What's Missing from the Housing Debate? Risk.
Commenter JPF311 asks:
Since the vast majority of home owners with mortgages bought their houses some years ago when they were worth considerably less than they are still worth today (even with the soft market and falling prices) where is the crisis here?
The problem is that reducing housing costs is a major family option to deal with risk of income loss.
In a normal housing market, you could reduce housing costs by selling the house and downsizing or by refinancing for longer terms (meaning, lower monthly payments). This strategy won't work when homes don't sell and when homeowners can't refinance because prior refi's plus lower sale prices have stripped the equity to the amount of the debt -- or less. (Refi's dry up when equity equals debt since lenders usually want some equity wiggle room when they lend. This way they don't lose money on a house that brings less than the loan at foreclosure.)
The escape route is cut off, and families that thought they could deal with job loss, death of a wage earner or medical catastrophe by cutting expenses find out the hard way that they're wrong.
You have identified a key issue underlying the statistics. Some families will get totally hammered, while others will emerge unscathed.
The pattern will be different than the cyclical recessions of the past few decades. Rather than recessions in regions because of specific industry contractions (due to deregulation or restructuring or a reaction to overexpansion), now the recessions will be dispersed, within households.
Housing continues to be a leveraged investment for young families, and the ready availability of the cash-out refi has kept many highly leveraged. This scenario amplifies the effect of the leverage, both in favor of wealth, but also against wealth if the supporting cash flow collapses (loss of job or financial emergency).
Likewise, the home values that the credit is based on are driven by recent sales of comparable properties. Obviously, those sales are relatively few compared to the total housing stock in any particular area and embed the assumption that current level of trading volume remains about the same.
The ready availability of credit for consumers is counterbalanced by much more aggressive collection and foreclosure practices. The over-hyped sale of credit on the front end [wow, I can get cash out of my house, or wow, I can buy a bigger house!] fails to properly educate the consumer about the potentially dire consequences within 90 to 120 days of nonpayment, i.e., foreclosure begins.
While many homeowners do live mortgage-free,
many are older and, as they retire, will be seeking to take their equity out also to move to smaller quarters. Falling prices will also affect quality of life for these retirees.
Clearly, those who have taken on riskier obligations are at greatest risk. I am concerned that, instead of a really well-defined downturn in a particular industry, the coming housing recession will be one of the quiet desperation of individuals, families, and retirees, some of whom will suffer disproportionately and it will take a long time for them to recover.
December 7, 2006 10:17 AM | Reply | Permalink
You keyed in on a core issue of this debt problem. Few people understand risk. They are willing to take big risks, as long as they don't ever lose. Those who takes risks, rarely are prepared for the downside of the risk. They count on being on the winning side of the risk, and if they aren't they are bankrupt. Our whole monetary system is built on the assumption that we'll beat the risk of debt. So it is a certainty it will eventually fail, unless action is taken to cover the risk of monetary failure.
Someone with the power to make it a standard, needs to come up with a way to quantify risk, so that the average person can guage risk on a scale. Then, along with that scale is a set of prudent actions to take to mitigate the risk, to insure survival if the effort fails.
Jim Anderson
The Truth About Credit
December 7, 2006 10:54 AM | Reply | Permalink
Let's have a poll!
This posting should have been entered under JPF311's comment on ewarren's "Fake Numbers . . . " posting: (Agree) (Disagree)
December 7, 2006 11:11 AM | Reply | Permalink
Nah.
Managing risk is at the core of the problem. It deserves it's own discussion.
Jim Anderson
The Truth About Credit
December 7, 2006 11:24 AM | Reply | Permalink
You bring up an interesting theoretical point, Jon. However, the empiricist in me has to ask how many people actually exercise this "option"? My sense is that homeowners often stay in their homes to the point of foreclosure when they could often sell their houses, grab at least a little equity, and try again if and when their financial situation improves. However, for reasons that are personal, they stay and lose their homes.
If this is the case, then our concerns should be on those factors that influence someone's decision to buy a particular home, like loans for 100+% of a home's value or appraisal fraud.
December 7, 2006 4:29 PM | Reply | Permalink
I agree that this is ultimately a hypothesis we could test empirically. I know homeowners who have done a variety of things in the face of rising housing costs or lower income, including refinancing for longer terms, downsizing, and stubbornly sticking with the house when it was no longer a good idea financially. (I haven't personally seen anyone get to foreclosure yet, but of course that happens.) So there could be any number of responses to the situation, and I know no particular evidence that many people do actually exercise the option to deal with less disposable income by reducing housing costs.
All the same, there's reason to think it might be an important option. This alone should lead people to look into it empirically. Besides, you usually have to make decisions about the world with imperfect information. Even if there is little chance of this problem proving true, there may be a little-to-lose solution. (Anyhow, we could just pretend to be economists, agree that reasonable people would sell or refi, infer that actual people do just that, and have a perfectly respectable basis for major policy shifts in today's world -- cf. the 2005 bankruptcy amendments.)December 7, 2006 7:39 PM | Reply | Permalink
One nice thing about falling home prices is that it gives new buyers a chance to purchase a home at an affordable price. Hopefully the people that get bargains in this current market will avoid some of the mistakes that some current home owners have made. Seems like when it comes to home a singler fixxed rate mortgage may be the way to go.
December 9, 2006 7:23 AM | Reply | Permalink