The Truth About Mortgages

Megan McArdle has a couple of blog entries worth responding to, both on the subject of housing. First is her pushback against the meme that it's not the borrowers' fault they're underwater on their mortgages:

It seems to me that this sort of acts like borrowers shouldn't have any obligation to repay money on an asset that has fallen in value--as if there were some sort of moral right to take highly leveraged bets on housing and pass off any losses to someone else. The borrowers ought to have known that they couldn't be repaid, because of course the natural and right thing to do, in the event that an item you have purchased on credit falls in value, is to default on your loan.
On the other hand if we assume as a matter of public policy that people who have signed a loan contract are actually obligated to pay back the money they borrowed even if their house is not rapidly appreciating, then the primary risk is not a fall in house prices; it is that borrowers will not be able to repay the loan.

This misses the fact that, like any leveraged borrower, the homeowner has already taken substantial losses. Homeowners are no different from any other leveraged borrower. Is Cerberus on the hook for all of Chrysler's losses? Are bank shareholders liable for unlimited capital calls in the event their company loses lots of money? No. Most secured loans are non-recourse, and banks understand full well the concept of a non-recourse secured loan: if the value of the security falls below the value of the loan, they're liable to lose money.

Now legally, it's true, many US mortgages have recourse to the borrower. But it's equally true that in the real world, the overwhelming majority of mortgages are de facto non-recourse. Here's how housing works, in California and indeed in most of the US: you buy a house with a combination of downpayment and mortgage. The downpayment is your equity. If the value of the house rises, so does the value of your equity, and you happily pay your mortgage, since you're getting richer. If the value of the house falls to the point at which your equity is wiped out, however, you've got precious little reason to keep on paying that mortgage.

Are homeowners "actually obligated to pay back the money they borrowed"? Mark Gimein wrote a great blog entry on this back in November:

A bank that doesn't want to get bogged down in a two year long morass has little option but to take back the keys, accept a huge loss, and call it even. Is this an "abuse" of the system? I don't see how. The loss was something that lenders could have anticipated at least as easily as borrowers. The reality is that ordinary people are lousy at figuring out the ins and outs of real estate transactions. Relying on the one act rule to get out of a mortgage is not to abuse the system--it is to use the system in precisely the way it was intended to be used. The reason that the one act rule exists is that lenders and developers have through the years shown a great deal of ability to maneuver unsophisticated buyers into crummy real estate deals. The reason that the one act rule exists is to put the risk of these deals on the lender, not the buyer. The purpose is to discourage bad underwriting, dishonest marketing, and unjustified price inflation by making it very, very hard for a lender to get back the money if they lent more on a mortgage than a house was worth. The system is designed to let people walk away. California has a system that puts a higher premium on keeping people out of debt slavery than avoiding bank losses. I see nothing wrong with that legislative choice.

It's interesting that whenever anybody proposes a debtor-friendly piece of legislation, a thousand bank flacks' knees jerk at once, and suddenly we journalists are deluged by people saying that it's a dreadful idea, because banks will simply stop lending and/or raise interest rates as a result. Well, the California mortgage market is living disproof of that notion: it's incredibly debtor-friendly, but would-be homeowners never had any more difficulty getting a mortgage there than they did anywhere else.

Which brings me to Megan's second blog entry, on mortgage interest tax deductions:

Current homeowners bought their homes on the expectation not only that they would enjoy tax deductibility, but that they would be able to resell their house at a higher price because of the imputed value of the tax deduction to the next owner. If you remove the deduction, most people will see a permanent decline in the value of their largest asset.

Again, this is something which makes sense in theory. But it can also be tested empirically, and shown to be false. Just look at what happened to the housing market in the UK when the mortgage-interest tax deduction was abolished: it exploded.

Megan is looking for a homeowner who's in favor of abolishing mortgage-interest tax deductions: I'm perfectly happy putting myself forward on that front. But as a renter, Megan might be surprised to learn that most homeowners don't get any benefit from the tax deduction at all.

I first boned up on tax deductions back in 2004, when George W Bush was thinking about abolishing them. Basically, there's a standard deduction, which everybody gets; if you'd rather, however, you can opt to itemize a bunch of separate deductions instead, if they add up to more than the standard deduction.

The standard deduction in 2009 for a married couple filing jointly is $11,400. That means you get to subtract $11,400 from your income even if you don't pay any mortgage interest at all. Now suppose that married couple bought a home for $200,000, put 20% down, and got a 6% mortgage. Then their annual interest payments are 6% of $180,000, or $10,800. They own your own home, but they get no benefit from the tax deduction: they're still better off taking the standard deduction.

Of course, if you own a home in Washington DC or in New York, you're likely to have a mortgage of much more than $180,000. But let's say that our married couple bought a $350,000 house instead, and have annual mortgage interest payments of $16,800. Then their taxable income will be reduced by $5,400 as a result of the mortgage-interest tax deduction, which means that their taxes will be reduced by about $1,900, or about $150 a month -- compared to $1,400 in mortgage interest payments. By contrast, refinancing from a 6% mortgage into a 4.5% mortgage will save them $350 in mortgage interest payments: movements in interest rates are much more important to homeowners than tax laws are.

It's easy for cosmopolitan journalists to lose sight of where house prices really are, given that they live in such expensive cities. The median home price is now just $170,000, and with mortgage rates where they are, anybody looking to buy such a home isn't going to get any kind of benefit from the mortgage-interest tax deduction. So let's go ahead and abolish it: it's a great way of raising revenue for the government while leveling the housing playing field for everybody else.

Update: Megan replies. I was going to get into the whole issue of other, non-mortgage deductions, but didn't; suffice to say that yes, they matter, but in the grand scheme of things all you need to do is look at the number of people who itemize anything (they're very few, and they're rich, and they're overwhelmingly in New York and California) to see how little this issue matters to Middle America.

Comments

[mlee952:]

I have been saying this for months to anyone who would listen.
Now, I have seen it in print for the first time:

"Carbon credits, if cap-and-trade is approved in the US, instead of a sensible carbon tax, will be another new toy for the boyz."

dandelionsalad.wordpre.../

Cap-and-trade will further impoverish the people and make the banks even richer.

Not to mention: Fractional reserve banking (Federal Reserve System) is the ultimate fraud of immense magnitude and is the root of our financial problems.

Feb 26 03:47 AM

[Mad Hedge F...:]

Here is a novel plan put forth by a hedge fund in Florida, Derivatives Bridge, LLC. Securities backing performing mortgages worth 100% are being sold for 20% because there is no market for these securities. Have the government buy these securities for 60%, rescuing the banks, and then sell them back to the original homeowner. The homeowner then is able to refinance his home, see his mortgage principal drop by 40%, restoring his net worth, and purchasing power. The cost to the taxpayer is zero. This is already possible in some countries like Denmark. If someone offered me a deal like this I’d take it in a heartbeat, even if I had to clean out the sofa cushions and raid my kids’ piggy banks. They say necessity is the mother of invention.

Feb 26 08:17 AM

[farmer448:]

Your Mortgage intrest deduction needs to include property taxes. Then you would propably beat the standard deduction at least for the first years of the mortgage.

Feb 26 10:04 AM

[henarl:]

For a mortgagor to profit on a mortgaged real estate purchase when the value of the property increases but default harmlessly on an underwater mortgage when the value decreases is like going to a casino and keeping any winnings but expecting the other gamblers in the casno to pay your losses if you are unlucky.
Also the authors example of the borrower losing his down payment equity if he defaults is invalid in the case of the many no, or very little (5%), down transactions. In these cases almost no loss is experience by the defaulter.

Feb 26 11:49 AM

[evergreen16:]

henarl is Making a valid point. Most of the people actually had no or very small down payment.
In addition, a lot of people took advantage of Less-then-interest financing, so they were already paying less then rent on their house.
And finally, after they stopped making payments, they could stay in their house for around 1 year for free!
That is still not the end for some, as a lot of people take whatever valuable on the house with them, like copper pipes, cabinets, facets, appliances, carpeting etc.
So add it up and you'll see that a lot of these folks actually made nice fortune...

Feb 26 01:00 PM

[J. D. Swampfox:]

The writer says "Most secured loans are non-recourse, and banks understand full well the concept of a non-recourse secured loan: if the value of the security falls below the value of the loan, they're liable to lose money." I don't know what bank he deals with, but I want to borrow from them too... It's simply NOT true that most secured loans are non-recourse... at least not at the banks I used to work for.

Feb 26 03:11 PM

[henarl:]

I think there are only three or four non recourse mortgage states, California being one of them. However even with a recourse mortgage, if the defaulter has no other valuable assets to go after, which is the case with a lot of the no-doc, zero down, loans, they are effectively non recourse, You can't squeeze blood out of a dried up turnip!

Feb 26 04:23 PM

[TinyTim:]

very nice article on the ethics of mortgages.

It's certainly true now that mortgages are defacto non-recourse loans.
The IRS will even forgive the imputed gains on a walk-away, which seems plenty generous.

People that got in trouble with their mtgs and walked are taking full advantage of a situation created by the banks and ratings companies. They aren't getting off scot-free, but with a comparative wrist slap. The fact that the banks won't pursue recourse just shows how badly they screwed up. Do they deserve rescue?

People that are about to get in trouble with their mtgs due to job loss or ARM updates and are looking for help is a sticky issue. Banks should be highly motivated to make mods for the reasons in the article, even though most don't work out. Should these people be required to spend down their assets like Medicaid before they get govt help? Should the apps be checked for liar loans?

What about the people who took out HELOCS every time their equity went up $10K for a trip to Europe? They can make the payments, but simply don't want to because they're under water. I hear rumblings that the govt wants to step in to help these people. This is the razors edge of moral hazard. The only thing stopping them from walking away is the wrist slap. If they're not willing to walk away, they can keep whining about the payments. Jubak has an excellent article on the "Chumps" that practice financial responsibility.

Feb 26 04:30 PM

[Hmm?!:]

ONCE AGAIN!

I will keep reposting it, until everybody knows it. These two statements say it all, if you can do simple math (from Mortgage Liquidity Du Jour by Credit Suisse, March 2007)

"low/no documentation loans increased from just 18% of purchase originations in 2001 to 49% in 2006"

"sampling 100 stated income loans found that 60% of borrowers had "exaggerated" their income by MORE than 50%"

That means 30% of ALL mortgages in 2006, the buyer only had 66% of the income they claimed. Some of the other mortgages were also likely bad from minute one. If the buyer lied by 49% or 30% on their application? There is nothing to save!

Except the lack of integrity that got us here in the first place.

Feb 26 11:02 PM

[nym:]

This neighborhood has gone downhill.

Feb 27 12:47 AM

[StanleyWD:]

Felix,

You said "but in the grand scheme of things all you need to do is look at the number of people who itemize anything (they're very few, and they're rich, and they're overwhelmingly in New York and California) to see how little this issue matters to Middle America."

So yes, why don't we do that - look at the number of people who "itemize anything".......

According to the IRS (www.irs.gov/taxstats/i...) in 2006 (the most recent year statistics are available for, there were a total of 138,394,754 individual income tax returns filed. 49,123,555 of those returns included itemized deductions. That's over 35% of individual income tax returns that itemized.

And, far from being "very rich" - over half of those who itemized (53.6%) had AGIs of less than $75,000, and 70.5% had AGIs less than $100,000.

The number one itemized item? State and local taxes - NOT mortgage interest.

Personally, I have itemized for 22 of the 30 years I have filed taxes, and I have never lived in NY or CA - rather, in places like Iowa, Utah and Texas. So, I'm about as 'Middle American' as it gets.

So, doing a bit of fact-checking yourself, before declaring that itemization doesn't matter to Middle America, would be in order.

Feb 27 08:57 PM

[Paul E. Meisel:]

Almost everybody I know who owns a home with a mortgage itemizes -- the mortgage interest and property taxes put them over the limit before any other deductions. And my sample size is large (used to do tax preparation, still do some for friends, and have relatives who are or have been tax accountants).

Feb 28 08:01 AM

[jimmy46:]

Anyone who defaults on a mortgage now will probably not be able to buy another home for 10 years or more.

If you're thinking about default, do you really want to be a renter for that long?

The market will turn around before then.

Feb 28 02:35 PM