Strategic Default Gaining in Popularity

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strategic defaultThe growing popularity of strategic default can't be denied. Forty-eight percent of homeowners surveyed say they would consider a strategic default -- also known as walking away -- if their home were underwater, in the latest research done for RealtyTrac and Trulia. That's up from 41 percent in May. Yet the banks still seem to be in denial that a strategic default wave may be building.
Strategic default is when a borrower makes the strategic decision to stop paying his mortgage. Since it takes 1½ to 2 years to foreclose on a home in most states, the borrowers then use the cash that would have gone toward paying their mortgage to pay off other debts and improve their own financial position.

Rick Sharga, senior vice president of RealtyTrac, says there's $300 billion worth of adjustable mortgages expected to reset in the next 12 to 15 months. That will increase monthly mortgage payments by $1,000 on homes already underwater by 30 percent to 50 percent. He thinks its "tough to make an economic decision to stay in that situation."

"Some families, who like their neighborhood and their kids are in a stable school environment, will likely stay in their homes, even if the mortgage payment goes up, if they can afford it," Sharga explains. There's another group of people, mostly young couples, "who don't have an emotional attachment to the location." For them it's more an investment decision about keeping a roof over their heads. They will ask themselves whether they can live more cheaply in a rental, since they don't expect their home to regain enough in value in the next 10 to 20 years.

"We're a more mobile society," Sharga says. "People just don't have the same emotional ties to their home as in the past." He also thinks there is a "visceral anger toward lending institutions," which is driving some of this movement toward strategic default. People watched as the banks got their bailouts, but they're not willing to share in the loses of the general public by offering principal reduction. Interestingly, men (57 percent) are more likely than women (40 percent) to consider strategic default as an option for dealing with negative equity, the survey found.

Jon Maddux, one of the founders of You Walk Away, has seen a 45 percent increase in the number of people signing up for his service in 2010 over 2009. He expects 2011 to be even bigger year for his company. The web traffic to his website has jumped 20 percent in December 2010 versus December 2009.


Sharga thinks the banks may still be living In some state of denial. He thinks there is "wishful thinking in the banking community" that strategic default won't grow in popularity. He believes the only way to stem the tide is for the banks to consider principal reduction programs to give an incentive to underwater borrowers to stay in their homes.

The banks must face the "harsh reality that there is about $1 trillion sitting on their books" in property that has lost value. Sharga explained that $1 trillion number comes from an executive of JP Morgan Chase who testified before Congress that it would cost the banks between $900 billion and $1 trillion to "right size" the market values of the mortgages on the books.

He thinks banks should consider modifying the loans of underwater borrowers so that the payments are based on the home's current market value. Any difference should be set up as a balloon payment that can be partially earned out as the homeowner continues to make on time payments. That way both the borrower and lender share in potential losses in the future. That gives the borrower an incentive to stay in the home and pay the mortgage on time.

Another inventive incentive is being promoted by the Loan Value Group called the Responsible Homeowner Reward. Right now only a few banks have signed on to the program, but Frank Pallotta, executive vice president and managing partner of the Loan Value Group (LVG), says more and more lending institutions are showing interest. LVG has commitments in excess of $1 billion of face value of mortgages with rewards ranging in size from 10 percent of the unpaid balance to as much as 30 percent. LVG signs nondisclosure agreements with the banks that do sign on to the program, so he could not divulge which banks are currently working with him.

The way the reward program works is that if your home is underwater LVG works with the borrower to get details about the current value and the borrower's current financial situation. Using this information it then works with the bank to come up with a reward specific to the borrower's situation. The reward is then set aside in an account that the borrower can earn as he makes on time payments over a two to five year period depending on the terms. Then the reward sits in a reserve account and is given to the homeowner when he pays off the mortgage, sells the home or refinances the home. After the borrower earns his reward, he can lose it if he becomes delinquent more than once in any 12 month period. This gives the homeowner an incentive to pay on time even if underwater.

Pallotta thinks that "if the banks decide to do nothing they do it at their own peril." He said by their "doing nothing it is a proactive decision" to enable strategic default. He sees a "lack of connection between the servicer and the borrower." His company works to improve the communications between the two and come up with a win/win solution for both.

Will banks begin to consider principal reduction for underwater borrowers to stem the tide of strategic default? No one knows that answer for sure, but there are good solutions for the banks to consider and companies out there ready to help them. Yet while the Obama administration supports principal reduction as an option for struggling borrowers, the regulator for Fannie Mae and Freddie Mac does not, according to recent reports.

Lita Epstein has written more than 25 books including The 250 Questions You Should Ask to Avoid Foreclosure and The Complete Idiot's Guide to Improving Your Credit Score.

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