Why underwater mortgages lead to foreclosures

A reader writes, in response to my column of a couple weeks back about the pre-Fannie-Freddie-bailout housing bill:

All this mumbo jumbo coming out of D.C. and the financial community is so much smoke screen. Don’t fall for it. Question EVERY single thing they say. Force them back to the basics.

For example, you reported that the finance industry is saying, “The fear is that mass foreclosures could accelerate price declines, bringing on a cascade of additional foreclosures . . .” AND “9 million U.S. homeowners owe more than their houses are worth; they’re upside down, in the parlance, meaning that if foreclosures are to be slowed, the mortgages themselves must shrink.” Both of these statements are nonsense!!

If I own a house that I have a mortgage on, and 4 guys down the street default, and the price of houses in the neighborhood decline, it has NO effect, ZERO, on me as long as I just keep paying my mortgage and live in the house. The only time it would effect me is when I needed to sell. The same logic applies to the second statement. …

I hear this argument a lot, so let me repeat the explanation for why underwater mortgages bring on more foreclosures: People who are underwater on their mortgages are much more likely to default and be foreclosured upon than people who aren’t. If you’re having trouble making your payments but you still have positive equity, you can sell or take out a second loan to avoid foreclosure. If you’re underwater, neither of those options is really available to you. This Boston Fed study, published in May, found declining house prices to be the biggest single factor in generating foreclosures.

What started this real estate mess was that lots of people got mortgages they couldn’t ever hope to pay back unless house prices kept rising. Now we’re reaching the point where even people with less-dodgy mortgages are running into trouble because of declining prices. The vast majority of homeowners who are underwater on their mortgages will keep making their payments. But being underwater significantly increases the risk of foreclosure. And having lots of foreclosures in a neighborhood tends to accelerate the decline in house prices.

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DN

Your response does not address the user comment – there are approx 120 million (I believe) owned homes in the US, and as you mention, approx 9 million homes have debt more than their house is worth – that .075% of all homes. I dont understand why this group is worth bailing out -

if you brought at the height of the market so you could flip the house and sell it for more, like many of these buyers did, you should take your loss, just like everybody else who invests (I thought there were no garauntees in investing – apparently, this is not the case with some investments).

If you are not planning to flip, then what is the difference is the value goes down – it will eventually go back up in the long term.

If you are now having trouble paying your mortgage because your interest rates have gone up (variable rate), wasn’t that your agreement when you brought the house? What responsible adult doesnt take this into account?

So, if you want to throw responsibility out the window, then by all means, bail these people out, and send a msg to the world that this country is not adult enough to take their medicine and eventually regain their health – instead, we will push the ‘sickness’ into others (the taxpayers) – spread and nationalize it until we are all a bit infected – and for what? To prop up the .075% of households that were too irresponsable to read and understand their mortgage contracts (note I am not talking about folks who were swindled by morally bankrupt mortgage brokers/lenders – but how do you determine that)? Isnt it better to send the msg of personal responsbility, rather than moral hazard?

And BTW, arent many of the homes in foreclosure abandoned anyway (folks not currently living in them (according to a bloomberg economic podcast)?
DN

oops – sorry – thats 7.5% (.075%).
Justin Fox

Actually, my response directly addressed the arguments from the reader e-mail. I didn’t address the bigger question of what we (i.e. the government) should do about foreclosures because I’m far less sure of the correct answer. I’m just tired of people making the false claim that falling prices and foreclosures are somehow unrelated.
JordanT

If you are not planning to flip, then what is the difference is the value goes down – it will eventually go back up in the long term.

I think a lot of people stretched to buy the house, because of the promised return. They weren’t planning on flipping, but more buy a less than ideal house, hold for 5 years, sell and move up. Without that return combined with being house poor for a house they don’t really want, may cause many people to give up. This doesn’t mean that I agree with any attempt to bail anybody out though.

I speak more for the market in San Diego where we had some of the largest concentrations of exotic loans. Who really thought that it was a good idea to give so many loans to those who could barely make the minimum payment, and that minimum payment doesn’t even cover all the interest accrued that month?
Curmudgeon

@JordanT: The return on a house was promised by someone? Sounds like fraud to me.
JordanT

@JordanT: The return on a house was promised by someone? Sounds like fraud to me.

Read some brochures from the National Association of Realtors and you’ll see what I mean. Even now they tout the “housing historically doubles every 10 years line” Or the “housing is they key to building wealth/success line” Nearly everyone I know still thinks that you buy a house and in 3-4 years you have a ton of equity and can move up. However, this does not excuse the buyer for taking money they could never hope to pay back.

Maybe promised was too strong of a word, but from speaking to many people when they were buying none thought that house prices would ever go down. In any case, I’m sure the statements had some type of boilerplate disclaimer attached to them.