Understanding Home Foreclosures

Kennon-Green & Co. Fiduciary Financial Advisor, Wealth Management, Global Value Investing

To understand home foreclosures, you need to understand how bank mortgages are structured.  Once you do, it will be easier to see how I view the problem of dealing with losing a home because you will see there is no “bank”, there is only a conduit through which depositors – waitresses, business owners, factory workers, teachers, doctors, lawyers, and accountants – lend their money to try to combat inflation.

Imagine that on Monday, your friend asks to borrow $50 from you.  You agree, on the condition that he repays you the $50 plus $5 for the time you didn’t get to enjoy your savings.  A year later, he uses the money to buy a stock that falls to $20.  

[mainbodyad]He knocks on your door and says, “I’m sorry.  I know that I owe you $55 because I borrowed $50 of your savings plus $5 for the cost of renting those savings for the past year, during which time you didn’t get to enjoy your money.  Unfortunately, things didn’t go my way.  Had I enjoyed a gain, I would have kept all of the profit for myself.  I didn’t.  I lost $30.  Thus, here is the $20 I have left.  Take it.  I think it is wrong of you to demand the other $30 I promised, plus the $5 I agreed to pay you.  You aren’t getting that money.  It’s your responsibility to subsidize my losses.”

That kind of behavior would be sociopathic.  To behave in such a way would require such an unfathomable lack of empathy it is almost hard to imagine.  If you are like normal people, the chances are good you wouldn’t remain friends for long.  It not the fact that your friend couldn’t repay the debt, it is the fact that he thought it was your responsibility to bail him out of his mess.  

Understanding Home Foreclosures

Home foreclosures are not pleasant but they are not the end of the world.
Image published under Creative Commons Attribution-Share Alike 3.0 Unported license by Vincent van Zeijst

Understanding How Bank Loans Work Are Key to Understanding Home Foreclosures

In this scenario, banks are like you.  They lend money to people.  The difference is, for every $100 a bank lends to someone, maybe $8 or $10 belongs to the bank owners (stockholders).  The other $90 to $92 belongs to savers who deposit their cash for safekeeping.  The bank’s job is to take those savings and conservatively lend them to people who have a good chance of paying back the money, plus interest.  That interest, penalties, late fees, and service charges are then divided up by the bank into one of five piles:

  1. To cover losses on loans that go bad and are only repaid in part, 
  2. To pay its own expenses (salaries for tellers, bank officers, expanding or renovating branch offices, etc.), 
  3. To pay the local, state, and Federal government taxes for streets, schools, military, Social Security, Medicare, and other programs,
  4. To generate a return for the owners of the bank who risked their own savings to build the institution in the local community, and 
  5. To pass on interest income to the savers who own the certificates of deposit, money market mutual funds, checking accounts, and savings accounts held on the institution’s books.

That is it.  All of the money a bank makes has to go to one of those five categories.  As a society, we have some safety procedures in place to protect the depositors.  For smaller amounts, up to certain limits, the banks have to take part of the interest and kick into the FDIC fund.  This fund pays out like insurance to depositors who don’t get their money back from borrowers during bank failures.  If the FDIC fund runs dry, taxpayers step in and dip into the money sent to the IRS to pay the insurance claims.

Expanding the Lesson to the Home Foreclosures of the Housing Crisis

Now, take a few moments to think about the process when you buy a house.  Say you purchased a $200,000 home and only put down $20,000 of your own savings.  You finance the remaining $180,000 by taking out a mortgage.  What really happened?

  • $20,000 of the home purchase price came from your savings
  • $14,400 of the home purchase came from the savings of the bank owners (shareholders)
  • $165,600 of the home purchase came from the savings of bank depositors; the retirees, factory workers, small business owners, corporations, soldiers, waitresses, executives, teachers, politicians, doctors, and lawyers who put their money in checking accounts, savings accounts, money market mutual funds, and certificates of deposit.  This money includes vacation funds, retirement funds, college funds, allowances given to kids, etc. 1

You agreed to pay rent on the $180,000 you borrowed ($14,400 from the bank owners and $165,600 from the depositors).  In addition, you agreed to give the bank and the depositors a right to seize the real estate as a last resort in the event you break your word.  That way, the bank and depositors can sell the house and recapture some or all of their savings.  You also agreed to allow penalties and fees to be added to the debt to compensate the savers for breaking their promise to return their money, plus interest, on time. 

You Don’t Have a Right To Stay In “Your Home” and Avoid a Home Foreclosure If You Don’t Return the Savings You Borrowed

No one made you borrow money.  Until you have repaid the savings you rented, it is not “your home”.  You don’t own it.  You never owned it.  You won’t own it until it is your name on the title deed, free and clear.  That happens once you’ve fulfilled your promised and returned the savings you borrowed.  It is incredibly simple.  There is nothing complex about the situation.

Yet, I sometimes get messages from incensed readers, wanting to know what to do because the bank “refuses to work with them”.  The bank is going to “steal [their] house”.  

[mainbodyad]It is not the bank’s fault you borrowed money.  It is not some Wall Street CEO’s fault that you borrowed money.  It is not your employer’s fault that you borrowed money.  You made a choice, like an adult, to rent other people’s savings.  Now, you screwed up or you had bad luck.  That happens.  It doesn’t make you a bad person.  Going forward, you have a choice.  Either: 1.) Return the savings you borrowed, or 2.) Give up the collateral that you pledged (the house) so the bank can recover the savings it lent for its owners and depositors.  It is their money that bought the house.  They have first claim over you.  You knew that at the time, you agreed to it at the time, and had housing prices skyrocketed, you were going to keep all the gains for yourself.  On the flip side of the Janus coin, it seems a bit hypocritical to be upset.

Make a decision and get on with your life.  The bank, acting on behalf of its owners and the depositors whom have entrusted their savings, has no obligation to “help” you.  If you can’t live up to your promises – and that does happen in life, don’t beat yourself up over it – accept the bargain you struck, forgive yourself, learn from the mistake, and get over it.  Study the experience so that you never have to go through it again.  If ever there were a time to act rationally in life, this is it.

Don’t Destroy Your Life and Family Trying to Avoid a Home Foreclosure

Instead, I see people destroy their families, their finances, and their happiness by trying to save a material possession.  You know the old saying attributed to Jesus Christ in the gospels, “life does not consist of an abundance of things”?  It is just a house.  It is wood, gypsum, marble, wool, and grass.  To cling to it to the point of self-destruction is a level of materialism I just do not understand.  Your kids grew up there?  Your parents own it?  That doesn’t matter.  The house is not your kids.  The house is not your parents.  I’ve watched members of my own extended family make this mistake.  They inevitably lose the house to foreclosure, anyway, but only after having depleted everything they worked for in life.

Take a lesson from Paula Cole.  She penned one of my favorite lyrics, “I am not my house, my car, my songs.  They are only stops along my way.”  Your life consists of your choices and your relationships.  Those are the things that matter.  So what?  You have to move into a two bedroom rental for a few years as you rebuild your life.  The only thing it hurts is your pride.  People will destroy any chance at long-term success just to avoid wounding the first of all sins.  

Get over your materialism.  Get over your pride.  Get on with your life.

1. Technically, a portion of these savings come in the form of fractional reserve entries since that is the foundation upon which the modern banking system relies. Practically, since most deposits are guaranteed by the FDIC, this portion of the funding is represented by a claim on the future interest income of bank depositors taken in the form of an insurance premium at the institution level or the taxpayers of a nation as a whole, in the event the insurance pool needs to be supplemented from tax receipts paid into the Treasury. A discussion of those factors would be beyond this article.