Feb.03, 2010 in Education, News
You heard it here first:
By the end of this year, “strategic default” will be a familiar media buzzword describing the next phase of the foreclosure crisis.
In a strategic default, mortgage borrowers who owe more than their house is worth, but who can afford their loan payment, decide it is simply smarter to stop paying. In 2009, 500,000 foreclosures, or roughly a quarter of all foreclosures, were strategic, meaning their was no financial hardship other than the homeowner was underwater. Currently there are about 16 million households with negative equity, and about 10 million of those are underwater by 20% of the value or more. The strategic foreclosures we saw in 2009 were just the tip of the iceberg. If just a small fraction of those underwater homeowners choose to strategically default, the effects will be tremendous.
strategic defaults
The Business Case for a Strategic Default
Let’s look at a typical scenario of a fictional Mr. Fish, an underwater homeowner who should consider a strategic default. He bought his home between 2004 and 2007, and lives somewhere like California, Florida, Nevada, or Arizona, where property values are down more 50% from their peak. He paid a full, bubble-inflated price for something that is now on clearance for half off, and he’s stuck paying the inflated price for 30 years. Should he move down the street for half price, or bend over and honor his mortgage contract?
In round numbers:
* $500,000 purchase price
* $400,000 loan balance
* $300,000 current market value
At 2.5% appreciation, it would take Mr. Fish 21 years to “break even” and re-coup his initial down payment. So much for the idea of a “starter home.” That 100 grand down is the definition of a sunk cost: it’s gone and shouldn’t be a factor in his decision. Plus, assuming any appreciation at all in the near term is foolishly optimistic, given the number of upcoming strategic defaults that will flood the foreclosure market.
Options
His monthly carrying costs are around $2800, including principal, interest, taxes, insurance, and any applicable homeowner’s association dues. He could rent a similar place for $1800 a month, and pocket the difference. This also rules out keeping the property as a rental, unless Mr. Fish wants to take a $1000 bath every month. He could also buy that similar place down the street, and end up paying about $1800 a month too. But in that case, he’d have to come up with another $60k down.
Breach of Contract
A mortgage is a contract between the homeowner/borrower and the bank. If the borrower breaches the contract by not making his monthly payment, the bank seizes the house. It’s written into the contract: the property is the collateral. Unfortunately for the bank, the house isn’t quite worth what they hoped it would be. Too bad so sad.
The laws may be different elsewhere, but in consumer-friendly states like California, that’s where it ends; the bank can’t come after any of Mr. Fish’s personal assets to settle the debt. If he’s lucky, he might get to live in the house rent-free for several months while the bank and the county finalize the foreclosure proceedings.
Reasons to Stay
There are three reasons Mr. Fish might feel compelled to stay in this house:
* Wanting to get back his down payment.
* Wanting to preserve his good credit score.
* Wanting to take the moral high road and honor his commitment.
Let me examine these reasons individually, and explain why they’re not good ones. First, as we learned above, it could take Mr. Fish 21 years to recoup his down payment. If he invested the $1000 savings each month he’d realize from walking away, and earned just 5% interest, he’d have nearly $450,000 at the end of the 21 years. If he just stuffed it under the mattress, he’d have $250,000. Yes, it’s painful to walk away from your $100,000, but at this point, it is simply irrational not to.
It’s true, a strategic default will hurt Mr. Fish’s credit. In most cases, the foreclosure will cost him 100-140 points on his credit score, and will stay on there for 3-7 years. Is it worth it? It’s just a number, and $1000 a month is a pretty steep price to pay to just for the sake of preserving a number.
Some people have moral qualms with strategic defaults, including President Obama (who obviously wants to encourage stability and stop the bleeding on the foreclosure crisis, but has yet to come up with a program that addresses strategic defaulters). Is it immoral to foreclose, even when you can afford the payments? Is it immoral to buy groceries at Trader Joe’s, even when you can afford the ones at Whole Foods? Others have asked what kind of example a strategic default sets for Mr. Fish’s children. I think it sets a great example in that it shows them the power of rational behavior. Mr. Fish’s tax dollars have bailed out his adjustable-rate neighbors and even the bank that holds his mortgage, yet he’s got nothing to show for it. Again, the mortgage is a legal contract with the penalties for breach explicitly spelled out. There’s nothing moral or immoral about it; he’s not stealing anything, not killing anyone, not polluting the river. It’s just business.
What will you do with your extra $1000 a month? Take a trip? Start a business? Change the world?
Five Things to Do Before You Strategically Default
1. Contact the bank and explain your situation. Explain how they could prevent the strategic default by renegotiating your loan principal balance, and how a foreclosure will certainly cost them more money in the long run. They probably won’t do anything, but at least you’ll be able to say you tried.
2. Consult a real estate attorney in your state to make sure the bank can’t come after your personal assets.
3. If you have a co-borrower, try and remove them from the mortgage. This might cost a little bit of money, since it will basically be a new loan application for just one person. But if you’re successful, the mortgage will show “closed” on your co-borrower’s credit so their credit score remains undamaged by the strategic default.
4. If you have a co-borrower, try and remove their name from the title. Just an extra step of precaution to try and preserve their good name.
5. If you plan on making any big purchases in the near future (car, boat, another house…), finalize the deal before you default.
And then stop paying. It tastes like freedom!
No comments:
Post a Comment