Thursday, April 12, 2012

Strategic Defaulters vs. Strategic Modifiers

by Bill McBride on 4/12/2012 11:42:00 AM

In FHFA acting director Ed DeMarco's speech on Tuesday, he discussed the risk of "strategic modifiers". Felix Salmon and I have been discussing this via email. Here is Salmon's post this morning: Ed DeMarco and the spectre of strategic modifiers

A couple of definitions: A "strategic defaulter" is a borrower who is underwater on their home mortgage (they owe more than the house is worth), and who is willing to walk away from their home, even though they have the capacity to make the payments. Strategic defaulters intend to go to foreclosure - and probably will - even if offered a modification.

A "strategic modifier" is a borrower who intends to stay in their home, but is willing to miss some payments to qualify for a loan modification.

Salmon writes:

I don’t believe that the problem of strategic modifiers (over and above the problem of strategic defaulters) is likely to be huge. One reason is that I’ve been writing about the upside of strategic default for a long time, and it really hasn’t caught on, outside a few second homes and the like. Strategic default is not something that Americans like to do, and one of the main reasons is that they really care about their credit rating. Even if a strategic modifier keeps her house, she’ll suffer the same hit to her credit rating as a strategic defaulter would. And people don’t like that at all.
I disagree somewhat. First, someone who goes to foreclosure will take a much larger hit to their credit than someone who misses a few payments. So there is a difference - "strategic modifiers" will not take the same credit hit as "strategic defaulters".

Second, I think most people feel an obligation to pay their mortgage, if they can, even if they owe more than their home is worth. But some of those same people will be willing to stand in the "free money" line (principal reduction), even if that means missing a few payments.

So, depending on the guidelines, I think there will be a higher percentage of "strategic modifiers" than "strategic defaulters".

Salmon concludes:
[L]et’s try principal reductions in the real world, and see what happens. If they turn out to be incredibly expensive, then we can revisit the issue. But my guess for the most likely outcome is not a wave of strategic modifiers. Rather, it’s that the program turns out to be much like all other government attempts to deal with underwater borrowers: a damp squib where very little happens at all.
I think some sort of principal reduction program will be announced, with tight guidelines, but I agree with Salmon, I expect the program will have little impact.

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