According to a recent headline-grabbing study, “26% of the record numbers of home mortgage defaults across the country are ‘strategic‘ — that is, calculated economic decisions to bail out of loans by owners who actually have the money to make the payments but can’t handle the negative equity they’re carrying caused by local property value declines.” In most of the coverage to-date surrounding the foreclosure crisis, this class of defaulters has been largely ignored.

The study found that there were a few variable which correlate closely with borrowers’ respective willingness to intentionally default. First, and most obviously, is the value of the mortgage compared to the current value of the home. Specifically, those whose mortgages are most “underwater” are also most willing to default: “Researchers found that almost no homeowners would default if their equity shortfall was less than 10% of their home’s value, but one-in-six homeowners would default if their equity shortfall reached 50% of their home’s value.”

In controlling for age, location, and education level, the study determined that “Well-educated borrowers, homeowners in the Northeast and West, and people under 35 or over 65 were less likely to have moral reservations about choosing to walk away from making mortgage payments.” One’s sense of morality evidently plays a strong role in this calculation, with those who regarded strategic default is immoral 2-3 times less likely to default than their amoral counterparts. This relationship, however, is also proportionate to the size of one’s negative equity position: “While four out of five homeowners said they believed it was morally wrong to intentionally default, as negative equity rises, more borrowers—including those who said strategic defaults were immoral—would consider walking away.”

However, morality (in the case of strategic default at least) is apparently received from social cues. In other words, borrowers surrounded by default were themselves more likely to accept default as an amoral possibility. “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.’ ”

This has some important implications for the recent federal legislation, which has aimed to prevent foreclosure by simply helping borrowers to modify their monthly payments, thereby making their mortgages more affordable. However, this legislation is built implicitly on the ideas that underwater borrowers will still repay their mortgages, and that affordability should be measured/enhanced on a monthly – rather than an aggregate – basis. If this report is to be believed, both of these assumptions are questionable. Perhaps this means that we will soon seen a corollary to this legislation passed, in which borrower equity (i.e. mortgage value) is also adjusted. Or maybe not.

There seems to be an important exception to that notion that this is a buyers’ market when it comes to housing: distressed real estate. Properties that are delinquent and nearing foreclosures or are already in foreclosure are now attracting bubble-like interest.

According to a report by RealtyTrac, “1.5 million U.S. owners have been told they are in danger of losing their homes. The company Thursday said one in every 84 households got at least one foreclosure notice during the first six months of the year, a new record.” As a result, “The existing home market is still vastly oversupplied, and we continue to be inundated with an influx of distressed and foreclosed properties,” observes another analyst.

Unfortunately – at least from the standpoint of “genuine” buyers – many of these properties are being snatched up by speculators and institutional investors, who have finally found a corner of the real estate market that remains buoyant. “Vornado Realty Trust, one of the biggest real-estate investment trusts in the U.S.,” made headlines when it announced its intention to “raise $1 billion for a private-equity fund to invest in the wave of distressed properties expected to hit in the next few years.” According to marketing materials, the fund is aiming for a 20% annualized return on its investment, which is in indication of just how excited people are about the market for foreclosed properties. Distressed commercial real estate, meanwhile, is nearing $100 Billion and growing rapidly.

Other investors, meanwhile, are hoping to benefit indirectly from a new federal program “designed to stabilize and revitalize neighborhoods ravaged by foreclosures and abandonment.” Across the country, “Out-of-state speculators continue to swoop into these neighborhoods, plucking properties they might fix up and rent out. Then again, they might try to flip them or simply sit on them, perhaps fouling any attempt to stabilize these areas.” These properties are being snatched up for eye-poppingly low prices- under $10,000.

Real estate agents are also getting into the game. A just-announced arrangement “will give local RE/MAX agents…access to RealtyTrac’s database of properties that are in some state of foreclosure — including properties in default, homes scheduled for public foreclosure auction and bank-owned properties…Going forward, prospective homebuyers visiting remax.com also will be able to search RealtyTrac’s database.” While ostensibly affording both buyers and sellers of foreclosed homes more opportunities, a byproduct of this arrangement is that speculators will also have an easier time spotting such properties.

Investors have another advantage – beside deep pockets – over regular homeowners; they almost always pay cash. Until the credit crisis is fully resolved and banks once again trust each others’ credit, it seems speculators will have the upper hand.

The recent stabilization of the housing market now appears to be a mirage, brought on by stopgap measures. “Until recently, many banks have put off launching foreclosure action on the troubled properties, in part because they had signed up for the Obama administration’s home-stability plan, which required them to consider the alternative of modifying loans to make it easier for borrowers to make payment. Unfortunately, the federal push to promote loan modifications and the related moratoriums that some states have imposed on foreclosures are already fading, at which point the foreclosure crisis is likely to expand.

“A new set of economic theorizing holds that any bottom that might have been glimpsed was a false one – just a plateau before a bigger drop, when lenders try to clear their books of bad loans. If that’s the case, the economic hole starts to look a lot deeper, and the housing crunch becomes another part of a larger, vicious cycle.” In other words, if banks move to place a fresh supply of foreclosed properties on the market, it will cause all prices to suffer. This will put even more pressure on those whose mortgages are already underwater (1 in 5, according to one estimate), and perhaps compel banks to race even faster to liquidate mortgages in default.

According to RealtyTrac, April “was the worst month ever, with more than 340,000 properties in some state of foreclosure nationally…They are expecting June’s numbers (to be released next week) to ‘give April a run for its money’ as worst month ever.” This was discerned from a large uptick in delinquent mortgages, many of which can be expect to result in foreclosures. “In the first quarter, some 1.8 million homeowners nationwide fell behind on their loans by 60 to 90 days, a 15% increase from the prior quarter, according to Moody’s Economy.com. The research firm said that loan defaults rose sharply as well, to 844,000 in the first three months of this year.”

Who’s to blame for this? The government appears to be doing as much as it can. “Foreclosure counseling is an extremely effective service; HUD reports that 45 percent of those who participated in 2008 were able to hang onto their homes.” While estimates vary, hundreds of thousands of borrowers have probably benefited from the loan modification program.

The problem is the banks, which continue to prefer foreclosure over loan modification. According to a new Federal Reserve paper, “lenders rarely renegotiate. Fewer than 3 percent of the seriously delinquent borrowers in our sample received a concessionary modification in the year following the first serious delinquency.”  There are two main reasons for banks’ entrenched resistance: “The first is ‘self-cure risk,’ which refers to the situation in which a lender renegotiates with a delinquent borrower who does not need assistance…The second cost comes from borrowers who default again after receiving a loan modification. We refer to this group as ‘redefaulters,’ and our results show that a large fraction (between 30 and 45 percent) of borrowers who receive modifications, end up back in serious delinquency within six months.”

More on loan modification- and why it’s failing – tomorrow….

One of the cornerstones of the Obama administration’s plan to overhaul the US mortgage system is an emphasis on so-called “plain-vanilla” financing. Specifically, “The government would give its seal of approval to a handful of mortgage types — a standard 30-year fixed-rate mortgage and perhaps a few varieties of adjustable-rate loans. For a loan to get the ‘vanilla’ label, the lender would have to verify borrowers’ income and have them set aside money for property tax and insurance.” A 20% down-payment would be required, prepayment penalties would be eliminated, and all fees/costs would have to be clearly stated. [See chart below, courtesy of WSJ].

The primary purpose of the plain-vanilla system would be to protect borrowers, many of whom were burned by complicated mortgages during the height of the housing boom. Types of mortgages have exploded both in number and complexity, such that there are now hundreds of different variations, requiring various levels of risk disclosure and creditworthiness. Ostensibly, this innovation was designed to help consumers by giving them more choices. Human nature being what it is, many borrowers opted for the riskiest mortgages. Meanwhile, banking profits soared. Given how opposed the banks are to the return to plain-vanilla lending practices, it’s pretty obvious as to who is benefiting most from the current system.

There is a strong political bend to this regulation, given the assumptions about human nature that it makes. Still, there is something to be said for simplicity. A fixed-rate mortgage is predictable and easy to understand. Income verification confirms the borrower’s ability to afford the mortgage, and a large down-payment lowers the possibility of default. Sure there are borrowers who liked the freedom to use their mortgage to make a bet on the direction of interest rates, and/or who successfully exploited liar’s loans to purchase a house they otherwise wouldn’t have received lending approval for. But for everyone who came out ahead with a zero down payment ARM, anecdotal evidence suggests that there are 9 who came out behind and are now in default.

Under the new system, those who want to play roulette with their home/finances can still do so, but will be strongly discouraged in the form of un-preferential treatment/pricing. “According to the administration’s ‘white paper’ on the proposal, the agency ‘could impose a strong warning label on all alternative products; require providers to have applicants fill out financial experience questionnaires; or require providers to obtain the applicant’s written ‘opt-in’ to such products.’ ” In this way, banks will also be protected, since consumers can no longer pretend that they weren’t aware of the risks when they signed up for the mortgage.

In the wake of the housing crisis, risk aversion has increased, and it looks like banks/consumers are actually one step ahead of the government. “With the housing bubble burst and mortgage rates near historic lows, fixed-rate loans — 30-year, 15-year and other types — now account for about 95 percent of the market,” compared to only 50% during the height of the boom in 2004. But people have short memories. If this regulation passes, it will make it more difficult for people to overextend themselves when the economy begins to recover.