In our previous post we pointed out the fact that many homeowners have an economic incentive to walk away from a property if they owe more than it’s value.
What we didn’t add, due to time constraints, was a discussion about how this this behavior (which we will see more of in 2008 than ever before,) is not without consequences.
What are they?
When the shooting is over, we will see lenders attempt to adjust their pricing and underwriting standards to account for the fact that if properly incented, borrowers will simply walk. This means higher rates, down payments, and tougher underwriting standards in the future. From Calculated Risk, Tanta style:
Ultimately, there is no way anyone can mobilize “social acceptability” as a defense against the ruthless put (even if you wanted to). The industry has, in fact, created the conditions in which it’s rational, and as long as it’s rational it will go on. Just as it was rational to buy at 100% LTV. The only possible way to get back to an environment in which ruthless default is rare is to abandon the “innovations” that give rise to them: no-down financing, wish-fulfillment appraisals, underpriced investment property loans, etc. The administration is currently pushing for increasing the FHA loan amounts and the FHA maximum LTV up to 100%. This is not likely to remove the incentive to take another reckless loan on a still-too-high-priced house. If we aren’t going to ration credit with tighter guidelines and loan limits, then it will have to be rationed with pricing: eventually the models will “solve” the problem by increasing the costs of mortgage credit. You cannot simply keep writing “free puts.”
Options Theory and Mortgage Pricing [Calculated Risk]