Strategic Foreclosure & Back Door Bailouts

Strategic foreclosure is a subject near and dear to all our hearts. We had a pretty robust debate about it back in May after 60 Minutes ran a special on it (video below). For those who don't know, strategic foreclosure is when a homeowner who can otherwise afford to pay their mortgage defaults on purpose, usually because their mortgage balance is well above the market value of the property. The idea is catching on like wildfire, with the Wall Street Journal reporting in June that nearly 1 in 5 foreclosures during the first half of 2010 was a strategic foreclosure.

Naturally, a cottage industry has sprung up in response to the phenomenon, guiding homeowners through the process and assuring them that there is no longer any social stigma to walking away from your obligation - even though you can still afford to pay. There's even a nifty online calculator that estimates how much money you will save by pulling a strategic foreclosure.

Our debate on the subject in May seemed to center on the morality of the issue, as in "Are these people scumbags, or are they just exercising the inherent put option in a mortgage?" I see both sides of the argument, frankly. Yes, it's pretty sleazy to bust a contract you've willingly agreed to, especially while you still have the ability to perform. However, the bank did agree that the property would be fair compensation in the event of a default, so it's not the homeowner's fault that the market for the home has dropped below the value of the mortgage.

In response to this growing problem, Fannie Mae is proposing a solution that could end up being worse than the problem itself. The mortgage giant is proposing to lock out strategic defaulters from receiving a new mortgage for seven years.

Those home owners who walk-away and had the ability to pay the mortgage or did not complete a workout alternative in good faith will be ineligible for a new Fannie Mae-backed mortgage loan for a period of seven years from the date of foreclosure.

This might seem like a good idea on the surface, but if the numbers are correct and 20% or more of 2010-2011 foreclosures are strategic, locking that number of buyers out of the market for seven years could stall a real estate recovery for a decade.

Meanwhile, a back door bailout of sorts is being proposed which will enable the most underwater and least credit-worthy borrowers to not only remain in their homes, but to refinance under better terms. The argument in favor of such largess is that it would enable consumers to spend more, which is kinda what got us into this mess in the first place.

Analysts at the investment bank contend that millions of mortgages backed by the U.S. government could be refinanced without the need for an analysis of a borrower's credit quality because the principal is already backed by the government. Many homeowners who are unemployed, have poor credit or who owe significantly more than their homes are worth currently can't refinance, but would be permitted to use such a program.

In a final bit of irony, Fannie Mae and Freddie Mac have returned hat-in-hand seeking another $1.5 and $1.8 billion respectively, just to keep the lights on (not two weeks after President Obama pledged there wouldn't be another penny of taxpayer money spent on bailouts, I might add). Are these really the smartest guys in the room when it comes to American real estate?

Isn't it possible to let homeowners do what they're going to do and just let the chips fall where they may? What is the argument against that, exactly? Shouldn't the market regulate who gets a home loan and who doesn't? How would locking someone out of the mortgage market for a number of years help anything? And is strategic default really bad for the economy when in fact it helps properties to seek their proper value?

Going forward, what changes should be written into mortgages to prevent strategic foreclosures? A margin call on your mortgage, maybe? Finally, I wanted to leave you with the original 60 Minutes video because it does the best job of explaining the phenomenon to those who haven't seen it.


Watch CBS News Videos Online

WSO Elite Modeling Package

  • 6 courses to mastery: Excel, Financial Statement, LBO, M&A, Valuation and DCF
  • Elite instructors from top BB investment banks and private equity megafunds
  • Includes Company DB + Video Library Access (1 year)
Start Discussion

Total Avg Compensation

June 2021 Investment Banking

  • Director/MD (9) $911
  • Vice President (35) $364
  • Associates (204) $233
  • 2nd Year Analyst (115) $151
  • Intern/Summer Associate (97) $145
  • 3rd+ Year Analyst (27) $145
  • 1st Year Analyst (420) $131
  • Intern/Summer Analyst (338) $82