There is no doubt that the housing market is stumbling to a recovery.  This past week Lawrence Yun, NAR’s chief economist, predicted a 4% increase in sales next year. Last month, Celia Chen of Moody’s Analytics projected sales to increase over 20% in 2012.  Any increase in transactions will be welcomed.

However, we believe there is one headwind that could jeopardize a recovery: fragile consumer confidence. Consumer sentiment, as measured by the University of Michigan, has seen modest improvement in the last few months after nose diving over the previous several months. Moving forward, any hit to consumer confidence will impact a real estate rebound.

Prices are predicted to soften through the first two quarters of 2012 before reaching modest levels of appreciation by year’s end. Falling prices will force more homeowners into a position of negative equity. Being underwater is one of the triggers that cause people to strategically default on their mortgage obligations. If this happens, there will be an increase in the number of foreclosures. This, in turn, could cause a relapse in consumer sentiment.

Bottom Line

We believe that there will be a dramatic increase in residential real estate transactions (both existing sales and new construction sales). The only thing that may stand in the way is a loss of confidence in a housing recovery. The next six months will tell us a lot regarding this possibility.

As prices continue to soften, more and more homeowners will fall into a position of negative equity on their homes. This means that the balance on their mortgage is greater than the value of their home. The reason this is important is that people are more prone to strategically default on their mortgage when ‘underwater’.

What is a strategic default?

Let’s first define strategic default in simple terms. According to Wikipedia:

A strategic default is the decision by a borrower to stop making payments (i.e. default) on a debt despite having the financial ability to make the payments.

This is particularly associated with residential and commercial mortgages, in which case it usually occurs after a substantial drop in the house’s price such that the debt owed is (considerably) greater than the value of the property – the property negative equity or “underwater” – and is expected to remain so for the foreseeable future, such as following the bursting of a real estate bubble. Such borrowers are called “walkaways.” 

This definition itself serves as the explanation as to why people will default.

How do Americans view strategic default?

In Fannie Mae‘s recent National Housing Survey, they shed some light on American’s thoughts on strategic default.

• The number of underwater homeowners who believe it is okay to default on your mortgage if you are under financial distress has almost doubled in the last twelve months (14% to 27%).
• 47% of people that are underwater and behind on their mortgage have considered strategic default.
• Those who know a strategic defaulter are more likely to have considered defaulting.
• 1 in 5 Americans knows a strategic defaulter

Bottom Line

As more people enter into negative equity, more will be tempted to ‘walk away’ from their mortgage obligations. If they do walk, that will increase the number of homes entering foreclosure.

Back in October, we posted that falling home prices would drive more homeowners into a negative equity situation where their home was worth less than the amount of their mortgage (also known as the house being ‘under water’ or ‘upside down’). If a homeowner falls further into negative equity, it increases the chances that they will walk away from their mortgage obligation. This is known in the industry as a strategic default. This could dramatically increase the number of foreclosures coming to market and cause house values to fall further.

The Wall Street Journal reported on the impact of negative equity on strategic default:

Most defaults are typically driven by a combination of income shock and negative equity, or what’s known as the “double-trigger” hypothesis. While borrowers who lose their jobs but have equity in their homes can sell and avoid default, those without any equity are left with fewer options.

The most recent Fannie Mae National Housing Survey looked at how people viewed walking away from their mortgage obligation. Here are some of their findings:

• Underwater delinquent borrowers are the most likely to have considered stopping their mortgage payments.
• Delinquent borrowers are almost three times as likely to have considered stopping their mortgage payments if they know someone who has defaulted on their mortgage.
• 17% of all people who are delinquent believe the amount they owe on their mortgage is 5-20% more than the value of their home. That number jumps to 29% when they believe the amount they owe on their mortgage is at least 20% more than the value of their home.

The CoreLogic 3^rd Quarter Negative Equity Report released Monday showed

 … equity data indicating a third consecutive quarterly decline in negative equity for residential properties. CoreLogic reports that 10.8 million, or 22.5 percent, of all residential properties with mortgages were in negative equity at the end of the third quarter of 2010, down from 11.0 million and 23 percent in the second quarter. This is due primarily to foreclosures of severely negative equity properties rather than an increase in home values.

Obviously, the fact that the number is declining is good news for the housing market. However, with prices again falling there is concern that the current situation could worsen. Mark Fleming, chief economist with CoreLogic said

“Negative equity is a primary factor holding back the housing market and broader economy. The good news is that negative equity is slowly declining, but the bad news is that price declines are accelerating, which may put a stop to or reverse the recent improvement in negative equity.”

Radar Logic addressed the CoreLogic report yesterday in an opinion piece:

According to research by CoreLogic, borrowers become more likely to default the further underwater they become in their mortgages. Thus, falling home prices could increase defaults, foreclosures and, as a result, the inventory of bank-owned properties. Based on our analysis, homes sold by financial firms sold for 38 percent less, on average, than homes sold by other sellers as of September 30, 2010. As such, foreclosed homes represent a low-priced alternative to homes for sale by owner/occupants, and as sales of foreclosed homes become a larger percentage of total sales, owner/occupants face increasing pressure to reduce their asking prices in order to compete. So falling prices could create a self-perpetuating cycle of negative equity, foreclosures, and further price declines.

Bottom Line

If people fall into negative equity, the chances they will strategically default increases. This would lead to more foreclosures which will mean more downward pressure on home values. More homeowners will see themselves in negative equity as prices fall. And round and round we would go. Let’s hope prices hold thus preventing this from happening.

Strategic default:  when a borrower defaults on their mortgage even though they have the financial ability to repay it. 

Strategic defaults lead to foreclosures. It is important to realize that an increase in the number of foreclosures will dramatically impact any possible housing recovery. A loss of income or an increase in negative equity (where the house is worth less than the mortgage on the house) are the two main reasons that will cause a homeowner to strategically default.

The Wall Street Journal reported on the impact of negative equity on strategic default:

Most defaults are typically driven by a combination of income shock and negative equity, or what’s known as the “double-trigger” hypothesis. While borrowers who lose their jobs but have equity in their homes can sell and avoid default, those without any equity are left with fewer options.

Are strategic defaults about to skyrocket?

This week, Clear Capital sent out a special release where they reported:

This special Clear Capital Home Data Index (HDI) alert shows that national home prices have declined 5.9% in just two months … This significant drop in prices, in advance of the typical winter housing market slowdowns, paints an ominous picture.

The reason this caught our attention is that the 5.9% equated with a number we recently read on strategic defaults. CoreLogic in their most recent Negative Equity Report stated:

11 million, or 23 percent, of all residential properties with mortgages were in negative equity at the end of the second quarter of 2010 … An additional 2.4 million borrowers had less than five percent equity.

Almost two and a half million homes were within 5% of negative equity and prices just fell over 5%. Strategic defaults may soar! The CoreLogic report quotes Mark Fleming, their chief economist:

“Negative equity continues to both drive foreclosures and impede the housing market recovery. With nearly 5 million borrowers currently in severe negative equity, defaults will remain at a high level for an extended period of time.”

What about the ethical responsibility to pay our debts?

As the housing crisis has savaged more and more families, there seems to be a growing number of people who now see strategic default as acceptable. According to a recent Pew Research Center survey:

More than a third (36%) say the practice of “walking away” from a home mortgage is acceptable, at least under certain circumstances … two-in-ten (19%) say it’s acceptable and an additional 17% volunteer that it depends on the circumstances.

Bottom Line:

There will be more strategic defaults as prices fall. That will mean more foreclosures which will cause prices to fall leading to more homes in negative equity. An increase in negative equity will create more strategic defaults which will cause…

That is the vicious cycle we must break.

The current administration continues to attempt a myriad of policies aimed at bringing about a recovery in the housing industry. It is not their belief in the importance of homeownership that drives this policy. This administration has openly questioned whether the government should continue to support homeownership as an American ideal. Every policy had one purpose in mind: that stabilizing home prices would help stabilize the economy.

The purpose of the original stimulus package (the homebuyers’ tax credits, the lowering of interest rates by purchasing mortgage-back-securities, different modification programs) was to stabilize housing prices. It had nothing to do with getting families into homes or keeping families in their current homes. The government realized very early on that a recovery in housing would require a stabilization of values. Why? Because a large percentage of homeowners ‘walk away’ from their homes once they fall into a negative equity situation (where their home is worth less than the mortgage on the home). That would create more foreclosures and continue the cycle below:

The administration had to stop home prices from falling. Their ability to control prices would be determined by the theory of ‘supply and demand’. At first, they attempted to increase demand by lowering interest rates and providing tax incentives. They attempted to influence supply by controlling the flow of distressed properties coming to the market with an assortment of loan modification programs. These policies had a short-term positive impact on pricing. However, supply is again skyrocketing and demand seems to be plummeting.

The administration realizes that another drop in house prices will create a new group of homeowners who will fall further into a ‘negative equity’ position. That is why they have introduced the new FHA Short Refinance Option today. The purpose:

The FHA offers help to qualifying non-FHA borrowers who are “underwater” on their home loans. The FHA Short Refinance option is open to those who are current on their existing mortgage—but the lender must agree to forgive at least 10% of the unpaid principal on the original note.

The program’s intent is to prevent homeowners falling further into a negative equity. The Wall Street Journal posted frequently asked questions here.

Bottom Line

Will the program help families? We’re sure it will. If you qualify, jump on it. Will it help enough families to turn the housing market around?  We doubt it.