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Strategic Defaults: Naughty or Nice?

You can’t pick up a paper or turn on a television today without hearing about the foreclosure situation in this country. There is no doubt the current economy and unemployment numbers have devastated the finances of many families and thus made it impossible for them to pay their mortgage.

However, what many don’t realize is that there is a growing number of homeowners who can afford to pay their mortgage – but don’t! They wrote the check for the mortgage payment last month. However, when they sat down to write it this month, they decided not to. They could afford to, but refused to make one more payment.

This phenomena is know as a ‘strategic default’ and over 25% of the foreclosures today fall into this category. And that number is on the rise! Below is a graph showing the last several years. As has been reported, the 2009 numbers will show another dramatic increase.

Strategic Defaults

Why are more people walking away from the obligation they created when they agreed to take the mortgage?

The answer to that question seems to be aligned with two issues:

1.) Negative equity is making people question whether making payments on a depreciating asset makes sense.

Many people are beginning to look at their house solely as a financial investment and that investment is turning sour. They are questioning whether it any longer makes sense to make payments on an investment which continues to lose value.

An article in the Los Angeles times addresses this issue:

But research by three academics suggests that the willingness of people to default depends largely on just how far underwater they are. Or, as the study’s authors put it, “People default because of the size of their negative equity, not just because they cannot afford to pay.”

2.) People are questioning if there is an ethical, or moral, imperative to pay back a debt you have entered into.

The ‘stigma’ for not paying your debts isn’t as strong as it was even a decade ago. As more and more families are forced into foreclosure, it makes it easier for others to accept that fate.

Earlier this year, a research paper on homeowners with negative equity walking away, entitled Moral and Social Constraints to Strategic Default on Mortgages, stated:

We find that people who have been exposed more to defaults are more willing to strategically default. Holding morality constant, people who know someone who defaulted strategically are 82% more likely to declare their intention to do so.

Couple that with the fact that financial institutions such as Morgan Stanley are now walking away from their mortgage obligations on commercial properties, the moral imperative has almost become obsolete.

Not a decision without consequence.

A foreclosure stays on a consumer’s credit record for seven years and can send a credit score plunging by as much as 160 points . A lower credit score means auto and other loans are likely to come with much higher interest rates, and credit card issuers may charge more interest or refuse to issue a card.

What does that mean for housing in 2010?

I believe there will be a flood of distressed properties already coming to the market in 2010 which will put continued downward pressure on prices. Strategic defaults will just add to those numbers.

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  1. […] That is when a homeowner has the resources to pay the mortgage but decides not to. (I have posted on this […]

  2. […] This post was mentioned on Twitter by Florian Steciuch, Steve Harney. Steve Harney said: Strategic Defaults: Naughty or Nice? http://bit.ly/65le8a […]

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