Banks May Be Facing A Tidal Wave Of Mortgage Defaults

Although bank stocks have rallied recently, it may be premature to expect a recovery for the banking industry.   There are multiple indicators that a housing recovery is little more than a distant dream and current trends suggest that mortgage defaults may increase substantially.   With banks currently holding approximately $3 trillion dollars in residential mortgages, the prospect of additional mortgage defaults could be catastrophic for bank loan portfolios and the economy in general.

Consider the following dire statistics and trends, none of which remotely suggest that the banking crisis or housing collapse has peaked.

The second half of the year has seen a plunge in the sale of new and existing home sales.  Sales in October were down 25% from last year.  In addition, the Federal Reserve’s effort to lower rates by purchasing Treasury debt with freshly printed money (quantitative easing) has resulted in a large increase of almost 1% in mortgage rates.

According to RealtyTrac, more than 1 million homes will be foreclosed this year, adding huge inventory to an already glutted real estate market.  Core Logic estimates that there is a “shadow inventory” of 2.1 million homes that are foreclosed on but still in bank inventory awaiting sale, in the foreclosure process or 90 days past due that will soon be in the foreclosure process.  With housing demand down and supply increasing geometrically, the laws of economics dictate a continued erosion in housing prices.

Core Logic, the leading provider of property information, reported today that a staggering 10.8 million or 22.5% of all residential properties with mortgages are now “under water”, meaning that the homeowner owes more on the mortgage than the property is worth.  Although the number of properties with negative equity has declined for the past three quarters, Core Logic notes that this is due to completed foreclosures on defaulted home mortgages and not because of a recovery in property values.  Chief Economist at Core Logic, Mark Fleming, noted that home price declines appear to be accelerating which would place greater numbers of homeowners in a negative equity position.

The factor that could ignite another tidal wave of foreclosures is the changing attitude by consumers regarding their obligation to continue making mortgage payments when they are underwater.  The most recent Realty Trac/Trulia survery of homeowners shows that 48% would consider a “strategic default” or walking away from their mortgage obligation.   In May, only 41% of those polled said they would consider a strategic default.

Americans have long believed that home values could only increase which allowed many homeowners to psychologically dismiss previous short term dips in housing values and not even consider defaulting on their mortgage.   That long held belief in a divine right of property appreciation now appears to be eroding as home values continue to decline.  Zillow Inc. reports that it expects US home values to decline by a staggering $1.7 trillion this year and that values will continue to erode in 2011.  According to Zillow’s Chief Economist, Stan Humphries, in an interview with Bloomberg,  “It’s definitely going to continue into 2011.  The  back half of 2010 looked horrible and 2011 should look like the mirror image of that.”

Further indications that Americans do not expect a quick recovery in home real estate values is found in the latest Fannie Mae National Housing Survey.  Most Americans do not think housing has hit a bottom with 22% expecting further declines in values (up from 18% in June).  Almost half of those surveyed said homeownership was less safe than keeping their money in the bank.  Doug Duncan, Vice President and Chief Economist at Fannie Mae, said “Consumer attitudes toward buying a home are more negative since last quarter.  Our survey shows that American’s declining optimism about housing and their personal finances is reinforcing increasingly realistic attitudes towards owning and renting.”

As long as homeowners believed that future home values would recover, the risk of underwater borrowers defaulting was mitigated, thereby limiting further defaults, foreclosures and price declines.  If underwater homeowners become convinced that home prices will not recover but in fact will continue to decline, the motivation to default becomes financially compelling.

The Federal Reserve, in a study on strategic defaults noted that:

“It is worth noting that borrowers who default live rent-free until the lender takes possession of the house (property taxes, though, must still be paid by the mortgage holder), strengthening the incentive to default. Furthermore, delays on the part of the lender to foreclose extend states’ mandated preforeclosure period – the amount of time between a notice of foreclosure and when the lender can seize and sell the property.”

Meanwhile, efforts to modify mortgages have been a resounding failure as housing values continue to plunge and the government attempts to keep homeowners in homes that they cannot afford.  Furthermore, many of the well intentioned programs that impose statutory delays on the foreclosure process are increasing the incentive for mortgage default.

According to LSP Applied Analytics, it takes an average of 492 days before a home foreclosure process is completed, up from 289 days in 2005.  In states such as New York, the foreclosure process takes a leisurely 604 days due to regulations that make the foreclosure process more difficult and lengthy.

The conviction that home prices will continue to decline, combined with a mortgage in excess of the home’s value could result in a tsunami of additional mortgage defaults for the banks.

For a homeowner under financial distress with a mortgage in excess of the home’s value and no expectation of future price appreciation, the financial appeal of living rent free for 2 years or longer will become irresistible.   Is the country ready for TARP 2?

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