Remember this guy? David Walker of the Peterson Institute gets nostalgic about debtors prisons for strategic defaulters.
There is a norm asymmetry being ruthlessly exploited between how people and businesses view debt. Strategic default is not a phenomenon in any empirical data, but it is a boogeyman that needs to be ruthlessly pounded on before people realize that bankruptcy is something they pay for in their mortgages, and it is their ultimate safeguard against abusive practices. It’s telling to watch financial elites freak out about the prospect of strategic defaults waves, even as they don’t happen. It shows what really worries them about the state of the economy, about where they may not have control.
A Multi-Year Foreclosure Pipeline Slowdown Slows Down More
Cardiff Garcia has a post outlining the the economic impact of the foreclosure slowdown. I want to show this dated graph, where you can see that the foreclosure slowdown has been happening for a while now:
(Source.) The foreclosure slowdown is some mix of book valuation statistical juking (the banks don’t want to mark down the property and take the loss, and perhaps the property of the neighboring properties), pipeline limitations and a collapse of the new, ‘thin’ servicing model used by the largest banks. The foreclosure slowdown will likely increase as the result of servicing fraud, recordkeeping errors and the irresponsible practices for assembling mortgage-backed securities coming to light in the courts.
Garcia points us to recent remarks by Joseph S. Tracy, Executive Vice President of the Federal Reserve Bank of New York, at the Connecticut Business and Industry Association/MetroHartford Alliance Economic Summit and Outlook. Tracy has a specific worry about the foreclosure slowdown (my bold):
The combination of declining house prices and increasing delays in the foreclosure process will put upward pressure on default rates as well as losses on defaulted mortgages. CoreLogic estimates that in the third quarter of 2010 there were 10.8 million borrowers in negative equity where the balance on the mortgage exceeds the current value of the property…This increases the risk that these borrowers will default on their mortgages either out of necessity—say as the result of a job loss—or out of choice, which is called strategic default as borrowers determine that there is little economic advantage to keep paying the mortgage. Longer delays in the foreclosure process further increase the incentive for a borrower to strategically default by extending the period of time that they can live “rent free” in the house. In addition, declining house prices increase the expected losses on those mortgages that do default.
We should be worried about slowdowns in the foreclosure process because it will encourage people to default on their mortgages when they could otherwise afford to pay. Not that it exposes that the primary prestige industry in the United States over the past decade was a boiler room sham operation, but that people may start to really look at their debt obligations like a businessman.
Talk about a dog that didn’t bark in 2010. The funny part about this rhetorical crackdown is that there’s been no wave of strategic default people can point to. Homeowners really value their promises and are doing anything they can to try and do right by them, and the industry is using that leverage over them anyway they can.
There’s Been No Wave of Strategic Defaults.
You’ll sometimes hear the number that a third of defaults are strategic. That number comes a survey conducted by Luigi Guiso, Paola Sapienza and Luigi Zingales. They asked random people if they’d strategically default if their home was X% underwater, took their answers, and projected them onto the actual defaults and how underwater they were. There was no actual look at household budgets in creating this number. I’m a fan of Zingales’ writings, but this is simply not useful for the debate. There’s nothing here.
The Experian study from June, 2010 found that strategic defaults peaked in fourth quarter 2008. What’s a strategic default? “The research follows on an earlier report by Experian and Oliver Wyman that first aimed to quantify the share of mortgage defaults that are “strategic.” Strategic defaulters are defined as those who miss six straight mortgage payments without missing multiple payments on auto loans and other consumer debts for the six months after they first fell behind on mortgage payments.”
I don’t see that as a good working definition of strategic default. From their model a strategic defaulter is someone who misses six straight months of mortgage payments without missing multiple payments on auto loans and other consumer debts. It is fairly easy to keep consumer debt “current” by negatively amortizing it, or making the bare minimum payments. What is a legitimate default here? One where the person can’t make any payment on any of their bills.
All this definition means is that someone has enough money to pay their car payment and the minimum on their credit card but not enough money to pay their mortgage payment. The mortgage payment is going to be bigger than each of the other two, and there is no benefit to paying part of the mortgage payment, as it doesn’t keep it current. The definition you want is whether or not someone has income to make all their payments, not how they allocate payments.
It’s interesting that one of the few datapoints that find current (as opposed to 2008) strategic defaults, by CoreLogic, find them happening disproportionately among the rich, whose views on obligations probably mirror MBA and corporate logic more than community norms.
Borrowers Will Pay “A Substantial Premium”
Anyone actually looking at the data would conclude, in the words of the Federal Reserve Board: “The fact that many borrowers continue paying a substantial premium over market rents to keep their homes challenges traditional models of hyper-informed borrowers.” People take their obligations seriously, they (irrationally, in an economic sense) value their communities, neighbors and promises, and they work desperately to try and make good on them.
You can see this in the testimony of David Lowman, Chief Executive Officer, JPMorgan Chase Home Lending, at a House committee: ”In fact, almost 64% of borrowers who are 30-59 days delinquent on a first lien serviced by Chase are current on their second lien. It is only at liquidation or property disposition that first lien investors have priority.” So what you see is a lot of people, over half, who have stopped paying their first mortgage trying to make some sort of payment. If people were economically informed, financially literate and strategic they’d not pay the second (especially if they can’t pay the first). But they want to be paying something.
Consider it from a debt point of view. The (back-end) DTI ratio of someone applying for HAMP is 77.5%, and is 61.3% after modification. Think about that. Here’s someone who spends 77.5% of their income servicing debt payments. To put that in perspective, this person will work until around October 10th in order to see the first dollar that doesn’t go to a creditor.
Instead of ditching this form of debt peonage, defaulting, going underground, etc. they are fighting to get into and through a program that will make it so they still spend the majority of their productive labor to pay off rentiers. Strategic default isn’t a binary on-or-off switch. You can have people putting the large majority of their productive labor towards debt payments and this is fine. And that’s what we see from people in the HAMP program.
With that in mind it’s almost shocking to see how little strategic default is going on. Wouldn’t it be great to have a system that met people trying to do the right thing halfway?