How Non-recourse loans amplified the American Housing Crisis
Firstly, let me say that the current Real Estate situation in America is a humanitarian disaster. It will be many years before the market returns to 'normal' behaviour. It is hard not to feel for all those people losing everything, and the numbers grow every day.
So what is this article all about?
There is one unique aspect of the American property market: The non-recourse nature of mortgages. Many Americans are unaware that most of the rest of the world do not operate on this system. I believe that although it is not responsible for the Global Financial Crisis (you can thank the banks for that), it has made the situation much worse than it would have been.
The ability to walk away from a property owing thousands of dollars while having other assets protected removes the risk from the borrower. When the property market is booming, many people find it hard to imagine a down side. You're young, you can probably afford a house, the bank is willing to give you the money, what's stopping you? In America the answer is: not much.
In the rest of the world it is a different story. If you default on your home loan and the bank forecloses, the debt remains. They can go after any other assets you have with the usual result being bankruptcy. No house, no car, no savings and no chance of getting a mortgage again.
This scenario is of course also possible with non-recourse loans: if you have no other assets or liquidated them all in trying to keep you house. The difference is that in a full recourse loan environment, this is not just possible but certain.
In a non-recourse system, if there is a possibility you will lose your house, there is a strong incentive to stop paying the mortgage and put your money somewhere else where it will be safe. There is nowhere to hide in a full recourse system.
Buying a house is therefore a much more serious proposition in most countries. The incentive here is to ensure you do not overstretch yourself and if possible build a financial buffer zone to protect against the unexpected.
So what is happening elsewhere?
In Australia, less risky home owner and investor behaviour has resulted in some interesting comparisons.
The ratio of average home price to average wage in America before the crash was around 3:1. Although difficult to measure now due to the chaotic nature of the market it is probably closer to 2:1
In large areas of Sydney, the current ratio is over 8:1 and this is down from a peak in excess of 10:1. These are amazing figures. 10 times the average wage to buy a house! How is this possible? Who can afford that?
The answer is in very strict lending requirements and large deposits combined with a supply shortage. Deposits so big they took many years to save and acted like a 'practice mortgage' giving people a very good understanding of how far they can stretch themselves safely.
Property prices have so far remained fairly stable despite the Global Financial Crisis. This will be tested over the coming year as rising unemployment puts pressure on prices. Despite this, the number of foreclosures is likely to be among the lowest in the world.
An obvious question is: "If a non-recourse system places the risk on the bank, surely they are more qualified to manage risk than the average home owner?". Unfortunately the opposite is true. When your whole financial life is closely tied to one transaction, you are extremely careful. The banks however, sees your $100,000 mortgage as insignificant when they have tens or hundreds of billion dollars worth of loans on their books. Your loan only becomes significant when a million other people get in the same situation as you and default on the loan. The result is the domino effect that is the Global Financial Crisis
So am I suggesting the United States adopt a full recourse system?
No.This would be too large a change that politically would not work. I'm afraid you are stuck with it. The answer lies in the regulation of lending practices to lower the risks taken by both the lender and lendee.
Having said that, I feel the most likely scenario is for the government to talk tough on regulating the banks before passing a watered down version of regulation that changes little.
Thats what my crystal ball is telling me. What does yours say?