From the WSJ today:

"As home prices plummet, growing numbers of borrowers are winding up owing more on their homes than the homes are worth, raising concerns that a new group of homeowners -- those who can afford to pay their mortgages but have decided not to -- are starting to walk away from their homes."

"Raising concerns?"

Let's look at this in more detail.

I've written repeatedly that in my opinion these people are fully justified in walking away and sticking the bank and investors with the bad paper (but of course - you must talk with both a tax and legal professional before doing such a thing so you understand all of the trade-offs involved.)

I want to explain the "why" behind my perspective and opinion.

The individual referenced in the article is an E7 in the military. This makes dissecting things fairly easy, since military pay scales are public.

With Iraq "bonuses" and the tax-free nature of pay for serving in Iraq, this gentleman makes a pre-tax equivalent of a civilian making about $80,000.

Under traditional underwriting guidelines, this means he can afford a house that costs $240,000, providing that he has 20% down and no significant amount of additional debt. His total "back end", including his house payment and all additional mandatory debt service, should not exceed $2400.

(The math on this is $80,000 / 12 = $6666 monthly; 36% of that is $2400)

If he puts 20% down (or $48,000) and gets a 30 year fixed loan at 6.25% his P&I is $1,176.05. This leaves him about $1,300 for property taxes, insurance, his car and credit card payments.

Now let's run this for the house he actually bought ($455,000) and assume he did one of those fabulous "zero down!" deals.

Assuming that he did a conventional 30/fixed again with the same interest rate, his P&I is $2786.99. That doesn't sound so awful, but it is in fact over 36%, and we haven't paid the insurance, the property taxes, his car payment or anything else.

The loan is unsound in the first instance, and that is with the most favorable terms available - a 30 year fixed mortgage at 6.25% fully-blended (e.g. zero points) which is likely better than the terms he could have obtained.

More damning, should the Iraq deployment and/or war end, and E7 makes about $35,000 a year! In other words, absent deployment to Iraq this family can afford a house that costs about $120,000 - maximum.

The foundation of lending is in fact what is called the "Three Cs", just as it is with diamonds - except that the "Cs" are slightly different.

Those are Character, Capacity (to pay) and Collateral.

Sound lending requires you evaluate all three.

Character? Check - this individual is in the military at a known rate of pay that is unlikely to decrease materially, and we can generally presume that a military job is secure.

Collateral? Ha. A bubbly area that has experienced rapid price increases. Remember that a house typically "turns over" to a new owner in 7 years. The odds of a bubbly market remaining bubbly for another seven years certainly aren't all that good. Horrible odds? No, but not great odds. So therefore the collateral has to be judged as "shaky" and given a valuation haircut against the loan. This makes a zero-down loan inherently unsafe.

Capacity? Not a snowball's chance in hell. The original loan on the original terms is unaffordable under traditional safe underwriting guidelines, even assuming his "heavily bonused" present pay. Should he not be redeployed or the war end, this house was priced at nearly four times the maximum safe affordable limit for this individual's income. PERIOD.

Therefore, this loan fails the "Three Cs" test and is presumptively unsafe.

More importantly the bank knew this when it made the loan but did it anyway.

The bank, in short, gambled with its capital that home prices would continue to increase rapidly enough that two of the three "C"s didn't matter.

Now the bet has turned out badly, and the borrower is going to walk away and "stick" the lender with the loss.

In my opinion the borrower should evaluate this from a strict business perspective with full knowledge that the lender intentionally violated the standards of safe lending at the outset and treated his loan not as a sound residential mortgage but as a gambling instrument.

When looked at this way the decision becomes quite simple - you look at the impact to your credit rating and for how long it will last, you evaluate whether or not your mortgage is a "recourse" loan (e.g. can the bank sue you or are they limited to recovery via the collateral and, if the former, whether you have enough other assets for it to matter or do you simply file bankruptcy if that were to happen) and from there you make your decision.

That's it, in a nutshell.

To those crooners who say "oh but you have a moral obligation to try to pay the loan" I will remind you that the bank had a moral obligation to make sound loans in the first place and intentionally violated those principles. The bank or other lender in question then sold that paper off to investors knowing that the underlying loans were unsound on traditional underwriting principles.

Who wants to argue "morals" and "ethics" with me with these facts irrefutably established?

Now the person who has been screwed by a lender who treated their credit and home as a gambling device is suddenly supposed to become a full-on evangelical priest in their behavior while the lenders are assaulting little boys in the rectory of the same church?

I think not.

Millions of loans exactly like this one were made during the last four years. In my opinion every one of the borrowers in this situation should perform this evaluation and make their decision based strictly on the business merits above, with no moral or ethical qualms of any sort.

Recognize one thing right up front - the banks and other lenders made these loans and sold this paper off intentionally gambling on the direction and magnitude of home prices, exactly as someone who buys PUT or CALL options does in the securities markets.

Do you feel bad for me when I buy a passel of PUTs and have them expire worthless? Of course not - I gambled knowingly using the best information I believed I had at the time and was wrong. As a consequence I lost money. Oh well.

If you are in this position, do not be rooked into raiding your retirement accounts (pretty much the only "bankruptcy-sheltered" money you have) to try to stay out of trouble. Make a pure business decision after consulting with competent tax and legal advisers.

By the way, the lenders are freaking out - they know. Essentially all no-down-payment programs are gone and we are rapidly headed to where you need 20% skin or you're not going to get the loan. The only exceptions soon will be FHA and VA, which is pretty much where we were before the Tech Bubble.

Incidentally, this is how it should be.

There will be exceptions from lenders who portfolio their loans, but you can forget about the "can you fog a mirror" loans - they're done and not coming back. For those markets dependant on those, you're about to see the waterfall cascade effect as forced short sales and REOs hit the market this spring.

Buckle up - this is going to get fun.

PS: The PMI firms are likely all dead (should have kept those shorts on damnit!) and both Fannie and Freddie are very likely to be in serious trouble either now or very shortly. Possibly critically bad. As I said the other day, I believe Fannie in particular is a short-to-zero candidate due to their attempt to prevent market-to-market losses via their "secured to unsecured" program; I'm willing to bet there are some CDS games in there somewhere too that make preventing those marks a bit more "urgent" than they would be otherwise.

Dow down 315, S&P down 37 handles. Booya boys.