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I was reading this Wikipedia article about the subprime mortgage crisis, where it says the following (emphasis mine):

By September 2008, average U.S. housing prices had declined by over 20% from their mid-2006 peak. This major and unexpected decline in house prices means that many borrowers have zero or negative equity in their homes, meaning their homes were worth less than their mortgages. As of March 2008, an estimated 8.8 million borrowers – 10.8% of all homeowners – had negative equity in their homes, a number that is believed to have risen to 12 million by November 2008. By September 2010, 23% of all U.S. homes were worth less than the mortgage loan.

Borrowers in this situation have an incentive to default on their mortgages as a mortgage is typically nonrecourse debt secured against the property. Economist Stan Leibowitz argued in the Wall Street Journal that although only 12% of homes had negative equity, they comprised 47% of foreclosures during the second half of 2008. He concluded that the extent of equity in the home was the key factor in foreclosure, rather than the type of loan, credit worthiness of the borrower, or ability to pay.

When foreclosures were related to the level of equity in the house, was the foreclosure started solely because of the negative equity? And if so, why? What benefit would the bank receive by foreclosing on someone who had the ability to pay their mortgage?

Alternatively, if the foreclosures were due to people who simply stopped paying the mortgage on their negative-equity home and let the mortgage default, why would they do this? I understand that negative equity would pose a significant risk if for whatever reason you needed to sell your house, but for people who aren't in that position would it not be better to continue paying the mortgage because you still have your home, and barring catastrophic damage to the property the equity will eventually correct itself? Is there some benefit to letting the home be foreclosed on that would outweigh the damage that would be done to your credit history?

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    iirc part of the issue with the subprime crisis was that entire subdivisions and housing developments were sold in this way, leaving some people living in the only occupied house on their street as their neighbours defaulted. Wanting to walk away from that was probably at least part of the motivation. Oct 22, 2021 at 2:34
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    In addition to my answer, I'll note that you seem to be oversimplifying the situation. In particular, the author says it is 'the key factor', but you call it 'the sole reason' - these aren't synonyms, and for any decision so large, there is likely to be a confluence of factors. Oct 22, 2021 at 2:45
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    "What benefit would the bank receive by foreclosing on someone who had the ability to pay their mortgage?" Because they weren't paying it?
    – DJohnM
    Oct 22, 2021 at 3:56
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    The Wikipedia article doesn't seem to quite join the dots between negative equity giving borrowers an incentive to default, and lenders foreclosing. It might be that defaults and foreclosures match well enough that this is splitting hairs, but it might not
    – Chris H
    Oct 22, 2021 at 12:15
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    It's worth noting that this is a very US phenomena. In Europe/UK retail loans and mortgages are almost exclusively full recourse (so you still owe the shortfall from selling the house), and bankruptcy is punitive. The jingle mail effect was dominant in a number of US states where mortgages were strictly non recourse. In that situating it is simply a case of comparing the "profit" from defaulting vs the cost to your credit score. Ironically this isn't as bad for your score as you'd think since its not a sign that you are a bad credit - it has little predictive power about your future behaviour
    – Corvus
    Oct 24, 2021 at 14:15

7 Answers 7

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'Being able to pay your mortgage for the next few months' is not the same as 'Being able to bear the weight of the outstanding debt in an uncertain future'. There is also a psychological weight to being underwater on your mortgage when you don't know if you'll be the next person to be laid off - the pressure cannot be overstated.

If you think you won't be able to pay your mortgage next year, starting the 'bankruptcy clock' [credit history falls off after 7 years in most circumstances], that can be preferable. Bankruptcy affords protections to borrowers that may also be preferable to their current situation.

As well, note that people leave their homes all the time for various reasons [job change, family moves, etc.], but when your home isn't under water, we don't call that 'foreclosure', we call that 'selling your house'.

Finally I'll note that this: 'barring catastrophic damage to the property the equity will eventually correct itself?' is just a gambler's fallacy, that 'what goes down, must come up'. It is not necessarily true, especially note within the relevant time frame.

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    I think that this is a good answer, but I must dispute your last point about the gambler's fallacy. Even if the value of the property doesn't increase over time, the debt will eventually be payed, bringing the equity into a positive condition, granting that that may require a significant time period. Oct 22, 2021 at 3:05
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    @EnduringLobster Every debt can be brought to a positive condition by paying it off. If I sell you $1.000 for $5.000, and you pay these $5.000 off in a year, eventually, you have money worth $1.000 (not regarding inflation) and no debt.
    – Solarflare
    Oct 22, 2021 at 8:42
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    If you could notionally default on the mortgage and later buy the same property back at a much lower price, then paying the mortgage instead has comparatively negative utility (at least, depending on how you value your credit rating and bankruptcy status)
    – Useless
    Oct 22, 2021 at 12:31
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    @EnduringLobster Imagine you bought a house for $500k, with $50k down payment and a $450k mortgage. 2 years later, global financial crisis happens, and your home is worth only $100k. Let's assume you've paid $25k against the mortgage in the meantime, so now you owe $425k on a house worth $100k. If your options are: 1) Declare bankruptcy, walk away from the house; or 2) pay $425k over the next 25 years for something worth $100k, do you see why 'ending up with no debt' is not necessarily the best possible solution? Extreme example, but the principle remains. Oct 22, 2021 at 18:48
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    Bankruptcy is a 10 year clock after about a 9 month legal process. However, it's often possible to navigate an insolvency without declaring bankruptcy (creditors know they can't get blood from a stone), and doing so will preserve the 7 year clock. Oct 23, 2021 at 3:45
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Let's say your house used to be worth 400k and you had a mortgage for that amount. A 100% mortgage would be considered crazy and/or not be available a lot, or most, of the time but during the bubble leading up to the 2008 crash it was quite common.

The quote in your question talks about a 20% decrease in house prices but that is an average and for some it was a lot more. For the sake of making a point let's say our example house dropped by 50% and is now worth 200k. The person living in that house is paying a monthly mortage payment on 400k which is quite likely to be an amount they can barely afford. It's very likely they can reduce their monthly expenses by thousands by walking away from the house and renting somewhere. Perhaps the value of the house will recover but as Solarflare pointed out in a comment that is not guaranteed and even if it does how long will it take? 5 years? 10? Until they have positive equity they are trapped in that house or they will eventually have to realise their losses.

Sending the keys to the lender (the jingle mail) and restarting from 0 may be better financially than trying to work back from 200k down.

It's worth noting that the concept of being able to walk away from your mortgage by returning the keys to the house isn't universal. In my jurisdiction you would still be liable for the difference between what you owed on the mortgage and the amount the lender realised by selling the property.

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    On the last point, a lot of jurisdictions that allow for the lender to seek that difference have to show that the home is still valued at the purchase price i.e. they can't seek more than the current value. That provision seems to make it largely moot aside from perhaps transaction costs. It makes little sense to sell a home for less than it's worth just so you can continue to try to get money from someone who has already demonstrated a inability or unwillingness to pay.
    – JimmyJames
    Oct 22, 2021 at 17:47
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    Even besides JimmyJames' comment, you might still be liable in principle, but surely many people are going to seek bankruptcy protections in this situation? Oct 22, 2021 at 18:04
  • As the question puts it, "a mortgage is typically nonrecourse debt secured against the property", so the last paragraph doesn't really apply to the situation at hand. Oct 25, 2021 at 10:08
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What benefit would the bank receive by foreclosing on someone who had the ability to pay their mortgage?

There would only be a benefit if the homeowner is refusing to make payments. By foreclosing, the bank will recoup some of the remaining mortgage balance, rather than none.

Alternatively, if the foreclosures were due to people who simply stopped paying the mortgage on their negative-equity home and let the mortgage default, why would they do this?

If you have negative equity of -$X, then by defaulting and giving up the house, you receive an immediate boost of +$X to your net worth (assuming a non-recourse loan). This may be worth the damage to your credit depending on what $X is.

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It's worth noting that this is a very US phenomena. In Europe/UK retail loans and mortgages are almost exclusively full recourse (so you still owe the shortfall from selling the house), and bankruptcy is punitive. The jingle mail effect was dominant in a number of US states where mortgages were strictly non recourse. In these places walking a way from a mortgage loan was basically just an option in the contract - there was no need to declare bankruptcy. Remember also that a lot of loans effected were Alt-A not strictly sub prime. These are simply loans that don't fit the Fanny and Freddy criteria, including, for example, jumbo loans which are good credit scores but the loan is too big. So relatively well off people could have a very large underwater mortgage. They can simply buy another house and immediately increase their net worth by the negative equity amount.

In that situating it is simply a case of comparing the "profit" from defaulting vs the cost to your credit score. Ironically this isn't as bad for your score as you'd think since its not a sign that you are a bad credit. Walking away is a perfectly rational action and your right in the contract. It has little predictive power about your future behaviour. Think about it this way, would you be willing to lend to someone who has done this? Of course, no reason not to, but you might ensure there was plenty of equity in the next house! (But you should have done that the first time!)

One funny consequence of all this was that a number of lenders were willing to reduce the loan amounts to stop people walking away. Having an empty house in a housing crash is terrible for the bank - you lose even more money as the house gets vandalised or just decays from neglect.

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  • The walk-away option seems like it should be an important safeguard against ridiculous housing bubbles: investors shouldn't buy loans for more than the true value of the property. (and banks shouldn't issue them if nobody will buy them)
    – user253751
    Oct 25, 2021 at 11:58
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    @user253751 you'd think wouldn't you? But it clearly didn't. In any case I believe that wasn't the intention of these antideficiency laws. I believe their origin is thinking about potential abuse by lenders, since generally they only apply to non judicial foreclosure. This means that the mortgage contract allows them to sell your house without a court order, and the walk away option is there to balance it. In Europe a foreclosure would almost always require a court.
    – Corvus
    Oct 25, 2021 at 12:24
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There are a lot of people* out there who only think in the short term. They see a short-term trend, expect it to continue, and react accordingly. You see the same thing at work in e.g. panic selling during a market downturn.

So they see the expected value of their house decreasing, expect it to decrease more in the future, and decide to get out now, never thinking that if they just held on for a few years, real estate prices would start climbing again.

You see this in the other direction too, with people jumping in to popular investments - Apple, Bitcoin, &c - simply because they are popular.

PS: To address a comment, there's also a difference in intent that comes into play. Some people look at houses primarily as investments, others as places where they want to live. If you regard your house as an investment, then it makes sense to cut your losses by selling if you're underwater, and especially if you expect that the market will not recover quickly.

OTOH, many people buy houses primarily to live in. For these people, the current market price is irrelevant, because (barring major life changes) they have no intention of selling. What matters is their mortgage payment.

*Of course there were some people who actually needed to sell for various reasons besides not being able to make the payments, but AFAIK they were a small minority.

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    I don't see this argument. People weren't mainly selling houses they owned for less than they'd paid, they were walking away from under-collateralized debts, and often able to write that debt off completely. That's totally different from selling a stock you actually own on a market crash. Oct 22, 2021 at 18:07
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    @Kevin Arlin: It amounts to the same thing. Perhaps like selling stock you'd bought on margin?
    – jamesqf
    Oct 22, 2021 at 20:10
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    I don't see how. Walking away from an underwater house, as described in another answer, immediately increases your net worth. That's not the case for selling a stock at a loss. Seen another way, if you ignore credit score impacts and just look at the numbers, you could walk away from your underwater house and then buy it again at its new market value, with a suddenly smaller mortgage. Pure gain. This theoretical gain can be approximated more or less well depending on the individual's situation. Oct 22, 2021 at 20:14
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    Just to note, in some places if you had bought at the height of the bubble in '06 you would only just now - 15 years later - be above water on your mortgage. And that's after the recent 30% run-up in prices. (Also not counting transaction costs.)
    – user12515
    Oct 22, 2021 at 21:52
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    @Michael: But you would have had a place to live for those 15 years :-)
    – jamesqf
    Oct 23, 2021 at 16:36
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It possible if the house is underwater (in terms of equity) to just hand over the keys and walk away. That is, if there is no other security and the lender has no recourse to assets other than the house.

In the time of Bear Stearns this was referred to by some insiders as "jingle mail".

Your payments to date are a "sunk cost".

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  • However, this will result in a bad burn on the credit report. Oct 23, 2021 at 3:48
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    And depending on the contract/wording of the mortgage, the mortgagee is still liable for the difference.
    – Criggie
    Oct 23, 2021 at 6:19
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would it not be better to continue paying the mortgage because you still have your home?

It's not your home. When you're "underwater", you owe to the bank more money than the house is worth. Simply abandoning the house and letting the bank foreclose it essentially puts this difference in your pocket, at the expense of damaging your credit score. If the difference is big enough, it simply makes sense to take that hit.

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