Academic journal article Business Case Journal

Underwater

Academic journal article Business Case Journal

Underwater

Article excerpt

The choices facing Deborah and Karl Eriksson and their young family were daunting. Should they continue to try holding on to save their new home or just walk away and let the bank foreclose or put it up for a short sale? Was their house just like their old computer or car, nothing more than a sunk cost that they should accept as having lost much of its former market value? These types of questions had never entered their minds during the many years of increasing real estate prices. Now, questions about their real estate decisions had become frequent topics of conversation. What should they do to unwind the real estate mess they now faced?

Their first house had been purchased in 1998 and they had lived happily in it for over seven years until 2006 when they purchased their second home in Echo Rim Estates. At the time, they had not been concerned about selling their first home because of the rapid turnover in listed properties. Houses regularly sold within a few days of being listed for sale with a real estate firm. Selling it quickly at a good price seemed virtually certain because their house was in a great location.

The Great Recession

Like much of the rest of the country, in central Oregon buying residential real estate had been a "no-brainer"; home values increased almost every year throughout most of the 1990s and mid2000s. Home builders worked at a feverish pace to keep up with unquenchable demand for new homes and financial institutions were lending money to eager borrowers, often with no questions asked. The real estate boom defied logic but no one seemed to care as "everybody" appeared to be making money.

Unfortunately, like other booms of the past, this one too started to unravel and then came to a halt. Homeowners throughout the country found themselves in financial distress. Honest, hardworking, bill-paying citizens got caught in an economic downturn that developed into a major recession over which they had no control. Many found themselves unable to make their mortgage payments on homes that had significantly decreased in value in just a few short years.

The events leading up to the recession were numerous. Traditional mortgage norms were set aside or ignored by lenders. First, "No Doc" loans were being made where borrowers were not required to document that they had either the assets or the income to pay for the loans they were receiving. Second, required down payments dropped and many loans were granted with no down payment when traditionally borrowers had been required to make down payments of 10% to 20% to qualify for a home loan. Finally, borrowers with questionable credit ratings were being granted sub-prime loans. Almost everyone qualified to buy a home, including many who could barely pay rent. No one seemed to care as unemployment rates were very low and construction workers, whose work normally was seasonal, found themselves with financially rewarding year-round work and as much overtime as they could handle in an attempt to service the seemingly unquenchable demand of the new housing market.

Realizing that many home buyers were marginal in terms of their ability to make their mortgage payments, underwriters attempted to reduce risk through diversification. Derivatives that bundled a number of weak mortgages with some that were strong became investments that were often shown at, or near, face value with no way to assess risk. For awhile, that masked the mounting economic losses faced by a financial industry that had set aside long-standing conservative lending standards. But, when it became obvious that the banking industry had lost its liquidity and was carrying excessive amounts of overvalued mortgage investments, the industry tumbled. Many trusted names in the financial community were substantively bankrupt, including many that were thought to be "too big to fail." Mortgage money for buying houses almost dried up; only the relatively few with strong credit scores who did not "need a loan" could qualify to get one. …

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