I recently came across a few interesting articles on Strategic Default (the decision to voluntarily stop paying one’s mortgage despite possessing the means to continue making payments), and I want to share them here.

The first was an article in the NYTimes (”Biggest Defaulters on Mortgages Are the Rich“), which sought to draw attention to the fact that wealthy borrowers are defaulting on mortgages in proportionally greater numbers than those of other economic strata. “More than one in seven homeowners with loans in excess of a million dollars are seriously delinquent” compared to “About one in 12 mortgages below the million-dollar mark is delinquent.”

Analysts have surmised that a large portion of defaults by the wealthy are deliberate. According to this line of thinking, the wealthy are inherently more “shrewd” and “ruthless,” and hence, they have no qualms about voluntarily walking away from an underwater home, in much the same way that they wouldn’t hesitate to dump a faltering investment. From my point of view, though, it seems equally plausible that those with expensive homes are necessarily more likely to involuntarily default, since repaying an expensive mortgage places a bigger burden on the borrower.

According to another story (”Fannie Mae Gets Tough With Walk-Away Mortgage Defaulters“), meanwhile, Fannie Mae is well aware of the strategic default phenomenon and is now ready to take action to curb it. Those who are found to have strategically defaulted (i.e. cannot demonstrate indigent financial circumstances) will be barred from obtaining a new mortgage for seven years. In addition, Fannie will actively seek deficiency judgements against borrowers in states that allow them to do so.

Borrowers that had no choice but to default will not be punished excessively. They will be locked out of the mortgage system for three years. If they agree to sign a Deed in Lieu of Foreclosure, this sentence will be reduced to two years. In short, it’s important to remember that defaulting (whether involuntary or strategic) carries real consequences. Personally, I think strategic default is an economic (rather than a moral) decision, which means it can be made rationally. Still, borrowers should understand that like any economic decision, there are drawbacks as well as benefits.

According to the final article, however, all of this talk might be moot. There is evidence that the strategic default trend is already peaking: “After a seasonal reduction in both measures from Q4 2008 to Q1 2009, the Q2 [2010] numbers then declined further, breaking the historical trend of quarter-over-quarter increases.” This is probably due to a stabilization n home prices, such that borrowers that were contemplating strategic default have probably already so. Of course, if home prices resume their decline, strategic defaults could likewise increase.

According to both anecdotal evidence and statistical data, strategic default (when a borrower purposefully defaults on a mortgage despite having the financial ability to continue making payments) is on the rise.

Precise figures are hard to come by. Morgan Stanley estimates that strategic defaults represent 12% of all defaults in February, while research from the Chicago Booth/Kellogg School Financial Trust Index has yielded 31%. On a nominal basis, it is estimated that 600,000 borrowers strategically defaulted in 2008. Regardless of whose numbers you trust, all of the research indicates that strategic default is indeed rising by an annualized rate of more than 50%.

As for why this phenomenon is becoming more prevalent, it is proximately tied to the explosion in underwater borrowers, of whom there are an estimated 11 million nationwide, comprising 25% of total mortgages outstanding. However, negative equity is not by itself driving people to default on their mortgages. Rather, it is the result of frustration with lenders and occasional cost/benefit analyses.

Brent White, a University of Arizona law professor that is leading the chorus in support of strategic default has found that, “People who intentionally default on their loans are not as economically rational or calculating in their decision-making as widely thought…They walk anyway, in large part because [of] outright anger at their lenders, the government and a financial system they consider unfair.” They are helped along in their decision by growing social acceptance: “Forty-one percent of homeowners with a mortgage would consider walking away from their home if the loan were to go underwater…according to a survey from Trulia.com and RealtyTrac.”

Who can blame them? White’s research (and anecdotal evidence) has shown that virtually all borrowers that ultimately choose to strategically default begin by contacting their respective lender and asking for assistance and/or loan modification. Unsurprisingly, most of these borrowers report that their lenders were completely unwilling to help in this regard.

The downside of not paying is only a damaged credit score. The upside (in addition to no longer being bound by your mortgage) is that you get to continue living in your home free-of-charge, for 14 months on average. If you are fortunate enough to reside in a state whose foreclosure laws are designed to benefit borrowers, it will be 18 months, on average, before you are finally evicted by your lender.

This is perhaps the real story- that defaulters, involuntary and strategic alike, are actually being foreclosed upon in smaller and smaller numbers. As the NY Times explains, “The pace of resolving these problem loans is slow and getting slower because of legal challenges, foreclosure moratoriums, government pressure to offer modifications and the inability of the lenders to cope with so many souring mortgages.”

It’s not my intention encourage strategic default; I only wish to present the facts. After all, by not paying your mortgage, you will also punish your fellow homeowners (in the form of lower property values) as well as future borrowers (in the form of higher interest rates). As with any decision, there are pros and cons. Weigh the decision carefully, and as Jack Guttentag, The Mortgage Professor, opined earlier this week, “Let your conscience be your guide.”

Before HAMP, HAFA, and the handful of housing programs brainstormed by the Obama administration, there was the NSP. The so-called Neighborhood Stabilization Program was actually conceived by the Bush administration in 2008, as a preemptive solution to the then-imminent foreclosure crisis. As part of the Housing and Economic Recovery Act, it allocated $4 Billion for the program, and the Obama administration recently added another $2 Billion.

What exactly is the NSP? According to the Department of Housing and Urban Development (HUD), which is charged with administering the program, it “provides grants to every state and certain local communities to purchase foreclosed or abandoned homes and to rehabilitate, resell, or redevelop these homes in order to stabilize neighborhoods and stem the decline of house values of neighboring homes.” Rather than try to directly avoid foreclosure (by making mortgages more affordable for at-risk borrowers), the NSP attempts to mitigate foreclosure indirectly by attacking the glut of unsold, undesirable homes. In addition to making a dent in the foreclosure crisis, NSP is also intended to stimulate employment (i.e. contractors must be hired to renovate the homes) and revitalize neighborhoods that have been ravaged by foreclosure and have become hot-spots for crime.

State and local governments must first identify the properties, purchase, and renovate them (using funds from their local budgets). Then, the homes are sold (at market value) to qualifying families, which pay for the properties presumably through mortgage loans that they qualified for and obtained independent of NSP. If there is a disparity between the market value of the home and the amount that the local government spent to buy it and fix it up, that shortfall (up to $80,000) can potentially be covered by NSP grant money. As long as the buyer remains in the home for 20 years, the grant is “forgiven” by the government. If the home is re-sold in the interim, however, the grant must be repaid as though it were a secondary mortgage. (This is intended to discourage speculation).

Presumably, all of the NSP funds have already been allocated to specific state and local governments. However, it will take time for these funds to actually be deployed towards the purchase and rehabilitation of actual properties. If you want to participate in this program in any capacity (whether as a taxpayer/voter, contractor, borrower, etc.), you can view a breakdown of fund allocation by state and locality, and browse a list of grantees.

In trying to stem the foreclosure crisis, the government has enlisted the help of lenders, servicers, investors, and of course homeowners, themselves. Conspicuously absent from this list of participants, however, are the courts.

Thus far, the only meaningful involvement by the courts has seen renegade judges unilaterally challenge the authority of lenders on a case-by-case basis. Sometimes, they have eliminated mortgages completely for homeowners facing foreclosure, but these stories remain the exception. For the most part, they have merely rubber-stamped the foreclosure petitions of lenders, since the law is the law.

According to experts, it is unfortunate that bankruptcy courts haven’t been vested with enough power to really help homeowners work around foreclosure: “A big advantage of bankruptcy over government-subsidized modifications is that bankruptcy is a difficult process that does not entice anyone to purposely default in order to get better repayment terms.” In other words, government programs are currently structured such that homeowners must (deliberately) default before they become eligible for relief. If the courts were involved, however, this incentive would disappear.

Under current laws, courts don’t have the power to modify primary mortgages, unless the borrower has first declared bankruptcy. Even then, the lender will still probably be successful in foreclosing on your home if it is determined that you can’t afford to continue making mortgage payments. [Thanks to aggressive lobbying, mortgage debt and student loans are basically "exempted" from the bankruptcy process].

If the borrower files for Chapter 7 Bankruptcy, then he can usually achieve a temporary stay of foreclosure. While this will give you automatic relief, the lender can usually petition to have the stay lifted within 3-4 months, which means that at best, this is merely a stopgap measure. If the borrower instead files for Chapter 13 bankruptcy, he can usually work out a repayment plan for the missed mortgage payments. Unfortunately, this procedure won’t do anything to reduce the size of one’s primary mortgage. (Second mortgages may be eliminated, but bankruptcy courts are barred from meddling with the primary mortgages). Rather, it will help those suffering from “temporary” financial distress that still have enough income to remain in their homes.

However, common sense dictates that those who could still afford to pay their primary mortgages probably wouldn’t go through the hassle of filing for bankruptcy, except in rare circumstances where their other debt was crippling, which means this avenue is basically useless. Fortunately, some institutions have started to lobby the government to think about changing bankruptcy laws, for the sake of creating an end-all solution to the foreclosure crisis. Let’s hope that they succeed!

On April 5, the federal government officially inaugurated another acronym: HAFA, which stands for Home Affordable Foreclosure Alternatives and represents the latest attempt to deal with the housing crisis. As implied by the name, this program aims not to make mortgages more affordable for struggling homeowners, but simply to avert foreclosure. Towards this end, it will encourage short sales (a sale that is expected to net less than the unpaid mortgage balance) as a more palatable alternative.

Just like with its predecessor programs (HAMP, etc.), lender participation in HAFA is completely voluntarily. Instead of forcing participation (which would be unconstitutional), the government instead will try to encourage participation through incentive payments. Lenders will receive $1,500 for processing a short-sale, investors will receive up to $2,000, and second mortgage holders stand to get $3,000, a pittance relative to what they are owed in most cases, but better than the $0 that they would probably get in the event of foreclosure. Even borrowers (who in most cases require no incentive) are eligible for up to $3,000 in “relocation assistance.”

Before a homeowner can qualify for HAFA, he must first apply for a HAMP loan modification. Those who are rejected outright or miss payments (doesn’t this create a perverse incentive?!) will then become eligible for a HAFA short-sale. The borrower must also demonstrate that the mortgage is unaffordable (i.e. exceeds 31% of gross income) and that without lender intervention, loan default would be imminent. (In addition, the unpaid mortgage balance cannot exceed $729,500, the property must be a primary residence, and the mortgage must be owned by Fannie Mae or Freddie Mac).

Within 30 days of being denied a loan modification, the lender MUST make a short-sale offer to the borrower in the form of pre-approved terms and a minimum sale amount. The borrower, then, has 14 days to agree. Once the home is put on the market, buyer offers must be submitted to the lender within 3 days, and the lender, in turn, has 10 days to respond. This latter provision is crucial to the success of HAFA, since the main complaint prior to its implementation was that short-sales took too long to process. This deterred many buyers from even making offers, because they knew it would be many months before the respective lender would even deign to respond.

Under the terms of the program, borrowers are relieved of all obligations after the completion of a short sale, and lenders are forbidden from seeking deficiency judgments. In fact, even if the short-sale cannot be completed, the lender is still required to accept a deed-in-lieu-of-foreclosure, which likewise eliminates all debt obligations. Because of the incentive payments, then, it is in lenders’ best interest to try to complete a short-sale.

It looks like this program has a pretty good shot as succeeding, and more than 100 lenders (covering 89% of all outstanding loans) have already signed up. Let’s hope that this is the last time the government has to announce a new program…I think they are running out of acronyms.

On April 5, the federal government’s latest effort to address the mortgage crisis kicks off. Known as Home Affordable Foreclosure Alternatives (HAFA), it basically stipulates that lenders have two main options for dealing with bad loans. Either they offer the customer a loan modification, or they agree to a short sale / deed-in-lieu of foreclosure. While lenders are crafty and will certainly find a way around the requirement, it’s important that borrowers understand their rights.

So what is a Deed-in-Lieu of Foreclosure? For borrowers who are behind on their mortgages, it represents an opportunity to avoid outright foreclosure. Basically, a borrower signs over the title (the “Deed”) to his home to his lender, and in return is supposed to receive a cancellation of his debt. For those borrowers with underwater mortgages (the mortgage balance exceeds the market price of the associated property), this is an incredible benefit, since it essentially allows them to walk away from their mortgages and leave the bank with the balance. However, it is also beneficial for delinquent borrowers whose mortgages are not underwater, since the deed will probably result in a higher sale price (and more leftover equity for the borrower after repaying the bank) than if the property had slipped into foreclosure.

You’re probably wondering: If this is the case, why would any sane lender make such an agreement? The answer is that foreclosure is costly, complicated, and just plain annoying. It can take six months (and even longer) for a foreclosure to be completed, from initiating proceedings to evict a delinquent borrower and sale of the property. During that time, the lender receives nothing from the borrower, and must in effect, pay property taxes and utilities itself. In addition, many spiteful borrowers will deliberately fail to maintain the property or even vandalize it, while waiting to be evicted.

In short, lenders have come to the conclusion that a Deed-in-Lieu will actually save them money, especially if a foreclosure is imminent. In fact, this realization is behind a new Citigroup program which provides for the borrower to live in the home for six months free-of-charge, and then offers them $1,000 in “relocation assistance” as long as the property is in move-in condition. Wells Fargo has a similar policy. Anyone with a Fannie Mae loan, meanwhile, has the right to remain in the home for up to one year following a deed-in-lieu agreement, and must pay market-rate rent (which is presumably lower than their mortgage payments were).

There are a few downsides to signing a Deed-inLieu. As with a foreclosure, your credit will be severely impacted, and you won’t be able to obtain a mortgage for at least a couple years. In addition, a handful of states have laws which allow lenders to go after borrowers for the remaining balance when an underwater mortgage is involved. Thanks to recent legislation, however, there are no longer significant tax consequences associated with the cancellation of a (underwater) mortgage, but as with any aspect of the tax code, certain conditions must be met.

Since a Deed-in-Lieu agreement must be entered into voluntarily, most lenders will not initiate one for fear that it makes it look like they are pressing to take control of a property. Thus, if you think you are eligible for, and would benefit from a Deed-in-Lieu, you should speak to your lender, and make it clear that you are doing so voluntarily. You can also cite HAFA if you think it would help.

Previously a fringe issue, strategic default is expected to take center stage of the foreclosure “epidemic” that continues to sweep the country. This is due to two primary factors:

The first is that more than 20 million mortgages will soon be underwater (the mortgage exceeds the current market price of the home); that’s 25% of the total. More worrisome is that 5 million of these will be underwater by more than 25%, which is a “critical” threshold as determined by analysts. Of course, there is a certain arbitrariness to this threshold, but the idea behind it is that at a certain point, the idea of owing more than your home is worth takes on a real significance as parity in the near-term becomes less of a hope and more of a dream.

Even assuming that starting today, home prices will start appreciating by 5% per year, that means it will be five whole years (10 for a borrower that made a 25% down-payment) before a borrower that is 25% underwater can get back to the starting point of the mortgage. When you consider that underwater borrowers are predominantly located in markets that also experienced the largest bubbles (i.e. Nevada, Florida, Arizona), even assuming 3% a year looks generous at that point. When you further consider that some of those borrowers are more than 50% underwater, the idea of waiting 20 years before they can get back to even can seem sisyphean. Purely in terms of the numbers, then, there is already a critical mass of borrowers for whom strategic default will be attractive.

The second factor driving strategic default is increasing attention by the (mainstream) media, which appears largely indifferent – sometimes cautiously supportive – of strategic default. At the beginning of the credit crisis, when default was seen as “legitimate” (there was no way many of those borrowers could make good on their mortgages under current circumstances), nobody made much attention to strategic default. Those that noticed it thought of it as “baffling” (in the words of Wachovia), and a handful of columnists ventured to call it irresponsible.

Since the release of the University of Arizona Professor Brent White’s paper on the subject, strategic foreclosure has gradually gained mainstream acceptance. Professor White examined the issue from the legal perspective, noting that contracts are frequently broken when one of the parties determines that it’s in his best interest (i.e. the benefits outweigh the costs) to do so. Public opinion, meanwhile, has focused more on the comparison with Wall Street, which behaved irresponsibly during the years leading up to the credit crisis, only to avoid collapse by being out by the government. To hold borrowers up to a higher standard, goes the argument, seems unfair.

As I have argued in previous posts on the subject, for many people, it would indeed seem that the financial benefits outweigh the costs. In states where non-recourse loans are mandated, lenders are entitled to the home and nothing else in the event of foreclosure. In the majority of states, recourse loans are the norm, which means that a lender can technically sue for the difference in the event that a foreclosure sale turns up less than the value of the loan- though few lenders actually bother doing so. In addition, there are no tax consequences for the majority of defaulters, thanks to the Mortgage Forgiveness Debt Relief Act of 2007, which “applies to debt forgiven in calendar years 2007 through 2012. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately).” The only costs then are those associated with moving, and the inability to borrow for the next few years due to a flattened credit score. For many defaulters, these costs pale in comparison to the immediate savings from renting a comparable property rather than making mortgage payments.

The main argument against foreclosure continues to be a moral one. But even this is somewhat flimsy, when you consider that the possibility of default is an inherent feature of mortgages (that’s why borrowers have to pay interest!). This is especially the case with non-recourse loans, where a study recently determined that borrowers unwittingly pay lenders an extra $800, when compared to recourse loans. In these states, then, strategic defaulters can perhaps rest assured that one way or another, they paid for the right to default.

You’re mortgage is underwater. What do you do?

A few years ago, this would have been a fringe question for a fringe audience. Nowadays, though, 25% of all residential mortgages are underwater. In states like Nevada and Florida – two of the epicenters of the housing bubble and subsequent bust – more than half of borrowers owe more on their mortgages than their homes are worth. In other words, for a growing portion of homeowners, this question is of foremost importance.

For argument’s sake, let’s assume that you have already discussed a loan modification with your lender, and you have been either rejected or presented with an inadequate offer. As a result, you have made the decision to part with your home. [Admittedly, this is a weighty decision]. Should you sell your home at a loss, or simply walk away from your mortgage and allow your lender to deal with the fallout?

The first option is known as a “short-sale,” since the proceeds from the sale of your home wouldn’t be enough to cover the balance of your underwater mortgage. Accordingly, a short sale (or its first cousin, the deed in lieu of foreclosure) first requires the approval of the lender, because it is tantamount to writing off part of the mortgage as a loss. Still, many lenders are amenable to this possibility, because it is often less complicated – and hence, less expensive – than outright foreclosure. You will also need to confer with any junior-lien lenders as well as the mortgage insurance company, if applicable. After receiving an offer on your home, this must then be submitted to the lender (via its loss mitigation department) for final approval.

Here are a few additional things to keep in mind: Minimizing the transaction costs of the sale (by hiring an expensive real estate agent, for example) will go a long way towards convincing the lender that the deal is worthwhile. Next, while a short-sale is less painful than a foreclosure, there will still be some inevitable damage to your credit. In addition, you might be expected to pay taxes on the portion of your mortgage that was forgiven by the bank. Finally, be advised that short sales typically take longer to complete than normal sales, as lenders will often spend a long time deliberating over whether to approve the deal.

If your house has depreciated too much in value, and/or your lender is not willing to approve a short-sale, then a strategic default might be your last option. So-called as to distinguish it from a “conventional” foreclosure, a strategic default is a voluntary decision to stop making mortgage payments despite the capacity to do so. While choosing foreclosure might strike some as oxymoronic, it turns out that for many, it is actually a perfectly rational choice. Simply, the negative impact on one’s credit score and the possibility of a deficiency judgment, pales for some when weighed against the prospect of spending the rest of one’s lifetime paying off a mortgage that is well underwater.

That’s because while foreclosure technically remains on one’s credit report for 7-10 years, it can become functionally irrelevant in the eyes of lenders in half that time. In addition, deficiency judgments (in which the lender sues to collect the difference between the value of the property at the time of foreclosure and the amount owed under the mortgage) are illegal in many states, and rare in the rest. That being the case, the only remaining consideration is the moral one- deliberately breaking a contract that you have the ability to honor. While there are strong arguments to be made for both sides, I don’t think this is an appropriate forum to explore that dimension, however. Let your conscience be your guide.