Who Defaults, and Why?

This month we’ve run a series for distressed homeowners and published NC foreclosure data. To round out our coverage on the topic I want to discuss a paper written by James E. Rogers of the University of Arizona’s College of Law because it runs counter to what people generally believe is happening with people “walking away” from their mortgages.

Professor Rogers says most homeowners continue to make their payments even when they are significantly underwater and suggests that most homeowners choose not to strategically default as a result of two emotional forces:

1) the desire to avoid the shame and guilt of foreclosure

2) exaggerated anxiety over foreclosure’s perceived consequences

Who’s walking away?

While reading that article, I recalled several news items detailing studies tending to show that borrowers with super-prime credit, and borrowers with larger mortgage balances, are far more likely to strategically default on a mortgage than either borrowers with lower credit scores or lower mortgage balances.  For example, this article in the LA Times from September 2009:

The number of strategic defaults is far beyond most industry estimates — 588,000 nationwide during 2008, more than double the total in 2007. They represented 18% of all serious delinquencies that extended for more than 60 days in last year’s fourth quarter.

Strategic defaulters often go straight from perfect payment histories to no mortgage payments at all. This is in stark contrast with most financially distressed borrowers, who try to keep paying on their mortgage even after they’ve fallen behind on other accounts.

Strategic defaults are heavily concentrated in negative-equity markets where home values zoomed during the boom and have cratered since 2006. In California last year, the number of strategic defaults was 68 times higher than it was in 2005. In Florida it was 46 times higher. In most other parts of the country, defaults were about nine times higher in 2008 than in 2005.

Two-thirds of strategic defaulters have only one mortgage — the one they’re walking away from on their primary homes. Individuals who have mortgages on multiple houses also have a higher likelihood of strategic default, but researchers believe that many of these walkaways are from investment properties or second homes.

Homeowners with large mortgage balances generally are more likely to pull the plug than those with lower balances. Similarly, people with credit ratings in the two highest categories measured by VantageScore — a joint scoring venture created by Experian and the two other national credit bureaus, Equifax and TransUnion — are far more likely to default strategically than people in lower score categories.

People who default strategically and lose their houses appear to understand the consequences of what they’re doing. Piyush Tantia, an Oliver Wyman partner and a principal researcher on the study, said strategic defaulters “are clearly sophisticated,” based on the patterns of selective payments observable in their credit files. For example, they tend not to default on home equity lines of credit until after they bail out on their main mortgages, sometimes to draw down more cash on the equity line.

Tugging the heartstrings

Professor Rogers of Arizona says that the government and other social control agents actively cultivate the social and moral norms related to the honoring of financial obligations, which leads homeowners to ignore market and legal norms which might indicate that strategic default is both viable and the wisest financial decision. On the other hand, the norms governing lenders drive them to maximize profits or minimize losses irrespective of concerns of morality or social responsibility.

End result? Individual homeowners, not corporate entities, shoulder a disproportionate burden from the housing collapse.

Strategic Defaulting in North Carolina & South Carolina

The conclusion we draw from these studies and anecdotes, and from our own experiences, is that strategic defaulters tend to be more sophisticated and better educated about the consequences of strategic default — they do so with eyes wide open. We often see high earners with a high debt to income ratio, seeking advice now because they know an interest-only loan or other artificially low mortgage payment will reset within the next 18 months, resulting in a mortgage payment that they may not be able to afford.

In contrast, borrowers with lower credit scores and/or lower mortgage balances may tend to muddle through for longer, hoping that something will change.

When consulting with a bankruptcy attorney or financial advisor be sure to tell them how you FEEL about the options they lay before you. That level of candor is necessary to choose the best option among the many.