Via a post on the Bogleheads forum, I read this piece of news from the WSJ Developments blog:
Study Finds Underwater Borrowers Drowned Themselves with Refinancings
From that WSJ blog post, I read this research paper:
LaCour-Little, Michael, Eric Rosenblatt, and Vincent Yao, 2009. Follow the Money: A Close Look at Recent Southern California Foreclosures
A professor from California State University and two researchers from Fannie Mae studied about 3,600 residential foreclosures in five counties in Southern California in 2006 and 2007. They found the vast majority of homeowners in these foreclosures had negative equity (not a surprise). They then tried to trace the source of the negative equity.
How did they become upside down? Was it because the value of the homes dropped below the original purchase price or was it because of something else? The researchers found that the primary driver for the negative equity was the homeowners’ post-purchase equity extraction through home equity loans, HELOCs, and cash-out refi’s, not the home price declines.
That rings a bell. I posted a story I heard on the radio last year in Refinanced to Foreclosure. A lady called a talk show program saying WaMu foreclosed the family home she owned for 35 years. She loved the home. She raised her kids in it. How did she lose a home she owned for 35 years? The only explanation would be she took her equity out through subsequent borrowing.
If the lady took her equity out already, was the foreclosure a financial loss to her? We don’t know about her specifically, but we can look at the homeowners in the study. The authors of the study wrote:
“Even after these foreclosure events, the unleveraged return on investment for these property owners is very high: roughly 40% over their holding period. If borrowers financed these purchases with 100% financing, of course, the returns on investment are infinite. Why such borrowers should enjoy any special government benefits such as waiver of the income taxation on debt forgiveness or subsidized loan modifications to reduce their borrowing costs is at best unclear.”
Now, that’s an inconvenient truth. The foreclosed homeowners made money. Who knew? On average they held their homes for 5-1/2 years. Making 40%, tax free, over 5-1/2 years is quite good, isn’t it?
I have to say these homeowners are smarter than I am. I did several refi’s but I never took any cash out. My home’s value is back to the same as my original purchase price. My rate of return is zero.
Learn this trick from the foreclosed homeowners: when your home goes up in value, follow the high watermark and get your equity out. When your home’s value goes down, demand a loan modification. If that doesn’t work, exercise your put option. That’s how you make money in real estate.
I e-mailed Professor LaCour-Little and asked him if he calculated the average rate of return grouped by the year of the purchase. He said he’d look into it in the next iteration of the paper.
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The Incidental Economist says
Such a good point. It isn’t just the large financial institutions that can profit when times are good and get bailed out when times are bad. Doesn’t the put option have some bad implications for your credit though? If one can factor that in to some calculation and show one is still ahead then maybe this is a rational strategy. Yikes.
Dave C. says
All I can say is, “wow”. I suppose Wall Street doesn’t have a monopoly on financial sneakiness, it looks like Main Street has a view tricks up their sleeves too.
Good idea. Sometimes you really feel that the financially irresponsible people are being rewarded.
Of course walking away is a reasonable strategy. The mortgage loan is a non-recourse loan, the guy walking away got free rent, money to boot, and no extra liability. If you’re loan is in default, I can only assume that your credit rating is already in the crapper, so there’s not much more to lose at that point.
Wai Yip Tung says
The foreclosed homeowners made money? How? I thought they all have negative equity, and losing all their down payment, right?. Otherwise they would have sell the home themselves.
Let me see if I understand the scheme correctly.
Say I bought a 500K home with 0% down. House price then shot up to 1mil. I take out 300K HELOC. House price fall back to 500k. I default on both loan. My credit is ruined. But I walk away with 300K of free money in the bank? That’s infinite returns on investment. Is it how one can make money from foreclosure? Wouldn’t the lenders have a claim on my cash?
Harry Sit says
Wai Yip Tung – In a nutshell, yes, although the numbers don’t have to be that dramatic and the money doesn’t have to stay in the bank. Let me give a more realistic example. Buy a house worth $200K with 5% down ($10K) and $190K in 80/15 piggyback loans. When the value of house goes to $260K, refinance both loans to one loan at 80% LTV ($208K) and get $18K cashout after paying off the $190K old loans. The $18K can be used for food, clothes, cars, vacation, kids’ college tuition and what have you. At the time of foreclosure, there’s no money in the bank. The homeowner still made 80% ($10K down, $18K out).
The lender theoretically can go after the homeowner for the deficiency, but they don’t do that in practice because there is no money in the bank.
Wai Yip Tung says
It is gratifying to have $18k to spend on cars and vacation. But if the final outcome is no house and no cash, then I won’t consider it a profit. What I really wonder is say I originally want to use the $18k for traveling around the world. Then I lost my job and living on my saving for 6 months. At the same time I watched the house price plummeted. I come to realize there is no way I can keep the house. The money is still in the bank, or maybe it is in a shoebox. Can I default and walk away with the money? If the lenders knows the cash is still there can they have a claim on it?
The number that I’ve used is semi-realistic in my region. The number in your example is like toy money in my market. Just how sad for me to slave so much on housing 🙁 I’m just curious if it is possible for foreclosed owner to actually profit from the house while the lender lose big money.
Harry Sit says
Wai Yip Tung – Yes, it’s possible. The lender has to sue the homeowner in order to recover the loss. In practice it doesn’t happen even if the homeowner has money in the bank. Read more about it under “Legal system is swift but generous to defaulters” in the research paper I linked to in my previous post Why the United States Is More Prone to Housing Problems.
Wai Yip Tung says
Aha – Non-Recourse Debt! Learned something new today.
I know that I’m going back into the annals of history here, but a mortgage is a form of non-recourse debt? For reals? I had no idea!
And yet, I’m not sure, that even with the foreclosed owner making a HUGE return on investment if the lender loses big money. I think that the taxpayers lose the big money in the end ;(