This Model Needs Some Quick-Dry Crazy Glue

Traders, strategists, analysts, economists, and politicians will always review models of past behaviors in an attempt to forecast future developments. In the process, the models are only as robust as the inputs. Many of the aforementioned individuals will become overly dependent on models. The risk in that process is that the models ‘work until they don’t work.’ As a result, programs, policies, and procedures are implemented that perhaps exacerbate rather than amend a situation. I believe this scenario is playing out in our housing market.

The breakdown in Washington’s housing model revolves around the newly developed phenomena known as “strategic mortgage defaults.” I highlighted this topic a few weeks back in writing, “Strategic Mortgage Defaults Have Major Implications for Markets and Economy.” We see more evidence of this new extension on our housing model in a report released by Reuters, The Flood of Foreclosures Shows No Sign of Ebbing:

The Center for Responsible Lending says foreclosures are on track to wipe out $502 billion in property values this year.

That spillover effect from foreclosures is one reason why Celia Chen of Moody’s Economy.com says nationwide home prices won’t regain the peak levels they reached in 2006 until 2020.

In states hardest-hit by the housing bust, like Florida and California, the rebound will take until 2030, Chen predicted.

“The default rates, the delinquency rates, are still rising,” Chen told Reuters. “Rising joblessness combined with a large degree of negative equity are going to cause foreclosures to increase,” she added.

Anyone doubting that the recovery in U.S. real estate prices will be long and hard should take a look at Japan, Chen said.

Prices there are still off about 50 percent from the peak they hit 15 years ago.

The pressure from homes currently in foreclosure only further depresses home values which lead to an increase in strategic mortgage defaults. Kudos once again to our friends at 12th Street Capital for leading us down new highways and byways along our economic landscape. Today, 12th Street highlights a riveting report produced by Paola Sapienza (Kellogg School of Management at Northwestern University), Luigi Zingales (University of Chicago Booth School of Business) and Luigi Guiso (European University Institute) for International Communications Research. This report, Moral and Social Restraint to Strategic Mortgage Defaults:

Using data collected from surveys conducted within the last six months as part of the Financial Trust Index, this paper is the first to examine the economic and moral implications of strategic default in the current recession. The finding of a strategic motivation to default contrasts with an earlier study of the Boston housing market during the 1990-91 recession in which homes devalued by approximately 10%. In that study, which Sapienza, Zingales and Guiso believe is the basis for the Obama’s administration’s current housing policy, found that very few homeowners who could afford their mortgage chose to walk away from their homes.

“Housing policy under the current administration has focused on reducing households’ cash flow problems in response to the housing crisis, but no one has addressed the negative equity issue as part of public policy regarding housing,” said Sapienza. “We’re in a completely different economic environment today, where for the first time since the Great Depression millions of Americans have mortgage loans that exceed the value of their home.”

While the administration swims upstream on this issue, bank policy of tight credit and restrictive lending only further exacerbates the housing market. Make no mistake, though, banks are taking that approach to tight credit at the behest of regulators who know the level of losses in the banking system and are trying to preserve the industry as a whole.

I like a rallying equity market as much as anybody, but I wouldn’t spend any paper gains just yet. Why? The new housing model is displaying that:

“As defaults become more common, the social stigma attached with defaulting will likely be reduced, especially if there continues to be few repercussions for people who walk away from their loans,” concluded Sapienza. “This has an adverse effect on homeowners who do pay their mortgages, and the after-effects of more defaults and more price collapse could be economic catastrophe.”

This model needs some quick-dry crazy glue, which could only be applied in the form of a serious principal reduction program. Banks would take immediate and massive hits to capital which they clearly won’t accept.

About Larry Doyle 522 Articles

Larry Doyle embarked on his Wall Street career in 1983 as a mortgage-backed securities trader for The First Boston Corporation. He was involved in the growth and development of the secondary mortgage market from its near infancy.

After close to 7 years at First Boston, Larry joined Bear Stearns in early 1990 as a mortgage trader. In 1993, Larry was named a Senior Managing Director at the firm. He left Bear to join Union Bank of Switzerland in late 1996 as Head of Mortgage Trading.

In 1998, after 15 years of trading and precipitated by Swiss Bank’s takeover of UBS, Larry moved from trading to sales as a senior salesperson at Bank of America. His move into sales led him to the role as National Sales Manager for Securitized Products at JP Morgan Chase in 2000. He was integrally involved in developing the department, hiring 40 salespeople, and generating $300 million in sales revenue. He left JP Morgan in 2006.

Throughout his career, Larry eagerly engaged clients and colleagues. He has mentored dozens of junior colleagues, recruited at a number of colleges and universities, and interviewed hundreds. He has also had extensive public speaking experience. Additionally, Larry served as Chair of the Mortgage Trading Committee for the Public Securities Association (PSA) in the mid-90s.

Larry graduated Cum Laude, Phi Beta Kappa in 1983 from the College of the Holy Cross.

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