Residential Real Estate: How Strategic Defaults Will Torpedo Your Home Value

Alexander Green
by Alexander Green, Chief Investment Strategist Market Trends Market Trends

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

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