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.
Related Foolishness:
Start investing today – just $7 per trade with Scottrade. Or find the broker that's right for you.
