One in four mortgages today is underwater, and it might get worse. According to Deloitte, nearly half of all homeowners by 2011 will owe more than their homes are worth as property values continue to spiral. These disastrous negative-equity numbers forecast a potential catastrophe for bankers and mortgage services in bringing forth more "walkaways" - people who strategically default on mortgages because the property value has sunk too far below their principal loan obligation.
It's a problem that's already caused up to 26 percent of current foreclosure activity, according to a University of Chicago economist, and could get worse as people see their neighbors skipping out and mailing in keys - often after months of rent-free living. "I'm really concerned" about walkaways, says Luigi Zingales, an economics professor studying the foreclosure crisis at UofC's Booth School of Business. "This can spread like wildfire."
Zingales is among those who have raised the idea of widening a so-far little-used tactic for preventing foreclosures: the principal-reduction modification. Debt forgiveness has not only shown to have a lower recidivism rate over term-based modifications (according to a Credit Suisse study) but it can aid the consumers who would be more likely to be long-term adherents to a renegotiation plan, a crucial yardstick for lender performance under the Treasury's Home Affordable Modification Plan (HAMP). For example, Ocwen Financial Corp. in West Palm Beach, Fla., has seen only 12 percent of its reworked mortgages with reduced balances fall back to 60-day past-due status, compared to 22 percent for rate-based modifications.
Principal reductions received short-lived attention during the 2008 presidential race after John McCain proposed to authorize a government-backed buyout of mortgages in order to renegotiate every underwater mortgage to current market rates. Estimated cost at the time: $300 billion. But bankers and servicers, wary of the precedent of knocking down balances or posting immediate losses to the books, have largely ignored the idea. They would also face significant hurdles in getting approval for reductions from secondary investors. Still, the consequences of 9 million potential foreclosures are hard to ignore: if a foreclosure costs a bank an average of $122,000, we're talking a trillion-dollar hit to the industry's bottom line regardless.
Zingales himself backs an idea that may be worth a further look. He and colleague Eric Posner have proposed federal legislation that would enable a "debt-for-equity" swap program for certain homeowners to reduce their loan balances to 10 percent below market value, in exchange for a later 50/50 split with the lender on capital gains on the eventual sale of the house.
He hasn't gotten far with his idea, only gaining an audience to date with an apparently disinterested Fannie Mae official. The growing problem of walkaways "does not seem to be recognized at the higher levels," says Zingales. "The industry is completely oblivious...and afraid to talk about this problem because of the social contagion."