A million foreclosures

by John Quiggin on January 30, 2008

The news that over a million homes went into foreclosure in the US in 2007, affecting about 1 per cent of all households or around 3 million people, supports the view that foreclosure has taken over from bankruptcy as the primary mode of financial catastrophe.

As with bankruptcy, however, the high frequency of financial distress is partly offset by the fact that US law and standard contractual arrangements are more debtor-friendly than in other countries. Compared to those in other places (at least in Australia) US mortgage contracts have commonly favored borrowers in two important ways. First, they have been fixed rate contracts with no, or limited penalties, for early repayment. That means that borrowers can stick with their fixed rate if market rates rise, but can refinance at lower cost if market rates fall.


Second, most mortgages are non-recourse, meaning that the lender can take the house but cannot recover the debt from the borrowers income or other assets. That means that once the value of the house falls below the amount owing (equity becomes negative) the borrower can walk away from the house and the debt. As Felix Salmon notes, the difficulty of pursuing deficiency payments means that most loans are non-recourse in practice even if the contract says otherwise

In the jargon of financial assets, the standard contract gives borrowers both a put option on the house (the ability to walk away) and a call option on the debt (the ability to pay early). Both of these make the contract more valuable to borrowers and less valuable to lenders. There’s quite a good discussion of all this from Tanta at Calculated Risk, though the author makes heavy weather of the put option and seems to me to be unreasonably exercised about the fact that households are now treating their debts to banks with the same calculating attitude that corporations have long shown to their workers and other creditors, paying them if it is profitable to do so and defaulting otherwise.

The relatively generous treatment of debtors in the US seems to illustrate, at the national level, a pattern found among US states. Pro-debtor institutions are, in political terms, a substitute for redistributive taxation.

Where credit is easy, and the consequences of non-repayment are not too drastic, households can maintain consumption for long periods even when their income is falling. So, the political resistance to pro-rich policies is much less sharp. The massive increase in income inequality in the US since 1970 has coincided with an equally massive boom in consumer credit.

The obvious question is whether this political equilibrium can survive. We’ve already seen a tightening of bankruptcy laws in the US and a big shift away from fixed-rate loans. Almost certainly, in the wake of the current debacle, lenders will act to protect themselves from jingle mail by lending lower proportions of house value and demanding additional security.

But, on the other side of the coin, there are indications that the willingness of average Americans to put up with a system in which virtually all the gains in income of the last few decades have gone to the top 10 or 20 per cent of households with the top 1 or 2 per cent getting the lion’s share. The candidate who has pushed the issue hardest, John Edwards, has not done well in the race for the Democratic nomination, but there seems to be general support for letting all or most of the Bush tax cuts expire, which would be the first effective tax increase for the rich in quite some time.

{ 28 comments }

1

abb1 01.30.08 at 12:54 pm

What’s happening with “the willingness of average Americans to put up with a system”?

2

superdestroyer 01.30.08 at 1:05 pm

A few small points.

1. Homeowners can renegotiate the loan but cannot sell the loan to someone else. The U.S. gave up most assumable loan years ago. Homewoners received the ability to refinance instead.

2. Most people do not live in the homes for decades. The real estate market has been built on the idea that the mean time of ownership is less than seven years. Thus, many old loan go away anyway. It is one of the reasons that 30 year, fixed rate, 20% down loans did not seem to make as much sense.

3. The are still negative impacts from just “walking away” such as impact to credit rating, ability to get another home loan, and even get employment due to bad debts.

4. The unanswered question is how many homes were purchase on speculation instead of for owner occupancy? Many understanding that many foreclosures are for speculator purchase properties.

3

rm 01.30.08 at 1:37 pm

The willingness of Americans to put up with the system is a bit like the willingness of chickens to put up with overcrowding. We didn’t exactly choose it. Yes, we, unlike a chicken farm, are a democracy, but it takes a political movement to make people feel empowered to change things. It seems to be taking a long time to generate a movement. Meanwhile, the industries write the laws, hand them to their legislators, and the laws are passed. And yes, cheap credit does look like how we got bought off for our higher payroll taxes and payoffs to the aristocracy since 1981.

One such industry-written law made it much, much harder to declare bankruptcy. So that might be one reason why people are more willing to dump off their house loan on the mortgage lender. Mortgages get sold around to different lenders, so it’s hard to feel loyalty to the fifth institution to which one has written checks. And if one can’t pay, and has other debts that can’t be escaped through bankruptcy, walking away from the house may really be the only choice.

Yes, a lot of speculators are stuck with their get-rich-quick schemes. But it’s a classic phenomena of a bubble that a bunch of ordinary rubes jump in to invest at the peak, so a lot of people who were intending to “flip” the house are also living in it, and are gambling with everything they have.

4

Steve LaBonne 01.30.08 at 1:45 pm

The obvious question is whether this political equilibrium can survive.

I hope this analysis is right. But I’m not sure any politician has ever lost an election by overestimating the false consciousness of the typical member of the American middle class. They all think they’re going to be rich, any year now.

5

SamChevre 01.30.08 at 2:02 pm

Felix is right for California; the non-recourse nature of loans is mostly a California issue.

I don’t think “most mortgage loans are effectively non-recourse” is the case anywhere else.

6

Keith 01.30.08 at 2:10 pm

Congress also changed the rules for bankruptcy last year, making it essentially the atom bomb of financial ruin. No more walking away with a clean slate. Declaring bankruptcy now in the US is the last step before you take up residence in a cardboard box under the bridge.

So comparatively, foreclosure is less hazardous to your credit rating, leaving open the possibility that, in a few years when the market turns again, you might still be able to salvage something.

7

derek 01.30.08 at 2:47 pm

Chapter 7 bankruptcy was taken away because the corporations felt the little people were abusing (that is, using) the facility. Will clean-slate foreclosure disappear by Act of Congress for the same reason?

8

Barry 01.30.08 at 3:06 pm

From reading various discussions of the bankruptcy bill last year, I gathered the impression that bankruptcy wasn’t so much an ‘atom bomb of financial ruin’ as no longer accessible to Joe Schmoe (Joe Schmoe, Inc. can still do it, of course). Whatever is still accessible to Joe Schmoe will not negate debts, leaving Joe still encumbered.

9

Barry 01.30.08 at 3:13 pm

sorry, derek – I posted before I saw your post. I expect clean-slate foreclosure bans to sweep state legislatures in the near future. And probably (g*d d*mn them) even in the Democratic Congress.

10

Barry 01.30.08 at 3:17 pm

John Quiggin: “Almost certainly, in the wake of the current debacle, lenders will act to protect themselves from jingle mail by lending lower proportions of house value and demanding additional security.”

Wouldn’t this just be a return to normalcy? The classical example was requiring a 20% down payment – this provided the orginating institution with a margin to cover foreclosure/sale costs and a drop in the house price.

11

Steve LaBonne 01.30.08 at 3:20 pm

And probably (g*d d*mn them) even in the Democratic Congress.

We’ll continue to get “that” kind of Democratic Congress until a sizeable number of voters get smart enough to stop voting against their own interests. I’m afraid I’m not holding my breath.

12

Barry 01.30.08 at 3:26 pm

Neither am I, Steve. Sometimes, I can’t – the ability of so many people to scr*w themeselves over is breathtaking.

13

rm 01.30.08 at 3:32 pm

In related news, apparently John Edwards is dropping out of the race. So much for influencing the eventual nominee towards good policies.

14

Colin Danby 01.30.08 at 3:34 pm

Calculated Risk had a story of a guy who, finding himself underwater on his current house, had bought another (now much cheaper) house while his credit was still good, and was gonna stop payments on the old one as soon as he moved. This could be one more reinforcing mechanism as prices slide.

I’ve seen little discussion outside Calculated Risk of legislative efforts to raise the cap on mortgage guarantees, which seems like a really bad idea.

15

SamChevre 01.30.08 at 4:14 pm

keith/derek/barry,

It seems a review of what the bankruptcy reform bill actually did would be helpful, as you are obviously very confused.

Chapter 7 (liquidation/clean slate) bankruptcy is still available automatically, provided you: (1) Go to credit counseling first and (2) have a household income less than the state “family with 2 children” median (about $70,000 in VA). Otherwise, (if you have above average income), you have to show that Chapter 13 is not appropriate for some reason.

Chapter 13 (5-year restructuring) bankruptcy is still available, on pretty much the same terms as before.

16

Jim S. 01.30.08 at 4:22 pm

Sorry, the American people once supported 90% top income tax rates, it could happen again. That is, if the left would start advocating these causes, instead of programs that benefit only certain small portions of the population as a whole-women, gays, minorities, etc.
As for Edwards not doing too well-it may be due to Democratic primary and party voters being actually more conservative than the population as a whole. That is something to consider.

17

lemuel pitkin 01.30.08 at 4:47 pm

certain small portions of the population as a whole-women, gays, minorities, etc.

Um, you need to rethink this one, Jim.

18

Slocum 01.30.08 at 5:06 pm

“foreclosure has taken over from bankruptcy as the primary mode of financial catastrophe.”

“Second, most mortgages are non-recourse, meaning that the lender can take the house but cannot recover the debt from the borrowers income or other assets.”

Those two statements are mutually contradictory — as you note, in the U.S. walking away from a house and mortgage doesn’t result in financial disaster. At least not for the borrower. Which explains why this has been so disastrous for lenders and mortgage holders (and holders of mortgage-backed securities). In fact, the bubble was a gold-mine for many people — they repeatedly refinanced their house, taking out tens of thousands of ‘new equity’ at a shot, spent it all, and now can walk away without paying any of it back. Here’s an extreme case of people who managed to supplement their income somewhere between half a million and a million dollars over a five year period:

http://www.irvinehousingblog.com/2007/12/19/heloc-abuse/

It’s worth pointing out that this no-recourse system is also ideal for speculators who made a bundle flipping houses during the run-up. They got to keep any profits they made and turned the last batch of houses they were holding back to the bank (which was not really a big deal since they generally put in virtually no equity).

By the way, UK, you’re next.

19

Nix 01.30.08 at 5:38 pm

The URL for this article suggests that its original title was ‘Two million foreclosures’.

At this rate (halving every, what, six hours or so?) there’ll only be about fifty foreclosures by this time next month ;}

(I was talking to a broker last month who said that the foreclosure wave was ‘a myth’. I suspect he’s now eating his words, or at least his bonus.)

20

Steve LaBonne 01.30.08 at 6:28 pm

I would like to encourage our Republican friends to go on bashing debtors at every opportunity. Quite a winning strategy under current circumstances.

21

Slocum 01.30.08 at 7:11 pm

I would like to encourage our Republican friends to go on bashing debtors at every opportunity. Quite a winning strategy under current circumstances.

It cuts both ways — most Americans know people who took cash out of their house through refinancing and lines of credit at every opportunity. They also know there were a lot of speculators in the market flipping houses. Propose policies that will bail all those folks out and a lot of ordinary people who were careful with their money, and you’ll make those people feel like chumps and they’ll resent it.

But Americans also know there were also plenty of people who were persuaded by unscrupulous loan originators/scammers to take out mortgages with onerous interest rate resets and prepayment penalties that they could possibly afford. And people will want to see help for people in those situations and will be angry to see them take all the blame for their predicaments.

22

Steve LaBonne 01.30.08 at 7:13 pm

Thanks! I knew I could count on you. Please do keep it up, and more importantly encourage your candidates to do the same. Hillary’s going to need your help.

Am I being cynical? Sure. I learned that from watching Republicans. Turnabout is fair play.

23

Slocum 01.30.08 at 8:32 pm

Am I being cynical? Sure. I learned that from watching Republicans. Turnabout is fair play.

There’s clever cynical and stupid cynical. The stupid cynical move, I think, would be to be completely tone-deaf to the issue of responsibility and pretend that greed or reckless behavior on the part of borrowers played no role whatsoever.

It strikes me that a politically smarter approach is to acknowledge that the group of defaulters includes both speculating house-flippers who deserve worse than they’re getting and people who used their homes as ATMs in order to live far beyond their means — but also financially unsophisticated working class people who were conned into ‘teaser rate’ refinancing that may cost them a home they’ve lived in for many years. And to propose remedies targeted at the latter but not the former.

As Edwards demonstrates, the pure populist approach just doesn’t seem to be selling all that well — not even in the Democratic primaries let alone the general election.

24

Steve LaBonne 01.30.08 at 9:21 pm

I’m not personally tone deaf- I have no love whatsoever for the a-holes who milked imaginary equity from their houses and then walked away having banked far more money than I’ll ever see (though the lenders also deserve to lose because of their greed and stupidity). But what I will guarantee you is that this line of argument will not play well with voters anxious about their own futures.

25

Stuart 01.30.08 at 10:02 pm

Especially if you factor in most of the people in the former group have probably convinced themselves their situation was different to the other flippers/equity milkers, and they had good reason to do what they did and they would have had no trouble if it wasn’t for the irresponsible borrowers and flippers.

26

dave heasman 01.30.08 at 11:40 pm

27

Down and Out of Sài Gòn 01.31.08 at 12:02 am

As for Edwards not doing too well-it may be due to Democratic primary and party voters being actually more conservative than the population as a whole. That is something to consider.

That explains a lot.

28

Kent 01.31.08 at 5:43 pm

But most of Edwards’ support came from conservatives!

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