Strategic default
Encyclopedia
A strategic default is 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.
This is particularly associated with residential and commercial mortgages
, in which case it usually occurs after a substantial drop in the house's price
such that the debt owed is (considerably) greater than the value of the property — the property has negative equity
or is "underwater" — and is expected to remain so for the foreseeable future, such as following the bursting of a real estate bubble
. Such borrowers are called "walkaways." The process of strategically defaulting on a home mortgage has been colloquially called "jingle mail" — metaphorically, one mails the keys to the bank.
and Hal Varian
have acknowledged that strategic default will be an inevitable result of the collapse of the finance and property bubble
of the era following 2006. They also note that this is one of the few ways of freeing people from the burden of mortgage debt. Once free of the mortgage, debtors are free to use their income for other expenditures.
A study in September 2009 from the credit reporting agency Experian
and consulting outfit Oliver Wyman
estimated that close to a fifth of troubled mortgages in the U.S. involved borrowers who were strategically defaulting.
and non-recourse debt, meaning whether the mortgage lender can pursue claims against the defaulted debtor. Further, mortgage refinancing
may be treated differently from an original, un-refinanced mortgage, and mortgages on second homes may be treated differently from mortgages on primary residences.
The borrower after deciding to not make payments any more can live (free of the costs of payment or rent) until the lender forecloses
which may take from several months to years. A borrower may use this time to extinguish or negotiate other debt. Mortgage lenders may negotiate with defaulting borrowers to assure maintenance and occupancy of the property until the lender can take title and market the house, and may provide the defaulting borrower with greater than the minimum legal notice to quit (which can be as little as three days) and may even agree to pay a fee to leave the home in pristine condition.
Foreclosure of the borrower's house will result in a negative entry on the borrower's credit rating
, possibly making obtaining loans in the future more difficult or more expensive for the borrower. With otherwise good credit a new mortgage from US government agencies will be denied until 3 (FHA) to 7 years (FNMA) have passed since the actual date of foreclosure.
The difference between the value of the property at the time of foreclosure and the amount of the note (assuming the note is larger) is considered by the IRS as "debt forgiven" and may be considered "income" subject to federal income tax. For a short period ending at the end of December 2012 due to the Mortgage Forgiveness Debt Relief Act of 2007
, this "phantom income" will not be subject to tax on primary residences.
or shame
", as lenders who do not modify mortgages do the same, "seek[ing] to maximize profits or minimize losses irrespective of concerns of morality
or social responsibility," or more bluntly stating that "The economy is fundamentally amoral
." Further, obligations to honor a contract are balanced by obligations to oneself and one's family, the latter speaking in favor of strategic default, some arguing "You need to put yourself and your family's finances first," while one also has obligations to a community, which may be damaged by default.
Default (finance)
In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...
) on a debt despite having the financial ability to make the payments.
This is particularly associated with residential and commercial mortgages
Mortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
, in which case it usually occurs after a substantial drop in the house's price
Real estate pricing
Real estate pricing deals with the valuation of real estate and all the standard methods of determining the price of fixed assets apply....
such that the debt owed is (considerably) greater than the value of the property — the property has negative equity
Negative equity
Negative equity occurs when the value of an asset used to secure a loan is less than the outstanding balance on the loan. In the United States, assets with negative equity are often referred to as being "underwater", and loans and borrowers with negative equity are said to be "upside down".People...
or is "underwater" — and is expected to remain so for the foreseeable future, such as following the bursting of a real estate bubble
Real estate bubble
A real estate bubble or property bubble is a type of economic bubble that occurs periodically in local or global real estate markets...
. Such borrowers are called "walkaways." The process of strategically defaulting on a home mortgage has been colloquially called "jingle mail" — metaphorically, one mails the keys to the bank.
Prevalence post-housing bubble
Distinguished economists Paul KrugmanPaul Krugman
Paul Robin Krugman is an American economist, professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University, Centenary Professor at the London School of Economics, and an op-ed columnist for The New York Times...
and Hal Varian
Hal Varian
Hal Ronald Varian is an economist specializing in microeconomics and information economics. He is the Chief Economist at Google and he holds the title of emeritus professor at the University of California, Berkeley where he was founding dean of the School of Information...
have acknowledged that strategic default will be an inevitable result of the collapse of the finance and property bubble
United States housing bubble
The United States housing bubble is an economic bubble affecting many parts of the United States housing market in over half of American states. Housing prices peaked in early 2006, started to decline in 2006 and 2007, and may not yet have hit bottom as of 2011. On December 30, 2008 the...
of the era following 2006. They also note that this is one of the few ways of freeing people from the burden of mortgage debt. Once free of the mortgage, debtors are free to use their income for other expenditures.
A study in September 2009 from the credit reporting agency Experian
Experian
Experian plc, formerly known as CCN Systems, is a global credit information group with operations in 36 countries. The company employs 15,500 people with corporate headquarters in Dublin, Ireland and operational headquarters in Nottingham, England and Costa Mesa, California, US...
and consulting outfit Oliver Wyman
Oliver Wyman
Oliver Wyman is an international management consulting firm. Founded in 1984, the firm adopted its current form in May 2007, when Mercer Oliver Wyman joined with Mercer Management Consulting and Mercer Delta to become one firm named Oliver Wyman. Oliver Wyman is headquartered in New York City with...
estimated that close to a fifth of troubled mortgages in the U.S. involved borrowers who were strategically defaulting.
Effects
Effects vary by jurisdiction; different countries and different states in the United States treat default on mortgage debt differently, notably distinguishing whether it is recourse debtRecourse debt
Recourse debt is a debt that is not backed by collateral from the borrower. Also known as a recourse loan, this type of debt allows the lender to collect from the debtor and the debtor's assets in the case of default as opposed to foreclosing on a particular property or asset as with a home loan...
and non-recourse debt, meaning whether the mortgage lender can pursue claims against the defaulted debtor. Further, mortgage refinancing
Refinancing
Refinancing may refer to the replacement of an existing debt obligation with a debt obligation under different terms. The terms and conditions of refinancing may vary widely by country, province, or state, based on several economic factors such as, inherent risk, projected risk, political...
may be treated differently from an original, un-refinanced mortgage, and mortgages on second homes may be treated differently from mortgages on primary residences.
The borrower after deciding to not make payments any more can live (free of the costs of payment or rent) until the lender forecloses
Foreclosure
Foreclosure is the legal process by which a mortgage lender , or other lien holder, obtains a termination of a mortgage borrower 's equitable right of redemption, either by court order or by operation of law...
which may take from several months to years. A borrower may use this time to extinguish or negotiate other debt. Mortgage lenders may negotiate with defaulting borrowers to assure maintenance and occupancy of the property until the lender can take title and market the house, and may provide the defaulting borrower with greater than the minimum legal notice to quit (which can be as little as three days) and may even agree to pay a fee to leave the home in pristine condition.
Foreclosure of the borrower's house will result in a negative entry on the borrower's credit rating
Credit rating
A credit rating evaluates the credit worthiness of an issuer of specific types of debt, specifically, debt issued by a business enterprise such as a corporation or a government. It is an evaluation made by a credit rating agency of the debt issuers likelihood of default. Credit ratings are...
, possibly making obtaining loans in the future more difficult or more expensive for the borrower. With otherwise good credit a new mortgage from US government agencies will be denied until 3 (FHA) to 7 years (FNMA) have passed since the actual date of foreclosure.
The difference between the value of the property at the time of foreclosure and the amount of the note (assuming the note is larger) is considered by the IRS as "debt forgiven" and may be considered "income" subject to federal income tax. For a short period ending at the end of December 2012 due to the Mortgage Forgiveness Debt Relief Act of 2007
Mortgage Forgiveness Debt Relief Act of 2007
The Mortgage Forgiveness Debt Relief Act was introduced in Congress on September 25, 2007, and became law on December 20, 2007. This act offered relief to homeowners who would formerly owe taxes on forgiven mortgage debt after facing foreclosure. The act extends such relief for three years,...
, this "phantom income" will not be subject to tax on primary residences.
Ethical issues
Some ethicists have questioned the morality of strategic default, arguing that one has a duty to make payments on debt if one is able. Others argue that there is no such moral duty, a loan being a contract between consenting adults, and noting that financial investors routinely default on non-recourse loans that have negative equity. Some argue further that there is a moral duty to strategically default, and that one should make such decisions based on one's financial interest "unclouded by unnecessary guiltGuilt
Guilt is the state of being responsible for the commission of an offense. It is also a cognitive or an emotional experience that occurs when a person realizes or believes—accurately or not—that he or she has violated a moral standard, and bears significant responsibility for that...
or shame
Shame
Shame is, variously, an affect, emotion, cognition, state, or condition. The roots of the word shame are thought to derive from an older word meaning to cover; as such, covering oneself, literally or figuratively, is a natural expression of shame....
", as lenders who do not modify mortgages do the same, "seek[ing] to maximize profits or minimize losses irrespective of concerns of morality
Morality
Morality is the differentiation among intentions, decisions, and actions between those that are good and bad . A moral code is a system of morality and a moral is any one practice or teaching within a moral code...
or social responsibility," or more bluntly stating that "The economy is fundamentally amoral
Amoral
Amoral may refer to:*Amorality, the absence of morality; for example, a stone, a chair, or the sky may be considered amoral**Specific amorality, the absence of some particular moral standard, principle, code, or knowledge...
." Further, obligations to honor a contract are balanced by obligations to oneself and one's family, the latter speaking in favor of strategic default, some arguing "You need to put yourself and your family's finances first," while one also has obligations to a community, which may be damaged by default.
See also
- Bank walkawayBank walkawayA bank walkaway is a decision by a mortgage lender to not forecloseon a defaulted mortgage , or to not complete foreclosure proceedings...
, opposite situation where bank walks away - Strategic bankruptcyStrategic bankruptcyA strategic bankruptcy may occur when an otherwise solvent company makes use of the bankruptcy laws for some specific business purpose. For example, in 2002 Kmart filed chapter 11 for protection from creditors; however one of the main problems affecting Kmart's cash flow and therefore liquidity...
, corporate analog
External links
- The Menace of Strategic Default, City Journal, Spring 2010
- Is Strategic Default a Menace?, City Journal online, 4-27-10
- Moral and Social Constraints to Strategic Default on Mortgages (pdf)
- http://www.bankrate.com/finance/mortgages/life-after-foreclosure-2.aspx#3
- Home Foreclosure and Debt Cancellation, IRS
- American Dream 2: Default, Then Rent
- A Perspective on Strategic Defaults, by Don Bisenius, Freddie Mac, May 3, 2010
- HomeLiberty offers ‘strategic defaulters’ chance to keep homes, SanFrancisco Business Times, Mark Calvey, May 23, 2011