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RISMEDIA, February 16, 2010—“Defaults, foreclosures plummet in January. Analysts discern signs of stability.”

So read the headline of my local paper.

Signs of Stability? Really? Now what might those be? I saw the Virgin Mary on a piece of toast once so I know we tend to see what we want to see but my tea leaves aren’t spelling relief.

In fact, things appear to be getting worse. See “White Washed Windows and Vacant Stores.”

Last year, I correctly argued against the common wisdom that there was this shadow inventory of foreclosed property that banks were holding back that would soon swamp the market. They weren’t showing up anywhere. So far, so good.

But, as continuing price declines push more and more homeowners deeper and deeper underwater, we are going to see a second wave of defaults. And, this one is not only going to swamp the market, it’s going to take the future with it when it recedes.

The employment numbers don’t mean anything. They don’t count failed business owners and other self-employed, and there are a lot of them, who are not entitled to unemployment insurance. There are those who have simply given up looking for work or those who have “graduated” and have maxed out their benefits.

Without substantial job creation, more homeowners will lose their grasp on their finances as unemployment insurance, savings, and retirement accounts are depleted.

Then there is the thorny issue of deferred interest loans made between 2005 and 2007, the peak of the market, that will adjust upwards in the months to come. Property values in some cases have fallen by as much as half, making the possibility of a refinance remote and increasing the likelihood that the borrower will exercise a strategic default.

I’m not sure where the good news is being found, but according to RealtyTrac:

One in every 409 homes in America was sent a default notice, scheduled for auction or bank owned in January, while 87,000 homes were seized and that is 31% more than January 2009.

Last year there were a record 2.8 million households facing foreclosure and that number is supposed to increase 40% to 3.5 million this year, according to RealtyTrac.

Consequently, that good news about stability is just the first wave receding.

There are two parts to a Tsunami. The first big wave is usually more of a curiosity, and then the water pulls way back from the coastline. It’s time to run for higher ground. When that tide comes back in, it comes with a vengeance and a wall of water several stories high.

Those who have referred to the economic collapse as a Tsunami may be faulted for being overly dramatic, but not for being inaccurate. Prepare for the next wave.

The bad news is we cannot stop it. We could lesson its impact on our communities. Cities like mine are already stuck with a bunch of vacant commercial buildings, and others like Buffalo, Detroit, and Baltimore are being squeezed by the burden of vacant houses that the banks don’t want to be bothered with. In Flint, MI, there are about 10,000 vacant homes.

According to the Brookings Institution, vacant and abandoned properties make up about 15% of the area of the typical large city. We don’t need to be rebuilding other countries; we need to rebuild our own.

There will be more strategic defaults in the commercial sector. There comes a point when the idea of continuing to struggle to make payments on something worth half the loan amount stops making sense. At that point, you no longer own the home; it owns you—for life. Because, we are not going to see these prices double in our lifetime.

And, they know when that point is. Researchers at the University of Chicago’s Booth School of Business and Northwestern University determined that owners with negative equity of 10% or less rarely default. But, when negative equity reaches 50%, close to one in five owners would default.

My bet is that will increase as the story of crooked banksters unfolds and as the numbers of people defaulting increase; the stigma will lessen and many people will be kicking themselves for not defaulting sooner.

Now, banks are pretty smart. They know that as values continue to fall, the number of defaults will continue to increase. And, in order to collect on the lucrative default swaps, they will continue to act in ways that cause values to fall, pushing more homeowners below the Mendoza line.

According to Time magazine, by June, as many 5 million homeowners will be underwater. Most will be concentrated in a few states.

The only way to avoid more and deeper pain across all sectors of the economy is principal reduction to market value. What is a short sale but a principal reduction for the new owner? How does that solve anything while getting us to the same place?

Obviously, the banks will resist and not just so they can collect on the default swaps. Principal reduction would require bringing the borrower and the true holder of the note, the investor, to the same table. The last thing the banks want is for borrowers and investors to come face to face.

The investors would realize that half of their money was skimmed off the top and that the value of the security is only a fraction of what they were led to believe.

As investors, they understand the difference between a 75% loss of value and a 100% wipe-out. Sooner or later, these assets have to be corrected on someone’s balance sheet. Not only would they more readily agree to mark to market rather than lose everything, but in most cases, these are the only people who could legally agree to a permanent loan modification or a short sale.

The upside for them is that the revenue stream is restored. Once the pools are in default, they get nothing, even though there may be performing loans within the pool.

Foreclosing and reselling in most markets is done at a price that represents the true market…what a willing buyer will pay tempered by what a willing lender will appraise the collateral for, often, some tentacle of the foreclosing lender. In this scenario, the financial intermediary also gets any proceeds from the foreclosure, not the investor.

These are extraordinary times and they call for extraordinary approaches. Here are 10 reasons why reducing loan balances and restoring lost equity is the best approach now.

1. What we are doing to address the problem isn’t working.

It isn’t going to work and, in fact, the longer we pretend that there will be significant loan modifications, the worse things are going to get.

2. Everyone who is upside down should get relief.

By “re-equifying” those households, we free up consumer spending, stimulate lending, and start putting people back to work—everyone wins.

3. It will cost less.

By keeping people in their homes, we reduce the costs of social services that are breaking the budgets in every community.

4. We were all gamed by the system.

Some worse than others. Here is just one little trick that even the smartest know-it-all usually wouldn’t catch in their loan documents. It is in the disclosure of Yield Spread Premiums. Most of us are used to seeing four percent written as either 4% or .4. But financial intermediaries express it this way, .04. The way we might express four tenths of a percent. On a $500,000 loan, it’s the difference between $2,000 and $20,000.

5. It will happen anyway.

The equity is gone; the loss is real. Foreclosure is the most expensive, least desirable way to bring the property back to its true market value

6. We all win if we do and we all lose if we don’t.

I’m sure that a handful of people who haven’t felt some real pain may be taking some perverse pleasure in watching their neighbors pack up and leave, but when you hear the stories of some of the homeowners who have stayed in vacant neighborhoods, the actual cost to those who remain is probably greater.

7. Borrowers and investors both gain.

Securitized loans put the investor and the borrower in same boat. Both were defrauded by the financial intermediaries and neither has received any remedy for their losses.

Trillions for financial intermediaries and nothing for the parties that were scammed. Instead of giving the money to the financial intermediaries that perpetrated this Ponzi scheme, it should have gone to the investors who were willing to accept the reduction in value of the pool. Instead, we give the money to the financial intermediaries who conceal the values of the assets. It’s a game.

8. We can afford to do it; we cannot afford not to.

Since the start of the meltdown, the Fed has amassed a whopping $9 trillion in loans to foreigners, but they will not say and, apparently there is no record of, where the money went. That’s $30,000 for every man, woman and child in America. That’s our money and right now, we need it.

At the moment, Congress is pushing for an audit of the fed, something that hasn’t been done in over ninety years. You would think everyone who is working for the taxpayer would want the taxpayer to know where their money is going, but this is shaping up to be one heck of a fight.

9. Some players in the mortgage arena are starting to get it.

Wilbur Ross owns American Home Mortgage Servicing, Inc. the third largest mortgage servicer in the country and he recently became one of the leading advocates for principal reduction. His reason, loans with significant principle reduction that give the owner equity in the property stay current.

In an interview with HousingWire he said, “The price of housing needs to be cleaned out. The Obama administration could right-size every underwater home and reduce principal to fit the current market value of the home. If they are going to deal with it they have to deal with it in a severe way.”

This was demonstrated in a study by investment firm Ellington Management which showed that every month, 8% of homeowners whose mortgages were 160% of the value of the home became delinquent while only one percent of those with loans that were 60% of value become delinquent.

10. It would jump start the economy.

Uncertainty isn’t good for the economy. Not knowing how far values will fall, not knowing when job losses will abate, and seeing no light at the end of the tunnel are paralyzing. Not just to consumers, but also to small business owners who are the hiring engines we need to pull us out of this recession. They need to know that consumers can and will spend before they start rehiring.

By restoring the lost equity in homes, we immediately stabilize real estate prices by establishing a “floor” and the true market value of property.

By stopping foreclosures, communities start to see their tax basis improve. They can start to rehire laid off workers such as teachers and emergency responders.

As distasteful as this may be to some people, it’s time to admit that there are no other solutions. The value is gone, never was really there, a few people got rich, a lot of people got poor, and now we have to fix it.

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