In Part I of this series on Strategic Default, we discussed financial circumstances that make mortgage foreclosure the best option for people who owe more on real estate than the real estate is worth–people who are “underwater” on their mortgages. As was discussed, the choice to walk away from such a mortgage is a no brainer in terms of the economics involved. But is it morally right to allow your property to go into foreclosure? To answer this question, we need to take a look at and understand how this economic crisis came about. There will be countless books written on this subject, so this is going to be a basic overview.
Loose Money
Aside from having a messed up monetary and financial systems, which you can learn much more about at www.MindOfMoney.com, the immediate cause of the current situation was a combination of relaxed credit standards (“loose money”) and relaxed down payment requirements. When credit standards are relaxed, it becomes easier for people to get loans. Here are a few consequences of relaxed credit standards:
1. People with good credit can borrow much more money than would normally be permitted.
2. People with bad credit are permitted to borrow money, even though they might have previously been “unqualified” for a loan.
3. Interest rates are reduced, sometimes drastically.
4. Terms offered by banks often seem too good to be true.
Relaxed Down Payment Standards
Relaxed down payment requirements are easy to understand. Traditionally, banks required borrowers to make down payments of 20%. FHA and VA standards were lower, but borrowers had to meet specific requirements to qualify for those types of loans. What contributed to the current economic crisis in real estate is that fact that just about anyone could qualify for a mortgage and obtain between 95% and 100% financing. That’s correct: In some cases, there was no down payment required at all!
What happened as a result of loose money and relaxed down payment requirements is that people began speculating in the real estate market. This is the part where individuals are partly to blame for the meltdown. Speculation is gambling. It is the act of trying to buy low and sell high, and it happens every day in the stock market. With real estate, however, speculation seemed safe. That’s because we have been conditioned to believe that real estate always increases in value. The old adage “It’s the one thing they’re not making any more of” comes to mind.
The truth of the matter is that anything that becomes the subject of speculation will fluctuate in price. Both upward and downward price fluctuations can be drastic. The reason is that price becomes disconnected from value. People buy with the intent to sell for a profit. But when there are no more buyers, when the music stops, prices fall drastically. That is exactly what is happening in the U.S. right now.
The big difference, however, between real estate and other assets that become the subject of speculation (e.g. stocks, commodities, etc.) is leverage. In the stock market, when a stock loses value, investors lose real money which they had to provide upfront. With real estate, because of the existence of mortgages and 100% financing, speculators don’t have real skin in the game and nothing to lose. When millions upon millions of speculators stop paying their mortgages, the effects trickle down to everyone–responsible long-term homeowners included–as prices spiral downward.
Read the next article in this series to see why a Strategic Default can be the morally correct choice.
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