Over the past few years as home values have taken a nose dive, we’ve witnessed a new group of borrowers in the default arena – enter the strategic defaulter.  A strategic default occurs when a borrower who is financially able to make their monthly mortgage payment, chooses to walk away from their property because they owe more than the home is currently worth.  The rationale is that it doesn’t make financial sense to continue to pay for negative equity, waiting and hoping that the home’s value will increase and they will re-coup their lost equity.

To banks that are already struggling to cope with the thousands of borrowers who are legitimately unable to make their mortgage payments, this group represents a growing challenge.  According to studies by the Chicago Booth School of Business, strategic defaults in September 2010 represented 35% of all defaults, up from 26% in March 2009.  Last year the problem became so large that Fannie Mae announced that it would seek stringent penalties against borrowers who are able to pay, but choose to walk away.

Hoping to stem the tide of strategic default, banks are looking for ways to identify those borrowers most likely to walk away from their mortgage obligations.  The problem however, is that to date there has been no reliable way to identify the potential strategic defaulter.  Intervention is impossible if you don’t know who you’re looking for.

FICO Research Labs may have developed the tool banks are lacking.  The credit assessment company announced that it has developed a method that analyzes consumer spending and payment habits and allows lenders to identify borrowers who are 100 times more likely to default than others.  

So what is the profile of the strategic defaulter?  They are actually quite savvy managers of their credit having higher FICO scores, lower balances on revolving debt, less retail credit usage, and fewer instances of exceeding credit limits than the general population.  FICO claims the company’s new analytics can provide loan servicers with a method of reaching two-thirds of these would-be strategic defaulters, and according to Dr. Andrew Jennings, head of FICO Labs, “The ability to spot likely strategic defaulters before delinquency enables servicers to intervene early.”

But then what?  It is one thing to identify borrowers who might choose strategic default, but, what intervention can banks offer that will actually deter would-be defaulters? If lenders follow Fannie Mae’s example and simply threaten legal action to recoup outstanding mortgage debts, I doubt that will be much of a deterrent or solve any of the real problems.

The issue comes back to a point I’ve often made in this blog:  I don’t believe we are going to see a significant reduction in defaults, both strategic and involuntary until lenders are ready to consider meaningful principal reductions for borrowers who owe more than their homes are worth.   If Savvy Bob the Homeowner is considering default because he owes $80,000 more than the home is worth, do you think he might consider staying in his home if his principal balance was reduced by $60,000?  Throw-in a lower interest rate and I’m pretty sure you’d have a deal.  Considering the bottom line expenses for banks to foreclose, costs for carrying an REO, lost revenue, and a lower net sales price, principal reduction should start to look pretty good.

So I’m all for identifying those who are likely to choose to walk away, but before banks rush to hit them over the head with penalties, l hope they’ll put some thought into resolving the equity issues that are driving strategic default and offer borrowers a meaningful alternative.

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