Thursday, November 5, 2009

Expanding some thoughts on homeowners acting irrationally

The esteemed Bill Watkins responded to my post regarding Brent T. White’s assertion about homeowners acting irrationally. It should be noted that both our responses were to the press release and not going through the whole study. But I would like to focus on a few points and add in some anecdotes.

First, the point that I thought was most compelling from the original article. Many places that a homeowner turns for help will be designed to maximize the lenders profit not maximize the homeowners current situation. I clearly disagreed that the homeowner’s credit score shouldn’t be affected during default as they are causing the lender a loss and that is the contract they signed up for. They get the walk away option at some non-zero cost to themselves.

For Bill’s response he took umbrage with Brent’s (I’m on a first name basis with everyone I’ve never met before, which is basically everyone) suggestions that homeowners basically need even more leverage over lenders. Bill's point is this would lead to an under-allocation of credit as more borrowers could strategically default and fewer lenders would be willing to make loans.

The point I was trying to make in my comments last night (and utterly failed) and why I thought the article was originally interesting is that I think most underwater homeowners are incapable of making the best economic choice for themselves due to many of the factors Brent suggested. The “solution” given by Brent is immaterial. I think the focus should be at what point is it in the borrower’s economic best interest to walk away from a home. There are of course a tremendous amount of variables, personal income and savings, overall debt level, amount underwater, local rents, future price appreciation, cost/need of the loss of access to credit, tax level, liability for any debt that was forgiven, etc. That is a model I want to see but I am sure there is no money being spent on researching it (though I have seen studies at which point an underwater homeowner is most likely to walk away from a home).

I have two personal anecdotes I’d like to share about underwater homeowners and rational choices. First would be my landlord. They purchased this home in late 1990’s for under $200,000 and ran up the debt to a bit under $500,000 culminating with a single 2/1 interest-only ARM. We found out earlier this year they went into default so they could get a loan mod. This person is 62 years old and the lender reduced the interest rate to market, added the missed payments onto the loan and amortized the loan over 40 years. Since the banks have tremendous political pressure and are playing extend and pretend I can see why they offered this modification. But I can’t for the life of me figure out why the landlord took it. Her credit is trashed over 8-9 months of non-payment; it isn’t the foreclosure that hurts your FICO as much as the rolling 90 day lates, so it isn’t the credit score. This mod basically let them go a bit less cash flow negative (I obviously know the rent and have the modified deed of trust) every month and reduced the worry about if the interest rate will change. Their liability is limited since there is only one mortgage and with the single action rule in California that severely limits the lenders ability for collecting deficiency judgments.

The second anecdote was a neighbor I had met for the house we had bid on (which we ultimately didn’t get). We were looking at the house when the neighbor came over and started talking to us, her husband soon joined us and I met their son as well, they were very nice people. In the conversation the wife asked how much the house we were looking at was on the market for and when I told her she said “OH no! We got all these flyers saying our house was worth so much and now look at it.” It was in a nice tone but there was a seriousness to it as well, I noticed right when I said the price the husband looked agitated and excused himself right after and though he came outside several times after never looked at us again. I later looked and saw they refinanced $200,000 out of their home and were now, conservatively, $140,000 underwater. I don’t know these people personal financial situation at all, they could be the Rockefeller's for all I know. But not too many people can take such large hits, remember the debt service obligation on the debt as well, and have much of a nest egg leftover for later. Is the cost of owning a home causing their overall financial situation to be less stable? Have they even looked or thought about it?

I bring up these anecdotes because I think your average homeowner isn’t very real estate knowledgeable and are working at an informational disadvantage relative to lenders. Not only is there the emotional side of it: the tremendous desire for stability, to have something you call your own, to not have to say you failed at what was up until now a tremendous point of pride, fear and uncertainty of what to do even if you wanted to get out from under your obligation, the basic goodness is most/all to want to fulfill the contracts they signed. But there is the informational side: knowledge of the law and liability (“can the lender come after me?”), how much is my home currently worth (I am thinking many simply do not know and are staying willfully ignorant), tax issues, etc.

I think because of the emotional and informational disadvantages your average homeowners are basically incapable of making the right economic choice without a LOT of work and study of their personal situation. The home ownership side of the housing market simply isn’t that efficient and that was the point I was trying to emphasize when highlighting the research paper yesterday. The number of true ruthless default stories are small. And while lenders have a right to be worried IF it ever became a problem I see no wholesale shift in homeowners mindsets yet. I think it is just too great of a leap for most people to even start to contemplate.

Both Bill and Brent argue either side of the coin, whether it is rational for underwater homeowners to pay for underwater homes. I don't think we are even at the point where we can have the discussion with any accuracy. And I would bet due to our cultural bias towards fulfilling obligations we won't see much effort put into studying the economically correct thing to do. So I can have my opinions over what I think is the right thing for many heavily indebted people to do. But it will remain that, an opinion.

I will have some other discussion in the comments section of yesterday's post. I was also planning to read Brent's paper tonight but that will have to be put off for the weekend as I have just burned up my free time writing this and tomorrow night I'll be watching Penn & Teller at the Kavali Theater in TO.

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