Wcw explains the economics of the housing bubble, in a smart comment:
As for borrowing the money, I think the folks who did so did absolutely the right thing. When someone offers you a government-subsidized non-recourse loan on an appreciating asset, they're giving you a put option. The more you borrow and the less you put down, the more that option is worth. These borrowers maximized their leverage. The market turned, and they exercised their put options. They are not the dumb ones, they are the smart ones. The dumb ones are the ones who gave away the farm lending this money.
It’s well worth noting, here, that there was an extra necessary ingredient: fudgy accounting on the bank side. If the banks had marked those put options to market, they would either have never made the loans in the first place, or they would have noticed their balance sheets eroding long before it was too late to raise new capital.
But they still aren’t marking those options to market. Everybody in America who has a mortgage has the option to default on that mortgage. That option is worth some non-zero sum, and in aggregate, across all the homeowners in the country, that option is worth billions, if not hundreds of billions, of dollars. And if homeowners own an option worth billions, then lenders have a liability of exactly the same magnitude.
The biggest lenders, in this regard, are Fannie and Freddie. But many banks are in the same position.
Look at the question another way. The likes of Mike Konczal have been looking for a while at second liens, and asking tough questions about how much they’re really worth. But let’s zoom back and look at the first liens, and think of it like this:
Let’s say you’re a good, creditworthy borrower: a tenured university professor, say, earning $200,000 a year. You ask for a $500,000 30-year amortizing loan at a 5% interest rate, which would involve you paying back about $2,900 a month — well within your earnings. The bank would laugh you away. But ask for the same loan in mortgage form, and suddenly it’s no problem. Why? Because the loan is secured.
Clearly, the existence of the security radically changes the economics of the loan. And equally clearly, the value of banks’ mortgage security — the houses the mortgages are borrowed against — has been falling fast. We know that the value of a home is the best predictor of future default, and that mortgages become much riskier when the homeowner doesn’t have any equity. We also know that roughly 25% of homeowners with mortgages have negative equity.
So it’s pretty obvious that even without taking into account a single actual default, the value of banks’ performing mortgages has been falling fast. And it’s equally obvious that no one has even attempted to quantify the numbers involved here — just how much has the value of banks’ performing mortgages fallen? And how does that number compare to the banks’ own equity?
This is one of the reasons why I’m still very nervous about markets generally: while there are lots of big sovereign and geopolitical risks out there, it’s far from clear that the big mortgage/housing risk is even behind us yet. And I would be much more reassured if there were some numbers marking banks’ mortgage books to some kind of market or model. Even if those numbers didn’t turn up in the formal GAAP accounts, it would be good to know that someone was at least keeping an eye on them. Especially when prices could easily plunge again, if and when the government stops artificially propping up the market.
But you and I and a lot of other people know that if the banks do that, half of them will be insolvent. The government won’t allow that to happen, so we are all merrily playing along as if nothing bad is going on and everybody is making record profits. It’s just a ploy to buy time for the banks to earn enough money to be solvent again. The financial system should’ve imploded in 2008. Now it’s been delayed because we are all paying for it via government debt. That bill, unfortunately, is coming due.
I feel like it’s been well established that, in most states, lenders have recourse against borrowers. That should do a fairly good job of keeping the strategic defaults down since you can either 1) pay the loan or 2) pay the loan plus the legal fees if you have the assets worth going after.
At least in Illinois, lenders very rarely pursue borrowers for deficiency judgments. That costs extra time and legal services on the lenders’ side, too, and unless the borrow has significant assets, it’s not worth the trouble. At that point, borrowers also have the option of declaring bankruptcy, since the debt owed to the lender is no longer secured. It is not so easy to collect.
Thanks for the kind words. Worth noting, folks who analyze MBS pools do model both defaults, which captures these implied puts, and prepayments, the explicit loan calls every US mortgage contains. If MBS guys can, you would think banks already do the same. I am not an accounting-policy guy, but existing FASB regs should cover the event of a serious impairment via expected defaults. That would cover your mooted liabilities. I grant, we know banks are not always the best at marking down impaired assets, but off the top of my head I don’t think adding more accounting rules is the answer.
As for recourse, I would bet dollars to donuts that the bulk of underwater homes are not attached to borrowers with assets worth pursuing. You can spend a bunch of money to get your judgment, of course, but if your judgment is onerous, your debtors are going to wipe them out in bankruptcy anyway. Yes, a few banks may do this out of spite, but I can’t see it being a positive-NPV strategy in any but a few edge cases.
Pricing the simplest of “options” is complex. I’m not sure how banks could appropriately account for the option value of a non-recourse mortgage AND also mark the asset to market prior to actual default. Bank balance sheets are opaque enough already.
Also, the higher the (required) down payment the less a mortgage looks like and behaves like an option "“ and the less need to price option risk into the rate. Put the borrower in first loss position and a lot of this goes away.
The very wealthy, i.e., Mr. & Mrs. Privileged Class (PC), simply don’t live in the same world as we do, i.e., Mr. & Mrs. Middle & Working Class (M&WC)…although each of them likes to think of himself as wearing the mantle of a Mr. Wise Everyman who…even though often quite wealthy…is still widely admired and respected by Mr. & Mrs. M&WC for his ability to “feel the pain” of Mr. John Q. Public, i.e., feel the pain of Mr. & Mrs. Average American (or European or Asian or whomever).
It is likely that the subject of this article thinks of himself in that way also. Likewise, the former head of the Federal Reserve. Likewise, the head of Toyota. Likewise the head of BP. Likewise “whomever”.
However, they feel neither pain nor guilt.
The fact of the matter is that these extremely wealthy people have forgotten what “pain” is (or never experienced it in the first place). Their view of the world is from a protective bubble. That’s just the way of it though. That’s simply a fact that cannot be changed.
If and when the wealthiest people in the world give away their wealth, we here at our M&WC Disabled Veterans’ Research Group (where “pain” is quite familiar) will take them and their financial and other prognostications seriously…and give them the respect and admiration that they crave—even more than they crave money.
“I would be much more reassured if there were some numbers marking banks' mortgage books to some kind of market or model.”
To the extent banks’ mortgage books are held in the form securities (i.e. MBS, as opposed to whole loans)–and I thought this was most of it, no?–I believe the rule is that they be held in three accounting buckets: trading, available for sale, and held to maturity. The first two buckets should be marked-to-market on the balance sheet, with periodic changes flowing through P&L and “other comprehensive income”, respectively. And the fair values of all these, even held to maturity loans, should be disclosed at fair value in the footnotes.
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