Strategically Distressed

It has been over two-and-a-half years since the National Bureau of Economic Research called an end to the recession that began in late 2007. Nonetheless, the recession’s negative effects on the U.S. housing market remain.

One potential headwind facing the housing market is foreclosures. The majority of foreclosures are initiated by banks after a borrower has missed three or more payments, a situation called serious delinquency. Borrowers who are seriously delinquent but who have not yet been foreclosed on may receive a mortgage modification from their bank or continue to live in the home without making payments until the bank forces them out.

Since the recession began in 2007, the percentage of mortgages that may enter foreclosure has ballooned. The rate of potentfial foreclosures can be determined by subtracting the average foreclosure rate from the average serious delinquency rate from the previous period. Data from the Mortgage Bankers Association shows that 2.0 percent of mortgages serviced (900,000 mortgages) may enter foreclosure or need to receive a mortgage modification.

Another potential problem facing the housing market is borrowers who strategically default on their mortgages. Strategic defaults occur when a borrower, who is current his mortgage, defaults because the value of the mortgage is higher than the value of the home. According to an April survey by FICO, 45.5 percent of risk professionals expect strategic defaults to be higher in 2012 compared to 2011. Moreover, nearly half of risk professionals believe that the current generation of home owners does not consider their mortgage to be their most important credit obligation. If risk managers are correct, this attitude would have negative implications for the housing market. According to CoreLogic, the number of home owners with negative equity or near negative equity on their mortgages remains largely unchanged since the height of the housing crisis in December 2009. Furthermore, after declining for three consecutive quarters, the share of mortgages with negative or near negative equity rose to 27.8 percent, the highest level since December 2010.

According to Inside Mortgage Trends, the possibility of a large wave of strategic defaults has driven the debate as to whether Fannie Mae and Freddie Mac should offer principal write-downs in addition to their current practice of principal forbearance. Principal write-downs would allow mortgage servicers to reduce the principal of the mortgage to a level the homeowner would be more likely to afford. Principal forbearance, on the other hand, postpones principal payments for a period of time, which means the unpaid principal is still a part of the mortgage obligation but it is due to be paid later. There are concerns, however, that allowing principal write-downs could increase the number of strategic defaults, as consumers who are current on their mortgages would become noncurrent in order to obtain a principal write-down.

Interestingly enough, despite the headwinds facing the U.S. housing market, mortgage banking appears to be extremely profitable again. According to the most recent issue of Inside Mortgage Trends, a survey of the eight largest bank-held mortgage operations shows that first-quarter profit in 2012 was over three times the profit recorded in the first quarter of 2011. The increase in profits came despite the fact that mortgage originations fell 1.3 percent to $234.9 billion compared to the fourth quarter of 2011. Given the large levels of borrowers with negative equity and the large number of potential foreclosures, it is difficult to determine if mortgage banking will be as profitable going forward.