Saturday, February 23, 2008

10 percent of Homeowners Upside Down???!!!

That was the headline in yesterday's NYT, based on calculations from economy.com. Because the article doesn't describe how the calculations were done, it is not possible to agree or disagree with them, but I don't find the number on its face implausible.

Let us say for the sake of argument that the number is correct. It means that for 10 percent of owners, the put option contained in their mortgage (i.e., the option to put their house back to the lender) is in the money. If all these households default, the mortgage market will be cooked: Fannie and Freddie, who put 45 basis points of capital behind each mortgage they guarantee, would likely not be able to withstand so many defaults. Moreover, if ten percent of the market becomes REO, inventories will swell further, putting more downward pressure on house prices, which in turn will lead to more borrowers being underwater.

It is unlikely, however, that all such households will default. Past work by people such as Bob Van Order and Yongheng Deng has shown that people in the past usually needed to face a trigger event, such as divorce, job loss or sickness, before they default. The question is whether things are different this time: that because people are so aware of the declining housing market, they will understand more quickly that their house value is less than their mortgage balance, and will therefore default. After all, in principle, if one observes that her house is less valuable than her mortgage balance, she could default one day and buy the house back the next, and be better off.

But default doesn't actually work that way. When a borrower defaults, she trashes her credit score, and therefore reduces her options for either owning or renting going forward: people like having a roof over their heads. Beyond that, houses are idiosyncratic and can be more valuable to their dwellers than they are to the market. Houses become associated with memories, neighbors, gardens, strange paint colors, and other characteristics that make them valuable to their occupants in a way that cannot be reflected in the market. These things prevent people from defaulting (or selling when it makes more sense financially to rent). Finally, many households still feel an obligation to pay their bills. The fact that so many mortgage borrowers in Louisiana continued to make payments for homes Katrina destroyed is quite remarkable, and quite germane to the situation in which we find ourselves now.

How much these phenomena will prevent defaults in the next few years is an open and interesting question. I suspect we will know the answer pretty soon.

5 comments:

North GA Real Estate said...

I think people as you said suffor some sort of tragedy will not leave there homes and just wait for a time when there homes value is better to consider moving.

For those who must sell for job relocation, divorice, illness this can be a tough time and should always consider when buying a home in a sellers market did you overpay for the house. What was the value the last two years.

Shenghua Si said...

As data shown in recent years, more investors go into the housing market. They would more tend to ruthless default than homeowners, because these are not houses they live in but just financial investments.

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