The Menace of Strategic Default
July 13, 2010
Eighteen years ago, when I bought my first apartment in Chicago, I asked my broker whether, if I defaulted on my mortgage, the lender could come after my income after repossessing the house. I had heard that some states didn’t allow that, and I wondered if Illinois was among them. To my surprise, the broker didn’t know, either, but she promised to find out. It clearly wasn’t a burning question for her, since she still wasn’t able to answer it the next time we met. Our ignorance wasn’t unique. Confident that house prices would never stop rising, most Americans never bothered to check what would happen if they defaulted. After all, who would walk away from a house worth more than the mortgage?
Today, the matter is far from theoretical for the 15.2 million American households holding mortgages that exceed the value of their homes. It will help determine how many of them choose to “default strategically”—that is, walk away from their mortgages even when they can afford them, because they’ve determined that it’s no longer worth it to keep paying. And that, in turn, will help determine the future health of the American housing market—and thus of the U.S. economy.
Many people think that we don’t have to worry about widespread strategic defaults. When I discussed the problem with a board member of one of the top four American banks, he categorically denied its existence: “The idea that people would walk away from their homes when they can still afford to pay the mortgage is unfounded.” A study from the Federal Reserve of Boston seems to confirm his skepticism. Evaluating Massachusetts homeowners during the 1990–91 recession, it found that only 6.4 percent of “underwater” borrowers—that is, those burdened with mortgages that exceeded the value of their homes—ended up in foreclosure. And not all of those households were defaulting strategically; many, presumably, were actually unable to pay their mortgages.
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