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What a Rash of Strategic Mortgage Defaults Could Mean for Investors

Some more positive numbers in housing came out today. The National Association of Home Builders/Wells Fargo Housing Market Index was at 21, the first time that builders’ confidence improved three straight months since 2009. Of course, with real-estate in this country so interconnected with employment, I’m not taking this as a sign that we’re seeing real progress on the home front (pun intended!). But I am hoping it’s a step in the right direction.

I mentioned on the show this morning about an article about housing that I ran across that hit close to home. In it, the author brings up American Airlines’ bankruptcy, and how that company was generally patted on the back by the financial world as having made a smart decision to restructure despite the fact that they had plenty of money to keep paying its debts.

He compares American Airlines to the large number of people who are underwater on their mortgages in this country. He contends—and I’m paraphrasing here—that if you’re underwater 50% or more on your mortgage and you continue to pay the debt, you’re a sucker. Walking away, or what’s called a “strategic default,” may the better course of action from a purely business perspective. I hate to agree, but I definitely understand where he’s coming from.

Of course, like American Airlines restructured its debt, a homeowner can restructure his—it’s called Chapter 13 bankruptcy. But for people who may never see daylight on their properties without a hyperinflationary scenario, strategic default could make a lot of sense. And we could see cases start to proliferate around the country, it could create even more damage to an industry that is already in a very fragile state.

For most of us, walking away from a mortgage is simply unfathomable and borderline immoral. But I also understand a business decision. My fear is that strategic defaults could become increasingly common and work their way into the agendas of certain people running for Congress. And we all know how much they like to pander to their constituencies. If there’s a huge population of people looking for a way out and politicians give it to them, it’s tantamount to a bribe.

As investors looking to put together our strategies for 2012, we need to keep an eye on this story. A rash of strategic defaults could have a substantial impact on the domestic economy. Right now, strategic defaults account for only about a quarter of foreclosures. Hopefully, we’ll see continued signs of a real recovery in housing and that percentage doesn’t grow larger.