Dec302010

Strategic mortgage default became common and accepted in 2011

Anyone who is underwater on their mortgage and struggling with payments is considering strategic default. Many of these people will succumb to mortgage distress whether or not they chose the timing of their default. They are debt zombies. Many others who are underwater and struggling could survive the real estate recession and divert significant family money toward excessive loan payments, but they see the advantages of a lower housing cost, so many of them are choosing to strategically default because it is in their best interest financially to do so.how_to_live

Many of those who chose not to strategically default make this choice because they believe making the payment is a moral obligation — an obligation above and beyond what is written in the contract. Banks are relying on those borrowers motivated by their perceived morality to keep making payments. Unfortunately, there is no longer a moral stigma associated with strategic default.

Banks need a moral stigma to be associated with loan repayment. If the transaction were viewed by borrowers as a simple business transaction — which it is — then issues of morality are not effective at cajoling debtors into repayment, particularly when default is in the best interest of the debtor. Banks have long relied on borrower morality to get repaid.

Due to the events of the Great Housing Bubble, borrowers no longer feel a moral obligation to repay their mortgage debts. Borrowers view the system as corrupt. Many borrowers believe greedy lenders inflated prices with oversized loans to pad their own profit margins. Those borrowers are correct in their views and beliefs, and based on that view, many borrowers no longer feel compelled by morality to repay their mortgage debt.

More see walking on mortgage as a viable plan

‘Strategic default’ losing stigma as homes go deeper underwater

By Jane Hodges
msnbc.com contributor msnbc.com contributor
updated 12/20/2010 12:11:34 PM ET

More Americans than ever are showing a willingness to walk away from their underwater homes, according to a recent survey. Chris Kelly is a perfect example of someone who never thought she would send the bank “jingle mail” — mailing the keys back. But she did.

Until last year Kelly, a 46-year-old administrative assistant, was living in a 3,000-square-foot home she owned with her ex-husband in the Seattle suburbs.

The duo had put the three-bedroom, three-and-a-half bath home on the market before finalizing their divorce in the spring of 2009 but had no luck luring move-up buyers to the $600,000 home even after price markdowns.

Kelly wound up living there solo, struggling to make the mortgage payments. But as she kept writing checks, and worrying, she became aware that she’d have to make a hard choice: Leave the house while she still had decent savings, or pay until she’d emptied out all her accounts and then enter foreclosure.

In the latter scenario, she’d have to look for a lease with no money left for a deposit. Either way, she’d lose the home, whose value had dropped underwater — below what the couple owed on it.

I know people who have wiped out their personal and retirement savings because they were unable to get themselves to default while they still had the ability to pay. It’s like the slot machine gambler that refuses to get up until every last dollar has been lost. The decision to default gets forced upon them when they can no longer raid savings or Ponzi borrow to make payments. Decision by indecision is very painful in cases where accelerated default would have proven beneficial.

“It was a pretty clear decision,” says Kelly, who now lives in Austin, Texas. “I knew I had to walk away. The longer I stayed there, the worse my credit would be and the harder time I’d have finding a rental.

So a year ago she walked way, joining the growing number of Americans willing to turn their backs on homes they can neither sell nor afford to keep. The real estate industry calls this “strategic default,” referring to people who choose to walk away even when they can technically afford to continue paying their mortgage.

Lenders would certainly prefer all borrowers to be dutiful on their way to the debtors gallows by draining every last drop of savings rather than considering options and making a “strategic” or considered decision.

Nearly half, 48 percent, of homeowners with a mortgage said they would consider walking away from their home if they owed more on it than it was worth, according to a Harris Interactive survey released this month. The survey was conducted in November for real estate listings site Trulia and foreclosure research firm RealtyTrac.

Just six months ago, a similar survey indicated that only 41 percent of consumers would consider walking if they were underwater on their mortgages.

Is a 7% movement in this statistic meaningful? I think it is. Who do you think this 7% who changed their minds are? Who else would be thinking about it? Those faced with the decision, of course. A certain amount of the stigma will fall away as people know “good people” including family, friends, and acquaintances that have elected to accelerate their defaults. The trend will be for this statistic to trend toward complete acceptance over the next several years.

“It’s a phenomenon we haven’t seen before in the housing market,” said Rick Sharga, senior vice president of RealtyTrac. “The mindset of why people purchase a home has changed over the past decade.”

In the early 2000s, as home prices rose sharply and steadily, many buyers saw their home as an investment. But in the wake of the housing bust, it’s clear that a home has become far more of a “utility” — a form of shelter — than an investment.

Actually, only the public perception has changed. Houses have never been a good long-term speculative investment. The rate of appreciation only matches inflation, the carrying costs are high, the transaction costs are high, and the market is prone to bouts of illiquidity. Given these circumstances, only during brief periods of upward volatility (sucker rallies) is it possible to reap major appreciation benefits from owning residential real estate. It has always been about utility of ownership, but people are only now detoxifying from the kool aid enough to see it.

Over the next year, hundreds of thousands of homeowners will face the question of whether to walk away as their mortgage payments spike.

Sharga said that $300 billion worth of adjustable rate mortgages are expected to reset upward over the next 12 to 15 months, adding on average $1,000 to monthly mortgage payments on homes that already are worth 30 percent to 50 percent less than their original sale price.

Remember, it isn’t the reset of the interest rate that is a problem because rates are still low, the real problem is the recasting of these loans from interest-only to fully amortizing. The recasts add significantly to the payment as Sharga suggested above.

Roughly 23.2 percent of all single-family homeowners who have a mortgage are underwater on their property, according to third-quarter data from Zillow. (Zillow estimates that 40 percent of single-family homes are owned, with the rest mortgaged.)

Major banks, including Bank of America and Wells Fargo, are preparing to work with these owners through modification programs that may include principal reduction or temporary interest-only loan payments until markets improve and refinancing is possible, Sharga says.

But clearly, many homeowners may have motivation to walk. They’ll see their mortgage payments spike at a time when their home value is underwater the deepest.

American homeowners lost $1.7 trillion in home value during 2010, a far higher loss of equity than the $1 trillion lost during 2009, according to Zillow data released earlier this month. Zillow also reported on a blog that less than one-fourth of the 129 metro areas it tracks showed home value gains in 2010.

In addition, the impacts to credit from a foreclosure are typically less damaging than those from a bankruptcy, which hits more lines of credit and loans than just the home loan. According to Barry Paperno, consumer operations manager at myFico.com, the consumer site for Minneapolis-based credit scoring company Fair Isaac Corp., a personal bankruptcy can shave 130 to 240 points off a person’s credit score, while a foreclosure typically reduces a score by 85 to 160 points. (FICO scores range from 350 to 850, with higher scores better.)

“It’s serious, and it certainly complicate future purchases,” Paperno says. “Compared to a bankruptcy, though, the score impact can be surprisingly different.”

The latest Harris survey also revealed some interesting gender differences in attitudes about strategic default: Men were nearly 50 percent more likely than women to consider walking away from an underwater loan, with 57 percent indicating willingness, vs. 40 percent of women.

That one surprises me. It may be interesting to see that broken down by who manages the money in the family. It’s probably a higher percentage among those who face the realities of the bills than those that do not.

Pete Flint, CEO of Trulia, said that this may indicate men take a more investment-minded approach to homeownership and evaluate when to walk as a financial decision, while women may view their property as a home and have a harder time with the concept of leaving it even under fiscal duress.

Kelly embodies both approaches. She says she was torn about the decision, but couldn’t let sentiment overtake what, ultimately, was a move toward self-preservation.

“I never thought that this was something that would happen,” she says. “I loved that house.”

Is this about survival, or is this about entitlement? Ultimately, each borrower evaluates financial alternatives, determines the emotional toll to be paid, and finally makes a decision and acts on it. Some may consider that survival, but it is really the survival of entitlement. It is wise to squat in a nice home and avoid sending those resources to a lender, and it is wise to find a comparable rental for less than the former house payment. That’s why borrowers quit paying and squat until finally moving into a rental. It’s a trend we will see more of in 2011.