Friday, August 1, 2008

The Economics of Walking Away

We are always hearing about people who walk away. There seem to be two groups in the walking away stories. The first group are jumping ship early since they know they will not be able to the resets and recasts. The other group, and the real "walk away" are those that can afford the house payments but are choosing foreclosure.

Usually the latter group is looking at the choice as a financial one for their own best interests. The few real examples of this group are people who are extremely underwater - 40%, 50% even 70% percent - and have calculated that the time to restore their credit will be sooner than the time it will take to have any equity.

In an article form the BBC titled America's Price Time Bomb we are given an example of someone who is 40% underwater and has decided that her choice involved her house versus her retirement funds. She chose her long-term future (retirement) over her immediate future (foreclosure).

The article also discusses the changing social stigma from walking away. But we noted back in April (here), with plummeting house values there will be little stigma left with foreclosure in parts of the country.

Some of the most powerful parts of the article come at the end. Let's take a look -

It is impossible to know for sure how many of the people who are now walking away from their homes could have gone on paying their mortgages.

But Professor Nouriel Roubini of New York University, one of the first economists to warn of the dangers of the American house price boom, believes the number of people positively choosing to walk away is growing rapidly.

"This is becoming a tsunami of voluntary defaults," Professor Roubini says.

"The losses for the financial system from people walking away could be of the order of one trillion dollars when the entire capital of the US banking system is only $1.3 trillion.

"You could have most of the US banking system wiped out, so this is a total disaster."

Losses of even a fraction of that magnitude would be huge. One trillion dollars in write-off? A wipe-out of the US banking system? These predictions coming true could make The Depression look like the good old days. In the next coming weeks and months there will probably be more moral discussions surrounding walkaways. There has already a bit of scolding regarding walking away as speculators. We expect this rhetoric will be ratcheted up a few notches to try to make the stigma and the economic scars worse than ever.

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