Strategic Default Double Standard

Business Decisions,
Big and Small

What happens to a homeowner who strategically defaults? (that is, they walk away from their home because it's worth less than what they owe).

Their credit is damaged -- if not wrecked -- for as long as seven years.

What happens to a commercial property owner who strategically defaults?

If it's a REIT, its stock goes up, due to its improved cash flow -- and hence greater appeal to investors:

In the business world, there is less of a stigma [associated with strategic default] even though lenders, including individual investors, get stuck holding a depressed property in a down market. Indeed, investors are rewarding public companies for ditching profit-draining investments. Deutsche Bank AG's RREEF, which manages $56 billion in real-estate investments, now favors companies that jettison cash-draining properties with nonrecourse debt, loans that don't allow banks to hold landlords personally responsible if they default. The theory is that those companies fare better by diverting money to shareholders or more lucrative projects.

"To the extent that they give back assets or are able to rework the [mortgage] terms, it just accrues to the benefit" of the real-estate investment trust, says Jerry Ehlinger, RREEF's co-chief of real-estate securities.

--"Commercial Property Owners Choose to Default"; The Wall Street Journal (8/25/2010)

Good luck getting Joe and Jane Homeowner to honor their underwater, $300,000 mortgages when Corporate America is ditching their $30 million (or $3 billion) mortgages.

What's that line about "what's sauce for the goose is sauce for the gander?"

Benjamin Franklin, Strategic Default, and Economic Recovery

Strategic Defaults Driving Retail Sales?

A penny saved is a penny earned.

--Benjamin Franklin, circa 1780

A penny defaulted on is a penny earned.

--Benjamin Franklin, 2010??

No, I have no way of knowing whether a modern-day Benjamin Franklin would have uttered the second quote. In fact, he didn't even say the first one (that hasn't stopped him getting credit for it, though!).

But the sentiment is well-placed.

More and more economists now see a connection between rising strategic defaults -- the term for owners who walk away from their underwater homes to preserve their cash flow -- and recovering retail sales.

That link helps explain a conundrum -- namely, why are retail sales improving when hiring is anemic and unemployment is still high?

Strategic Default Economics

The (partial) answer appears to be that people who've ditched their expensive mortgages have more disposable income to spend at Target, Bed Bath & Beyond, restaurants, etc.

Sometimes, A LOT more.

So, somebody who bought a home at the peak in Las Vegas (or Southern Florida, or Phoenix) for, say, $600k and has seen prices subsequently drop 40% could easily rent for $2,500 a month, instead of paying their $4,500 monthly mortgage. And live in just as nice a place.

Voila! An extra $2,000 in monthly disposable income.

Multiply that phenomenon by a couple hundred thousand people, and suddenly it's no surprise to see retail sales pick up.

Here's what David Rosenberg, former chief economist at Merrill Lynch and now playing the same role at Canadian firm Gluskin Sheff, says in today's edition of his daily market analysis ("Breakfast with Dave"):

Speaking of the U.S. housing market, we are convinced that strategic defaults by various homeowners, along with double-digit growth in tax refunds, have spurred the jump in retail sales (Easter timing helped too) of late. The economy is growing, the bulls are in a great mood, apparently we are into a new phase of job creation, and yet somehow 320,000 mortgage loans that were current when 2010 began were at least 60 days past due in March. Interesting.

--David Rosenberg, "Breakfast with Dave" (4/19/2010)

Of course, more borrower defaults ultimately means more foreclosures, which translates into more housing market supply -- and more bank write-off's.

But thanks to the Federal Reserve's policy of zero percent interest rates, banks are now booking huge profits to help offset their mortgage and housing-related losses ("Citigroup Posts $4.4 Billion Profit" -- WSJ).

They also continue to benefit from the government's unofficial policy of "too big to fail," with the implicit promise of future bailouts, if and when needed.

It all sort of recalls the chorus from a classic rock 'n roll song:

Take a load off Annie, take a load for free;
Take a load off Annie, And (and) (and) you put the load right on me

--The Band; lyrics, "The Weight"

The (financial) weight, indeed.

Untapped Market: The Un(der)employed

"Rich in Time," or,
Making Lemonade
Out of Un(der)employment

No, they don't have a lot of disposable income -- that's kind of the whole point, actually.

But it turns out that the nation's 20 million-plus un/underemployed represent a huge, untapped market -- and companies with a recreational and/or social networking angle are catching on.

Apple Computer sure has.

It makes sense, actually; after all, how much reality TV can one person really watch?

How many resumes can you launch into the ether on Monster.com?

(Hey, they didn't have those things during The Great Depression -- not to mention iTunes, the Internet, Google, flat-panel TV's, Facebook, etc.).

Consider this headline from today's Wall Street Journal:

TGIFF: Some Idled State Workers Find "Furlough Fridays" Can Be Fun: Forced to Take Time Off, Some Hit the Ski Slopes; a Discount on Sushi

It turns out that some California ski resorts are offering steeply discounted lift passes to state workers every Friday, when literally tens of thousands are now "furloughed."

Making Lemonade

Instead of wallowing in one's idleness, why not use it, productively?

To educate one's self.

To get in (better) shape.

To spend quality family time.

To prepare cheaper, healthier food (at home, of course!).

To connect with friends -- or make new ones.

Why not, indeed??

None of the above activities needs to cost a fortune (skip the health club and go hike in a state park); some -- like cooking at home -- actually save money.

And, of course, more companies are targeting such consumers with discounts and other price breaks.

"Furlough Friday"

Stigma loses it power when everyone is similarly affected.

So in the housing markets that dropped the most -- places like Las Vegas, South Florida, etc. -- "strategically defaulting" on one's mortgage isn't such a big deal.

How long until being under/unemployed is viewed similarly?

Unfortunately, it just doesn't pay so great . . .

Strategic Default Like Pre-'70's Divorce?

From Stigma to "the Norm"

I was at an industry conference yesterday where the speaker compared "strategic default" -- making a business decision to walk away from an "underwater" mortgage -- to society's notion of divorce up until the 1970's.

Back then, relatively few people divorced, so there was a stigma attached to it.

Fast forward a couple decades, when more than half of all marriages end in divorce.

Voila! No more stigma.

Similarly, "strategic default" is a big deal -- until everybody does it.

With millions of homeowners deeply underwater in markets like Las Vegas, Southern California, and Arizona, you'd guess that a similar evolution is in store for the housing market.

And yes, if enough people strategically default, you'd expect the lending rules to change: the same speaker speculated that FHA will face pressure to reduce its "rehabilitation period" for defaulting borrowers from the current 7 years to 3 years.

"The Prisoner's Dilemma," Real Estate Edition

Game Theory & Strategic Default

Should I stay or should I go now?
If I go there will be trouble
And if I stay it will be double
So you gotta let me know
Should I stay or should I go

--The Clash, "Should I Stay or Should I Go?" lyrics

As more homeowners nationally find themselves "underwater," i.e., they owe more than their properties are worth, they face a difficult decision: should they continue to pay the mortgage -- very possibly throwing good money after bad -- or should they simply walk away ("strategically default")?

To answer the question, some homeowners invoke morality ("should we break our promise to the bank?"); others, a cost-benefit analysis ("will the savings we realize exceed the damage to our credit?").

However, arguably the most important criterion is to ask, "what are my neighbors likely to do?"

Game theory aficionados will recognize this as a variant of the Prisoner's Dilemma.

The classic version of the Prisoner's Dilemma is presented as follows:

Two suspects are arrested by the police. The police have insufficient evidence for a conviction, and, having separated both prisoners, visit each of them to offer the same deal. If one testifies (defects from the other) for the prosecution against the other and the other remains silent (cooperates with the other), the betrayer goes free and the silent accomplice receives the full 10-year sentence.

If both remain silent, both prisoners are sentenced to only six months in jail for a minor charge. If each betrays the other, each receives a five-year sentence. Each prisoner must choose to betray the other or to remain silent. Each one is assured that the other would not know about the betrayal before the end of the investigation. How should the prisoners act?

Source: Wikipedia

Like the classic version, in the real estate version of the Prisoner's Dilemma, there are also four options.

The optimal outcome (Option #1) is for all underwater homeowners to continue to pay their mortgages.

That way, foreclosures abate, home prices (and the economy) start to recover in earnest, and borrowers gradually dig out from the holes they're in.

Bare Cupboards

At the other extreme, if underwater homeowners strategically default en masse (Option #4) . . . all hell breaks loose.

The tidal wave of foreclosures swamps still-teetering banks (notwithstanding the grotesque bonuses they've continued to pay out); still-fragile national housing prices resume their free-fall; and the resulting mess necessitates the "Mother of all Bailouts."

Except that this time, the government's cupboards are already bare, because Wall Street made off with the first bailout (and then some).

Options #2 & #3

Which leaves Options #2 and #3: you default but your neighbors don't -- and vice versa.

Clearly, the better outcome for any single underwater homeowner is the former.

That way, you move on to cheaper housing (albeit with damaged credit), but the housing market and overall economy stay afloat. (While borrowers in so-called "deficiency states" are potentially liable for any mortgage shortfall, the risk of that happening appears to be low.)

On the other hand, if your neighbors default and you don't (Option #3) . . . you're very much left holding the bag.

As bank foreclosures inundate your neighborhood, property values plummet, making you further underwater. Meanwhile, living on a block full of foreclosed homes poses its own safety and quality of life issues.

Best Outcome vs. Likeliest

So, how is the housing version of the Prisoner's Dilemma likely to play out?

To forestall the horrific consequences of Option #4 -- widespread strategic default -- one would expect rational banks to finally get serious about proactively reducing the principal balances of underwater mortgages.

Of course, that assumes that "rational bank" isn't an oxymoron.

Stuyvesant Town Collapse

Strategic Default . . . Minus the Consequences

Imagine you bought a house 4 years ago for $540,000, putting in a (very) modest 2% down payment, or $11,000, and borrowed the other $529,000.

Today, your home was worth $180,000 (no, not a typo), yet you were still faced with making payments on the original $529,000 mortgage.

What would you do?

Now, change two of the facts: 1) the property in question isn't a single family home, but a huge Manhattan apartment complex called "Stuyvesant Town": 2) the buyer isn't a person, but a big-time real estate investor, Tishman Speyer Properties.

Oh, and one other thing: add 4 zeros(!) to the numbers cited above.

So, Tishman paid $5.4 billion for Stuyvesant Town less than four years ago; today, the property has lost more than 67% of its value, long ago wiping out Tishman's 2% equity stake.

Current estimated value: $1.8 billion.

Is the suspense building yet?

"Tish-Tosh"

Well, on a massive scale, Tishman just did what hundreds of thousands of underwater homeowners in especially stressed housing markets like Florida, Las Vegas, and Southern California have already done: it "strategically defaulted" on its mortgage.

That is, it handed title to the property over to the lenders, and walked away.

Left holding the bag: pension funds representing California and Florida school teachers, amongst (many) others.

Unlike homeowners who lose their home and credit when they default, Tishman is unscathed:

The Stuyvesant Town deal is one of several Tishman Speyer did at the top of the market that the company is trying to save. But the company itself isn't threatened. It took advantage of easy credit and investors' eagerness to buy into real estate during the good times. As a result, it didn't put much of its own cash into deals.

Of the $5.4 billion price tag on the Stuyvesant property, Tishman invested only $112 million of its own money, with about $56 million from Jerry Speyer and Rob Speyer, co-chief executives of the New York-based company.

--"Tishman Venture Abandons Stuyvesant Deal"; The Wall Street Journal (1/25/2010)

The article then notes that against the $56 million it put in, Tishman collected more than $10 million in property-management fees running the property.

Nice.

I guess that would be Exhibit A in artfully using "other people's money."

"American Dream 2.0"

Not Exactly a Dream -- But No More Nightmares

Thanks to a rare confluence of factors -- mortgages that far exceed home values and bargain-basement rents -- a growing number of families are concluding that the new American dream home is a rental.

Some are leaving behind their homes and mortgages right away, while others are simply halting payments until the bank kicks them out. That's freeing up cash to use in other ways.

"It's just a better life. It really is," says [one former homeowner who's now renting].

--"American Dream 2: Default, Then Rent"; The Wall Street Journal (12/10/09)

Good read for anyone who wants real-life examples of homeowners wrestling with mortgage defaults -- strategic and otherwise.

As I've been posting lately, a "strategic" default is when the homeowner can still pay the mortgage -- at least for the time being -- but walks to conserve their cash flow, and because their house is so underwater it's not likely to rebound.

The article makes two other points:

One. As strategic defaults rise, the stigma is falling. Put it this way: when a housing market "Katrina" strikes, everyone gets hit -- not just the financially irresponsible. And businesses hungry for otherwise-solid customers know that.

Two. Strategic default may be bad for the banks, but it's (very) good for the broader economy.

That's because -- surprise! -- homeowners who ditch $4,000 - $5,000 monthly PITI payments (principal, interest, taxes, and insurance) for $2,000 monthly rent suddenly have another couple grand a month to spend on everything else!

I knew there was a silver lining in there somewhere . . .

When Does 2 -1 = 0?

Housing Market Math, Circa 2010

When does 2 - 1 = 0?

When a two-income family that's "upside down" on their mortgage loses one of those jobs ("upside down" is Realtor-speak for owing more on your home than it's worth).

The first wave of foreclosures largely consisted of marginal borrowers -- putting very little (or nothing) down -- paying inflated prices in especially overheated housing markets.

By contrast, today's second wave of foreclosures disproportionately consists of homeowners who are financially stretched because they've lost their job(s).

That's from Bob Peltier, Edina Realty President & CEO, who spoke at City Lakes' weekly meeting this morning.

That unfolding, second wave of recession-driven foreclosures is likely to be one of the dominant stories of the 2010 housing market (as I've blogged previously, I'd add to that list Option-ARM's, strategic defaults, and the economy generally).

Less Stigma, More Ditched Mortgages?

Social Stigma vs. Financial Self-Interest

Across U.S., Food Stamp Use Soars and Stigma Fades

--Headline, The New York Times (11/28/09)

[A new academic paper] argues that far more of the estimated 15 million American homeowners who are underwater on their mortgages should stiff their lenders and take a hike.

--Kenneth Harney, "The Moral Dimensions of Ditching a Mortgage"; The Washington Post (11/28/09)

During the Vietnam War, civil disobedience consisted of burning your draft card.

In Colonial New England, civil disobedience took the form of throwing highly taxed tea into Boston harbor.

Might civil disobedience, circa 2010, manifest as homeowners ditching their underwater mortgages, even though they still have the means -- at least for now -- to pay them?

Moral "Double Standard"

Called "strategic default," the practice is the subject of a new academic paper by Brent White, a Professor at the University of Arizona Law School. White argues that strategic default is a rational response for millions of beleaguered homeowners:

"Homeowners should be walking away in droves," according to White. "But they aren't. And it's not because the financial costs of foreclosure outweigh the benefits. Most owners are too worried about feelings of shame and embarrassment following a foreclosure, and ignore the powerful financial reasons for going through with it," he said.

--Brent White, "Underwater and Not Walking Away: Shame, Fear and the Social Management of the Housing Crisis"

According to White, would-be defaulters can organize their financial affairs to minimize the disruptions caused by the inevitable damage to their creditworthiness. That includes making major purchases prior to defaulting.

Aside from the morally repugnant nature of Wall Street executives paying themselves billions barely a year after their recklessness jeopardized the financial system, their behavior risks an even greater harm: it allows millions of Americans to rationalize their own bad behavior.

"The system screwed us," they might logically conclude. "Why shouldn't we screw it?"

Under Water Mortgages & Strategic Defaults

Future Foreclosures?

1 in 4 Borrowers Under Water

--Headline, The Wall Street Journal (11/24/09)

In truth, this isn't just a headline in today's Journal; it's THE headline.

As the accompanying story spells out, even the startling, 1-in-4 statistic understates things: in Nevada, Arizona, and Florida, the corresponding percentages are 65%, 48%, and 45%, respectively.

As I just posted last week ("Watching Strategic Defaults"), the biggest wild card in so-called experts' 2010 housing predictions is what happens when homeowners stop paying their mortgages not because they can't, but because they won't.

This is an unfolding story with huge implications for the entire housing market . .

Rick Sharga, Cont.

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.

Are 'Strategic Defaults' Contagious?

New Real Estate Vocabulary

Amongst other things, the current recession/financial melt-down/housing bust has inspired some new real estate terms (or at least adjectives).

So, a "normal" transaction involving one Buyer, one Seller, and two Realtors is now called a "traditional sale," to distinguish it from all the ones that are "lender-mediated" (foreclosures and short sales).

Now, get ready for "strategic defaults" -- also known as "intentional defaults" or "walkaway's."

As in, not paying your mortgage because you can't.

Rather, not paying your mortgage because you've made a rational decision not to.

According to a new academic study, fully 26% of recent mortgage defaults are now of the "strategic" kind. Unfortunately, as more people default, others' reluctance not to weakens, too:

The higher the number of foreclosures in a given Zip code, the higher owners' willingness to walk away, the researchers found, suggesting what they call a"contagion effect that reduces the social stigma associated with default as defaults become more common.

Here's hoping we don't coin too many more new terms before the housing cycle turns up.