Tuesday, October 24, 2006

The Great Risk Shift

Today on Calculated Risk (see link to his website in the sidebar), CR placed a post about expected rising foreclosures -- which is expected to rise to 4% of mortgaged homes, an unprecedented high.

What I think is not commonly discussed in the coming real estate crash and ensuing mass foreclosures is how many people counted on their home being paid off during their retirement years. Now many more Americans (how ever many it ends up being) will feel disenfranchised again. In the macro sense, this will only add to the sense that, in America, you now cannot make it as a success (financially, anyway) in life unless you already start with capital (born into wealth) or find some way to steal it (as in the accounting industry and law practice "all great wealth starts with a crime"). This is not good for the country.

Now that many ordinary middle class and lower middle class Americans have been sold on the fraudulent idea that housing always goes up in value and everyone can afford a home, the ensuing bust will lead to a sense of despair and depression in the same population. The psychological effect on these people will be much more severe than simply losing money in the stock market, and it will impact more than just those who lose their homes. The idea of losing your home will have, I think, a much more severe and long-lasting impact than the stock market crash did in 2000.

And don't forget the new bankruptcy law that makes it much harder -- and much more expensive -- to file for bankruptcy. That many more people will be priced out of the bankruptcy market and will not be able to have the "fresh start" that bankruptcy is supposed to afford. The threat of bankruptcy was supposed to put the risk on the lender, rather than the consumer, to make only loans that have a high likelyhood of being paid back. Traditionally, real estate loans were among the least risky of all loans. That is why the interest rate was so low. Owning a home was supposed to be a sign of stability.

This is just another example where the "risk of loss" has been shifted from the educated and wealthy to the ignorant and poor. Again, traditionally, we have moved away from the concept of caveat emptor ("let the buyer beware") to one where the seller accepts more of the risk of loss. The reason for this is that the seller, being a merchant in goods of a kind, was in a better position to know the product and the risks that could be suffered by the user or consumer. Therefore, we required the seller to make the product safe for the consumer, and, in the case of products liability, strict liability was imposed on the seller as a means of insuring that products were tested to be safe for the ultimate user or consumer of the product. We now seem to be shifting the risk of loss of debt to the consumer.

Another way that the risk of loss has been shifted away from the lenders is through the use of "tranching." Why bother making safe loans when you can merely sell the loan to someone else? Which leads to another axiom of great wealth creation: always play with OPM -- other people's money. That is exactly what the lenders are doing. They are playing with our money. Therefore the risk of loss has shifted from those who should be taking the risk -- those who best understand the risk and consequences, the seller -- to those who are least able to afford or understand the consequences: the consumer.

More on this later...

6 comments:

charts said...

I like the points you make here.

OkieLawyer said...

Thanks for the compliment, Daniel.

Teri said...

There are a couple of other points to this (that I keep beating my head against the blogosphere to make.) The first is that people were allowed to tap into their 401ks to buy a home. You can use it without penalty to buy a home or to pay for college. If you try to tap into it for an extended period of unemployment, you get to hand 30% of the money over to the government. This is why I will never again participate in a 401k.

The second is what happens when you sell for less money than you owe. The difference is considered a "gift" and you now owe taxes on it. Never mind that the original price you paid was inflated due to the easy credit and housing bubble. You now get to pay the government back taxes forever.

I am so very happy that I was able to sell my place and I didn't mind that I didn't get a lot of money for it. I own my Silver Streak trailer outright. The land I am buying now is owner contract using simple interest. In 10 years, I will truly own it. I'd have paid on the house for another 20 years before I could say that. The property taxes and utilities bills were killing us.

Good post and very timely.

OkieLawyer said...

[The second is what happens when you sell for less money than you owe. The difference is considered a "gift" and you now owe taxes on it.]

This must be unique to where you are, because here in Oklahoma, you cannot sell any real or personal property for less than what is owed on it. Unless I am reading the statute wrong below, if you were to do that, you would be in violation of a felony criminal statute here in Oklahoma.

See http://www.oscn.net/applications/oscn/deliverdocument.asp?id=70141&hits=504+429+282+167+92+

Teri said...

It's the IRS (article at http://ocregister.com/ocregister/money/housing/article_1206268.php):
The tax man

Even if a lender doesn't go after a homeowner's personal assets, a foreclosure can trigger income tax consequences.

Hall notes that lenders usually want to get rid of foreclosed properties as quickly as possible and often will sell them at auction prices much lower than the true market value. If the house is listed or sold for less than the loan value, the homeowner will not only lose his house but also may have to pay income taxes on the difference because it is considered debt relief income.

For instance, if the foreclosed homeowner has a $500,000 loan and the lender sells the house for $450,000, the homeowner will have to pay taxes on the $50,000 difference. The $250,000 tax exemption for singles and $500,000 for joint filers does not apply to debt relief income, in this case the $50,000.

The tax owed on the debt relief is based on the homeowner's ordinary income tax rate, not the lower capital gain rates. The exclusion, however, may still be available to reduce any capital gains in the difference between the sales price and the homeowner's basis.

"Some would say that's a disaster, but it's better than having the lender take you to court, obtain a judgment and then go after (your other assets)," Hall says.

Hall recommends homeowners who are getting behind to talk to their lender to see if they can restructure the loan and/or payment terms. At the same time, they should seek financial counseling and tax advice.

If they have a recourse loan, they should consider selling before allowing a lender to foreclose to obtain the maximum sales proceeds and reduce their financial or tax exposure, Hall says.

Norm Bour, owner of Priority Plus Lending in Laguna Niguel, thinks there are some homeowners who should just cut their losses now.

"There are a lot of people who are homeowners who shouldn't be, living day to day just to support the house," he says.

"My advice to them: Sell."

OkieLawyer said...

Teri:

OK, I didn't realize that you were referring to the IRS code. I was aware of the IRS code that you were referring to, but I thought you were referring to a debtor selling the house, rather than it getting sold under a foreclosure.

Also, if someone files for bankruptcy before the assessment, there would be no tax liability. I think there are some other exceptions, too, under the IRS code.