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More homeowners choose to default on loans
Choosing not to pay has consequences beyond damaged credit scores

By Amy Hoak, MarketWatch

CHICAGO (MarketWatch) -- "Strategic defaults" are on the rise as more borrowers who are underwater on their home loans decide it's not worth it to stay current on their payments each month. That trend could have repercussions for the housing market, and for borrowers, in the future.

Strategic defaults are when borrowers who owe more on their homes than they're currently worth choose to stop paying their mortgage but continue to meet other financial obligations, according to a definition by Morgan Stanley in a research report on the topic.

In other words, these homeowners neglect their monthly principal and interest payments, but still pay other bills on time, including credit cards and auto loans.

The Morgan Stanley report estimates that 12% of mortgage defaults in February were strategic. Other reports estimate an even higher proportion of this type of loan default.

Growing social acceptance of this behavior could have ramifications not only for personal credit histories and the health of neighborhoods, but also for the future of mortgage lending, according to those studying the issue.

For one, there's a contagion effect: As more people watch their friends or neighbors choose to default, the more it becomes a viable option for homeowners who may otherwise wait years just to return to a positive equity position in their properties, said Sam Khater, senior economist for CoreLogic, a provider of consumer, financial and property information. The volume of foreclosures on the market today is also chipping away at the stigma that used to come with defaulting on a home loan.

"If you know someone who has defaulted strategically, you're more likely to declare you're willing to do it," said Luigi Zingales, professor of entrepreneurship and finance at the University of Chicago's Booth School of Business.

In areas where home prices are severely depressed, social acceptance of this decision could lead to pockets "where strategic default becomes the norm, versus the exception," Zingales said.

But look even farther in the future, and the repercussions of substantial strategic defaults could have a larger-scale effect.

"If it really does become a legitimate problem, the implications are pretty dramatic for anyone that wants to buy a home in the future," said Rick Sharga, senior vice president of RealtyTrac, an online marketplace of foreclosure properties. "The lenders would have to build this into their risk models with either larger down payments or higher interest rates."

Some owners 'mimic investors'

Many agree the ranks of people taking this route are growing, but putting a number on the trend isn't as easy. To measure the number of people who are strategically defaulting on their mortgage obligations, you have to assess borrower intent.

"Take all the numbers with a grain of salt, because it's one of those topics which is really difficult to get a firm grasp on," Sharga said. "The projections are based on limited sample sizes, and [people are] doing projections that have a lot of implications on societal behavior and political policy."

Researchers believe that being underwater on a loan is a prerequisite to strategic default, and the more underwater you are, the likelier you are to consider defaulting -- even if you can afford to keep making payments.

"In our data, what we've noticed is at about 25% negative equity, the behavior of owners begins to mimic that of investors -- they're more ruthless and rational, they're looking at it from a cash-flow perspective," Khater said. "The default rate rises as the negative equity gets deeper and deeper."

Here are some estimates of how big a problem strategic default is:

Morgan Stanley's recent report examined the payment habits of 6.5 million borrowers with first-lien mortgages that originated in 2004 or later, and estimated that 12% of all mortgage defaults were strategic in February -- that is, the borrower who is underwater on his or her mortgage obligations and stops paying on that home loan, yet still meets other, "meaningful" non-mortgage obligations. The authors used data from TransUnion in their analysis. The report found that the incidence of strategic default is higher among those with higher credit scores and larger loan balances.

Analysis from Experian and Oliver Wyman estimated that strategic defaulters made up about 18% of all borrowers who went 60 days past due on their mortgage in the fourth quarter of 2008; about 588,000 borrowers strategically defaulted in 2008, up 128% from 2007. Strategic default was also found to be most prevalent in areas that experienced steep price declines, including California and Florida, and among mortgages that originated in or after 2006, because those borrowers didn't experience home price appreciation before prices headed south.

Research from the Chicago Booth/Kellogg School Financial Trust Index found a rising percentage of homeowners are willing to strategically default: The percentage of foreclosures perceived to be strategic was 31% in March, compared with 22% in March 2009. The data is collected through a survey of about 1,000 people.

One possible reason the numbers are rising is some homeowners' belief that lenders aren't aggressively pursuing those who default, according to the Chicago Booth/Kellogg School report.

"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," said Paola Sapienza, professor of finance at the Kellogg School of Management at Northwestern University and co-author of the report, in a news release. Zingales was a co-author.

People are also learning they often have one or two years before they get thrown out of a home after stopping payments, said Frank Pallotta of RH Reward, or Responsible Homeowner Reward, a program that works with lenders to provide financial incentives for borrowers who are at a high risk of strategically defaulting.

Getting above water

A recovery in home prices could give people hope to stick it out and stay in their homes, even if they're underwater, Zingales said. "If prices were to drop again, people might lose hope," he said.

CoreLogic estimates that the typical underwater borrower is five to seven years away from regaining their lost equity.

Eventually, those who do stick it out will see their equity increase due to simple amortization: Over time, less of your payment is going to interest and more is going to the paying down of principal, Khater said. "If they remain current on their home, simply paying their loan will help drive them back to positive equity," he said.

But for some homeowners, that won't be enough.

"Strategic default will begin to pick up in numbers as the housing market begins to stabilize," Pallotta said. "Now you can almost quantify how long it is to see the light at the end of the tunnel."

If people figure they'll wait more than a decade before regaining the equity they've lost, they're much more likely to cut bait and leave, he said.