Some thoughts about strategic defaults...

A few weeks ago when I did an REO update I mentioned that I thought that one of the sources of upcoming REO's in our market was some potential "strategic defaults". And sure enough, a day later I saw this article about the topic, which I followed up with the next day. At the time I thought that I'd be through with that topic for a while.

Well, not so fast there, sport. Last week we saw this announcement from Fannie Mae on the topic. It pretty much echoed and drove home that CNN article from a few weeks ago. And I don't think we've heard the last of these types of announcements.

Let's back up here a little bit. What is a "strategic default" anyway? What we're talking about here are homeowners who can afford to make the payments on their mortgage, but choose not to as a calculated financial decision. Let's say someone bought a house in 2006 for $450,000, but now that house is worth around $230,000. They financed it 100% like so many people did in that period. They make good money, and their payments aren't outside the affordability range for them, although they are much higher than the guy down the street who just bought a very similar house. They're probably twice as much as it would cost to rent a similar house. There's a school of thought that says that if you find yourself that far upside down in a loan, you should just stop paying your mortgage, let the bank take the property back in foreclosure eventually, and take your lumps on your credit. You'll save up a bunch of money, and in a few years it'll all blow over, and you can buy another house like it for less money.

I'm not a subscriber to that theory. First of all, we aren't talking about a few years. We're talking about 7 years now before Fannie Mae guidelines - the guidelines that are followed by most conventional lenders - will allow a borrower who has defaulted on a mortgage without a demonstrable hardship to qualify for another loan. It appears that the lenders are talking about some leniency for those who had a legitimate financial hardship that caused a foreclosure. Fannie is talking about as little as 2 years for borrowers who try to work things out via a short sale or deed-in-lieu. So if you think that you will want to own a home again before 7 years, this may not be a good choice for you.

The second reason I think that this could be a bad idea for a lot of borrowers is the potential of a deficiency judgment. In some states that's a very real possibility regardless of the type of loan, and regardless of the reason for the default. In California, the laws are a little different, and purchase money loans are typically protected from a deficiency judgement. But if you refinanced that loan somewhere along the line, that protection goes bye-bye. There's a bill going through the Legislature that will extend that protection to refinanced loans with some limits, but it's not through yet, and the banking lobby is fighting it. So we'll see what happens there.

Proponents of the strategic default route say that this isn't a moral issue - it's simply a dollars and cents decision. There is a contract between the borrower and the lender, and the contract lays out what happens if the borrower doesn't perform. True enough. But the way I look at this is a little different. I don't want to get on my soapbox here, but I don't think you can divorce this decision from the bigger picture. More strategic defaults means more foreclosures. More foreclosures are bad for us in a lot of social and economic ways, and the longer we go through this cycle, the more painful this is going to be. None of us likes to have the neighbor that drags down our property values by parking five cars in the driveway (and on the lawn) and letting his yard get overrun with weeds. By the same token, none of us are going to be fond of the neighbor who abandons a home and lets it go to foreclosure when it could have been prevented.

Bottom line here is that the powers that be in the mortgage world are taking a hard line on strategic defaults. They may be cutting some slack to the borrowers that legitimately had a hardship and couldn't afford their payments. But if you can afford to make your agreed payment and choose not to do so, they're not going to be so forgiving. If you ask me, that's as it should be.