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 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 better off financially 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 checked 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 at Sense on Cents this past May 20th.
What are the implications of these strategic mortgage defaults?
- more 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.
- 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.