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Economic Forecasts

Pain of "Strategic Defaults" Real But Dwindling

It can be hard to figure out what made a homeowner punt on their mortgage.

Strategic defaults on mortgages are throwing more properties on an already glutted market. But such walkaways are less prevalent than commonly thought and probably trending downward.

If a borrower can make good on a payment -- either from current income or assets -- but opts not to, that qualifies as a strategic default. In one of the most frequently cited studies on the subject, the consulting firm Oliver Wyman and the credit bureau Experian estimate the number of strategic defaults over the first half of last year was 355,000 -- or 19% of mortgage defaults during that time span.

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But defining a strategic default is easier than identifying one. It would take a thorough individual financial review to determine whether a default was voluntary or forced by distress. The Oliver Wyman/Experian study skirts the problem by using an alternative definition; it defines a strategic defaulter as someone who goes directly from 60 to 180 days past due on a mortgage, with no intervening payments, while remaining only slightly delinquent on credit card payments (less than 90 days) and auto loans (less than 60 days). “The fact that they made payments on non-real-estate trades for eight-plus months strongly suggests an absence of distress and availability of some form of income; the real estate default is then solely driven by negative equity,” note the study’s authors.

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The second half of that statement is reasonable. After all, if there was substantial equity to be lost, a borrower would give higher priority to paying the mortgage. But the first half of the statement is preposterous. Just because borrowers can keep up with some payments doesn’t mean they can keep up with them all. And if their card and auto payments are less than their mortgage, they may simply be paying what they can, with home payments falling by the wayside. So putting one-fifth of defaults in the voluntary, strategic category is almost certainly an overestimate.

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It’s also likely that the number of strategic defaults is on the wane. The Oliver Wyman/Experian report notes, “The absolute number of strategic defaults for the first half of the year … declined in successive quarters in 2009, suggesting they may have peaked in Q4 2008.” Why? At least two reasons: Precipitous job losses have given way to modest gains, and the stabilization of house prices (along with ongoing principal payments) has reduced the number of under-water mortgages. In fact, according to CoreLogic, a respected source for mortgage data, that number shrank by 100,000 during the first quarter alone.

Additionally, lenders are working through the most toxic mortgages made during the peak of the housing bubble. For example, the subprime “2-28”, which offered low “teaser” rates that were fixed for the first two years before being adjusted sharply upward for the next 28, was hugely popular among speculative investors, with use of those loans peaking in 2006. Speculating buyers wagered that price appreciation would enable them to flip the house before interest rates adjusted upward. But when house prices fell, they were stuck holding the bag -- until they strategically defaulted, that is. These kinds of mortgages haven’t been available for three years, however, and the wave of damage they caused has already crested.

As for the question of who’s doing most of the walking away and why, here’s what the Oliver Wyman/Experian team has to say: There’s a higher incidence of strategic default among borrowers with the highest credit rating. Sam Khater, CoreLogic’s senior economist, speculates: “The rich are different: They are more ruthless.”

But there may be another reason for the prevalence of wealthy deadbeats: Greater incentive. As a rule, more-expensive homes have lost the most value over the past few years. And if people are going to destroy their credit rating, as happens with a default, they’re more likely to do it for $200,000 than for $20,000.

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