Strategic default? What is that?

On September 24, 2009, in Bankruptcy, Mortgages, by David C. Winton

May 11, 2010 UPDATE:   60 Minutes with Morley Safer did a piece on Strategic Defaults on May 9, 2010 that you may want to check out.

As noted in a prior post, the number of so-called “strategic defaults” and “strategic bankruptcy filings” is increasing, and this is a trend that will continue to escalate.  This post will look at the concept from the borrower’s perspective, and describe what is meant by the term.

A strategic default is simply a default on a mortgage loan obligation precipitated by the “upside down” relationship of the loan balance to the value of the collateral.  Example:   You owe $500,000 on a house worth $400,000.  That loan is “upside down” or “under water.”  What do you do?

Assuming that you have tried and been unable to get a modification of the loan terms from the lender–which describes the vast majority of people attempting loan mods–many people are choosing to default on the mortgage loan, and increasingly, file a Chapter 7 or 13 bankruptcy petition, in an attempt to get out from under the obligation.  It’s considered “strategic” because it’s premised on the economics of the loan, rather than the economics of the borrower’s income or other unrelated debt structure. The default and/or bankruptcy is triggered by a larger set of strategic objectives than simply desperation or creditors pounding on the door: Get out from under the declining value asset and expense. In fact, most people filing “strategic bankruptcies” or permitting “strategic defaults” are solvent and employed.

Why do this?  Several reasons:

First, it provides a “clean break” from the bank and avoids the months and months of uncertainty and negotiation with a large lending institution that probably doesn’t really want to modify the loan anyhow.  In other words, it’s faster and gives closure.

Second, if there is any risk of a deficiency, the foreclosure will nuke that lien, and a bankruptcy will discharge the underlying obligation.  (They’re different by the way; the security and the obligation can get severed from one another in a foreclosure or bankruptcy.)  This is assuming the loan wasn’t fraudulently induced, which I’ll assume for present purposes. Some people with seconds, HELOCS, etc. may find after months of negotiating with the holder of the first that the holder of the second doesn’t want to play ball, and intends to hold the borrower to the original loan terms.  If the borrower defaults, and the holder of the first forecloses, that second lien is wiped out. Basically, they’ve lost their seat at the table. Taking it a step further, if the borrower files bankruptcy, then the whole loan is wiped out forever.

Third, credit (“FICO”) scores are believed to recover faster from bankruptcy filings and discharges than from foreclosures. This is because the bankruptcy discharge gives the debtor a “fresh start,” which is essentially a total credit profile “reboot.” Foreclosure doesn’t do that. In fact, of the four most common remedies for any upside mortgage loan–deeds-in-lieu, straight foreclosure, short sale and bankruptcy–bankruptcy is widely believed to give the debtor a faster reboot and fresh start than any of the other three.  This is because the primary trigger for the FICO plummet isn’t the actual final remedy itself, it’s the 90 days of delinquency that is required as a predicate. Without a bankruptcy, that 90 day late stays on the FICO much longer; with a Chapter 7, it shows up only as a bankruptcy filing and subsequent discharge.

Fourth, in California, post petition wage income is exempt from collection in bankruptcy.  However, consideration of the debtor’s income is critical to a lender’s analysis and review of the borrower’s eligibility for a mortgage loan modification.  What this means is that you may make too much money, or have too many other assets to qualify for a loan modification, but still be able to jettison the loan in Chapter 7.

So is this for you? It depends, of course, on your total financial picture. Obviously, if you have a non-exempt stock portfolio worth $1 million that would be vulnerable in bankruptcy, and you’re only trying to get out from under a $100,000 loan deficiency, then the default or bankruptcy options aren’t going to be very “strategic” options. In fact, they would be foolish.

I know and I almost hate to say it but…the first stop is a qualified bankrutpcy practitioner who can help you get the whole road map out on the table so you can plot your course before taking irrevocable actions.

 


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