Should lenders attempt collection from strategic defaulters?
Whatever you believe about the morality of strategic default or the desirability of punishing them to prevent moral hazard, the practical problems of identifying and pursuing strategic defaulters makes the task too costly and difficult to be effective.
I first began writing about strategic default back in 2008 in the post Should you walk away from home debt?. Many people faced a cost of ownership greatly exceeding the cost of a comparable rental, and with declining prices, they were sinking underwater and had no realistic hope of future equity; therefore, on a purely financial basis, borrowers who strategically defaulted were wise because the shortest path to equity was to walk away from the huge debt, save money, and wait until the credit scores improved enough to repurchase again at lower prices. I gave that advice frequently from 2008 through 2011, and as it turned out, borrowers who strategically defaulted early on made the best choice.
Borrowers who strategically defaulted avoided repayment of a huge debt, and up through 2013, the government didn’t require them to pay taxes on the forgiven debt income. When people avoid their contractual obligations, particularly without resorting to a procedural cleansing like a bankruptcy, it angers many who rightly decry the unfairness of the special benefit strategic defaulters obtained. Some are calling for more stringent collection efforts from those who walked away.
… Now, some of [strategic defaulters] could be the target of renewed efforts by government-backed mortgage companies Fannie Mae and Freddie Mac to pursue money the borrowers owed on their foreclosed homes. The focus follows two inspector general’s reports last September that chastised both firms for failing to go after people who could have paid on their mortgages but chose to walk away. Doing so could recoup more of the $187.5 billion in taxpayer bailouts that Fannie and Freddie have gotten since 2008, the reports said.
It’s worth noting that nearly all of that money — $185 billion — has already been paid back. With the rebound in the housing market, the two government-run providers of housing finance have returned to profitability. They sent $39 billion in dividends to the Treasury last month, meaning that taxpayers could soon start profiting from the investments that saved the mortgage giants from insolvency.
Since the GSEs repaid the money injected into them by the Treasury Department, intensifying collection efforts against strategic defaulters to recover taxpayer losses no longer applies. Many conservatives may be angered by the unfair enrichment strategic defaulters enjoyed, but that enrichment wasn’t paid for by taxpayers. That will remove much of the impetus toward collection.
In most states, after Fannie and Freddie foreclose on a home and then sell it, they can pursue the former owner for the difference between the sale price and what the borrower owed on the loan. But the inspector general concluded that the companies failed to do so in more than 100,000 cases that together represented at least $6 billion. The FHFA is developing plans by the end of this month to ensure that the Fannie and Freddie do a better job of pursuing those who defaulted but could have kept paying.
The inspector general noted that going after those borrowers for the deficits could help deter future strategic defaulters. Barry Habib, CEO of mortgage market intelligence company MBS Highway, says that defaulting, once considered “shameful,” is now widely acceptable. …
The threat of collection was always a bluff to deter strategic defaulters. Going after these people long after the fact with little or no fanfare does not serve their purposes, so it likely won’t happen, particularly with Mel Watt in charge. The handlers at the GSEs will bluster about improving their procedures, and claim they will do better collecting in the future, but those who already got away will face no repercussions.
An October 2012 national survey commissioned by consumer risk management firm ID Analytics found that a third of those polled said homeowners should be able to strategically default on their mortgages without facing any consequences. Thirteen percent said they’d likely strategically default on a mortgage, and 17 percent said they know someone who has.
I argued that strategic default is moral imperative to prevent future housing bubbles. People should be allowed to strategic default as a deterrent to bankers to prevent them from irresponsibly inflating future housing bubbles.
Even if the inspectors think Fannie and Freddie should go after more strategic defaulters, actually doing so may be another story. One reason is state law: 12 states bar lenders from suing foreclosed owners for the deficits, and 10 others have very short statutes of limitations for doing so — between 30 to 180 days, depending on the state.
The statute of limitations will run out on lenders who don’t file paperwork to keep their claims alive. (See: Lenders ambush newly solvent borrowers seeking old bad debts)
Another problem is figuring out who had the ability to pay and who didn’t. “If you have to install a new computer system or spend hundreds of thousands of dollars to do this, it might not be worth it,” says Robert Pozen, senior fellow in economic studies at the Brookings Institution. … Even if Fannie and Freddie can identify voluntary defaulters, the inspector’s reports admit that actually collecting can take months or years. “Trying to get a billion dollars out of a bank is one thing. Trying to get $20,000 out of 50,000 homeowners is an entirely different story,” says Pinto. “You have to go down a torturous road to do it.”
Therein lies the real problem.
I faced a similar decision a couple of years ago with a squatter in a house owned by the fund I manage. The occupants quit paying their mortgage, I bought the house in foreclosure, and they repeatedly filed bogus bankruptcy applications after the foreclosure in an attempt to keep the property. After a year of legal wrangling, I finally got them out; By law, my fund was owed rent for the year these people squatted, but what chance did I have to recover? They were broke, they had no assets, and they had no prospects of obtaining assets any time soon. It would have cost money to obtain a judgment, and I had no realistic chance of recovering anything. I left them alone. So will most lenders facing the same dilemma.
In any case, the changing market already has cut into the pool of strategic defaulters. No one keeps statistics on their number, but Habib thinks it’s quickly falling as home values rise and improve homeowners’ equity. Already the proportion of those who are upside down on their mortgages has shrunk from a third to under 15 percent, he says. A likely factor in the reduction is the FHFA’s Home Affordable Finance Program, which lets many underwater and near-underwater homeowners refinance, minimizing their motivation to default.
By far the best deterrence for strategic default is rising prices. When people know their misery could end when they get back above water, rising prices give them hope; they will struggle and persevere as long as they see the light at the end of the tunnel. (See: Rising home values will halt strategic default)
Whatever you believe about the morality of strategic default or the desirability of punishing them to prevent moral hazard, the practical problems of identifying and pursuing strategic defaulters makes the task too costly and difficult to be effective. Should lenders attempt collection from strategic defaulters? I don’t think so.
13892 MILTON Ave Westminster, CA 92683
$874,500 …….. Asking Price
$890,000 ………. Purchase Price
10/15/2006 ………. Purchase Date
($15,500) ………. Gross Gain (Loss)
($69,960) ………… Commissions and Costs at 8%
($85,460) ………. Net Gain (Loss)
-1.7% ………. Gross Percent Change
-9.6% ………. Net Percent Change
-0.2% ………… Annual Appreciation
Cost of Home Ownership
$874,500 …….. Asking Price
$174,900 ………… 20% Down Conventional
4.42% …………. Mortgage Interest Rate
30 ……………… Number of Years
$699,600 …….. Mortgage
$172,323 ………. Income Requirement
$3,512 ………… Monthly Mortgage Payment
$758 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$182 ………… Homeowners Insurance at 0.25%
$0 ………… Private Mortgage Insurance
$0 ………… Homeowners Association Fees
$4,452 ………. Monthly Cash Outlays
($900) ………. Tax Savings
($935) ………. Principal Amortization
$284 ………….. Opportunity Cost of Down Payment
$239 ………….. Maintenance and Replacement Reserves
$3,140 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$10,245 ………… Furnishing and Move-In Costs at 1% + $1,500
$10,245 ………… Closing Costs at 1% + $1,500
$6,996 ………… Interest Points at 1%
$174,900 ………… Down Payment
$202,386 ………. Total Cash Costs
$48,100 ………. Emergency Cash Reserves
$250,486 ………. Total Savings Needed