Strategic default is the intentional default on mortgage obligations by ‘underwater’ borrowers which is a rising and continuing trend for the last few years. This arose due to the ‘heavily contingent’ on home stabilization prices that came about when the government stimulus aimed at controlling home prices. This paper will discuss why strategic default and its moral obligations.
What is strategic default?
Strategic default is defined as the decision by a borrower to default (stop making payments) on a debt although with the ability to pay the debt. This term is usually associated with mortgages and in this case it occurs after a substantial drop in the price of the house such that the debt owed is greater than the current value of the property. This means that the house has a negative equity (the house is underwater) therefore it is expected to remain in this way in the foreseeable future. An example is the ‘recent real estate house bubble’ in the U.S. Borrowers in this case are called ‘walkaways.’
This means that in strategic default, mortgage borrowers who owe the bank more than what their house is worth, but are in a position to pay off their loan, decide not to because it is expensive to do so in the long-run. A report in a New York report by Timiraos suggests that in 2009 there were 500, 000 foreclosures in the U.S.; this represented about a fifth of all foreclosures despite the fact that there was no financial foreclosure other than that the homeowner was underwater. According to statistics, foreclosures have been in the rise since 2009 and they are predicted to continue and the 2009 strategic default was just a tip of the iceberg. There is fear that just a small fraction of the underwater foreclosures choose to strategically default, then tremendous effects will be felt (Timiraos, 2010). The following figure shows that strategic default has been on the rise since 2006 to 2009.
Why do homeowners default on their mortgages?
The big question in this case is why should a borrower consider strategic default? According to a report by Loan Value Group, traditional banking is based on the assumption that homeowners will pay their mortgage if they are in a position to do so; this has the implication that they will default if they are not able to pay. Therefore, if they are not in a position to pay for the mortgage, they cannot pay for it. But another supported view is that many homeowners who can afford to pay for the mortgage make a decision not to pay especially because the value of the mortgage exceeds the value of the same house they are paying for. This is the rational choice and support for this reason has a substantial support. A 2000 report by Deng, et al. published in econometrics found out that the driver of default is homeowner’s equity, while another study by Bajari et al. found out that a 20% decline in house prices leads to a 15% increase in the probability of strategic default (Loan value group). Another article by Morgan Stanley Research indicates that borrowers will start defaulting at an increasing pace when their equity is 10% of the value of their house but the barriers to strategic default is moral and social reasons.
An article by Professor Stan Liebowitz published in the wall street Journal titled new evidence on the foreclosure crisis asserted that the huge national database containing millions of individual loans indicated whether the homeowner has negative equity in that house. He noted that although only 12% of the homes in 2009 had negative equity, they comprised 47% of all the foreclosures in that year. Another article in The new York times by professors Susan and John stated that monthly default rates depends whether a homeowner has ownership stake in that house or not. They found that despite the hard economic times, homeowners with real equity can find a way to pay off the loans but it is those ‘underwater’ who are defaulting in their mortgages. This shows that strategic default is a big concern in the current crisis especially due to high frequency of negative equity mortgages.
Issues with current solutions to mortgage default
Loan owners and the government are devising ways on how to default although they have not yet worked. This is because some solutions are founded on the understanding that default occurs because households do not have a choice due to insufficient income hence failing to address default and also that certain solutions face hurdles to implement them. The main solutions to mortgage default that are currently practiced are:
- Lender initiated solutions_ these involve modifying the loan by reducing interest or the principle but suffers from the following issues;
- Involves a lot of costs like the legal and documentation fees
- Requires use of existing mortgage servicing resources
- Requires disclosure by homeowners of other additional information that was not required when underwriting the loan.
- Difficult to achieve legally with scrutinized loans.
- Government initiated solutions
- Tax credits_ tax credits improve homeowners’ income although ineffective for balance sheet driven default.
- Hope for homeowners Act of 2008_ involves the FHA insuring lenders that refinance loans into fixed rate mortgages. But it seems that it is not popular because by February 2009 only 451 applications had been received.
- Homeowners Affordable Modification Program_ this happens when the servicer modifies the loan to reduce monthly payments to 31% of a homeowner’s pre-tax income.
- An alternative approach to mortgage default_ a strategic view implies looking on how to shift thinking about how to prevent defaults. The first way to do it is to provide incentives for the homeowner not to default and secondly is for the solution to target the owner’s balance sheet rather that his/her income.
Evidence shows that incentives have a powerful effect on people behavior. Lazear found out that there was a 44% increase in performance if flat wages were shifted to output wags. This implies that if incentives are given, then homeowners are likely not to default but honor and pay their mortgages. For mortgage, the party that gives incentives is called the principal and the party that receives is called the agent. For an optimal incentive plan to be achievable, it should meet the following criteria;
- Use a performance measure that can be easily measured and closely tied to the principle.
- Be simple to be easily understood by all parties.
- Be salient especially to the agent such that it can be considered.
- Be politically viable to be able to provide incentives rather than welfare payments as well as be able to support future performance.
- Be scalable to a large number of loans at a little cost and try to avoid high cost of loan modifications and unnecessary write downs.
Effects of strategic defaults vary depending on such factors like the country and available jurisdiction. In the U.S. for example, they treat strategic default by distinguishing whether it is a recourse debt or not. This implies whether the loaner of the mortgage can pursue claims against the defaulted debtor.
Some ethical issues questions have been asked on the morality of strategic default. The argument is that people have the duty to make payments if they are able because a loan is a contract between two consenting parties. Also, financial investors default on non-recourse loans that have negative equity. Some people also argue that that it is morally right to strategically default based on a person’s financial interest.
Strategic default occurs when borrowers intentionally default on their mortgage payments although they have the ability to pay. Strategic defaults have in the recent past emerged to a the main subject matter in the ongoing foreclosure housing crisis in the U.S. Strategic default is likely to accelerate as the price of house prices continue to decline sharply. This means that an incentive based solution should be adopted as soon as possible to reverse the trend. Therefore, adopting a successful solution to strategic default will bore out substantial benefits. It will result to the homeowner remaining in his property and preserve his/her credit rating thus avoiding disclosure costs of relocating after a foreclosure. Thus it will save time and money for mortgage lenders, insurers and investors and benefit from low servicing costs because of reduced delinquency costs. The society in large will benefit from social costs associated with foreclosure like vandalism, mass emigration from the neighborhood.
The government will also benefit from accruing tax revenues from homeowners and other social services related to owning a home. Clearly because we understand that strategic default is driven by negative equity in mortgages, understanding probability of such default will increase a direct relationship to negative equity. Although many people are waiting to see if the government’s programs will work to stem the situation, seems like much more work needs to be done.