Jingle Mail: How Do You Value Home Equity?

One of the biggest questions overhanging the housing market right now concerns the behavior of underwater mortgage borrowers. If the mortgage is non-recourse - and let's assume for the moment that it is - does it always make sense for such a borrower to walk away from the house? If you listen to the likes of Nouriel Roubini, the answer seems to be yes - he expects as many as half such borrowers to walk away. But many other people, including myself, think that the incidence of "jingle mail" will be much, much lower.

The key concept in this debate is the idea of equity. If you're in a "negative equity" situation, then on a purely economic level there is a strong case to be made for leaving your house and its associated mortgage. But how do you value equity? A blog entry by Buce got me thinking today: when people talk about "equity" in the context of residential housing, they're actually talking about book value. And as any stock-market investor knows, there can be a world of difference between equity valuations and book value.

If your outstanding mortgage is larger than the value of your home, then you're in a situation where liabilities (the mortgage) exceed assets (the house), and book value is negative. But it's entirely possible for a company with negative book value still to have positive equity: Look at General Motors, which is trading at $20 per share even as its book value is -$65.

If you sell your house, you're essentially liquidating: You're selling off the assets and paying off the liabilities, to the extent that they can be covered with the proceeds of the asset sale. But most companies are worth more than their book/liquidation value, and there's no reason why home equity shouldn't be thought of in the same way.

Buce points out that the equity can be valued as an out-of-the-money call option: It might not be worth much, but such options are generally worth something. And more generally, just as there's value in operating a company as a going concern, there's value in owning and living in your house, even if your mortgage payments are higher than they would be if you bought the house today.

Why do houses generally cost more to buy than they do to rent? Because there's a speculative component to the price: Buyers pay extra for the possibility that they might be able to make a large capital gain when they come to sell. Nowadays, of course, they're likely to do the opposite, and force a discount to compensate for the possibility that they might have to suffer a large capital loss when they come to sell. But if you bought your home to live in it, and if you expected to make the mortgage payments you signed up for, and if you're able to make those mortgage payments, then owning a house does still give you that possibility of future capital gains. And walking away will probably mean you can't buy another house for at least two years, so you lose that option. (Theoretically, of course, you could buy your new house before you walk away from your old one, but I haven't yet heard of anybody doing that.)

So where does that leave us? I suspect that prime fixed-rate mortgage borrowers are not going to walk away in significant numbers. Prime ARM borrowers expected to be able to refinance before their reset, and they might find that impossible if they're underwater, so jingle mail is a possibility there, depending on whether the reset rate is significantly higher than their initial rate or not. Subprime ARM borrowers, of course, are already defaulting in record numbers. Which leaves just subprime fixed-rate borrowers: They'll probably continue to make their payments unless or until they can't.

But the willful jingle mail - can pay, won't pay - I think is still going to be a very rare thing.

Comments

[Ashley D]

I do think that there will be a significant amount of prime fixed borrows walk away from there homes. I live in the Los Angeles area and almost everyone I know that purchased homes between 2000 and 2006 took out home equity lines of credit. They all have prime fixed loans. Their original home loan plus their HELOC will put them significantly underwater. Losing equity or book value or any type of value has a tremendously negative psychological effect. Couple the negative psychological effect with the bombardment of negative news (foreclosures, unemployment, inflation, etc….) and I think you WILL see people with prime fixed loans walk away from their home (well not really their home because almost all did not make a down payment, they are basically renters with a nice tax deduction with the right to extract equity / cash from an inflated asset). Additionally, “short sales” allow borrows to walk away owing hundreds of thousands of dollars without financial consequence…well other than a dinged credit report - but I would rather have a dinged credit report than own money on a deflated asset (and would probably sleep better too)!!!

[jimmy46]

Who knows what irrational people will do.

For the rational, walking away from a mortgage is foolish for many reasons.
1. Tax advantages of owning
2. Renters have to live by the owners rules.
3. Clearly inflation is on the move up, within a few years houses will follow this inflation.
4. You won't be able to get any kind of mortgage within the next 5 years, and for the next 10 years you'll probably need at least 20% down. And a great FICO score, and, and, and...

This isn't a situation where a person can walk today and next month buy another house at a lower price.

The banks were stupid till last year, now they've wised up.

[thoroughbred]

I think a big part of what is being missed is this, if I have a house that I am underwater on, by say $50K, I still may have over $100k of MY money in the house (equity), so even though it's worth less than the mortgage I still wouldn't leave $100k on the table and leave.

[Griz]

The reason that stocks trade for more than their book value, is due to the expectation that they will reflect greater value in the future (i.e. the discounted expected future cash flows from the assets exceed the current net book value). Can that argument be made for housing when you factor in taxes, maintenance, insurance and capital depreciation? I think economic triggers (i.e. Job Loss) will be a strong stimulis for even prime borrowers to walk away if they are underwater. As the realization sets in that we may be a decade+ away from our recent peak in housing prices (real & nominal), more and more people wont be able/willing to "hold on" that long.

[nickgogerty]

non-recourse loans and a large behavioural shift in debtor responsibility mean the options to "put" the hosue to the bank will be used more than historical data would indicate. time to dust off those CDO and CDS risk models again.

[selene]

The problem of jingle mail is to a large extent a cash flow problem, not an asset gain/loss problem. Too many people ended up in ARMs (adjustable rate mortgages) where they could afford the low monthly teaser payments for the first 2-3 years but not the later, higher payments. Some may have been people who expected income to rise significantly (law students, etc.) but most were just told by lenders "you can always refinance when it resets." On top of that, there's folks in IO (interest-only) loans with fixed payments. Us guys might understand right away that this opens the borrower up to the risk of negative amortization, but a lot of borrowers did not. I think this is the only kind of "subprime fixed" there is. Most subprime loans are ARMs I think.

So now it's a few years later and these folks can't refinance, can't easily get out by selling because mortgage is underwater, and good luck getting Countrywide to return your call.

Only bright spot is that since interest rates are still so low, the ARM reset may actually not be that big a blow as expected.

[Pent updemand]

Hmm. Let's see a public company that isn't going out of business generally has positive cashflow. What's the cashflow look like on a house (that you live in)? It's all negative in my experience.

The value of a way OTM call vs. the present value of 15-20 years of carrying costs? No contest.

[Recourse Bob]

In most states, mortgage loans are recourse to the borrower. Lenders need to pull out those balance sheets submitted by borrowers with their loan applications, and go after those who have substantial assets. If borrowers knew lenders would enforce the recourse aspect of loans, fewer borrowers would consider walking away from their loans.

[WAKEUP]

Here we go, again. The air is full of "Stay in that house! Stay in that house!" advice. It's as if "owning" a house has become some sort of sacred cow, totally apart from financial considerations. I know a couple who jumped off the house-slave wagon in early 2006, and rented comparable housing for considerably less than the house payments they had been making. They invested the money thus saved in a small entrepreneurial enterprise. Yes, their enterprise prospered, and they are well ahead of where they would have been, financially, if they had stayed in the sacred cow / house. I know that many would consider theirs a "minor" success story, since they are "only" worth about $2.5 million, now, as opposed to their previous paycheck-to-paycheck existence. The point, though, is that they made profits by getting OUT of the homeowner mode.

[Mr. SpecYou Later]

This article is forgetting about the large number of people who are Prime ARM borrowers.
Those who have prime loans fixed for 5 years. We can't refi because of all the losers who bought more house than they could afford, and the lenders who gave it to them.
Yeah, thank you, you Effed me along the way.

I can afford the house, even though it is a negative income, but it would be stupid to sit in a negative income that is about to go more negative in another year. Especially when we are looking at 5 to 10 years before the market value returns to ground zero.

So the bottom line is this. Mr. Greedy Banker made a bunch of bad loans that is now having an extremely negative affect on people like me.
Eff me? No, Eff you, here is your house. ENJOY!

[grouper]

Where do you come up with the notion that home loans are non-recourse? They are typically in the name of the owner, personally, and in the case of a primary residence, jointly with your spouse. So, typically, all joint or solely owned non-retirement assets can be seized in the event of a deficiency and a judgement. Short sales may or may not help, as the bank can pursue you for the deficiency, even if they allow the sale, unless you specifically get that right waived (in writing and signed, as they say in contracts 101). One more thing, the lender will likely file a 1099 for debt forgiveness (don't think they can agree not to do this), that leaves you with the IRS to fight with next year....although the anti-capitalists in congress are trying to eliminate this issue for primary homes (won't help investors or second homes).

It should be about cash flow, not debt/equity. If you can make the payments, make them. If you can't, don't, but triage your non-payments in the following order: unsecured, non-essentials like boat/RV/timeshare/seco... homes, home equity loans/helocs, cars (unless you live and work without a car), first mortgage should be the last thing you stop paying. Why? Because you have to live somewhere, and the first mortgage is likely less than renting a comparable place, and once your credit is screwed, renting gets harder. If you have to stop paying, don't send in the keys, stay until the sheriff carries you out. With proper planning, you can live payment free for at least 12 months, and pros can do it for 24 months or more.

[jimmy46]

@grouper
In California, home mortgages are non recourse by state law.
I don't know if any other state has such a law.

[Mr. SpecYou Later]

Grouper,
What state do you live in? You are substantially out of touch.
1st mortgage less than renting. Not in California.
Not for several years. Even with the dropping prices we have today, your rental dollar still buys more living space than purchasing.

As Jimmy said, if the loans are the original purchase loans, they are non-recourse. Foreclosure in California is also non-judicial.

Be careful not to apply what your states laws are or perceived to be to everyone in the country. You risk making yourself look like an arrogant fool.

[ArnoldCountry]

Recourse in California will be on the sold out junior lien holders left behind that were not purchase money. Even still, that will just increase the number of bankruptcies. If a HELOC lender pursue a borrower for the second, most likely the consumer will qualify for a 7 under the means test that they would not otherwise qualify for, wipe all the creditors and making banking problems worse. Its a mess out there and all this "personal responsibility" talk is bunk. These are real people out there trying to feed their kids and keep a roof over the head and when the Option ARMS and subprime loan reset or hit their true rate, feeding the kids comes first and Mr. Lender here are your keys. This is not rocket science guys, this is just living.

[Voice ofReason]

Speaking of being seen as a arrogant fool, and being out of touch, what do you call some bozo that lives in La La Land and willing pays 700-800K or more for a 30 year old run down two bedroom house no more than 1500 SQ feet?

Further, putting all the blame on "Mr. Greedy Banker" is simplistic at best. I assume they teach basic English and reading comprehension in Kalifornia, even if Arnold is the Gov. So all these people crying in their beer because they got what looked like a nice a teaser rate for 2-5 years up front and now it's time to pay the pipper, get zero sympathy from me. Ditto if you down put some cash in as a down payment.

Sure banks were stupid to give ANYBODY a mortgage and the flip side is the BORROWERS were stupid to not read or understand the mortgage provisions that reset to much higher interest.

[grouper]

If CA home loans are non-recourse by law that explains the unfathomable price-income ratios in CA for so many years. Borrow all you can, you never have to repay. I'm not arrogant, but 20 years ago I was the greedy banker and took a bunch of houses, businesses, land, shopping centers, hotels, cars, etc in the last good RE crash. Tthat is why I outlined what to pay or not, and strongly advocate: don't leave until the sheriff carries you out. I see all kinds of crazy stories and posts about people moving out of their houses and renting while the mortgage lenders are still chasing them. Make them work for it, live for free and protect your liquidity. And oh, by the way, I can't rent a house close to mine for my first mortgage payment. Stupid people borrow more than they can afford (or at terms they don't understand), but stupid lenders loan it to them. Happens in every up cycle, always has, always will. In the down cycle, lenders say "We have plenty of money to lend and our policies haven't changed" (They say it today at every seminar I attend). The BIG difference between an up cycle and a down cycle is how many policy exceptions you can get approved.