At the end of last month I proffered three potential explanations for the continued fall in the US savings rate. The first explanation was that the economy was in a cyclical recovery predicated on asset price inflation and this gave enough troubled debtors breathing space to spend more freely. The second explanation was the opposite, that distress amongst those troubled debtors was leading them to spend a larger percentage of income. The third explanation was that strategic defaults were giving a lot of people money in their pockets that would have otherwise gone to servicing debt and this had increased consumption.
(Note: Because savings is not actually measured in the national income and product accounts as it is a residual calculated by subtracting consumption from output, I focus more on why consumption is increasing.)
Early this month, I wrote why the fall in the savings rate is not meaningless – because it gives us insight into the sustainability of this cyclical recovery. I said
Understanding why savings rates are dropping in the midst of a still severe economic shock, weak credit growth and sustained high levels of unemployment will tell you something about the durability of the policies used to goose GDP over the past three quarters.
And so I want to take another look at some of the anecdotal evidence here. I have talked a lot about the first explanation in the past. And because all measures of retail sales and consumption are increasing in the US, I don’t put a lot of stock in the second explanation. So I wanted to focus on the third explanation today, namely that people are defaulting and that is boosting spending.
Defining strategic default
Strategic default has been the subject of a lot of chatter in the media and in the blogosphere. I would define strategic default as a refusal by a debtor to make repayment of a debt obligation as contractually specified despite the means to make repayment, therefore triggering a different set of default terms as specified in the contract. The point is two-fold:
- a debtor has refused to pay according to the obligations specifically laid out in a legal contract
- the debtor could make the payment as specified, but has strategically opted to revert to the default language of the contract because it is in the debtor’s best financial interest.
As I see it, a contract sets out an agreement between counterparties on how obligations must be met. However, contracts generally contain a loophole specifying what remedies can be taken if either party does not fulfil her obligations. So, a debtor who strategically defaults is implicitly saying, "I don’t want to fulfil the repayment obligations in the contract. feel free to take the remedies designated in the contract for default on payment."
Why might someone do this? Basically, someone strategically defaults because one finds oneself in a situation in which repayment no longer makes financial sense. For example, you buy a house for $400,000, $40,000 in cash and $360,000 as a mortgage. The value drops to $300,000, so you are now 20% underwater and rentals are half the price of your mortgage payment. Meanwhile your repayments are 60% of income and you and your spouse have two children to take care of.
A person in this scenario who could continue paying the mortgage might opt to default, knowing that the bank might even delay in foreclosing on them, giving them rent free accommodation on top of defaulting. Remember banks are playing the pretend and extend game in order to avoid credit writedowns. The growing divide between delinquencies and foreclosures tells you that this is what is happening. I outlined a lot of this last month in the post "Strategic default: In come the waves again."
Now obviously, there is a certain morality that comes in to play here. I won’t go into that here but Interfluidity delved into this in December with three excellent posts:
- Strategic default and the duty to shareholders
- Strategic default: a soldier’s perspective
- Norms of credit
Evidence on defaults
What I do want to pick up on is the anecdotal evidence that strategic defaults are rising and leading to increased consumption. Here are some articles whose titles tell you defaults are indeed rising and that many of them them are strategic:
- Dec 2009: Serious U.S. mortgage delinquencies up 20 percent | Reuters
- Jan 2010: U.S. 2009 foreclosures shatter record despite aid | Reuters
- Jan 2010: The Way We Live Now – Walk Away From Your Mortgage! – NYTimes.com
- Jan 2010: ChumpChanger: Morally Conflicted About Walking Away? Don’t Be.
- Jan 2010: Alex Dalmady’s Blog: My Neighbors Mortgage
- Feb 2010: Walking away from negative equity | Dean Baker | Comment is free | guardian.co.uk
- Feb 2010: O.C. has 13 months of unlisted foreclosures – Lansner on Real Estate : The Orange County Register
- Mar 2010: ROI: When It’s OK to Walk Away From Your Home – WSJ.com
- Mar 2010: More homeowners are opting for ‘strategic defaults’ – latimes.com
- Mar 2010: Fannie Delinquencies Reach All-Time High at 5.52% – HousingWire
Evidence on strategic defaults
But what about the consumption link? After I wrote the first article in March (based on a reader tip), I started to see articles talking about strategic defaults increasing consumption popping up in the media.
Here’s one from Housing Wire last week:
Here’s a provocative thought: what if ‘extend and pretend’ within our nation’s troubled mortgage markets is actually providing a lift to consumer spending? It’s not as far-fetched as the idea might initially sound, and it might help explain some interesting data we’ve seen as of late — and it also might explain why the statistical recovery we’re seeing now doesn’t really feel like a recovery to most Americans.
And, if I’m right, it also explains why we may very well slip right back into the throes of recession all over again as we head into 2011.
Let’s start with what we know. We’ve got 7.4 million non-current loans in this country, according to data source Lender Processing Services, Inc. (LPS: 36.93 0.00%) — that’s an awful lot of households still living in a house, without a mortgage or rent payment draining their available disposable income. And the mortgage or rent borne by most households has historically been one of the most significant capital commitments any household makes, relative to other purchases.
In fact, as I’ve shown in previous columns, most Americans behind on their mortgage have gone more than a year without making any payments. The average age of a loan in foreclosure is now 410 days delinquent, after all, according to LPS; and that’s just the average. Many delinquent borrowers are able to stay in their homes for even longer than that.
Just yesterday, Diana Olick pointed to strategic defaults saying:
I opened up a big can of debate Monday, when I repeated some chatter around that consumer spending might be juiced by all those folks not paying their mortgages.
They have a little extra cash, so they’re spending it at the mall.
Some of you thought the premise had some validity, others, as is often the case, told me I was an idiot.
Well after the blog went up Erin Burnett put the question to Economist Robert Shiller, of the S&P/Case Shiller Home Price Index, during an interview on Street Signs.
He didn’t deny the possibility, and added:
"In some sense there might be a silver lining in that."
Then I decided to ask Mark Zandi, of Moody’s Economy.com, who will often shoot down my more ridiculous theories.
I asked him if this was a crazy idea:
No, not crazy. With some 6 million homeowners not making mortgage payments (some loans are in trial mod programs and paying something but still in delinquency or default status) , this is probably freeing up roughly $8 billion in cash each month. Assuming this cash is spent (not too bad an assumption), it amounts to nearly one percent of consumer spending. The saving rate is also much lower as a result. The impact on spending growth is less significant as that is a function of the change in the number of homeowners not making payments.
I’m not sure I would say this is juicing up spending, but resulting in more spending than would be the case otherwise.
Many of these stressed homeowners (due to unemployment) are reducing their spending, just not as much as they would have if they were still making their mortgage payment.
So, there you go.
My anecdotes on strategic defaults
Here’s what I have uncovered via two anecdotes a friend sent me.
This first one comes via Bill Fleckenstein from a retired hedge fund manager. Catch Fleck via his daily newsletter (subscription) or his MSN column, which is free. Bill says the reader told him the following five anecdotes:
- 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.
Another hedgie in San Francisco, responded with this after seeing these anecdotes:
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!!).
Small business here are getting killed, however. There is very little new money and the terms to renew a line, or refi a CRE mortgage, are crazy. Almost all small business lines are also tied to assets – real estate in most cases – and it’s very hard to renew with a smaller bank.
I know this sounds like lunacy but these are stories I know personally.
Clearly this is not scientific data in the least. But I hope you see the evidence is pretty substantial that strategic defaults are indeed goosing retail sales. The question is what comes next?