A recent article in The New York Times has created some controversy by suggesting that wealthy borrowers were more willing to strategically default because they are “more ruthless” than the rest of us. While it is true that the default rate on 1M+ mortgages is now significantly higher than on smaller loans, the reasons why remain far from clear. And, those reasons could end up having a profound impact on real estate prices in high-end communities throughout the Bay Area and around the country.
If social mood is indeed beginning to shift in high-end areas, the housing collapse may indeed be entering it’s next leg down.
The Ruthless Rich
Here are some snips from the Times article, followed by some different takes from other influential bloggers and publications:
David Streitfeld writes for The New York Times: Biggest Defaulters on Mortgages Are the Rich
More than one in seven homeowners with loans in excess of a million dollars are seriously delinquent, according to data compiled for The New York Times by the real estate analytics firm CoreLogic.
By contrast, homeowners with less lavish housing are much more likely to keep writing checks to their lender. About one in 12 mortgages below the million-dollar mark is delinquent.
Though it is hard to prove, the CoreLogic data suggest that many of the well-to-do are purposely dumping their financially draining properties, just as they would any sour investment.
“The rich are different: they are more ruthless,” said Sam Khater, CoreLogic’s senior economist.
Lenders are fearful that many of the 11 million or so homeowners who owe more than their house is worth will walk away from them, especially if the real estate market begins to weaken again. The so-called strategic defaults have become a matter of intense debate in recent months.
The CoreLogic data suggest that the rich do not seem to have concerns about the civic good uppermost in their mind, especially when it comes to investment and second homes. Nor do they appear to be particularly worried about being sued by their lender or frozen out of future loans by Fannie Mae, possible consequences of default.
“Those with high net worth have other resources to lean on if they get in trouble,” said Mr. Khater, the analyst. “If they’re going delinquent faster than anyone else, that tells me they are doing so willingly.”
The Christian Science Monitor suggests that the Rich don’t have the same pressures to pay their debts that the rest of us do (but doesn’t explain why).
The wealthy likely, rationally, believe that walking away from a debt laden deflated home is the best financial choice that they could make while individuals of more modest means face more scrutiny and pressure to make good on their debts.
Felix Salmon argues that a greater percentage of these high-end defaults are probably forced, not strategic, and by people in real trouble.
Streitfeld’s piece is bylined Los Altos, California, a town where the median home is $1.5 million. In such towns, you don’t need to be a millionaire to find yourself in a multi-million-dollar home. Let’s say you’re a tech geek who found yourself with $200,000 for a downpayment on a house over the course of the dot-com bubble. So you buy a million-dollar home, and then start up a series of companies. You need to live, of course, and you can’t afford to pay yourself a salary, so you do two or three cash-out refinancings on a home which by 2007 was worth $2.5 million. Before you know it, you’ve got a $2 million mortgage, no way of paying it, and a home which is worth significantly less than the mortgage. Realistically, you have no choice but to default.
Megan McArdle doesn’t buy it. She argues that most of the people with million-dollar mortgages live in expensive communities that grew wildly during the bubble. Many of these areas have since seen huge price declines.
This is just nonsense. The CoreLogic data tell you how many people are in default. They do not tell you how concerned those people are about the civic good, nor what may or may not be worrying them in those 3 am moments when they contemplate the wreckage of their housing dreams.
We don’t even know that these people have more resources to draw upon, as Mr Khater implies. All the data I’ve seen show that millionaires–aka “high net worth individuals” are not particularly likely to live in million dollar homes. Who are? People who live in areas with expensive real estate. And where is the expensive real estate? Why, often in the areas that experienced the biggest inflation during the housing bubble.
Shouldn’t people with million dollar homes have more resources to fall back on? Absolutely. The best you can say about people in that situation is that they were probably living beyond their means well before things got to this point. But the bubbly areas–especially California–were characterized by a grim competition in which the houses in the good school districts went to the people who were most willing to overstretch themselves. Those people didn’t build up a big reserve of savings that might allow them to meet the mortgage payments while they find a new job, because they were pouring everything into securing the best possible education for their children.
Ross Douthat doesn’t buy it either. He argues that the Rich are defaulting because, well, they aren’t rich anymore.
The rich are different from you and me. They know how to game the system.
That’s one interpretation, at least, of last week’s news that Americans with million-dollar mortgages are defaulting at almost twice the rate of the typical homeowner. It suggests an infuriating scenario in which the average American slaves away to keep Wells Fargo or Bank of America off his back, while fat cats and high fliers cut their losses and sail off to the next investment opportunity.
That isn’t exactly what’s happening, most likely. Just because you have a million-dollar mortgage doesn’t make you a millionaire, and a lot of the fat-cat defaulters probably aren’t that fat anymore.
Stretched Too Thin
Working in some of the East-Bay’s high-end communities like Danville, Alamo, Piedmont, and Orinda, I would suggest that everyone here is at least partially correct. There is a lot of “real money” in the Bay Area, but not enough to account for all of the properties priced at 1M+ during the boom years. So, while many of the 1M+ buyers were (and still are) financially-sound, many others were stretched too thin, perhaps betting on being able either sell or refinance if they ever got into trouble.
David Streitfeld is probably correct in reporting that some of the “real-money” buyers are considering strategic default and perhaps are more willing to treat their home more like an investment. But, he ignores that most million-dollar mortgages belong to more regular people who stretch and sacrifice to enjoy the benefits of living in a higher-end community.
Personally, I don’t see many legitimately-wealthy people choosing to strategically-default. Where Streitfeld sees reduced pressure to honor obligations, I see more pressure simply from the fact that legitimately wealthy people have no other ways to justify the decision. Where regular folks could morally justify walking away by saying that the money either goes to the mortgage or towards their kid’s college education, the wealthy, by definition, can already afford both.
What Will Drive Prices
The fate of these high-end communities will largely be determined by two factors: exactly how many of these 1M+ buyers can’t really afford it, and how successfully will their Alt-A and Option-Arm loans be modified.
Too many 1M+ buyers were able to buy such expensive homes because they used shorter-term, riskier financing. Now, many of these 5-year-interest-only loans are beginning to reset (lower, for now) and popular Option-Arm loans are beginning to recast. As you can see from the chart, we’ve got another 3 years of reset trouble ahead of us.
If prices continue to stabilize and loan modification programs can find ways to perform better, there is a chance that there won’t be too many high-end defaults here in the Bay Area. But, if prices continue to fall and modifications continue to fail at alarming rates, then those considering walking away will have more reasons for doing so.
If, as the Times suggests, the wealthy really are more prone to walking away, then social mood could darken very quickly. If strategic default ever becomes socially acceptable in million-dollar neighborhoods, then look out below.