Monday, May 17, 2010

Recent Updates from the Strategic Default Monitor

The Wall Street Journal reports that "More US Homeowners Choose To Default on Mortgages".

Let's quote the most salient parts of the article. Each quote can stand alone. It points to the realization by WSJ that strategic defaults are real. It points to the realization that Wall Street is concerned and hints that something better be done. It presents a strong summary of the current trend.

"Strategic defaults are on the rise as more borrowers who are underwater on their home loans decide it's not worth it to stay current on their payments each month. That trend could have repercussions for the housing market, and for borrowers, in the future."

"These homeowners neglect their monthly principal and interest payments, but still pay other bills on time, including credit cards and auto loans"

"Growing social acceptance of this behavior could have ramifications not only for personal credit histories and the health of neighborhoods, but also for the future of mortgage lending...As more people watch their friends or neighbors choose to default, the more it becomes a viable option for homeowners who may otherwise wait years just to return to a positive equity position in their properties"

"If it really does become a legitimate problem, the implications are pretty dramatic for anyone that wants to buy a home in the future...[t]he lenders would have to build this into their risk models with either larger down payments or higher interest rates"

MY COMMENT : I find the above quote the most interesting of all. How could a lender price strategic defaults into its lending risk model. Is the implication that those individuals who strategically default will face higher interest rates and down payment requirements than someone else who unintentionally defaults on their mortgage? Or will lenders just price this risk generally, across the board, so all borrowers will face higher costs for loans? Whatever the implication, I am interested in seeing the underlying factors that will make up this new risk model. I doubt it will amount to much except an excuse for lenders to charge more for loans and blame it on strategic defaulters.

"In our data, what we've noticed is at about 25% negative equity, the behavior of owners begins to mimic that of investors -- they're more ruthless and rational, they're looking at it from a cash-flow perspective...The default rate rises as the negative equity gets deeper and deeper...People are also learning they often have one or two years before they get thrown out of a home after stopping payments...CoreLogic estimates that the typical underwater borrower is five to seven years away from regaining their lost equity...If people figure they'll wait more than a decade before regaining the equity they've lost, they're much more likely to cut bait and leave."

MY COMMENT: Its about time that owners behavior mimics investors. Why should any individual, investor or not lose money on a worthless asset.
Bottom Line: The Wall Street Journal has taken notice and the larger investment community is nervous. If consumers start acting like all business players aka "action rationally (not emotionally) about investments where does it leave investment models as it relates to consumer behavior.

Let's explore another update:

JP Morgan Warns Investors that Strategic Defaulters Will Cause Losses.

Before I get into this article, my initial comment is HUH!. I thought the losses had to do with exposure to bad bets on credit default swaps and derivatives, declining values of asset back securities, poor lending practices, acquisition of Washington Mutual (albeit for only $1 billion with none of the WAMU lossess) and throwing money to international ventures that went sour.

Let's look at JP Morgan's explantion in detail:

Now I do not want to be dismissive but lets get to the bottom line of JP Morgans recent announcement. Recognizing that negative equity is a primary factor for people to choose strategic defaults, JP Morgan reported "As of March 31, [2010] 27 percent of the home mortgages in its consumer credit portfolio were worth more than than underlying property, meaning those homeowners are underwater, according to the bank's Monday filing with the SEC. At the end of the previous quarter, which ended Dec. 31 of last year, that rate stood at 26 percent, according to the bank's filing...JPMorgan's Washington Mutual loans, though, are detailed in the bank's SEC filing -- and they're even worse than JPMorgan mortgages: The entire portfolio -- $98 billion of unpaid mortgage principal -- is underwater...And those mortgages are even deeper underwater at the end of this year's first quarter than they were at the end of last year's fourth quarter. The options ARMs loan-to-value ratio was at 113 percent, meaning they were 13 percent underwater; now they're at 119 percent, according to JPMorgan's Monday filing. Home equity loans were 15 percent underwater; now they're 20 percent. Prime mortgages were at 6 percent; they've climbed to 11 percent. Subprime jumped from 10 percent underwater to 13 percent." UH OH! That's Huge.

MY COMMENT : So in essence, JP Morgan understands that consumers who own properties with no value and such property having little chance of regaining value, are likley to stop paying their mortgage even if they could afford to pay. Hmmm...seems like something JP Morgan would do. JP Morgan doesn't like it but respects it.

The company respects it enough that it felt compelled to make mention of strategic defaults as a factor in future lossess.

So let cut to the chase. JP Morgan is using a very tangible issue by putting it out in the press. Essentially, the battle lines have been drawn. The consumer who strategically default (because it was in their best finanical interest) will start be to get a negative label. Where this goes, no one really now because this represents a major and permanent shift in consumer behavior. To further emphasize this point just read the following:

"[D]uring a conference call with investors and analysts, Dick Syron, Freddie's former chairman and CEO, in noting that the firm had seen a rise [in strategic defaults], used different terminology to phrase it...'[T]he term that['s] used for people walking away when they are caught up upside down, more frequently used in autos than it is in homes, is ruthlessness. Right? And we are seeing an increase in ruthlessness and I think, it is probably not just speculators or investors, but [I] think it is a different period and the changes... we have seen an enormous amount... [have] the potential for changing consumer behavior'...It's that change that JPMorgan Chase is warning its investors about."

And so it is.

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