Prime Time

We are nearing the end of the subprime crisis, but this is not exactly grounds for celebration. There are still millions of low- and moderate-income homeowners who are facing the loss of their house through foreclosure. Nothing currently on the horizon seems likely to change this fact.

The reason the subprime crisis is about to fade from the headlines is that the mortgage crisis is moving upmarket. The rate of foreclosures among people with prime loans has been rising rapidly. By the end of the year, the foreclosure rate on prime loans will be where it was with subprime loans just a few years ago. The reason is simple: House prices are plunging.

The latest data show house prices were falling at a 16 percent annual rate in the fourth quarter of 2007 and were already down by almost 8 percent from their year-ago levels. In several cities, the rate of price decline was considerably more rapid. In San Francisco, prices were dropping at a 22.2 percent annual rate, in Los Angeles at a 24.7 percent rate and a 27.0 percent rate in San Diego.

This rate of price decline means millions of recent homebuyers, who put little or nothing down on their home, now have houses that are worth less than the value of their mortgage. This is important for two reasons. First, homeowners with no equity in their homes have no margin for error. If they lose their job or get a serious illness, they cannot borrow against equity to pay their mortgages through the bad times.

This is the situation that has caused many subprime homeowners to lose their homes. While predatory mortgages are a key part of the story in many cases, if the house was worth more than the value of the mortgage, it would always be possible to borrow against the equity to meet a monthly mortgage payment. If house prices were not falling, the subprime crisis would not be happening.

However, there is another dimension to this story. When the house price is less than the value of a mortgage, there is a strong incentive to give up a home even if the homeowner is able to pay the mortgage. The logic is simple. Suppose a homeowner owes $400,000 on a home that is now worth just $300,000, a situation common in places like Los Angeles, Miami and San Diego. If the homeowner continues to pay their mortgage, they will have eventually paid $400,000 (plus interest) for a home that is worth $300,000. That’s not a very good deal.

Alternatively, suppose the homeowner decides to buy the comparable home across the street for $300,000, and stops sending the mortgage check to the bank each month. The bank will presumably foreclose on the first house, but the homeowner has effectively pocketed $100,000 on the day he moves across the street. That would be a good payday even for the Wall Street crowd. Of course, the bank will take a big hit, since it will not be able to recover anything close to its original $400,000 loan, but that is not the homeowner’s problem.

Is it moral to just walk away from a loan and leave the bank holding the bag? That’s an interesting question.

We live in a country in which CEOs can run a corporation into the ground and then walk away with pay packages worth tens, or even hundreds, of millions of dollars. Equity and hedge fund managers, who rank among the richest people in the country, have successfully lobbied Congress so that they pay a lower tax rate on their earnings than schoolteachers and firefighters. After walking away with this multi-million dollar tax break, at least one prominent member of this crew has been leading the charge to cut Social Security, pointing out he doesn’t need his Social Security check.

Then, we have the pharmaceutical companies and insurance industry. They designed a Medicare drug benefit that will unnecessarily add hundreds of billions of dollars to federal spending over the next decade, and needlessly complicate the lives of tens of millions of seniors. Of course, this benefit will add hundreds of billions of dollars to their profits over this period. And then, we have Halliburton, Blackwater, and the other defense contractors in Iraq and Afghanistan. Nothing needs to be said about this one.

In this world, is it moral to profit by walking away from a mortgage you can actually afford to pay? Perhaps President George “WMD” Bush can address this issue for the country in a fireside chat.