What's happening to the American Dream of homeownership? Today, an increasing number of borrowers are voluntarily walking away from their contractual mortgage obligations because it is in their economic self-interest to do so, even as they pay other bills. Their home is worth less than their mortgage — commonly referred to as being "underwater"— and they are increasingly losing interest in making the monthly payment to their mortgage servicer.
Many feel that the servicer breached the mortgage contract by ignoring or mistreating them, which relieves them of their duty to pay and makes the decision to strategically default a purely economic one. If defaulting on an underwater mortgage becomes an economic rather than moral decision, it becomes rational and the social stigma dissipates.
Strategic default can hinge on small impressions — say, a mortgage servicer failing to return phone calls, showing signs of not wanting to help. Fortunately, doing the right thing defines most borrowers and they view voluntary defaults as unethical behavior.
Yet strategic defaults are continuing to grow as more and more people see them as socially acceptable as they become more aware of them through the media and in their neighborhoods.
The Chicago Booth/Kellogg School Financial Trust quarterly index showed that 31% of all foreclosures in March were perceived to be strategic. That compares to 22% in March 2009. "One likely reason for this growing trend is the increasing perception that lenders are not going after borrowers who walk away," according to the survey.
But it's likely not in a borrower's long-term interest, economic or otherwise, to voluntarily walk away from his or her mortgage. At some point equilibrium will be established and housing markets will begin to recover, and those who held on to their underwater homes will eventually see losses shrink and equity increase.
And I don't think people take into full consideration the credit ramifications of walking away from their mortgage loan and the eventual foreclosure that follows. Analysts estimate that it could result in a more than 200-point hit to their credit scores. Most borrowers with underwater mortgages are better off staying in their homes if they have a counterparty who will take the time and effort to work out a loan modification deal.
However, the economics of mortgage servicing is not conducive to loan modifications and workouts, thereby inadvertently encouraging strategic defaults.
The business model of gigantic servicers dictates that it is too expensive to work with underwater borrowers in need, to spend more time with them, to make more phone calls on their behalf. That's why despite the best efforts of federal government programs such a small percentage of loans in trouble have been salvaged from foreclosure.
Primary mortgage servicers typically do not own the credit risk of the loans. Investors, banks and other stakeholders hold that risk.
For example, a servicer might save $4 million in credit losses for investors and stakeholders if it added a more personal touch to resolving delinquencies and nonperforming loans. But it might cost the servicer $1 million in added expenses. The servicer sees none of the credit risk savings. Thus there is no economic incentive for the servicer to spend more time with borrowers in trouble.
The gargantuan scale of nonperforming loans offers a possible solution to the temptation of strategic defaults: a shift in the mortgage-servicing paradigm. The rise of the activist mortgage stakeholder/investor has beaten down servicer resistance to the sharing of loan information with special servicers, whose expertise is to turn bad loans into good performing ones.
More and more loan investors/stakeholders are seeking better loan workouts. The economics of special servicing and the benefits accrued by investors when a bad loan turns good is changing the industry's mentality toward assisting borrowers in need. By maximizing the loan's value for the stakeholder, a servicer also maximizes the number of borrowers who are able to avoid foreclosure and stay in their homes.
In the 20 years I've been involved with risk management in the mortgage industry, I've noticed that most borrowers who fall behind on their mortgages and those underwater want to stay in their homes. They've built up what I call "psychological equity" in their homes. The borrower's emotional attachment to their home — their possessions and family memories, their neighborhood, the local schools, community activities — should not be underestimated.
To mitigate losses and discourage strategic defaults, it's critical to encourage these borrowers to make sacrifices to avoid foreclosure, vesting the time and energy to show them the value of staying in their home, which also creates value for mortgage investors and stakeholders.