Lessons Learned from the Strategic Default Phenomenon

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Given how far the housing market has come since the foreclosure crisis, it's easy to forget how recently it was that "strategic default" was a top-of-mind concern in the mortgage industry.

The debate surrounding this phenomenon was fierce. The notion that borrowers who could afford their homes would rather walk away than be saddled with the debt of an underwater mortgage was so inconceivable that the industry's initial reaction was out of touch. Warnings about tarnished credit scores and the harm strategic defaulters cause to their neighborhoods fell on deaf ears when coming from the same banks blamed for far greater offenses.

Meanwhile, critics claimed the mortgage industry was holding borrowers to a double-standard, perhaps most notably in an Oct. 2010 episode of "The Daily Show," where the Mortgage Bankers Association was lambasted for the perceived hypocrisy of expecting consumers to remain current on their loans when itself walked away from the headquarters building it purchased at the height of the real estate bubble. The video, seen below, didn't pull any punches, going so far as to refer to then-MBA president and CEO John Courson as a "deadbeat dad."

Now that the fog has cleared and strategic defaults have declined in step with overall mortgage delinquencies, it's helpful to look back at this issue and what it means for the future of mortgage lending.

As the cover story of the February issue of NMN magazine explains, strategic defaulters who expected their credit to recover faster than their homes' value were wrong. Still, enough time has passed that strategic defaulters are now beginning to see their foreclosures come off their credit reports, positioning them to become homeowners again.

The timing couldn't be better. After years of refi-fueled origination volume, lenders have their hopes pegged to a resurgent purchase market in 2016 and beyond. But it raises the question: will strategic default rear its head again in the next downturn?

A 2013 study published in the Journal of Finance gauged consumer perceptions on strategic default in a series of surveys conducted over two years. It found some 82% of respondents said it was morally wrong to strategically default. However, the study also found that knowing someone who strategically defaulted increases the probability of declaring a willingness to strategically default themselves by 51%.

What's more, the study found that while consumer attitudes toward caps on executive compensation and greater regulation of financial institutions have softened over time, the rate of homeowners willing to strategically default, as well as those who believe strategic default is morally wrong, have held steady.

"Taken together, these results are consistent with the view that the decision to default is based not just on economic considerations, but also on ideological or emotional ones," the study concludes.

These observations suggest that despite the gamble of walking away not paying off for most homeowners, strategic default was not an anomaly of the Great Recession and the industry must account for this risk in the years ahead.

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