by Wolf Richter, Wolf Street:
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.