The dangers of De-Occupy Your House

By Felix Salmon
December 14, 2011
Jim Surowiecki's sentiments this week about strategic default and the way in which it's entirely rational for homeowners to walk away from their underwater mortgages.

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I agree wholeheartedly with Jim Surowiecki’s sentiments this week about strategic default and the way in which it’s entirely rational for homeowners to walk away from their underwater mortgages. But I think he soft-pedals the consequences of what he calls “a De-Occupy Your House movement”:

Of course, many borrowers made bad decisions and acted irresponsibly. But so did lenders—by handing out too much money and not requiring sensible down payments. So far, banks have been partially insulated from the consequences of those bad decisions, because Americans have been so obliging about paying off overinflated mortgages. Strategic defaults would help distribute the pain more evenly and, if they became more common, would force lenders to be more responsible in the future.

This is all true, as far as it goes. If more people default on their mortgages, total mortgage-lending losses will rise — but a large part of that will simply be the transference of pain from homeowners to lenders. At the same time, however, there would also be a huge rise in foreclosures, evictions, and fire sales — with the result that house prices, which are still falling alarmingly, could see another stomach-churning lurch downwards. That in turn would only serve to increase the number of underwater homes, and would set off another set of of walk-aways and foreclosures, and — well, the vicious spiral is easy to foresee.

The fact is that if homeowners act rationally with regard to their mortgages, the housing market becomes unpleasantly volatile. The New York Fed recently put out a compelling piece of research saying that both the sharp rise in house prices and the subsequent sharp fall can in large part be attributed to speculative buyers — the small minority of people who do act rationally and are perfectly willing to overpay in bull markets and walk away in bear markets. What Surowiecki is encouraging, here, is that the rest of us start to behave much as the speculators did when house prices fall.

Historically, homeowners haven’t behaved that way, and not just because they’ve been guilt-tripped into paying their debts. Rather, they’ve done what bank lenders used to do in the good old days: hold their assets at par, rather than marking them to market. I’m a homeowner myself, and I simply don’t know what my apartment is worth; I certainly have no easy way of attuning myself to the ups and downs of the East Village real estate market each quarter. When I was looking to buy, I was hyper-aware of such things. But when I’m not actively in the market, I have much better things to do with my time.

A healthy housing market, in other words, is a reasonably opaque market. People buy the house they want to live in for the long term, and then slowly pay their fixed-rate mortgage down over 15 or 30 years. When they have to move, they have to move. And every so often, if interest rates fall substantially, they’ll refinance — but that’s just a function of interest-rate movements, and not at all a function of house-price movements.

What happened during the housing boom was the rise of cash-out refinancings. Homeowners were being encouraged to take their existing home and extract equity from it — that is, to essentially mark their home to market periodically. And once people started marking to market on the way up, it was inevitable that they would do the same thing on the way down.

Surowiecki’s ideal world, then, looks a lot like the kind of world that housing speculators live in. People constantly mark their homes to market, and they flip or cash out when house prices are rising, and strategically default when home prices are falling. This is a recipe for bubbles, busts, and general house-price volatility — and remember that house-price volatility is a lot more dangerous than stock-market volatility, because it’s an inherently highly-leveraged market. Even if lenders tightened up their lending standards substantially, people buying homes would still be levered up four or five times — the kind of leverage which is unthinkable even in the most insane leveraged ETFs.

To put it another way, in Surowiecki’s ideal world, the residential real estate market starts to look a lot like the commercial real estate market — a place where fortunes are made and lost, rather than a place dominated by individuals simply buying a roof over their heads and a place to bring up their family.

I’m not convinced that a world where homeowners mark their homes to market is an obvious improvement on the status quo ante — even though I’m wholly convinced that in any given case, it’s entirely rational for homeowners to walk away from their underwater houses. The question, of course, is whether we can ever return to the status quo ante.

In his excellent book The Devil’s Derivatives, Nick Dunbar explains how banks used to lend across the business cycle, more than making up in good years for the losses they suffered in bad years. Today, however, when banks mark their assets to market daily, that kind of activity is impossible, and the markets become convinced (justifiably) that all banks are insolvent whenever there’s a crisis.

Let’s say that you’re significantly underwater on your mortgage and you don’t have much in the way of savings. Does it then make sense to say that you’re insolvent? Historically, homeowners never thought that way — the mortgage was a monthly payment they made to stay in their home, and their home was a place to live rather than a financial asset.

If we move to a world where houses do become financial assets, that might be a good thing. But let’s be honest about what such a move entails: a large decrease in homeownership. It’s not sensible, on a financial level, to have so much of your net worth tied up in one illiquid asset. So if homes are marked to market, they become attractive mainly to landlords who will in turn rent them out to the rest of us.

If Surowiecki wants millions of Americans to walk away from their underwater mortgages, I hope he knows where the buyers of those homes are going to be found. Because if they don’t appear, we could have another massive housing crash and another huge recession.

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