Strategic Default Penalties Threaten Struggling Homeowners

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On Wednesday, Fannie Mae, the government-sponsored enterprise that buys up mortgage contracts from loan originators to keep the housing market liquid, announced new penalties for homeowners who strategically default. “Defaulting borrowers who walk away and had the capacity to pay 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,” the company announced, adding that the policy goes into effect July 1. “Fannie Mae will also take legal action to recoup the outstanding mortgage debt from borrowers who strategically default on their loans in jurisdictions that allow for deficiency judgments.” The new provisions mean that if you strategically default, you likely cannot get a conforming mortgage for seven years. And if you strategically default in some areas, Fannie Mae will come after you in court.

[Economy1] But the Fannie Mae rule — one of several new provisions aimed at penalizing strategic defaulters — raises the possibility that the government and loan servicers might imminently begin targeting an economically vulnerable population, one characterized by housing insecurity and joblessness. It brings up the immediate concern — for both defaulting homeowners and the agencies trying to keep them paying — of how to distinguish “strategic” defaulters from those defaulting because they have no choice. And the data shows that those considering default are by most metrics in financial straits, whether solvent or not.

Consider, for instance, the situation of Charlene Mueller-Holden of Newark, Del. Mueller-Holden is a wife and the mother of two young boys, ages three and six. She lost her $60,000-a-year job as an instructional designer in January 2008. Two and a half years later she has not found a job, despite persistent searching.

“My family is slowly starting to lose the things that everyone takes for granted — a roof over our head and food on the table,” she says. “I was living the American dream. I did everything that everyone tells you to do. I had a great 401k, life insurance and five months’ [worth of] bills sitting in the bank in case of an emergency,” she notes.

The family lives in a modest three-bedroom. After Mueller-Holden exhausted her $1,200-a-month unemployment benefits and the family traded in for a cheaper car, exhausted its savings and tapped its retirement accounts, it has still had trouble keeping up on the mortgage. Her husband brings home around $1,800 a month — the family’s only source of income now. The $1,046.73 monthly mortgage payment started eating up 60 percent of the family’s income. Given food, gas and utilities — plus the cost of keeping the kids clothed and unexpected car repairs — the Mueller-Holdens became hard-up. They refinanced their mortgage under the Home Affordable Modification Plan, seeking to bring the payment down to a sustainable level. Their new payment? $1008.77 — 56 percent of their monthly income. And the balance on the mortgage increased.

“This year my husband’s overtime has been cut out and his hourly salary has been cut and now we are just grateful he has a job,” Mueller-Holden says. “We are beyond struggling. Each month I have to go through our bills to see which one might be able to wait, because we have to buy bread and peanut butter so the kids have something to eat. No more vegetables, no more fresh fruit. No new or used clothes for them this year.”

According to Mueller-Holden, it is not a question of whether the family will default on the mortgage if she does not find work, and fast. It is a question of when and how. The family’s credit score is already seriously tarnished. “I used to have an 820,” Mueller-Holden, says, referring to her FICO score. Imminent default and the six- or twelve-month period before actual foreclosure would provide some relief. No other federal program or bank refinancing initiative will. Indeed, the government itself is on the verge of penalizing strategic defaulters. The FHA Reform Act passed by the House but not yet taken up by the Senate excludes strategic defaulters from receiving Federal Housing Administration-backed loans — a provision included with bipartisan backing, including from most Republicans and Rep. Barney Frank (D-Mass.), the head of the House Financial Services Committee.

The question confronting Mueller-Holdens and the millions of other homeowners facing default is this: How will Fannie Mae and other entities going after defaulters decide what “strategic” default really is? Will they qualify? Will the government or their bank come after them, even when they are on the verge of poverty?

Certainly, over the course of the recession, strategic default has emerged as a phenomenon, with a few particularly famous cases of families pulling the plug on the mortgage and heading to Disney World. The most cited study of strategic default, from credit firm Experian and consulting firm Oliver Wyman, found that as many as 588,000 families strategically defaulted nationwide in 2008 — mostly prime and subprime borrowers in the “sand states” worst hit by declines in home values. Experian and Oliver Wyman deemed people defaulters strategic if they went from having “perfect payment histories” to stopping paying the mortgage entirely, intentionally and suddenly. (All in all, more than three million homeowners received foreclosure filings from banks that year, and banks repossessed 850,000 houses.) But a more recent study by the Federal Reserve showed that four in five strategic defaulters walked away only when deeply underwater, and generally after an “income shock,” such as job loss.

Fannie Mae did not respond to repeated requests for clarification about how hard-up homeowners will need to be before they can default without the new penalties. Thus far, none of the housing experts reached by TWI knew the definition either. The FHA Reform Act that might institute federal penalties for some defaulters instructs the Department of Housing and Urban Development to figure it out. But Mike Konczal of the Roosevelt Institute points to the strictures used by one subprime lender in the 1990s: post-mortgage income of less than $400 a month per family member.

By that standard, Fannie Mae would let homeowners like the Mueller-Holdens off of the hook. They live on just $790 a month after taxes and mortgage payments, but before utilities and all other expenses. (Additionally, they attempted to ameliorate their situation through a HAMP refinancing that ultimately proved useless, as Fannie requests hard-hit borrowers do.) But they exemplify the 5.5 million Americans currently in the foreclosure pipeline. A majority have suffered an “income shock,” like job loss. For many, their mortgage is eating up more than half of their post-tax income.

And now, they have Fannie to worry about.