Strategic Default and Walk Away from that Albatross of a Mortgage – Strategic Default increased by 68 Times from 2005 to 2008 in California. The Economic Psychology of Walking Away and is a 200 Point Drop in Your Credit Score Worth Holding Onto a Property?
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As the stigma wears away and more Americans find themselves with unmanageable housing payments, many are making the conscious decision to walk away from their mortgage. What occurs in a walk away, as opposed to a standard foreclosure, is the borrower is making a business decision to stop making their housing payment. Now this compares to the millions of Americans who are losing their homes because they have no means of paying for their property. During this decade long housing bubble, we have seen trends and products that have no historical basis. We’ve never seen the volume of nothing down or low down payment mortgages flood the system. We’ve also never seen a time when massive numbers of Americans who have the means to pay for their mortgage suddenly decide that it is an economic move to simply stop paying on their loan.
Data on strategic defaults is hard to come by. The last nationwide data we have comes from a study published by Experian that looked at 24 million profiles and found the following:
In 2008 nationwide it was estimated that 588,000 people decided to strategically walk away from their property. This was double the number of 2007 and I would imagine that in 2009, when data is finally released we will see that the number has also increased. Part of the hold back is that many people still feel a social stigma regarding walking away. In reality, in law school they teach people that contracts are purely economic decisions. That is, if a contract states that if you stop paying the bank gets the home back then that is really all there is to it. Yet there is still a social stigma and recent research shows that people stay in their home for this reason. If people would simply run the numbers, it would be obvious that they should walk away.
There’s an interesting Podcast on Planet Money discussing this issue. An attorney that has been working with real estate since 2006 has seen both sides of the housing equation. Early on, she was seeing many people calling her up, emotional and agitated, trying to save their homes. Yet today the market is completely different:
“(NPR) We hear from Mary Kinsley, a lawyer in Phoenix who works at a legal help-line for people with real estate questions. She says her unit gets around 100 calls a day, almost all from people asking about foreclosure.
Mary says that starting last year, the questions changed dramatically. In 2007 and 2008, callers couldn’t pay their mortgages but wanted to Mary to help them find a way to keep their houses. Now most callers aren’t trying to avoid foreclosure, instead they want Mary to help them bring it on as fast as possible. It’s called strategic default, where the borrower owes so much more than the house is worth, that it makes more sense to just give the keys back to the bank.”
Yet how can you be emotional if 25% or even 50% of a block is in some state of foreclosure? At that point, and research backs this up, suddenly the stigma becomes less and with more people either facing foreclosure or walking away we can expect this trend to continue. I view this like divorce. The stigma of divorce was once enormous but now with it being a more acceptable fact of life, people simply live with it. And no one is saying divorce is easy and I doubt people that strategically default are actually proud and joyful about this choice either. But economically many people should walk away.
The attorney talks about a situation where someone calls up saying they have a $400,000 mortgage on a home that is now worth $200,000 to $300,000 (tops). They have $80,000 in the bank and want to buy a home on the street for a lower price and walk away from the property with minimal repercussions. In a state like Arizona, with anti-deficiency statutes people will only lose their purchase money and an approximate 200 points from their credit score. In many cases, this is enough to cause people to walk away.
And pulling up data from the previous study, most of these strategic defaults are occurring in states that are most underwater like California, Florida, Arizona, and Nevada:
In California from 2005 to 2008 strategic defaults have increased by a stunning 68 times. This in comparison to a factor of 9 for nationwide strategic defaults. Why is that? Because these states are more underwater and also have loans that go well with strategic defaults like option ARMs that are heavily concentrated in the state. Some data tells us that a crossing point is made when a home hits 20 or 30 percent of negative equity (i.e., a $100,000 home is now valued at $70,000). At this point, strategic default makes a lot of sense and looks appealing. In California where the median price is still down by nearly 50 percent many people find themselves in this precarious situation:
Source: Forbes.com
Just look at the above data. These areas rank highest in the country with foreclosure rates but I would also imagine, some of the highest strategic default rates. And it is hard to say if the data captures everyone. After all, the only way we can find out if someone is strategically defaulting is if they admit it. The latest survey gives us a peak but how many opted not to respond? That is, how many knew they were going to do it but still felt some stigma associated with strategic default? I would imagine many said they would keep paying and simply stopped. Theses still show up as foreclosures and get clustered in with other foreclosure data. Unlike divorce, a strategic default looks like a foreclosure, there is no monthly data to track this.
What we also hear from the attorney is that before, the foreclosure process would occur in a more streamlined fashion. After 3 missed payments, you would receive a notice of default. Miss 3 more payments and the house gets scheduled for auction. A few months later the home is taken over. Now, many people are living 6, 9, and even 12 months with no payment before the bank makes any move. In their view, they rather not pay the taxes or upkeep on the place so there is no need to rush. It is the case that banks have a full plate of work to do so this might make sense but again distorts the data.
So as many areas still find many underwater homeowners, we can imagine that this strategic default trend will continue. If your neighbors did it maybe it isn’t such a bad thing. Banks are horrified at this trend but then again, they are doing their own strategic defaults on major commercial real estate properties. Do as I say, not as I do.
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