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The massive 50%-plus decline in California property values during the Great Recession has turned roughly 2,500,000 California homeowners who purchased or refinanced after 2001 into negative equity owners who owe more on their mortgages than their properties are worth. Thus, a disconnect has developed between the use of a home as a family’s shelter and the worth of a home as a family’s largest financial asset, due solely to the cyclical reversal of fortune for homeowners who bought or refinanced after 2001.

Homeownership incentives for a negative equity homeowner have been more than neutralized since, though he is the legal owner, he is not the “economic owner” of his property until the day the mortgage’s loan-to-value (LTV) ratio returns to 94% (100% of the fair market value minus 6% lost to transaction expenses). Thus, having been reduced to a “tenant-in-effect,” it is rational for the homeowner to walk away from excess debt and vacate the home in order to free up his income for family expenditures and accumulation of wealth. But what are the consequences of walking away from a home?

It is a common myth that after a homeowner suffers a major financial shock – such as bankruptcy, strategic default, short sale or foreclosure – it is impossible for him to access new credit during a “penance period” of seemingly unknowable duration. Mortgage lenders are quick to note that these items will taint a credit report for up to ten years. This lender-contrived theology holds that this period of self-flagellation must be endured as punishment for a homeowner’s financial miscalculations before he can be given a fresh start.

However, this is pure fiction and unsupported by facts. 90% of individuals who file for bankruptcy and thus receive a financial baptism have access to some type of significant credit within just 18 months of their filing. 75% of individuals who file for bankruptcy even have access to unsecured lines of credit after 18 months – not a very long penance period for the atonement of a purportedly major financial “sin.” Furthermore, the delay is just about enough time for a prudent negative equity homeowner who strategically defaults to save up for the 20% down payment needed to purchase another home (as mortgage lenders in California now take 12 months from the first month’s delinquency to complete a trustee’s sale).

To completely dispel this lender-concocted credit myth, look no further than the conduct of the Federal Housing Administration (FHA) which presently insures around 40% of all the home loans in California. The FHA will insure a home loan up to $729,500 for an employed buyer with a 3.5% down payment who was declared bankrupt a mere two years earlier.

Negative equity is a lurking menace to our California society, our state’s tax revenues and a fast economic recovery. Retention of an underwater home poses more long-term damage to a family (and California’s economy) than losing a home to foreclosure or taking a temporary hit to their credit score. Like a cancer, negative equity exists unobserved as it slowly, but persistently, erodes a family’s financial health. Credit always heals as it can be rebuilt relatively quickly after a singular disruptive event, such as a crisis-induced foreclosure.

With lenders and Congress deliberately refusing to provide legitimate solvency assistance to negative equity homeowners by principal reductions on their purchase-assist loans down to the home’s value, only one rational choice exists for the negative equity homeowner. He must get his short-term credit needs in order, then walk away from the home by defaulting and forcing the lender to buy the property for the amount of the loan since no personal liability is attached to a homeowner’s purchase-assist mortgage. The negative equity owner will reside (payment and rent free) until the foreclosure sale some 12 months hence, then vacate and hand the keys to the lender – in exchange for additional key-money cash.

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Copyright © 2011 by first tuesday Realty Publications, Inc. Readers are encouraged to reprint or distribute this information with credit given to the first tuesday Journal Online — P.O. Box 20069, Riverside, CA 92516.