Upside-Down Home Loans and the Mortgage Crisis

Burning House Made of Money
At the turn of the century, the real estate market was on fire. Men and women of all ages in all walks of life were looking at their current job, their paycheck, and their financial situation, and telling themselves, I need to get into the real estate business. Property prices soared through the roof, borrowers were taking out record-breaking home loans, and the younger generations looked at real estate price tags with open mouths and wide eyes, wondering how on Earth they would ever afford to put a roof over their heads.

Then the unthinkable happened: America’s economy collapsed in 2008.

Nationwide, home loan borrowers watched in awe as their property values declined by 30 percent or more. For those who put an adequate amount of money down on their purchase, this was a severe blow, but something manageable. For the vast majority of recent homeowners, however, this was something out of a dark and twisted nightmare.

The No-Doc Home Loan with Zero Down

While experts have always advised homeowners to put at least 20 percent down on a new home loan originations, big banks and financing originators did away with that requirement through what became known as “no-doc loans.”

No-doc home loans referred to financing in which an originator would simply ask borrowers what their monthly income was. When borrowers replied with a number, the originator would say something along the lines of, “You know, if you made this much more, you could qualify for a much larger home loan and secure the house of your dreams.”

Then, as if out of some twilight zone, the originator’s would pull an Enron-esque move and agree to just put that higher number down—requiring no documentation as proof for the borrower’s income. It was that practice which led to the "no doc" prefix being tacked onto the name of these home loans.

In addition to blatantly lying about borrower’s income, originators then began waving the usual practice of a large down payment.

The originators’ thinking? With such a high amount of income—which was a complete lie to begin with—there wasn’t a need for a large down payment since these homeowners would have no problem satisfying their obligation to the lender.

Thus began the rise of a huge amount of unsecured home loans being held by people who couldn’t afford them.

The Underwater Epidemic

On January 24, 2008, the National Association of Realtors (NAR) released a horrifying study that took a look at 2007’s home prices.

“It’s the first price decline in many, many years and possibly going back to the Great Depression,” was what NAR had to say about the previous year’s trend.

The New York Times reported that just one month before NAR’s report was released, in December, 2007, home prices dropped by 2.2 percent. In a single month, home values plummeted by thousands and thousands of dollars.

Those who took out no-doc home loans started to feel the weight of their decision, as their home’s value dropped and, without that initial down payment to act as equity security, they found themselves owing far more money on their homes than it was worth.

In some cases, these homeowners owed 150, 200, even 300 percent of their home’s value. Homeowners impacted by this loan-to-value (LTV) crisis were colorfully described by experts as owning “underwater” homes, since the home’s values dipped below the threshold of being worth anything—signifying a drowning or dying asset.

According to an article on Trulia, an online real estate listing service, about 12 million homes in secured by existing home loans in 2011 were underwater.

That’s 24 percent of our nation’s mortgage-backed homes.

The Nation’s Response

“A large number of Americans who are underwater on their mortgages would be better off financially if they walked away from their homes,” Brent White, a Law Professor at the University of Arizona, told Business Insider.

Walking away from a home is the term given to those who cannot afford to repay their home loan, so they decide to stop paying their monthly bill. Those who "walk away" abandon their mortgage agreement, and default on their financing.

Similarly, strategically defaulting is a more gutsy form of walking away, in which the homeowner is financially able to repay their home loan, but decide not to. Strategic defaulters take a look at their monthly home loan payments, compare that to the current value of their home, and say, "Enough is enough." 

And the nation’s underwater homeowners did exactly that.

Experian, one of the big three credit rating agencies, reported that by the end of 2008 strategic defaults hit a record high: one in five mortgage borrowers willingly let their homes fall into foreclosure.

That was 20 percent of the nation’s mortgage-backed homes.

Since that time, the number of strategic defaulters has been steadily falling, but it’s remained in double digits since the collapse.

What’s the Cure to Our Nation’s Illness?

The government has recognized the severity of housing crisis, and they’ve tried to help—but so far their attempts have been largely unsuccessful.

They began with the first Home Affordable Refinance Program (HARP), which, by all accounts, was a complete and total failure.

Other programs, such as the Troubled Asset Relief Program (TARP) and the Home Affordable Modification Program (HAMP) have been introduced and tried, but they lacked success as well.

Just this year, however, the government re-released the HARP program, in what’s been dubbed HARP 2. While it’s only been active for a few months, the changes made to the program seem promising—but it will take a little longer before we know whether or not this is successful.

In the private sector, banks have been toying around with home loan modifications, principal reductions, and relaxed short sale terms, but widespread relief has yet to be seen.

More than four years ago, we saw the beginning of what some experts have called the Great Recession. Experts have yet to find a cure for this economic downturn, the illness that’s forced our nation to be on a four-year bed rest. But we take it day-by-day and continue to drag on.