Banks Should Treat Home Mortgages More Like Other Investments

A while back I got embroiled in a little blogger debate about whether a house should be considered an investment. I contended that it probably should be, though I have a pretty weak standard for how something could qualify as technically being called an investment. An article today in the New York Times led me realize an interesting difference between real estate and other investments: over the past decade, banks have made if very easy to walk away from your home.

The Times article I'm talking about explores the new and disturbing trend of homeowners who can continue to make mortgage payments on their underwater homes but simply choose not to. After all, it seems pretty awful to have to pay a $150,000 mortgage on a home only worth $100,000 in this brave new housing market. The article begins:

In 2006, Benjamin Koellmann bought a condominium in Miami Beach. By his calculation, it will be about the year 2025 before he can sell his modest home for what he paid. Or maybe 2040.

"People like me are beginning to feel like suckers," Mr. Koellmann said. "Why not let it go in default and rent a better place for less?"

Indeed, it seems an easy way out. But that's only because banks developed the bizarre notion that it's okay if people contribute little or no money as a down payment on a home. Oddly, they generally wouldn't be willing to sell investors a security or asset where they pay little or nothing down. They even have higher margin requirements for stocks than they did for houses. So you can't generally welsh on most other investments the way you can with your promise to pay for a home. Investors have money at stake; underwater homeowners don't.

With a home, if you've got little (or no) principal to lose, then it's pretty easy to walk away and not incur any monetary loss. That's vastly different from most other investments. Think about a stock. Imagine if you bought a share of Toyota's stock on January 19th for $92 (before the recall), then right now you'd have lost $18, since its price has dropped to around $74. You can sell the stock, but you'll be $18 poorer.

An underwater borrower certainly wouldn't want to sell the home. If sold at prevailing market prices, then the former homeowner would still owe the bank money but have nothing to show for it. By just walking away, however, the only thing underwater homeowners have to lose through foreclosure is their credit rating. While that's not completely insignificant, if you've got a home, say, $50,000 underwater, at some point you have to ask yourself what a few hundred point hit to your credit score is really worth.

And therein lies the central problem: other than their credit rating, underwater homeowners have nothing to lose on their investment. That makes one of the biggest problems of the boom-time housing market pretty clear: the lack of substantial down payments. As I mentioned yesterday, that's one of the reasons why the mortgage modification effort isn't going so well. Who wants to keep a mortgage that costs them more than the home is now worth?

Going forward, I don't think it would be too bad an idea to have a universal, regulated minimum down payment standard for a home. Something in the range of 10% to 20% seems reasonable. The housing market would be a lot better off. Only then can a bank responsibly write a mortgage, because whoever purchases the asset will then have something to lose.