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business newsStrategic Defaults Threaten All Major US Housing Markets
Two reports suggest that as home values continue to decline and LTV ratios rise, the number of homeowners walking away from mortgage obligations will grow.
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In my last article, In Reality, Housing Is Not Even Close to Stabilizing, we examined the shadow inventory to determine how many distressed properties (not on MLS) were almost certain to be forced onto the market in the not-too-distant future.
For a sensible follow up, let's take an in-depth look at so-called "strategic defaults" to see how many homeowners are likely to "walk away" from their mortgage debt although they might be financially able to continue paying it.
Strategic Default Defined
According to Wikipedia, a strategic default is "the decision by a borrower to stop making payments (i.e., default) on a debt despite having the financial ability to make the payments." This has become the commonly accepted view.
In a recent, thorough study of strategic defaults, an effort was made to narrow its definition even more specifically. The report examining 6.6 million first lien mortgages was published this past April by Morgan Stanley analysts. They considered a default to be strategic only if a borrower went from being current on the debt to 90 days delinquent in consecutive months "without any curing in between or thereafter."
The authors went further and included two other prerequisites. First, the borrower had to be "underwater" on the first lien mortgage. Second, the homeowner had to have an outstanding non-mortgage debt balance of more than $10,000. The purpose of this last requirement was explained to me in a phone conversation with the lead analyst. He clarified that unless the borrower had at least $10,000 in non-mortgage debts which continued to be kept current, it was very likely that the mortgage default was induced by the inability to continue making the payments.
While this definition by the Morgan Stanley analysts is plausible, I consider it to be too narrow. It excludes too many borrowers who choose to stop paying the mortgage even though they may miss payments on some of their other debt obligations. I define a strategic defaulter to be any borrower who goes from never having missed a mortgage payment directly into a 90-day default. We'll examine a graph a little later which clearly illustrates this definition.Why Do Homeowners Walk Away From Their Mortgages?
In the midst of the housing bubble, it was inconceivable that a homeowner would voluntarily stop making payments on the mortgage and lapse into default while having the financial means to remain current on the loan.
Then something happened which changed everything. Prices leveled off in 2006 before starting to decline. With certain exceptions, they've been falling ever since around the country. In recent memory, this was something totally new and it's radically altered how homeowners view their house.
In those metros where prices soared the most during the housing bubble and collapsed most severely, many homeowners who have strategically defaulted shared three essential assumptions:
1. The value of their home wouldn't recover to their original purchase price for quite a few years.
2. They could rent a house similar to theirs for considerably less than what they were paying on the mortgage.
3. They could sock away tens of thousands of dollars by stopping mortgage payments before the lender finally got around to foreclosing.
Put yourself into the mind and the shoes of an underwater homeowner who held these three assumptions. The temptation to default became very difficult to resist. What would you have done?
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