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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Another issue with second liens is the fact that many lenders have no incentive to give up their position.  Under HAMP, a current HAFA initiative is pushing for second liens to be relinquished for a small sum (i.e., $1,000) but the likelihood of success is small.  Why?  First, this will make the second mortgage holder realize a massive loss for a small sum.  Say the loan was made by WaMu for $50,000.  They either get $1,000 and realize the loss or pretend the asset is still worth $50,000.  Many banks will opt to pretend with the latter option.

This chart was examined on Rortybomb:

The chart is full of juicy data.  But take a look at the Alt-A and option ARM categories.  Even with the first mortgage only, under the “Curr LP LTV” category we already have astronomical negative equity.  But throw in that second lien and combine the loans and we start getting negative equity that is off the charts.  Many of the second note holders are completely underwater.

This is where another problem becomes present.  What if the second mortgage originated from the same lender as the first?  This is the case on many loans:

The above data is for a home in pre-foreclosure in Irvine California.  Countrywide has a second for $330,000 and a third mortgage for $280,000.  So do you think $1,000 is an incentive to take a $610,000 write down?  The home would probably sell for $700,000 today or barely enough to cover the first mortgage.  This is where the real problems will hit and bigger write downs are destined to happen.

Or here is a more clear cut case:

This is a pre-foreclosure in Garden Grove.  MortgageIT is imploded lender number 306.  The home above is probably valued at $280,000.  So the 2^nd is worth zero and the 1^st is worth half of the current balance.  A $1,000 may not be incentive enough for whoever holds this note to move on the place if it requires a major writedown.

The short sale program looks to move forward in April so we’ll have to wait and see how many lenders are ready to jump on this.  There is little reason to believe that option ARMs or Alt-A will have a pretty outcome.

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Let us look at this new updated chart and try to figure out what is really going on with option ARMs but also with other toxic loans in states like California:

Source:  SNL, Credit Suisse

The data released only this month, highlights that between 2010 and 2012 some $253 billion of option ARMs will adjust and another $163 billion in Alt-A loans will reset.  This is extremely troubling because most of these loans were made in states that experienced the brunt of the subprime disaster.  You can imagine this hitting in a two wave fashion.  First, the subprime wave filtered through and now the option ARM and Alt-A wave will cast a shadow but only on a select number of states.  This older chart shows this two wave process:

Source:  Amherst Securities

For the last few months we have been in the eye of the hurricane.  While wave one has largely passed, wave two is only beginning to gear up.  One of the ideas being bandied about is that nothing will come from this second wave.  The assumption is all will be well.  We bought some time with the government loan modification programs known as HAMP but after almost one year of the program, only 168,000 permanent loan modifications have been made nationwide and many of the option ARMs don’t even qualify for this.  Banks have been trying to figure out what they can do with option ARMs but not much can be done because many of the borrowers do not or cannot continue to make payments on the loan.

Some staggering data from a Fitch report released late in 2009:

94% of borrowers made minimum payment only*

46% of all option ARMS were 30+ days late (with only 12% hitting recast)

Average loan-to-value ratios up to 126%

*With minimum payment loan balance increases through negative amortization

The above data was released back in September 2009 and most of the option ARMs are in California (roughly 50 to 60 percent).  Since that time housing prices in the state have not gone up.  So it is highly likely that more option ARMs are 30+ days late and LTV ratios are even worse as balances continue to grow while asset prices remain stagnant or retreat.  It is understandable that following nationwide coverage of the housing problem can ignore the option ARM issue because it is pinned on only a few states.  But these states will continue to face issues as these loans linger in financial limbo.  If we look at some of the option ARM lenders like WaMu (many are now gone) we can see how concentrated they were in only a handful of states:

The above is from the $52.9 billion option ARM portfolio of WaMu in 2008, at a point when the option ARM spigot had turned off.  WaMu had 50% of its option ARM loans in California.  If we add in Florida, that number jumps to 62%.  So this really is a problem that will hit a few states squarely.  But to understand the depth of this, let us first get an actual number of loans in California:

California Housing Units with a Mortgage:            5,290,276

Source:  Census, 2008 American Community Survey

We then have to figure out how many loans are currently in some form of distress or in foreclosure:

“(MBAA) The delinquency rate includes loans that are at least one payment past due but does not include loans in the process of foreclosure.  The percentage of loans in the foreclosure process at the end of the fourth quarter was 4.58 percent, an increase of 11 basis points from the third quarter of 2009 and 128 basis points from one year ago. The combined percentage of loans in foreclosure or at least one payment past due was 15.02 percent on a non-seasonally adjusted basis, the highest ever recorded in the MBA delinquency survey.”

The latest mortgage data shows us that 15.02 percent of all mortgages are 30+ days late or in the foreclosure process.  Now California has more troubles because of the option ARM concentration but we’ll be conservative and use the 15.02 percent figure:

5,290,276 * 15.02 percent = 794,599 properties 30+ days late or in foreclosure

I ran the numbers a few days back and found that only 154,000 properties are listed on the MLS in California.  So what is going on with those 600,000+ properties that are 30+ days late or in foreclosure?  Wells Fargo which acquired a large option ARM portfolio from failed Wachovia tried a few adjustments but they seem to be more extend and pretend methods of stalling the inevitable:

“(CNBC) Pay option ARMs are the new subprime, defaulting at high rates now thanks to adjustments as well as good ol’ unemployment. According to its Q3 earnings report, Wells Fargo, the fourth largest U.S. bank by assets, has $79.2 billion in debt on these loans alone, down from $101 billion a year ago, in addition to other ARMs and fixed-rate loans and full-term loan modifications. Wells didn’t make the Pick-a-Pay loans, they just inherited them when they bought Wachovia at the beginning of this year. Wachovia relished in selling these risky products in the most overheated housing markets. Suffice it to say, many many many of these borrowers are way way way underwater on their loans.

Enter the interest-only product, which will allow borrowers to defer their balances from 6 to 10 years. This keeps the borrowers in their homes, paying a little every month.  I called over to Wells Home Mortgage and spoke with CFO Franklin Codel. He told me that Wells has written down principal on the “vast majority of these loans.” Yep, just given that debt away, written down so far the tune of $2 billion, or about $46,000 per modified loan. So far Wells has turned about 43,500 Pick-A-Pays into interest-only ARMs.”

Since that time, mortgage distress has risen to a historic 15.02 percent and in California, there is little reason to believe the rate is any lower.  The above adjustment is yet to be seen as helping any sizeable number of borrowers.  It is also the case that banks have been reluctant to do any kind of principal reduction because this would force the bank to realize the actual loss on their balance sheet.  In other cases loans have been extended out to 40 years with lower rates but as HAMP has shown, even this isn’t enough to make a change if you have no job:

Source:  HAMP

Only 168,000 permanent loan modifications have occurred through HAMP.  What needs to be remembered that over the last decade, housing has shifted into a commodity where very little value is placed on the home as a place to set your roots and instead became a place to count your home equity.  With much of the equity stripped out, how many people will want to continue supporting a high mortgage when the home isn’t worth that value?  A handful of studies have shown that the number one predictor of foreclosure is negative home equity.  Virtually every option ARM in California is in a negative equity spot so that probably means 70 to 90 percent foreclosures on these places once we roll through the next wave.

What will banks do?  Well so far they have shown us that ignorance is bliss.  They have left the mortgages at face value and have no desire in pursuing a foreclosure (at least for now).  Why would they?  Say they have a $500,000 option ARM on a home now worth $250,000.  The loan has now grown to say $575,000 because of negative amortization but the borrower stopped paying once a recast was hit.  The bank can now claim an asset of $575,000 and lose $3,000 or $4,000 a month in missed monthly payments or realize a loss of $250,000 to $300,000 by foreclosing on the home.  So we may not see a big tsunami hitting us all at once but the wave will hit and it will be painful and drawn out.

In fact, if we pull data on some of the areas in California we will see entire blocks with massive amounts of distress:

Source:  Foreclosure Radar

Just look at the estimated equity column.  Most of these homes don’t even show up in the MLS.  But these are massive losses.  If we look at the loan data we find a few option ARMs and a few familiar names including IndyMac.

Yet that isn’t the only problem falling on a state like California.  There is also a number of jumbo loans:

California has 845,000 active jumbo loans.  And a large number are already in foreclosure or are now 30+ days late.  These loans carry big balances.  What is even more troubling is 55% of jumbo loans are adjustable rate mortgages.  With mortgage rates slated to increase this year, we can expect the foreclosure rate to zoom up.

The option ARMs, the Alt-A toxic loans, jumbo loan issues, and a 12.5 percent unemployment rate the highest in recorded history tells us the next wave will hit.  The mainstream media isn’t covering this because it really is a state specific problem.  But that is of little solace for those that live in sunny California.

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