Walking Away from Underwater Homes

A phenomenon that we have witnessed with increased frequency lately is the act of homeowners walking away from their mortgaged homes. Not only is this a new phenomenon, but it is also quite disconcerting for the stability of the housing market. 

When a homeowner applies for a mortgage, the banks receive an appraisal on the home as part of the application process, and if accepted, homeowners are given loans for the appraisal amount or some fraction of the appraisal amount. Very commonly, homeowners must put down 10 or 20 percent of the appraised value and take a loan for the rest. During the years leading up to the crisis, however, it was not uncommon for mortgage lenders to give loans with no down payment at all.

In the ensuing years home prices declined at unparalleled rates and unheralded speed.  So what ensued were homeowners that had outstanding mortgages for far more than the home was now worth.  Homeowners were now on the hook for mortgages well exceeding the value of the home.  Understanding this, many homeowners simply walked away from their homes – leaving the home to be foreclosed.  

Two important conditions exacerbated this phenomenon. The first is economic; the less one is forced to down-pay on a home, the greater the chances that the home will go underwater (the home price will fall below the value of the mortgage), creating an incentive to walk away from the mortgage obligation. The second is moral; once upon a time homeowners would go to their local mortgage lender for a loan. It was a local mortgage lender, a small shop, where the homeowner received the mortgage. The in-person connection created an ethical obligation to repay the loan that was given to them. Today, most mortgage loans are made by large banks or even online.  People no longer feel the same moral obligation to repay a personal debt. 

And the Goldman Sachs Shareholders Have Spoken

In an interesting turn of events, Goldman Sachs shareholders have actually asked the bank to scale down bonuses and pass more of the profit to the investors. Although eerily familiar to my previous post on the subject, I doubt my blogging was a major contributory factor in the move.

You can read the story in more detail here.

A Few Words on Bank Bonuses

The issue of Wall Street bonuses is actually very interesting because it is more so a story of the history of Wall Street than anything else. The big investment banks, which are on track to dole out record bonuses just eighteen months after being bailed out on the taxpayers' dime, have long roots dating back to nineteenth century America. Before there were organizations like the SEC or NASDAQ, banks operated very much like law firms; banks were owned and operated by a group of partners. Goldman Sachs, Bear Stearns and Morgan Stanley were once all privately owned. This structure not only allowed the group of partners to have full control of how much money would be retained by the firm, but it also allowed the partners to decide how much to distribute in bonuses. In simplistic (but also quite truthful terms) the banks would decide what percentage of the profits to disperse to partners and what percentage to reinvest in the firm. What did these privately owned banks decide to do? For the most part, they dispersed about 50% as profits to their employees, and the other 50% was reinvested in the firm to help it expand.

Today Goldman Sachs, Bear Stearns and Morgan Stanley are all publicly traded companies. What this means is that they are no longer owned by a small group of partners, but rather, by a vast array of investors, both small and large. Who decides how much bonuses will be given to employees at these banks? Usually, an internal Committee on Compensation decides on bonuses. These Committees, however, are steeped in the old traditions of Wall Street and treat bonuses as though they are partnership disbursements when in fact the owners of these banks are shareholders. Let’s take a look at Goldman Sachs’ SEC filings. What is disturbing is not only the absolute magnitude of compensation, but also the upward trend in 2008 (the year in which Goldman received bailout money from the US Government).

We all know that the banks give out bonuses, but the real question is why do the shareholders of these companies continue to allow these banks to give out these extravagant bonuses – if the shareholders exerted control and vetoed the bonuses, the result would be higher retained earnings for the shareholders – and higher profits for the company. Something shareholders would certainly not be opposed to.

Some Lessons from the Past

Widespread speculation, lack of regulation, and lack of transparency - these were the headlines in 1929. Doesn’t this sound eerily familiar to the present crisis?

In 1929 it was hyped stocks. Today it’s a hyped housing bubble. In 1929 it was the absence of a Securities and Exchange Commission. Today it’s the absence of a competent SEC. The exotic securities that we created in the past decades (MBS, CDOs, CDS) may not have played a role in the crisis of 1929, but the principles are nevertheless the same.

While we may have failed to learn a crucial lesson in preventing future crisis from 1929, what we did learn was how not to aggravate crisis that do occur. I think Milton Friedman, the famed economist of monetarism, sums the crisis of 1929 best:

The Fed was largely responsible for converting what might have been a garden-variety recession, although perhaps a fairly severe one, into a major catastrophe. Instead of using its powers to offset the depression, it presided over a decline in the quantity of money by one-third from 1929 to 1933 ... Far from the depression being a failure of the free-enterprise system, it was a tragic failure of government. —Milton Friedman, Two Lucky People, 233

This time, Ben Bernake, the current Chairman of the Federal Reserve, took more drastic measures and pumped over $800 million. Why did Bernanke take such measures? As we have discussed before, in a nutshell printing more money lowers interest rates, and lower interest rates spur economic expansions – GDP and job growth.

Did the Fed learn its lesson in 1929? It appears so and It’s looking more and more like the current crisis might just be another garden-variety recession. Yes we have high unemployment (though not by historical standards) and the market crashed 50%, but that's still a far cry from what happened in 1929.