A few days ago, I wrote about my worry that it's too easy to foreclose, because banks got too comfortable with the culture of little or no down payment. Adam Ozimek at Modeled Behavior disputes my worry that there isn't a high enough economic cost to foreclosure. He believes other significant costs exist to deter people from walking away. Let's look at his arguments.

First he says:

1. Interest

But is interest less than rent? Most of these underwater homeowners we're talking about are generally pretty early on in their mortgages. So most of their payments consist of interest. And many of those interest rates are also pretty high. In one model I just ran, by the end of your second year paying a $150,000 mortgage at 6% (which is relatively low), you're still paying over 80% interest. This also doesn't take maintenance costs into account or homeowners insurance, which can often be higher than renters insurance. Finally, since rents tend to decline as home prices decline, those rents should be falling at a similar rate to home price, making renting a much better deal than paying even only the interest on an underwater mortgage. In some markets you could have a $3,000 mortgage payment (originated during the boom), but can now rent a comparable home for just $1,800. For these reasons, I'm generally unconvinced that rent will be greater than interest for most underwater homeowners.

Next, he says:

2. Moving = $ . . .


Sure. But does it cost more than whatever money you'll save by not having to pay the underwater balance on your mortgage? Probably not.

And then:

3. Recourse: If the mortgage is a recourse loan, the borrower faces the possibility of losing other assets if the bank comes after him.


Right, this is the best criticism, when applicable. In some cases, the bank may go after your other assets. Of course, this only matters if you've got more assets than the money you'd save by walking away. In a country that doesn't do much saving, that's probably not the norm for deeply underwater homeowners.

Moreover, in the states with the biggest foreclosure problems, I understand that banks are often treating the difference between the principal balance and market price kind of like a credit card settlement. I'm hearing stories about banks encouraging short sales, then forgiving most of what the original borrower still owes. For example, someone with a principal balance of $400,000 is preparing a short sale of the property for $240,000. The lawyer he's working with believes they can settle the $160,000 difference for $10,000 to $15,000. There are so many pending foreclosures right now that banks just don't have the time or resources to take all of these people to court. So if even if the mortgage is a recourse loan, the banks often aren't going after the borrowers with much vigor.

As for the additional argument that there's a psychological barrier to foreclosing, I'm sure that's true. I think few people relish in the idea of foreclosing (though I could tell you some awful stories about people bragging). But I also question the theoretical poll that Ozimek mentions where he says that:

Even when the home is 50% underwater, only 17% said they would default if they could still afford the mortgage.


Frankly 17% is still too high. But I don't really believe the statistic. A few days ago, I mentioned actual servicer experience shows that when underwater homeowners undergo a "strategic reevaluation" of whether they should continue to pay their mortgages there's a 75-80% likelihood of default. I'd trust actual experience over a poll.

So I concede (and didn't really mean to assert) that it isn't truly economically *costless* for a borrower to suffer foreclosure. But I do mean to assert that the cost is quite low. And when faced with the alternative of foreclosing on a deeply underwater home, that cost is comparably negligible under these market conditions. That's why I still believe that higher down payments would rightly add to that economic cost, which is why I argue in their favor.

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