naked capitalism

This blog warned a few weeks ago of a coming campaign by the officialdom against so-called “strategic defaulters”. It has arrived even sooner than we expected.

We warned that this development was the inevitable result of financial firms, taking an increasingly predatory posture toward their customers. Borrowers are responding in kind, by taking a cold-blooded and legalistic look at their agreements with lenders.

Now having said that, it is well nigh impossible to determine how frequently “strategic” or “ruthless” defaults are taking place. Even though it is in theory an appealing option for borrowers with severely underwater mortgages, it nevertheless comes with a lot of costs: moving and a trashed credit rating. And note that a bad credit report does not merely mean restricted access to borrowing, but it it is a big negative in the job market, now that many employers routinely pull credit reports. So I suspect the talk of strategic defaults greatly exceeds the reality.

In addition, the “strategic default” label presupposes that the borrower is under no financial stress and the default was purely elective. I suspect, instead, that the “strategic” defaults are instead anticipatory, that the borrower sees that he will wind up defaulting at some point and has decided to cut his losses.

Cynically, I must note a paper on this very topic by Luigi Guiso, Paola Sapienza, and Luigi Zingales appeared the very same week that Fannie announced its plan to Get Tough with the miscreants. And mirabile dictu, it does tell us what proportion of defaults are strategic (26%) and attributes it to the perception that the bank won’t pursue them.

Yet the authors admit it is difficult to identify which defaults are strategic defaulters:

It is difficult to study the strategic default decision, because it is de facto an unobservable event. While we do observe defaults, we cannot observe whether a default is strategic. Strategic defaulters have all the incentives to disguise themselves as people who cannot afford to pay and so they will appear as non strategic defaulters in all the data.

Yves here. So what did they do? They conducted a survey of “representative sample of US households” in December 2008 and March 2009:

We asked the respondents information about their home ownership and the date when they bought or refinanced their house. Moreover, we asked the following questions: ―If the value of your mortgage exceeded the value of your house by 50K would you walk away from your house (that is, default on your mortgage) even if you could afford to pay your monthly mortgage? where people could answer ―yes,‖ ―no,‖ or ―I do not know.‖ For people who answered negatively, we repeated the same question with a negative equity of 100K. For people who answered negatively, we repeated the same question with a negative equity of 200K (March survey) or 300K (December survey). In addition, we asked whether the respondent thought it was morally wrong to walk away from a house when one can afford to pay the monthly mortgage. Finally, we asked a list of questions about their political views and their views about recent economic policies and current events.

Yves here. I know this may sound terribly logical, but this is actually rubbish. I’ve done a tremendous amount of survey research. In general, you need to do a great deal of validation of the survey to make sure the question order or phrasing is not biasing answers. Businesses who have real money decisions hanging in the balance almost never do this, and I doubt these academics took this step either.

And more important, surveys on possible future actions involving money are notoriously unreliable. It is routine that consumers in a survey will say they will make a certain purchase in the next six months or buy a new product when in fact they do not. This approach is so notoriously useless that people involved in new product design have been using other approaches like conjoint analysis for over fifteen years.

Nevertheless, these suspect surveys (an update claims the percentage of strategic defauters is now 31%) appear to have provided the impetus for Fannies’ new aggressive announcements

The first is that the borrowers that the agency deemed to be able to make mortgage payments but nevertheless defaulted will not be eligible for a Fannie-backed mortgage for seven years after the foreclosure. Second is Fannie announcing it will start pursuing “deficiency judgments” in jurisdictions that permit it:

Fannie will instruct its servicers in an announcement next month to monitor delinquent loans on the verge of foreclosure. They will recommend cases for Fannie to pursue deficiency judgments.

Terence Edwards, executive vice president for credit portfolio management at Fannie, said these steps are meant to urge borrowers to work with the servicers.

“Walking away from a mortgage is bad for borrowers and bad for communities and our approach is meant to deter the disturbing trend toward strategic defaulting,” Edwards said. “On the flip side, borrowers facing hardship who make a good faith effort to resolve their situation with their servicer will preserve the option to be considered for a future Fannie Mae loan in a shorter period of time.”

Yves here. Let’s parse this: if you don’t talk to your servicer and then default, it presumably increases the odds greatly of being deemed a strategic defaulter. But the flip side is I can see plenty of instances where a sudden change in circumstances (job loss, medical emergency) could lead a borrower to conclude that he was now destined to default, and he needed to preserve whatever cash reserves he has, and talking to the servicer would be pointless. And of course, if you DO talk to your servicer, you will have to provide information about your finances, which might be used against you later if you default.

But more broadly, how credible is the threat of Fannie going after defaulters? Given the economics, this is mainly bluster, although I expect the agency to pursue some cases that appear obvious (to the extent it can judge “obvious” ex ante). collect a few scalps, and then run a very loud campaign about the cases it won in the hopes of deterring others.

Let’s consider some of the many problems Fannie faces:

1. It is going to have a very hard time determining who is a strategic defaulter. A credit report is not a complete picture. Small businesspeople often have corporate borrowings that are guaranteed personally; per above, a borrower could have had a sudden change in income or expenses. So it will be launching lawsuits with incomplete information

2. Litigation is expensive. If the borrower fights, legal costs will mount quickly. Fannie has the burden of proof and will likely need to do discovery (get the borrower to provide various financial records) and bring in an expert witness to make its case that the borrower was able to make payments for more than a short period beyond the default.

3. You can’t collect blood from a turnip. Even in those cases Fannie wins, the borrower may not be able to satisfy the damages and could file bankruptcy.

4. Fannie may lack standing. Recall that foreclosures are increasingly being challenged successfully because the party pursuing the foreclosure, usually the servicer, cannot act on his own, as an agent. The party bringing the action has to be the owner of the note, which is a specific trust. In many cases, the servicer or the foreclosure mill cannot establish that the trust it claims owns the note really is the owner.

A lot of these cases of “who really owns the note?” involve private label (non Fannie/Freddie) deals, but some important precedents also involve cases where the mortgage (which is the lien, and is separate from the note, which is the debt) was assigned to the electronic mortgage recording system, MERS. Recall that in all states except five, the note is the critical instrument, and must be correctly endorsed by all the intervening parties (a minimum of two between the originator and the trust, so a minimum of three endorsements are needed). It appears in many cases when MERS was used that the parties in the securitization chain instead relied upon it and fell down on endorsing the notes. I won’t bore you with details, but doing it ex post facto is not kosher. Since Fannie and Freddie required the use of MERS (IIRC starting in 2000), the same failures may have occurred, and as a result, the same arguments that have been perfected in some states to contest foreclosures may be applicable here.

Of course, this announcement also means that anyone who is a real strategic defaulter will need to be a bit cagier just in case (for instance, no e-mails or talks to friends or colleagues about strategic defaulting; in fact, having a document trail of current or expected financial stress would be advisable).

But either way, have no doubt the PR and threats of action to combat this trend will become more and more visible in the coming months.