May122016

Did distressed homeowners ruthlessly default or merely chose the timing of the inevitable?

Most people who defaulted on their mortgages couldn’t afford to pay off the debt. They chose when to default, but the default was unavoidable.

accelerated_defaultNo accepted definition of strategic default exists. Lenders attempted to define a strategic defaulter as any borrower who is capable of making a payment and chooses not to. On the surface that sounds reasonable, but that definition misses a very important distinction: Some people chose to default because they know they can’t afford the payments long term, and they are merely choosing the timing of the inevitable. The only thing strategic about the default is the timing, not whether or not they will lose the home.

I prefer the distinction between ruthless default and accelerated default. A ruthless default is a default by a borrower who is fully capable of making payments for the full term of the loan, but chooses not to purely for financial reasons. An accelerated default is a default by a borrower who is not capable of repaying the debt under the full terms of the loan, but is capable of making payments in the short term.

Nearly everyone labeled a strategic defaulter is most likely an accelerated defaulter. True ruthless default — a default by a non-distressed homeowner who can afford the payment on a fixed-rate amortizing mortgage — is rare.

In cases where the owner is severely underwater and they can rent for far less than their current payment, the incentive certainly exists, but most borrowers in that circumstance with a fixed-rate mortgage will chose to ride out the collapse. The borrowers with most incentive to default are those with toxic financing or temporary loan modifications that know they are facing an increased debt and an increasing payment. When those borrowers default on their own schedule, is their default truly strategic (ruthless) or merely accelerated?

Turns out strategic mortgage defaults weren’t really strategic

Russ Wiles, The Arizona Republic 7:32 a.m. EDT May 7, 2016how_to_live

One of the interesting things about the housing bust of several years ago … was the many people who walked away from their homes voluntarily.

“Strategic default” was the buzzword phrase to describe owners who simply defaulted on their mortgages based on declining values rather than an inability to pay. Their actions fostered a debate centered as much around ethical implications as the financial causes. …

One of my former co-workers is a deeply moral man. He views life rather simply, and most issues to him are either black or white. I watched him deal with the struggles of declining incomes as the real estate bust dragged on, yet he dutifully paid his mortgage on a house in Riverside County that declined about 50% in value. He paid $3,200 per month for a property he could rent for $1,800.

Late in 2008, the pain became unbearable, and in a sudden change of heart, he moved out of his house to a rental in the same neighborhood and stopped paying his mortgage. In fact, he simply stopped everything: He left the house, stopped communicating with the bank, and moved on with his life. His was a purchase-money, non-recourse loan, so the bank was powerless to stop him or punish him beyond trashing his credit score, which they did.

I never questioned him about his decision as it was none of my business. But knowing the kind of man he is, I’m certain it pained him deeply. I know he cared about the standard of behavior he modeled for his children, and he worried his family and his community would lose respect for him.

lost_in_foreclosure

As it turned out, he was one of the last on his street to strategically default. All his neighbors he worried about already bailed on their homes. In fact, he was the last holdout who fought acceptance of strategic default as an option. It cost him $20,000 more than it would have if he had made his move a year earlier when the situation was already hopeless.

A 2015 study, recently highlighted by Harvard’s Shorenstein Center on Media, Politics and Public Policy, takes a much closer look at the types of homeowners who engaged in strategic defaults from 2009-2011. …

A job loss, the researchers concluded, is probably the single biggest financial shock that can lead to a mortgage default. More than 40% of defaulting households who couldn’t make payments were headed by an unemployed individual or one who went through a recent divorce or faced hefty medical expenses.

huge_paymentWhich means that 60% of mortgage defaults were NOT caused by unemployment, divorce, or medical expenses. If not a financial catastrophe, what caused these other 60% of defaults?

Why didn’t they study the kind of loans these borrowers had? Escalating payments on toxic loans accounted for most of the problems.

Nevertheless, most financially distressed households didn’t default, which the researchers said reflected the ability of many of these people to tap resources such as friends or relatives to tide them over. Even among unemployed households lacking enough savings to make even one monthly mortgage payment, more than 80% stayed current.

In other words, despite no income and no savings, most households in the group continue to pay their mortgages,” the researchers wrote.

While most (80%) did, that also means that 20% did not. Given that default rates are typically about 2%, this is a ten-fold increase in the default rate.

Another intriguing issue was centered around families who could afford to keep paying their mortgages but chose not to do so. Despite a lot of media attention at the time paid to strategic defaulters, they were rare, according to the study. Fewer than 1% of households with the financial means to pay instead chose to walk away.

“Most households in positions of negative equity with relatively high net worth choose not to default,” the researchers wrote.

IMO, the only reason this is surprising is because so few bothered to make the distinction between an accelerated default and a ruthless default when thinking about this issue.

The study  largely confirmed that personal financial shocks lead to mortgage defaults — job losses in particular — without citing negative housing equity as an overriding factor. It also showed that many homeowners struggle to hang onto their homes when times get tough, perhaps longer than they should.

This matches my anecdotal observations as well.

Steve_and_Tasha_McLaughlin

(See: Borrowers who strategically defaulted early on made the best choice)

Strategic default is never an easy choice. In my opinion, walking away from mortgage debt was the best way to secure their children’s future. Many didn’t heed my advice, and they paid a heavy price for their principled approach.

Once home prices stopped falling, strategic default no longer made sense. Any deeply underwater borrower making payments in excess of a comparable rental benefited financially from strategic default. That’s the math. However, defying the math, very few homeowners actually defaulted.

People cloak their reasons with intellectual rationalizations, but it’s an emotional decision based on the desire to keep their family home and the ethical considerations that go along with the decision. As with any emotional decision, it may be right, or it may be wrong, depending more upon the perceptions of the decision maker rather than some outside measuring stick.martyr

Since strategic default is an emotional decision, anything pertinent to the decision maker impacts the number of people who strategically default. Most people default because they can no longer take the emotional strain of trying to make payments they really can’t afford. Their willingness to endure this hardship depends on what they perceive as the reward.

Many potential strategic defaulters don’t quit paying because they can’t accept the loss of self-respect that accompanies what they interpret as breaking a promise. Many others believe losing the family home would inflict more pain on themselves and their families than continuing to make the payments. For many, the additive impact of both of these factors compel them to endure the financial distress rather than walk out the strategic default exit.

Another major weight on the decision-making scale is the perception of future financial reward. People bought houses during the housing bubble because they believed they would be rewarded with HELOC money or increasing value in their properties. The housing bust squelched most of these dreams, but hope springs eternal, and many are holding on with the belief the market will eventually make them whole again. The belief in this future reward can push a borrower in either direction depending on what’s happening with home prices.

As home prices plummeted, so did borrower’s hopes of ever having equity again. Borrowers without hope of equity often strategically default. Once it became widespread perception that house prices were on the mend, the psychological impact on underwater borrowers was profound. Many who would not gain equity in many, many years saw the distant light at the end of the tunnel. Rising home prices gave distressed borrowers hope, and this hope dramatically changed the strategic default equation.

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