This article studies the loan-to-value (LTV) ratio of 162% as the median point where negative equity homeowners exercise their implicit put option and force their lender to take their underwater property.
The negative equity threshold and the point of no return
Nearly 2,500,000 California homeowners have a negative equity condition which imprisons them in houses that are black-hole assets. Each month of continued ownership sucks up sums of money in multiples of what the home would rent for – the home’s sole current value to the homeowner. Thus, a disconnect has developed between the primary use of the home to shelter the family and the secondary consideration as the family’s largest financial asset – due solely to the cyclical reversal of fortune for homeowners who bought or refinanced after 2002.
As upwards of 30% of California homeowners are now consumed by the negative equity trend which inverted the value of their home, the number of people choosing to walk away from their underwater properties is on the rise. Those rational homeowners who choose to walk away or strategically default (voluntarily defaulting on their home loan when they have the means to pay) account for nearly one out of every four defaults today in California and one in five nationally.
But what is the negative equity threshold at which underwater homeowners make the decision to strategically default and walk away from their upside down properties – even when they have the means to continue making their mortgage payments?
This question is aggressively addressed in the May 2010 Federal Reserve Board (the Fed) study “The Depth of Negative Equity and Mortgage Default Decisions” written by Neil Bhutta, et al. The Fed’s study of homeowners in the four sand states (California, Nevada, Arizona and Florida) concludes that a loan-to-value (LTV) ratio of 162% is currently the magic “median” tipping point at which half the homeowners in their sample concluded the financial benefits of defaulting outweighed the adverse consequences of continuing to pay on their mortgage.
The homeowners in the study made no down payment and financed 100% of their purchase, making them acutely vulnerable to the slightest future decline in property values. Close to 80% of these homeowners defaulted during the period of 2006 through 2009.
Two widely recognized hypotheses explain why homeowners default. Under the strategic default theory, homeowners default purely as the result of their home’s negative equity, independent of any other factors.
However, under the double trigger hypothesis, defaults occur after the combination of two deciding factors:
- negative equity, due to property value declines; and
- income shock, usually the result of job loss, or a disruptive life event, such as divorce, sickness or death.
In the instance of the double trigger theory, the owner’s motivation to default is clouded – the default does not occur on just rational mathematical grounds, a family balance sheet requisite of a true strategic default, but may be partially involuntary due to income loss and the inability to sell the underwater property. [For additional commentary on the use of a balance sheet as a financial yardstick to determine solvency, see the April 2010 first tuesday articles, The underwater homeowner, his future and his agent: a balance sheet reality check – Part I and Part II.]
The Fed’s study concludes that the study’s median homeowner who does not experience an income shock or disruptive event only strategically defaults on his mortgage (read: rationally defaults) if his level of negative equity is around an LTV of 162%. However, if the level of negative equity is significantly lower, say 110%, the average homeowner will not likely default unless the negative equity condition is combined with an income shock or disruptive life event, the double trigger theory. [For more information concerning the relationship between a homeowner’s negative equity position and foreclosure, see the October 2009 first tuesday article, Negative equity and foreclosure.]
Editor’s note – A negative equity homeowner is also more likely to strategically default if he has knowledge and awareness of others who have strategically defaulted. The legal escape route provided by a strategic default is greatly destigmatized when the homeowner personally knows of others who have done the same. So much for the rational homeowner…
Strategic default: a prudent (and legal) option
While 162% may be the median homeowner’s tipping point for a strategic default, we at first tuesday promulgate a more prudent choice for negative equity owners. Homeowners with an LTV exceeding 125% are hemorrhaging money; they are stuck in a long-term financial condition requiring them to crunch the numbers of their personal situation and give serious consideration to strategic default – for the future well-being of their family and California’s economic recovery.
Default is logical for 125% LTV homeowners as no temporary or permanent loan modification relief is available to most all underwater California homeowners. And even if they were to be granted a 30% loan reduction (which hasn’t happened and likely never will without the oversight of judicial intervention in bankruptcy), most will still not be made solvent. A homeowner realistically needs a 94% LTV (100% of value minus 6% for transactional expenses) just to break even on a sale (or equivalent purchase), let alone have any sale proceeds to apply towards the purchase of a replacement home.
To default is especially advantageous in California: California is a nonrecourse state, effectively relieving underwater homeowners of their excess purchase-money mortgage without the cost of a bankruptcy. Lenders who make mortgage loans in California well know they cannot pursue an individual to recover losses due to deficient property values on “bad” one-to-four unit, purchase-assist loans made to buyer occupants. Likewise, on recourse loans, such as refinances or equity loans, lenders cannot obtain a money judgment for any deficiency in the property’s value when they hold a quick, down-and-dirty trustee’s sale (in contrast to a time-consuming and expensive judicial foreclosure).
The promise to pay contained in the note for a loan which funds the purchase of a one-to-four unit residential property in California which the buyer occupies is unenforceable against the homeowner. When this type of loan is originated, the lender knows a trust deed foreclosure on the real estate is the lender’s sole source of recovery on a default. Thus, for underwater single family homeowners, default is not only a prudent financial strategy, it is sanctioned by law as no personal liability exists to allow the lender to collect any part of their purchase-assist loan, legally referred to as purchase-money loans. [California Code of Civil Procedure §580b]
Most importantly, a strategic default is the legal act a homeowner takes to exercise the put option they hold under all trust deeds. On default, the lender is forced by contract (the trust deed) to take the property in exchange for the amount remaining due on the loan – or the lender takes nothing. [CCP §726; for more information on the put option, see the November 2009 first tuesday article, California homeowners: exercising your right to default.]