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What Exactly is a Strategic Default?

There is more and more conversation regarding strategic defaults. And that only makes sense since the number of borrowers deciding to take this path is increasing exponentially.

What is a strategic default?

Let’s first define strategic default in simple terms. According to Wikipedia:

A strategic default is the decision by a borrower to stop making payments (i.e. default) on a debt despite having the financial ability to make the payments.

This is particularly associated with residential and commercial mortgages, in which case it usually occurs after a substantial drop in the house’s price such that the debt owed is (considerably) greater than the value of the property – the property negative equity or “underwater” – and is expected to remain so for the foreseeable future, such as following the bursting of a real estate bubble. Such borrowers are called “walkaways.”

This definition itself help serves as the explanation as to why people will default.

Why do people strategically default?

There is a feeling which is growing among many borrowers that once their house falls in value so that it is no longer worth the amount of the mortgage(s) on the house, it might make sense to walk away from the obligation of paying the mortgage(s).

This way of thinking has been supported by many main stream players such as a law professor at the University of Arizona, the New York Times and the Wall Street Journal which said in a blog post that:

Whether we like it or not, walking away from debts is as American as apple pie.

Who are the people who choose this method?

Many are surprised to find out that all different types of borrowers have decided to walk away from what many feel is a moral obligation to pay your debts.

In a recent study, Amherst Securities reported that all categories of loans are being impacted. Here is a graph from that study:

Here is an explanation of the graph from a Reutersarticle on the subject:

The x-axis measures combined loan to value ratios (CLTV). In other words, combine the balance of all mortgages attached to a property (e.g.: a first mortgage + a home equity loan) and compare that to the property’s value. CLTV over 100% means more is owed on the house than it is worth. Yes, there’s a higher default rate for more poorly written mortgages (lower FICOs, low/no documentation), but even those that are well-underwritten (high FICOs and verified income) show spiking strategic defaults as equity goes negative. In other words, more folks who could pay their mortgage are choosing not to.

We can see that all categories of purchasers are picking this option as they fall deeper into negative equity.

How long will this practice of walking away last?

As long as housing prices continue to fall, there will be more and more families choosing this option. We are currently trapped in a vicious cycle which will continue to force people to make a decision. Below is a simple visual depicting the issue:

What does this mean to you?

It depends on whether you are a buyer or seller or if you are in a negative equity position or not. All we know for sure is that more people are deciding to walk.


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2 replies
  1. dg
    dg says:

    Walking in many cases is the best financial decision you will ever make in your life. For me it will probably save $1,000,000 over the course of my entire life. Run the numbers if you are thinking about it. Chances are if you paid $400,000 for a house in the mid 2000s it could save you a million to walk away.

    Reply

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