Thursday, February 26, 2009

The Truth About Mortgages

Felix Salmon (

Megan McArdle has a couple of blog entries worth responding to, both on the subject of housing. First is her pushback against the meme that it's not the borrowers' fault they're underwater on their mortgages:

It seems to me that this sort of acts like borrowers shouldn't have any obligation to repay money on an asset that has fallen in value--as if there were some sort of moral right to take highly leveraged bets on housing and pass off any losses to someone else. The borrowers ought to have known that they couldn't be repaid, because of course the natural and right thing to do, in the event that an item you have purchased on credit falls in value, is to default on your loan.
On the other hand if we assume as a matter of public policy that people who have signed a loan contract are actually obligated to pay back the money they borrowed even if their house is not rapidly appreciating, then the primary risk is not a fall in house prices; it is that borrowers will not be able to repay the loan.

This misses the fact that, like any leveraged borrower, the homeowner has already taken substantial losses. Homeowners are no different from any other leveraged borrower. Is Cerberus on the hook for all of Chrysler's losses? Are bank shareholders liable for unlimited capital calls in the event their company loses lots of money? No. Most secured loans are non-recourse, and banks understand full well the concept of a non-recourse secured loan: if the value of the security falls below the value of the loan, they're liable to lose money.

Now legally, it's true, many US mortgages have recourse to the borrower. But it's equally true that in the real world, the overwhelming majority of mortgages are de facto non-recourse. Here's how housing works, in California and indeed in most of the US: you buy a house with a combination of downpayment and mortgage. The downpayment is your equity. If the value of the house rises, so does the value of your equity, and you happily pay your mortgage, since you're getting richer. If the value of the house falls to the point at which your equity is wiped out, however, you've got precious little reason to keep on paying that mortgage.

Are homeowners "actually obligated to pay back the money they borrowed"? Mark Gimein wrote a great blog entry on this back in November:

A bank that doesn't want to get bogged down in a two year long morass has little option but to take back the keys, accept a huge loss, and call it even. Is this an "abuse" of the system? I don't see how. The loss was something that lenders could have anticipated at least as easily as borrowers. The reality is that ordinary people are lousy at figuring out the ins and outs of real estate transactions. Relying on the one act rule to get out of a mortgage is not to abuse the system--it is to use the system in precisely the way it was intended to be used. The reason that the one act rule exists is that lenders and developers have through the years shown a great deal of ability to maneuver unsophisticated buyers into crummy real estate deals. The reason that the one act rule exists is to put the risk of these deals on the lender, not the buyer. The purpose is to discourage bad underwriting, dishonest marketing, and unjustified price inflation by making it very, very hard for a lender to get back the money if they lent more on a mortgage than a house was worth. The system is designed to let people walk away. California has a system that puts a higher premium on keeping people out of debt slavery than avoiding bank losses. I see nothing wrong with that legislative choice.

It's interesting that whenever anybody proposes a debtor-friendly piece of legislation, a thousand bank flacks' knees jerk at once, and suddenly we journalists are deluged by people saying that it's a dreadful idea, because banks will simply stop lending and/or raise interest rates as a result. Well, the California mortgage market is living disproof of that notion: it's incredibly debtor-friendly, but would-be homeowners never had any more difficulty getting a mortgage there than they did anywhere else.

Which brings me to Megan's second blog entry, on mortgage interest tax deductions:

Current homeowners bought their homes on the expectation not only that they would enjoy tax deductibility, but that they would be able to resell their house at a higher price because of the imputed value of the tax deduction to the next owner. If you remove the deduction, most people will see a permanent decline in the value of their largest asset.

Again, this is something which makes sense in theory. But it can also be tested empirically, and shown to be false. Just look at what happened to the housing market in the UK when the mortgage-interest tax deduction was abolished: it exploded.

Megan is looking for a homeowner who's in favor of abolishing mortgage-interest tax deductions: I'm perfectly happy putting myself forward on that front. But as a renter, Megan might be surprised to learn that most homeowners don't get any benefit from the tax deduction at all.

I first boned up on tax deductions back in 2004, when George W Bush was thinking about abolishing them. Basically, there's a standard deduction, which everybody gets; if you'd rather, however, you can opt to itemize a bunch of separate deductions instead, if they add up to more than the standard deduction.

The standard deduction in 2009 for a married couple filing jointly is $11,400. That means you get to subtract $11,400 from your income even if you don't pay any mortgage interest at all. Now suppose that married couple bought a home for $200,000, put 20% down, and got a 6% mortgage. Then their annual interest payments are 6% of $180,000, or $10,800. They own your own home, but they get no benefit from the tax deduction: they're still better off taking the standard deduction.

Of course, if you own a home in Washington DC or in New York, you're likely to have a mortgage of much more than $180,000. But let's say that our married couple bought a $350,000 house instead, and have annual mortgage interest payments of $16,800. Then their taxable income will be reduced by $5,400 as a result of the mortgage-interest tax deduction, which means that their taxes will be reduced by about $1,900, or about $150 a month -- compared to $1,400 in mortgage interest payments. By contrast, refinancing from a 6% mortgage into a 4.5% mortgage will save them $350 in mortgage interest payments: movements in interest rates are much more important to homeowners than tax laws are.

It's easy for cosmopolitan journalists to lose sight of where house prices really are, given that they live in such expensive cities. The median home price is now just $170,000, and with mortgage rates where they are, anybody looking to buy such a home isn't going to get any kind of benefit from the mortgage-interest tax deduction. So let's go ahead and abolish it: it's a great way of raising revenue for the government while leveling the housing playing field for everybody else.

Update: Megan replies. I was going to get into the whole issue of other, non-mortgage deductions, but didn't; suffice to say that yes, they matter, but in the grand scheme of things all you need to do is look at the number of people who itemize anything (they're very few, and they're rich, and they're overwhelmingly in New York and California) to see how little this issue matters to Middle America.

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