This Is Killing Housing Prices

The Economist recently profiled a real estate investor who bought a $6.2 million home in 2005 "on a whim." Today, with high-end real estate following the rest of the market down the toilet, things aren't going so hot.

No matter: "I'll walk away before I take a loss on the property" the investor declared.

Walk away. Before I take. A loss.
These are important words. As home prices crater, the incentive to give your home back to the bank -- even if you can afford the monthly payments -- grows by the day.

I've written about this several times now. Some readers complain the evidence of homeowners walking away is purely anecdotal, and no such phenomenon is actually occurring.

But a new report led by economists from Northwestern University, the University of Chicago, and the European University Institute confirms that it's indeed happening on a grand scale.

In a study of more than 1,000 American households, the report concludes that more than a quarter of existing mortgage defaults are "strategic" -- done by those who can afford their monthly mortgage payments, but choose to default anyway.

A main factor in strategic defaulting is the extent a home is underwater, or worth less than what's owed on the mortgage. Have a look:

Amount Underwater

Percentage of Sample Declaring Intention to Default

$50,000

9.38%

$100,000

25.81%

$200,000

41.23%

$300,000

44.65%

The report also found the propensity to walk away within a specific ZIP code fed on itself, which the researchers attributed to "a contagion effect that reduces the social stigma associated with default as defaults become more common."

In other words, "Hey, if my neighbor's doing it, I might as well, too."

Or how about this: When people see Citigroup (NYSE: C  ) , Bank of America (NYSE: BAC  ) , and AIG (NYSE: AIG  ) bathing themselves with taxpayer money, it's probably easier to say, "You know what? I'm entitled to tell the bank to shove it." An offshoot of the effects of moral hazard, I suppose.

Where to now?
When we discuss these issues, people just want to know when prices will stop falling. The honest and correct answer is that no one knows when that'll happen. But looking at a few metrics, we can at least ponder where we're at.

For example, here's one popular gauge, the price-to-income ratio, using 1987 as the base year (i.e. I arbitrarily set 1987 to 1.00; hence a reading of 2.00 indicates that housing prices are twice as high in relation to income as they were in 1987):

Year

Housing Price-to-Income Ratio

2009

1.04

2008

1.31

2007

1.55

2006

1.64

2005

1.53

2004

1.39

2003

1.27

2002

1.17

2001

1.09

2000

1.00

1999

0.95

1998

0.93

1997

0.93

1996

0.94

1995

0.96

1994

1.00

1993

1.00

1992

1.02

1991

1.02

1990

1.06

1989

1.05

1988

1.03

1987

1.00

Sources: Case Shiller National Values, U.S. Census Bureau, author's calculations.

Not bad, huh? Prices in relation to income are inching close to pre-bubble levels. I was pleasantly surprised putting this table together. I, like many others, assumed the relationship between prices and income would still be way out of whack.

Problem is, and back to our original point, a good chunk of defaults have nothing to do with income levels. High mortgage balances, not mortgage payments, are a key factor fueling defaults and keeping prices compressed. After a while, this feeds on itself: Lower prices equal more strategic defaults; more strategic defaults equal lower prices.

Tying it all together
When a home hits a tipping point of being 15% underwater, the researchers found, homeowners start to "walk away massively." And that can really gum up the way markets are supposed to bring things back to harmony.

Think of it this way: In a normal market, if prices collapse far enough, no one will sell. But if housing prices collapse far enough, people just walk away, creating a situation akin to mass selling. Sound crazy? Oh, it is. Welcome to a bubble built on debt, in a nation where non-recourse mortgages are the norm.

Now, this doesn't mean the end of the world is near. Home prices, like all busted bubbles, will find a bottom. But it means price-to-income levels will probably fall well below their historical norm. And it means we're probably in for a long, painful recovery that won't rebound anytime soon. And it means housing-heavy financial institutions -- like Wells Fargo (NYSE: WFC  ) , Freddie Mac (NYSE: FRE  ) , Fannie Mae (NYSE: FNM  ) , and even JPMorgan Chase (NYSE: JPM  ) -- will be slogging through mortgage losses for years, not months.

In the end, markets work. What happens in between is prone to all sorts of madness. And that's where we are today. Enjoy the ride.

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Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. The Fool has a disclosure policy.


Read/Post Comments (14) | Recommend This Article (61)

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 28, 2009, at 1:16 PM, Cutter1978 wrote:

    The root of this issue is a change in owner perception over the past several decades. Buyers view their purchases as an investment and not as a home.

    It started in the second half of 1980. Amateur ‘investors’ (aka homebuyers) bragged about their property value increases. But these Donald Trump wannabes were fooling themselves. Every homeowner saw similar increases.

    For most of us, a property purchase should be a way to establish roots in communities and a base to raise our children.

    We need to get back to that mentality.

  • Report this Comment On July 28, 2009, at 1:18 PM, biggart wrote:

    What Morgan fails to realize is that the majority of the debt held by banks has been written down by 80%--considered by some as toxic. You also don't take into consideration the buying power one has when when in '87 interest rates were in the 8% range then here and now 5%. Give me a 300K home in 87 and I'll show you a 500k home in 2006 I can buy with the same income! Wait until the housing bubble corrects or even flatlines to a true market value in which assets will end up being repriced to a "true market value". My prediction will be a significant bounce to the upside that will ultimate dwell from past overreactions created by the industry and its analyst. Take it from a cost estimator...I can make any number magical and all I need is buy-in from the peanut gallery to make it work. Hence where this market is today--lack of confidence! The sugared recipe goes something like this: Flood the market with confidence (aka easy money...roughly $2T), this creates jobs (short term) as industries being hiring as gov't spends money hand over fist, spurs the simple minded to spend/not save, administration looks good, more regulation (remember the DOTBOMB era, oversight really worked didn't it?...remember all those "lesson learned" our leaders quoted), we float the economy for another 10 years, then your life savings is lost in a few days. Repeat.

  • Report this Comment On July 28, 2009, at 1:20 PM, FreundInvesting wrote:

    Good article, Morgan. I think that just as we overshot on the high side (1.64 in 2006), we'll overshoot on the low side (perhaps going to 0.94). If that's the case, we definitely still have a ways to go.

  • Report this Comment On July 28, 2009, at 3:20 PM, OIFAirborne11C wrote:

    So what happens when the banks decide not to do anything with the mortgage loan? I.E. the homeowner 'walks' away from the home/loan, moves on, lives another live, a year or two down the road applies for some type of loan/credit/bankruptcy, and discovers they still have that previous house in their name.

    Lets be real, the home owners dont want a loss, the banks dont want a loss, neither wants to acctually pay for the cost of foreclosure/bankruptcy, so what do you do then? The home cant be sold, the owners cant make the payments, they cant get them off their records, etc.

    This is happening now. Just like people walked away from their homes/loans to 'get back at the banks', the banks 'getting back at the victims' by just sitting on the homes. They might not have a recourse to collect from the owners, but they don't have to foreclose or sell the house either. They already own it, they don't make payments to themselves. The property is on their books as a negative asset, but what bank doesn't have millions in negative assets right now? In fact, it pays to have negative assets in the form of bailouts. Think on that...

  • Report this Comment On July 28, 2009, at 4:11 PM, cjb44 wrote:

    If someone can't make the payments on their home, it doesn't matter that they are underwater. What matters is that they bought too much house. I bought a house two years ago and it's declined in value but I can still make the payments (although I'm not underwater) and that's the difference.

    People who can't afford their payments, can't afford to ride out this decline. Maybe they should have thought twice before buying the bigger house. There are plenty of people underwater who are still making payments because they can and it's their home.

    Anyone who walks away doesn't realize what they've done to their neighborhood and to their own credit.

  • Report this Comment On July 28, 2009, at 5:14 PM, plange01 wrote:

    with the US just over 7 months into a depression home prices have barely started to drop..so much talk over losses that have only just started....give it a few years to bottom..then talk about it...

  • Report this Comment On July 28, 2009, at 5:55 PM, CaptainFiveBaggr wrote:

    We can point fingers all we want about people "walking away". But lets be serious. Their credit will take a hit.. but the hit will do much less damage than paying mortgage payments for 3-5 years in the hopes that in year 5 their home is worth as much as their loan. The rules are too laxed on foreclosures. If I bought in 2005-2006 I would walk away in a second. Rent for the next 7 years, work to get your credit up. Then have a huge downpayment on a house that you can afford.... thats sounds better than breaking your back to maybe break even with no equity in your current house after 5 years...

    Dont blame the people, blame the system..... how about getting creative refinancing solutions and allowing these people to take their lost equity over time and give them tax incentives to do so. And make the ramifications of foreclosures more serious. Put a limitations on former foreclosed borrowers. Obviously pay a higher rate, but why not enforce a 35-40% down payment if they have foreclosed in the past 7-10 years.. that way the $100K cash they might have will be good towards a $250K house instead of a $1mill house they would want.

    Need to be more strict with these people, or they will continue to find loopholes. Same goes for bankruptcy laws in my mind. too many loopholes.. too many ways to turn failed debt filled investments into marginal losses. Risk vs Return needs to be equal

  • Report this Comment On July 29, 2009, at 9:44 AM, plange01 wrote:

    the best season for home sales is almost over and sales along with prices will soon resume and increase their decline.the US is in a depression and over the next 3-5 years it will get worse much worse.............

  • Report this Comment On July 30, 2009, at 12:20 PM, badnicolez wrote:

    The real reason for the strategic defaults is exactly why our best friends in Phoenix are contemplating walking away from the house they bought in 2006, even though they can "afford" the payments.

    They put down more than $100k in cash, paid $25k in additional principal over the past 2 years, and still owe $400k plus interest for something that is now worth maybe $285k and losing value every day, with little to no hope of being worth ever again even what they owe, never mind what they paid.

    Then they see luxury condos in a nicer area going for $100k that they could pay cash for and have no mortgage payment.

    Add to this that they can't sell for what they owe, can't refinance what they owe, and make "too much money" -even though their income has taken a $25k hit this year- with "too little debt" to qualify for a modification since the mortgage is their only debt.

    What would you do?

    I don't blame them a bit. It just makes sense financially for them to walk away from what is essentially $3,200 in rent every month.

  • Report this Comment On August 01, 2009, at 10:56 AM, plange01 wrote:

    killing house prices? its called a depression and the US is in one...

  • Report this Comment On August 02, 2009, at 6:55 AM, brocksamson wrote:

    This article has failed to mention the coming tsunami of alt-A, option-ARM, jumbo loans, and the (still related) CRE market.

    Add to this the fact that we are having massive defaults at these incredibly low interest rates despite a doubling of the monetary base and huge inflation fears.... and like some of these posters mention: you get World Depression II.

    Price to income ratios might have been a useful metric in a normal market, however we have record homeownership and record inventories at the same time. Real estate has a long.... long way to go to compensate for the oversupply.

  • Report this Comment On August 03, 2009, at 3:19 PM, faheyd wrote:

    I guess I am old-school. Back in the day, the family would do whatever it took to make that mortgage payment. Heaven forbid that someone in the neighborhood would find out you missed one.

    I guess the 'give-me' generation is going to get some pain. The spoiled bastards will now feel what it's like to actually 'work' for something.

  • Report this Comment On August 05, 2009, at 2:15 PM, ajahns wrote:

    Excuse me for asking a stupid question, but what exactly is this "walk away" business. As far as I know you signed a legal contract to pay the loan and you are not permitted to simply walk away from it. If your house is under water you can stop paying and the bank may reposses. But you are still responsible to pay the bank on the loss of principal. If you cannot pay, you may chose to declare bankrupcy. But if you have any money in any bank account, the court will confiscate it and give it to the bank. If you have a job, the court might say you have to pay the loss over time. If you don't have a job, the court might say you can start paying when you get one.

    If you declare bankrupcy, have emptied all your bank accounts, have no job and have no prospect of getting a job, the court might then forgive your loan and stiff the bank.

  • Report this Comment On August 05, 2009, at 2:25 PM, ajahns wrote:

    And one more thing. It is not just your bank accounts the court can confiscate to pay your debt to the bank. It is any assets you have of any kind. You will be left with nothing. Maybe they will let you keep your car if you promise to drive it to work and give all your pay back to the bank to pay off the loss.

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