Strategic Default of Mortgages

Throughout the current housing crisis, most of the negative economic data has been clumped into one large group.  That is, housing has been a nationwide problem and job losses have impacted virtually every state.  Yet there is a coming crisis that has its targets on very specific states.  In fact, many states will not even feel the repercussions of this new economic problem.  The issue is that of strategic defaults.  Most Americans have not heard of this term but they will know this intimately like they learned about subprime loans or interest only loans.

A strategic default occurs when a homeowner stops paying their mortgage even though they are still financially able to do so.  A recent study shows why this problem will impact mega-housing bubble states like California more than other states.  You will also find that many people that walkaway from these products have stellar credit scores.  So why would someone strategically decide to leave their mortgage?  The reasons are many but first let us look at the distribution of late Alt-A loans in the country:

Now why focus on Alt-A loans?  Under this category of loans we will find most Interest Only and option ARM products.  These are loans most at risk for a strategic default.  In many cases for example option ARM loans were given to people with good credit but simply did not have the income to back up the purchase of a home.  In these situations you would see a family with good credit and a household income of $100,000 taking on a $700,000 mortgage in California.  With a teaser payment, the family could pull this off.  But when the recast of the payment occurs the family will default especially given the crash in housing values in California.

Let us examine a few reasons why and how people strategically default.  A recent study may surprise you.  This study examined 24 million credit files and gives us a good view of the overall situation:

“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.”

This number is enormous and we can expect this number to rise.  Why?  Many of the interest only and option ARM products will start hitting recast dates in 2010 to 2012 that will severely impact borrower's monthly payment.  Many of these loans are far below the current loan modification program caps of being underwater at a ratio of 125 percent or higher.  In some case, some of these loans have 150 to 200 percent LTV ratios.  That is, someone might have a $600,000 mortgage on a home worth $300,000.

“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.”

This is probably one ...