Strategic Defaults

More About Strategic Defaults and Strategic Foreclosures

Mortgage Subject to Strategic Forclosure
House for Sale Sign

A strategic default or strategic foreclosure 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.

Strategic forclosures are usually associated with residential and commercial mortgages, and they happen after a substantial drop in the house’s price so the remaining debt is considerably greater than the value of the property. The property is said to have negative equity or be “underwater,” and is expected to remain so for the foreseeable future. This typically happens following the bursting of a real estate bubble. Borrowers who do strategic defaults (subsequently leading to strategic forclosures) are called “walkaways.”

Economists, including Hal Varian, Paul Krugman, and others, note that strategic forclosures are one of the most straightforward ways of freeing people from the burden of mortgage debt. Once free of the mortgage burden, people are free to use their income for other purposes…including purchasing a house at a discounted price.

According to the Wall St. Journal (May 11, 2010), strategic default is frequently described as a “rational response by homeowners who are ‘underwater,’ owing farmore than the current values of their homes.”

A J.P. Morgan study finds the number of strategic defaults growing quickly, with 12% of all defaults in February 2010 being strategic defaults. This compares with an insignificant number three years earlier. Mortgage lenders, and many economists, fear that these “walk aways” will greatly increase the industry’s foreclosure-related losses.

Is Your Mortgage Underwater?