Putting the kibosh on strategic default

Flickr photo by U.S. Geological Survey

A strategic default arises when a mortgage borrower who has the capacity to make the payments on his mortgage decides not to pay any longer because of negative equity -- the loan balance is substantially larger than the house value. To use the popular terminology, he "walks away" because he is "underwater."

Strategic defaults are distinguished from defaults stemming from a drop in income that makes the mortgage payment unaffordable. However, some defaults have "double triggers" -- they are due to the combination of income loss and negative equity.

If the borrower has positive equity, a loss of income will in most cases lead to the sale of the property and a payoff of the mortgage, rather than to default. But if the borrower has negative equity, loss of income will result in double-trigger default.

It is important to distinguish between strategic defaults and double-trigger defaults because strategic defaulters have the option of not defaulting. Strategic defaults (but not double-trigger defaults) raise moral issues for the borrower, and policy issues for government and lenders.

Prior to the financial crisis, strategic defaults were rare because very few borrowers found themselves underwater. Since 2006, however, home prices have declined on average by about 28 percent, and in Arizona, California, Florida and Nevada, the declines have been much larger. The price drops have resulted in an unprecedented bulge in strategic defaults, though the problem should not be blown out of proportion.

Two recent studies using different data sources and different approaches both found that strategic defaults constituted about one-fifth of total defaults. The other four-fifths were largely double-trigger defaults, resulting from income declines combined with negative equity.

What determines whether underwater borrowers elect to default when they don't have to?

Probably the major factor is how deeply underwater they are. A recent Federal Reserve Board study covering "no-downpayment" mortgages originated in 2006 in the four states listed above found that strategic defaults did not account for half or more of total defaults until negative equity was 50 percent or higher.

If negative equity is less than about 15 percent, borrowers will ride it out. The benefit from ridding oneself of a small amount of negative equity is outweighed by the costs of default -- and these costs can be substantial.

A default can drop the borrower's credit score by about 20 percent and prevent him from becoming a homeowner again for three or more years. In some states, lenders can obtain a deficiency judgment against the borrower, which gives them the right to collect whatever part of the loan balance and foreclosure expenses are not covered by sale of the property.

Borrowers who have invested in their properties must write off the investment. The costs of moving and having one's lifestyle disrupted can also be high.

In addition, defaulting on an obligation when one has the option of not defaulting runs against the moral grain of many borrowers.

A survey taken by Fannie Mae this year indicated that 88 percent of Americans "do not believe it is acceptable for people to stop making payments on an underwater mortgage, while 8 percent believe it is acceptable."

Underwater borrowers "were more than twice as likely to believe stopping payments was acceptable than borrowers who were not underwater," but the great majority of underwater borrowers were still negative on the morality of stopping payment.

It is clear that to this point the deterrents to strategic default, including moral qualms, have been strong enough to prevent a major problem. Some observers believe that most homeowners who are inclined to be strategic defaulters have already defaulted.

The opposing view is that the deterrents to strategic defaults will gradually lose their force, especially if house prices remain depressed, and that we soon will be faced with a cascading problem.

I worry that the moral constraints that borrowers impose on themselves will weaken as they see others like themselves walking away. The Fannie Mae survey found that borrowers "are more than twice as likely to have seriously considered stopping their payments if they know someone who has already defaulted." This could result in a contagious increase in strategic defaults -- unless steps are taken to prevent it.

On the day this article was submitted for publication, the Obama administration initiated a program to help borrowers with negative equity. The program is limited to owner-occupants with negative equity who are current on a conventional (non-FHA/non-VA) mortgage, and who may or may not have a second mortgage.

Under this program, which is voluntary for lenders, the first mortgage can be refinanced into an FHA mortgage equal to 97.75 percent of property value, subject to the following conditions: the balance of the first mortgage must be written down by at least 10 percent, the second mortgage lender must agree to maintain a second lien position, and the sum of both mortgage balances after the first is refinanced cannot exceed 115 percent of property value.

Will this program head off a rise in strategic defaults? The answer depends heavily on whether the program will be widely used in cases where negative equity (and the danger of strategic defaults) is high.

On the face of it, the program is most attractive where the negative equity is modest, because the required write-down is smaller. I can't see a balance write-down from 140 percent of value to 97.75 percent in order to obtain FHA insurance when the loan is in good standing.

Where there is a second mortgage, there is a little more promise, but not much. If the first mortgage lender limits the write-down to 10 percent, the sum of both mortgage balances at the outset can't exceed 125 percent of value because of the 115 percent cap on the new loan. Getting the voluntary cooperation of second mortgage lenders can also be problematic.

If I were designing a program to prevent strategic defaults, it would provide the largest inducements for balance write-downs where the negative equity was the largest, and it would aim to reduce negative equity, but not necessarily eliminate it. Homeowners don't voluntarily default when negative equity is small.

I am indebted to Neil Bhutta for helpful comments.

The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.

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