Debtors in today’s lukewarm economy are not always as they appear on paper.
Before 2008, before the economy collapsed, behavior patterns may have accurately predicted a debtor’s ability to pay. Creditors could rely on factors such as a good prior credit history and a judicious use of credit.
But these are no longer reliable indicators of how a debtor may behave, and certainly not when it comes to mortgage delinquencies.
With housing values still declining and expected to continue dragging the economy, more consumers who have been living in their homes just a few years are learning they are underwater - owing more on their homes than the properties are worth. An estimated 25% of homeowners in the U.S. are in this predicament, reports FICO, an analytics services provider.
The rising number of homeowners underwater has sparked a new trend, the so-called strategic defaulter – the debtor who has the money to pay the monthly mortgage, but elects not to because they believe it is in their best interest financially to default and, eventually, move.
Research by the University of Chicago’s Booth School of Business indicates that in September 2010, 35% of mortgage defaults were strategic, up from 26% in March 2009. The problem is likely to get worse. Home prices in the first quarter of 2011 were 32.7% lower across the U.S. than at their peak in the first quarter of 2006, according to credit bureau Experian.
What makes the strategic defaulter such a problem for risk managers and collection agencies is that until recently there was no reliable way to identify the debtors that are likely to become strategic defaulters. There are just so many variables involved in defining this demographic - including low to no down payment, geographic variance of housing values and economic or geopolitical conditions.
“Collection managers are not going to identify the strategic defaulter using a traditional scoring model, because strategic defaulters are not interested in lower payments or working out a repayment plan,” says Jeff Bernstein, an executive strategic consultant at Experian Decision Analytics, the firm’s global consulting arm. “The intent of the strategic defaulter is to walk away from their house, because in their mind no matter how much money they throw at the loan it will not solve their problem, which is they owe more than the house is worth.”
To help lenders and collectors understand the problem Minneapolis-based FICO Labs introduced a scoring model in April to identify debtors and borrowers at risk of becoming strategic defaulters.
As part of its research, FICO Labs found strategic defaulters tend to be savvier managers of their credit with higher FICO scores, lower revolving balances, fewer instances of exceeding limits on their credit cards and lower retail credit card usage—characteristics different from those displayed by a distressed debtor.
FICO Labs used credit bureau data and pooled master file data to build its model, as well as historical and forecasted property valuation data. The model analyzes consumer credit behavior patterns with dynamic real estate market factors, such as relative change in property value over time and velocity of change to predict the likelihood of a strategic default.
“Strategic defaults are a big issue for lenders and collectors because delinquent mortgage holders were one segment lenders felt they could justify spending money to work with because of their likely desire to stay in their home,” says Christine Pratt, a senior analyst at Boston-based Aite Group. “The scoring technology is certainly there to identify a strategic defaulter and having models to predict strategic defaults coming to market is a very positive development.”
Equally as troublesome for lenders is the inability to accurately identify the distressed borrower, who typically borrows from one lender to pay another. Their strategy of borrowing from Peter to pay Paul can often fool risk managers because all they see are timely payments, not an increasing debt load that is always shifting around.
Strategic debtors will take advantage of balance transfer offers, using the checks provided with the offer to pay bills or get cash at a low introductory interest rate to pay bills. They will use home equity lines of credit to pay bills, even their mortgage.
“There are a lot of telltale signs of distressed debtors that can be overlooked, such as the use of revolving credit in relation to cash flow,” says Experian’s Bernstein. “Lenders and collectors can’t rely on traditional behavior scores in these cases, because they don’t necessarily reflect the behavior of the distressed debtor that is creating the appearance he can pay.”
Instead, risk management experts recommend overlaying external behavioral data, such as credit bureau information about new lines of credit, balances transfers, etc. and census data that provides geodemographic insights into behavior patterns.
The goal of using public data in determining the level of distress a borrower may be under before they become severely delinquent is to find linear relationships between that data and the behavior of the account in question.
“There’s been an explosion of data sources and how they are used in the last three to five years,” says Bernstein. “What analysis of the data comes down to is spotting attributes that not only signal distress, but indicators that can suggest treatment strategies to triage the situation including how best to communicate with the debtor and the skill level of the agent needed to work the account.
“Scoring analytics today are more about determining the strategies to triage the debt and what resources are needed to carry out the strategy. They are becoming more closely linked to operations.”
