Strategic Defaulters: Still No Reason Why Some Stop Paying Their Mortgages
Currently, about 25% of homeowners nationwide are underwater – meaning they owe more on their homes than the properties are worth. A strategic default occurs when a homeowner decides to stop paying his or her mortgage, even while that individual generally keeps up with other payments, such as credit card bills or an auto loan.
This latest study on strategic defaults comes from Fair Isaac Corp., creator of the FICO credit score. It adds to a growing body of research that aims to help banks and other lenders predict which consumers are most likely to walk away from homes that are underwater.According to Fair Isaac's study, called Predicting Strategic Default, some key characteristics of strategic defaulters include:
• Better FICO Scores
FICO credit scores range from 300 to 850 points. Fair Isaac's research shows that nearly all strategic defaulters previously had a "good" credit rating and a score of 620 or higher. Many strategic defaulters even have scores in the high 700s or 800s.
• Less credit card debt and lower retail balances
Surprisingly, those who strategically default on a mortgage tend to manage their credit card debt well, spending money carefully and generally keeping their credit card and retail balances lower than that of the general population.
• Shorter length of residence in the property
Because strategic defaulters typically haven't lived in their homes for very long periods of time, Fair Isaac officials suggest this translates into less emotional "attachment" to a home.
• More recently opened credit in the past six months
Strategic defaulters are more likely to have opened credit card accounts in recent months, perhaps, according to Fair Isaac, as a way to prepare for life after a strategic default – when credit will become much harder to obtain.
Fair Isaac's research into strategic defaulters follows other recent studies on the topic, including data from the credit agency Experian, as well as VantageScore Solutions LLC, developer of the VantageScore. The VantageScore is a credit score that was developed by the three credit bureaus, Equifax, Experian and TransUnion. VantageScores range from 501 to 990 points.
During a recent webinar on the topic of improving risk prediction, VantageScore Solutions Senior Vice President Analytics, Product Management & Research, Sarah Davies, highlighted what lenders and credit risk managers should be focused on when trying to spot people who are more likely to be strategic defaulters.
"We're all aware of a great deterioration in credit quality. Default levels are increasing across the board in all industries, but what we're also seeing are shifts in the way consumers are thinking about their debts," said Davies. "Historically, we've known that mortgage payments were the most important payment for the average consumer, but with the recent phenomenon of strategic defaults, we're seeing people prioritize their debts in different ways."
For instance, consumers with at least one late payment on their credit reports are increasingly choosing to pay their credit card debts and auto loans before their mortgage, she said.
But defaulting on a mortgage, whether by choice or by economic circumstance, obviously has several negative ramifications. The two biggest penalties for consumers: taking a hit to your credit rating and being locked out of a big segment of the mortgage market for several years.
"Making the decision to willfully default on a mortgage is not only ethically questionable but it will take its toll on a credit score," says VantageScore Solutions CEO Barrett Burns. "If a consumer with a starting VantageScore of 862, which is considered 'prime plus,' can lose up to 140 points from a foreclosure, someone with a slightly higher score should be prepared for a major reduction."
In studying strategic defaults, the Experian-Oliver Wyman Market Intelligence Report has found that:
• Individuals with ultra-high credit scores – those consumers boasting so-called "super prime" VantageScores of 901 to 990 points – became strategic defaulters at a rate 50% higher than the overall delinquent population.
• Borrowers with multiple first mortgages (i.e., real estate investors) had higher levels of strategic default.
• Consumers with bigger mortgage balances were also more likely to be strategic defaulters. This was true even when researchers controlled for variables like geography, number of first mortgages and the borrower's VantageScore
Despite Penalties, Strategic Defaults Gain In Popularity
Beyond the toll on a person's credit, there's also the prospect that a strategic default will make it much tougher to jump back into home ownership. In 2010, Fannie Mae announced that strategic defaulters would be banned from getting Fannie Mae home loans for seven years from the date of the foreclosure.
Despite the threat of a damaged credit rating and diminished access to home loans in the future, it's clear that defaulting on a mortgage is nonetheless gaining ground with consumers as a viable option for dealing with their financial predicaments.
In a December 2010 survey published by RealtyTrac, nearly half of all homeowners polled (48%) said they would consider walking away if their mortgage was underwater. That 48% figure shot up from 41% in May 2010, suggesting that a growing number of Americans think it would be acceptable, at least under certain circumstances, to abandon their mortgages.
Also noteworthy, RealtyTrac's data found that men were far more likely to consider strategic default than women, by a margin of 57% to 40%.
So the real challenge for banks and credit reporting agencies shouldn't be about simply trying to predict who's likely to default, but figuring out how to deal with the core problems facing these borrowers. But no one seems to be studying what's driving these desperate borrowers into making such a drastic decision.
And herein lies the problem with the research thus far into strategic defaults.
First, the research begins with the enormous assumption that strategic defaulters do – in fact – have the financial means to pay their mortgages but simply opt not to.
I think this is a huge – and faulty – assumption.
The Fair Isaac study states: "Where the key driver for the behavior of traditional defaulters is affordability, the key driver for strategic defaulters is incentive. Strategic defaulters can afford to continue making mortgage payments, but they believe that it is not in their financial best interest, generally because they are 'underwater,' owing more on their mortgage than their house is currently worth."
While it may be true that strategic defaulters are a more financially savvy bunch - and more likely to view their homes as an investment - it's a major leap for researchers to assume that strategic defaulters definitely have the ability to repay their home loans.
Neither FICO scores nor VantageScores track or calculate a person's income. So while these agencies can make guesstimates about a consumer's income, they really don't know how much money a borrower earns and whether or not there's been a decline in a family's economic standing.
Besides, even if researchers had the exact income of a borrower in question, those researchers have no way to know – and don't appear to be interested in – whether the person has other liabilities impacting the borrower's willingness or ability to repay a mortgage.
For instance, is the homeowner also paying for private school for their children or a kid who just entered college? Is the borrower financially supporting aging parents or a family member with big medical bills? Or has a two-income couple just gone through a separation or divorce, or has one party in the relationship lost a job?
None of this is reflected in the research. So if the only criterion being used is a belief that "well, these people are somehow paying all their other bills, so they must be able to afford their mortgage, too," that's a poor way to gauge affordability.
On paper, it might appear that strategic defaulters can "afford" their existing mortgages, but what if they truly can't? What about the scores of people who've sought out help with their mortgages - to no avail – before making the decision to walk away from a home?
Struggling homeowners nationwide have lamented for more than three years about limited options when they reach out for help in restructuring unaffordable mortgages. They tell stories of banks that repeatedly lose paperwork; about being rejected for forbearances and loan modifications after making reduced, trial repayments as agreed; and of course, about getting the door slammed in their faces when they try to refinance homes that are underwater.
In short, U.S. homeowners have dealt with a lot of headaches, hassles and heartbreak when it comes to fixing their mortgage woes. So why should we think that strategic defaulters are any different? Simply because they have higher incomes and better credit?
What's more likely is that strategic defaulters are simply better able to mask their financial difficulties. They have more options (like family members they can borrower money from, lines of credit they can tap, or 401(k) plans they can dip into) to help them ride out a financial storm. Consequently, the cracks in the financial façade simply aren't as visible.
But just because their financial pain isn't showing up in the research on strategic default doesn't make it any less real.
So until researchers from FICO, VantageScore and elsewhere delve into the human side of strategic defaults, they're really just guessing about who's a strategic defaulter – not to mention who's likely to default and why.