Hanging upside down

Analysts from the venerable Marty Feldstein to various small fry are very worried about the risk that homeowners will walk away from the houses on which they are "underwater"--i.e., where the mortgage is greater than the value of the house. In most states mortgages are non-recourse loans (the lender can take back the house, but if it sells for less than the outstanding mortgage balance, the bank has to eat the loss.) This, they argue, makes it economically logical for people to let the bank foreclose.

I know that I'm the eternal optimist, but this particular risk strikes me as wildly overblown--that's why I think this is fundamentally a liquidity crisis, not a solvency crisis. By which I mean that I do not believe that the various mortgage backed securities and their descendants will bankrupt firm after firm with their massive defaults. The problem isn't that they will not produce any cash flow; it's that because no one knows how much cash flow they'll produce, no one wants to be a buyer in the current market. I think it's very likely that individual firms may go bust as their toxic waste goes nuclear, but I don't see this as a deep insolvency problem for the broader market. Most firms, I'd wager, would be fine if they could just ride out the credit crunch.

It would be a solvency crisis if the worrywarts are right that huge numbers of those homeowners are going to walk away. But I don't see that. People who can't make the payments will, to be sure, be forced out of their homes. And I don't want to soft-pedal that problem: the numbers are grim. Almost twenty percent of subprime loans are delinquent, and 5% of subprime ARMS have entered the foreclosure process.

But as terrible as these numbers are, they are not yet "widespread financial insolvency" terrible. And though it's hard to know exactly when the peak will arrive, given that the bubble peaked in August 2005, we should be somewhat close to it now; the most generous teaser rates should either have already reset, or be about to.

I find it very unlikely that the 80+% of borrowers who are not delinquent will let their homes go into foreclosure. This may be the economically rational thing to do--but people are not computers, nor even economists. They do not want to destroy their credit rating with a foreclosure or a bankruptcy, and more to the point, they don't want to lose their home. They will, I predict, go to some pretty extraordinary lengths to hold onto that house, even if no federal bailout is forthcoming. I think the people declaring that all these borrowers are going to hand the bank the keys and stroll away whistling have been spending too much time on Wall Street, not enough time on Main Street.

But that's just my opinion. I could be wrong.