Amy Crews Cutts is SVP and Chief Economist at Equifax. A recognized industry expert, Amy brings more than 17 years of economic analysis and policy development experience. She is responsible for analytics and research relating to the consumer wallet–assets, income, credit, and spending, along with macroeconomic factors affecting the consumer. She previously worked at Freddie Mac for 14 years, the last eight of which were spent as Deputy Chief Economist from 2003 to 2011. She has published numerous studies in academic journals and books on topics such as the economics of subprime lending and the impact of technology on foreclosure prevention. Amy recently spoke with DS News about strategic defaulters and their effect on the mortgage industry.
Who or what are strategic defaulters?
It is important to distinguish strategic defaulters from distress defaulters. There are borrowers who fit into the category of distress defaulters and then there are those who have the capacity to carry the mortgage but choose not to, and those are strategic defaulters. If you're a distress defaulter, you might have too little money to meet all your obligations, so you have to decide who you're going to let down. That can come from a major life event such as divorce, job loss, a serious health issue, or death. The pool of borrowers who have negative equity and suffer a major life event are trigger defaulters.
To distinguish between the distress defaults and strategic defaults, you have to consider the fact that nobody defaults, at least not all the way to foreclosure, if they have equity in their home. You can have someone who has plenty of equity in their home, but they have an economic setback like job loss or a health issue, and they can sell the house – but they can't sell the house before they go delinquent on the cash flow basis. Those borrowers might go 30, 60, or 90 days delinquent, and then the home sells and they don't go to foreclosure. If you have negative equity in your home and you're a distress defaulter, there's really no reason to even try to make that up because you simply can't make the cash flow work. Strategic defaulters have to have negative equity – they're not going to default if they have positive equity in their home. That just doesn't make sense.
The first study that came out on this was from our competitor, and their definition was based entirely on credit files. They looked at borrowers who were delinquent on their mortgages and they met all their other credit obligations – they weren't delinquent on their bank loans, they weren't delinquent on their credit cards, and everything else was fine. In my definition, we looked at a set of 1.7 million loans that were 60 days past due for the first time between June 2008 and June 2011. In order for someone to be defined as a strategic defaulter, they had to roll all the way out to 180 degrees delinquent. Then we did a match using two different samples of income data from Equifax. One was our payroll data and the other was a model of household income. After that, we ended up with 850,000 loans.
We started with that sample of 850,000 loans and applied the competitor's definition of paying all your other obligations. We found that roughly 20 percent of borrowers that first went 60 days delinquent met the competitors' definition of being delinquent on their mortgage but paying everything else. But we also wanted to know how many of those borrowers had negative equity. We looked at the total LTV ratio and that brought the sample down to 16 percent. So that means 16 percent of borrowers who were 60 days delinquent who paid all their other bills were also in a negative equity position. Then we said, "Wait a minute. . . you've got to have capacity to pay your bills." We started with the assumption that everybody had initially had the capacity to pay all their obligations. Then we looked for economic shocks from no income shock to a loss of income of up to 20 percent. When you consider borrowers who did not have a major economic setback, the range dropped from 16 percent down to between 7.7 and 11 percent of borrowers who were strategic defaulters. We strongly believe that strategic defaulters are a minority of all defaulters, and the combination of falling house prices, but more importantly the Great Recession and all the job losses that happened, led to most defaults that happened during the Great Recession being distress defaults.
What is the industry's perception of strategic defaulters?
It's not enough just to know that strategic defaults happen. The foreclosure laws by state might mean that you can't seek a deficiency judgment – or if you want a deficiency judgment, the process is so onerous and costly that it's just better for the lender to walk away and be done with it. So I think the industry's perception is 1) it's not what everybody's doing, and 2) even if we thought somebody was doing it and we had the proof, it would be very difficult to make that economically pay off, given how many state laws work for deficiency judgments.
What impact do strategic defaulters have on underwriters, investors, regulators, and servicers?
Servicers are under a lot of pressure to get borrower cooperation. If the borrower is a strategic defaulter, there is certainly not going to be any interest in participating in a workout, because they've walked away. So it can gum up the system in that sense. In other cases, where the borrower simply says, "Do whatever you need to, I'm done," it can speed up the process.
In terms of underwriters, investors, and regulators, I don't think anybody takes out a home loan with the intent of strategically defaulting. It doesn't really make economic sense. There are mortgages now that have an ability-to-repay criteria, so from that standpoint, I don't think it affects underwriters directly relating to strategic defaults.
I think for investors, the problem is not strategic defaulters so much, it's that across the board we lost the one thing that made home mortgages very unique relative to other lines of credit, and that was the stigma effect. Economists have written about this for 30 years. There were plenty of times when borrowers were very much in the money enough to walk away, and yet they fought to keep their homes. You might say, "This makes no sense. Home prices have fallen dramatically." If you're just looking at it from a business decision, they should walk away. But the embarrassment of having that foreclosure sign go up in front of your house and parading all your stuff out during the foreclosure was a reason why many people kept their homes. That, and if the home had some sort of intrinsic moral value to the family. What this financial crisis did was take away the stigma effect. Now you can default because it's "one of your options." There's nothing moral about it. You do what's best for you family, and if it's keeping your car loan, then you'll pay your car loan and default on your mortgage.
"I think for investors, the problem is not strategic defaulters so much, it's that across the board we lost the one thing that made home mortgages very unique relative to other lines of credit, and that was the stigma effect."
As far as regulators, there was some noise that came out of the CFPB and the FHFA about strategic defaulters, and it doesn't really matter what the federal regulators have to say about it when so much is really in the hands of the state legislators and their foreclosure procedures. Regulators were concerned that everybody was doing it because there was a lot of news about it, but I think the realization that we and they have come to is the economic distress and what do there and not so much the strategic defaulters.
The other thing I think is important about strategic defaulters is, for example, Florida is a judicial foreclosure state, and for a number of reasons there, the foreclosure timelines stretched out very long. A big part of that was that the courts were out of money and had to lay off staff. So in Florida, there was a long period where it was a thousand days or more between the due date of the last installment and when the foreclosure gavel would fall in the courts. For the record, strategic defaulting implies that these borrowers are "sticking it to the man." Default is a rational exercise - you look at your options and say, "What do I do? I get a thousand days of free rent and pay all my bills. Heck, I can even put that money in a savings account." And then I finally get evicted. The house isn't worth anything, because it's underwater. Now I have all this "rent money" that I've saved up. I could have even moved out into a new place and rented my old place to somebody and taken all that money. For those borrowers looking at that, it's a very rational decision. We did find that judicial foreclosure states had a higher incidence. We also found that in a neighborhood where there was a high preponderance of regular defaults or strategic defaults, we were much more likely to see strategic defaults. In that context, it's kind of like the stigma effect going away. "Everybody else around here is leaving, so I might as well leave, too."
Are strategic defaulters worried about their credit scores, or is that not a consideration?
They have a thousand days, which is almost three years. Let's suppose your mortgage payment is $2,000 a month. So every year you get $24,000. At the end of that three years you get to walk away with $72,000 that you saved by not paying that mortgage. I could say, "Your credit score is going to fall to 560," and he'll say, "I've got $72,000." In that context, the incentive there to strategically default was very high.
Editor's note: Click here to read a complete white paper on strategic defaulters by Amy Crews Cutts, Michael G. Bradley, and Wei Liu.