With the current housing crisis, more individuals are voluntarily choosing to cease payments on their mortgages. This scheme, known as “strategic default,” is most common where the mortgage balance exceeds the home value. The phenomenon has fueled a rigorous debate, with some arguing it is immoral to default on a mortgage which is still affordable, and others taking the position that for some homeowners the “benefits” of willingly defaulting outweigh the consequences.
A cost-benefit analysis as to whether a homeowner should strategically default is not as simple as it seems. Initially, a borrower’s credit score can plummet as much as 160 points. Although a foreclosure will stay on a credit score for seven years, its impact will lessen with time. Another risk depends on whether a homeowner resides in a non-recourse or recourse state. Non-recourse states forbid lenders to pursue borrowers for the money owed which exceeds the value of the home. Recourse states allow lenders to sue borrowers; yet, the overwhelming amount of foreclosures has lenders scrambling to stay afloat without the problem of pursuing defaulting homeowners. Finally, many defaulting homeowners wonder if they will be able to buy a home again. With a poor credit score, it can be difficult to buy a house. But financial institutions across the nation specialize in “mortgage repair” which targets homeowners who have recently defaulted on a mortgage.
Even with the uptick in the current crisis, it is surprising how few homeowners choose to default strategically. Luigi Zingales, author of “The Menace of Strategic Default” in a recent issue of the City Journal, argues this is due to moral implications: “the idea that people would walk away from their homes when they can still afford to pay the mortgage is unfounded. What does prevent people from strategic default, it seems, is their sense of what’s right.” Zingales feels social norms have a direct impact on whether an individual chooses to default or not; i.e. knowing someone who has done it makes you more likely to do it.
On June 10, in response to the wave of mortgage defaults (strategic or otherwise), a Federal Housing Administration (FHA) reform bill passed the U.S. House of Representatives with a 406 to 4 vote. The FHA Reform Act (H.R. 5072), among other goals, seeks to withdrawal FHA approval from lenders with abnormally high default rates. The bill has organizational support from those such as Robert E. Story, Jr., Chairman of the Mortgage Bankers Association, who hopes the bill “will allow FHA to address lender enforcement without discouraging responsible lenders from participating.”
Although homeowners may individually benefit from strategically defaulting, it raises an additional obstacle to the recovery of the broader housing market. When a neighbor defaults, home values in the vicinity plummet and mortgage prices increase as lenders cover default costs. Yet, what is to prevent an individual owner making a rational financial decision that it is better to breach than continue paying on a mortgage balance that substantially outweighs home value? Perhaps the idea of opportunistic, or willful, breach has trickled down to the American consumer.