With tougher mortgage underwriting rules a virtual certainty under Congress’ new financial reform legislation, lenders have begun confronting still another vexing issue: Can home buyers who have high credit scores really be trusted not to pull the plug — strategically default — when the economy hits a rough patch and home values tank?
New research based on data from 25 million active consumer credit files suggests that the answer might be no. Though people with the highest credit scores are less likely to default compared with people with lower scores, when they do default they are much more likely to do it strategically — that is, simply stop paying with little or no warning.
In a study released June 28, researchers from credit bureau Experian and the Oliver Wyman consulting firm found that borrowers with “super prime” credit scores accounted for 30% of all mortgages outstanding in mid-2009 and produced just 5% of all serious mortgage delinquencies.
However, 28% of those elite scorers’ defaults were calculated and strategic, compared with 18% for the overall population in the statistical sample. This pattern is forcing lenders and the credit industry to seek new ways to evaluate risk beyond traditional credit scores.
The June study, which follows up on earlier research involving credit files where consumers’ personal identifiers had been removed, tracked strategic defaulters in 2009. By examining payment patterns in individual credit files, Experian and Oliver Wyman estimate that about 19% of all mortgage defaults last year involved strategic walkaways.
Though there was some evidence that total defaults may have peaked at the end of 2008, the walkaway issue remains a costly and controversial one for the mortgage industry. Fannie Mae announced in late June that strategic defaults have become such a problem that it was toughening its policy and would pursue walkaways for unpaid balances and penalties where permitted by state law.
The Experian-Oliver Wyman study confirmed that geography played a significant role in the strategic default phenomenon. Homeowners in volatile boom-and-bust states such as California and Florida have been especially prone to walk away from deeply negative equity situations.
A separate study by three researchers at the Federal Reserve found that not only is geography crucial, but state law treatment of unpaid mortgage debt balances after a walkaway may play a major role as well. The Fed study examined 133,281 loan histories from Arizona, California, Florida and Nevada where borrowers were underwater on their loans.
According to the researchers, in California and Arizona, where state law limits lenders’ ability to collect post-foreclosure deficiencies on principal residence mortgages, borrowers were more likely to walk away from their houses at lower levels of negative equity compared with borrowers in states such as Florida and Nevada, where lenders face fewer restrictions.
“This result suggests,” the Fed study said, “that borrowers may factor into the costs of default the potential legal liabilities resulting from a foreclosure.”
The Fed researchers concluded that the depth of borrowers’ negative equity positions is an important tripwire to their decision to send back the keys. Borrowers whose negative equity is relatively modest appear to be much less willing to strategically default, probably because they hold out hope that market conditions will improve enough to restore them to positive equity one day.
But as negative equity approaches 50% — and borrowers see no prospects for higher real estate values — roughly half of all mortgage defaults are strategic.
The Fed researchers cited a hypothetical case from Palmdale to illustrate the economic logic of strategic defaulters: Purchasers there in 2006 paid $375,000 for a median-priced single-family home. By 2009, the same house was worth less than $200,000. Meanwhile, a three- to four-bedroom house in Palmdale rented for $1,300 a month at the end of 2009 — far less than what the deeply underwater borrowers were paying for their homes.
Why stay in a seemingly hopeless situation, bleeding money indefinitely? Both studies document that many borrowers asked themselves that very question — and decided to just stop paying.
Distributed by Washington Post Writers Group.