The Big Short movie tells the story of three outcast groups of investors who predicted in 2005 that home prices would crash and found ways to make fortunes out of it.

One of the real-life heroes of the action/adventure/wall-street flick is Michael Burry, the quirky character played by Christian Bale. New York Magazine published an interview with Burry in December which generated buzz among financial pundits.

Several writers anchored on Burry’s answer to a question about whether the crash resulted in any positive changes;

“The biggest hope I had was that we would enter a new era of personal responsibility. Instead, we doubled down on blaming others…”

After all these years, the conventional wisdom seems to be that everyone is to blame for the Great Real Estate Bubble and the Great Recession; regulators, politicians, the Fed, rating agencies and so on, but especially, Wall Street and the banks. The financial bloggers – feeling a little defensive I think about the movie’s portrayal of Wall Street – make the point that it wasn’t just Wall Street, home buyers were irresponsible too.

That’s true. The banks put out interest only loans, no-doc liar’s loans, pick-a-pay neg-am loans, buyers qualifying for mortgages using the teaser rate only, and of course, we had an ever expanding number of house flippers and first-time, mom-and-pop, “Law of Attraction” blind optimist wannabe real estate investors who were signing those toxic mortgages. No one forced those buyers to take those irresponsible loans.

The financial writers seem to be saying that greedy home buyers got mortgages from greedy banks who sold them to greedy Wall Street, so see, it’s not just the financial industry’s fault.

But most U.S. home buyers during the bubble didn’t use those crazy risky loans, they used plain vanilla 30-year fixed rate loans.

I’m still amazed at the number of responsible people we saw during the real estate bubble (perhaps, too responsible for their own good, however).

These people were largely ignored by the media during the bust but millions of them are still being hurt by the Great Real Estate Bubble. Their Big Short stories haven’t ended yet, 10 years later, but so far their stories have been unhappy.

And most surprising to me is the perverse impact they continue to have on home prices in some major real estate markets.

Flashback

The movie ends in 2008 but in the real world foreclosures were just starting to skyrocket in 2008.

Investors were the first to bail. Then those people with 2-year teaser rate mortgages who walk away before their teasers expired. And of course, we can’t forget all those geniuses who lied about their incomes on their no-doc, liar’s loans and then found out they couldn’t afford the monthly payments.

But I don’t want to talk about them here.

The people I want to talk about weren’t investors, liars or true believers. They were conservative financially. They played by the rules. They got sensible, full-doc, 30-year fixed rate mortgages to buy homes for their own personal use. Some put 20% or more down. They weren’t trying to get rich, they just wanted a nice place to live.

Their only problem was they bought their homes at the top of the market in 2005, 2006, 2007 or 2008 in bubble states.

Strategic Default

Remember in 2009 when the expression “strategic default” appeared out of nowhere? Strategic default stories boomed. Even “60 Minutes” had a story in May 2010.

After foreclosures from investors, liars and teaser rate buyers started to hit the market, home prices fell for everyone, including for those who played by the rules, and so the downward spiral began.

Strategic defaulters were those people who could afford to make their monthly mortgage payments but who chose to walk away anyway because they were so far underwater.

Not paying their mortgages was a strategy, not a necessity for them. A lot of the early news stories asked if it was ethical for strategic defaulters to stop making mortgage payments when they had the money to make the payments.

In time, social norms about personal responsibility adapted to the new reality of millions of foreclosures. Foreclosure became the new divorce, what was once shameful became unfortunate but sometimes it’s the best thing for the family. 

But this story isn’t about strategic defaulters.

Underwater Non-Defaulters

Today’s story is about those people who specifically chose NOT to default.

This story is about those people who were able, but also willing, to make their mortgage payments every month despite being incredibly underwater.

Financially, it can make a lot of sense to walk away from a $200K mortgage on a $100K house but these people didn’t. The Wall Street Journal reported in 2012 that 81% of Fannie Mae mortgages with 25% or more of negative equity were still making payments.

We don’t have a term for the opposite of “strategic defaulters.” So let’s call them “underwater non-defaulters” here, those people who bought in 2005, 2006, 2007 or 2008 but chose not to default despite being scarily underwater. (Sorry I couldn’t come up with a better name. If you’ve got a better name for them than “underwater non-defaulters,” I want to hear it.)

  • How many of them are still making payments and are still underwater today, 10 years later?
  • How do they affect the real estate market today?

Lose-Lose Situation

Now, just to be clear, I don’t think either the “strategic defaulters” or “underwater non-defaulters” were right or wrong.

Being underwater for $100K or more on your home would be a horrible situation to be in. All your options are bad. You just have to do the best you can to find the least bad option for you and your family with the information you have at the time.

I was not in that situation, thank goodness. I know, however, that it would have made me completely, 100% miserable if I was. I can only imagine the pain those underwater homeowners felt.

How Many are Still Underwater?

Zillow estimates that the value of 6.5 million homes in the U.S. are still short of what the owners owe. That’s 6.5 million underwater homes.

See the table at the bottom of this post which shows Zillow data on the negative equity of the 30 largest metro areas with the metros with the most underwater homes at top.

Not all of those underwater homes were bought in 2005 , 2006, 2007 or 2008 but in metro areas where home prices are still far below their bubble peaks, I think more than half probably are. (Another significant portion would likely be people who bought their homes years earlier, had a lot of equity, but then did cash-out refinancings at the top of the market and so have been underwater since 2008. But this story isn’t about them.)

(Dear Zillow, Can you please break out your negative equity data by year of home purchase so we can see how much of today’s negative equity comes from homes purchased 2005 to 2008? Also, by year of mortgage origination would be cool to see so we can look at the cash-out refis. Thank you! -John)

The cities with the highest number of underwater homeowners aren’t the real estate bubble cities but rather Chicago and New York.

Case-Shiller Home Price Index - Percent Change from Peak to Now (October 2015) for 20 CitiesHome prices in Chicago (-22%) and New York (-16%) are still far below their peak prices of 10 years ago, at least according to the Case-Shiller Home Price Index. See the list in the sidebar or see price graphs here.

Looking at the table at the bottom again, over 300,000 homes are underwater in Chicago and nearly 300,000 in New York.

Over 100,000 homes are underwater in Atlanta, Washington DC, Philadelphia, Detroit, Miami, Phoenix and Los Angeles, according to those Zillow estimates.

Impact on Today’s Housing Market

These underwater homeowners are trapped in their homes. They wouldn’t make enough money selling their homes to pay off their mortgages so they just don’t sell.

The default-free 2005-08 buyers have a 10-year history of making their mortgage payments even when their homes were far deeper underwater than today so they’re unlikely to walk away or do short sales now unless they absolutely have to due to divorce, job loss, job change, illness or death in the family.

It doesn’t matter if they need a bigger home, smaller home or just a different home, they’re staying put in their current underwater, negative equity homes.

Their commitment to not walk away from their mortgage debt has had the perverse effect of lowering the number of homes that go up for sale. This is especially true in areas with a high percentage of homes with negative equity.

Mythical Phoenix Example

Let’s look at Phoenix, one of the big-time real estate bubble areas. I’m going to say that negative equity in Phoenix is 10% above normal. (Looking at the table at the bottom of the page, it seems 5% to 6% negative equity is “normal” in this dataset for whatever reason. Zillow estimates that 16% of homes in metro Phoenix are underwater so I’m proposing that negative equity in Phoenix is 10 percentage points above normal.)

So, let’s imagine that miraculously in January 2015 the negative equity in metro Phoenix went from 16% to 6%. That would mean 10% of homeowners would no longer be trapped in their underwater homes so 10% more homes would go up for sale each month. Right?

How many months of 10% more homes hitting the market would it take until Phoenix had a much larger supply of homes for sale?  And what effect would that larger supply have on Phoenix home prices?

The point I’m struggling to make here is that small changes in the flow of homes hitting the market can, over time, have big impacts on supply and home prices. That is, large numbers of homes with negative equity reduce the number of homes that go up for sale and that puts upward pressure on home prices. 

Who Won? Strategic Defaulters or Underwater Non-Defaulters?

(I don’t like the answer to this question. I hope I missed something and I’m wrong. Let me know.)

If you bought near the top of the housing market and home prices in your city are still significantly lower than they were at the top, then you might have been better off – at least financially – by doing a strategic default back in the day.

That is, if you had defaulted years ago, you could now buy the same house for significantly less than you paid in 2005, 2006, 2007 or 2008.

But money isn’t everything. The disruption to your family and kids is high. I suspect many divorces were triggered by the stress of foreclosure.

Some chose not to walk because it would have killed their credit score for years.

Others couldn’t walk away because, in some fields, a foreclosure can hurt your career. In some jobs, foreclosures are actually prohibited, you could lose your job.

No doubt morals and ethics were why some people didn’t walk away. A study done in 2009 asked the general public this question, “Do you think that it is morally wrong to walk away from a house when one can afford to pay the monthly mortgage?” Over 80% said “Yes.”

Even if you disagreed with that statement, you felt a lot of social pressure to not default.

(I bet that survey would be a lot less than 80% “Yes” today! The Great Real Estate Bubble did change America. Also, women were 41% less likely to say they would do a strategic default so I wonder if women homeowners are overrepresented in today’s underwater non-defaulters.)

Foreclosure Penalty Box

It’s true that after a foreclosure, lenders put you in a “penalty box” so it’s tough to get a mortgage to buy a house for years after a default. If you did a strategic default, you would need to rent for years.

The conventional wisdom is that you have to wait 7 years before you can buy again but actually, it’s often a lot less than that. You could get an FHA mortgage only 3 years (or less) after a foreclosure. (BTW, this explains in part why FHA loans were so popular in 2015, the shorter penalty box. Strategic defaulters and others are switching to FHA loans to buy homes not because they have bad credit or small down payments but because FHA has a shorter penalty box than conventional mortgages.)

So theoretically, if you completed a strategic default in 2010, by 2013 you could have bought a similar home at a much cheaper price using an FHA loan.

Millions of People Still Hurting 10 Years Later

In a normal market, after owning a home for 10 years, it would likely be worth 30% or more than what you paid. Homeownership was a traditional way American families built wealth.

If you bought a home in Phoenix from early 2005 to early 2008, it's still not worth what you paid for it.

If, however, you bought in Las Vegas, Phoenix, Tampa or Miami from 2005 to 2008, your home would likely be worth at least 25% LESS than you paid even after making monthly payments for 10 years. In Chicago, 22% less. In New York, 16% less. That’s after making payments for 10 years!

That’s gotta hurt.

If you bought a home in a bubble city in 2005, 2006, 2007 or 2008, homeownership likely destroyed wealth.

Collateral Damage

The real Michael Burry was hoping the crisis would trigger a “new era of personal responsibility.” One of the few groups that acted responsibly – at least according to pre-real estate bubble definitions of “responsibility” – was the 2005-08 buyers who chose not to default.

Unfortunately, many would have been better off financially if they weren’t so responsible.

In that same interview in New York Magazine, Michael Burry said;

“As for punishment of those responsible [for the real estate bubble], borrowers were punished for their overindulgences — they lost homes… But the executives at the lenders simply got rich.”

The people I’m concerned about were not overindulging. They played by the rules. Their only mistake was buying a home in 2005, 2006, 2007 or 2008 in a bubble city.

To me, the 2005-08 buyers who didn’t default are heroes. I hope they thrive. I bet they’re those reliable people you can trust in business and your personal life.

It’s sad the system bailed out the executives at the lenders who didn’t fulfill their responsibilities while some of the most responsible people are still paying the price.

We can’t change the past but I’m worried we haven’t done enough to prevent future debacles that punish the most responsible Americans.

Those homeowners who are short on equity but long on reliability have been forgotten. They aren’t a feel-good story. They might indirectly break into the 24-hour news cycle when CoreLogic, RealtyTrac or Zillow come out with their quarterly reports on negative home equity but that’s about it.

According to Zillow, 6.5 million American families are short $500 billion in home value.

For millions of Americans, the real Big Short today is half a trillion dollars of negative home equity.

30 Largest Metro Areas Sorted by Number of Homes with Negative Equity

 

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See Also

  • Are you underwater on your home and looking for options? Check out this government website.
  • Online economic reviews of The Big Short movie, click here.
  • Story of The Great Recession in 11 Minutes, here.
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