A morality deficit? what is motivating a growing number of Americans to "strategically" default?
Kessler has plenty of company these days, and the likelihood of more to come. That's increasingly worrisome to industry insiders.
University of Chicago studies in 2009 and 2010 estimated that 35 percent of defaults are strategic. Minneapolis-based FICO estimates that these defaults pose a $20 billion problem annually.
First notices of default increased 33 percent in August 2011, according to FICO. And the firm's survey of risk managers predicted the housing market would remain weak until 2020. The estimated 6 million homeowners with current loan-to-value (LTV) ratios of 120 percent or more are considered twice as likely to default; according to FICO.
But there's more to the story about strategic defaulters than sheer numbers. It's about homeowners making cold, calculated decisions in what they perceive as their best interests--more akin to boardroom strategies--and the psychology and social influences behind their thinking.
They are armed with studies and testimonies and reports of lender bailouts, servicer conflicts, mortgage fraud and robo-signing scandals, national investigations by attorneys general and examples of huge commercial owners who walk away from underwater mortgages.
And because they are likely to increase in numbers, these defaulters have spurred a cottage industry with a growing number of industry predictions; analyses and software programs geared at quantifying and predicting their behavior.
Servicers who see moral hazard in doing principal reduction, or who are prevented from doing so by investor policies, are scrambling to figure out what to do with this breed of borrowers who look at the mortgage contract as a piece of paper signed in better times when home values were rising.
Understanding the behavior starts with determining who these default strategists are.
For certain, as defaulters go, they are a different breed. They aren't necessarily excited about giving up the house. But they aren't panicked, either.
Yes, there's distress when a home purchased for $760,000 is now valued at $200,000 and the mortgage is $500,000--but the borrower can afford to keep paying it.
That's different from a homeowner who lost his or her job and stops paying the mortgage because it happens to be the biggest bill. But the homeowner continues to pay other debts.
"They still use the credit card for groceries and the car for job-hunting," says Mark Fleming, chief economist for CoreLogic, Santa Ana, California. "I classify that individual as rational. They aren't immorally strategically defaulting."
The more troublesome strategic defaulters are those who walk away despite being able to pay their mortgage. They also pay their car loans and credit cards.
These strategic defaulters typically have higher credit scores that edge close to 800. And some even take out other credit lines before stopping the mortgage payment, knowing that their FICO[R] score will drop after the default, says Joanne Gaskin, FICO's director of product management global scoring.
"They are getting their house in order," as she puts it.
And about 40 percent of defaults on jumbo loans for more than $500,000 appear to be strategic.
"This doesn't happen by accident. They are not distressed borrowers," Gaskin says.
Yet some think they actually are--but in another way, according to Susan Herman, mortgage banker with First Equity Mortgage Bankers Inc. (FEMBi Mortgage), Miami.
The jumbo-loan market has the biggest possibility of strategic defaults because underwater homeowners have less relief being offered them, says Herman, former president of the Mortgage Bankers Association of Florida's South Florida chapter.
"There are these expensive homes and condos, many of them with adjustable rate mortgages on them, that have de-valued greatly, and many of those owners are self-employed and have seen declining income," she says.
The owners may still have good credit, but they are the riskiest group for lenders because the mortgage default is considered a business decision.
"To them, this is just another asset that they have leveraged. When those clients talk to me about a mortgage, they talk about it as a financial instrument," Herman says.
Declining property values
There's real fear that this kind of thinking will increase if property values continue to drop.
A Fiserv Case-Shiller report released in November indicated single-family home prices dropped almost 6 percent during the second quarter of 2011 over the same period a year earlier. Prices dropped in 340 of 384 markets, with 302 of those areas hitting new lows.
For states that saw the most overheated markets and the most foreclosures--California, Florida, Nevada and Arizona--Brookfield, Wisconsin based Fiserv Inc. reported double-digit price decreases: Las Vegas, 16 percent; Miami, 13.5 percent; Riverside, California, 15 percent; and Phoenix, 10 percent.
Fiserv predicts another 3.9 percent drop nationwide by the second quarter of 2012, and then a rise of 2.4 percent by the same period in 2013.
"The two biggest predictors of defaults are home prices and unemployment," says David Stiff, Fiserv's chief housing industry economist. "So the fact that we're in a second dip is worrisome."
For homeowners to consider strategic defaults, their negative equity has to exceed the cost of the default, he says. That cost includes moving, replacing the primary residence and lower credit ratings.
But what the neighbors will think is one thing less to consider, it seems. Like most things, the decision to walk away becomes more socially acceptable as more people do it.
Just as divorces and bankruptcies became more common and lost much of the shame once associated with them, so will foreclosures and walk-aways as more people do them, says Don Calcaterra Jr., CMB, AMP, president of Troy, Michigan-based Towne Mortgage Co.
AmeriCU Credit Union, Rome, New York, the credit union morlgage servicer on Kessler's mortgage, is a division of Towne. Calcaterra declined to discuss Kesslers situation specifically, saying only, "We could tell he had been coached."
A study or social networks' influence on strategic defaults, released in November and sponsored by the Mortgage Bankers Association's (MBA's) Research Institute for Housing America (RIHA), describes the influence of real estate experts, called "mavens," on strategic defaulters and the subsequent effect on housing markets.
"In fragile markets, advice by influential mavens can result in a flood of strategic defaults, causing a contagious downward spiral of home prices and potentially a market collapse," states the study, Strategic Default in the Context of a Social Network: An Epidemiological Approach. The report won the Virginia Governors Technology Award for 2011 in the category of cross-boundary collaboration in modeling and simulation.
There's no mention of specific "mavens." But YouWalkAway Chief Executive Officer Jon Maddux says his five-year-old firm's strategic default business has increased 70 percent, particularly after an interview on CBS' 60 Minutes last year. The company's website also boasts coverage by ABCs Good Morning America, NBCs Today show and other media outlets.
"It's hard to trust [lenders'] incentives," Maddux maintains of the attraction some borrowers have to his company. "Will you get unbiased advice? We've always said this is an option--that it's not your first option and you should try to work it out with your lender." People come to YouWalkAway because the process is a mess, he says.
Another maven, financial guru Suze Orman, writes in her book The Money Class: Learn to Create Your New American Dream that she understands the rationale of walking away when mortgages are 50 percent or more underwater.
She does, though, counsel that mortgages are contractual obligations. She doesn't condone walking away when homeowners are 5 percent, 10 percent or even 20 percent underwater and can afford the mortgage. Even marginally underwater owners who can afford the mortgage should consider the home's value to the family and realize that values will rebound, though it could take 10 years, she writes.
Credit score shame?
The social influence that is more accepting of the practice of strategic default also extends to borrowers' decreasing concern about the effect of defaults on credit scores and the ability to get future loans.
FICO's Gaskin says that a strategic default can drop a borrower's credit score from 780 to 620-640, providing other trade lines remain the same. If those other lines remain constant, the score could begin to improve within 24 months after the default, she says.
Consumers' payment history is 35 percent of their F1CO score. The numbers of past-due days and delinquent frequencies are considered, she says. So if there are no other delinquencies, the impact of the mortgage default diminishes over time.
The FICO score also considers how leveraged a borrower is--how much the borrower owes compared with his or her credit availability. Seeking new credit lines also will lower a score.
As for defaulters' ability to get future mortgages, Fannie Mae's directive last year requires a seven-year waiting period for Fannie-backed loans if borrowers had the ability to pay their previous mortgage but walked away instead.
Other borrowers who faced extenuating circum-stances, such as divorce or unemployment, and did deeds-in-lieu or short sales, will have to wait less--especially if they put down bigger deposits.
Borrowers seeking Federal Housing Administration (FHA) loans will wait three years after a pre-foreclosure sale, deed-in-lieu or foreclosure. But FHA hasn't had as much difficulty with strategic defaults. Most of its borrowers go into foreclosure because of unemployment or underemployment, says Lemar Wooley, public affairs specialist with FHA.
Will loan originators be able to identify a former strategic defaulter? Foreclosures or other mortgage-related problems will appear for seven years on a credit report, says FEMBi Mortgage's Herman.
"They will always need to explain this for as long as it is on the report, so they will need to 'fess up," she says.
A 2010 study, Underwater and Not Walking Away: Shame, Fear and the Social Management of the Housing Crisis, by Brent White, law professor at the University of Arizona's James E. Rogers College of Law, Tucson, Arizona, contends that homeowners are made to feel morally obligated to keep paying an underwater mortgage even when it's in their best interest to walk away.
White is another commentator who focuses on the moral obligation but gives short shrift to borrowers' legal obligation to pay back their mortgage--no matter where home prices may be heading. White argues that owners of commercial real estate--generally corporations whose legal duty to shareholders includes maximizing profits and minimizing losses--walk away from underwater mortgages.
White cites the much-publicized default by New York-based Morgan Stanley on five properties in San Francisco. This notion of if-business-can-do-it-so-can-I has gained a lot of traction among strategic defaulters.
But commercial deals aren't structured like residential loans. Transactions often are done through limited liability companies (LLCs)--single-purpose entities set up to own just that one piece of real estate. The principal of that LLC may or may not guarantee the loan, depending on how the deal is put together, says real estate attorney George Pincus, shareholder in Stearns, Weaver, Miller, Weissler, Alhadeff & Sitterson PA's Fort Lauderdale, Florida, office.
The LLC that borrowed money only owned that one asset, which collateralized the loan, says Pincus, a former national director of Herndon, Virginia-based NAIOP, the Commercial Real Estate Development Association, as well as former president of the group's South Florida and Florida chapters.
"The difference in the commercial world is that it isn't George and Julia defaulting, it's the [limited liability company]. And George, who owns the LLC, is not liable," Pincus says.
The moral issue
But is a strategic default actually a moral issue?
Absolutely, says Luigi Zingales; professor of entrepreneurship and finance, and faculty fellow at the University of Chicago Booth School of Business, who has coauthored two studies on the moral hazards of these types of defaults.
And the more that people walk away, the more communities can slide into blocks of abandoned homes that further depress prices, That makes future mortgages more costly and credit access less likely, he wrote in a 2010 article.
Companies like YouWalkAway do a disservice to borrowers and communities because defaults leave a string of empty houses that invite crime and help reduce property values even more, says Joe Dombrowski, chief mortgage strategist at Fiserv.
A lack of strong negative consequences to defaults--such as deficiency judgments even in recourse states--helps lower traditional [moral] barriers to defaults, he says.
"Unless there is a huge campaign to save the community and be a team player--and that's a campaign I haven't seen yet--people will look at values dropping and say, 'I can't afford lo live here anymore,'" says Dombrowski.
On the other hand, financial consultant John Tuccillo of JTA Inc., Arlington, Virginia, doesn't believe making a decision to default or not is a question of moral obligation.
"The thinking is that strategic defaulters are bad people, that they are morally reprehensible," says Tuccillo, former economist for the National Association of Realtors[R] (NAR), Chicago.
"The key word is 'strategic.' It's a contractual obligation. There is no moral obligation. The moral obligation is to self or family," he says.
"I think these are individual decisions. My view of the world is that if you are in a position to pay your mort-gage and your home is underwater, it is shortsighted to do a strategic default," Tuccillo says.
The more profitable strategy, he says, is to wait out the market while paying down the principal.
Advice for servicers
So what can servicers do differently to stop the strategizing?
"That's the $65,000 question," Fiserv's Dombrowski says.
First, determine the borrower's circumstances.
"There are people who are pushed into the strategic-default category only because they haven't been offered sufficient alternatives," he says. "They aren't sitting there thinking that it's the best financial decision, and the bank be damned."
That can be at least partly determined by tracking payment of their mortgage and other trade lines, Dombrowski says.
"Early and often are my watchwords," he advises. "If I'm always paying on the first of the month and f start paying more toward the middle and pushing the grace period, that's a reach-out indicator. A wise servicer will dedicate resources to that."
If the mortgage payment is 30 days delinquent but other credit is current, "they are headed to become a strategic defaulter/' he says. "That's the time to have that 'defaulting is a bad decision and here's why' discussion."
Late last year, FICO announced that four of the top servicers were working with its "predictive analytics" program to determine borrowers at risk of strategic defaults. Servicers submit borrower and loan information, and the program considers credit bureau data and uses an automated valuation model (AVM) to evaluate home-sale prices and current and predicted values.
Gaskin, who declined to identify the servicers, says the program also can differentiate among borrowers.
"We didn't want to capture someone who is distressed and defaults on the mortgage first because it's their biggest payment," she says.
CoreLogic's Fleming says his firm is involved in a study that incorporates what he calls "income shock" to determine default risks. Wage data about layoff's and other income losses will help differentiate between "rational" and strategic defaulters, he says.
Servicers need the help, Dombrowski says.
"Historically, servicing is a profit-margin business, and you have to take a cookie-cutter approach to make any money," he says.
That generally relies on quick turnarounds with streamlined staffing. In fact, the latest Fannie Mae and Freddie Mac guidelines for servicers dealing with struggling borrowers emphasize speed.
Issued in October 2011, the guidelines offer monetary incentives and penalties for servicers that do or don't meet agency-imposed deadlines in resolving defaults or pending defaults.
"It will be clear which borrowers want servicers' early assistance, and the servicers are incented to reach them early and will incur penalties if they don't says A my Bonitatibus, Fannie Mae's senior media relations manager.
A business boon
Like the cottage industry that has sprung up to handle short sales, third-party special servicers and other loss mitigators have gained a foothold in the business of strategic defaults.
At Wingspan Portfolio Advisors, Carrollton, Texas, President Steven Horne believes servicers are inaccurately labeling borrowers as strategic defaulters simply because they are unable to help them on a timely basis.
"One thing that leaps out [at] me in interviewing borrowers is that they felt they were justified [in defaulting] because the banks had breached their social contract by ignoring them or not giving them a reasonable alternative," he says.
As a special servicer, Horne says it's essential to understand the borrowers' situation.
"We have to reinforce that social contract, that 'we will do what's right for you and you should do what's right for us,'" says Horne, former director of servicing risk strategy at Fannie Mae.
Despite some beliefs that a mortgage 90 days or more in default is beyond recovery Horne says Wingspan has customers who are delinquent 18 months or more. And they are talking about keeping their mortgage and home.
"That's for two reasons: Borrowers have had time to get back up on their feet, and they are seeing the day when they may lose their home," he says.
Wingspan, in turn, uses third-party loss mitigators like Santa Barbara, California-based Equi-Trax Asset Solutions LP to determine property values and occupancy, visit borrowers and deliver documents.
The "high-touch" approach is crucial, says Guy Taylor, Equi-Trax's chief executive officer.
"It's really the ability to break down what barriers there are, and issues the borrower has, that are income and job-related, and personal situations that would allow [our customers] to salvage the deal through modifications, short sales or some other solution/' he says. "The big piece of this is that big servicers don't have the personnel for a high-touch approach."
To reduce or not?
Despite all the hoopla in November about the revamped Home Affordable Refinance Program (HARP), it wasn't yet clear at deadline for this article how individual lenders would underwrite the new HARP refis.
The program's intent is to offer refinancing options to underwater borrowers or those with little equity. But they must be current on their mortgage, and have no more than one 30-day-late payment in the prior 12 months--and none in the six months prior to their application. The earlier HARP 125 percent LTV cap was removed--a big perk, especially for jumbo-loan borrowers--and lenders' liability for defaults has now been limited.
In a written statement, Fort Washington, Pennsylvania-based GMAC Mortgage, the mortgage origination and servicing operation of Detroit-based Ally Financial Inc., says it intends to adopt the new HARP "enhancements."
"We anticipate HARP will now be able to help a broader group of borrowers, especially homeowners living in areas where home values have dropped significantly, preventing them from getting assistance in the past," the company states.
But HARP is a refinancing plan. When it really comes down to preventing strategic defaults, the elephant in the room is mortgage principal reduction.
"Unless a lender is willing to write down the principal so that the value and mortgage are comparable, you won't have a systematic deterrent to strategic defaults," maintains consultant Tuccillo.
Reductions could restore equity and lower mortgage payments, allowing homeowners to better weather other financial setbacks--including further declines in property values, the thinking goes.
"If you're got borrowers who are 60 percent underwater, a principal reduction has to be on the table or the borrower isn't going to make it," says Bob Dorsa, president of the American Credit Union Mortgage Association (ACUMA), Las Vegas.
But lenders and servicers today do most of their business with Fannie Mae, Freddie Mac and FHA--and they don't participate in principal-reduction programs.
"We think we can achieve the goal of reducing the monthly payment for struggling homeowners to an affordable, sustainable level through our existing modification tools, including term extension, rate reduction and principal forbearance, without having to reduce principal," says Fannie Mae's Bonitatibus.
That leaves servicers able to reduce the principal only on loans they own or service for private investors if contracts allow that.
O'Fallon, Missouri-based CitiMortgage Inc. will reduce the mortgage principal on a case-by-case basis on its own loans, says President and Chief Executive Officer Sanjiv Das in a written statement.
Wells Fargo Home Mortgage, Des Moines, Iowa, led the industry from January 2009 through September 2011 with $4 billion in principal forgiveness, says Tom Goyda, vice president of corporate Communications. Like Citi, Wells' reductions are done on a case-by-case basis.
Towne Mortgage's Calcaterra isn't alone when he raises the issue of social influence on principal reduction. Industrywide, a key concern about principal reductions is their "moral hazard." Will borrowers who see their neighbors get reductions also go into default?
"I think it's a slippery slope," he says. "If the only way to reduce principal is if they are past due, you'll have everyone going past due."
But the University of Chicago law professor Zingales proposes a solution: shared-appreciation mortgages.
Mortgages would reset at current home values. In exchange, lenders would get 50 percent of future appreciation. And to keep owners from doing only minimal upkeep because they won't share fully in the price increase, the appreciation would be based on an average of area sales prices.
Laurie Goodman, senior managing director at residential mortgage-backed securities (MBS) trader Amherst Securities Group LP, New York, who coauthored a study titled The Case for Principal Reductions last year, says if lenders created enough "frictions," only those borrowers who really needed principal reductions would get them.
In an email, she offers an example of a borrower likely to default with a 150 loan-to-value ratio. The borrower could get, say, a reduction to 115 LTV and the lender will get 50 percent of the upside. The borrower will think this is a great deal. But his neighbor at 120 LTV won't try to get that reduction because he is giving away the upside for only a 5 LTV reduction, Goodman says.
"There are ways of combating moral hazard," she says. "But we have to recognize that the borrower is making an economic decision and provide the right set of incentives to do so."
And that's called strategy.
Terry Sheridan is a North Conway, New Hampshire-based freelance writer who has covered real estate and mortgage finance for 20 years. She can be reached at firstname.lastname@example.org.
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|Title Annotation:||Default Servicing|
|Comment:||A morality deficit? what is motivating a growing number of Americans to "strategically" default?(Default Servicing)|
|Date:||Jan 1, 2012|
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