Thursday, April 15, 2010

More on Anecdotal Benefits of Strategic Defaults

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As I wrote yesterday I need to rethink my whole investing theme based on strategic defaults.  [Nov 25, 2009: America's Stealth Stimulus Plan; Allowing It's Home "Owners" to be Deadbeats]   The change in accounting rules for the banks relative to what they have to admit on their balance sheet about 14 months ago, truly was a game changer that I underestimated...

I am now fascinating reading the stories about what people are doing out there in Cramerica, since it is so different from 'my world'.  Via Edward Harrison on SeekingAlpha are some anecdotes on this phenomenon - obviously unverifiable, but simply from reading the 'comments' sections of major US papers the past 6-9 months I have heard countless similar "I know so and so" stories.  While this is going to provide a boost to the US economy the next few years, it says a lot about the breakdown of rules in a society and just another step on the social acrimony ladder as those who play by the rules are paying the price.  While the entire housing market is currently government supported and government mortgage makers don't price for risk, if someday we exit this dependence on Fannie, Freddie, FHA [Feb 1, 2010: Hockey Stick Growth in Delinquencies at Fannie, Freddie] and return to a privately funded mortgage market, rates for everyone have to go up to compensate for the risks now considered "ok" by the American borrower.

Let me also refute the "this will ruin their credit" argument.  FHA is giving out mortgages to people sub 580 FICO.  [Nov 18, 2009: Toll Brothers CEO - "Yesterday's Subprime is Today's FHA"]   This is bottom of the barrel credit risk, we're talking the bottom 15 percentile.  If you have good credit otherwise (700+), and default on a mortgage you might lost 200 FICO points.  (I don't know the exact number)  But within a year or two, with steady payments elsewhere you can get it rebuilt... the older the delinquency the less effect on your score.

But whatever the case - if you are median America at FICO 781 and lose your 200...you can go right back to FHA and get a 3.5% mortgage even at 581.  If it falls below 581, give it 9-12 months and continue to make steady payments on other obligations.  Even today you can get a mortgage below 580 with FHA, but seeing the losses they were taking they have increased the down payment over and above 3.5%.  Here is the distribution curve to show you how bad your credit has to be to get 580 - which again FHA is happy to offer loans... and until 2 months ago 3.5% down loans.  (which will lead to a new wave of strategic defaults in the coming years)



But the larger point is, "bad" FICO is increasingly meaningless.  If 2% of the population walks away from their mortgage then they are tagged with a big red flag.  If 15% of the population does it... it was just a 'black swan event'. Those who delve out credit will compensate since the 'strategic default' is being employed by countless people who otherwise had good credit.  Thus the penalties will be minor.

So is it worth it?  Increasingly yes.  Who needs great credit in this environment?  Especially since if you just take the 1 blemish, and keep paying your other obligations your FICO score will rebound swiftly.  (ironically the money being used to maintain 'good credit' in auto loans and credit cards is the same money that used to go to the mortgage - talk about irony!)  And we're not talking peanuts here - simply walking away from a $1400 mortgage payment for 18 months, generates $25,000.  Effectively a new car for 18 months of "non compliance".  That's 1 new car every year and a half for well over 7 million American households.  Obviously some people have far higher payments than $1400.  And many are getting away with this for longer than 18 months... especially if they can hide out in a government modification program for 6 months  [Mar 26, 2010: Half of US Home Modifications Default - Again] to get the clock restarted for a 2nd cycle of non payment.  So is $25K? $40K? $50K worth it to lose 200 FICO points for 2-3 years?  Especially with so many in 2004-2007 putting zero of their own money, or close to it to purchase said 'asset'?  Put another way, if someone offered the typical American $35K to lose 200 FICO points for a few years, while continuing to live in their current accommodations, what % would do it?   That's the offer the government and Fed have now dangled.

And we're wondering why the consumer is "back" in Cramerica?  On this basis alone, I have to rethink the bearish model... UNTIL we exhaust the foreclosures.  Amazingly the bear case returns more prominently in America when this cycle of strategic default has exhausted... not when foreclosures and delinquencies are surging... as they continue to. [Apr 13, 2010: One out of Ten US Mortgages is Now Delinquent ... Which is Great for Consumer Spending]

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Read on for what our fellow citizens are enjoying....

First Edward recounts an email Bill Fleckenstein received from a reader

My 25 year old niece had $10,000 of outstanding credit card debt. Recently, she told the bank she couldn’t pay. She is not unemployed so the ‘hardship’ is all relative. Nevertheless, the bank offered her a concession which she refused. They offered another concession, she refused again. Finally, they told her if she paid $150/month for 2 years (total of only $3600 with no interest), they would call it paid in full! She accepted in a heartbeat. It is less than a month later, and she celebrated her good fortune by going on a cruise to Hawaii.
 
A friend owns a small manufacturing co. He tells me of one of his female employees who was saddled with a $450,000 home she purchased almost five years ago with no down pmt. One year after her purchase she pulled $75,000 home equity and purchased ‘fun stuff’ including a boat. She recently walked away from the house (now saddled with $525K mortgage), purchased a new house for $200,000 (in her sister’s name) and kept all the goodies purchased from the home equity withdrawal. With the much lower mortgage payment she just bought a new car.

Almost everyone in my "survey" is aware of, or knows someone living rent free in their home for an extended period of time, having stopped paying their mortgage. Many of these free boarders are spending lavishly on non-essentials. My hard-working part-time assistant knows two different 35+ yr olds who have enjoyed over 9 months (one is up to month eleven) of rent-free living in very nice homes they purchased in 2004/2005! Both are employed and both enjoy a non-frugal lifestyle. My assistant wonders if he should do the same or have me pay him more so that he too can enjoy the ‘good life’.

My sister is a nurse with 25+ years on the job. She told me of a young couple that she is good friends with that both work at her hospital making a decent joint income. They didn’t like the fact that they grossly overpaid for their 3000 sq ft home in 2006. They stopped making hefty monthly payments six months ago and haven’t yet been contacted by the bank. They have decided to wait until contacted and then walk away. In the meantime, they just returned from NYC from a week vacation in the Big Apple.

My brother-in-law wanted to know if he should stop making payments on everything. He lives in Virginia and his carpentry skills are not as marketable as they were in the height of the boom. He and his wife’s best friend have lived close-by for many years. For the past 13 months since they strategically decided to stop paying their mortgage, they had yet to be contacted by their bank. Not even one letter! My brother-in-law doesn’t understand how they get to pocket the mortgage and spend carefree, including a 10-day Caribbean vacation.

I can list numerous other, verified examples. And these are just from my tiny, tiny universe. I can’t help but assume if I know of this many instances, there must be millions of similar stories across the country. And I am sure many of your readers have first or second hand knowledge of similar situations.

Bill, for me, the weight of evidence is pretty powerful. I am convinced that it is a specific government policy to increase consumer spending by allowing massive debt repudiation. And, I think they are pulling it off, at least for now.

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Next a reader from San Fran, upon reading the above anecdote emailed Edward with this:

From the West Coast I have at least that many stories. They come in clusters. One brave party takes the first step and "wins" then relatives or co-workers follow the successful example. The persons are still employed – default on debt – they rarely get contacted by lenders and then negotiate hard (the debtors that is). After some settlement they keep spending lavishly. In every case a vacation is part of the program. Every case!

In one example 5 employees at a local business that caters to wealthy clients have defaulted. The first guy and his ex were a classic accident waiting to happen – big lifestyle and all on borrowed $$. He’s still in his place 19 months later. Then a guy who got his hours cut back – same story. The last two are STILL making over $100k. No one is making his mortgage payment. No one is in foreclosure yet – only the first guy has even been contacted and he’s the most underwater. The last two (one guy I know well) are still religious about the credit card debt, however.

I have a place of the beach in Mexico. One of the newer buyers on our beach got the money from a refi in Oregon in 2006 (about $300k). He stopped paying last year on his Oregon place – still has the house, no proceedings – just some letters. He even rents it out during the winter to another couple who walked away and mailed in the keys on their home last year (foolish them).

I know this sounds like lunacy but these are stories I know personally.

If you are like me, this is all a very eye opening experience since these type of 'strategies' are not things that dominate my day to day thinking.  This is simply not my world....but I am being educated by the day on what is going on out there...

And like any person halfway responsible, I feel completely foolish by being so.

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