How much pain?

As subprime mortgages crater, here's one of the likely -- and as-yet-undiscussed -- consequences: Deficiency judgments, and perhaps a massive wave of them.

Here's how it works: Buying a $500,000 house, you put $50,000 down and take out an interest-only housing loan for $450,000. Then you can't make your house payments, two or three years later, and the bank forecloses. But the foreclosure is part of an enormous set of regional and national foreclosures, dumping houses on the market while mortgage lenders are cutting back sharply on new home loans. Far fewer buyers are chasing far more homes, so housing prices fall sharply; the bank sells your $500,000 house for $375,000.

You're out of a home -- and you're still carrying $75,000 in interest-bearing debt.

Where have we seen this dynamic before? Here's one noteworthy example:

In his 1965 book The Cornbelt Rebellion: The Farmer's Holiday Association, the historian John Shover discussed the metastasizing farm foreclosures in Depression-era Iowa, which (among other things) followed the burst of a farm-buying bubble caused by the decline of European grain production during the First World War. American farmers rushed to buy up land on borrowed money so they could expand their production for hungry European markets; fifteen years later, still carrying debt, they found themselves caught in a cycle of sharply declining crop prices. And then the trap closed.

From pages 16-17:

Between 1921 and 1933, 13 percent of Iowa farmland was sold at foreclosure. Yet at the end of 1932, one billion dollars of debt was still outstanding on 45 percent of the land in the state...Land values had declined so greatly (from $140 per acre in the late twenties to $92 per acre in 1932) that proceeds from a forced sale usually did not cover the full amount of the debt. As a result, the debtor was left with a deficiency judgment to cover the balance. In 1921, 26.5 percent of foreclosures in eighteen sampled Iowa counties ended with a bid for less than the amount of the debt; in 1932, 74 percent carried a defiency judgment.

This number will be worth watching in the years to come, but here's my guess: A significant number of families who took out subprime housing loans will not only lose their homes, but will be left with a crushing load of debt that will inhibit their recovery and hamper their ability to find new housing.

Barry DeCicco - 8/22/2007

Also, from what I've gathered in newspaper articles over the past several weeks, one big change is that it's no longer 'the bank'. Mortgages are resold, combined, and split into various financial instruments. This has led to problems where several parties have some sort of claim, at least good enough to block things. Also, it can be hard to locate the actual legal holder of the mortgage, assuming that there is only one.

Rebecca Anne Goetz - 8/13/2007

Although, bankruptcy is much harder now than it was a few years ago...that might be less of an option than it once was.

Chris Bray - 8/13/2007

All good perspective, and thanks. Should be interesting to watch how it all plays out.

William Hopwood - 8/13/2007

".....here's my guess: A significant number of families who took out subprime housing loans will not only lose their homes, but will be left with a crushing load of debt that will inhibit their recovery and hamper their ability to find new housing."

Interesting, but as I see it too pessimistic. Banks hate to foreclose. And what could they expect to get in the way of a deficiency judgement from a sub prime borrower anyway. A better option for the bank may be to extend or renegotiate the loan.

And, as creditors well know, from the standpoint of the debtor, there are several existing ways by which a debtor may alleviate the crush of a deficiency judgement, depending on the jurisdiction in which the debtor resides and/or the individual circumstances of the foreclosure.

In many jurisdictions deficiency judgements are limited by "fair value" appraisals conducted under strict judicial surveillance. Thus a creditor may not foreclose and re-sell at a fire sale price then expect to be made whole or better through a deficiency payment by the debtor, The amount of the deficiency thus being limited by the fair value of the property despite a lower price received from a foreclosure sale.

Bankruptcy may be another way for a debtor to seek relief.