Underwater homeowners hanging on

Fears that droves of underwater homeowners will walk away from their homes in “strategic defaults” may be overblown, research by economists at the Federal Reserve Bank of San Francisco suggests.

In California, Florida and Nevada, more than one in five mortgages have principal balances that are greater than the estimated value of the homes that serve as collateral on the loans.

Borrowers who can afford to make their monthly mortgage payments, but choose to stop making them because their home has become worth less than they owe, are said to be engaging in strategic defaults.

But depending on how deeply they are underwater, many of those borrowers still have an economic incentive to stay in their homes, John Krainer and Stephen LeRoy said in an Economic Letter.

A homeowner who has no apparent equity in their property, because they owe as much as their home is worth, is in a “heads-I-win, tails-you-lose” situation with their lender, Krainer and LeRoy write.

If home prices decline further, then the borrower can default immediately, with the decline in their home’s value translating into greater losses for the lender, they said. If home prices rise, it’s the borrower who benefits.

“With both upside potential and downside protection against future losses, the borrower rationally should wait before defaulting,” they conclude.

While that observation may seem obvious, it illustrates that the decision whether to walk away from a home is not based on the book value of their equity, but its market value.

The market value of equity depends on borrower expectations about whether the price of the house will recover and the perceived costs of defaulting, including damaged credit and moving expenses.

Together, those factors “move the rational default point well below the underwater mark,” Krainer and LeRoy say, citing statistics that back that conclusion up.

With the exception of mortgages originated in 2006 — which typically had the highest loan-to-value ratios — default rates keep rising steadily even as loan-to-value surpass 100 percent, 110 percent, and beyond.

That’s only possible because of the number of homeowners who continue to make their mortgage payments after the “book value” of their equity has vanished.

“Barring life events, borrowers are likely to stay in their houses until they are well beyond the book value underwater mark,” Krainer and LeRoy conclude.

More research on the subject is needed, they say, as “Many borrowers default when they seemingly have no rational incentive to do so, while other borrowers stay current on loans that appear to be irretrievably underwater.”

The Obama administration has encouraged lenders to forgive principle when engaging in Home Affordable Modification Program (HAMP) loan modifications, although most lenders opt to reduce borrower’s interest rates or extend their loan term instead.

In addition, the Home Affordable Refinance Program (HARP) provides incentives for lenders who agree to refinance mortgages with loan-to-value ratios of up to 125 percent. The HARP program was supposed to help borrowers who, because of falling home prices, might have been unable to refinance at today’s lower interest rates.

Only borrowers whose loans are owned or guaranteed by Fannie Mae and Freddie Mac are eligible for HARP, and the program has fallen far short of its initial goal of helping up to 4 million homeowners.

Since the program was announced in March 2009 through the first six months of 2010, about 380,000 homeowners have refinanced through HARP, and most weren’t underwater. Only 3.2 percent of borrowers taking advantage of the HARP program — 12,244 all told — had loan-to-value ratios exceeding 105 percent, Fannie and Freddie’s federal regulator reported.

Fannie and Freddie’s loan servicers have been more successful in accelerating the pace of short sales and deeds-in-lieu of foreclosure, the report showed. During the second quarter, short sales were up 151 percent from the same time a year ago, to 29,375.

Last month the Federal Housing Administration (FHA) launched a “short refinance” program that allows some non-FHA borrowers who are current on their loans to refinance into an FHA-insured loan if their first loan holder agrees to write off at least 10 percent of their unpaid principal balance.

In another new twist, Rumson, N.J.-based Loan Value Group is reportedly working with hedge funds and a major bank to offer underwater homeowners incentive payments they can claim only if they stay current on their mortgage until they sell or refinance.

The payments average 10 percent of the unpaid mortgage balance, the San Francisco Chronicle reported, and about 2,500 homeowners have signed up since the program launched in January.

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