What Were You Thinking?

Underwater? Let’s make a deal!

Jeremy Hobson Mar 12, 2010
What Were You Thinking?

Underwater? Let’s make a deal!

Jeremy Hobson Mar 12, 2010


TESS VIGELAND: The housing crisis was a primary cause of that market meltdown. And in a lot of ways, that sector of the economy hasn’t shown much improvement.

This week RealtyTrac said more than 300,000 mortgage holders received a foreclosure notice last month. Even more mortgages holders aren’t waiting around for a notice. They’re seeing their property value scrape bottom. And they’re calculating that maybe it’s time to just walk away. Send the keys to the bank, which prompts us to wonder…

Comedian: Let me start with question number one: What were you thinking?

In our continuing look at why we do what we do with our money, today we profile a private industry effort to keep people from walking away by playing “Let’s Make a Deal.” Marketplace’s Jeremy Hobson reports.

“Ain’t to proud to beg” sung by the Temptations: I know you wanna leave me, but I refuse to let you go…

Jeremy Hobson: Frank Pallotta has an idea. He’s managing partner at Loan Value Group, essentially a consulting firm for lenders. And he thinks banks shouldn’t be too proud to beg borrowers to stay in their homes, by offering them a little cash.

Here’s how it works: Pallotta finds homeowners who owe much more than their homes are worth, and are therefore, more likely to choose to walk away.

Frank Pallotta: There’s approximately 10 million homes that have negative equity, and we think somewhere between five and eight million of those homes are in what we call a “high risk category,” meaning that negative equity is enough that the borrower is truly contemplating this option.

But whether a person walks away has to do with more than just the difference between the value of the home and the mortgage, Pallotta says.

Pallotta: We then look at things like income, we look at parts of the country that the borrower is in. The more foreclosures there are in a given square mile or a given radius, the greater the likelihood of strategic default.

So once Loan Value Group identifies the high risk borrower, the question is: How much money would the bank have to pay that person to get them to keep paying their mortgage? Under Pallotta’s plan, it comes in the form of cash when the mortgage is paid off or the house is sold.

Pallotta: The reward size is really designed to have the borrower feel as though, one, he’s got skin in the game again. Second, that that equity light at the end of the tunnel is no longer a decade or more away, it’s a lot closer. But we also make sure the borrower understands that this reward is real, it’s tangible, it’s something that they can get their hands on at some point in time when they do the right thing, when they pay off their mortgage, when they refinance or when they sell their home.

It’s good for borrowers, Pallotta says, because ultimately, they’ll lose less than they would have. And it’s good for banks, because they’d take a bigger loss on foreclosure.

Sound of kettle whistling

Paul Buck is brewing some coffee at his home in Las Vegas. He’s owned the property for seven years, and is, like virtually everyone else in Las Vegas, underwater on his mortgage. Way underwater.

Paul Buck: By some calculations, the house may be worth $175,000 instead of what we owe on it, which is $295,000.

Buck is the perfect bait for the plan being offered by loan value group. He could really use the money he’s spending on his mortgage to pay for his kids to go to college. And he’s not all that attached to the house.

Buck: It will cost us $140,000 or $150,000 more over the next 10 years to keep paying our mortgage on the house than if we made a strategic default and just walked away.

He’s not worried about taking a hit to his credit score, because he says he doesn’t need much credit. And he says he’s not swayed by the moral argument either. Just look at the investors that recently walked away from their $6 billion obligation at the Stuyvesant Town apartment complex in New York City, he says.

Buck: And they just said, “Well, it’s only worth $1.8 billion, so now we’re bailing out,” and left the lender holding the bag. So you know, nobody cried about that and said, “Oh, you’re bad people, what an immoral decision.” They just said, “Well, that’s business. Right? That’s business.” So that’s kind of the attitude we have to take, too, I think.

Still, Buck says he’s thinking twice. In Nevada, the lender can go after more than just his home if he walks away. Would he keep paying his mortgage if he could cut his losses with a wad of cash from the bank?

Buck: It might be possible. ‘Course it depends on the cash lump sum.

That response makes perfect sense to behavioral economist Eric Johnson. He’s the director of the Center for Decision Science at Columbia Business School. He says for borrowers like Paul Buck, it’s more about psychology than math. And it’s easier to convince people to stay in their homes than you’d think, because borrowers are generally more sensitive to short-term pain than they are to long-term gain.

Eric Johnson: So what happens if I’m thinking about walking away? What do I have to do first? Well, I have to pack up, move, take my kids, perhaps, to another school. Do lots of things that are unpleasant, probably some things that are embarrassing, like tell the neighbors I’m walking away.

And what are the benefits? When do they come? Well, I find this nice rental, and I save maybe $100, $200, even $500 a month. But that accrues over time, it happens over a long term, so basically if I’m sensitive to what happens now, walking away looks a lot less attractive.

Johnson says borrowers also have to consider the money they’ve already sunk into the house.

Johnson: One of the classic examples of this is: I’m in a restaurant, I’m hungry, I have to order the souffle early on in the dinner, because, of course, it takes an hour-and-a-half to prepare. So I have this delicious dinner, I’m stuffed, but here comes the souffle. Now, I’ve already paid for it, but if I don’t eat it, I feel like I’m wasting that $15.

So he eats the souffle. That’s something that banks and Frank Pallotta hope that a lot of underwater home owners decide to do too.

In New York, I’m Jeremy Hobson for Marketplace Money.

Vigeland: By the way, the Obama administration is planning a program that would give home owners cash not to stay in their homes, but to leave them through a short sale. That effort is supposed to get underway next month.

There’s a lot happening in the world.  Through it all, Marketplace is here for you. 

You rely on Marketplace to break down the world’s events and tell you how it affects you in a fact-based, approachable way. We rely on your financial support to keep making that possible. 

Your donation today powers the independent journalism that you rely on. For just $5/month, you can help sustain Marketplace so we can keep reporting on the things that matter to you.