Strategic Default: The Next Chapter

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.