Strategic Default Under Fire at Fannie Mae

Posted by  on Sep 28, 2010

It gets easier every day to play a game I like to call "Six Degrees of Strategic Default." A decade ago, you wouldn't have been able to broach the subject in polite conversation. Now, it seems like every coffeehouse contains at least one person talking about the practice in tones far above a whisper. What's "right" and what's "fair" might just lie within the eye of the beholder, at least until Fannie Mae weighs in on the issue.

Both sides of the strategic default story make legitimate claims. Mortgage lenders assert that borrowers made moral and financial obligations to pay back money they borrowed, under terms that were favorable at the time. Borrowers counter by saying that it's unfair for banks to avoid loan modification discussions until their customers have reached the brink of foreclosure.

Homeowners try to refinance by default

What makes strategic default different from true financial distress is that participants actually do have the means necessary to make their mortgage payments on time. By simulating a crisis, they hope to provoke lenders into a refinance deal that they would not otherwise qualify for, especially when the deal involves lower mortgage rates and an adjusted home value.

The strategy might just work for families that bank their mortgage payments instead of spending them elsewhere. Some mortgage lenders have already made offers on "cash-in" refinance deals that fall outside the guidelines of the government-backed loan modification program. Yet, some advocates of the practice aim to take things as far as they can. In extreme cases, borrowers exploited backlogged foreclosure processes to remain in defaulted properties as long as possible before bailing out to a (formerly) second home.

Fannie Mae busts the party

However, recent statements by Fannie Mae officials could douse the hopes of borrowers who use strategic default simply to save some money. Simply put, the party's over. Fannie Mae intends to track and punish strategic defaulters by blackballing them from guaranteed home loans for seven years. Even if a strategic default doesn't collapse your credit score, winding up on Fannie Mae's naughty list will prevent you from getting any kind of mortgage, even one with penalty interest rates. That move shifts the debate about strategic default from an ethical dilemma to a practical choice.


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