Falling house prices are pushing more loan owners underwater and into strategic default.
by JASON PHILYAW -- Monday, May 9th, 2011, 8:55 am
Home values in the first quarter fell 3% from the prior quarter and are now nearly 30% lower than the June 2006 peak.
Real estate data analytics firm Zillow said its home value index for the first three months of 2011 declined 8.2% from a year earlier to $169,600. The first-quarter decline was the steepest since 2008.
Zillow now doesn't expect home values to reach bottom before 2012, "at the earliest."
"Home value declines are currently equal to those we experienced during the darkest days of the housing recession," Zillow Chief Economist Stan Humphries said. "With accelerating declines during the first quarter, it is unreasonable to expect home values to return to stability by the end of 2011. We did expect substantial payback from the homebuyer tax credits, which buoyed the housing market last year, but underlying demand post-tax credit, as well as rising foreclosures and high negative equity rates, make it almost certain that we won't see a bottom in home values until 2012 or later."
The level of single-family homeowners who owe more on their mortgage than the property is worth rose to a new high of 28.4% at March 31, up from 27% at the end of 2010, according to Zillow.
The percentage underwater is very important because strategic defaults go up significantly when home owners become loan owners as evidenced by the dismal cure rates on underwater loans.
As the author of our next article points out, the 28% figure above is misleading. The truth is more dire. These studies of underwater loan owners only considers the first mortgage. When you factor in the total debt on the property and include the second mortgages and HELOCs, the percentage who are underwater is much higher than 28%.
May 4, 2011, 2:01 p.m. EDT-- By Keith Jurow 
BRIDGEPORT, Conn. (MarketWatch) — In an article posted last September I discussed the growing threat that so-called “strategic defaults” posed to major metros which had experienced a housing bubble.
With home prices showing renewed weakness again, now is a good time to revisit this important issue. See Strategic defaults threaten all major U.S. housing markets
I define a strategic defaulter to be any borrower who goes from never having missed a payment directly into a 90-day default. A good graph, which I will discuss shortly, illustrates my definition.
For purposes of statistical analysis, his definition is useful because it is an easily identifiable trait which can only be explained by a sudden and conscious decision. However, it doesn't pick up the millions of strategic defaulters who struggle for a time juggling payments until they either give up or run out of resources. Many borrowers finally give up after missing some payments, getting behind, and realizing they can never dig out.
Who walks away from their mortgage?
When home prices were rising rapidly during the bubble years of 2003-2006, it was almost 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 in most bubble metros leveled off in early 2006 before starting to decline. With certain exceptions, home prices have been falling quite steadily since then around the country. In recent memory, this was something totally new and it has radically altered how most homeowners view their house. In those major metros where prices soared the most during the housing bubble, homeowners who have strategically defaulted share three essential assumptions: • The value of their home would not recover to their original purchase price for quite a few years.
• They could rent a house similar to theirs for considerably less than what they were paying on the mortgage. • 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 shoes of an underwater homeowner who held these three assumptions. Can you see how the temptation to default might be difficult to resist?
Those are the standard reasons for strategic default we have discussed at length on this blog. They are good reasons. Anyone facing those circumstances will benefit financially from walking away. That's why strategic default is so common and will become the norm before this crisis has past.
In fact, one of the primary reasons lenders should never loan money when the rental cashflow doesn't cover the loan payment is because it exposes them to strategic default risk. There is no amount of signatory assurance that will prevent strategic default. The only way lenders can limit their risk effectively is to make sure that the property can cover the payments even if the borrower cannot.
Who doesn’t walk away?
... Last year, two important studies were published which have tried to get a handle on strategic defaults. First came an April report by three Morgan Stanley analysts entitled “Understanding Strategic Defaults.” The study analyzed 6.5 million anonymous credit reports from TransUnion’s enormous database while focusing on first lien mortgages taken out between 2004 and 2007.
The authors found that loans originated in 2007 had a significantly higher percentage of strategic defaults than those originated in 2004. The following chart clearly shows this difference.
Why are the 2007 borrowers strategically defaulting much more often than the 2004 borrowers? Prices were rising rapidly in 2004 whereas they were falling in nearly all markets by 2007. So the 2007 loans were considerably more underwater than the 2004 loans.
Note also that the strategic default rate rises very sharply at higher Vantage credit scores. (Vantage scoring was developed jointly by the three credit reporting agencies and now competes with FICO scoring.) Another chart shows us that even for loans originated in 2007, the strategic default percentage climbs with higher credit scores.
Notice in this chart that although the percentage of all loans which defaulted declines as the Vantage score rises, the percentage of defaults which are strategic actually rises.
A safe conclusion to draw from these two charts is that homeowners with high credit scores have less to lose by walking away from their mortgage. The provider of these credit scores, VantageScore Solutions, has reported that the credit score of a homeowner who defaults and ends up in foreclosure falls by an average of 21%. This is probably acceptable for a borrower who can pocket perhaps $40,000 to $60,000 or more by stopping the mortgage payment.
Most people overestimate how damaging strategic default, short sale, or foreclosure are going to be on their credit score. This is a perception lenders foster because if everyone facing strategic default realized how light the punishments really are, nearly everyone would do it.
Further, some people facing strategic default see the light and realize their credit score doesn't matter at all if they simply abstain from using credit. If you have no desire to use credit, your FICO score could fall to zero, and it wouldn't impact your life.
Why do homeowners strategically default?
Is there a decisive factor that causes a strategic default? To answer this, we need to turn to the other recent study.
Last May, a very significant analysis of strategic defaults was published by the Federal Reserve Board. Entitled “The Depth of Negative Equity and Mortgage Default Decisions,” it was extremely focused in scope. The authors examined 133,000 non-prime first lien purchase mortgages originated in 2006 for single-family properties in the four bubble states where prices collapsed the most -- California, Florida, Nevada, and Arizona. All of the mortgages provided 100% financing with no down payment. By September 2009, an astounding 80% of all these homeowners had defaulted. Half of these defaults occurred less than 18 months from the origination date. During that time, prices had dropped by roughly 20%. By September 2009 when the study’s observation period ended, median prices had fallen by roughly another 20%.
People who stretched to buy at the peak were counting on mortgage equity withdrawal to afford their payments and their lifestyles. When it became obvious that money was not going to materialize, the borrowers bailed.
This study really zeroes in on the impact which negative equity has on the decision to walk away from the mortgage. Take a look at this first chart which shows strategic default percentages at different stages of being underwater.
Notice that the percentage of defaults which are strategic rises steadily as negative equity increases. For example, with FICO scores between 660 and 720, roughly 45% of defaults are strategic when the mortgage amount is 50% more than the value of the home. When the loan is 70% more than the house’s value, 60% of the defaults were strategic.
This last chart focuses on the impact which negative equity has on strategic defaults based upon whether or not the homeowner missed any mortgage payments prior to defaulting.
This chart shows what I consider to be the best measure of strategic defaulters. It separates defaulting homeowners by whether or not they missed any mortgage payments prior to defaulting. As I see it, a homeowner who suddenly goes from never missing a mortgage payment to defaulting has made a conscious decision to default.
The chart reveals that when the mortgage exceeds the home value by 60%, roughly 55% of the defaults are considered to be strategic. For those strategic defaulters who are this far underwater, the benefits of stopping the mortgage payment outweigh the drawbacks (or “costs” as the authors portray it) enough to overcome whatever reservations they might have about walking away.
Each borrower has a different tolerance for financial pain. Some bail as soon as they go underwater, and some wait until they are deeply submerged. In markets like Las Vegas where over 80% of loan owners are deeply underwater, even the most upstanding morally guided borrowers with firm beliefs about paying their mortgage will walk away.
Where do we go from here?
The implications of this FRB report are really grim. Keep in mind that 80% of the 133,000 no-down-payment loans examined had gone into default within three years. Clearly, homeowners with no skin in the game have little incentive to continue paying the loan when the property goes further and further underwater.
While the bulk of the zero-down-payment first liens originated in 2006 have already gone into default, there are millions of 80/20 piggy-back loans originated in 2004-2006 which have not. We know from reports issued by LoanPerformance that roughly 33% of all the Alt A loans securitized in 2004-2006 were 80/20 no-down-payment deals. Also, more than 20% of all the subprime loans in these mortgage-backed security pools had no down payments.
Here is the most ominous statistic of them all. In my article on the looming home equity line of credit (HELOC) disaster posted here in early September Home Equity Lines of Credit: The Next Looming Disaster?, I pointed out that there were roughly 13 million HELOCs outstanding. This HELOC madness was concentrated in California where more than 2.3 million were originated in 2005-2006 alone.
Last April I reported that
Banks refuse to recognize HELOC and second mortgage losses. Negotiations with these second lien holders is primarily what holds up short sales.
How many of these homes with HELOCs are underwater today? Roughly 98% of them, and maybe more. Equifax reported that in July 2009, the average HELOC balance nationwide for homeowners with prime first mortgages was nearly $125,000. Yet the studies which discuss how many homeowners are underwater have examined only first liens. It’s very difficult to get good data about second liens on a property.
So if you’ve read that roughly 25% of all homes with a mortgage are now underwater, forget that number. If you include all second liens, It could easily be 50%. This means that in many of those major metros that have experienced the worst price collapse, more than 50% of all mortgaged properties may be seriously underwater.
Realistically, the only thing that kept most of these people paying since early 2009 was the false bottom engineered by the federal reserve. Many more borrowers will strategically default now that prices are falling and hopes of a price recovery are flagging.
The Florida collapse
Nowhere is the impact of the collapse in home prices more evident than in Florida. The three counties with the highest percentage of first liens either seriously delinquent or in pre-foreclosure (default) are all located in Florida. According to CoreLogic, the worst county is Miami-Dade with an incredible 25% of all mortgages in serious distress and headed for either foreclosure or short sale.
An article posted on the Huffington Post in mid-January 2011 describes the Florida “mortgage meltdown” in grim detail. Written by Floridian Mark Sunshine, it begins by pointing out that 50% of all the residential mortgages currently sitting in private, non-GSE mortgage-backed securities (MBS) were more than 60 days delinquent — either seriously delinquent, in default, bankruptcy, or already foreclosed by the bank. I checked his source — the American Securitization Forum — and the percentage was correct.
for more details on mortgage delinquencies by product type, see the interactive graph at the Federal Reserve Bank of New York. Below is the graph for delinquent jumbo loans. Orange County, California has 8.3% delinquent. Apparently local wages don't support the jumbo loans underwritten here.
The author then goes on to discuss a strategic default situation among his friends in Florida. One of them had purchased a condo in early 2007 for $300,000. By mid-2010, it had plunged in value to less than $100,000 and he decided to stop paying the mortgage. When he expressed his concerns about the possible consequences to his buddies — including an attorney, an accountant, and a doctor — all expressed the same advice to him. They told him to walk away from the mortgage, save his money, and prepare to move to a rental unit. To them, it seemed like a no-brainer.
The author was a little surprised that no one thought there was anything wrong with strategically defaulting. The attorney actually suggested that the defaulter file for bankruptcy to prevent the bank from going after a deficiency judgment for the remaining loan balance after the repossessed property was sold.
The attorney was providing sound advice. After a strategic default or a foreclosure on a non-recourse loan, borrowers should declare bankruptcy. Lenders are merely laying in the weeds waiting for borrowers to become solvent again before pursuing collections. No lender has forgotten they are owed money.
The conclusion expressed by the author has far-reaching implications. As he saw it, “More and more Floridians who pay their mortgage feel like chumps compared to defaulters; they turn over their disposable income to the bank and know it will take most of their lifetimes to recover.” 
As prices slide to new lows in metro after metro, will this attitude toward defaulting spread from Florida to more and more of the nation? A May 2010 Money Magazine survey asked readers if they would ever consider walking away from their mortgage. The results were sobering indeed:
• Never: 42%
• Only if I had to: 38%
• Yes: 16%
• Already have: 4%
In late January of this year, a report on strategic defaults issued by the Nevada Association of Realtors seemed to confirm the findings of the two studies I’ve discussed. The telephone survey interviewed 1,000 Nevada homeowners. One question asked was this: “Some homeowners in Nevada have chosen to undergo a ‘strategic default’ and stop making mortgage payments despite having the ability to make the payments. Some refer to this as ‘walking away from a mortgage.’ Would you describe your current or recent situation as a ‘strategic default?’”
Of those surveyed, 23% said they would classify their own situation as a strategic default. Many of those surveyed said that trusted confidants had advised them that strategic default was their best option. One typical response was that the loan “was so upside down it would never have been okay.”
What seems fairly clear from this Nevada survey and the two reports I’ve reviewed is that as home values continue to decline and loan-to-value (LTV) ratios rise, the number of homeowners choosing to walk away from their mortgage obligation will relentlessly grow. That means growing trouble for nearly all major housing markets around the country.
The momentum of this second leg down in pricing will likely pick up speed as more and more borrowers strategically default. The only option lenders have is to increase shadow inventory and allow more squatting, but that will in turn encourage more strategic default because borrowers know they get an extended period of free housing.
The herd is spooked, and the stampeded that follows will lead to Las Vegas style market capitulation in many other markets around the country.
One change in the market I have noted this spring is the number of heavy-cash or all-cash buyers from the bear rally who are bailing out. After two years of negative cashflow and no appreciation to show for it, many FCBs are becoming impatient.
The owner of today's featured property paid $755,000 on 12/26/2008. He used a $417,000 first mortgage and a $338,000 down payment. Like many before him, he is pricing the property at breakeven in hopes a greater fool will come along.
I don't think that greater fool exists in this market. We will see.
Large master bedroom with huge views over the city of Irvine and a spacious bathroom with separate shower and tub, double sinks and walk in closet. There is a separate laundry room, off the huge kitchen with gorgeous granite counter tops and new dishwasher and a private outside patio just right for BBQ's and a quiet morning coffee and paper reading! New upgraded carpet and padding throughout and Italian porcelain tile on the bathroom and kitchen floors. New fittings and fixtures in wetbar and bathrooms and kitchen, just move in!! What a FIND! 
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