24 November 2009

Denver's Housing Bust Was Mild

My father-in-law and mother-in-law are in town for Thanksgiving week. They live in Las Vegas. The real estate bubble collapse there has been brutal. According to the Case Shiller index, house prices there have fallen 55.4% from their peak, the worst of the top twenty metropolitan areas it follows.

In contrast, Denver has fared second best of the top twenty cities that Case Shiller examines (only Dallas, whose housing prices are down 4.7% from the peak has had less of a housing bubble bust). Denver's house prices are down 7.7% from the peak, and have improved in 2009 compared to December 2008. Denver had already suffered the brunt of its declining housing prices by the end of December 2007.

In contrast, some cities have had significant declines in their housing prices in 2009, including Las Vegas, Phoenix, Miami, Detroit, Tampa, Seattle, Portland (Oregon), and New York City. At least one prominent economics blogger thinks that there will further declines in markets that had moderate to high magnitude housing bubbles.

Colorado also has a falling unemployment rate below 7%, while the national unemployment rates is above ten percent and rising.

The prospects of a healthy recovery are cloudy, however. One particularly troubling indicator is that the number of FDIC insured banks, nationally, that are struggling financially, or need to be shut down, continues to grow. Commercial banking managed to largely avoid the catastrophic meltdowns that were seen in the less regulated investment banking, mortgage finance and securitization industries. But, a prolonged economic malaise has started to sap Main Street financial institutions, not just Wall Street. Indeed, Wall Street appears to have taken its medicine and started itself on the road to recovery, for now.


Negative Equity

One factor that may be pushing banks into trouble at this late stage may be the delayed impact of negative home equity.

Declining housing prices have left almost one in four mortgage holders (about one in nine households) with negative equity in their homes. This, in turn, has made job hunters resistant to moving to places where the job market is better, increasing the number of people who are unemployed. Often, the negative equity situation is truly dire, "5.3 million U.S. households are tied to mortgages that are at least 20% higher than their home's value." Obviously, those deeply upside down homeowners are concentrated in places that have seen the deepest housing bubble collapses.

If you have just a little negative equity, hanging on until real estate prices recover a little and you pay down more of your mortgage before selling your home, may make sense. If you can return to break even status, you can pay off your mortgage in full when it is sold. As long as you can make the payments in the meantime, you won't seriously hurt your credit rating. But, if your house is deeply upside down, the point in time when that is possible may be hopelessly distant.

In California, where home mortgages are generally non-recourse, the best solution for households with negative equity is often to simply hand the keys over to the lender once the foreclosure process has run its course, and walk away. The lender takes a loss, while the former homeowners have a foreclosure on their credit records but owe nothing. Unlike a bankruptcy, not all of a household's debts will be discharged, and the household will need to rent a place to live (few will be able to get mortgages in the post-subprime world with a recent foreclosure on their credit records). But, a foreclosure taints a homeowner's credit for only seven years and involves almost no home owner paperwork or expense, while a bankruptcy clouds one's credit for ten years and involves a considerable paperwork burden and expense. A homeowner who waits to move until the eviction notice arrives can even get several months of free housing as the foreclosure process advances, using money that might have gone towards housing to pay down credit cards and other debts.

The net result is a poor man's bankruptcy, sometimes with better results than a true bankruptcy. The mortgage debt will be discharged. Meanwhile, if the money saved on transaction costs in the bankruptcy and housing costs as the foreclosure process ticks along is used to pay down other debts like credit cards, those debt payoffs will look much better on the homeowner's credit than a discharge in bankruptcy. The entire process may also take no more time than a bankruptcy. And, the homeowner faces a much lower chance of being accused of fraud (often no representations are made at all by the homeowner to anyone in this poor man's bankruptcy), and a middle income homeowner will not be required to enter into a five year payment plan, while in bankruptcy five year Chapter 13 payment plans that devote "all disposable income" to creditors are required of many debtors who have above the median income for the state.

Increasingly, many non-mortgage debts aren't dischargeable in bankruptcy anyway, even under Chapter 13. Debts for taxes, for alimony and child support, for student loans, and for criminal penalties, for example, generally can't be discharged in bankruptcy. The "luxury purchase rule" which prevents large cash advances or luxury purchases made in the three months before filing for bankruptcy from being discharged also has much more bite than it did before the 2005 bankruptcy reforms that Congress adopted. Often, the amount of non-mortgage, dischargable debt that an upside down California homeowner (who may have paid old personal debts with prior mortgage refinancings) may be fairly modest.

Also, to my knowledge, Congress has not authorized bankruptcy judges to cramdown home mortgages, so homeowners don't have the option of filing for bankruptcy and keeping their mortgages with the principal balance reduced to the value of the home, if they keep current on payments under a court authorized plan. The unavailability of this kind of relief similarly gives homeowners in California an incentive to stop paying their mortgages, wait out the process, and then let their home be foreclosed upon.

Rents are more reasonable now than they were a couple of years ago in most of the bust markets, so once a homeowner starts paying rent, the monthly cost may be smaller or similar to what that homeowner used to pay to the bank on a mortgage (often with a high interest second mortgage on it). Renting is now roughly equal in monthly cost to owning, and low housing prices mean that rent is often cheaper than mortgages based on inflated housing prices when the house was bought. When renting is cheaper than buying, the cash flow freed up by not having to pay as much on housing each month provides another source of cash to pay down non-mortgage debts.

Why go on so about a sequence of events particular to California? Because California is a massively disproportionate share of the problem. Greater Detroit and Florida are the only non-contiguous areas that have seen comparable great housing price collapses. Most of the areas seeing much bigger housing declines than they did housing price increases since 2000 are in the Rust Belt, where the bankruptcy of two of the three big three automakers and a general recession triggered decline in manufacturing have damped local housing markets.

The California experience is not unique either. Some of the other hard hit states also appear to have non-recourse mortgages (caution, I haven't reviewed and confirmed the state of the laws in these states and I am not admitted to the practice of law in any of them):

North Carolina
North Dakota

Arizona, California, Florida and Washington have all experience major boom/bust housing markets and the existence of non-resource mortgage laws may go a long way towards explaining why these markets were hit. But, details vary. For example, this site says that deficiency judgments can be pursued in Florida, but only after a foreclosure in separate action. I don't have the expertise to know for sure what practical limits exist on the ability of lenders to obtain deficiency judgments.

UPDATE (11-24-09 at 4:45 p.m.):

•The distribution of negative equity is heavily concentrated in five states: Nevada (65 percent), which had the highest percentage [of mortgages with] negative equity, followed by Arizona (48 percent), Florida (45 percent), Michigan (37 percent) and California (35 percent). Among the top five states, the average negative equity share was 40 percent, compared to 14 percent for the remaining states. In numerical terms, California (2.4 million) and Florida (2.0 million) had the largest number of negative equity mortgages accounting for 4.4 million or 42 percent of all negative equity loans.

About 19% of Colorado mortgages have negative equity.


The most prominent exception to the pattern of areas with major housing price declinies being in non-recourse states or manufacturing driven economies also had housing price bubbles. The most prominent of these is Nevada, where a housing price bubble may have been driven by sales of California properties at a profit with proceeds invested in Nevada.

The incentives for upside down homeowners aren't nearly so clear in states like Colorado, where a homeowner has personal liability for an unpaid mortgage balance if the lender bids an appraised home value in the foreclosure sale, rather than the full balance of the mortgage. But, Colorado doesn't have nearly as many upside down mortgages as California does, and many homes that were upside down have already worked their way through the system, so those issues are less relevant here. Tightened underwriting standards for mortgages and private mortgage insurance have also reduced the availability of low downpayment loans to people with less than ideal credit that make negative equity situations more likely.

Some lists call Colorado a non-recourse mortgage state, but while there are additional steps that lenders must take in Colorado to secure deficiency judgments in the case of an upside down mortgage on a primary residence, they are relatively modest barriers in the case of a seriously upside down mortgage.


Michael Malak said...

Colorado had a somewhat different housing bubble -- caused by unlicensed mortgage brokers, leading to rampant fraud. This led to foreclosures early in Colorado, keeping a drag on Colorado home prices and preventing them from bubbling up with those in the rest of the country.

So it wasn't so much that the housing decline wasn't as severe in Colorado as it was the bubble wasn't as pronounced in Colorado. Ironically, this is thanks to the mortgage fraud.

Andrew Oh-Willeke said...

I agree that the bubble in Colorado wasn't as pronounced and that the lack of a bubble is a key reason that we haven't had a bust.

I also agree that Colorado's real estate market had its mini-bust sooner than many other markets.

I don't agree that fraud from unlicensed mortgage brokers was a material cause of Colorado's mini-housing bubble or pre-mature bust. Certainly, there was fraud by unlicensed mortgage brokers in Colorado. But, there is little evidence to support the claim that the level of unlicensed mortgage broker fraud in Colorado was exceptional.

Colorado's early wave of foreclosures came several years late to account for a lack of housing price growth. The housing bubbles elsewhere (and to the extent that Colorado had one, here) were firmly in place long before foreclosures were putting a drag on Colorado home prices.

Also, almost all of the causation is on the upside. Bubble appreciation is a very strong predictor of bubble collapse depreciation outside the Rust Belt. Explaining foreclosures is not the problem. The problem is explaining the appreciation, which largely happened before we were seeing foreclosures anywhere (because in an appreciating market it is easy to sell a house you can't make payments upon on a break even basis or at a profit).

Also, while the housing price decline has hit many places across the nation, it has been a predominantly regional crisis. It makes more sense to look at why a handful of states have experienced massive housing price booms (followed by return to gravity declines). And, the very fact that the booms were localized suggests strongly the causes were local.