Watching “Strategic Defaults”

A couple other points from Rick Sharga’s excellent presentation yesterday, including a much-needed “silver lining”:

The “X” factor in everyone’s foreclosure projections is what happens with “strategic defaults.”

Typically, people don’t pay their mortgages because they can’t. A strategic default is when someone doesn’t pay their mortgage because they’ve decided not to.

Basically, the borrower decides that the “cost” of wrecked credit — at least for a few years — is less than the “benefit” of preserving what cash flow they have, and being freed of making payments on a house that will never be worth what they bought it for (if by “buying” you mean putting next-to-nothing down, and making nominal payments for a few years — the case for millions of “Buyers” at the peak of the housing boom).

The odds of strategic default increase as homes become more deeply “underwater” — that is, worth less than the mortgage against it.

Nationally, Sharga estimates that more than 20% of all mortgages now meet that description.

A sea change in how otherwise solvent borrowers regard their mortgage obligations would obviously wreak havoc with the experts’ current default predictions.

One Solution: Equity Sharing

Precisely because of the risk of strategic defaults, many experts are calling for some sort of “equity-sharing” feature in new mortgages, and in restructuring existing ones (I’m one of them).

For existing, “underwater” mortgages, the bank reduces the mortgage balance in exchange for an ownership stake in the collateral (the home that secures the mortgage). That’s pretty much what happens now with creditors and corporations that file for bankruptcy protection.

Prospectively, new mortgages would provide that banks share in both a percentage of the upside and downside in the home’s future value. In exchange, borrowers would have to forfeit the “non-recourse” nature of mortgage debt, as it’s currently defined.

Oh, yes, the silver lining?

As bad as the foreclosure numbers are nationally, and despite signs of “metastasis” (discussed in my previous post), for now the pain is still geographically concentrated in places like Southern California, Arizona, Las Vegas, and Florida.

About the author

Ross Kaplan has 19+ years experience selling real estate all over the Twin Cities. He is also a 12-time consecutive "Super Real Estate Agent," as determined by Mpls. - St. Paul Magazine and Twin Cities Business Magazine. Prior to becoming a Realtor, Ross was an attorney (corporate law), CPA, and entrepreneur. He holds an economics degree from Stanford.

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