Strategic Defaulters as the New Welfare Queens

A well placed Washington contact wrote:

I was in a discussion with the staff at one of the Federal agencies involved in housing to ask them about the new policies on strategic defaults. It became clear almost immediately that regulators obviously have no idea how to identify strategic defaulters except by asking big banks. They cited the Oliver Wyman study, which is garbage, and other than that had NO evidence except anecdotal reports from ABC News that strategic defaults are happening. Strategic defaulters, they said, are people who won’t even contact their servicer to renegotiate their mortgage. Now, a lot of people are saying that they can’t get in touch with their servicer, so I put the question about whether servicers would tell the truth about strategic defaulters, and they were just shocked that anyone could believe servicers might lie. In other words, the agencies and regulators are simply taking the word of Bank of America and Citigroup that people are strategic defaulters rather than the victims of predatory loans or abusive service.

But what was shocking was the extreme anger they showed. These are bureaucrats, so I expected a kind of boring process-talk. Not so. The guy in charge frequently dropped in lines like, ‘back when people used to actually PAY their mortgages and follow through on their promises.’

It was weird. People in Congress, except certain safe seat powerful Democrats, are afraid of touching the issue, because of the fear of being associated with deadbeats, but also because it is the explicit policy of the leadership of both parties and the administration to continue to squeeze as much blood from a stone as possible. Yves here. What continues to amaze me is how fast the disinformation is being shoveled out:

1. The strategic default “trend” is almost without a doubt wildly exaggerated. First, while foreclosures are rising, it’s the result of banks finally starting to move on a seriously clogged pipeline. There hasn’t been an increase in the rate of serious delinquencies, despite the continued slide in home prices, to support this idea.

Second, the costs of default are high: a trashed credit record (which limits access to jobs, not just access to loans), having to move, and probably a tax bill if the home has negative equity. If the defaulter wants to rent, a landlord will generally seek a much higher deposit given the concerns raised by his credit history. These are all considerable offsets to the supposed economic advantages of a strategic default

2. There isn’t any clean neat way to determine if someone has made a strategic default. Colloquially, it is supposed to mean someone who is capable of paying the mortgage but suddenly defaults. The problem is I suspect that the alleged strategic defaulters are in the vast majority of cases anticipatory defaulters: they can, by dint of great struggle, make their mortgage payments, but they are falling further and further behind (say escalating fees and charges on credit cards), anticipate a fall in their income (they can read the tea leaves at work), or are so close to the edge they know even a minor spell of bad luck (say the need for car repairs) will put them over the edge, and they decide to exit what is certain to become an untenable situation now.

One reader argued that, as with student loans, one could easily get IRS data and determine ability to pay. That’s rubbish. Student loans cannot be discharged, even in bankruptcy, which makes them senior. And most people need a car to work (and in extremis, can live in a car) so auto loans will be given priority in payment over mortgages by many borrowers. So to determine whether someone can afford their house, you need to look at their total debt burden, not simply their mortgage payments.

A credit report similarly gives an inaccurate picture of debt loads. they merely show balances, not interest charges, so you cannot determine debt servicing costs. For small businesspeople, credit reports also do not show loans to their company, even though they usually have to guarantee them;

3. Fannie, Freddie, and their friends and allies in DC labor under the delusion that the push that the GSEs have announced to pursue deficiency judgments (as in, where state law allows, to try to collect from defaulting borrowers where the proceeds from the sale of the house fails to cover the mortgage balance) is something new. Au contraire. In bankruptcies, any shortfall is presented to the court to obtain a recovery from other assets. In other types of foreclosures, the bank (or foreclosure mill hired by the servicer on behalf of the trust that owns the note and mortgage) will use a debt collector to go after any shortfall

4. The misguided targeting of this effort is certain to backfire. To the extent the authorities try anything new (per 3 above, I’m skeptical, but we’ll at least see an aggressive push to find examples of bad behavior to put in stocks in the town square), their misguided targeting is almost certain to backfire. People do not trust their servicers. Why call them if something has changed or you have come to the conclusion that eventual default is inevitable? Moreover, many borrowers might be loath to try to work out a deal because the media has reported numerous cases where borrowers complied with servicer instructions, made higher payments to get a temporary mod, and failed to get a permanent mod, with the net result that their cash was even more depleted had they defaulted when they had determined they could no longer afford their mortgage. Moreover as the DC expert noted, servicers are often very hard to reach. So contact with the servicer is a ridiculous proxy for borrower intent and condition.

Moreover, anyone who is a true strategic defaulter (as I define it, can afford the mortgage but abandons it) is likely to have the savvy to hide financial assets from debt collectors, and given that the GSEs are letting people know that they are using contact with the servicer as the proxy for “good borrowers”, a savvy strategic defaulter will be sure to contact his servicer with a charming tale of why he is a hopeless goner financially.

So why all this hysteria about strategic defaulters? If I were conspiracy-minded, I’d say this is a very clever push to stoke jealousy among what is left of the middle class to keep the focus off the way the banksters wrecked the economy, got lots of cash and prizes, and have every reason to repeat that profitable exercise. So focus public ire instead about the commies in our midst, um, the new welfare queens, aka various forms of alleged housing deadbeats. The immediate reason is that the more people are made to resent the breaks they fantasize their neighbors are getting, the more they will oppose deep principal mods, which historically is what banks always did when they had a borrower get in trouble who still had a remotely viable income.

Why would the banks oppose principal mods? It will force an end to extend and pretend, and when THAT happens, a lot of financial firms will be shown to be undercapitalized and in need of rescue or resolution (as we and others have pointed out repeatedly, Mike Konczal’s conservative analysis of second mortgage portfolios at the four biggest US banks, Bank of America, JP Morgan, Citigroup, and Wells Fargo, shows that they probably need another $150 billion in equity among them, and others contend the writedowns on seconds should be much more aggressive than Konczal assumed).

This push could also be an effort by the GSEs to shift blame, Whocouldanode 2.0: “whocouldanode prime borrowers would default at such high rates?” It wasn’t our crappy procedures and unduly optimistic assumptions, it was the black swan of a change in values!

Now let us say I am wrong and the banks and GSEs are about to embark on new tactics versus defaulting borrowers, say by getting more aggressive in trying to garnish wages when recoveries fall short. That has the potential to backfire massively.

Right now, contrary to popular opinion, virtually the only parties fighting foreclosure are either people who think they can afford the house but are the victims of massive servicing mistakes (I could write a separate post on this, trust me) or people who have filed for Chapter 13 bankruptcies where the servicer (acting on behalf of the trust) tries to block the bankruptcy stay. In 45 of 50 states (this is a simplification but pretty accurate), the mortgage (which is a lien, in some states called a deed of trust) can only be enforced by the legitimate owner of the note (the IOU). Mortgage securitizations had very specific requirements as to what the trust (the securitization entity) needed to do to obtain the note. Trust are very brain dead vehicles, they can only do what their governing agreements permit them to do, nothing more. In short form, it appears to be widespread, if not endemic, that securitizations starting around 2004 began not bothering to do what they needed to do so that the trust had clear ownership of the note (the key item being proper endorsement of the note by all the parties in the ownership chain of the securitization prior to or on the day of closing. Limited fixes were permitted post closing, generally up to 90 days, but they were designed to be narrow and apply only to a small percentage of the notes in a pool).

Increasingly people who are fighting foreclosures are having good results by questioning whether the party who shows up in court to foreclose is entitled to do so (the legal concept is “standing” and is fundamental). Note the person fighting the foreclosure is NOT arguing that they don’t owe the money but whether the party who wants to take the house has the right to. And this is not a theoretical objection; there have been cases where the same note has been sold to multiple securitizations. If the wrong party forecloses, the borrower is at risk that ANOTHER trust will show up, and again demand that he pay the mortgage debt in full. Although decisions vary (usually by state, based both on state law considerations and the temperament of the judiciary), many judges are ruling for borrowers, typically dismissing cases without prejudice (meaning the lender can try foreclosing again if he can get his act together, but typically the issues that led to the unfavorable ruling are insurmountable).

So if the banks and Freddie and Fannie start on a big, and very badly aimed push to go after defaulting borrowers to extract more blood from stones, one outcome may be that they don’t get the headlines they want. Instead of “Greedy guy reneged on his mortgage when he has plenty of dough (be sure to include photo of deadbeat with luxury car or in front of very fancy new residence)” you will get “Cancer victim who had to abandon beloved home harassed by greedy banks.”

But more important, this sort of move will lead incorrectly targeted “strategic defaulters” who willingly gave up their houses to fight the efforts to extract more cash from them. That in turn has the potential to increase awareness of the widespread problems with mortgage securitizations, with the potential to shift to dynamic. What if the owners of private label mortgage bonds come to realize that in many cases, the instruments are effectively unsecured? What happens if Fannie and Freddie’s strategic defaulter push backfires from a financial standpoint (the cost of a badly-targeted collection effort exceeds any increased recoveries?)

And most important, what happens if the public comes to understand the hypocrisy of the banks’ stance, that they are demonizing borrowers for failing to live up to contracts, when they couldn’t be bothered to comply with the terms of their own contracts, which set up procedures for conveying notes to the securitization entity, and in many cases foreclosure mills have forged documents to cover up that fact? Whoever is behind the “strategic defaulter” push may well wind up hoist on his own petard.

Originally published at naked capitalism and reproduced here with the author’s permission.