Could This Prevent Another Housing Blowup?

Former baseball player Jose Canseco had a problem: His $2.5 million home was losing value, and he didn't like it. Real estate is only fun when it, you know, goes up.

So he handed the keys back to the bank and walked away. He played the housing game. It didn't treat him well. So he called it quits. "It didn't make financial sense for me to keep paying a mortgage on a home that was basically owned by someone else," he said. "I decided to just let it (the house) go …"

That "someone else" was, of course, the bank.                                 

This walk is actually a foul
It's called walking away, and it's becoming a big problem. In general, mortgages in the United States are non-recourse loans (although laws vary state by state). This means the collateral backing the mortgage is limited to the house. In short, when a borrower like Canseco walks away from his home, the bank often can't go after his other assets if the house is worth less than the loan. It can't garnish his wages or take his savings, car, boat, watch, or firstborn. The bank gets the house, and nothing else.

Interestingly, this little loophole is almost exclusively an American tradition. As Harvard economist Martin Feldstein put it:

The 'no recourse' mortgage is virtually unique to the United States … Officials and investors in other countries are amazed to learn that U.S. mortgages are no recourse loans. It is indeed surprising that this rule in the U.S. applies to home mortgages but not to any other type of loan.

In most countries, banks can shake you down for all you're worth if you stop paying your mortgage. Australia is one of those countries. If you can't pay your mortgage in the Land Down Under, banks will hold you accountable. An op-ed in the Wall Street Journal elaborated on this last year:

When Australians borrow money to buy a house, they know that if they default and the mortgaged property doesn't cover the debt, they will be responsible for the shortfall. And the lender will chase them for it. It's a neat way of reminding Australians to borrow responsibly.

Yeah, that is neat!
With this in mind, it makes sense to look at differences between real estate markets in Australia and the U.S.

Australia has had an epic real estate boom that started in the mid-'90s. What it has not had -- at least not yet -- is an epic real estate bust. Here's how changes in home values compare:

Year

Australia

United States

2003

18.9%

11.0%

2004

2.7%

15.3%

2005

2.3%

14.5%

2006

8.3%

0.4%

2007

12.3%

(8.6%)

2008

(3.3%)

(16.7%)

Source: Australian Bureau of Statistics (weighted average of eight capital cities), S&P Case-Shiller 20-City Composite Index.  

Australian home prices's failure to plunge isn't entirely attributable to the country's full-recourse loan system. It's just one variable in a big, burly economic system. Prices could also drop like a stone any day -- we just don't know.

But the greater stability of its housing market is definitely encouraging. Could it be that full-recourse loans encourage homeowners to:

  • Not act like Canseco, walking away from your home just because you can?
  • Think real hard before taking out a mortgage, knowing the bank will hound you if you fail to pay? And maybe keep a sizable rainy day fund handy, just in case the bank comes a-knockin'?
  • Jump through hoops to pay your mortgage, even if it means severe sacrifices?

Crikey! Yes!
We've quibbled about how to prevent another financial collapse. The ideas at hand mainly include throwing rotten eggs at Bank of America (NYSE: BAC  ) , Citigroup (NYSE: C  ) , and AIG (NYSE: AIG  ) . But what if we acknowledged that a burden of responsibility lies with homeowners as well? What if, rather than treating banks as pure villains and homeowners as pure victims, we spread the responsibility more equitably? Would full-recourse mortgages promote responsible borrowing, and thus a more stable housing market, financial system, and economy? I'm tempted to say they would.

The downside of full-recourse mortgages
Some might argue that such an approach could backfire. After all, our economy's growth lies in its acceptance, if not encouragement, of failure. That's capitalism. Lenient recourse laws and bankruptcy protection encourage the risk and innovation that create the Googles (Nasdaq: GOOG  ) , Microsofts (Nasdaq: MSFT  ) , and Boeings (NYSE: BA  ) of the world. Full-recourse mortgages would therefore divert dollars away from housing investment, stifling advancement.

But that is actually what's crazy about a non-recourse mortgage system. For the past decade, we treated housing like it was something capable of innovation, somehow worthy of investment dollars because it was destined to achieve great things. We believed that housing could change your life. That it could make you rich. That it was the new "new" thing -- an Internet we'd never discovered before.

But that was all a sham. A thousand years ago, a home was a place to sleep. A thousand years from now, it'll be the same. A house is not an investment -- it's a place to live, and nothing more. Artificially supporting a degree of risk that encourages failure is kinda nuts, since homes are incapable of innovating into anything beyond what they've always been.             

I know this is a touchy issue that'll draw a wide range of opinions. So I'm handing this article over to you. What do you think? Should the U.S. follow the rest of the world and move toward a full-recourse mortgage system, making homeowners liable for unpaid balances? Let us know in the comment section below.

For related Foolishness:                                                                   

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article -- or a house, for that matter. Google is a Motley Fool Rule Breakers pick. Microsoft is a Motley Fool Inside Value selection. The Fool's disclosure policy would never give up on you.


Read/Post Comments (12) | Recommend This Article (15)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 09, 2009, at 11:57 AM, mrwizard555 wrote:

    i always treated my mortgage like a recourse loan and my house as a home only. the two main reasons that i own it outright today.

  • Report this Comment On July 09, 2009, at 12:07 PM, TMFThump wrote:

    The problem isn't no-recourse loans. It's mortgages being written that require no equity for the borrower. It used to be that in order to qualify for the load you had to put 20% down or pay for mortgage insurance. That was sufficient to protect the lender against default. Banks were also considerably more diligent in assessing the credit-worthiness of the borrower.

  • Report this Comment On July 09, 2009, at 12:18 PM, questioner5000 wrote:

    Borrowers sign a contract - - a promise to pay if they are lent money for something they want/need - - in this case a house. Somehow this "obligation" has evolved into the idea that if a borrower is unwilling to pay, (whether able to pay or not), it's somehow completely the bank's fault for making a bad credit decision - - in other words, the bank "should have known" that the borrower would eventually default, despite the borrower's contractual promise that they WOULD repay the loan.

    So now the deal is this - - if the value of the property rises, the benefit accrues to the borrower, but if it falls, (even if the borrower is still capable of adhering to their contract), then it is the responsibility of the bank, (by being forced to lower the principal amount or reducing the contracted interest rate to some "bargain", below market rate, or to foreclose on the property and sell it at a loss), or the taxpayer, (via certain subsidy programs to encourage banks to make concessions to the borrowers).

    In other words, "heads" and the borrower wins, or "tails" and the bank and taxpayers lose. What a country!

  • Report this Comment On July 09, 2009, at 12:19 PM, Fool wrote:

    Whenever something is made easier more people do it, right? If some item is in high demand the seller can ask a higher price over their cost, right? If homes were only bought and sold out of the basic need to have shelter that is appropriate for your income level and the size of your family and not as get-rich-quick schemes, prices would only be based on true need for shelter and the cost to build it. If only a few people had incomes that could afford to buy a home instead of rent there would either be less houses built or the prices would have to come down to where more people could afford them. If houses were seen as a place to live and not a cash cow there would be less of this crazy speculating that artificially drives up prices and eventually crashes when too few people can afford to buy and there are too many houses out there. If the risk of buying a house you can't afford or are speculating will give you a quick profit was greater (i.e. a loan you could not casually walk away from and just deal with a dinged credit score) there wouldn't be so much incentive to use housing as a way to wealth. People would have to work harder at using their minds and bodies to earn a living that provides REAL value to the world. Not the money created from thin air way that has doomed us all to suffering.

  • Report this Comment On July 09, 2009, at 12:26 PM, dhthompson wrote:

    The problem is both no-recourse loans coupled with eased standards for obtaining mortgages during the housing run-up. The lack of responsibility in our society today is sickening. People's feet should absolutely be held to the fire instead of being allowed to walk away so easily. I'll give a perfect case in point: we recently bought a house in foreclosure, owned by a husband/wife real estate team, who together had taken out hundreds of thousands of dollars in equity loans on this one property. They didnt reinvest into the house, they went to Vegas and otherwise found ways to squander the money handed over by the bank. Instead of remorse from the "victims" one of the perps detailed to me a "how to" in case I wanted to do the same. Granted, most people don't fall into this boat, but many at least waded in the same pond. How many cars were bought and brokerage accounts funded by raided home equity purchased with 5% down? Instead of having to face the piper, Americans are allowed to walk away, make it someone else's problem, and whine about how they've been victimized. I'll call my congressman today and harp on the value of implementing methods outlined in Morgan's article above, and hope all readers will do the same.

  • Report this Comment On July 09, 2009, at 12:50 PM, MKArch wrote:

    I completely agree with the sentiment that it's time for borrowers to start taking their fair share of the blame and stop scapegoating the banks for the WHOLE mess. I posted a similar idea to your recourse loans recently suggesting anyone who CHOSE to walk gets a black mark on their credit report for life. I still disagree that at this point in the game there are a significant amount of people who view their house as an investment that they will willingly walk away from based on the CURRENT market price.

    For most people an automobile is a significant investment that is well underwater the second they drive it off the dealers lot with virtually no hope that it will ever do anything but lose more value. How many auto owners turn in the keys to the dealer because their investment is under water? Yes there were some flippers and speculators in the housing market during the bubble that I'm quite sure were among the first to get wiped out. The vast majority of people who buy a house do so to live in it just like they buy cars for transportation. This late in the game the flippers and speculators are long gone with real home owners left that will be paying their mortgage unless they run into financial distress.

    BTW I think home owners are more sophisticated investors than financial pundits and realize that once the economy turns around house prices will appreciate again and the CURRENT distressed market price does not necessarily represent the long term value of the house.

  • Report this Comment On July 09, 2009, at 1:03 PM, Kar1a wrote:

    Greed makes bank ignore the risk and our system makes homeowners irresponsible. After all, you should pay what you owe and you don’t deserve to own what you can’t afford. It’s so simple.

  • Report this Comment On July 09, 2009, at 2:35 PM, questioner5000 wrote:

    MKArch,

    You mentioned giving "walkers" a "black mark on their credit report for life". While I think that that should also be the case with those who hear those commercials on the radio, advocating that "people with $10,000 or more in credit card debt have a RIGHT to get their debts forgiven, in these days of government bailouts of the credit card companies", (with no mention of whether or not the borrowers actually have the ABILITY to pay down their credit card bills, but simply, out of greed, want to walk away), I think that the deadbeats will eventually get away with it.

    You see, some people are deliberately withholding their mortgage payments, living "rent-free" until they decide to walk away and/or the bank decides to foreclose, (thus actually enabling the deadbeats to build up a "nest egg" to be used as equity in buying another home at a greatly depressed current market price). Eventually, with such a large segment of the population having this "black mark", SOME banks will start making loans to these people, even though the "walkaway" is reflected on their credit report. Suddenly, other banks, fearful of losing too much of this segment's "market share", will loosen THEIR own standards, and, thus, the walkaways will prematurely, be "forgiven". You see, the stigma of the failure to pay will be watered down. It wasn't their fault for simply walking away - - "it's just the economy, man!"

    You also noted that financial pundits underestimate the sophistication of the American homeowner. Unfortunately, with the constant drumbeat of "neo-populist" government officials OF BOTH PARTIES telling people that it's all the banks' faults, that the borrowers were misled, uninformed, or unsophisticated to the point that the entire problem was caused by the "greed of the bankers", people have now convinced themselves that they are truly "victims", and have a right to punish the bankers who fooled them!

    What crap!

  • Report this Comment On July 09, 2009, at 6:19 PM, ThisisGod wrote:

    Full-recourse loans would encourage banks and lenders to push the shady and fraudulent mortgages even more. Hey, if they can go after your wages and other assets, why not push zero down mortgages, no principal payments, 2% interest for the first 3 years? The banks would reduce their chances of losses to zero. There are no ethics and morals in American business anymore - its profits no matter what.

  • Report this Comment On July 09, 2009, at 6:49 PM, simonffg wrote:

    Yes and No. Lovely fence-sitting from the land downunder and it's probably that that has saved Australia more than anything else. Generally we're a risk averse nation, highly regulated financial services helps, but we don't appear to have the massive drive to World domination. Sure we're in recession, just take a look at the hedge fund managers warning us that the worst is still to come whilst the government refuses to accept it. Good credit control is essential, what's even better is we're a nation full of "get rich slow" proponents using real estate. We're also a giant kangaroos leap from anywhere that matters with thousands of people wanting to live the Australian dream of surfing before work. The demand for housing and rental accommodations will not diminish. It's foolish to say that full-recourse is the only factor. If you lend to people who can't afford to repay you then what use is full-recourse, if they lose their house you can almost guarantee they'll have no money anywhere else.

  • Report this Comment On July 28, 2009, at 8:54 PM, hybridinvestor wrote:

    Non- vs. full-recourse loans are not the problem in this case as stated by several others. First, being a homeowner myself I am not trying to allow homeowners to escape some blame for their actions, but as an investor as well I know the buck stops with me on making prudent investment decisions. I don't actively pursue handing money to investment opps or people which/who in my opinion have a high chance of default. The banks, hedge funds, investment banks, etc. failed themselves miserably in this regard and knew it. I do not feel any sympathy for their greed of pushing questionable products on the masses and bundling and selling of the risk to unsuspecting (and imprudent) other investors. Second, I would be willing to hear arguments for a full-recourse loan system but if and only if a house then becomes more like every other investment product out there. That is, if it increases beyond my initial price plus expenses, that is a taxable gain. If it decreases from my costs, then it is a tax loss and should be deductible similar to other investment losses. Some argue that the current system favors the homeowner. I disagree strongly on this point alone. If the government is going to tax gains from homes (beyond the exemption which I think they should just get rid of and move to something similar to investment property like-kind exchanges) then I should be able to deduct losses as well. It is lopsided, asymmetric and favors the banking system and discourages tax loss selling. All property in some senses (not completely) becomes investment property. Finally, for those of you who have not read the book "The Birth of Plenty" then it is a very good read. I agree with comments here that tend to lean more toward non-recourse systems due to the fact that in a non-intuitive (at first glance) way they encourage innovation and risk taking because they take away the fear of the equivalent of "debtor's prison" where the entity making the loan cannot take one's family, property, etc. which was a stiff penalty for failure. I am not advocating taking risks unabashedly and a system that does not have checks and balances but simply that I favor some level of risk taking without crushing penalties. In this regard, our market regulators (the Fed, SEC, etc.) outright failed in their responsibilities and only stepped in to address the problem after it was already out of hand. I'm sorry folks but trying to pin this situation on the shoulders of the masses is just barking up the wrong tree. Just because someone is ignorant (meaning not knowledgeable about some topic) does not mean we take advantage of them. That is exactly what the system did to many people and it is unsympathetic to not acknowledge the pain and hardship it has caused many decent hard working people because of the greed of a few.

  • Report this Comment On September 01, 2009, at 11:23 AM, TCaskey wrote:

    While I agree that there should be some recourse on the borrowers let's not forget that the banks have acted quite irresponsibly in this as well. Should they espect to be safe after giving a NINJA loan, or misrepresenting the way an ARM works. Some of these consumers were assured that their ARM rate would not raise substantially which was not true in any economic client. Then the banks decided to sell these mortgages in securities to private investors. So in many occasions the bank has avoided the risk and transferred it to other investors. Both parties in this situation should share responsibility, if the banks don't want all these forclusures make the mortgage affordable like it was in the first place.

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