Ben’s Take on Strategic Default

Definitions of Strategic Default

Wikipedia defines strategic default as:

the “decision by a borrower to stop making payments (i.e., to default) on a debt despite having the financial ability to make the payments.” It goes on to say that strategic default is typically associated with a “substantial drop in home price”, where the home’s price is significantly below the amount owed on the home’s mortgage, and such situation is expected to remain for the foreseeable future.

I would argue that a better definition of strategic default is:

the “decision by a borrower to stop making payments, despite the present financial ability to make the payments, because future default appears to be inevitable”. I would also argue that nearly every default is strategic.

The Situations Leading to Strategic Default

Nearly every person who defaults on a series of mortgage payments could probably continue to pay if they stop paying everything else; or more specifically, had stopped paying everything else months or years earlier. If all one had to secure is a place to live, one could reasonably stop paying for food, utilities, clothing, fuel, medical and dental, right?

Being more realistic, what happens when the basics exceed one’s present income? Or, if one can scrape by with just the basics, what happens when emergencies or unplanned expenses arise: unexpected medical bills, roof damage, A/C unit goes kaput? This is the reality that many Florida residents are facing (or even worse, ignoring) while clinging to the hope that property values recover.

Consider this example:

A new retiree who is upside-down in his mortgage, has a $2,000.00 mortgage payment inclusive of taxes and insurance. He’s now on a fixed income of $2,500.00 per month of social security, and has a $75,000 in savings. Other monthly expenses run $1,200.00. It doesn’t take a genius to figure out that he is going to run out of money in a few short years. If his property wasn’t $100,000.00 upside down, he could simply sell the property and downsize – but this isn’t presently an option.

The real question is, would anyone be writing about strategic default, if home prices in Florida and elsewhere had not risen and declined so drastically? Would hundreds of thousands of people with equity in their properties stop paying and risk incurring continued interest, late fees and legal fees. Not likely.

Common sense would say, sell the property and put the equity in your pocket.

Stated another way, if everyone had equity in their home, there would be no such thing as a strategic default. If someone needed to move to a smaller house, to a larger house, to another city to find employment or to retire – they would simply sell the house, pay off the mortgage and purchase another home.

However, where properties are significantly upside down, a true financial hardship exists; the owner cannot simply sell it and move elsewhere.

In the final analysis, the drastic decline in home prices is a true financial hardship.

Strategic default is born out of necessity. A determination is made that the property is simply not worth the cost.

How Banks Caused the Real Estate Bubble

One reason that I can stand behind my clients’ decisions to embark on a strategic default is that few, if any, got there alone. Based in large part on my banking and financial analysis background, I believe that the real estate bubble – the substantial and historically unprecedented rise and decline in home prices – is a direct result of relaxed lending standards brought on by lender greed during the 2001-2006 period.

During this period, executives at large lending institutions decided that they could make more money by originating and securitizing loans, instead of holding the loans on their books for the life of the loan. The executives then decided, if these loans aren’t going to be on the bank’s books for very long before they are sold, “what is the incentive to make quality loans?” or “Who cares about loan quality, let’s just make loans.”

The lenders then adjusted their business models to make money on the loan-making process itself. Lenders pushed stated-income, no documentation and negative amortization loans. The availability of these new loan types pushed real estate prices to never before seen levels. The lenders actually pushed “stated-income” and “no documentation” loans in an effort reduce checks and balances in the loan-making process, and to reduce paperwork and overhead. Many mortgage brokers and lenders “stated” the amount of income necessary for a borrower to qualify for loan.

In turn, the relaxed lending standards made it “affordable,” at least temporarily, for borrowers to pay more for the same house, or to purchase a larger house, or purchase a second home or investment property.

The chart below tells a large part of the story. The historical relationship between average home prices and average incomes is roughly 3:1 respectively. In other words, if the average income in a particular neighborhood is $40,000.00 per year, the average home price historically tended to be $120,000.00. However, after the lenders relaxed the lending standards, someone that makes $40,000.00 per year could buy a $240,000.00 house, and home prices rose accordingly.

The increase in value was a temporary fiction. The houses themselves were not more valuable – people could just pay more, and did. This chart shows that the real estate market peaked in 2006 in the Tampa Bay area (Tampa, Clearwater and St Petersburg), with home prices exceeding six times average incomes.

Is Strategic Default Your Fault?

The large lenders now want to vilify strategic default. But, based on their conduct over the past 10 years, who is really at fault?

There is a legal concept in negligence law that I would argue is also applicable here. The concept states: between two innocent parties, the party in the best position to assess the risk, should bear the loss. I ask you, between the lender and the borrower, who is responsible for the unprecedented decline in home prices?

The large lenders have teams of financial analysts and the FDIC makes lenders engage in such analysis. They certainly knew that they had created this bubble, and they certainly expected it to eventually burst. Thus, the large lenders share responsibility for you being upside-down in your home loan. This is a concept that we use at Castle Law Group to defend foreclosure suits in the Tampa Bay area and to advise clients on getting out from under upside-down properties.

We firmly believe that you didn’t get into this position on your own. The large lenders helped.

To learn more about the options available in your situation and get advice from a competent foreclosure defense attorney, call our office and set an appointment. Our average clients are typically about $150,000 upside and come from all walks of life.

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