Study: Nearly One in Five Mortgage Defaults Are ‘Strategic’

June 28, 2010, Wall Street Journal

By Nick Timiraos

A new report estimates that nearly one in five mortgage defaults through the first half of 2009 were “strategic,” where borrowers who appeared to have the capacity to pay their mortgages stopped doing so.

The research follows on an earlier report by Experian and Oliver Wyman that first aimed to quantify the share of mortgage defaults that are “strategic.” Strategic defaulters are defined as those who miss six straight mortgage payments without missing multiple payments on auto loans and other consumer debts for the six months after they first fell behind on mortgage payments.

The report finds that the share of borrowers who strategically defaulted through the first half of 2009 is unchanged from the end of 2008. Still, the absolute number of strategic defaults in the first half of 2009 increased 53% from the year ago period.

Researchers suggest that the share of strategic defaults may have hit a plateau as total mortgage delinquencies and may have also peaked in the fourth quarter of 2008. “We’re seeing this encouraging break in the quarterly data,” said Charles Chung, general manager of decision sciences at Experian.

But those results are “heavily contingent” on the stabilization in home prices that materialized one year ago, as government stimulus aimed to set a floor for home prices.

One big question going forward: do strategic defaulters begin to account for a growing share of defaults, especially if the total pool of mortgage defaults shrinks as unemployment subsides. While a better job market would slow the pace of traditional mortgage defaults, many potential strategic defaults—those who owe far more than their homes are worth—would need home prices to appreciate to change their calculus.

Indeed, the report finds that strategic default remains heavily concentrated in California, Florida, and western states that have seen the biggest run-up and decline in home prices. Strategic defaulters in California were nearly 80 times higher in the first two quarters of 2009 versus 2005.

While those states had higher concentrations of investor-owned properties that are particularly vulnerable to walkaways, the report finds that 68% of all strategic defaulters had just one first mortgage, up from 64% in 2008.

The report comes as Fannie Mae last week stepped up a public-relations campaign to warn of the possible repercussions of strategic default. The government-owned mortgage-finance titan said it would begin to pursue legal actions against borrowers who walked away from mortgages when they had the capacity to pay.

It also said it would lengthen to seven years, from five, the amount of time that borrowers must wait before receiving a new loan after a foreclosure unless those borrowers could show that they had defaulted due to hardship and after seeking a workout from their lender.

Readers, are you thinking about walking away from a loan you could afford to pay? Would tougher sanctions change your mind? Email us: nick.timiraos@wsj.com.

Follow for more mortgages and housing news on Twitter: @NickTimiraos

A new report estimates that nearly one in five mortgage defaults through the first half of 2009 were “strategic,” where borrowers who appeared to have the capacity to pay their mortgages stopped doing so.

The research follows on an earlier report by Experian and Oliver Wyman that first aimed to quantify the share of mortgage defaults that are “strategic.” Strategic defaulters are defined as those who miss six straight mortgage payments without missing multiple payments on auto loans and other consumer debts for the six months after they first fell behind on mortgage payments.

The report finds that the share of borrowers who strategically defaulted through the first half of 2009 is unchanged from the end of 2008. Still, the absolute number of strategic defaults in the first half of 2009 increased 53% from the year ago period.

Researchers suggest that the share of strategic defaults may have hit a plateau as total mortgage delinquencies and may have also peaked in the fourth quarter of 2008. “We’re seeing this encouraging break in the quarterly data,” said Charles Chung, general manager of decision sciences at Experian.

But those results are “heavily contingent” on the stabilization in home prices that materialized one year ago, as government stimulus aimed to set a floor for home prices.

One big question going forward: do strategic defaulters begin to account for a growing share of defaults, especially if the total pool of mortgage defaults shrinks as unemployment subsides. While a better job market would slow the pace of traditional mortgage defaults, many potential strategic defaults—those who owe far more than their homes are worth—would need home prices to appreciate to change their calculus.

Indeed, the report finds that strategic default remains heavily concentrated in California, Florida, and western states that have seen the biggest run-up and decline in home prices. Strategic defaulters in California were nearly 80 times higher in the first two quarters of 2009 versus 2005.

While those states had higher concentrations of investor-owned properties that are particularly vulnerable to walkaways, the report finds that 68% of all strategic defaulters had just one first mortgage, up from 64% in 2008.

The report comes as Fannie Mae last week stepped up a public-relations campaign to warn of the possible repercussions of strategic default. The government-owned mortgage-finance titan said it would begin to pursue legal actions against borrowers who walked away from mortgages when they had the capacity to pay.

It also said it would lengthen to seven years, from five, the amount of time that borrowers must wait before receiving a new loan after a foreclosure unless those borrowers could show that they had defaulted due to hardship and after seeking a workout from their lender.

How Far Underwater Do Borrowers Sink Before Walking Away?

At what point do borrowers who owe more than their homes are worth decide to stop paying the mortgage?

A new study from economists at the Federal Reserve Board aims to answer that question. The research found that the median borrower who “strategically” defaults doesn’t walk away from the mortgage until the amount owed exceeds the value of the home by 62%.

The study is bad news for the mortgage industry in that it backs up the idea that a growing share of borrowers are walking away from loans. Concerns are mounting among lenders and investors that some borrowers who owe far more than their homes are worth are now choosing not to pay mortgages that they can afford.

But the silver lining here is that it suggests a rather high threshold for borrowers to walk away.

“The fact that many borrowers continue paying a substantial premium over market rents to keep their homes challenges traditional models of hyper-informed borrowers” choosing to simply walk away, the authors write. The results suggest “that borrowers face high default and transaction costs” that make strategic defaults less widespread than they might otherwise be.

The study examined borrowers in Arizona, California, Florida and Nevada who bought homes in 2006 with no money down. Nearly 80% of those borrowers had defaulted by September 2009. The authors then attempt to estimate and separate out defaults caused by job loss and other income shocks from those that had been spurred simply by negative equity.

Nearly 80% of all defaults in the sample resulted from the traditional combination of income shocks and negative equity. But for borrowers that had a loan-to-value ratio of 150%, half of all defaults were strategic defaults, driven purely by negative equity.

Most defaults are typically driven by a combination of income shock and negative equity, or what’s known as the “double-trigger” hypothesis. While borrowers who lose their jobs but have equity in their homes can sell and avoid default, those without any equity are left with fewer options.

“Borrowers do not ruthlessly exercise the default option at relatively low levels of negative equity, broadly consistent with the ‘double-trigger’ hypothesis,” the authors write. “But by the time equity falls below -50%, [half] of defaults appear to be strategic.”

(Read about a separate study released on Monday that finds that around one in five mortgage defaults could be considered “strategic.”)

Empirical evidence suggests that more borrowers may be walking away from their primary residences, but this is a much bigger problem in housing markets that saw stunning home-price gains followed by a free fall. Look to the desert suburbs of Phoenix and Las Vegas, the southwestern coast of Florida, and the far-flung exurbs of California’s San Joaquin Valley and Inland Empire.

The Fed study finds, as have others before, that borrowers are more likely to walk away from homes in states where lenders can’t sue them for a deficiency judgment. The median borrower in a state where lenders have recourse to borrowers’ assets, such as Florida or Nevada, defaults when he or she is 20 to 30 percentage points further underwater than the same borrower in a non-recourse state, such as Arizona or California.

Borrowers with higher credit scores also find it more costly to default. The median borrower with a credit score between 620 and 680 walks away when their loan-to-value ratio hits 151%, while the median borrowers with a credit score above 720 walks away with a loan-to-value ratio of 168%.

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