Read between the lines on housing

There is a lot of inaccurate information surrounding the laws governing mortgages in America, therefore, it may be vital for investors to conduct their own research before making decisions.

House prices and economic growth go together. Cause and effect are perhaps impossible to ascertain, but it seems clear that once house prices have begun to decline, economic contraction is a real risk. One factor that has brought some comfort to British and Australian journalists and research analysts is that America has a unique feature to its mortgage market, which reinforces the downward spiral. In America, the story goes, once home equity value is negative homeowners just walk away and mail the keys to the bank.

A new term – “jingle-mail” – has been created to describe this phenomenon. This is because in America – as stated repeatedly over the past 18 months in research reports from places as diverse as Morgan Stanley, the Wall Street Journal and a recent presentation by a large Australian bank – mortgages are made on a “non-recourse” basis. Banks can only repossess property and resell to recoup the money owed. Well then, there is no reason to worry in the British and Australian context. Maybe that helps explain the recent inaction on the part of the Reserve Bank of Australia. Only problem is, the story is just not true.

Mortgages in America are governed by state law. There are quite a few states and there is no homogenous mortgage law. Certain states are exclusively non-recourse mortgage states, whereby it is true that a borrower could walk away from the mortgage contract. In these states, if prices go up the homeowner wins, if prices go down the bank loses. However, in the vast majority of states, including many of the high-end and densely-populated property markets – New York, Illinois and New Jersey, for example – it is not true. Any amount due under the mortgage is the responsibility of the borrower. Under the terms of the agreement the lender can pursue all assets and earnings of that borrower. If a portion of the debt is forgiven, by whatever route, that forgiven amount is considered taxable income of the borrower. This was the reason for the Mortgage Forgiveness Debt Relief Act 2007, enacted by Congress in December, 2007, which would not have been required if mortgages were non-recourse.

Not convinced? Consider how many American homeowners are in a negative equity position. Reuters cites a study by First American CoreLogic, estimating that 20% of all homeowners in America are in that position. The Economist cited Moody’s in February, 2008 as estimating the figure to be 17%, and house prices have continued to fall significantly since then. How many foreclosures have there been? Surely every red-blooded capitalist with enough education to manage simple sums would have turned in the keys by now? A recent foreclosure map published in The New York Times shows that the highest range of foreclosure rates is in Nevada, where 2.6%-4.1% of homes are in the process. Even California is “only” at 1.6%-2.7%. Perhaps there is a shortage of envelopes suitable for house keys?

So why do research analysts and journalists spread such misinformation? Why would a large international investment bank write, in the spring of 2008: “There is a great temptation to compare the outlook of the UK housing market with the current situation unfolding in the US. However, there are fundamental differences… perhaps more importantly that in most US states mortgages are underwritten on a ‘non-recourse’ basis to the borrower.” Why would a newspaper like the Wall Street Journal print an editorial making the same point as a reason why the housing market in Australia is therefore more robust?

In some cases it might be a genuine misunderstanding. Some observers might confuse a bank’s actions – allowing the borrower to walk away because it thinks the cost to pursue is too great, relative to the potential payback – with the bank’s rights to pursue. Banks throughout the developed world always have the right not to pursue a borrower, but that is not to say that those loans are on a non-recourse basis, it simply means the lender has made a particular choice. This does not excuse the faulty reporting however.

Why is this important? After all, it is possible that, while this point of distinction between America and other housing markets is inaccurate, there are other features that are sufficiently different, so as to insulate non-American housing markets. It is possible that the Reserve Bank of Australia was right to leave rates on hold at its last meeting. Even so, it is important to know if the price depreciation in America really is the result of those jingle-mail subprime owners, or whether it has a different cause; one which might impact other housing markets such as Britain and Australia.

It is important because when we are next confronted with a housing downturn or other asset price collapse and we look back at this crisis, we should not reach conclusions based on inaccurate information. It is important because all an investor can do is use the facts and circumstances observed and overlay his experience and judgment to try to assess risk and return. If the facts are incorrect, any upside is solely the product of chance. Our banker counterparts make no representation to accuracy. We need to be reminded of this, and to rely on our own research and judgment to make sensible investment decisions.

GDP growth versus house prices

Recourse status for American mortgages