SERVING THE QUANTITATIVE FINANCE COMMUNITY

giobilkis
Topic Author
Posts: 39
Joined: February 18th, 2011, 10:06 am

### Housing Death Spiral

Joe Nocera (and then FTAlphaville) talks about "Housing death spiral":house prices fall ?> more borrowers become underwater ?> more defaults and foreclosures ?> house prices fall further.But why more underwater borrowers imply more defaults and foreclosures?It seems like if someone has a job and there is no significant decrease in the person/household revenue, why would this household default? It looks like that those who cannot pay the loan much more affected by their job status and size of monthly payments rather than house prices. Those who can pay, will not default in masses as they risk much more than the particular asset they already own - they risk their ability to borrow in the future (credit score...)What am I missing here?Thanks,George

exCBOE
Posts: 80
Joined: May 19th, 2010, 9:48 pm

### Housing Death Spiral

You are not missing anything but they are. When you first learn physics, you probably ignore friction, but no decent teacher fails to mention that. There are many feedback loops and boundary conditions impacting a decision to default. You mention credit score. That has an immediate impact on one's ability to finance or even rent another home. My guess is that the monthly payment is a more decisive factor than the equity estimate. If your housing costs don't go down considerably, there is little incentive to default. we are told that a lot of potential investment money sits on the sidelines impatiently. When will the next panic buying spree hit desirable properties? Ahh, if only we knew that...

mj
Posts: 3449
Joined: December 20th, 2001, 12:32 pm

### Housing Death Spiral

in some US states, your liability is limited to the value of the house. So if your mortgage is much greater than the house value why not walk away?

giobilkis
Topic Author
Posts: 39
Joined: February 18th, 2011, 10:06 am

### Housing Death Spiral

@mjDoes this "walking away" affect your credit score? If yes, this might hunt you down for years. It looks to me a very strong motivation not to default.@exCBOEI would go for any future knowing...

hayes
Posts: 1181
Joined: July 18th, 2008, 11:24 am

### Housing Death Spiral

QuoteOriginally posted by: giobilkisDoes this "walking away" affect your credit score? If yes, this might hunt you down for years. It looks to me a very strong motivation not to default.Yes it does - and you're right about a poor credit score being a strong motivation not to default, but if the reward from defaulting outweighs the punishment, people will default.If your house is worth 50% of the mortgage value, with a 30 year mortgage you may spend the next 10-15 years paying off this loss with nothing to show for it at the end except for a happy lender (assuming house prices don't recover dramatically, which they might do, but might not).OR alternatively you walk away, stop paying your mortgage and live there until they remove you, declare bankruptcy and know that you will probably be able to borrow again in as little as 5-10 years, where you can buy a similar home at a much reduced cost.This human pyschology is exactly the sort of thing they failed to model when consolidating debt into Mortgage Backed Securities and giving them AAA ratings. Basically because they had never seen an economic scenario that would cause that type of behaviour in borrowers before.

giobilkis
Topic Author
Posts: 39
Joined: February 18th, 2011, 10:06 am

### Housing Death Spiral

One question is the level of contribution of plunging prices on default rates.The contribution is through psychological threshold (unwilling to pay) and real economy (unable to pay).I totally agree that there is a threshold after which people prefer to default (by losing hope that the prices will ever go up to appropriate levels, by cold calculation, and many other aspects). But it looks to me that when we move up in the chain of defaults (people with more decent jobs, certain communities, etc...), the threshold moves up as well and the relationship between the LTV and defaults is not linear on time scale.As to the effect of plunging house prices on real economy, one can argue that US economy has already absorbed it, meaning that plunging house prices create very little "unable to pay" households. However there might be another factors that affect economy at much greater scale than plunging house prices and contribute much more to default rates.Another question is the effect of defaults on the level of prices, or how much the prices will plunge on the time scale.And ... just to put things in context - @hayes stated threshold of LTV = 200%Nocera's context in this case is different. He and Laurie Goodman are talking about APL (not yet beaten badly up by economy people) with LTV 100 -120 and LTV > 120. Goodman's assumption is that 40% of those with LTV > 120 and 15% of those with LTV > 100 will default. At my point of view it is too high for always performing loans.I wonder if there is any research as to this matter.

exCBOE
Posts: 80
Joined: May 19th, 2010, 9:48 pm

### Housing Death Spiral

No matter how you look at it, there are no reliable models. Predicting anything about the future is hard enough. How would you test a hypothetical model of mortgage defaults? What past data could be used? Even if you could develop such a model, its inputs would surely involve unknown future numbers like GDP, unemployment rates, various demographic and geographic facts.Is there a tendency, even among quants to want to model the future so badly that we accept arbitrary hypotheses? Not just flawed assumptions, which can be challenged, but the kind of reasoning which leads our numerically challenged rulers to welcome a best number in seven months as evidence of a turning point.Ironically, the surest solution to the financial mess would be to create new innovative financial products. This time around let's remember that opacity is not a virtue and transparency is not a crime.

Posts: 23951
Joined: September 20th, 2002, 8:30 pm

### Housing Death Spiral

Underwater mortgages cause defaults through a second mechanism beside intentional default.If a person has equity in their home, then they can avoid default by selling their home and downsizing if they lose their job or have financial difficulties. If a person has an underwater mortgage, then they are essentially trapped unless they have savings (unlikely). They cannot downsize. Moreover, if they lose their job, then they a most likely constrained to find work in the local area (unless they can afford to pay both the old mortgage and rent/mortgage in the location of their new job). Given the extreme clustering of underwater mortgages in certain states and cities, a person with an underwater mortgage who loses their job is especially unlikely to find another job in their economically-distressed area.(Note: the % of underwater homes is significantly underestimated due to the effects of closing costs which are paid by the seller in the U.S. If a person does not have 5% to 7% equity in their home, they will have a net loss at closing.)

lexington
Posts: 321
Joined: November 16th, 2008, 5:04 am

### Housing Death Spiral

QuoteOriginally posted by: giobilkisJoe Nocera (and then FTAlphaville) talks about "Housing death spiral":house prices fall ?> more borrowers become underwater ?> more defaults and foreclosures ?> house prices fall further.But why more underwater borrowers imply more defaults and foreclosures?It seems like if someone has a job and there is no significant decrease in the person/household revenue, why would this household default? It looks like that those who cannot pay the loan much more affected by their job status and size of monthly payments rather than house prices. Those who can pay, will not default in masses as they risk much more than the particular asset they already own - they risk their ability to borrow in the future (credit score...)What am I missing here?Thanks,Georgein some areas people pay 2% property tax + $1000 for maintenance fee. if you own a$500K house you need \$25K/year to live there.

giobilkis
Topic Author
Posts: 39
Joined: February 18th, 2011, 10:06 am

### Housing Death Spiral

@Traden4Alpha, exCBOE - I agree 100% that being with underwater mortgage means losing security margins and buffers you might have had. Anything that will incur substantial financial loss or cash outflow (such as illness, loss of job), will lead to default with bigger probability.However it does not mean it is 100% probability. In some cases you can downsize. It means you will lose money. How much money - it depends on a variety of conditions such as your equity in the property, LTV, savings, household income, price levels, familiy status (married, not married, kids just before college, or grown-ups), and others... At some point, of course, one prefers to walk away. The question is where is that point. And yet, based on what you are writing, the triggering event for default is a loss of substantial portion of the income and not the DEATH SPIRAL itself. It would have been if it was contributing significantly to the loss of jobs. But is this the case?@lexington - I am not sure I get your point. I agree that ongoing payments are part of the equation, but it is not new to those who live in these specific communities and it does feel right to me that it,on its own virtue, will send people en masse to default.

Posts: 23951
Joined: September 20th, 2002, 8:30 pm

### Housing Death Spiral

@giobilkis"Underwater" means LTV > 100%, equity < 0. Most Americans have very little in savings, especially Americans that used their houses as ATMs and had near 100% LTV at the peak of the bubble. Any financial setback is likely to eliminate any savings first, leaving the person with an underwater mortgage and no feasible way to sell the house or downsize.The DEATH SPIRAL contributes to defaults in two ways. First, a neighborhood with lots of defaults, foreclosures, and homes for sale will see depressed home values that trap more people in underwater mortgages. Second, the spiral depresses the local economy which reduces local employment which is especially hard for people who cannot move away to find a job without defaulting on their underwater mortgage.

giobilkis
Topic Author
Posts: 39
Joined: February 18th, 2011, 10:06 am

### Housing Death Spiral

@traden4alpha -You are right - when I wrote equity, I had in mind initial capital investment on behalf of home owner. No argue it is worth zero now. It is just a feeling that the size of it, i.e it's contribution to total loss, may influence the decision to default.As to the suppression of the economy - this is exactly the question I am asking: to what extent the spiral contributes to loss of jobs (which is especially painful for trapped members of the community). A couple of years ago, construction business died and people adjusted their spending to match the level of fear, which definitely had impact no the local community. But what is new now?

Posts: 23951
Joined: September 20th, 2002, 8:30 pm

### Housing Death Spiral

@giobilkisYes, starting equity does influence default. I've read that people who started with lots of equity in their home are much less likely to default than people that bought a house with little or no downpayment.There are a lot of lags in the economy that prolong the end-of-bubble adjustment. When the construction industry died, a lot of people lost their jobs immediately but that doesn't mean they lost their homes immediately. Some people lived off savings, stopped paying the mortgage, but stayed in the home during the very prolonged foreclosure process. Some retailers and local businesses tried to stay open despite losing money month after month because they couldn't afford to move and they couldn't afford to close. Similarly, local governments took years to cut jobs when their taxbase shrunk. The point is that some people are defaulting on homes today because they lost a job last year because business declined two years ago because customers lost their jobs 3 years ago.What is "new" is the impact of underwater homes on the normal cycle of job turn-over. In a normal economy, mobility allows the unemployed to search for jobs over a very large area and move to where they find a job. But in a region with underwater mortgages, a person can't take a job outside their commuting distance circle without defaulting on their mortgage. That employers in North Dakota or Texas are hiring is of no use to jobless people stuck in underwater mortgages in Las Vegas, Orlando, or Phoenix.