My buddy, Buce over at Underbelly, has a post up using the concept of option value to help explain why more people are not walking away from their underwater homes. By "underwater," we’re not talking about Homer Simpson’s imaginary home under the sea, but situations where the mortgage on the residence is more than the value of the residence. A cool, rational economic actor would walk away from the home, leaving the lender to take a loss (assuming the lender has no legal or practical alternative to collect the difference from the homeowner). We’re not seeing that as often as the cool, rational economic model might predict. Buce points out, correctly, that ownership of the house is just like having an option to buy (i.e., pay off the debt and the house is yours) and even underwater options have value. Thus, part of the reason why more people don’t walk away from their homes is because of this option value.
Buce is undoubtedly correct, but I think he has only a partial
explanation. Another reason people don’t walk away is that the home is
worth more to them than to the lender or anyone else in the
marketplace. Elizabeth Warren talked about that point in a previous
post on the concept of hostage value. Sure, a house has sentimental
value to its owner, but even beyond sentimental value there can be good
reasons to hang onto a house that is underwater.
Try this intellectual exercise. Suppose that
someone walked up to you and said you absolutely had to move from the
house you owned. Yeah, I know that doesn’t really happen, but assume it can for
the sake of the intellectual exercise. This person then asks you how
much money you would pay to avoid moving. Start to think about the effort in changing your place of residence —
the financial cost of moving, the time and effort to pack up your possessions and
move, the time and effort to find a new place, the out-of-pockets costs
of a search for new housing. For me, that quickly adds up to a pretty big number. A cool, rational economic actor would want to avoid these costs and would factor those costs into the decision of whether to walk away from an underwater mortgage.
Yep, avoidance of these costs also does not explain all of the reasons people don’t walk away from underwater mortgages. Put it together with the other reasons–sentimental value, option value–and we begin to see what people have powerful incentives not to walk away.
Comments
10 responses to “Why Don’t More Walk Away”
Don’t forget the moral issues as well. I would say they the overwhelming majority of people who take out a mortgage feel that they have a moral obligation to make the payments.
And, of course, there’s the hit on your credit score. A bad credit score can make life difficult in all kinds of ways beyond simply getting a loan. Finding a job, renting an apartment and even getting car insurance can be problematical if your credit score is low.
This is crazy. Sure people are in “underwater” situations now, but who’s to say that will be the case in the next 5 – 10 years. For those that are looking long term, the downturn is just that – a downturn and nothing to worry about. For those that really got in over their heads looking to make quick cash in a hot market, they got burned (or – the lenders got burned if they walk away from the investment).
The smart investor will be pouncing on real estate again in the next year or two, and having a 7 year black mark on ones credit report will do nothing for those that didn’t tough it out in this market.
I don’t believe that being upside down alone would be a reason for someone to walk away from their home. It’s the “American Dream” for crying out loud! I do believe though that a culmination of several different factors may.
Oh, let’s just say that if you are upside down on a home your property taxes may catch up to the silly amount you paid for that home. Taxing entity sees you paid $200k for a home that they are only taxing you on $120k. Well then, they can get more tax money from you can’t they? Maybe you thought you were only going to pay insurance on the tax appraised value but now you have to pay to insure $200k worth of mortgage note. (barring any Katrina like insurance increases) This is still not a good reason but its getting there. Maybe you got into that Mortgage note with no money down and you have a 80/20 split…… both ARMs’!. Better… Now you want to refinance that 80/20 split ARM for a fixed rate to get rid of having 2 mortgage payments… Houston we have a problem! Say because you got injured at work and missed a few payments… How can you refinance now? May Day. May Day.
I don’t think people should stay underwater because they feel obligated to the bank. The bank certainly doesn’t reciprocate any such feelings toward the borrower. They’d rather foreclose than work out a deal with a struggling homeowner.
Let’s not forget this situation is the result of the bank’s own greed. They offered bad loans that were easy to qualify for, and people took them. You can’t lay blame solely on the homeowners (maybe 20%). Some borrowers were too trusting, and yes, some were speculating, but the bank was capitalizing on both.
I can think of two other major ones:
– transaction costs. If I abandon my house, I’ve got move all my crap somewhere, find a new place to live, ect. That is not cost free, in terms of time or money
– the damage to one’s credit from defaulting on a loan – when you figure that I probably either wouldn’t be able to get a loan, or would be paying way more interest, on future loans after a default, it makes sense not to walk away, even if you are underwater.
For those that really got in over their heads looking to make quick cash in a hot market, they got burned (or – the lenders got burned if they walk away from the investment)
This is a classic understatement of the current housing crisis. Speculators were not the only ones who are getting burned. House prices on average are going to fall at least 25% — probably more in the overcorrection phase of this bust. That means that many buyers *who put 20% down and were not speculating* are going to see their equity completely wiped out. Ouch!
Walking away is a trend that we’re only seeing the beginning of — as recession gets full blown ugly, it’s going to be seen a lot more. At some point, the option value and other costs just aren’t enough to warrant “sticking it out” …
I’m not sure that option pricing is a particularly useful model. Considering only that, the homeowner should always default immediately. (I own a house that’s worth $300k, but owe $400k. So superficially, my net worth is -$100k, but I also have the “option” to keep paying my mortgage, and “buy” the house for real. Let’s say that I default on my current house, and buy a new identical house for the market price of $300k. Now my net worth is zero, and I still have the “option”. This was clearly a rational choice. So this option idea–ignoring practical considerations, like the difficulty of getting a new mortgage just after you defaulted on the old one–does not explain why borrowers would stay.)
It’s also an expensive option, unless you have an interest-only mortgage. Every month that the borrower pays, they are building equity that will be lost if the option expires out of the money.
Other factors, like the transaction costs of moving, and the damage to the homeowner’s credit (and more general reputation), would seem more important, and more than enough to explain why people stay.
The article is based on an assumption, which I think is wrong, that people know they owe more on their home than it is worth. I think a more realistic assumption is that few homeowners focus on the value of their home until they try to sell it. I think it is also a more realistic assumption that financial stress is not motivation to sell. Americans do not respond to financial stress by looking for ways to scale back their lifestyles, it’s one of the reasons we have the current mess. With little real wage growth, people financed their lifestyles with borrowed money, credit cards and home equity loans, and now the bills are coming due for all the stuff that was bought. I also know that in the market here another reason that someone would keep making a monthly house payment when there wasn’t any equity in the house, is that rents are just as high as the mortgage payments, if you want to be in a good neighborhood.
“A cool, rational economic actor would walk away from the home, leaving the lender to take a loss (assuming the lender has no legal or practical alternative to collect the difference from the homeowner).”
The only problem with that statement is that rationality in general has gone out the door in regards to the economy. With so much volatility in other markets, who is to say the real estate market won’t bounce back? The killer loans, option ARMs, from 2005 to 2007 START to readjust mid-2009.
THIS IS NOT LEGAL ADVICE MERELY OPINION: And as to your statement in parenthesis, in California many people have second mortgages like home equity lines and such, and I am not sure but the law sometimes allows a deficiency. Even the primary mortgage can get a deficiency under certain circumstances.
In my opinion, now is the WORST time to walk away. Rents are going up and landlords can readjust the lease every year. The dollar is going down, or down already, and home prices are down too. Many people are waiting for it to go down more but they dont realize that at that point there will be no more loans with reasonable interest rates. What is the point of walking away from an underwater house? Some lenders give 2000 dollars for mailing the keys, but arent you better off fighting the foreclosure and living in the house for free and saving money for your families needs?
I imagine most the walk aways were not primary residences.
I hate the banks and the greedy class. Three people in my family have walked away and we’re now all better off. Within 2 months we’ve gotten new loans on other just foreclosed properties. This was a no brainer folks. Get some boxes, pack it all up and get out now. No brainer people.