Once a Castle, Home is Now a Debtors’ Prison

Forget the notion of the home as "castle." Twenty-two percent of Americans owe more on their mortgages than the value of their homes. Nicolas P. Retsinas offers ideas for how these "debtors' prisons" can be turned into productive housing.
by Nicolas P. Retsinas

We have created a housing hybrid in America, refashioning the single-family home into a mini debtors' prison. Almost 11 million dot the landscape. In Las Vegas and Phoenix, over 50 percent of homeowners live in one.

“Understandably, most [underwater] owners … live shackled in what the Chinese call fang nu—slaves to their house.”

Forget the notion of the home as "castle," protecting the owner from greedy landlords. Forget too the expectation that a physical nest will morph into a nest egg. For 22 percent of people who hold mortgages, those notions are anachronistic—relics of a long-ago era before unemployment soared, the Dow plummeted, and credit default swaps surfaced. In today's jargon, these owners are underwater—they owe more than the value of their homes.

But underwater is a misnomer. People underwater either swim or drown.

These underwater owners linger, trapped in their very own debtors' prisons. Their task is Sisyphean: they work, pay the monthly debt to the lender, yet see a perpetual gap between payments and value. The payments can seem like an extortion episode from The Sopranos.

Exit strategies are few. If an owner sells the house for less than the mortgage, the owner must pay the lender the difference. Owners will still need to find someplace else to live.

An owner can walk away from the loan and join the "strategic defaulters," who defaulted not because they could not pay but because they did not want to. Their house was a bad investment. The advantage of this maneuver is real: strategic defaulters save money. Sometimes they can rent a comparable home. But they risk a lower credit rating, which could bar them from buying another home for up to seven years.

Understandably, most owners do not grab either of these solutions; instead, they live shackled in what the Chinese call fang nu—slaves to their house.

One owner's misery is personal; when over a fifth of mortgage-holders are shackled, the personal misery becomes national. For the country, these homes are an economic shackle, hobbling the housing market. They also distort the labor market: people offered jobs far afield stay put, reluctant (and unable) to leave their underwater homes. Since the recovery of the housing market will undergird any broader recovery, we must address these debtors' prisons.

Novel Solutions

The solutions will force lenders to throw out their textbooks.

First, lenders can recognize the wisdom of short sales, accepting less than the face value of the mortgage. Currently banks do accept short sales but only after protracted negotiations. One advice columnist recently advised sellers eager to unload an underwater house to keep trying—on the third try, a bank might relent. A short sale will put the house on the market, opening it to another buyer, letting the seller move. Lenders could proactively set prices for short sales.

“Lenders may be reluctant to morph into landlords, but they already own millions of empty units.”

Second, lenders can reduce the principal as part of loan modification. Consider a commonplace scenario. The value of a house has dropped 30 percent from its mortgage. The owner has already lost whatever equity she sank into the down payment. There is very little chance of an immediate surge in value. The owner cannot sell the house, is considering abandoning it, and has cut back on maintenance, which depresses the value further. If a few houses on a block are underwater, the blight will depress the values even of well-kept homes. Accepting this new reality, lenders might allow the entire mortgage payments to go toward the reduction of principal.

Third, lenders can transfer the mortgage-holder's status from "owner" to "renter." Often the owner has so little equity in the house anyway that the lender is in effect the owner. But making this shift from "owned" real estate to "rental" real estate will unshackle the occupant from the house. When the owner-turned-tenant makes his monthly payment, he will not be seeing a Sisyphean gap. If the rent is too high, the occupant will move. If the rent is low enough, he will stay. The occupant is free to decide. Lenders may be reluctant to morph into landlords, but they already own millions of empty units. At least the rental units will be generating revenue. Sometimes goals dovetail: in this case, the country needs rental housing as much as underwater owners need rescue.

Tony Soprano was not compassionate; the plight of his debtors would not have moved him. But he was pragmatic. I suspect that he would have modified these loans, releasing homeowners from their prisons.

About the Author

Nicolas P. Retsinas is a lecturer of business administration at Harvard Business School and director of Harvard University's Joint Center for Housing Studies.
    • Kevin
    • VP Operations, Illinois Brick Company
    Great article. I have worked in the Brick and Building Material Industry in Chicago for the last 30+years and like many others I have never seen the housing market in such disrepair. With the growing need for rental properties you would think more Banks would become Property Managers in an effort to keep the cash coming in on distressed properties. But then again a Goverment bail out is probably easier.
    • Rasheed
    • Malik
    In my opinions, short-sales have already depressed the market enough, so I would throw that proposition out of window. As for the Banks becoming Landlord, I think it is a plausible alternative solution. Thirdly and most importantly the notion of "principal reduction", in my view is the only concrete, time and tested proposition that has worked historically and will work now ... simple, if companies are allowed to renegotiate their debts and have their loans turned into grants by the same federal government (that collects taxes from us), then why would not Banks be forced (by the same govt) to renegotiate and reduce the principles for the consumers. I believe it is high time, that the government assumes a spine and tells the Banks to behave fairly and equitably, and if they dont, then they should face heavy fines.
    • Phil Hood
    • Principal, Transcend Strategy Group
    All three are worthwhile strategies. By refusing to face the underlying value of these "assets" banks are also transferring their pain to the economy at large. As a person who lives in a downtown neighborhood with some foreclosures my experience is that banks make desultory landlords. They'd need to become committed to this plan to make it work.
    • Anonymous
    Why don't lenders give underwater homeowners a break? Selfish myopia, of course. It's the same dynamic that prevents builders from lowering property prices in depressed Dubai or Mumbai. They would rather let real estate just sit there, depreciate, and take the hit on lost capital. But give the buyer or homeowner a break? No way. It bucks a system skewed in their favor. They hang on in quiet desperation, waiting for property prices to rebound. And worst case, you and I will bail them out with our taxes. They are not practical like Tony Soprano. They are soulless, like feudal landlords who own the farmland and try to exact their grain taxes from bonded peasants, regardless of a failed harvest or how parched their own fields have become.
    • Praveen Vukkalam
    • 448908
    It is indeed a near impossible scenario. Trying to alleviate the debtors would create trouble for the lenders (banks) as they are already in great trouble and leaving the owners as such does not seem a great option. This is real depression - in the minds and hearts of people all around with no hope in the horizon!!!
    • Guy Higgins
    • Principal, Performance2
    Good article. I have often wondered why lenders didn't take some of these pragmatic approaches. At the same time, people have been led to believe that home ownership is part of the American dream. I suspect that there are people out there who really don't want to own a home but bought because 1) it was easy, 2) it was cheap, 3) "everyone" else was doing it. Now, they have a home and the job they want is somewhere else -- somewhere they could pick up and go to if they didn't own a home. My father didn't own a home until he was over 50. I bought my first one when I was 27 and have bought six more -- I sold all them for more than I paid, and probably even (really) made money -- but ya gotta think!!
    • Anonymous
    It may need to look and to rethink a new direction. I do not know how mortgage works in the US banks. However, friends of mine in Herndon, Washington and in Chicago, Illinois, told me that, there are several shariah mortgage plan services (Islamic system of lending), which is not like conventional bank, you may pay according to your ability to pay. This shariah plan is prohibited to seize your home in case of difficulty/crisis. In some cases, these shariah mortgage plan services, may assist to bail out from mortgage trap.
    • Kapil Kumar Sopory
    • Company Secretary, SMEC(India) Private Limited
    This is a very painful scenario. Property prices losing sheen leads to plethora of problems to home loan borrowers. They are unable to sell and repay in case of dire need. In my view they have no alternative but to lower their life style may even be by moving out to a smaller lodging thereby reducing the impact.
    It is also for the government to fix a reasonable lower price tag for disposal of the properties.
    I don't think Banks should enforce sales and become owners of large number of properties which would create further problems.
    • Sarah Brown
    • Real Estate Professional, http://www.housebuyersofamerica.com
    In my opinion banks and other financial institutions are the major part of our economy. They are in the market to do business. It is obvious that if someone is selling his property less than its mortgage amount then they have to bear the difference. I believe banks should be more careful and cautious while giving loans. And we have a big example of "Great depression" that hit the US market in the year 1929.
    Nice and informative article! Thanks a lot.
    we buy homes Maryland
    • James
    • Owner, HouseBuyerSanAntonio.com
    Nicolas, what a fantastic read. I am a Realtor and an Investor in my area (San Antonio, TX). I've see your point play out in my business within the last year or two. As my house buying business has begun to grow, so did my need for capital and banks. However, due to the monthly obligations for primary residence, that are figured into my Debt to income ratios, it has made it very difficult to continue buying and selling houses with traditional financing. I've wondered for the last few months, if I would have been better off selling my current homestead and moving into a rental, just to take some debt off, and grow my house buying business.