RWE,

As I understand it, a first mortgage is non-recourse to the borrower. If the borrower defaults on the loan, the only recourse for the lender is to foreclose on the property. The logic is that they will then kick out the defaulting borrower, sell the house to some creditworthy person, and write off any difference (and if there’s a surplus, they have to pay the difference to the defaulting borrower, though that never happens).

Now, second mortgages or home equity loans, as I understand it, are different. They are recourse, and stay with the borrower even if the house is foreclosed on.

So, in your example, I think the “no money down” loan was generally split into two parts: a traditional 90% loan-to-value subprime mortgage ($180,000), and a 10% “downpayment loan” ($20,000). The first part is non-recourse, the second is recourse.

When the value of the house falls to $100,000, nothing necessarily happens. There are not “mark-to-market” triggers in mortgage loans. As long as the borrower keeps paying the note, everything is (sort of) hunky-dory.

But when the borrower goes into default, and the senior (first-mortgage) lender forecloses and auctions the house for $100,000, that lender takes an $80,000 write-down. The lender subtracts $180,000 from its assets (loan receivable), subtracts $80,000 from its earnings (which decreases equity), and increases cash by $100,000. The home equity lender ($20,000) gets nothing from the foreclosure, but isn’t necessarily flushed (more below).

The tricky part is the impact of mark-to-market. The lender is supposed to now write down “similar” loans by 44%. But what’s similar? No two houses are exactly alike. Maybe this house fell in value because the guy who owned it painted swastikas all over the exterior. Maybe the guy didn’t maintain his house. Maybe it was across the street from a liquor joint. Or, the bottom has fallen out of the market and every house value within a 3 mile radius has fallen by half. There’s a lot of information that’s needed to fairly value this asset, and the impact of that foreclosure. This lack of information to fairly value the assets is what was being discussed on another post. Transparency is part of the problem, but the sheer volume of data that is known and in need of processing is just as important.

Anyway, out of an abundance of caution, the senior lender writes down every subprime mortgage, and the cascade begins. Instead of an $80,000 loss, the lender may be facing an $80 million loss. Yikes.

With respect to the $20,000 home equity loan, the borrower is still on the hook, although in reality they will call a debt resolution service and negotiate that down to $10,000, paid over 3 years. The home equity lender eats the rest.

If the bank goes out of business, the loans will probably get transferred to another bank, along with the bank’s deposits. If the loans are bad, the FDIC may make up the difference. If the loans are good, the bank may be required to pay for the loans.

I’ve not seen independent confirmation of 50,000 unsold units in Miami. If it’s true, it will be a drag on the real estate market there for years. If you like vacationing in Miami, it will soon be a good time to buy!

Hope this helps.

L3