Article: The Rise of the Mortgage ‘Walkers’

Note on the chart above, it shows a loss to the owner of a straddle at asset prices close to the strike price. That’s because it usually costs money to acquire a straddle (or any other option). In those situations, for the long straddle to make money, the asset price has to move far enough into the money to cover the straddle’s cost. So if a straddle costs $10, the asset price has to move $10 into the money to break even (rise above the zero line of the y-axis on the chart above). Every penny further into the money is profit.

However, in the case of the options acquired by homeowners with “zero down” mortgages, the straddle was essentially free. In other words, homeowners get the profit if prices rise and they get to stick someone else with the asset if prices fall. Prices have fallen. Hence, the title of this article.

See below for more of my comments, plus the article that inspired this posting.

My thoughts on this Wall Street Journal article are as follows:

  • When you give someone a “zero down” mortgage you have given them a free ATM (at the money) call and a free ATM put. ATM means the option’s strike price equals the asset’s current market price.
  • The call remains valid as long as the homeowner makes the schedule payments.
  • The homeowner makes the scheduled payments as long as the asset price is rising.
  • When the asset price rises, the value of the put approaches zero and the value of the call increases exponentially. The put is “out of the money” and the call is “in the money.”
  • To realize the value of the call, the homeowner sells the house, repays the debt and pockets the difference. Everybody’s happy.
  • However if the value of the asset falls, the value of the call approaches zero and the value of the put increases exponentially.
  • To realize the value of the put, the homeowner stops making scheduled payments and “puts” the house to the lender (i.e., sends in the keys or waits until foreclosure). The put’s value equals the amount it is in the money (strike price minus the current market price), less transaction costs.

It’s funny and sad that lenders and investors (sucker institutions) didn’t realize, or more likely didn’t care, that the house of cards they built would topple if asset prices fell. The real problem is the perverse incentive system and corruption in all parts of the food chain.

The Rise of the Mortgage ‘Walkers’
By NICOLE GELINAS
February 8, 2008; Page A17

Fitch Ratings, while telling investors last Friday to expect additional “widespread and significant downgrades” on $139 billion worth of subprime loans, has cited a new factor in their “worsening performance.”

“The apparent willingness of borrowers to ‘walk away’ from mortgage debt,” the analysts noted, “has contributed to extraordinary high levels of early default” on loans issued during the 18 months before the mortgage bubble burst. It expects losses to reach 21% of initial loan balances for subprime mortgages issued in 2006 and 26% for those issued in early 2007.

Such behavior, where not precipitated by willful fraud, shows that American homebuyers supposedly duped by their lenders aren’t so dumb. They’re perfectly capable of acting rationally without political interference.

While mortgage fraud has abounded in recent years, voluntary foreclosures are not by themselves evidence of a newfound irresponsibility on Americans’ part. To be sure, until recently, mass-scale voluntary foreclosures were unthinkable. But markets have changed, and people are changing their behavior in response.

A decade ago, most people started off with enough equity in their homes to make foreclosure irrational from a financial standpoint. Consider: If you made a 20% down payment on a house, prices would have to fall by 20%, almost immediately, before you lost all your money and had much incentive to walk away. This scenario was unlikely, particularly since an independent appraiser had assigned a clear value to the home. Foreclosure was remote, absent a personal financial crisis, for another reason: Every month your mortgage payment would reduce your debt and increase your equity, giving you more room for prices to fall.

But over the past few years — until last spring — banks and the mortgage-backed securities investors who bought the loans the banks packaged weren’t demanding substantial down payments; they were happy with 5% or even nothing down. They also didn’t worry about whether or not borrowers were building up equity. “Interest-only” loans, quick mortgage refinancings to cash out any equity, and other inventions often led to just the opposite.

Now the bloom is off the residential mortgage-backed securities (RMBS) rose. And some borrowers, even those who can theoretically afford to keep their homes, realize they owe much more than what comparable houses in the neighborhood are selling for — and think that prices won’t rebound anytime soon. So they’re walking away, according to anecdotal reports as well as recent statements by top executives of both Wachovia and Bank of America.

In most cases, once a homebuyer splits, the mortgage-securities investors are stuck with the loss. In some states, including California and Arizona, this provision is the letter of the law. In others, the bank forgives the balance of the loan — a common practice that’s unlikely to change now, given the criminal and civil investigations banks are already sweating through.

Essentially, mortgage-bond investors, seemingly unwittingly, sold homebuyers a put option, without properly pricing it, and now homeowners are exercising that option. Moreover, prime borrowers in many markets face the same incentives.

Yes, this behavior is new — but only when it comes to houses. Americans have long been able to cut their losses from bad investments and start over. It stands to reason that when the market made houses into yet another speculative investment, Americans would do the same.

Borrowers acted rationally in response to market forces and incentives during the bubble: Buy a house because prices always go up; you can’t lose. Many are acting rationally now: Mail the keys back and un-borrow the money, because prices are sinking fast while the debt isn’t. When the house was purchased not as a first home but as a rental investment, the decision is even easier.

Imagine: Politicians keep saying that Americans need protection from their big, bad lenders — but that protection is already there.

Of course, there’s a price. Mortgage “walkers” will take a hit to their personal credit rating. Yet this once-forbidding punishment may be discounted. That’s because, just as when markets change their behavior, people change, when people change their behavior, markets change also.

If hundreds of thousands of people with decent work histories are going to have less-than-stellar credit because of foreclosures this year and next, they won’t suffer so much as in the past. Many walkers are going to want to buy houses again some day; and when they do, lenders are going to want to make money lending them money to do so (hopefully requiring a good down payment). Investors searching for yield likely won’t bypass what could be a large pool of borrowers.

This rapid transformation shows that the continuing political hand-wringing over what to do about failed mortgages isn’t needed. It’s beginning to dawn on lenders and their agents — who assumed that borrowers who could afford to do so would make payments no matter what — that they could be stuck owning hundreds of thousands of houses at a minimum. This realization will pressure the companies administering those mortgage loans to renegotiate more quickly with borrowers in cutting loan balances. Thus, some version of the “Paulson plan” would have happened without Treasury Secretary Henry Paulson’s pressure on the capital markets in December.

Nobody is going to debtors’ prison. Nobody is going to have to toil for 30 years and sacrifice their kids’ future to pay off burdensome loans that they’re stuck with forever because they overreached. (Even if banks and mortgage administrators pursue judgments for post-foreclosure loan balances, there’s always bankruptcy as a last resort.)

As for Sen. Hillary Clinton and her proposed “moratorium on foreclosures”: She may soon find that borrowers, not just lenders, are screaming to let them act within their contractual rights.

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3 thoughts on “Article: The Rise of the Mortgage ‘Walkers’

  1. Here’s the most recent article I’ve seen on this topic. The comments on the article are interesting, too.

    2010-2-3
    New York Times:
    “No Help in Sight, More Homeowners Walk Away”
    http://www.nytimes.com/2010/02/03/business/03walk.html

    Excerpt:

    The number of Americans who owed more than their homes were worth was virtually nil when the real estate collapse began in mid-2006, but by the third quarter of 2009, an estimated 4.5 million homeowners had reached the critical threshold, with their home’s value dropping below 75 percent of the mortgage balance.

    They are stretched, aggrieved and restless. With figures released last week showing that the real estate market was stalling again, their numbers are now projected to climb to a peak of 5.1 million by June — about 10 percent of all Americans with mortgages.

    “We’re now at the point of maximum vulnerability,” said Sam Khater, a senior economist with First American CoreLogic, the firm that conducted the recent research. “People’s emotional attachment to their property is melting into the air.”

    Suggestions that people would be wise to renege on their home loans are at least a couple of years old, but they are turning into a full-throated barrage. Bloggers were quick to note recently that landlords of an 11,000-unit residential complex in Manhattan showed no hesitation, or shame, in walking away from their deeply underwater investment.

    “Since the beginning of December, I’ve advised 60 people to walk away,” said Steve Walsh, a mortgage broker in Scottsdale, Ariz. “Everyone has lost hope. They don’t qualify for modifications, and being on the hamster wheel of paying for a property that is not worth it gets so old.”

    Mr. Walsh is taking his own advice, recently defaulting on a rental property he owns. “The sun will come up tomorrow,” he said.

    The difference between letting your house go to foreclosure because you are out of money and purposefully defaulting on a mortgage to save money can be murky. But a growing body of research indicates that significant numbers of borrowers are declining to live under what some waggishly call “house arrest.”

  2. NYT: “Owners Stop Paying Mortgages, and Stop Fretting”
    2010-6-1
    http://www.nytimes.com/2010/06/01/business/01nopay.html

    ST. PETERSBURG, Fla. — For Alex Pemberton and Susan Reboyras, foreclosure is becoming a way of life — something they did not want but are in no hurry to get out of.

    “Instead of the house dragging us down, it’s become a life raft,” said Mr. Pemberton, who stopped paying the mortgage on their house here last summer. “It’s really been a blessing.”

    A growing number of the people whose homes are in foreclosure are refusing to slink away in shame. They are fashioning a sort of homemade mortgage modification, one that brings their payments all the way down to zero. They use the money they save to get back on their feet or just get by.

    This type of modification does not beg for a lender’s permission but is delivered as an ultimatum: Force me out if you can. Any moral qualms are overshadowed by a conviction that the banks created the crisis by snookering homeowners with loans that got them in over their heads.

    “I tried to explain my situation to the lender, but they wouldn’t help,” said Mr. Pemberton’s mother, Wendy Pemberton, herself in foreclosure on a small house a few blocks away from her son’s. She stopped paying her mortgage two years ago after a bout with lung cancer. “They’re all crooks.”

    Foreclosure procedures have been initiated against 1.7 million of the nation’s households. The pace of resolving these problem loans is slow and getting slower because of legal challenges, foreclosure moratoriums, government pressure to offer modifications and the inability of the lenders to cope with so many souring mortgages.

    The average borrower in foreclosure has been delinquent for 438 days before actually being evicted, up from 251 days in January 2008, according to LPS Applied Analytics.

    While there are no firm figures on how many households are following the Pemberton-Reboyras path of passive resistance, real estate agents and other experts say the number of overextended borrowers taking the “free rent” approach is on the rise.

    There is no question, though, that for some borrowers in default, foreclosure is only a theoretical threat for a long time.

    More than 650,000 households had not paid in 18 months, LPS calculated earlier this year. With 19 percent of those homes, the lender had not even begun to take action to repossess the property — double the rate of a year earlier.

    In some states, including California and Texas, lenders can pursue foreclosures outside of the courts. With the lender in control, the pace can be brisk. But in Florida, New York and 19 other states, judicial foreclosure is the rule, which slows the process substantially.

    In Pinellas and Pasco counties, which include St. Petersburg and the suburbs to the north, there are 34,000 open foreclosure cases, said J. Thomas McGrady, chief judge of the Pinellas-Pasco Circuit. Ten years ago, the average was about 4,000. “The volume is killing us,” Judge McGrady said.

    Mr. Pemberton and Ms. Reboyras decided to stop paying because their business, which restores attics that have been invaded by pests, was on the verge of failing. Scrambling to get by, their credit already shot, they had little to lose.

    “We could pay the mortgage company way more than the house is worth and starve to death,” said Mr. Pemberton, 43. “Or we could pay ourselves so our business could sustain us and people who work for us over a long period of time. It may sound very horrible, but it comes down to a self-preservation thing.”

    They used the $1,837 a month that they were not paying their lender to publicize A Plus Restorations, first with print ads, then local television. Word apparently got around, because the business is recovering.

    The couple owe $280,000 on the house, where they live with Ms. Reboyras’s two daughters, their two dogs and a very round pet raccoon named Roxanne. The house is worth less than half that amount — which they say would be their starting point in future negotiations with their lender.

    “If they took the house from us, that’s all they would end up getting for it anyway,” said Ms. Reboyras, 46.

    One reason the house is worth so much less than the debt is because of the real estate crash. But the couple also refinanced at the height of the market, taking out cash to buy a truck they used as a contest prize for their hired animal trappers.

    It was a stupid move by their lender, according to Mr. Pemberton. “They went outside their own guidelines on debt to income,” he said. “And when they did, they put themselves in jeopardy.”

    His mother, Wendy Pemberton, who has been cutting hair at the same barber shop for 30 years, has been in default since spring 2008. Mrs. Pemberton, 68, refinanced several times during the boom but says she benefited only once, when she got enough money for a new roof. The other times, she said, unscrupulous salesmen promised her lower rates but simply charged her high fees.

    Even without the burden of paying $938 a month for her decaying house, Mrs. Pemberton is having a tough time. Most of her customers are senior citizens who pay only $8 for a cut, and they are spacing out their visits.

    “The longer I’m in foreclosure, the better,” she said.

    In Florida, the average property spends 518 days in foreclosure, second only to New York’s 561 days. Defense attorneys stress they can keep this number high.

    Both generations of Pembertons have hired a local lawyer, Mark P. Stopa. He sends out letters — 1,700 in a recent week — to Floridians who have had a foreclosure suit filed against them by a lender.

    Even if you have “no defenses,” the form letter says, “you may be able to keep living in your home for weeks, months or even years without paying your mortgage.”

    About 10 new clients a week sign up, according to Mr. Stopa, who says he now has 350 clients in foreclosure, each of whom pays $1,500 a year for a maximum of six hours of attorney time. “I just do as much as needs to be done to force the bank to prove its case,” Mr. Stopa said.

    Many mortgages were sold by the original lender, a circumstance that homeowners’ lawyers try to exploit by asking them to prove they own the loan. In Mrs. Pemberton’s case, Mr. Stopa filed a motion to dismiss on March 17, 2009, and the case has not moved since then. He filed a similar motion in her son’s case last December.

    From the lenders’ standpoint, people who stay in their homes without paying the mortgage or actively trying to work out some other solution, like selling it, are “milking the process,” said Kyle Lundstedt, managing director of Lender Processing Service’s analytics group. LPS provides technology, services and data to the mortgage industry.

    These “free riders” are “the unintended and unfortunate consequence” of lenders struggling to work out a solution, Mr. Lundstedt said. “These people are playing a dangerous game. There are processes in many states to go after folks who have substantial assets postforeclosure.”

    But for borrowers like Jim Tsiogas, the benefits of not paying now outweigh any worries about the future.

    “I stopped paying in August 2008,” said Mr. Tsiogas, who is in foreclosure on his house and two rental properties. “I told the lady at the bank, ‘I can’t afford $2,500. I can only afford $1,300.’ ”

    Mr. Tsiogas, who lives on the coast south of St. Petersburg, blames his lenders for being unwilling to help when the crash began and his properties needed shoring up.

    Their attitude seems to have changed since he went into foreclosure. Now their letters say things like “we’re willing to work with you.” But Mr. Tsiogas feels little urge to respond.

    “I need another year,” he said, “and I’m going to be pretty comfortable.”

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