Strategic Defaults on Mortgages are Rising, But by How Much?

More and more defaults are considered “strategic” — where borrowers choose to walk away from underwater mortgage obligations regardless of their ability to pay –although to what extent is still up for debate as two studies, one from academia and one from an investment bank, find differing levels of homeowners walking away. Strategic defaults account for more than one-third of all defaults, according to research released today by the University of Chicago Booth School of Business and the Kellogg School of Management. The data from Morgan Stanley (MS) finds this to be at a lower level, with 12% choosing not to pay their mortgage. The share of mortgage defaults perceived to be strategic — meaning voluntary in cases where previously current borrowers were underwater but could still afford to pay — grew to 31% through March 2010, from 22% a year earlier, professors Paola Sapienza and Luigi Zingales wrote in the research. The research pointed to a growing perception that lenders are not going after borrowers who decide to walk away. In December, the average survey respondent indicated they believe lenders are 56% probable to go after a borrower, compared with 54% in March 2010. “With more and more homeowners believing that lenders are failing to pursue those who default on their mortgages, there is a risk that a growing number of homeowners will walk away from their homes even if they can afford monthly payments,” Sapienza said. The results also indicate the likelihood of strategic default grows 23% if a borrower learns of an underwater neighbor receiving partial loan forgiveness. Additionally, strategic default increases by 29% if borrowers can find alternate ways to finance a new home. Although separate research released Thursday by Morgan Stanley does not put the share of strategic defaults quite that high, the data shows the trend is growing significantly to about 12% of all defaults in February 2010: Additionally, Morgan Stanley found that the highest proportion of overall defaults sits in the lowest credit score bucket. But strategic defaults display a “reverse phenomenon” in both earlier loans made in 2004 and more recent loans made in 2007: “While total default percentages drop as credit scores increase, strategic default percentages in each credit score bucket rise steadily as credit scores increase, dipping a bit only at the highest end of the credit spectrum,” Morgan Stanley said. Researchers note that prime jumbo collateral has the potential to be the most exposed to strategic defaults. The propensity to strategically default is higher in the 2006 and 2007 vintages — where strategic defaults could account for more than 40% of total defaults on the jumbo end of the credit spectrum, Morgan Stanley said. “This is also the collateral type that benefits the least from loan modification efforts such as HAMP, and is the least likely to be eligible for FHA refinancing,” researchers said. Write to Diana Golobay. Disclosure: the author holds no relevant investment positions.

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