but not where I live.
As for insuring against foreclosure, the best policy to me seems to prevent property bubbles. Replacing the mortgage interest deduction with a credit, or scrapping that subsidy entirely, seems like a good first step. Subsidies like that one just act as price supports, and we're seeing now what happens when residential housing prices get ahead of fundamentals.
It depends on the magnitude
how much you are underwater, how soon you expect prices to recover, how pressed you are and whether you can still afford it. The optimal course may be to hold on until prices reach bottom and then transfer to a different area buying at the low and forcing the lender into a short sale. Unemployment would work as well, but you would have to rent for a while to find work and rebuild your credit.
Here is the price to rent
Here is the price to rent ration (Case Shiller) link. This is why the assumption that it makes no sense to default on a mortgage is very wrong. Once housing price bottoms, that may be true. However the assumption does not hold at bubble prices.
Apparently, the financial institutions that wrote CDOs based on mortgages did not understand that we had a housing bubble. The Bush administration functionaries missed it as well. Obviously, they did not have the correct expertise to advise them.
http://4.bp.blogspot.com/_pMscxxELHEg/SSwHe3pC5eI/AAAAAAAAD2k/RQ9FZZsafJ...
In the end, Martin Feldstein
In the end, Martin Feldstein is a sright-winger. He believes strongly in things which redistribute wealth upwards, and opposes downward redistribution. That's what he's worried about, that people will start acting like cold-hearted corporations,and terminate disadvantageous (sp?) financial arrangements. It's O.K. when corporations decide that long-term employees are a net negative, or that a pension fund is just sitting there, but Market forbid that ordinary peons should act like that!
Mortgages
It's always helpful to get other peoples opinions about mortgages and how they are doing.
Depends on the location/situation
I live in Cape Coral FL. The condo that I purchased for $250K (with %15 down, btw)is now worth about $160K and still dropping. Unemployment in this part of FL is at 9.6% and rising. Houses that sold for $190K 2 years ago are now selling in the $60-70K range, and more are becoming available every day. For someone like myself, that is almost 50, walking away is the most viable option. The banks won't even talk to me unless you I am already 3 months behind (by which time my stellar credit is shot anyway.) The banks will not allow me to short sale, much less consider any debt forgiveness. I have tried to work with them, but they won't budge. So screw them. They can auction it for $90K and eat the rest. There are so many properties for rent here that I can get a place twice the size at half the cost, not worry about the expensive insurance,repairs bills, condo fees etc. As far as the blot on my credit, I'll just be part of the growing herd.
Post new comment