How Strategic Defaults Are Reshaping Economy

Includes: IYR, KME
by: Rick Newman

One thing that's fascinating about an economic crisis is the way ordinary people confound the experts. Consumers are expected to behave according to sophisticated economic models that have been built over decades, but sometimes they don't do what they're supposed to. That's happening now in the housing market.

"Strategic defaults" were once so rare that they didn't even have a name. If you had the money to pay your mortgage, you paid it. But the historic housing bust has changed that calculation. Home values have fallen so much in some areas that even people with good jobs and the income to keep up their mortgage payments are deciding not to do so. With ordinary defaults, there's usually something that goes wrong and disrupts household finances. But with voluntary walk-aways, homeowners simply decide they'd be better off if they stopped paying. They're deemed "strategic" defaults because owners are making a difficult decision with consequences they'll have to live with for years.

The experts have long assumed that homeowners would never willingly endure the punishment for defaulting on a mortgage: wrecked credit and the inability to borrow in the future, which effectively means they may never own a home again. But the experts were wrong, and the unexpected shift in the way consumers think could reshape the economy in ways that don't fit those fancy computer models.

Here's the logic behind a strategic default: In California, for example, the median home price was about $500,000 in 2006, the peak year for prices. Since then, home values have fallen 44 percent on average, according to Moody's So a median-priced home bought in 2006 would now be worth just $280,000 or so. If the homeowner thought the home would eclipse its original value within a few years, paying the mortgage might seem like a worthwhile investment. But Moody's estimates it could take 12 years for that median home to reach its former value. That means 144 monthly mortgage payments of perhaps $3,500 each—$504,000 of hard-earned income—will earn no return at all. If the owner were forced to sell the home before it regains its value, the return on that cash would be negative.

Sure, that $3,500 per month puts a roof over your head, but rents have plummeted too, so many homeowners can rent a comparable home for a lot less than they're paying to own. So let's say that median California homeowner was able to rent a home for $2,500 a month, which is a reasonable figure. The rap on renting used to be that you gained no equity for your money. But that's a lot better than the negative equity you get from owning if you bought at the wrong time. And it leaves an extra $1,000 a month to spend, save, or invest.

The financial logic seems convincing. But of course there are dire ramifications, which is where it gets interesting. Defaulting on a mortgage basically means that for the foreseeable future, you either need to live off cash or pay usurious interest rates. For the past couple of decades, with the proliferation of consumer credit, that has seemed like an antiquated way to live. But it's coming back in style. A strategic defaulter who has done his homework knows that he probably won't be able to use credit cards for ordinary purchases, but with debit cards that's not such a big deal. If you need to buy a car, it's trickier, since it's hard to pay cash for an automobile. So strategic defaulters may be prioritizing their car payments above their mortgages, or even securing a loan and buying a new car before they default on the mortgage. And tossing in the towel on one mortgage means there's a fat chance you'll ever get another, so defaulters are consigning themselves to life as a renter.

It wouldn't be surprising if a few people were doing this. But apparently a lot of people are. Nearly 4.5 million mortgages are in foreclosure or headed that way, and Moody's estimates that 20 to 25 percent of all foreclosures may be strategic defaults. With nearly 15 million homeowners owing more than their homes are worth, those numbers could still rise, which would further depress the housing market just when it seems poised to stabilize. More foreclosures would send prices down even further, exacerbating the problem that produced strategic defaults in the first place. And lenders, stung by a rash of defaults by qualified borrowers, could tighten lending standards even more, further strangling activity in the housing market.

But don't talk to homeowners about their civic responsibility or their obligation to banks. Once upon a time, Americans might have felt duty-bound to pay back what they owe. But deeply unpopular bank bailouts, plus unseemly bonuses for bankers and exorbitant pay for CEOs, seem to have diluted any sense of honor in financial transactions.

The strategic-default phenomenon also augurs other changes in American values. Some analysts think a recent spike in consumer spending—which has risen much more than incomes—comes from foreclosures that free people from onerous mortgage payments and put more spending money in their pockets. At the same time, consumer credit has fallen by double digits—which is more than expected—largely because consumers are spooked about the economy and reluctant to charge up their credit cards or apply for loans. That suggests Americans are getting more used to living off cash, which might end a 25-year borrowing binge and foster more responsible spending—if it lasts.

Even more significant could be the changing role of the home itself, which may no longer be the centerpiece of the typical American's financial life. The whole U.S. economy is built around the premise that home ownership should be every family's goal. The mortgage-interest tax deduction, for example, is a powerful inducement to buy rather than rent, yet it costs the government about $100 billion a year in lost revenue. Fannie Mae (FNM) and Freddie Mac (FRE) were founded to promote homeownership, yet ended up as a colossal financial disaster. And for years, home equity loans helped finance the purchase of cars, appliances, and many other accoutrements of middle-class life—until home equity went the wrong way. If a million home owners or more are walking away from their homes, then maybe owning a home isn't all that—and it's time to redefine the American Dream.

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Disclosure: No positions