[Nearly three years of strenuous efforts by the Fed to lift home prices has not added even a dime’s worth of inflation to the average dwelling. Perhaps it’s time to try a new approach by bailing out beleaguered homeowners, more than 35 million of whom owe more on their mortgages than their properties are worth. In the essay below, our astute friend Doug B, a Colorado-based financial advisor and formidable outside-of-the-box thinker, asserts not only that debt forgiveness can help return the real estate market to health, but also that lenders are likely to support it when they ponder the alternative of empty houses falling rapidly into an unsaleable state of neglect. RA]
With the latest round of discovery in the real estate market characterized by the foreclosure crisis, it is time to ponder the concept of Jubilee. Originally coined in Deuteronomy and Leviticus, Jubilee refers to forgiving of debt. Not being a student of the Bible, I shouldn’t try to interpret the reasons why it became law in the days of the Old Testament; but being a student of the Housing Bubble, I think I can weigh in on what it means for price discovery as we embark on the “C” Wave of the real estate market collapse. One look at the Case-Shiller Housing Index and you can see that calls for a bottom here or even another 10% lower is wishful thinking under the theology of Bob Farrell’s 10 Market Rules to Remember.
Household Debt Ratio
John Mauldin has written several thoughtful commentaries on how the carelessness in mortgage underwriting during the bubble will continue to create enormous friction in the foreclosure process, while revealing who the rightful owners are for much of the paper gone bad. Suffice it to say that the Financial Crisis still has some life in it from those perspectives. But I am more interested in how this will play out for the household. After all, I have been insistent that the Household Debt to Disposable Income Ratio has to revert to the mean with dramatic speed, much like oil prices did after that last bubble peaked. Back in the late 1930s, after the last secular credit collapse, the debt-to-income ratio bottomed below 30%. It spent the next 70 years climbing, finally in exponential fashion, to almost 140% before the housing/mortgage bubble burst in 2007. In order to get back even to high double digits, enormous amounts of debt will have to go away, because income growth cannot occur that fast even in the best of circumstances. And at the household level, mortgage debt is pretty much where it’s at.
So, how do we get there? I suggest that the only way to get there is through massive mortgage modification, whereby lenders are constantly marking their asset to market, which is 80% or 90% of the market value of the collateral. I am talking about offering the borrower a principle reduction to less than 100% of the appraised value and at an accompanying market rate (currently about 4%), just to deter the homeowner from sending in the keys. This is going to be big. We’re talking trillions of dollars.
But why will the lenders do this? I believe that Mr. Market will leave them no better choice. Let’s start with an example: an 80th percentile 55-year-old with $150,000 household income buys a $450,000, 4-bedroom house on a golf course in Tampa in 2006 with $75,000 down and a $375,000 6.5% mortgage. Now the place is worth maybe $250,000 and there are several places in the neighborhood where the lawn isn’t being mowed. The homeowner still makes $150,000, but he can’t refinance because he can’t make the loan-to-value. Then he finds out that the average homeowner in foreclosure won’t make a payment of any sort for eighteen months before he gets booted. And why does he have four bedrooms anyway? Nobody ever shows up except at Thanksgiving. They could stay at the Holiday Inn Express. Oh, and by the way, guess what happens to a house on a golf course in Tampa when the owner sends in the keys and shuts off the air conditioning. It turns into a rotten tomato in a matter of months. He feels a little bit like a chump.
Homeowner ‘Boxed In’
I would argue that the lenders and mortgage servicers really want to avoid foreclosing at all costs…because of all the costs. They own more empty houses than they can sell by their freshness date, so why not kick the can down the road until the market improves? But the guy in the above example is boxed in. He reads about affordability being at all-time highs, but he is trapped at 6.5% on $375,000 in debt on a (hopefully) $250,000 pad! Did you know that the Mortgage Debt Relief Act of 2007 allows homeowners who stiff their lender to exclude the debt forgiveness from ordinary income for up to $2 million through 2012? Did you know that, before that, when you told your lender to shove it, the IRS issued you a 1099 (subject to ordinary income rates) for whatever the lender wrote off as a loss on the foreclosure or short sale? No more. At least until 2013. So perhaps “strategic defaults” will start driving the market at the margin. Maybe Wells Fargo won’t care that you just stiffed Bank of America when you make a 0% down offer at $250,000 for the place across the street that they own. Bank of America has no recourse other than their collateral. Oh, and serve that with a 4%, 30-year fixed rate, if you please. My guess is that Bank of America intervenes by modifying so they don’t end up with the rotten tomato. How is that for taking knife to the Debt to Disposable Income Ratio?
I have thought of many reasons why lenders would not want to cooperate in this type of transaction, but sooner or later, Mother Nature shows up in the form of Mr. Market and makes a mess out of convention. It almost seems absurd to expect the process to be orderly when we just experienced the biggest, broadest credit driven bubble in human history. On the bright side though, whatever clears the market quickest is probably the cheapest solution for everyone involved. By marking the mortgages to the market, the lender gets a big piece of investment back and lives to fight another day. The homeowner, who lost all his money, can start putting one foot in front of the other again too.
Price Discovery
All this leads to the question of what such a process would mean for price discovery. On the positive side, it would keep a lot of supply (no pun intended) off the market and increase the disposable income for all those households who end up making lower mortgage payments. On the negative side, it does create a bit of a “Pandora’s Box” problem, as this much of a write-down at the margin would do little to improve demand while reemphasizing the imperative to downsize. And most homeowners are hanging in there hoping for the same recovery that the lenders are anticipating. Much would depend on how distressed the process becomes and how severe the impairment to the banking system. There would be an enormous amount of pain and conflict between parties. One way or another, we have a long way to go in this new, deflationary paradigm. Principle reduction appears to be the most likely part of process.
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….a wonderful comment and idea David unfortunately inbued with far too much common sense. Wow, a banker says “Hey Mr. homeowner, you can’t afford the payments to own your house because its value decreased substantially (doesn’t matter why). So, we’re going to foreclose on the mortgage since you can’t afford to own it anymore, ending your $2500 per month payment. (Owner: “Ahh that’s nice”). Oh by the way, we’ll make a new agreement to rent it to you instead if you like at prevailing rates which are around $1200 per month.” (Banker: Ahh that’s good – cash flow for our bank”) ..in fact the idea is impossible to argue with , therefore should be implemented by any sane bank manager immediately. But will that happen?…Nooooooooo
Ahh but there’s a rub or two; in the above scenario which sounds like a great deal for both parties, the buyer’s credit rating is destroyed by the official foreclosure on their credit report. Is that fair under the circumstances?…I think not. Secondly, it puts the banks in the home rental business. But of course the banks could easily setup such a department to do exactly that.
We’re getting into all kinds of fundamental market-driven rule and policy changes here, something our banking and political leadership doesn’t seem to have the will or capability to execute.
Cheers, Mario