Despite persistent and false memes to the contrary.
When a housing downturn gets big enough, there will be a mortgage crisis, and it will hit banks, shadow banks, and mortgage insurers no matter what the mortgage laws are: that’s what the US mortgage crisis has demonstrated. Yet many industry organs and media outlets in Canada, Australia, and other places with acute housing bubbles are trying to hide behind a false meme about US mortgage laws. What happened there cannot happen here, they say.
So we’re going to debunk this meme.
“Jingle mail” was a phenomenon during the US mortgage crisis when homeowners and small-scale investors, unable or unwilling to make mortgage payments, abandoned the place, figuratively mailing the keys to the bank. This phenomenon took various forms, such as homeowners who stopped making payments but continued to live in the home, sometimes for years, because the foreclosure process was hopelessly bogged down.
All this became a problem only after home prices dropped substantially below the amount people owed on their mortgages, which made it impossible for them to sell the home and pay off the mortgage.
This is rarely a problem in a rising housing market. Default rates are minuscule because it’s easy to sell the home and pay off the mortgage. And during these times, lenders hide behind these low default rates. But these default rates are only low because home prices are rising.
But when home prices drop sharply, after years of low-down-payment requirements and thus little equity cushion, suddenly soaring defaults are a problem that “came out of nowhere.”
Over the years, the meme spread that the US mortgage crisis happened because people could legally just walk away from their mortgages because banks could not pursue homeowners beyond recovering the collateral. Much of the commentary on why a US-style mortgage crisis cannot happen in Canada or Australia is based on this. And this is wrong.
In the US, each state has its own mortgage laws. In terms of residential purchase mortgages – not counting refinance mortgages – states fall into two categories: “recourse states” and “non-recourse states.”
A recourse mortgage allows the lender to foreclose on the home (the collateral) and then pursue the homeowner in court for the difference between the proceeds from the sale of the home and the outstanding mortgage amount (plus interest, fees, etc.). Armed with a deficiency judgment, the bank can go after the former homeowner’s assets, garnish wages, and the like, until the homeowner pays off the deficiency, settles with the bank, or seeks protection in bankruptcy court.
A non-recourse mortgage limits the bank’s recovery to the collateral. Once it has foreclosed on the home, no matter how large the deficiency, the bank has to swallow the loss and move on. And the homeowner has gotten rid of a big debt.
There are only 12 “non-recourse” states.
These are the only states where homeowners can walk away from a residential purchase mortgage without fears of being hounded by a bank (in some of these states, lenders may have recourse with other types of mortgages, such as a refis).
- North Carolina
- North Dakota
But 38 states and DC have “recourse” mortgages:
In the remaining 38 states and the District of Columbia, lenders are allowed to seek a “deficiency judgment” on residential purchase mortgages for the difference between what the property sold for and the outstanding mortgage debt, fees, interest, etc.
Hence, the vast majority of US states are recourse states. Of the big four states, New York, Texas, and Florida are recourse; only California is non-recourse.
There a numerous other differences between how states handle mortgage defaults. Florida has a “homestead exemption” that complicates matters for banks. Also, the property, especially an investment property, may be held by a dedicated LLC with no other assets, which limits recovery efforts by the bank.
States also vary in how much recourse the allow lenders. There are many nuances that blur the lines somewhat between “recourse” and “non-recourse” states. Note I’m just summarizing here. This is not legal advice. For legal advice, get a lawyer.
But what it boils down to is this: The mortgage crisis in the US was just as harsh in the 38 “recourse states,” including Florida, as it was in non-recourse states. Mortgage laws and the right to hound defaulted homeowners for their last dime have done nothing to slow down the housing crisis or the damage to the lenders and the mortgage insurers!
In Canada, mortgages are full-recourse except in two provinces that have non-recourse mortgages but with big limitations: Alberta and Saskatchewan. In Australia, the full-recourse mortgage is standard.
So Canada and Australia, with their majestic housing bubbles, face the same scenario that the US faced: when home prices drop sharply, some homeowners will abandon their mortgages because they’re unable or unwilling to make payments on an underwater mortgage or a money-losing investment property. This becomes a huge issue when people they lose their jobs.
If there are just a few cases, the banks may do what they can to get deficiency judgments. Even then, as in the US, people can seek protection by filing for personal bankruptcy. Usually, there is nothing left for the bank to recover. For banks and mortgage insurers, these are costly processes with minimal or no payoff at the end. So they often decide they’re better off not throwing good money after bad.
But under a tsunami of mortgage defaults, as in the US, lenders and mortgage insurers are totally overwhelmed and are even less likely to pursue defaulted homeowners for deficiency judgments.
In terms of a deterrent to commit jingle mail, so to speak, recourse mortgages are nearly worthless, as the mortgage crisis in the 38 recourse states has shown.
The Spanish fiasco.
For an even more drastic example on how draconian mortgage laws fail to deter defaults and thus fail in halting a mortgage crisis, look at the Spanish housing collapse, starting in late 2007, that eventually caused the Spanish banking system to implode, with numerous lenders going under, and with others getting bailed out.
Spanish homeowners borrowed under a draconian law where the banks, after the eviction, saddle ex-homeowners with the debts for life that continue to grow with fees and sky-high default interest that can eventually exceed the amount of the original mortgage. These people could not ever shed this debt. This draconian law was designed to protect the banks by being a brutal deterrent to potential mortgage defaulters. But this is precisely what it failed to do.
Clauses in this mortgage law have since been ruled “abusive” by the European Court of Justice, and Spain has changed the law.
So we know: even draconian deterrence doesn’t deter homeowners and investors from defaulting on their mortgages. A mortgage crisis happens because people at the margin – the most vulnerable 10% — along with people who’ve gotten in over their heads during periods of irrational exuberance, and investors throw in the towel, regardless of any theoretical rights that banks have in chasing after them. And this is why a US-style or Spanish-style housing bust and mortgage crisis can happen in Canada, in Australia, and other over-inflated markets.