What is a strategic default?
A strategic default is the decision by a borrower to stop making payments (i.e. 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. These “underwater” borrowers who now have negative equity and don’t see market values improving any time soon willingly choose to abandon their properties. These strategic borrowers are known as “walkaways.”
Borrowers whose negative equity is relatively modest appear to be much less willing to strategic default. But as negative equity approaches 50%, roughly half of all mortgages are strategic. The recent Experian-Oliver Wyman study also showed that in states like California, where state law limits lenders’ ability to collect post-foreclosure deficiencies on principal residence mortgages, borrowers were more likely to walk away from their houses at lower levels of negative equity compared with borrowers in Florida and Nevada,, where lenders face fewer restrictions to recover their money.
In another study, the Federal Reserve offered a typical strategic default scenario: Purchasers in Palmdale, Calif., paid $375,000 for a median-priced single-family home in 2006. By 2009, ,the same house was worth less than $200,000. Meanwhile, a similar house in Palmdale rented for $1,300 a month at the end of 2009, far less than what the underwater borrowers were paying for their homes. The homeowners decided to walk and rent.
Why stay in a seemingly hopeless situation, bleeding money indefinitely? The Federal Reserve researchers found that most homeowners in similar situations decided to just stop paying. Damaging their top credit scores – even when they had the ability to pay – didn’t seem to hold that much weight in making their decision. As a result, lenders and the credit industry are now evaluating new ways to measure risk beyond traditional credit scores.