Facing Foreclosure

The other day, Ryan Avent had a good post on who is actually defaulting on their mortgages.  Though you commonly hear the discussion framed as a question of when interest rates reset, Ryan points out that this isn't really accurate.  The problem is not principally people who can't pay their mortgages because their interest rates have reset--people will cut back on a lot of other things to keep their house, and if you can't afford a 1% rate increase even with drastic lifestyle cuts, you probably have too much house. 

Rather, the main problem is people who have an income shock.  Normally, if you lose your job, and you can't afford your house, you're eventually forced to sell it.  But when the market drops 20%, if you're a recent homeowner, or if you did a cash-out refi, you can't sell it, because you'll end up owing money at the closing.  Obviously, if you had tens of thousands of dollars to hand over at closing, you wouldn't need to get out in the first place.

This has tricky policy implications.  The supply of credit--for which interest rates are usually a good proxy--has huge effects on home prices in this world of majority mortgage financing.  We've pushed interest rates down as far as they're going to go, but that's not going to reinflate the bubble.  So huge numbers of people who have income shocks are going to end up in foreclosure unless their bank allows a short sale.

But what's the alternative?  Huge write-downs to the mortgage principal of everyone who gets in trouble?  They'll still have to sell the house in a lousy market.  And it makes the banks more fragile, while unfairly handing a giant subsidy to those who happen to lose their jobs.

On the other hand, it does mitigate the claim that this is about irresponsible borrowing--at least in a lot of markets.  In places like California and Florida, where prices of large houses have dropped 30-50%, the most sensible downpayment policies wouldn't have kept people from going underwater.  Though to be fair, highly insensible downpayment policies helped inflate the bubble, and a lot of people with tiny downpayments are getting themselves in trouble.