Wednesday, September 23, 2009

The morality question

Recently there was a blog entry over at the LA Times about "strategic defaults". If you are unfamiliar with that term, it refers to people that walk away from their mortgages even though they have the ability to pay it. They are making a strategic decision to default based on the numbers. This blog entry got quite a lot of comments. There were basically two sides arguing. One group agreed that in many cases walking away made sense. The other group played the morality card (it's kinda like the race card but more universal).

They have discovered a funny thing about all these defaults. The higher the FICO score the more likely the person is to pull a strategic default. I have my own theories about why that is. A higher FICO score usually means a better job and income. Better jobs and incomes are generally the result of a better education and probably a higher IQ. This is a group of people that CAN do the math. They can and obviously are figuring out that it's going to be far better financially to let the house go.

Most economist are coming around now and realize those bubble prices are gone for a long time. The most recent estimates I've seen say 2030 before prices recover. Personally, I think that is a little too optimistic. I don't think those prices will be back for another decade past that. For prices to return to bubble levels and be affordable under normal lending levels, incomes would have to nearly triple. In a 20 year span it's more reasonable to assume incomes will roughly double (that means you need a 3.5% increase per year). And the way employment and wages are going lately we might not see any growth for a few years. Traditionally the ratio of median income to median home price has been 2.3. In 2001 it had climbed to 3.7. That was probably the result of low interest rates allowing people to buy more home for the same payment. At the peak the ratio was over 7 times median income. We are back down to about 3 (median house is $190k, median income is $65K). With the ultra low interest rates we have today the actual affordability of houses (monthly payment) is lower than it has been for decades (as long as you don't buy one with a huge mello roos tax). Whoa, getting a little sidetracked here.....

So, smarter people do the math and realize it will be decades before prices recover. Lets say they are making a payment on a $600k house that is now worth $300k. Optimistically it will be 20 years before that house is worth $600k again. Equity gain in 20 years ZERO. Lets say they got a juicy loan mod and got a 4% rate on that $600k. That's a payment of roughly $2900/mo and they will pay $696k over the 20 years.

Let's say they default, ruin their credit and cannot buy for 5 years. In 5 years they buy a similar house for $300k. No sweet loan mod though so the interest rate is 6% (that might be optamisitc) so the payments are $1800/mo. Over the 20 years they spend $432k on payments.

The difference in payments alone is $264k BUT let's not forget that home is projected to double in value over that 20 years so they have an additional $300k in equity. The net difference for this family is $564k in 20 years!

Would you be willing to give $564k to a bank just so you could tell people you live by a higher moral standard?


Nicholas said...

That is an ethical dilemma that I have wrestled with for some time. Eventually come to the crossroads where you ask yourself what makes it wrong or an ethical dilemma?

If the government allows it without retribution or consequences other than credit scoring then is it not allowable in the issue of right v wrong?

Why as a society are we ok, as the majority is, with people letting their home go if they have no other option? You never hear people say "its too bad about the smiths across the street losing their jobs and all, but its still wrong of them to leave". As if the lack of options makes it no longer wrong.

If its wrong, it has to be for all parties. Can a government with lenient parameters and bailout packages supersede the greater issue of right vs wrong?

Interesting stuff. Thanks.

Al said...

"So, smarter people do the math and realize it will be decades before prices recover."

This is totally anecdotal, but I think that precious few people think that prices will take more than 15 years to recover. Still: that's long enough to make the walk-away decision a good one.

I don't believe they're correct, just polluted by residual Kool Aid molecules from the recent hysteria.

I have never thought much about recovery to peak prices. Mostly I just wonder how long prices will continue to fall, Japanese-style. I see a bottom in 2020-2025, which, I guess, means that 2040 might even be a little soon to anticipate the return to bubble-peak prices.

For some reason, you seemed a little pessimistic. But now that I think of it, I don't see that prices will recover much before 2050. Wow.

OSA said...

only 5 years?? are you talking short sale here? i did some research and never got a good answer as to whether a short sale is better than a foreclosure is better than a deed in lieu. from what i read it is more like 10 years. what am i missing??

FairEconomist said...

I think it boils down to: everybody has a price. When people are looking at gains comparable to likely lifetime savings (in your scenario), that's enough of a price to stiff some faceless corporation. No surprise, really; people often fall out bitterly with dearly loved relatives or spouses for less.

I want to point out that another things causing the creditworthy to strategically default at a higher rate is that, very often, people with bad credit have real money troubles, and thus can't strategically default. You have to be able to afford your place to strategically default.

Adrian Smith said...

If walking away is a moral decision, then said morality began with the banks making shit loans.

Sigma said...

GolferX, I have to respectfully disagree with you on this one. I think that prices *CAN* and *MOST LIKELY* will return to bubble prices in the very short term (less than 5 years).

It's called inflation. Hyper-inflation to be exact. It's not unreasonable to see that we may need $50k USD to buy a Honda Civic in the near future, and $20 loaf of bread or $10/gallon gas. Therefore, why would it be unreasonable to think a $300k house might be pear off its 50% loss and double in sticker price back to $600k in 5 years? I think it's highly possible and that's what I'm very afraid of.

golfer_X said...

I just don't think we will see hyper-inflation. Sure if that happens then all bets are off. Hyperinflation would be too destabilizing to the economy and I think the brainless wonders in Washington would do all they could to avoid super high inflation. Of course they might also think that inflating there way out of this mess is a great option.

The problem with hyper-inflation from the governments stand point is that wages lag behind. That would kill the economy, people would stop spending until wages caught up. And that usually takes a decade.

Sigma said...
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Christina said...

I don't believe the hyperinflation scenerio either. It doesn't address demand. Housing recently jumped because the price point was right- demand kicked in!

On that same note:
X you said: "We are back down to about 3 (median house is $190k, median income is $65K). With the ultra low interest rates we have today the actual affordability of houses"

I think when interest rates go up that ratio changes. Prices will begin to fall again even in the outlying areas. Buttom just hasn't come yet.

Sigma said...

Ok, so if we don't hyper inflation, we will get some sort of very aggressive inflation. It would just defy all laws to print trillions of dollars yet cause no inflation.

golfer_X said...

The ratio itself is independent of interest rates...sorta. Rates affect the ratio. Interest rates determine monthly payments and people buy homes based on monthly payments. Low interest rates means for the same payment you can buy more house. So the ratio jumps when rates are low. If rates went to where they were in the early 80's the ratio would plummet down to about 2. That would put tremendous downward pressure on prices.

Lets face it, everyone now thinks they should live in a 3000 s/f mansion regardless of income. if rates shoot up, prices will probably fall because people will not settle for a much smaller house. Sales would stagnate, defaults would rise and we will be right back into another housing crash.

That's another reason I don't see hyper inflation happening. In order to fight it the fed would have to jack up their rates to 10 or 15 or hell even 20%. That would make nearly every ARM unaffordable. People can't afford them when the rate goes up one or two percent. What would happen if it went up 10%. A $1600/mo payment would jump to nearly $4k/mo. You would have 100% default rates on all ARMs.

Sigma said...

I completely agree with your statement. However, that is in the short term. I fully am on-board with the notion that house prices still have a lot to drop in the near short-term especially South Bay and OC.

However, distant future (5 years+) is a different story. If the dollar drops in buying power by half, that's all it takes.

gprofessionals04 said...
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