Tuesday, December 1, 2009

This Time It's Different

Whenever someone says "this time it's different," especially in regards to some sort of investment strategy or new business paradigm, it's safe to assume that this person is either a) drinking the kool-aid, b) a moron, or c) both. Please refer to the current housing situation in Souther California if you have any questions.

Of course, now that I've made a sweeping generality, it should be apparent that I'm about to point out the exception. Yes, there is one thing about the housing boom and bust that's different this time. But it's not a good development at all.

Unlike in recessions past, homeowners have recently been quite willing to walk away from their mortgages as soon as the loans are underwater. "The hit to my credit rating," they rationalize, "is nowhere near as bad as throwing away hundreds of thousands of dollars. In 5 years my credit score will be fine, but it could take decades for the price of my house to recover." Now, a professor at the University of Arizona law school has written a paper that encourages people to do just that - walk away.

From a simplistic view, this makes a lot of sense. Yes, it's rational for you to walk away from a house that's badly underwater. It's also rational for the banks to jack up the rate on mortgages to mitigate their losses next time:

Lewis Ranieri, chief executive of several major mortgage-related companies and one of the pioneers of the mortgage securities industry, called White's entire argument "incredibly irresponsible and misinformed." Not only is the professor urging consumers to break legally binding contracts, Ranieri said, but if large numbers of them did so it would send home mortgage rates soaring and "tear apart the very basis" upon which mortgage lending rests -- the understanding that borrowers will honor their commitments and pay back the money they borrowed.
Yes, that's the same Lew Ranieri you may have read about before.

If buyers are willing to walk away from their mortgages at the drop of a hat, the result will be an adversarial relationship between the banks and the borrowers. The lenders' philosophy will change from "how do I get this person into a house" to "how do I make sure this person doesn't screw me." Mortgage rates will rise, higher down payments will be required, and far fewer homebuyers will be considered creditworthy. Unles the borrower has some major skin in the game, there's no way they're getting a loan. Ironically, it'll be the same banks that are less willing to lend that will be stuck sitting on too many empty houses. But that won't matter to the banks - they'll be so fearful of even more people defaulting that they'd rather sit on an empty house than write a mortgage to anyone with less than pristine credit.

Taken to the extreme, this will lead to a permanent renting-class in the country's major cities, since far fewer people will be able to afford the hefty downpayments and higher monthly charges. Ironic that the attempt to make home ownership possible will result in putting that dream out of reach for so many.

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