Anti-Deficiency Laws and our Mortgage Crisis

A Representative Homeowner’s Plight
A Way Out: Anti-Deficiency Legislation
Deficiency States
Leverage, Fairness and Moral Hazard
Conclusion

Economics is a quantitative science. Clear thinking about any economic problem requires numbers. There is no getting around that fact of life. You can come to some pretty wrong conclusions about economic problems if you rely solely on verbal reasoning, normal human intuition and “common sense.” If we take that risk now, we might turn a serious financial crisis into a replay of the Great Depression.

There is a simple and natural focus for economic thinking about our current crisis: the individual homeowner. All four components of our current crises revolve around her. The housing bubble affects the value of her home and therefore the collateral for her home loan. The collateral’s value and interest rates affect her ability to repay the loan, which in turn determines the loan’s value to investors, and therefore the value of the mortgage-backed security in which her loan is “packaged.” The loan’s value also affects the liquidity of credit: the lower and more uncertain that value is, the less likely anyone is to buy the loan or the security containing it, i.e., the less likely credit is to remain liquid. Finally, the homeowner is at the center of the humanitarian side of the economic crisis: what we do about the crisis will determine whether she can stay in her home and how much debt she will bear for the next decade or so.

Therefore the best way to get a handle on the meaning of the current crisis—and possible solutions for it—is to look carefully at the individual homeowner. What follows is a quantitative analysis of a typical homeowner’s plight and the conclusions that we can draw from it.

A Representative Homeowner’s Plight

Consider Mary, 29 years old and the head of her household. She makes $50,000 a year. A year ago she took advantage of the subprime credit bonanza and bought a $300,000 home with no money down.

Mary’s initial “promotional” interest rate on her subprime loan was 5%. To make her payments seem lower, the lender made the loan “interest only,” with no amortization, for the entire two-year introductory period.

To make the numbers simpler, we ignore compounding, which would raise Mary’s payments only slightly. So her introductory payments are simply 5% x $300,000, or $15,000 per year, $1,250 per month. That’s about 30% of her monthly gross income of $4,167 ($50,000/12).

Two points are worth noting at the outset. First, the absence of a down payment gives the lender absolutely no “cushion.” The lender is banking on an increase in the value of the home to provide some equity, or on Mary’s ability to repay the loan according to its terms.

The second preliminary point is more interesting. The fraction (30%) of Mary’s monthly gross income represented by the introductory interest-only payment (at an artificially low introductory interest rate) is precisely the minimum fraction that mortgage lenders used to require for lending before the subprime silliness began. For about three decades beforehand, the mortgage industry observed a 30% or rough “one-third” rule of thumb: it required mortgage payments not to exceed a third of the borrower’s gross income.

Now let’s see what happens when the loan’s promotional, introductory period expires in another year. Then Mary’s rate will go up to 7%. In addition, the rate will now include amortization, since Mary must eventually pay the mortgage off. We can find Mary’s monthly payment for a 30-year fixed-rate mortgage on $300,000 at 7% from any standard mortgage calculator. The result is $1,996.

This number includes only principal and interest. Since Mary put no money down, her actual payment would also have to include mortgage insurance (to protect the lender) and various other fees. The total would be about $2,150.

So at the end of the second year, when Mary’s payment hits this amount, it will increase 72%. It will go from a comfortable (and, before the subprime madness, customary) less than one-third of her gross income to more than half of her gross income.

Unfortunately for Mary, that’s not all. There’s still the housing bubble. In what most economists expect to be the worst case, the market value of her house will decrease by 30% over the next year or so as the housing bubble pops and normal market values resume. After that happens, Mary’s house will be worth only 70% of $300,000, or $210,000. But Mary will still be on the hook to pay the mortgage note for the full $300,000 price at which she bought the house.

That’s Mary’s plight in a nutshell. When her introductory payment period ends, her payments will increase by 72%. They will gobble up over half her gross income (before taxes and expenses) for the foreseeable future. In addition Mary will have $90,000 in new debt, not covered by collateral. Mary will have lost the equivalent of almost two years’ worth of her gross salary simply by buying the house and agreeing to the subprime loan.

In short, the present crisis has two distinct components, both of which are important. First, interest-rate step-ups threaten to put millions of homeowners into default on their mortgages. Second, if homes are foreclosed, the vast depreciation of home values (with more expected) resulting from the housing bubble’s burst will force homeowners, lenders or both to bear enormous financial losses.

A Way Out: Anti-Deficiency Legislation

Is there any way out for Mary? Her options depend mostly on the state in which her home is located.

A minority of states still has legislation that prevents lenders from holding homeowners liable for more than the value of their homes. These state statutes—a holdover from the Great Depression— are called “anti-deficiency” statutes because they prohibit mortgage lenders from seeking to recover a deficiency in the home’s value (below the loan value) from the homeowner. (Some of these statutes have exceptions for things like second homes and refinancings, but most cover mortgages taken for the purchase of a principal residence.)

These statutes give Mary a real out. She can give the lender the keys to the home and walk way, debt free, even when the home’s value is less than the amount of outstanding debt. The lender can look only to the home to recover the full amount of the loan. California—a state at the epicenter of both the subprime crisis and the housing bubble—is an anti-deficiency state. (See California Code of Civil Procedure § 580(b))

If Mary lives in California or another anti-deficiency state, she therefore has an attractive economic option. She can walk away from her home, giving the lender the keys, and by that act alone relieve herself of $90,000 worth of debt, nearly twice her annual salary. At the same time, she can substantially reduce her monthly housing expense, simply by renting, rather than buying, a home.

For several years now, renting has been a bargain compared to owing a home. Average rents have been far lower than the full cost of home ownership, including mortgage, maintenance, insurance, and depreciation. Therefore Mary can probably rent an apartment with size and amenities comparable to those of her abandoned home for even less than her $1,250 per month introductory mortgage payment. She might even rent a comparable home, as lenders seek to accrue some income from their foreclosed and unsellable properties by renting them out at bargain rates. With these low out-of-pocket housing payments, Mary can begin to save money for a down payment on her next home, hoping to buy later, at a market low rather than a market high.

By law, Mary’s default on her current loan will stay on her credit records for seven years. During that time, it is unlikely that any lender would make her a new home loan—although that risk might change in the future due to new legislation or changes in lending practices as a result of this crisis. So if Mary takes the default option, she should reconcile herself to foregoing home ownership for seven years.

Mary’s other option is to tighten her belt, live on less than half her gross income (with the other half going toward her mortgage), and stay in the house. She might do so if her chief personal goal is to own her own home.

After seven years of payments, the balance on Mary’s loan would be $273,442, and she would have paid $141,098 in additional interest (not counting the interest paid during her two year “introductory” period). Because mortgage interest is tax deductible, Mary would save about 15% of that total, so her net payment for housing would be 85% of that amount, or $119,933. Over seven years that works out to $1,428 per month.

Now let’s assume that, in the interim, Mary could have rented comparable housing for $1,250 per month. Then her “extra” payment over the seven years, to stay in the home rather than default and rent, would be 7 x 12 x ($1,428 - 1,250 = 178) = $14,952. After paying that “extra amount” for housing, Mary would still owe $273,442 on the house. If the house did not appreciate, but were still worth only $210,000, she would be $63,442 in the hole. In total, she would be $78,394 less well off than had she rented during the same seven years.

Mary might recoup this amount—or even make money—if the house appreciated in value during the interim. But it would have to appreciate $78,394 just for Mary to break even. As compared to the initial value of $210,000 (after the housing bubble burst), that’s a total appreciation of 37 % over seven years, or about 4.6% per year compounded.

That sort of appreciation is not impossible; it’s about the national average during the five years before the housing bubble. But Mary would have to take a big downside risk. Even if appreciation of about 5% per year is “normal” for housing in the United States, no one knows how long the housing market will take to return to “normal” conditions. The Japanese real-estate bubble, for example, took twenty years to work itself out. So if Mary stays in the home, there’s a big risk that she might still be in debt more than her annual salary after seven years of belt-tightening.

On the other hand, if Mary rented in the interim and banked the savings on her monthly housing payments, she would have that $14,952 to put up as the down payment for a new home. At ten percent down, she could afford about a $150,000 home. She might even get a loan with only five percent down, for a $300,000 home. And at the outset she would have some equity in her new home, rather than a large net debt.

Most of us are risk averse. We don’t like to take big risks with our financial future. So a rational person in Mary’s position would likely would walk away from her home and take a fresh start as a renter, with no debt. I certainly would. Only if Mary were less risk averse, more self-restrained (i.e., willing to tolerate using only half of her gross income for non-housing expenditures in the interim) or more optimistic about future appreciation than most of us would she stay in the house.

Deficiency States

The result is different in states with no anti-deficiency legislation, which we’ll call “deficiency states.” There, homeowners with mortgages remain liable to pay the full value of their mortgages even after foreclosure. They cannot escape this obligation by filing for bankruptcy, because current bankruptcy law requires mortgages on principal residences to be paid in full.

Thus, if Mary lives in a deficiency state, her best option is to tighten her belt and stay in the house. If she defaults and suffers foreclosure, she will have no home and still have to pay the difference between the home’s value ($210,000, presumed to be the foreclosure sale price) and her $300,000. In other words, she will be homeless and have a debt of nearly $90,000 (nearly equal to twice her annual salary), which she can’t discharge in bankruptcy. She has no choice but to stay and pay.

Leverage, Fairness and Moral Hazard

As this brief discussion shows, homeowners in anti-deficiency and deficiency states live in entirely different economic universes. A homeowner in an anti-deficiency state can walk away from a home that is financially “under water,” leaving the lender to suffer the deficiency. A homeowner in a deficiency state can lose the home in foreclosure and still owe the difference between its market value and the debt. Since the deficiency (as in our example) can be several times a homeowner’s annual salary, the practical difference among states is enormous.

The difference also has three other aspects. The first is leverage. By virtue of her ability walk away free of debt, a homeowner in an anti-deficiency state has the whip hand. If she defaults, the lender will lose the amount by which the home has depreciated since her purchase. Throughout the United States, homes have been depreciating over the last year—about ten percent on the average, so far. Economists predict they will continue to depreciate by another ten or twenty percent. A well-informed homeowner in an anti-deficiency state therefore has a “cushion” of up to thirty percent of the purchase price over which to bargain with the lender.

In contrast, a homeowner in a deficiency state has little, if any, leverage over the lender. The lender has the right to collect the full mortgage debt even after foreclosure. So the lender has little incentive to bargain to avoid foreclosure. The homeowner’s only leverage comes from her ability and incentive to pay. A practical lender will know that an individual in Mary’s position has only a limited ability to pay. It will also understand that a debtor paying for a home she doesn’t own will use every excuse—and every legal trick—to avoid paying. So the lender may bargain to avoid the annoyance and expense of repeated legal proceedings to enforce and collect the debt. But that is all.

The big second difference between anti-deficiency and deficiency states is a matter of fairness. Why should homeowners in different states suffer such different fates just because their legislatures responded differently to the Great Depression eighty years ago? From the perspective of economics and public policy, the enormous difference in economic outcome for homeowners is fortuitous.

When you consider the nature of some states involved, the enormous difference can seem capricious. California’s housing is some of the most expensive in the nation; yet California is an anti-deficiency state. So a person in California who rashly incurred the expense of a million-dollar home without any ability to pay for it can walk away from a million-dollar loan when the home’s value declines to $700,000, saving $300,000. Yet a no-down-payment purchaser of a $200,000 home in a rural deficiency state must pay every penny of the $60,000 by which the home’s valued is expected to decline, while the lender walks away with nary a penny of loss.

The final big difference between states is moral hazard. Much ink has been spilt about the moral fault of both subprime lenders and those who purchased homes from them. But one thing is clear. Lenders in anti-deficiency states like California knew exactly what they were getting into, or they should have.

Anyone who enters the mortgage lending business without competent legal advice is an idiot. There are few idiots in the industry: all have detailed and voluminous forms carefully drafted by lawyers. All who lend in anti-deficiency states had to know that—in any loan involving no or a small down payment—the law puts the full downside risk of depreciation on them. They knowingly took the full risk of depreciation. Homeowners, protected by the anti-deficiency legislation, did not.

At first glance, this observation seems to argue for harsher treatment of predatory lenders in anti-deficiency states. But wait a minute. Most predatory lenders operate nationwide or in a region containing both anti-deficiency and deficiency states. If the lenders themselves did not, then the investment banks that “packaged” their loans and sold them as securities certainly operated in these broader fields. No news reports I have seen suggest that they treated borrowers in anti-deficiency and deficiency states any differently. While the housing market was seeming to defy gravity, they were quite willing to ignore the risk of depreciation wherever they operated.

If you think it unfair to charge these sophisticated folk more than simple borrowers for a risk that affects both, try this little experiment. Ask friends and acquaintances (who are not lawyers or in the financial industry) what anti-deficiency legislation is and whether their state has it. If you get a coherent answer from more than one out of ten, then maybe you have a point.

Conclusion

In order to be fair, effective and egalitarian, any federal law to address the mortgage crisis must take account of two undeniable facts. First, the economic consequences of the subprime lending crisis and the housing bubble’s collapse vary enormously between anti-deficiency and deficiency states. Second, the collapse will cause enormous losses to lenders, borrowers, or both.

We can estimate the magnitude of the losses as follows. Multiply the estimated number homeowners facing possible foreclosure (2 million) by the mean home price ($200,000) and take the loss of value to be 30% of that (the worst-case depreciation that economists predict). The result is $120 billion.

That’s a lot of money, but it’s not particularly enormous these days. It’s less than one-eighth of the minimum estimate of the full cost of our war in Iraq. It’s less than three times Exxon’s profit for the last fiscal year. Yet how we handle that amount, and how we divide the pain between industry and homeowners, will determine what our society and our middle class look like for decades to come.

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