Morton's Fork

This post started as an update to my continued fascination with the changes in American business ethics (an oxymoron if ever there was one). The God and Game Theory series lacked structure and was, at times, a bit over the top, but the subject is important. The world is changing and changing very fast. The substitution of game theory for God began back in the late 60s or early 70s. I would contend the first truly egregious example was the exploding Ford Pinto. Ford knew that in certain types of rear end collisions the Pinto gas tank would rupture and their customers would be burned alive. They calculated the number of accidents multiplied that number by an average law suit settlement and decided it was better to pay the surviving family members and their attorneys than it was to reinforce the gas tank at $15.00 per car. At the time game theory did not exist as a mathematical discipline outside of a few foundational academic papers, but Ford already understood game theory.

A number of events pushed this kind of ethical decision making process out of corporate board rooms and into the main stream of American life, but by far the most significant event in this story is the subprime mortgage crisis and the subsequent collapse of the housing bubble. This story is still unwinding and the end is not yet is sight. Yesterday I talked to a real estate saleswoman, a friend and neighbor. She is on the verge of despair. Nothing is moving. Houses in my neighborhood have dropped in value from $450 K to $300 K. When the prices fell below $400 K everyone trying to sell their house just pulled it off the market, postponed their retirement and move or turned their house into a rental unit and left Poolesville. We had one house in the neighborhood repossessed by the primary mortgage holder. The former occupants did about $70 K worth of damage on the way out, leaving the bank with a property that sat on the market for about a year before it sold at something less than $200 K. Now a nice young couple and their children are restoring this house to its former state as a live in work project.

Multiply these events by a million and what do you get? Nationwide, due to an increase in rental properties, the percentage of American home ownership is dropping for the first time since the stagflation of the Carter years. In those days, it was cheaper to rent than it was to buy because mortgage rates were obscenely high. Today, in many markets, it is cheaper to rent than buy because home owners (banks included) want to sell their homes for what they think they are worth not what they are worth. It is also the basis of “strategic defaults,” the so called jingle letters. If the value of the house has fallen so far the mortgage payment has no basis in reality and the owner has no significant equity position in the property, it is in his rational self interest to just walk away and let the bank deal with the problem. In some instances, such as severely blighted working class neighborhoods in the rust belt, the bank is refusing to take possession of the property or pay the taxes, leaving cities like Detroit in a terrible state. Not only are they not receiving their property taxes but they are watching empty houses becoming campgrounds for the homeless or safe houses for drug dealers. To solve these problems, Flint, Michigan is bulldozing entire neighborhoods and turning them back into fields.

All this has left the banks and owners of mortgage backed securities skewered on what Mish Shedlock has termed Morton’s Fork.

From Wikipedia

A Morton's Fork is a choice between two equally unpleasant alternatives (in other words, a dilemma, or two lines of reasoning that lead to the same unpleasant conclusion.
The expression originates from a policy of tax collection devised by John Morton, Lord Chancellor of England in 1487, under the rule of Henry VII. His approach was that if the subject lived in luxury and had clearly spent a lot of money on himself, he obviously had sufficient income to spare for the king. Alternatively, if the subject lived frugally, and showed no sign of being wealthy, he must have substantial savings and could therefore afford to give it to the king. These arguments were the two prongs of the fork and regardless of whether the subject was rich or poor, he did not have a favorable choice.

If the banks renegotiate the mortgage to reflect the current realities of the housing market, they will lose substantial amounts of money over the life of the mortgage. If they do not renegotiate, more and more Americans are telling their banks to go pound sand, walking away from their house, and leaving the bank with a damaged property no one wants to buy. Since the official unemployment rate is at the near depression level of 9.8%, there is no guarantee that renegotiated mortgages will not fail in a few months anyway. This is happening. A substantial number (I believe it is actually a majority) of households with renegotiated mortgages are defaulting within a year.

And remember, there is a glut of rental properties. The cost of renting these properties is dropping. The people walking away from their mortgages can rent a nice home for less than their mortgage expense. Don’t look for a significant rebound in housing prices any time soon.

Jeremiah 8
[20] The harvest is past, the summer is ended, and we are not saved.