Strategic Defaults vs. Financially Prudent Decisions

I can’t help it. Every time I read something about “strategic defaults” I want to start pulling my hair out.  The issue has been most prominent since FNMA began threatening lawsuits against homeowners who engage in what Fannie calls “strategic defaults.”  To my knowledge Fannie has never actually explained what a strategic default is, except to say that it occurs when a borrower has the capacity to pay, but elects not to do so.

But who is going to make that call? In an article appearing in, the issue was recently addressed in a letter to FNMA by several U.S. Congressmen:

The legislators also questioned what objective criteria Fannie would use to determine whether a default was truly strategic. [FNMA] has said it will rely on the reports of its servicers to determine borrower intent.

“We have great concern with putting such faith in the servicers,” the lawmakers wrote, citing feedback from their constituents and a number of congressional watchdog groups that call into question servicers’ performance in dealing with huge volumes of defaults and communicating effectively with borrowers.

Oh great!  So the loan servicers will now become snitches.  This is sure to encourage a free exchange of information from borrowers seeking help.  If a servicer feels that one of their customers could actually afford to pay their home loan headed into foreclosure, they can report that fact to FNMA who will, according to the article,  sue the borrower for repayment. So how does a borrower’s private, confidential, and personally identifiable financial information become evidence that can be used to establish that their default was “strategic?” (Fannie professes to place a high value on privacy at their website.  See link.)

And if a default isn’t “strategic” then what is it?  Here is what Sheila Bair, FDIC Chair, says on the FDIC’s loan modification website:

Avoiding foreclosure, when it is financially prudent to do so, reduces the downward pressure on the price of nearby homes and helps communities to maintain the services they provide to neighborhoods. (Underscore mine – PCQ)

Now that helps.  Financial prudence is a good litmus test.  So if a borrower’s nonpayment and eventual foreclosure is the result of their good faith cost analysis based upon all available choices, it is not a “strategic” default, but a “financially prudent” one.  I can accept that.

There is really little question but that economic self-interest is what guides most individuals and companies when making their most important financial decisions.  And in fact, economic self-interest is exactly what lenders, servicers, and investors do when deciding to approve or deny almost all borrower-requested modifications, short sales or deeds-in-lieu (known as “pre-foreclosure events”).    However, rather than calling it the “financially prudent test” it is called the “NPV Test.”

“NPV” stands for “Net Present Value.”  Ignoring the terminology, formulas, and acronyms used in the NPV Test, it  is basically a number-crunching analysis of the underlying investment (i.e. the borrower’ s loan) based upon two opposite scenarios: (1) What is the net present value of the loan if the pre-foreclosure event (loan mod, short sale, deed-in-lieu) is approved, versus (2) The net present value of the investment if it is foreclosed.  If the NPV figure is higher under the pre-foreclosure scenario, it is declared “positive” and will be approved – since it is in the economic interest of the investment’s owner (e.g the bank or investor) to do so.  If the NPV analysis is higher under the foreclosure scenario, the test results are deemed “negative” and the borrower’s requested pre-foreclosure solution will be denied. For a fairly concise and objective discussion of  the NPV Test see the Mortgage Bankers Association explanation.

It is important to note that the explanation servicers usually give for preferring algorithms over altruism in their decision-making process, is that their loan servicing agreements require that they do so to maximize the yield for the owners of the loans.  Economic self-interest, again. The servicers rightfully don’t want to be sued by the loans’ owners for agreeing to distressed housing solutions that could result in lower returns…even if doing so is in the best financial interest of borrowers.  It is also important to note that Fannie stands squarely behind the NPV test for evaluating distressed housing solutions. See, link.

So, back to Fannie’s threats to sue borrowers who engage in strategic defaults.   In reality, the lenders’ “NPV tests” and the borrowers’ “financial prudence tests” are opposite sides of the same coin.  Lenders, servicers and investors, make their distressed housing decisions based upon economic self-interest… and so must borrowers.  In other words, as between borrowers and lenders, altruism plays no role on either side of the negotiating table.