When Homeowners Who Can Pay, Don't Pay

In the world of credit, there are two key variables which determine how risky an asset is. The first is the creditor's ability to pay – in order to gauge that you look at income, assets, that kind of thing. The second is much harder to gauge: the creditor's willingness to pay. Just because someone can pay a debt, doesn't mean he will.

Today real-estate blog Calculated Risk is worrying about credit problems among prime home loans. Not subprime, not alt-A, but prime: the borrowers with the very best credit. "As housing prices fall," says the anonymous blogger, "more problems will most likely emerge."

He's right, but I'm not sure about the degree to which this is a function of the looser underwriting cited in the WSJ article he's blogging about. Underwriting can only really concern itself with ability to pay, and these borrowers are the very definition of prime credits. The problem, as I see it, lies rather with their willingness to pay.

When I was house-hunting in 2005, I had drinks with a senior Wall Street analyst who even back then was worried about frothiness in the property market. He advised me to put down the smallest downpayment I could get away with, and take out the biggest-possible mortgage. If house prices went up I was golden, while if house prices went down I'd lose only my small downpayment and stick the bank with the rest.

Now, legally, mortgages don't work like that. If I borrow money to buy a house, I'm obliged to repay that money, whatever happens to the value of the home, and even if I sell it at a loss. Sometimes, a bank will accept a "short sale", for less than the outstanding amount of the mortgage, and write off the rest of the loan. But often, the bank won't. The sale proceeds are applied to the mortgage balance, and whatever's left remains an obligation of the (former) homeowner, and is just as real a debt as anything they're carrying on their credit cards.

That's the way the bank sees it, anyway. Homeowners often don't see it that way at all. They think that they shared the price of the home with the bank, and that they're sharing the risk of the home dropping in value with the bank, too. If they lose their home or they sell it after it has dropped in value, they're not likely to happily pay the bank everything it's owed.

And when homeowners start thinking like that, default rates rise.

Much of the time, these are people who could, if they had to, raise the money to make their mortgage payments in full and on time. They are prime credits, after all. But homeownership is an emotionally fraught thing, and people don't always do the legally right thing if they're in the process of losing hundreds of thousands of dollars. That's where the big risk with prime mortgages comes from. And I'm not sure that you can really blame the underwriters for it. After all, it's one thing to make big mortgage payments in order to pay off a house. It's another thing entirely to make mortgage payments after the house has already been sold.