I don’t have time to go into too much detail but just wanted to make a point inspired by a few pieces I have read lately.
That is the foreclosure process is deleveraging and a wealth transfer from the financial sector to homeowners. This may seem obvious or silly to various folks but let me give one quick thought experiment to see if I can hit on the importance of this.
Suppose there was a massive housing bubble and all the homes in America roughly doubled in price. Also suppose that many people either traded up homes or cashed out home equity so that in the aggregate homeowners had very little equity. Now suppose the bubble burst and home prices headed back down towards normal, further reducing total equity.
Perhaps this is a plausible scenario.
Now, suppose that while trying to set-up his ITunes playlist Chris Dodd accidently presses the Financial Armageddon Button. That button triggers immediate universal non-judicial non-recourse foreclosures for everyone with a mortgage, whether they are current on their payments or not.
What happens?
Well all of the mortgage debt goes away and the banking sector is left with a bunch of houses which it must sell. For the sake of argument lets assume that virtually no one can get credit.
So the prices of all of these will collapse until the inventory can be cleared even in a no credit world.
What does this mean for homeowners.
It means that they now have houses, but no mortgages.
They lost little because they had no equity. They gained a lot because they now have houses, but no debt. So they are much wealthier, at least in this part of the analysis
Where did the “wealth” come from? It was a transfer from the financial sector to homeowners.
Now of course there are a lot of other questions people will immediately ask about knock-on effects, financial collapse and who in the end owns the financial obligations, but this core dynamic is I think underappreciated.
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Friday ~ April 20th, 2012 at 11:39 am
Axel
“What does this mean for homeowners.”
Well if banks are not forced sellers, it means there is no homeowners left except for banks (and homeowners who weren’t indebted previously).
Which means there is only a small transfer of real wealth, and a full transfer of risk : previsouly people were exected to pay back debt with their revenue (mainly from labor or whatever source). now they are just expected to pay a rent to banks that are willing to sell the houses in the end, but have a monopoly/oligopoly on American houses whivch doesn’t bode well for future rents evolution.
Wealth transfer is only equal to the difference between overall mortgage amount foreclosed and actualization of future rents – HEL obviously are a full transfer of wealth as the bank gets potentially 0 from the collateral which goes to the first lien debt lender. But apart from this 2nd lien towards 1st lien, i’m not sure wealth transfer from banks to homeowners is huge.
So your point is really about why banks are gonna be forced sellers, ie. what’s going on their liability side and liquidity access.
Friday ~ April 20th, 2012 at 11:48 am
TomGrey
This is a GREAT thought experiment analyysis — and pretty fully explains why banks/ financial sector are desperate to avoid too much foreclosure and price reduction.
In real life, with most housing NOT being foreclosed, altho there were big price declines, the first hit comes against the homeowners with equity.
Those who (over-)paid for a $200k house by paying $400k in cash, have lost the $200k reduction. Or, if they made a $100k down payment, their down is gone, and they owe $300k … if they’re smart, they walk away. (Many will stay and pay, if they can; perhaps an absolute majoriity of under-water homeowners would rather keep their home than leave their lost investment. This is partly why Scott Sumner’s claim that house buying is saving seems so over-simplified that it’s wrong.)
I would guess that about half of the home price declines were eaten by lost homeowner equity — but I haven’t seen figures about this. Where would these numbers be found?
And, in the real world, most mortgages remain, and little or now wealth has gone from the financial sector to the home owners. They have lower valued, and lower priced houses, but still have similar mortgage principles.
Let’s also remember that, while in theory the seller of the $400k house might have been paying off a $200k mortgage and thus be left with $200k to invest, thanks to bubble profit, the vast majority of house bubble sellers immediately invested their house bubble profits back into houses, still overpriced by the bubbles, tho with some leakage for higher consumption (perhaps after making $200k, the newly rich seller tries to buy two houses with only $80k down each, and splurges on a vacation or car with the other $40k.) When the banks are giving 0% down teaser interest rate loans for buyers into the bubble, I have no sympathy for the banks after the bubble pop, and the seller now buyer/ speculator just walks away from the two houses he’s just bought which dropped to below their mortgage value.
Further, while the thought experiment no-mortgage debt applies to all, in the real world the biggest speculators lose all their houses, and it is the more cautious late-buyers who gain possession of the repriced low price houses. Having cash after a big drop is the best time to invest.