The vexing case of strategic defaults

With tougher mortgage underwriting rules a virtual certainty under
Congress’ new financial reform legislation, lenders have begun
confronting still another vexing issue: Can homebuyers who have high
credit scores really be trusted not to pull the plug — strategically
default — when the economy hits a rough patch and home values
tank? 

New research based on data from 25 million active consumer credit files
suggests the answer just might be no. Though people with the
highest-ranking credit scores are less likely to default on their
mortgage compared to people with lower scores, when they do default
they are much more likely to do it strategically — simply stop paying
with little or no warning in advance. 

In a study released June 28, researchers from credit bureau
giant Experian and the Oliver Wyman consulting firm found that
borrowers with “super prime” credit scores accounted for 30 percent of
all mortgages outstanding in mid-2009 but produced just 5 percent of
all serious mortgage delinquencies. 

However, 28 percent of those elite scorers’ defaults were calculated
and strategic, versus 18 percent for the overall population of
borrowers in the sample. This pattern, in turn, is forcing lenders and
the credit industry to seek new ways to evaluate risk beyond
traditional credit scores. 

Charles Chung, Experian’s general manager of decision sciences, said in
an interview that “lenders not only are looking at credit worthiness”
— as measured by traditional credit scoring models — but also at
applicants’ likely “ability to pay” under scenarios where real estate
values drop. In the future, lenders may need to adjust underwriting and
risk-rating rules — higher minimum down payments, higher interest
rates — to deal with loan applicants who fit the profile for walkaways
in a depreciating real estate market. 

The latest study, which follows up on earlier research involving credit
files where consumers’ personal identifiers had been removed, tracked
strategic defaulters in 2009. By examining payment patterns in
individual credit files, Experian and Oliver Wyman estimate that about
19 percent of all mortgage defaults last year involved intentional,
strategic walkaways. 

Though there was some evidence that total defaults may have peaked at
the end of 2008, the walkaway issue remains a costly and controversial
one for the mortgage industry. Fannie Mae announced in late June that
strategic defaults have become such a problem that it is toughening its
policy and will pursue walkaways for unpaid balances and penalties
wherever permitted by state law. 

The Experian-Oliver Wyman study confirmed that geography plays a
significant role in the strategic default phenomenon. Homeowners in
volatile boom and bust states such as California and Florida have been
especially prone to walk away from deeply negative equity
situations. 

A separate study by three researchers at the Federal Reserve found that
not only is geography crucial, but state law treatment of unpaid
mortgage debt balances following a walkaway may play major roles as
well. The Fed study examined 133,281 loan histories from Arizona,
California, Florida and Nevada where borrowers were underwater on their
loans. 

According to the researchers, in Arizona and California, where state
law imposes restrictions on lenders’ abilities to collect
post-foreclosure deficiencies on principal residence mortgages,
borrowers were more prone to walk away from their houses at lower
levels of negative equity compared with borrowers in states such as
Florida and Nevada, where lenders face fewer restrictions. 

“This result suggests,” the Fed study says, “that borrowers may factor
into the costs of default the potential legal liabilities resulting
from a foreclosure.” 

The Fed researchers concluded that the depth of borrowers’ negative
equity positions is an important tripwire to their decision to send
back the keys. Borrowers whose negative equity is relatively modest
appear to be much less willing to strategically default, probably
because they hold out hope that market conditions will improve enough
to restore them to positive equity one day. 

But as negative equity approaches 50 percent — and borrowers see no
prospects for higher real estate values — roughly half of all mortgage
defaults are strategic. 

The Fed researchers cited a hypothetical case from Palmdale, Calif., to
illustrate the economic logic of strategic defaulters: Purchasers there
in 2006 paid $375,000 for a median-priced single-family home. By 2009,
the same house was worth less than $200,000. Meanwhile, a three- to
four-bedroom house in Palmdale rented for $1,300 a month at the end of
2009 — far less than what the deeply underwater borrowers were paying
for theirs. 

Why stay in a seemingly hopeless situation, bleeding money
indefinitely? Both studies document that many borrowers asked
themselves that very question — and decided to just stop paying.

Ken Harney is a real estate columnist with the Washington Post.