The strategic default problem is probably bigger than many would have expected.  The number one reason for strategic defaults involves negative equity:

Source:  Census, Zillow

Now being underwater is the number one reason that sets people up for strategic defaults.  After all, if you weren’t underwater and wanted to get rid of your home you would presumably just sell at market value.  Yet with one-third of mortgages underwater, many are making the conscious decision to walk away from their mortgage obligation.  Keep in mind that this is one fraction of the foreclosure market.  The vast majority of people in or entering foreclosures get there because of their actual inability to pay for their monthly obligation.  This comes from job losses, wage cuts, or mortgage adjustments.

Strategic defaults have never been seen to this level because never had so many people purchased homes with little to no money down.  If there is really this anger out in the market, then people should move toward a mass movement of massively increasing down payments to at least 10 percent or even higher.  In this regards, strategic defaults are good because they bring forward the root problems of what led us into the housing bubble.  If someone had to put in say 10 percent of their own money, walking away would involve skin in the game.  Let us run this scenario with a 10 percent price decline:

Old method

Price of home:                  $500,000

Mortgage:                           $500,000

Current market value:   $450,000

Negative equity:              $50,000

New method

Price of home:                  $500,000

Mortgage:                           $500,000

Current market value:   $450,000

Negative equity:              0

It is clear that the second case not only provides a buffer for real estate price decreases, but it will also make people think twice about walking away from their hard saved down payment.  In the first case, the owner is now underwater by $50,000 with little money at play.  They either decide to keep paying and hope prices go up or walk away.  And many are deciding to pursue the latter option.

In fact, more people are strategically defaulting than getting help from HAMP:

“(UPI) Last quarter, more homeowners voluntarily defaulted on their mortgages and chose to walk away from their homes than the total number of mortgages permanently modified to date under the Administration’s year-old Home Affordable Modification Program (HAMP).

According to new data from the team of researchers at the University of Chicago and Northwestern University that first identified the scope of “strategic default” behavior last year, the number of homeowners willing to default when the value of a mortgage exceeds the value of their house, even if they can afford to pay their mortgage, has dramatically increased compared to just a year ago.

The percentage of foreclosures that were perceived to be strategic was 31 percent in March 2010, compared to 22 percent in March 2009. RealtyTrac reported foreclosure filings on 932,234 properties in the first quarter, a 7 percent increase from the previous quarter and a 16 percent increase from the first quarter of 2009.

Some 288,992 foreclosures per quarter are strategic defaults. Under the Home Affordable Modification Program, through March, 227,922 mortgages had been permanently modified since the program began March 4, 2009.”

The good news is the solution for future problems is rather straightforward.  We need to increase down payments by a large amount.  With FHA insured loans only requiring 3.5% down, this would mean a near tripling of cost out of pocket for a purchase of a home.  And this would in fact slow down the housing market but is this necessarily bad?  Let us run the numbers:

Home price:                                       $200,000

FHA down payment today:          $7,000 (3.5%)

Run these numbers with a new scenario:

Home price:                                       $200,000

New down payment:                     $20,000 (10%)

This benefits the buyer since they have more skin in the game but also, they have a buffer for a 10 percent price decrease instead of a 3.5 percent buffer.  And we already know that selling costs amount to 5 to 6 percent so technically that person buying with a 3.5% down payment is underwater the day they sign the mortgage.

We really need to think about the future of mortgages or we are simply setting up another housing crisis in the near future.

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The 60 Minutes piece is worth watching.  It seems like the question of morality comes up a few times.  But I can assure you that if people went in with 20 percent down, they would think multiple times before walking away.  Also keep in mind that big banks went into deals with little down and have also walked away from giant deals:

Watch CBS News Videos Online

“Despite some indications that the economy is recovering, the housing market remains a disaster area. Currently, about seven million homeowners are behind on their mortgages and that number is only getting worse.

Banks, with the help of the government, are offering some relief to homeowners who’ve lost jobs and just can’t meet their payments.

But there’s a growing number who can pay but are simply walking away from houses that are now worth as little as half of what they paid for them.

It’s called “strategic default.” People have done the math and decided making those monthly payments is just throwing money away, leaving the mortgage holders – the banks – as zookeepers of an ever-growing parade of white elephants.

In the past year it is estimated that at least a million Americans who can afford to stay in their homes simply walked away.”

Yet one point wasn’t discussed and this was why strategic defaults are only occurring during this housing crisis.  That is, people purposely trying to lose their homes.  The reason has to do with toxic mortgages like option ARMs that required very low down payments (or nothing).  The minimum down payment we should require on all home purchases is 10 percent.  Why?  To avoid massive problems like this.  Someone that has 10 percent in a home will think twice about walking away.  They also won’t jump into a home with no skin in the game.  Until we change these rules, we can expect more people to walk away from mortgages that are more valuable than the homes they are attached to.

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First, let us look at the MLS data:

Source:  MLS

For Los Angeles County 3,349 homes are listed with a price of $1 million or more.  Now for a county with 24,000 homes listed on the MLS, this is a large number.  But again refer to the above data.  Million dollar home sales are lagging.  Why?  Because the pool of million dollar buyers goes away when you require a down payment and actual income verification.  Do we have wealthy families in the county?  Absolutely!  But the products that stretched the dollar to unprecedented proportions are gone.  So this is what happened to sales statewide:

So the trend is definitely heading lower.  As many of you know option ARMs and Alt-A loans are largely absent from the market (option ARMs are now banned in California).  So if these home sales jump it will have to do with actual income verification and funding through jumbo loans.  The million dollar market is interesting.  Roughly 24 percent pay cash.  That isn’t going to change.  Yet that other 76 percent that actually have to get a loan is the game changer.  And make no mistake, there is a large amount of distress in this market:

And here is where we see the massive discrepancy.  2,205 homes with estimated values of $1 million or more are in some stage of foreclosure; either bank owned, with a notice of default filed, or scheduled for auction.  Yet the MLS only lists 32 homes with a $1 million price or higher as foreclosures!  Banks don’t want to move on these places because if you think it is bad trying to move a $250,000 home in a tough market, try moving a $2 million or $5 million home.  Ask Nicholas Cage if it is easy to sell a million dollar home in Southern California in this market.

And he isn’t alone:

“(WSJ) Big borrowers are more likely to default than ordinary people, according to data from First American CoreLogic. Its loan database, reflecting more than 80% of the overall home-loan market, includes 1,700 loans with balances of $4 million or more. About 14.8% of those loans were 90 days or more overdue at the end of January, compared with 8.7% for all home loans tracked by First American. Sam Khater, a senior economist at First American, said the bigger borrowers may be more prone to stop making payments when they have lost all their home equity.

Mr. Fuscone, Merrill Lynch’s one-time head of Latin America, put his mansion up for sale in November, asking $13.9 million. But he couldn’t find a buyer.”

Then you add into the mix L.A. County getting closer to bankruptcy and it is hard to see a market developing for these million dollar homes.  Banks are going to have some major losses coming up.  They can ignore and wait around but this won’t end pretty.  Want to see an example?

This is for a 3 bedrooms and 3 baths home in Beverly Hills that Zillow estimates to be valued at $1.1 million even though it has $5.2 million in loans.  Do the math and you will quickly find out that banks are simply deluding themselves at the moment with what they have on their balance sheet.

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