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I've gotten several questions recently asking if consumer spending is being propped up by mortgage defaults, especially the "strategic mortgage defaults." My take is: yes, but just by a little bit. Here's the story.

People who are forced to move out of their homes due to foreclosure have to make rent payments on a new house or apartment, so there's no extra money available for them to spend. However, there are people who stop making their mortgage payments yet keep living in their house for some time. These are sometimes called strategic mortgage defaults.

Let's say you bought a house for $500,000 a couple of years ago, borrowing $485,000 (maybe an 80% first plus a 17% second, for total loan to value of 97%). The house is now worth, let's say, $400,000, a 20% drop from the purchase price. The homeowner is underwater, and may not expect to be able to dig his way out. If the home appreciates in the future at 3% per year, which is about the long-term average, then it will take over four years before the home's value is equal to the loan balance.

If the homeowner is pessimistic about local prices, and doubts he'll see any appreciation for a while, what will he do? In many cases he will simply stop making the monthly payment. He can put $3000 plus taxes and insurance into his savings account rather than sending it off to the lender. It will take months for the lender to foreclose, and even then the homeowner-used-to-be may be able to negotiate a rent that's less than those monthly payments. The homeowner is not fulfilling his legal and moral obligation, but many people think that this default makes sense.

How big an issue is this, and is it propping up consumer spending? Mark Zandi of Economy.com estimates that $100 billion a year of mortgage payments are not being paid. (See this article.) How big is that compared to consumer spending? Less than one percent. Disposable personal income is about $11.1 trillion, with consumption expenditures about $10.4 trillion. Add $100 billion and you get a small shot in the arm.

However, most of that money is probably being saved. Recall Milton Friedman's permanent income hypothesis. A one-time windfall leads to just a little more spending, and a lot more saving. In contrast, an increase in income that is thought to be permanent will be mostly spent. The mortage payment savings is definitely temporary. And the people who are keeping their mortgage payments are very unsure of where they'll live next year. They are unsure if they'll be able to even rent a decent place given their credit scores after foreclosure. I bet they are keeping most of their mortgage payments in savings.

I think the better explanation of the increase in consumer spending is simply that disposable income is up, thanks to lower taxes.

Disclosure: No positions

Source: Is Consumer Spending Being Propped Up by Mortgage Defaults?