January 24, 2010

"It’s as if borrowers are playing in a poker game in which they are the only ones who think bluffing is unethical."

An analogy.

24 comments:

rhhardin said...

If you sign you'll be presonally liable for the debt, then that's a moral commitment. Assuming it's not buried in the fine print, where the bank's lawyers know something that you don't.

Otherwise it's a financial bet, with the bank taking the risk that the house price falls by more than the downpayment. That's what collateral is.

So the banks have to man up to that. A bet is a bet.

EDH said...

Poor analogy, isn't it?

In other words, they think they are obligated to repay their loans even if it is not in their financial interest to do so, while their lenders are free to do whatever maximizes profits. It’s as if borrowers are playing in a poker game in which they are the only ones who think bluffing is unethical.

Are banks really "free to do whatever maximizes profits"?

Isn't the only "bluff" here, like the subject of the article, entirely whether the borrower intends to repay the loan in accordance with its terms?

Michael said...

If Mr. Thaler wants homeowners to be able to really speculate on their houses, he's welcome to push for an alternative category of mortgage, where it looks more like a joint investment between the consumer and the bank, or where the speculative risk is priced into the interest and down payment requirements.

Also, when a mortgage goes seriously underwater, it isn't the bank who has made a nice profit or avoided a major loss -- the property's seller did.

Mortgage lenders have very little upside on the mortgage -- the interest rates are usually pegged against bonds, with a small risk premium, because both are senior debt that the borrower really tries to repay. Asking lenders to tolerate that limited upside and eat potentially huge losses is tantamount to asking them to go out of business.

Bushman of the Kohlrabi said...

Here's a novel idea. Let's hold people responsible for the loans they take and let banks face the consequences of bad loans. Bailing out one or both sides only ensures more bad behavior and negative consequences further down the line.

tim maguire said...

Figures the Times would discount the moral obligation to fulfill your contractual duties. They probably can't imagine a source for such an outlook. After all, the only thing hinging on it is civilized society.

Ignorance is Bliss said...

People are less likely to think it’s immoral to walk away from their home if they know others who have done so. And if enough people do it, the stigma begins to erode.

This strategy worked out so well for unwed motherhood, let's try it for home mortgage defaults too.

Eric said...

I'm not sure what people are thinking when they advocate borrowers walk away. The system won't work without some level of trust - if walking away becomes normal, only people who can put 40% down are going to get home loans.

rhhardin said...

only people who can put 40% down are going to get home loans.

Or the bank hedges the mortgage.

That adds to the cost of the mortgage, exactly as the article says happens in non-recourse states.

It's not a high-probability event that the price declines by 20%.

A little difficult to insure against in the large, perhaps, since all the hedges strike at once.

rhhardin said...

The down payment, by the way, is a price signal to the buyer whether he can afford the house.

Back when they had down payments.

Maguro said...

What EDH said. The lenders aren't free to do whatever maximizes profits, they have to abide by the terms of the contract. They can't just drop in and foreclose on you even if you're making your payments because it might be more profitable for them to repossess the house and sell it.

Freeman Hunt said...

I'm curious: Do people really get home loans without down payments? Is it common?

Paul Snively said...

Freeman Hunt: I'm curious: Do people really get home loans without down payments? Is it common?

I don't know how common it is, and my anecdote still isn't data, but: seven years ago I bought a house in Los Angeles County. The only way that was possible was to take a simultaneous first and second mortage, 80% and 20%, and, of course, PMI. The second mortgage also had a prepayment penalty associated with it. In fairness to the lenders and brokers, they did ask all kinds of questions to determine that, while I didn't have 20% to put down, I did have a relatively stable employment history (lots of job changes, being a software developer, but basically steady employment with good compensation).

Two years later (five years ago), the value of the house had increased to such an extent that, even with the prepayment penalty, it made sense to refinance into a nice, traditional 30-year fixed. So I did. Of course, the value of the house has gone down from its peak, but since it's not an investment property but rather my home, I don't care.

In other words, I'm exactly the kind of buyer the whole "creative finance" process was intended to help: able to make the payments, just lacking 20% of $1/3M = $66,600 lying around to put down.

Tyrone Slothrop said...

Another possibility is that defaulting is worse for the borrower in the long run than paying too much for a mortgage. I'm about even, or a little underwater on a modest home I bought in 2001 in California. I'm pretty sure I could rent for less than my mortgage payment, but if I leave the keys in the door and walk away, it's a pretty sure thing I won't be able to buy another house for a good long time. I am 100% positive my home's value will increase in the coming years by enough to have made the sacrifice worth it.

Freeman Hunt said...

The writer argues that because some aggressive, even unscrupulous, lenders exist, it is morally acceptable to walk out on a loan.

Say what?

If you borrow money from somebody and promise to pay it back, then you should pay it back.

A better argument would be that it is morally acceptable to walk out on a loan that you were somehow duped into getting. I imagine that circumstance is very rare, not the norm.

Freeman Hunt said...

The borrower and the bank are not both investing in the house.

The borrower is investing in the house. The bank is investing in the borrower.

rhhardin said...

It's not a simple investment. There are lots of what-happens-if clauses.

The prices all take that into account.

One of the what-happens-if events is that the price of the house plummets; and the price of the mortgage covers that.

Lisa said...

A few questions:

1. If your loan is secured entirely by the home and you turn the home in, then how are you not fulfilling the terms of the mortgage even if the home is underwater?

2. What would the bank do if they had a property that was costing them more than it was worth?

3. The bank assesses the value of the home before they grant a mortgage. It has been, up until now, in their best interest to overassess a home's value. Have they no responsibility for their poor evaluations?

John Thacker said...

It's a poor analogy. There are lots of different behaviors and expectations, but they're not all in the bank's favor. You, for example, can declare bankruptcy; the bank does not suddenly decide that it needs your money right now and call in the loan.

You can get a fixed rate loan and choose to pay it off early or refinance if rates go down, but not pay extra if rates go up. The bank can't do the equivalent of forcing you to refi if rates go up, or change your payments based on the rates.

rhhardin said...

There's a Japanese business practice, that if one party becomes unhappy with a contract, they renegotiate, as reported by Radio Japan.

That would keep transactions in the area that both sides are happy with when conditions change, if such an area exists.

They may have been Westernized enough by now so that they no longer do that.

It's not a bad practice; you can do it yourself at least half the time, and businesses sometimes lean enough into keeping the customer happy so that it's more than half.

It's outside the legal system I think, and can't be forced.

If it were forced, you couldn't make contracts because nobody would enter them. You don't control what you're stuck with.

Joe said...
This comment has been removed by the author.
Joe said...

You aren't underwater unless you actually sell. In most areas of the country is pretty damn unclear how underwater any given person is.

And what will values be in ten years, twenty? If you do walk away, what will you do? Are you really willing to be defacto prohibited from getting a house loan for seven to ten years? What if property values rebound in three to five years?

Besides, almost every loan puts you underwater, at least at the start of the loan. Historically, it took 3 to 5 years before you wouldn't lose money selling your house.

DSDan said...

What about the Musharaka al-Mutanaqisa system?
From Wikipedia: "The bank and borrower form a partnership entity, both providing capital at an agreed percentage to purchase the property. The partnership entity then rents out the property to the borrower and charges rent. The bank and the borrower will then share the proceeds from this rent based on the current equity share of the partnership. At the same time, the borrower in the partnership entity also buys the bank's share of the property at agreed installments until the full equity is transferred to the borrower and the partnership is ended. If default occurs, both the bank and the borrower receive a proportion of the proceeds from the sale of the property based on each party's current equity."

1jpb said...

Lisa,

The answer to your second question is that corporations routinely walk away from underwater properties, of course, you already knew that.

Just think of Morgan Stanley who walked away from some office buildings because they were underwater. That's good business, and it's legal. But, if citizens follow the law in this same way we declare that they are despicable.

Doesn't seem fair.

But, w/o folks going beyond the minimum legal requirements of their loans our housing disaster could get a lot worse.

BTW, I've started using cash to buy pre-foreclosure, short, auctioned, and bank owned properties, so folks may think that I'd want more folks to walk away from their homes so that I would have more houses to choose from. But, nothing could be further from the truth. I want the market to avoid falling of a huge cliff because I need to turn these houses around for resale.

The more folks who can workout deals w/ their lenders the better. I don't want or need anymore supply.

c3 said...

In other words, they think they are obligated to repay their loans even if it is not in their financial interest to do so, while their lenders are free to do whatever maximizes profits.

funny, my wife and I just had this conversation this morning. We are very much underwater. Will probably get back to the "surface" in about 10+ years. But i like the house and the location...

and most important of all, I made a commitment.