Residential Real Estate: How Strategic Defaults Will Torpedo Your Home Value
by Alexander Green, Chief Investment Strategist
Monday, April 5, 2010: Issue #1231
Les Christie of CNN Money says the big fall-off in home values is about to end.
In a recent column, he sites projections from Fiserv and Moody’s that indicate the residential real estate market is close to stabilizing and may even rebound in the year ahead.
Don’t believe him.
True, the S&P/Case-Shiller home prices index shows that home prices are leveling off and even turning higher in some areas. In Southern California, for example, February’s prices were up roughly 10% over a year ago.
Yet the primary trend is down. And thanks to your neighbors – some of them, anyway – that won’t change anytime soon. Here’s why…
The Housing Market… Another Seven Million U.S. Home Foreclosures?
The housing market is swelling with homeowners who are seriously delinquent, but have not lost their homes. According to the Mortgage Bankers Association, about five million to seven million properties are eligible for foreclosure, but have not yet been repossessed or put up for sale.
With unemployment near double-digits and teaser mortgage rates expiring, many (perhaps most) of these properties will move into the foreclosure process, undercutting housing prices.
This is not the real threat, however. The 100-foot financial tsunami headed our way is something we’ve never experienced in this country before. And it has little or nothing to do with the economy or unemployment. Bankers and economists call it strategic defaulting.
Goodbye, Real Estate Market… Hello, “Strategic Default”
In 2006, for example, Wynn Bloch paid $385,000 for a two-bedroom home in a hot real estate market. Today, comparable homes sell for $200,000. So she has decided to walk away from hers.
- Bloch hasn’t lost her job. (She’s a retired psychologist.)
- Nor has she lost her ability to pay.
- She’s lost the willingness.
Interviewed in the Los Angeles Times two weeks ago, she said there’s no chance that in her lifetime the house will ever be worth as much as the mortgage.
She mailed the keys back to the bank. And she has plenty of company.
Nearly one-quarter of U.S. mortgages – or more than 11 million loans – are “under water” (i.e. worth less than the balance of their loans.)
There was a time when Americans would do almost anything to keep their homes. It was part of the American Dream. But today, more homeowners are concluding that it’s smarter to walk away than stick it out.
Some claim unscrupulous lenders duped them. And in some cases, that may be true. But it strains credulity to believe that millions of high-school and college graduates never understood the word variable. It’s more likely that dramatically lower prices and the lessening of any stigma attached to foreclosure are the driving factors.
Why Home Prices Won’t Recover Anytime Soon
According to research by Luigi Zingales, a professor at the University of Chicago’s School of Business, strategic defaults accounted for more than one-third of U.S. homeowner defaults in December 2009.
His study found that borrowers were more willing to walk away if they had sizable negativity equity and knew someone else who had shrugged off a home loan.
That means we can expect millions more homeowners to “strategically default” on their mortgages in the months ahead. This, in turn, will set off a vicious cycle: rising foreclosures will depress home prices, which will set off more strategic defaults and so on.
There are now even for-profit companies like You Walk Away, founded in 2007, which guides homeowners through the default process. Founder John Maddux says his earliest customers struggled with emotional ties to their homes and remorse about reneging on an obligation.
But not so much anymore. With more homeowners concluding that the housing market won’t rebound soon and that cutting their losses is their best bet, millions are deciding not to pay.
That makes it tough to believe that the national home price implosion will end anytime soon.
Good investing,
Alexander Green
Any investment contains risk. Please see our disclaimer.
8 Responses to “Residential Real Estate: How Strategic Defaults Will Torpedo Your Home Value”
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Dear Mr. A.Green:
A couple of commetns here on your article:
1. everyone keeps talking about a ghost invesntory, but no -one can say how big it is. Strange no?
2. You are not explaining why banks do not foreclose now. There is a BENEFIT to the bank right now to keep the toxic asset on the books.
3. I wreto a (I agree not so nice) letter to the CEO of Wells Fargo how he could improve his bottom line with $400,000,000 and his secretary wrote back a cookie cutter consumer response letter. Banks are not interested in improving the real estate situation, and values.
4. I cannot blame people who walk away “strategically”. The reason we are in this real estate mess is becuase of the banks actions and lies in the last 5 years. They have already made billions on the poeples back. Not surpised they are returning the favor.
5. I am a real estate broker. I can assure you that banks are not interested in “selling” a short sale or foreclosure at market value. This explanation would require a whole new article. One example, I am awaiting a short sale response from a bank sinve april 19th 2009!!!!!!!
I am really trying to get on a rdio or tv show to explain all of this in context, but banks brought us into this mess and they have the power to get us out of this mess, but are not interested. Perhaps, I have no proof, becuase banks can tap in the discount window at 0.62 percent and invest in “their” portfolio at 8 or 9%. The spread is fantastic!! as long as they have toxic assets on the books? This is also why banks are NOT willing to lend at the 5% interest rates or refi at that rate. I have plenty of examples there too.
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How about factoring in the rebound in personal incomes as the economy recovers? The downside of personal bankruptcy is pretty bad. It’s hard for me to believe MILLIONS of homeowners will walk away from a commitment they can afford to keep, go through the multi-year process of building back credit-worthiness, and risk their ability to find decent financing in the future. It sounds shortsighted and un-strategic. Seems like re-financing at a lower, fixed rate mortgage would make more strategic sense. What am I missing here?
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Dear Alexander,
Generally, I (a former VP and Quantitative Analyst at Bear Stearns) agree with your analysis.
And yet, there is one more process that you haven’t factored in. It is “underemployment.” Its level is the same as a full unemployment, and combined they reach 17-20% of the American workforce.
Underemployment works in the same direction as unemployment. A full-time worker is transferred to a part-time position, and suddenly finds that he/she is unable to pay for an ARM, taken 3 years ago on a highly overpriced house and recently switched to a higher interest.
He/She feels being cheated, used, and gets quite angered. This makes the decision to walk away from the “nasty” mortgage an easy one.
This makes another 4 to 8 strategic foreclosures in the next couple years very likely. This number adds on top of 5-7 million that you have (rightfully) quoted. Thank you.
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Dear Alexander, Thank you for a fine article. All I care to add is welcome to the United States of Moral Hazard. This is I believe the bottom line – government bailouts have led Americans to believe that they are entitled to a bailout whenever things go against them. We used to be a free market society that flourished, now we are a government run economy that is losing all standing in the world. The Chinese own us – let’s hope they never figure it out.
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Alex, We have already reduced the housing values in California on average by anywhere from 30 – 70 % depending on the neighborhood. As an inveestor you are now able to get 8-10% annualized returns on most real estate if you must pay cash. For this reason I disagree, the ability for investors to make great current returns with strong future upside potential limits the downside. Where else could you put your money and feel so safe. Not Equities or bonds at these levels…..
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Well articulated analysis – simple and straight forward. I would add there appears to be a change in social attitude that comes with reduced discretionary income. Environmentally(economically) sustainable lifestyle(s), i.e. less things (toys)and expenses. The next generation may be wary or what has happened to their parents. Serious implication for local government tax structures.
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“cites” not “sites”…
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Another aspect to this article Some of the “strategic defaulters” will buy another home before walking away. Assuming they want to live in the second home, their credit situation will not impact their residence choice.
Never underestimate the ability of the American people to walk away from committments. Someone else is always to blame. Many of the home owners in trouble today speculated on housing. Unlike “speculators” in stocks and bonds, they did not have a 50% margin balance to absorb the loss so other than moving, sufferred little loss (remember, many loans had minimal down payments).
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