Just a few years ago, after all, everyone assumed that U.S. home values were bound to keep rising. In fact, on average, they have dropped by a third since the peak of the market. If prices can drop by a third, they could certainly drop some more.
That's why many private lenders wouldn't touch a 96.5 percent loan with a 96-foot pole. One dip in the economy, and the house is worth less than the mortgage. That's an invitation for the owner to stop paying, drop the keys in the mailbox, and find a place to rent--an invitation hordes of people have already accepted.
What most foreclosures have in common is that the mortgage holder owes more than the property could sell for. "Not everybody who has negative equity goes into foreclosure, but nearly everybody who goes into foreclosure has negative equity," says Paul Willen, an economist at the Federal Reserve Bank of Boston.
But Stevens sees no reason the agency should raise its down payment requirement to 5 percent. "All that's going to do is retard recovery," he says, by making it harder for people to buy homes. [Source]
The reason we need a recovery in the first place is because so many people lost so much wealth on these loans that there was a massive series of foreclosures which set the stage for the loss of untold billions of dollars in bank deposits that were invested into these mortgages. So, the solution is to encourage short-term spending, and by short-term I mean really short-term since in early December the $8,000 home buyer credit is going away and anyone who has been paying attention has noticed that that has been the one thing which got demand up high enough that values stopped plummeting. When the credit goes away, it's pretty much a given that demand will drop, and it doesn't help things either a lot of adjustable rate mortgages are going to get recalculated early next year.
The federal government has two choices to keep from going broke: institute a debtors' prison for people who voluntarily bail on these mortgages or tell people that 20% down is the "you must be this rich to play" marker for who will get a loan. It won't be either because no one in D.C. has the spine to tell the American people that they are not entitled to the American Dream.
On top of that, you have various govt backed programs that are still encouraging 100% financing (VA and FHA loans).
Of course, it is a falacy that people who owe more than their house is worth will automatically walk away. Most of them bought the house because they needed a place to live and the cost was within their means to pay. If neither of those 2 conditions change, there is every reason to believe the borrower will continue to make the payments no matter what the house is worth.
Dropping the keys in the mailbox is not an automatic solution either. Naturally, the banks would prefer you keep making full payments. In the absence of that, they would prefer to hold you liable to pay the full loan amount, less whatever the house sells for at auction or short sale.
It will become an issue when they go to sell the house and discover that the banks are demanding that they take out a personal note to cover the difference between sale price and mortgage amount. If the amount is large enough, bankruptcy becomes the preferred option.
I always thought is curious that a bank that would not write down a loan for a homeowner, would be willing to suffer an even bigger loss by selling the house short and forcing the borrower into bankruptcy.
I find it an even bigger injustice that if the bank does write down a mortgage, the IRS consideres that taxable income. And you cannot escape taxes through bankruptcy.