Flashback Commentary: Fannie Mae Cracks Down on Strategic Default

So another thing that happened while I was out of town was that Fannie Mae decided to get tough on "strategic defaulters"--people who default not because they can't make their mortgage payments, but because they'd rather spend the money on something more fun than an underwater house.  This has triggered some outrage. 


Felix Salmon writes:

When Fannie Mae got taken over by the US government, it became even more of an instrument of state policy than it was before. Today, Fannie Mae and its state-owned brethren (foremost among them Freddie Mac and the FHA) are responsible for funding the overwhelming majority of mortgages in the US: they essentially are the housing market, for most of us. So when it comes to the problems of default and foreclosure, it's crucial that Fannie Mae be part of the solution rather than part of the problem. Instead, it's decided to get onto a self-defeating moralistic high horse.

Whether or not this is self-defeating, I don't know why Felix is surprised by this outcome.  Every poll I've seen shows that most people think that strategic default is wrong, and feel so rather strongly . . . so expecting the government to be on the side of the strategic defaulters is probably not very realistic.

Nor am I so sure that this is self-defeating.  Felix and others have offered plenty of evidence that doing principal-reduction mortgage mods would be good for borrowers.  But I've never seen much analysis showing that they'd actually be good for the lenders.  Yes, a successful modification avoids foreclosure costs.  But a good calculation would also have to include the following:

1. The administrative costs of the modifications themselves.  It's easy to determine whether someone is in default or not.  It's hard to determine whether or not a) they need the modification b) how much modification they should get and c) how much they can realistically pay.
   
2. Some percentage of your modifications will redefault--somewhere from one third to more than half normally, though it's not clear what that number would be with sizeable principal reductions.  In the case of redefaults, you have all the expenses of the modifications, plus the expenses of the foreclosure.
3. The incentive problems:  principal write-downs are not simply a matter of writing down the principal of people who would have been foreclosed upon, instead of foreclosure.  Principal write-downs are obviously much more attractive than losing the house, which means more people will seek them, than will allow their houses to go into foreclosure.
   

Maybe write-downs on net benefit the banks.  It seems just as likely that they don't--more likely, even.  Which means the public policy question is whether we want to help folks who borrowed too much money on their houses, not whether this is "self defeating".  Doing principal write-downs might well costs Fannie/Freddie, and by extension taxpayers, quite a bit of money.  Is this what we'd like to spend that money on, when right now we can't even extend unemployment benefits?

Ezra Klein also argues that this is not sound business practice:

For one thing, a mortgage is a specific contract. It says that if the borrower stops paying, the bank forecloses on his or her house. It does not say that if the borrower stops paying because a massive recession has destroyed his or her home values and made it impossible to find a job in the area, he or she is barred from participating in the secondary mortgage market five years in the future.

Ah, but Fannie's secondary-market ban is not part of that contract.  It may be (almost certainly is) aimed at stopping people from strategically defaulting on mortgages that Fannie already owns.  But this doesn't alter the terms of an existing contract.  Rather, Fannie is saying that it will use the fact of strategic default in evaluating whose loans it will buy in the future.  This is not only perfectly legitimate; it ought to be standard practice.

After all, your bank already does this all the time.  It uses the information it has on how you have previously used credit in order to determine whether it is willing to offer you a loan (and on what terms).  In fact, we're currently mad at them because they weren't strict enough about this in previous years.

A strategic default is a valuable piece of information.  It tells the bank about your attitude towards credit, and whether or not you are willing to make strenuous efforts to repay your loans.  People who will make heroic efforts to repay loans at great personal cost to themselves are, in fact, better credit risks than people who act as if credit is nothing more than an exotic option, which you can repay if advantageous, or walk away if not.  A financial institution which did not use this information to evaluate future loans would be somewhat negligent.

Klein goes on to argue that strategic default would be hard to determine, but that's true of all mortgage underwriting:  there's always some gray area.  On the whole, however, I doubt that all that many people will fall into the gray area.  If you think it's possible to determine disposable income for the purposes of a mortgage modification, you pretty much inherently think it's possible to determine who defaulted strategically.  In both cases, some of the decisions you make will be bad, but most will be basically sound.

Now, in the future, perhaps we'll find out that strategic defaulters don't pose so much credit risk as we thought.  Then we should re-evaluate (though given their dominance of the secondary market, it might still be sound policy for Fannie and Freddie to use this as a tool to discourage strategic defaults that would otherwise put the taxpayer on the hook).  But until now, strategic defaulters have been rare, so we don't have much data.

Given that, we have to go on reasonable guesses.  If you wonder whether this guess is reasonable, ask yourself whether you would be more, or less, willing to lend a really large sum of money to a stranger who had walked away from their previous mortgage because the value of the home dropped.  Personally, if I wanted to take that sort of bet, I'd buy the house myself.