Casting Blame for Underwater Housing Defaults

According blame for unsavory circumstances is just human nature.  Blame is the ointment of the psyche — it relieves, if only moderately, the discomfort we feel when things go wrong and we suffer collateral damage as victims.

Even when there is no bleed-over that effects us directly or indirectly, blame is still a common psychological need.  When a surgery goes wrong, juries may compensate victims for medical errors due to nothing more salacious or untoward than simple human error — as though doctors should reasonably pay millions for something as common as human fallibility.

My wife lost her glasses this week, and my son lost his cell phone.  Both asserted that these events were a consequence of human error, and both objected to paying heavy fines for it.

Of course, surgical errors have heavier consequences and warrant higher remuneration, and, indeed, this explains a portion of the high insurance costs paid by doctors … costs which are passed down to institutional payers (insurance) and, eventually, to patients and employers in the form of higher insurance premiums, and, ultimately, to consumers and taxpayers in the cost of goods, services, and taxes.  Human imperfection is expensive.

Yes, blame is a necessary convenience, and, when there is no one else to blame, the victim is always an available target, under the logic of “Well, he should have … (fill in the super-human choice that you would ideally have made under the same circumstances).”  But, in the crisis or pivotal moment when the choice is upon us, it is human nature to make decision errors due to nothing more complex than the lack of complexity in human decision-making.  The logic center of the brain can only hold 7 ideas at a time (on average), and that means we are prone to error, because important decisions require more robust thinking than we are wired to produce.

Blessedly, we are also prone to amnesia when it comes to our errors — quickly forgetting our imperfections, while committing to long-term memory our successes.  If we had equal and vivid recall of our failures, we would avoid any measure of complexity or risk — which means we would not have children, start businesses, get married, turn on the stove, or have left the caves that provided protection to our forebears.

Of course, there are some people and groups who are favored targets for blame.  Mothers-in-Law come immediately to mind, as do lawyers, and bankers.  In fact, anyone who is more successful, good looking, powerful, or incongruously lucky represents a ripe target, because there must be an unsavory explanation for their more favorable position compared to our own.

With mortgage defaults due to underwater loans, this issue of blame is everywhere.  Underwater loan defaults follow from homeowners walking away from houses whose values have declined significantly below the loan amount — rather than due to an inability to pay the note each month.

The problem is large, and it impacts all of us.  High home-loan defaults make bankers leery of lending, and, if lending, increases the interest charged on loans.  Defaults lower the value of homes as resales glut the market and increase supply to the benefit of buyers motivated to purchase at the lowest price.  Reduced home values make consumers more reticent to consume due to a decline in the wealth effect — we are more confident consumers when the value of our investments is high enough to make us feel secure, solvent, and wealthy.  And, of course, lower home values undermine tax receipts to government, which promotes higher taxes.

Given all this fiscal carnage, someone must be to blame, and the candidates are numerous.  Some, for example, have argued that lenders are to blame, due to their lowered lending standards, aggressive marketing efforts, and willingness to lend to borrowers who lacked the necessary income to safely buy homes (financially).  So, the bankers are to blame.

Others maintain that the system which allowed lenders to off-load loans to secondary institutions (Fanny and Freddie, as quasi-government agencies, in particular) promoted lower standards by the original lenders.  So, government is to blame.

Some contend that breaking up large pools of home loans into investment vehicles — CDOs — and, thereafter, into secondary mixtures — CDO-squareds — is the cause.  So, Wall Street is to blame.

Of course, with no one in the financial chain prepared to take responsibility or suffer the losses, those who seek to legally limit the exposure of their clients bear some responsibility, and that, of course, would mean the lawyers are to blame.

Even more nefarious (frightening because it is mysterious, obscured by complexity, and international) are the derivatives, which provide default insurance for some parties and a means of gambling for others.  So, the Third-World Order must be responsible.

And perhaps the favorite target of blame is the homeowner.  If you were so poor you couldn’t afford the water necessary to generate a potty break — much less the pot to hold it –, it doesn’t take a rocket scientist to realize you have no business buying a home … even if the banker will lend you the money and begs you to take the adjustable-rate mortgage.  So, the homeowner is to blame.

Personally, I think all of this is wrong … not because each of these favored targets are without blame, but because those entrusted to prevent it were alseep at the wheel … and I’m not talking about Mothers-in-Laws.

Homes are also real estate, and, regardless of whether they were bought as investments, their value and potential for appreciation or decline make them investments.  They possess sufficient value that we treat them as we do other investment vehicles of substantial value.  At closing, we sign contracts for the property and, unless purchased with cash, the mortgage is a contract that must be signed and witnessed.  Thereafter, we insure the purchase against foreseeable disasters — such as the overflowing toilet in my son’s bathroom a couple of years ago.  In fact, the cost of a home and the property on which it sits represents the single largest investment of capital most of us will every make, and, after the empty nest arrives and retirement arrives, the home-value realized when it is sold constitutes a substantial portion of our retirement savings.  The homeowner is, therefore, right to consider the home as something of significant value and to give it a prominent degree of importance.

The lender, on the other hand, has an interest in making certain the homeowner represents a viable business partner.  Of course, this is less of a concern if the lender plans to offload the loan, but, under normal banking conventions, the lender wants assurance that the borrower can repay the loan and is a low risk of default.  That, however, is just one lender concern, but there are others to which we will turn when next considering the interests of the insurance company.

The insurance company is primarily interested in the value of the property and the risk associated with injury to it.  If the borrower fails to pay on the policy, the insurance company suffers only the loss of revenues, because the lender is under no obligation to cover damages incurred when the account is in arrears.  So, the insurer is primarily concerned with damage and, equally important, fraud.

The threat of fraud includes paying claims when no damage occurred, but it also includes arson arbitrage, where the home is destroyed in an owner-set fire for the insurance proceeds.  The financially solvent owner has little motivation to perpetrate this crime if the amount payed on the claim equals the replacement value of the property — even if there were no threat of incarceration.  Instead, arson arbitrage is only lucrative if the property is insured for a value greatly in excess of its replacement cost.

Consequently, the insurance carrier has an interest in making certain that the home is appropriately and accurately valued, and the banker has the same motivation, as well.  As the lender, the bank has little interest in issuing a loan that exceeds the value of the property.  The higher the loan amount, the higher the interest payments — which increases the threat of default.  This is partly why jumbo loans (covering homes costing more than $400 thousand) require higher interest rates — to compensate for the increased risk of default due to the higher loan amounts.

And the homeowner/investor has an interest in identifying an accurate value for the property.  Overpay for the property, and the returns on investment when the property is sold is greatly diminished and, more importantly, the higher the amount paid in total interest during the life of the loan.  During normal times, the threat of inaccurate valuation threatens the homeowner more than the lender or insurance, because the homeowner cannot diversify this risk across a large number of customers and because this unique purchase constitutes the single largest non-diversified deployment of capital for the party in this transaction with the skimpiest pockets (financially).

In fact, lets compare the purchase of a home with other common investments undertaken by non-institutional investors (you, me, and our neighbors).  Most invest savings in mutual funds —  effectively, hiring professional money managers to allocate capital and perform the valuations for us.  The managers of mutual funds, therefore, are expected to value the stocks and bonds and real estate and precious metals that form the core of their holding-choices.

By contrast, a smaller number of us invest on our own account, and, when we do this, we take responsibility for valuing our purchases.

Now, it must said that most individual investors do a poor job of valuing, primarily because they lack the training.  During the dot.com bubble, thousands of average investors were willing to pay a price for JDS Uniphase that was 120 times the company’s reported earnings.  Clearly, they never learned to sipher — add, subtract, multiply, or, in this case, divide.

Regardless, the competent individual investor values the revenue streams of the bonds they purchase (compared to the price), and, in the case of corporate bonds, consider the default risk of the issuing company and the value of the collateral designed to secure the bond.  If purchasing stocks (equities), the competent individual investor will consider the various reported or readily available ratios, such as PE, PB, PS, P/NAV, or, delving deeper, perform the discounted cash flow analysis to identify the approximate value of the company (on a per-share basis).

With real estate, this is more difficult.  If we were to value a prospective piece of real estate in the same way we would a stock, we would have to discard cash flows from consideration (assuming the property is not revenue generating).  The same holds for price to sales and P/NAV (unless undertaking significant modifications with P/NAV).  Even if valuing it on a price to book basis, the investor needs to be more accurate in the estimation of book value of a home than when doing so with long-established companies, because inflation related to book-value assets provides no margin of safety for the home buyer — as it does for the stock investor.

This means the competent real estate investor needs to value the current price for the building materials and labor, the pricing implications of builder taxes and fees, identify a reasonable ROI for the builder, and factor in the location premium, among other considerations.  In fact, those considerations would include the degree to which the market as a whole is over- , under- , or fairly-valued, in general.  These contributors to the price of a property are not publicly reported in a convenient Securities and Exchange filing, as it is with bonds and equities, and they certainly are not audited by an independent, certified, and bonded auditing firm.  Instead, the home buyer (to say nothing of the lender and insurance firm) would be operating under a system of Caveat Emptor (“Let the Buyer Beware”) if not for home valuation inspectors.

In fact, regardless of the degree to which the system became dysfunctional prior to the real estate crash, it relied on home valuation inspection to prevent the market from becoming an extreme and speculative bubble.  If the values had not represented a disconnect to intrinsic value, lenders would not confront the need to sell properties at such a substantial loss in comparison to the original loan amounts, the CDOs and CDO-Squared’s would not have been so severely undermined.  Instead, defaults would more closely represent an even exchange between the defaulted loan value and the actual value of the property.

In short, the system relied on valuation inspectors to do more than say “the house is sound and worth the price because the same model in the same neighborhood sold for a similar price last month … that will be $350 and I’ll mail you a copy of my report.”  In fact, what home buyer hasn’t thought, “The inspector spent 90-minutes looking at the house and is charging me lawyer’s rates for briefly climbing into the attic and doing a flash-light scan of the craw space … should I change careers?”

Well, the answer is that the fee was for more than just looking at the house and blessing the price, but, instead, included specialized knowledge about the costs of construction and the economics of the housing market.  It was on their independent and expert judgment that the whole of the system relied to serve as the trip-wire alarm if prices so severely exceeded intrinsic value as to make the loans suspect, the insurance invalid, and the buyer the victim of gouging.

And this is why most states passed legislation requiring home valuation prior to purchase.

When prisoners riot, we blame the felons, the guards, the parents, and the warden.  But after prisoners riot, we hire more counselors.  This strikes me as a mistake.  We should fire the counselors and promptly hire their replacements.  Why?  The counselors should have seen it coming.

In the case of Wall Street, it may have been the case that the SEC was understaffed and insufficiently trained.  With home valuation inspectors, the training may have been insufficient and the standards egregiously lax but the prices charged determined staffing, and none of us got what we paid for.

[Note:  I’ve written this piece as a thought response to an article read on an above-average investments discussion board.    The Crawford’s have not lost their home, nor are we in jeopardy of that happening.  Contributions, however, to the Robert Wealth Enhancement Fund are always welcome, as long as they do not trigger gift taxes or IRS suspicions.  If you are a close relative and my wife or I are beneficiaries of our your estate, we would prefer to wait for your donation until after your regretable demise.  If it is true that “to whom much is given, must is espected,” we would prefer to keep expectations low.  I know my limitations, even if my bride has none.]