Recourse mortgages don’t prevent housing busts

Yesterday, Delusional Economics linked a video from Sunday Sunrise showing SQM Research’s Louis Christopher and Sunrises David Koch (‘Koshie’) discussing the Australian housing market.

While much of what both commentators said was reasonable, I found one point made by Koshie misleading:

From 4.40 of the video, Koshie notes that a major difference between Australia and the US is that: “in the US, if the value of your property falls below your loan, you just hand your keys back and you say to the bank, ‘see you later fella, I’m leaving, you cop any loss’. Here in Australia, you are still on the hook for a loan. So that’s a very big incentive for Australians to keep paying their mortgage. And often, at times like this, we just put off selling the house”.

Australian foreclosure laws are more strict than the US, but the claim that borrowers in the US can simply walk away from their mortgages and the bank cannot go after their other assets is factually incorrect. The below table, which comes from a 2010 Federal Reserve Bank of Richmond Working Paper, classifies each US state into recourse (i.e. where the banks can go after a borrower’s other assets) and non-recourse (i.e. where they cannot):

As you can see, the overwhelming majority of states in the US have been classified by the Federal Reserve as recourse.

Moreover, the two states with the highest level of mortgage delinquencies – Nevada and Florida – are in fact recourse states:

We might add some cultural differences. For instance, Americans tend to be less negative than Australians about personal bankruptcy, owing to their entrepreneurial milieu, which might make some difference.

But let’s also not forget that Ireland – one of the epicentres of the global housing bust – has some of the harshest bankruptcy laws in the world, whereby citizens can be jailed for failing to repay a loan and it did very little to prevent a bust there.

Interestingly, the authors of the Working Paper claim that the threat of recourse reduces mortgage defaults by around 20%. This suggests that while Australia’s stricter full-recourse foreclosure rules could help to reduce the severity of any housing downturn, they are no panacea.

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Hat tip Ben Rabidoux for the Federal Reserve Working Paper link.

Comments

  1. Does anyone know what your credit rating/score would become if you handed in your keys in a (true) non-recourse state like Arizona, or any other non-recourse state?

    Michigan has recourse laws laws, and Detroit.

  2. Full recourse loans make a bust…worse when it happens. Those States that allow non-rccourse should see a continuous trickle of jingle mail over time, whilst those without it see stressed owners ‘hanging on’ en masse. When the dam burst it drags those stressed owners out, all at once. I’d argue that Austraia and New Zealand have a dam of stress building up, contained by recourse, that will eventually break in a spectacular fashion.

  3. Great post, totally demolishes the whole non-recourse argument.

    Something else to consider, is that non-recourse didn’t make the banks more prudent with their lending either.

  4. Just goes to show that a shiny pate doesn’t mean you know what the hell you’re talking about.

    Non-recourse would make banks more circumspect in lending as they may not make full recovery on their collateral.

  5. On another note – The home-buyer and renovation cable TV shows in North America have lately given way to several shows focused on vendors trying to sell or ‘get out’ of properties without losing their shirt.

    Episode I caught last night showed shocked couples in North Carolina and DC who were struggling to sell their houses for the same as they paid for them 11 and 6 years ago respectively. The NC couple had a mortgage only $15k less than their original purchase price (Equity mate!) They end up having to put all their remaining personal savings toward the selling cost shortfalls. On top of 11 years of mortgage payments.

    In spite of what has happened to the market already, many of these vendors have often purchased their next ‘dream’ house on the basis that their place is worth $100k or more than they actually end up getting for it. You’d think that after losing hundreds of thousands on their first home purchase some would have learnt from experience – alas, no.

    It appears the learning curve is slow when it comes to housing. Expect this to be long and drawn out in Australia too.

    PS- anyone want to pitch a new show – along these lines – to Channel 9 with me? It’s called “The Chopping Block”.

    • BTW note I’m certainly not wishing to make light of anyone’s financial misery, but I think such a show would provide some balance against the crap that’s out there, and be educational.

  6. Hugh PavletichMEMBER

    Leith – thanks for this clarification.

    Even if they walk away in a non recourse State, they create for themselves great difficulties in accessing credit going forward. And of course it can pose difficulties renting as well.

    The Banks in this part of the world though are blind to the risks of bubble lending.

    If the negative equity situation is bad enough, there comes a stage when it is in the home owners interest to “walk” – regardless of whether it is a recourse or non recourse environment.

    Bubble lending could be defined as when it exceeds about 2.5 times annual household income (housing should not exceed 3.0 times).

    It is not too difficult to quantify the extent of the bubble lending that has been occuring in Australia and New Zealand.

    • I don’t think that is quite right Hugh, but I admit that I’m not an expert in US credit history guidelines.

      It’s my understanding that in a non-recourse state they can walk away without a black mark on their credit file as long as they follow the correct guidelines.

      I also understand that there are tax implications for that, as many US citizens claim the interest off their tax, which won’t wash with the IRS if they never actually pay the interest. Perhaps someone else may be able to expand on that.

      This statement from above “Interestingly, the authors of the Working Paper claim that the threat of recourse reduces mortgage defaults by around 20%. This suggests that while Australia’s stricter full-recourse foreclosure rules could help to reduce the severity of any housing downturn, they are no panacea.”

      I don’t know if 20% is the appropriate weighting, but put it like this. The brakes on my car won’t stop a crash in every circumstance, but they do help.

      • @ Macrobusiness
        I usually read this blog but have never entered info before. I live in the US and I’m American – so I’ll share with you what info I can – from ‘on the ground experience’. I’m not an economist – but I do read a lot of blogs about worldwide economic situations – since it affects my business.

        @ Peter Fraser
        You cannot walk away from a home mortgage without it affecting your credit – recourse or non-recourse. In a non-recourse state, your credit can drop from excellent (800) down to 620 (poor). You’ll then need several years (5-7 years) of proper financial management to make it back up to a level over 740 (considered a good level).

        As far as the IRS goes, you can write off the interest payments as a deduction. If you ‘walk away’ from the home – then you’re not making these payments so obviously there is nothing to deduct against income. President Bush (Bush II) signed a law back in 2008/09 that forgives people from owing money to the IRS if they walk away from their mortgage.

        Normally the IRS could come after you for the amount the bank forgave in debt. But Bush signed a decree temporarily halting that. It’s in effect until Dec 2012 and allows stressed homeowners to not have to worry about debt forgiveness and the IRS.

        Lastly, even if you live in a non-recourse state – I can speak for California- it all depends on the type of loan you take out. If it’s a simple – single loan to purchase your primary home – then it is non-recourse in CA.
        If you purchase a home with a jumbo loan (primary loan + HELOC), then it gets interesting. If at any point in the home ownership process, you tap into your HELOC, then you’re on the hook for the entire amount of the HELOC. So the HELOC portion can become a recourse loan even in a non-recourse state. It’s up to the bank if they want to come after you for this money.

        Thanks for this blog and keeping me updated on the Aussie/NZ situation. Keep up the good work and the excellent quality of discourse.

    • Based on a number of years experience in lenders mortgage insurance in Australia, stressed borrowers are considerably more likely to default and “walk away” when they have negative equity.

      Borrowers seem to be more prepared to tough it out when they have some equity (which may disappear in a mortgagee sale scenario).

      I also believe that historically the stigma of bankruptcy has been far greater in Australian than the U.S. (as suggested by U.E.).

  7. I think the “Recourse” mortgage thing is irrelevant.

    In practice, it has always been possible, everywhere, for the mortgagee to hand in the keys and walk away from the loan. Some states have, quite sensibly, enacted legislation which simply takes what was already de facto and makes it de jure. In other words, some states call a spade a spade while others try to call it something else, but in practice there is no difference.

    The important point – the one Koshie should have made – is that most borrowers in Australia put a 20% deposit, whereas in the U.S. it was very common to buy on a 10% or 5% deposit. Therefore, the number of people with negative equity in their homes will be much smaller in Australia than it was in the U.S.

    • yogiman, sorry to be pedantic but it is the mortgagor (borrower) you mean not the morgtgagee (ie. lender)

      Although to be honest the mortgagee/lender could walk away from the loan if they were so inclined!!

      • First home buyers no, probably a bit less than 10% on average – maybe 7.5% at a guess.

        But many home buyers only need a small LVR to complete.

      • darklydrawlMEMBER

        Agreed Leith. Plenty of first homebuyers have LVR of 95% or greater.

        They are much harder to get now, but a couple of years back if you could walk and talk at the same time you would be considered for a loan.

        The main upside to having a 20% deposit was you could avoid the wonderfully titled ‘mortgage insurance’ charge added to your monthly payments.

        Sadly I know folks with mortgages who still don’t understand that the insurance is not to protect them, rather the insurance protects the bank from you defaulting.

    • Hugh PavletichMEMBER

      Yogiman – But look at the Lending Multiples to Income that have been and still are occuring in this part of the world.

      The gereater the stretch – the greater the risks.

      And very low deposit lending has certainly been happening here.

      • It’s the greater the loan size the greater the risk, the LVR is really irrelevant as a measure of serviceability.

      • Chinese appartment buyers don’t have to walk anywhere, they are in China. I read that 10% was common deposit and that has already evaporated in the exchange rate movements of late.

        Why would these foreign ‘investors’ not default on their obligations.

      • Professor Keen talks about LVRs of 97% !:

        “At present, you need a $30,000 deposit to bid $1 million for a property if you get a loan from the Commonwealth Bank, which currently has one of the highest maximum LVRs of 97%”

        http://www.debtdeflation.com/blogs/2010/12/23/loan-standards-drop-to-keep-the-bubble-afloat/

        From anecdotal experience I know some first home buyers in 2009 who bought with no deposit at all – just the first home owners boost. I guess that’s why they’re called “Ruddprime” 🙂

      • dumb_non_economist

        cyrusp,

        Likewise here as well (niece), fortunately they sold up 15 mths later and walked away with 50K in the pocket. LUCKY!!

    • I doubt many people over the last 5-8 years have been buying with a 20% deposit, especially a 20% deposit of real money (as opposed to a 20% deposit from the “equity mate” revaluation of their existing property(/ies).

  8. UE I watched and laughed at Koshie and have many Australians tell me the same thing. They really dont have a clue about the US and think they do. My sister and brother in law fell behind on thier house in the state of Tennesseee. They worked with the bank on doing a short sell basically a last step to selling before a foreclosure. Well they never got the house sold. It sold eventually but they still owed the difference to the bank. The only way out of it was for them to file for bankruptcy. So this notion of hand the keys in is just a bunch of MSM BULL#$IT and I wish the MSM in Australia would quit printing such S$%T.

    Short sell explanation http://en.wikipedia.org/wiki/Short_sale_(real_estate)

  9. The major difference between the US and Australian mortgage market is the variable interest rate, rather than recourse/non-recourse. Nevertheless, the law in regard to mortgage default does make a difference. Look at Spain as an extreme example : mortgage debt cannot be discharged even via bankruptcy. So despite the record unemployment rate (22.6%), mortgage arrears is still relatively low. (0.53%)

    • Very important point, Ronin.

      Note that in the USA, every episode of low interest rates results in almost everybody re-financing their mortgage at those low rates, for far MORE “years to come”, than in Australia or pretty much anywhere else in the world. This would SLOW the impact of rising interest rates on incumbent households, if the rising interest rates do not affect most of them for another decade or 2. But in Australia, when the RBA raises interest rates, the stress will hit incumbent households a lot sooner because their lower interest rates will be locked in for a shorter time.

      Something else I would like to clarify with Leith, is this: does the US statistics on “delinquent mortgages” include the voluntary walk-aways in non-recourse States? Note that California is a non-recourse State, and California is where the biggest bubble in PRICES occurred.

  10. Many Australians are in denial and will spout any rubbish to support their viewpoint.
    This non-recourse business is an example of housing “Bulls” contriving a point of difference to make an excuse for outrageous Australian house prices.
    Similarly, housing “Bears” contrive similarities to justify their crash predictions and to justify lack of action tackling the housing shortage. Many housing shortage-deniers keep telling me that the Australian property market is identical to Spain, Japan, Ireland or Nevada and therefore must crash soon. Any question is laughed-off with the pithy comment “We are different here” or “This time is different”.
    If I declared that every stock chart was identical, or every currency was identical, I would be instantly recognised as a moron. But apparently declaring that all housing markets are the same makes one a wise contrarian (in shortage-denier land).

      • I don’t require your permission or your tax dollars RodZone. What is stopping me and many others is lack of permission from government to build.
        Most land in Sydney has strict building limit applied to it. Federal govt invites in hundreds of thousand of extra immigrants and local council refuses to allow permission for extra housing to by built.
        This creates a severe shortage of housing which drives up price.

      • darklydrawlMEMBER

        Well said Claw. This is a huge problem in this country. Given how much money the local Government make from increased property prices, one cannot help but suspect there are vested interests at play.