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Interesting article from Business Insider: Strategic Defaults Are Real, Growing, And Scary

In my last article, we examined the shadow inventory to determine how many distressed properties (not on MLS) were almost certain to be forced onto the market in the not-to-distant future.

For a sensible follow up, let's take an in-depth look at so-called "strategic defaults" to see how many homeowners are likely to "walk away" from their mortgage debt although they might be financially able to continue paying it.

Strategic Default Defined

According to Wikipedia, a strategic default is "the decision by a borrower to stop making payments (i.e., default) on a debt despite having the financial ability to make the payments." This has become the commonly accepted view.

In a recent, thorough study of strategic defaults, an effort was made to narrow its definition even more specifically. The report examining 6.6 million first lien mortgages was published this past April by Morgan Stanley analysts. They considered a default to be strategic only if a borrower went from being current on the debt to 90 days delinquent in consecutive months "without any curing in between or thereafter."

The authors went further and included two other prerequisites. First, the borrower had to be "underwater" on the first lien mortgage. Second, the homeowner had to have an outstanding non-mortgage debt balance of more than $10,000. The purpose of this last requirement was explained to me in a phone conversation with the lead analyst. He clarified that unless the borrower had at least $10,000 in non-mortgage debts which continued to be kept current; it was very likely that the mortgage default was induced by the inability to continue making the payments.

While this definition by the Morgan Stanley analysts is plausible, I consider it to be too narrow. It excludes too many borrowers who choose to stop paying the mortgage even though they may miss payments on some of their other debt obligations. I define a strategic defaulter to be any borrower who goes from never having missed a mortgage payment directly into a 90 day default. We'll examine a graph a little later which clearly illustrates this definition.

Why Do Homeowners Walk Away from Their Mortgage?

In the midst of the housing bubble, it was inconceivable that a homeowner would voluntarily stop making payments on the mortgage and lapse into default while having the financial means to remain current on the loan.

Then something happened which changed everything. Prices leveled off in 2006 before starting to decline. With certain exceptions, they have been falling ever since around the country. In recent memory, this was something totally new and it has radically altered how homeowners view their house.

In those metros where prices soared the most during the housing bubble and collapsed most severely, many homeowners who have strategically defaulted shared three essential assumptions:

1. The value of their home would not recover to their original purchase price for quite a few years.

2. They could rent a house similar to theirs for considerably less than what they were paying on the mortgage.

3. They could sock away tens of thousands of dollars by stopping mortgage payments before the lender finally got around to foreclosing.

Put yourself into the mind and the shoes of an underwater homeowner who held these three assumptions. The temptation to default became very difficult to resist. What would you have done?

Now you may ask: What has kept most underwater homeowners from defaulting? This is not an easy question to answer. I suggest that you take a look at a very thorough discussion of this issue in a paper written by Brent White, a professor of law at the University of Arizona and published in February 2010. Its title is "Underwater and Not Walking Away: Shame, Fear and the Social Management of the Social Crisis." He asserts that there are strong societal norms and pressures that lead to feelings of shame, fear and guilt which prevent many underwater homeowners from choosing to default.

He also cites the strong moral condemnation heaped on strategic defaulters by the press as well as by significant political figures. Take the speech given in March 2008 by then Secretary of the Treasury Henry Paulson. Paulson declared on national television: "Let me emphasize, any homeowner who can afford his mortgage payment but chooses to walk away from an underwater property is simply a speculator - and one who is not honoring his obligations." Coming from the former Chairman of a Wall Street firm that earns billions every year by speculating, these words had a certain hollow ring to them.

Two Key Studies Show that Strategic Defaults Continue to Grow

Within the past six months, two important studies were published which have tried to get a handle on strategic defaults. First came the April report by three Morgan Stanley analysts entitled "Understanding Strategic Defaults." Remember their narrow definition of a strategic defaulter which I described earlier:

1. an underwater homeowner who goes straight from being current on the mortgage to a 90+ day delinquency "without any curing in between or thereafter"

2. has an outstanding non-mortgage debt balance of at least $10,000 which does not become delinquent

The study analyzed 6.5 million anonymous credit reports from TransUnion's enormous database while focusing on first lien mortgages taken out between 2004 and 2007.

One conclusion which the authors reach is that the percentage of defaults which they label strategic has risen steadily since early 2007. By the end of 2009, 12% of all defaults were strategic. Even more significant is that loans originating in 2007 have a significantly higher proportion of defaults which are strategic than those originated in 2004. The following chart clearly shows this difference.

It is also important to note that with higher Vantage credit scores, the strategic default rate rises very sharply. [Vantage scoring was developed jointly by the three credit reporting agencies and now competes with FICO scoring].

Another Morgan Stanley chart shows us that for loans originated in 2007, the strategic default percentage also climbs with higher credit scores.

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