As the mortgage industry works through a large volume of loan delinquencies, a new and growing concern has emerged: strategic defaults. In other words, borrowers who have the financial means to make monthly mortgage payments, but choose not to do so and, instead, purposely default on their loan.
Strategic defaults come from a variety of homebuyers: from real estate investors who sought to profit from rising house prices during the housing boom, to individual families who simply sought shelter. But these homebuyers have certain things in common: their properties reside in regions where house prices have declined considerably, and the amount still owed on the mortgage is far greater than the present value of the house.
Some in this situation believe they will be forever chained to a large debt owed when they sell the house. And so, even though they have the ability to keep paying the monthly bill, they have decided to walk away from the property without paying off the loan. An intentional foreclosure, if you will.
In essence, these borrowers are weighing the costs and benefits of a strategic default, and coming to a conclusion. Now, the costs can be considerable. Once a mortgage goes into default, a borrower’s credit rating is severely tarnished, making it more expensive, if not impossible, to qualify for any new form of credit. In certain states, a borrower’s personal assets can be subject to a deficiency judgment. And anything that involves a credit review, such as obtaining auto insurance or getting a new job, can be complicated. These detriments can be in effect for several years. The benefit: the borrower avoids paying for the lost equity in the house.
But that’s not all. Should strategic defaults become more common, mortgage guarantors and investors, including Freddie Mac, would need to factor this risk more prominently into their credit policies and prices. The likely impact on future homebuyers: the cost of a mortgage will go up and credit terms will be less flexible. Thus, the impact of strategic defaulters on still more families might be more expensive mortgages and loans that are more difficult to obtain. The strategic defaulter does not usually consider these costs.
We know from experience that foreclosures and vacancies drive down the property values of everyone else in the neighborhood. Thus, strategic defaulters, in effect, deplete the personal wealth of their neighbors. Get a critical mass of strategic defaults, and broader communities and regions become affected. Indeed, Economy.com, the analytic firm, recently said that more strategic defaults could tip a fragile housing market back into one of further price declines. Even more families harmed.
The implicit concession in this argument: There isn’t a whole lot that banks can do to change borrower behavior. Over the past year, banks and investors became more sensitive to the fact that strategic defaults are happening, particularly among homeowners who owe far more than their homes are worth and where they see little chance that home values will ever recover (we’re looking at you, Las Vegas and Phoenix).