Walking Away From Mortgages Can Be Costly

by 04 Dec 2012

Strategic default, the questionable practice of walking away from a mortgage that no longer makes economic sense from an equity point of view, would be an acceptable option to 68 million Americans. That’s 32 percent of those old enough to carry a mortgage in the United States, according to a recent survey by California-based ID Analytics.

The results from the ID Analytics survey are troubling because of the sheer number of borrowers who are underwater in their mortgages: 14 million, according to real estate website Zillow. That means that the total amount of negative equity in the U.S. is approximately one trillion dollars. Most borrowers who actually go through with a strategic default, however, are able to continue making monthly payments on their mortgage. The decision is tactical, and it is bolstered by statutes in states like California where non-judicial foreclosures are customary and the lender is not allowed to pursue deficiency judgments. 

The Problem with Strategic Defaults

Former Major League Baseball star Jose Canseco and renowned Hollywood actor Nicholas Cage are two of the most famous personalities who made headlines when they walked away from mortgages they owed on luxury properties that lost value after the collapse of the housing market.

It could be argued that there is no harm done in these cases; after all, the mortgage lenders took risks on loans that no investor like Fannie Mae or Freddie Mac could guarantee. Mortgages are contracts of equity in which the lender takes possession of the property in case when the borrower defaults. When this happens in states where mortgage lenders are barred from seeking a deficiency judgment by statute, it is difficult to sympathize with the lender. 

There is a problem, however, with strategic defaults in those states where laws prevent lenders from going after borrowers who choose to simply walk away from their financial obligations. Banks analyze these losses and figure out what they need to do to lower their exposure to risk. That often results in tighter lending requirements such as higher down payments, stricter loan-to-value ratios and mortgage provisions that offset the risk they undertake.

Strategic defaults have the potential to shape the future of mortgage lending in a way that impacts borrowers negatively. Should more of the 68 million Americans who are willing to walk away from their mortgages do so in the near future, banks will react accordingly and the rest of the borrowers will end up paying for these irrational reactions in the end.

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