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Strategic Mortgage Defaults Have Major Implications for Economy and Markets

Posted by Larry Doyle on September 21, 2009 11:29 AM |

The Brave New World of the Uncle Sam economy has brought our economy and markets into realms very rarely seen or experienced. One of those realms which has received very little coverage, but will have major implications for the economy and markets going forward, is “strategic mortgage defaults.” What are strategic mortgage defaults and what will be the growing impact of this phenomena? Let’s navigate.

High five to KD of 12th Street Capital for bringing this development to our attention. The Los Angeles Times profiles this very troubling slope on our economic landscape in writing, Homeowners Who ‘Strategically Default’ on Loans a Growing Problem:

With foreclosures, delinquencies and loan losses at record levels, strategic defaults and walkaways are among the hottest subjects in residential real estate finance. Unlike in earlier academic studies, Experian and Wyman could tap into credit files over extended periods to identify patterns associated with strategic defaults.

The number of strategic defaults is far beyond most industry estimates — 588,000 nationwide during 2008, more than double the total in 2007. They represented 18% of all serious delinquencies that extended for more than 60 days in last year’s fourth quarter.

Strategic mortgage defaults are nothing more than a very calculated financial maneuver primarily by people with high credit scores. These people are literally walking away from their homes – and the mortgages on those homes – with little to no warning or indication of stress typically identified by increased delinquencies on the mortgage payment or other credit payments.

Why are people doing this? To fully understand the reasoning behind people strategically defaulting, we need to understand why people bought these homes and took out these mortgages in the first place. Over the last decade, many people purchased homes, including their primary residence, for investment purposes as much as for shelter and protection. As with other investments, these high credit and financially savvy people are assessing the market value of their home relative to their carrying costs (mortgage payments, taxes, utilities, etc) and making the decision that they are financially better off walking away from the property and mortgage than continuing to make the payments.

Is there a moral failure in this practice, especially on behalf of those individuals who do have the financial wherewithal to make their payments? Perhaps, but we should not kid ourselves that people bring their morals – or lack thereof – into their financial affairs.

Have loan officers, bank examiners, and regulators factored these strategic defaults into their financial models and loan loss reserves? Rest assured, the thought of strategic mortgage defaults was not incorporated into a bank risk model prior to writing the loan.  Now loan officers, bank examiners, and regulators are likely working overtime to incorporate the actuality of this phenomena creating a vicious cycle downward for housing just as the actual lending practices and accompanying purchases of homes drove the housing market higher over the last decade.

Did Secretary Geithner incorporate this phenomena into the Bank Stress Tests? Not if we check the default assumptions on HELOC (Home Equity Lines of Credit) relative to the actual statistics. To do just that, please review “Bank Stress Tests: Vigorous or Sham? Let’s Review HELOC Losses” written here at Sense on Cents this past May 20th.

What are the implications of these strategic mortgage defaults?

>> more downward pressure on the housing markets where these loans were originated. Where’s that? Start with California, Arizona, and Nevada,  move to Florida, but also appreciate it will impact every market where Jumbo mortgages were written. This deflationary impact will certainly be incorporated into the Fed’s outlook for interest rates and keep rates low for a more extended period than otherwise deemed necessary.

>> increased losses for those holding these mortgages. Who is that? Institutional investors which originated or purchased the Jumbo mortgages in search of higher yields, including: bank portfolios, insurance companies, and the Federal Home Loan Bank system.

>> less credit availability in general and specifically for the Jumbo mortgage space. Why? Banks need to increase loss reserves against their current Jumbo mortgage portfolio.

>> as strategic mortgage defaults continue to increase and homes are foreclosed, real estate appraisals on these homes will continue to decline as the supply of homes in this segment of the market increases. As a result, potential buyers of these homes will wait and rent thinking the market will continue to soften.

Thank you again 12th Street Capital.

Thoughts, comments, questions always appreciated.

LD

  • To continue on this topic Larry, here is a Reuters story this morning about mortgage delinquencies. August saw a new record level of mortgage delinquences (7.58%), was the 4th consecutive monthly increase, and the pace of the increase is also escalating. Some other items from this story:
    – Credit card issuers have cut the overall number of credit cards by 19% over the last year
    – Credit card issuers have also cut credit limits by $720 billion over the past year
    – Credit card issuers have dramatically reduced the number of new credit cards issued, as June saw a nearly 50% decline in the number of new cards issued year-over-year
    – The new cards that are being issued are more and more going to people with very good credit scores (which is a lower and lower % of overall consumers) – this is consistent with what I said last night about going back to how credit cards were in the early 1980’s.
    – Total consumer debt is down 3% from a year ago, and the savings rate is nearing 5%

    http://www.reuters.com/article/newsOne/idUSTRE58K29E20090921

  • divvytrader

    Obama gonna send over the Rahm Emanual attitude adjustment crew to squelch all this negative talk ……. a ” Rain of Hellfire ” to come down on those who dare question Dear Leader ( http://www.huffingtonpost.com/2009/09/18/dnc-promises-rain-of-hell_n_291526.html )

  • Mortgage Truth

    Frankly I’m surprised there haven’t been more strategic defaults, especially since home prices won’t return to their peak (2006) until 2020-2030, according to Moody’s. If you’re sitting on $50,000-$100,000 in negative equity, why keep paying just to break even in a decade?

  • On MATTERS OBAMA and the current state of affairs of our Constitutional values.
    We did it to ourselves,,,,, If we want to heal theis Great Country of ours, and return to Constitutional values,,,, like any disease in the body we must identify the Beliefs,,,which have brought on the experience we suffer from Individually, and as energy flows collectively.
    We must own our responsibility in the current state of affairs.
    So how did we did we get here to this current Consitutional crisis, of Crooks in the executive branch, making off with Trillions from the Treasury, under the new speak terms of “Bailout“? With a Marxist usserper as President, blatantly flagrantly unwilling to provide his national allegence B.C. ? His lawyers (OUR LAWYERS) the DOJ defending him by saying “The Courts have no Juristiction in the issue” as his defence. With a Congress enabling the, thru either fear, or outright bribery? Judges who enable and condone socialist
    The answer is simple, we did it thru not standing up for the Constitution when its first breached, and further encouraged the usurpers by “believing paying taxes” is patriotic.
    The history is clear 1913, with the implimentation of the Federal Reserve a private corporation of European Bankers, taking control of our GOLD SILVER backed money, and the implimentation on income tax, passed in the middle of the night dispite many state constitutions allowing taxes on wages, gave the results we now experience. Worse, they are turning the Country to a Marx’s form of Socialism via OUR OWN MONEY which we pay each year in the form of income Tax.
    Why do you think they open the doors to south of the boarder? To increase the tax roles ONLY.
    40 million americans have quit, becoming aware thru auther like Irwin Shiff a great Patriot. Yes they did jail him, his teaching gained him notoriety, and the powers that be jailed him. But they cannot jail 40+million, and the powers will know its real when it becomes 100 million.
    My advise to turn this country around? Cast your biggest vote ever, cut them off at the hip pockets. Stop paying. Do your research its all true, the media has binded you, hypnotized you into self distruction, by making it appear unpatriotic to protest what is he wrong. Jailing the one who try to enlighten you, so much for free speech, and honest Courts
    Wake up America, its not too late, if you really love this Country, to Cast your vote.
    If you are employed make out a new W-2 claiming exempt, if your self employed its easier. They are only punishing those who still file.
    Read Irwin Shiff, the books are online, I have no affilliation but his works did wake me up to the grad scam of enslavement. givemeliberty.org find out the truth.
    Its time we take responsibility for how we spend our energy $.
    Some may say what about national defense? They won’t be able to defend the Country? I submit, where is the military now we have a foreign citizen sitting in as president, taking us to Marxism.
    If you don’t believe in feeding the war machine, killing innocents for oil, or whatever crisis they create to cause war, stop paying them otherwise you are helping to kill the innocents.

  • I have left a comment on this article on ‘Wall Street Pit’ pointing out that I proposed a solution to the problem of what I called ‘Walkaways’ one year ago on my blog, to quote the last paragraph of that old post I suggested:


    “Mortgages have always assumed the equity provided by the mortgagee is the first at risk. In this crisis that has to be changed. I suggest that for houses purchased since Gordon Brown, in the words of incoming BoE Governor King, to paraphrase ‘moved the Goal Posts and excluded house prices from the CPI’ any loss of value on the resale of such houses be directly proportioned between the first mortgage holder and the mortgagee. This is potentially expensive, but less so if it halts further slides in house prices. As the country is effectively bankrupt such a move will need financing and as a further step to somewhat also put the cost of the greed at the door where it lies I would further suggest the exemption of the first home from capital gains tax be withdrawn.”

  • Larry Doyle

    Martin,

    Certainly this proposal would be virtually impossible to implement retroactively.

    To do so on a going forward basis would dramatically ratchet interest rates higher. By how much? Great question. I would venture to say at least 1% if not 2%.

    I think the proposal being propped is that of “covered bonds” in which the sellers of mortgages retain an economic interest in the loan even after selling it. As such, the hope is that the initial underwriting process will be more rigorous. Even with that being the case, though, a large percentage of these loans which people are strategically defaulting would still have been approved.

    I think the penalties connected to default, that is the dramatic drop in one’s credit score, needs to be more onerous.

    Thanks for adding to the dialogue.

  • Larry,

    Thanks for your reply, a welcome change as my suggestions this side of the pond are inevitably met with a wall of silence.

    I agree the retroactive element of my proposal is a drawback, also within the US environment the impact on interest rates a potentially crippling disadvantage.

    Let me discuss these factors from a UK standpoint, however, and you might then be better able to determine whether there is later applicability for the US which has the major advantage, when compared with ailing sterling, of the dollar’s reserve currency status.

    Even a year ago it was obvious that the pound sterling was assuming junk status, hence my tagging of some posts on my blog with “funny money”.

    Here is the key “The loss of a good credit rating earned with “funny money” is of small immediate significance and zero long-term effect” – hence the walkaways.

    On the retroactivity consider a UK employee, retiring this year, who has saved a reasonable sum in a pension fund throughout his career. OK some decline would always have been a risk, but post credit-crunch he has been double zapped with both the fall in the funds value and the reduced annuity value which he can now purchase. This has been of such severity that a huge and retroactive pension fund reduction is effectively what has occurred in the private sector.

    His peer who has historically ridden the inflated UK property market to the maximum and therefore done nothing to promote the true free-market system with his savings, is presently sitting on a huge untaxed and unearned apparent asset gain.

    The UK Government, with the collapse of tax revenues from the City and escalating welfare bills has resorted to printing even funnier money with so-called Quantitative Easing.This is retroactive impoverishment par excellance.

    When foreign lenders no longer consider sterling interest rates sufficient to cover the risks of further devaluation where can extra sterling revenue then be found? The presumed wealth of the country, wasted during the apparent high-growth years, now rests in an over-valued private property pool. No surprise then that this week the third largest political party in the country has been the first to suggest property taxes.

    In the USA restoring faith in the national currency remains a viable possibility, thus a damaged credit rating might remain a deterrent to strategic mortgage defaults.

    In the UK outside of the casino style banking industry, the government and the civil service, people in the country at large have noted the stark reality and will likely start to cut their own losses in far greater numbers, possibly involving agreed cross-squatting (also covered on my blog last year).

    Walkaways, mutually agreed cross-squats and property taxes will dish the property market for certain …. and potentially the rule of law in the process.

    Things for the UK look sombre, hence my proposal for sharing property equity losses for the period during which Gordon Brown and Mervyn King deliberately distorted inflation indexes.

    I would welcome your further thoughts and will link this exchange from my blog.

    • Larry Doyle

      Martin,

      I find your comments to be very interesting. Your perspective from your ‘side of the pond’ is on one hand understandable to anybody following economics but on the other hand very difficult to fathom for those of us on ‘this side of the pond.’

      What is hard to fathom? The effective ‘taking’ of private property. I think that may create civil unrest of unprecedented proportions. Not that we may not have civil unrest for other reasons.

      Suffice it to say, both the UK and US economies have real issues all of which center on excessive debt. No surprise that the sterling and greenback are each having issues.

      Are we living through a multi-generational shift in the primacy of what once were two world leaders? I believe we are. To what extent? Time will tell.

      Living beyond one’s means is a recipe for underperformance.

      In summary, from an American perspective, I have a hard time grasping the government unilaterally assuming a degree of ownership in what was private property.

      I thank you for sharing your thoughts and perspectives. I welcome continuing the dialogue on this topic as well as others.

      Best.

  • Nikolai

    Real estate business usually swings and sometimes prices defer to where and what type of property.

  • Gari

    The United States Government is forcing Americans to become immoral and walk away from their mortgage. If the CORRUPT American Government gave a real CRA! and wanted to do something good to stabilize their pathetic situation in the housing market they certainly could.

    I say the CORRUPT American financial system has set the example and millions of Americans should immediately pursue “Strategic Default” on their home mortgages.

    • Larry Doyle

      Gari,

      So many moral hazards have been violated that it is hard to argue with your comment. I guess all I can say is that ’strategic mortgage defaults’ are one of the great unintended consequences of the practices that have been implemented by the government and our financial industry.

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