Strategic default represents a new phenomenon with potentially far-reaching ramifications. In the mortgage industry, the emphasis in Loss Mitigation for quite some time has been on aiding the struggling delinquent borrower, the one who lost his job and/or saw the value of his home drop significantly. While the government and mortgage lenders have been focusing on hardship situations, trying to help borrowers either stay in their homes with a range of modification options or, if necessary, liquidate by way of short sale or foreclosure, another group of borrowers has been making its own decisions independently and concluding it is in their best interest not to pay the mortgage.
These are not delinquent customers who are hard-pressed to pay; often, they have been the best customers and, while they still have the ability to pay, several factors have contributed to their decision to stop:
- Falling home prices – Renting has become a more attractive option, as property ownership in many areas is no longer an attractive investment.
- Quality of life – Strategic defaulters are finding more home to rent for a fraction of the former mortgage payment. Spending less on housing gives the borrower more to spend elsewhere, either making it easier to pay other bills, or making other things affordable that weren’t before.
- Impact on credit score – There is less stigma associated with poor credit due to the high levels of unemployment/underemployment; companies in other industries, e.g., auto lending, are re-evaluating their credit criteria to account for mortgage delinquencies due to pending modifications or other arrangements.
The strategic default scenario creates one of the toughest situations for mortgage servicers. Key questions to ask are: 1) How can you identify potential strategic defaulters?, and 2) What can you do to compel them to stay with you, without giving away the store?
Servicers have the information, buckets of it, at their fingertips. No one has been immune from strategic default, which means there is a great deal of data to mine. Ask questions about these borrowers –Were there more in particular geographic areas of the country where property values have fallen more sharply?, Did they change their payment behavior before ceasing to pay altogether? – and test the answers, look for similar attributes, in the non-delinquent portfolio population.
After identifying borrowers who may be at risk of flight, lenders start a tightrope walk, balancing a friendly call to keep in touch, on one hand, with an offer of some form of financial assistance to make the idea of sticking with the mortgage more palatable, on the other hand. Champion/Challenger testing can determine which strategies produce better “stick” rates and how much they cost the bottom line. Which way the balance tips, and how can be saved by granting concessions and keeping the borrower, versus how much may be lost by offering deals to borrowers who would not have defaulted, is anyone’s guess. The data lenders already have and the way they analyze, test, and use it, makes all the difference.
As far as the potential ramifications, when borrowers strategically default on a mortgage in favor of a lower rental expense, then, by default (no pun intended), they have more money available for their other monthly obligations. This may actually be, in a perverse way, good news for the other creditors, namely, auto finance and credit card companies. There still remains, however, a decision to be made by the mortgage lender as to whether or not to pursue the borrower for the deficiency when the property is ultimately sold for less than the outstanding mortgage balance. After all, this borrower did not default due to a hardship situation created by unemployment, illness, or other unfortunate events. This borrower can afford to pay. Aside from the credit bureau impact, which has already been disregarded by the strategic defaulter, there is little reason to believe a borrower would be inclined to pay after moving if he didn’t pay while living in the home.
Kathy Castle is a Director at Auriemma Consulting Group, responsible for managing several Industry Roundtables in the mortgage, auto lending, and credit card industries. She has a background in operations and risk management from major financial institutions, and plays a key role in consulting engagements. For more information, contact Kathy.Castle@acg.net.
About Auriemma Consulting Group
Auriemma Consulting Group (ACG) is a full-service management consulting firm serving the payments and lending industries since 1984. With offices in New York and London, ACG consultants are experienced practitioners, drawn from the credit card, private label, auto finance, mortgage, and retail banking industries that we serve.