Are Homeowners Walking Away From Their Mortgages and Into the Mall?

Blogging at Naked Capitalism, Edward Harrison provides a persuasive argument for why retail sales and consumption are increasing, despite persistent joblessness and a lack of income growth. He posits that homeowners in foreclosure or struggling with mortgage payments are deciding to stop sending checks to the bank, letting their banks reclaim their homes as collateral at some point but living rent-free until then and therefore having more money to spend on goods and services — an act known as “strategic default.”

If this is happening, it is a worrisome trend for big financial institutions, like Bank of America. Those banks often have hundreds of thousands, if not millions, of mortgage and home-equity loan customers — and therefore a lot of losses to stomach if homeowners decide to stop sending in checks and instead to grant the bank a house to try to sell on a very sluggish market.

Harrison explains, though, why strategic default might be a good idea for a homeowner:

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.

Harrison argues that the data imply that homeowners are taking money that would have gone to their mortgages or other loans — sometimes eating up as much as 60 or 70 or 80 percent of take-home income — and using it for personal expenditures. (I mention the mall in the headline, but I’ll note here that distressed homeowners are generally pretty hard up. Food and gas is more likely.) And he finds a number of anecdotal accounts of just this happening. HousingWire offers a similar argument as well.

Ultimately, if this phenomenon is as widespread as one might imagine — given that as many as 3 million households will receive a foreclosure notice this year — I’d expect to see that reflected in decreased expenditure on housing and increased expenditure on goods, on aggregate. I hoped to find information on how Americans spend their post-tax income, proportionally, but I could not find more recent data than from 2007. (If anyone has it, put it in comments!)

But the Bureau of Economic Analysis does provide often-updated, detailed data on spending on housing, goods, services and other necessities. It turns out that as of last quarter Americans were still spending a bit more on housing last quarter than in the one before it. But given the dire state of the housing market in the first quarter of 2010 and increasing numbers of defaults, I would not be surprised to see that red line bend down soon.