Using strategic defaults to stop the bleeding
Every time a new crisis comes along there’s a brand new vocabulary trailing right behind. The country’s financial meltdown and mortgage catastrophe has generated a lexicon of terms like sub-prime, negative equity, loan modification and re-equifying among others. Over the past several months, we’ve started to see another expression taking us to a whole new level, maybe even the lowest level of the crisis.
Strategic defaults in the mortgage industry refers to a mortgage default by borrowers who owe more on their homes than they’re currently worth and who choose to stop paying their mortgage. These are individuals who can afford to make their monthly payments, but choose not to because their homes are underwater, another term unique to the mortgage crisis, meaning worth less than the outstanding mortgage balance.
Generally, these homeowners continue to pay their other bills on time, including credit cards and auto loans, but decide not to pay their monthly principal and interest payments. In February, Morgan Stanley estimated that 12 percent of mortgage defaults during that month were strategic, however, other reports estimate a higher proportion, and certainly by this point in time, the percentages are undoubtedly higher.
This strategy is becoming so widespread that the House of Representatives passed a bill in June (HR5072) to make it more difficult for burrowers who choose to strategically default to get a future FHA insured loan. As of this writing, the bill still has to be passed by the Senate but it’s unlikely, even if it becomes law, that it will have an appreciable effect since most homeowners who choose strategic default are not worried about getting a future FHA loan.
More important than denying future loans in the case of a strategic default is the growing social acceptance of this behavior and the ramifications for the future of the mortgage industry. As more people watch their friends and neighbors choose to default, the more it becomes a viable option for homeowners who may otherwise wait years just to return to a positive equity position.
The impact of this behavior will not only have a negative effect on personal credit histories, but also on the health of entire neighborhoods. The volume of foreclosures on the market today is also chipping away at the stigma that used to come with defaulting on a home loan. In some areas, strategic default could become the norm not the exception.
In addition, the future large-scale effect could result in lenders building into their risk models either large down payments or higher interest rates to protect their interests. This could change the mortgage industry as we know it and subsequently the real estate market, going back to the days when only buyers with a lot of cash and very high incomes were able to buy homes.
Being underwater on a loan is a prerequisite to strategic default, and the more underwater you are, the likelier you are to consider defaulting, even if you can afford to keep making payments. It is estimated that at about a 25 percent negative equity, the behavior of owners begins to mimic that of the rationale of investors and businesses who are accustomed to making ruthless business decisions.
By definition, strategic default is a plan of action designed to achieve a particular goal. The goal in the case of underwater homeowners is to stop the bleeding, and their business decisions are taking us down a road no one ever anticipated – a very low and dangerous road.