The Volokh Conspiracy - Federal Regulators Take Over IndyMac:

Back in August 2005, at the tail end of the housing bubble (but when many VC readers were still berating me for saying [or, more precisely, siding with the many "doomsayers" who were saying] there was a housing bubble), I pointed out one future source of trouble for the housing and mortgage markets:

Just read that 61% of all new California mortgages this year are interest only, no money down. This is especially important because California (like a few other states, but, unlike, say, D.C. area jurisdictions where about 50% of the new mortgages are interest only) has a law requiring that all mortgages be "non-recourse," i.e., if a mortgagee defaults on his loan, the bank cannot attach any of the mortgagee's other assets, but can only foreclose on the house. If prices drop significantly in the next couple of years, as they likely will (given that only 17% of Californians can now afford the median house), thousands of people are going to walk away from their loans and let the bank foreclose, with no bankruptcy consequences. Sure, it will ruin their credit record, but how much is a good credit record worth? Probably not $120,000 (the negative equity on a $600K loan--median single family home price in California--if prices decline a modest* 20%). Anyway, many of the loans are adjustable with "teaser" rates used to qualify the buyers, who understand that in two years they will have to refinance or sell, because they won't be able to afford the new payments. They are counting on interest rates being lower, or on being able to "flip" the house for more money, and using the proceeds to get "back in the game."

A Conspiracy reader who was an executive at Indymac emailed me that the banks were aware of this possible dynamic, but were confident that home buyers would protect their credit rating at all costs, and wouldn't default on their mortgage unless they really couldn't pay their mortgage, regardless of how far "underwater" they were. This is when I first concluded that the banking industry was out of its collective mind. (And of course, as it turns out, even in "recourse" states, "jingle mail" is an ever-growing problem, and banks rarely try to go after any assets that the borrowers may have).

UPDATE: Part of the problem, from what I can tell, is that the mortgage industry was relying on worst-case scenarios based on default rates from past housing busts, such the early 90s in California, and the 80s in Texas. Yet those were totally different circumstances, not least that those default rates were based on borrowers who generally put 20% down, and thus would think really hard before defaulting, credit rating aside.

	[David Bernstein, July 11, 2008 at 9:49pm] Trackbacks Federal Regulators Take Over IndyMac: Back in August 2005, at the tail end of the housing bubble (but when many VC readers were still berating me for saying [or, more precisely, siding with the many "doomsayers" who were saying] there was a housing bubble), I pointed out one future source of trouble for the housing and mortgage markets: Just read that 61% of all new California mortgages this year are interest only, no money down. This is especially important because California (like a few other states, but, unlike, say, D.C. area jurisdictions where about 50% of the new mortgages are interest only) has a law requiring that all mortgages be "non-recourse," i.e., if a mortgagee defaults on his loan, the bank cannot attach any of the mortgagee's other assets, but can only foreclose on the house. If prices drop significantly in the next couple of years, as they likely will (given that only 17% of Californians can now afford the median house), thousands of people are going to walk away from their loans and let the bank foreclose, with no bankruptcy consequences. Sure, it will ruin their credit record, but how much is a good credit record worth? Probably not $120,000 (the negative equity on a $600K loan--median single family home price in California--if prices decline a modest* 20%). Anyway, many of the loans are adjustable with "teaser" rates used to qualify the buyers, who understand that in two years they will have to refinance or sell, because they won't be able to afford the new payments. They are counting on interest rates being lower, or on being able to "flip" the house for more money, and using the proceeds to get "back in the game." A Conspiracy reader who was an executive at Indymac emailed me that the banks were aware of this possible dynamic, but were confident that home buyers would protect their credit rating at all costs, and wouldn't default on their mortgage unless they really couldn't pay their mortgage, regardless of how far "underwater" they were. This is when I first concluded that the banking industry was out of its collective mind. (And of course, as it turns out, even in "recourse" states, "jingle mail" is an ever-growing problem, and banks rarely try to go after any assets that the borrowers may have). UPDATE: Part of the problem, from what I can tell, is that the mortgage industry was relying on worst-case scenarios based on default rates from past housing busts, such the early 90s in California, and the 80s in Texas. Yet those were totally different circumstances, not least that those default rates were based on borrowers who generally put 20% down, and thus would think really hard before defaulting, credit rating aside.