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

Following on the heels of my post the other day on the Option ARM perfect storm that’s brewing in the San Francisco Bay Area, the LA Times recently ran a piece on the growing phenomenon of“strategic defaults”, by which is meant the intentional defaulting on a mortgage loan by a borrower despite an ability and the wherewithal to make the payments. In other words, just walking away.

Why would someone do this? Simple: The debt far exceeds the value of the collateral by such a margin that continuing to make the payments can no longer be justified by sound economics or abstract moralizing, guilt, sense of duty or any other non-economic reasoning. In other words, the numbers just don’t crunch any more.

The Wall Street Journal Economic Insight Blog also recently ran a piece on the subject in June, called “When is it cheaper to walk away?” The answer, according to the writers of that piece is 10%. When the balance of the loan is more than 10 greater than the value of the property, economically, it makes more sense to just walk away rather than keep making the payments.

The WSJ articles was, in turn, based on a very thorough paper prepared jointly by the University of Chicago School of Business and Northwestern’s Kellogg School (under the auspices of the Financial Trust Index). The paper, called WHEN HOMEOWNERS WALK AWAY: NEW RESEARCH REVEALS MORE THAN 25 PERCENT OF MORTGAGE LOAN DEFAULTS ARE STRATEGIC” concludes about 25 percent of foreclosures are “strategic,” meaning intentional and driven by larger economic considerations than merely the borrowers’ ability to make the payments, and that…

Homeowners start to default at an increasing pace, and walk away massively after decreases of 15 percent and more. In fact, 17 percent of households would default, even if they can afford to pay their mortgage, when the equity shortfall reaches 50 percent of the value of the house.

As for “strategic bankruptcy,” this is just the next step after the “strategic default.” (I wrote about this last year in an only-partially tongue-in-cheek “Top 10” list for why bankruptcy is the “ultimate mortgage modification tool.” I won’t repeat myself here.)

What does all this mean? Well, for one thing, it means that what we’ve known all along is now starting to attract the attention of economists and journalists.

As for what it might mean for an individual or family? Probably not much frankly. It seems to be giving an academic gloss to what people tend to know at a gut level anyhow: That we’re not out of the woods yet, there are lots more foreclosures and bankruptcies to come, and the housing market probably has a few more bumps in the road awaiting it before things smooth out.

As to whether this data or these reports can help you or anyone you know as you wrestle with difficult decisions: whether to default, whether to file bankruptcy, what other options you have, it probably can’t. Everyone’s situation is unique. Just like everyone else’s as the old saying goes. But before you decide that you’re going to “strategically default,” or file a “strategic bankruptcy,” you should consult bankruptcy counsel. There are lots of moving parts, and the amount of your home loan and the value of your house are just two pieces or a much larger puzzle.



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