Are Mortgage Defaulters Getting a Pass?

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Don’t just walk, skip (Photo: Getty Images)

It appears not paying your mortgage won’t hurt your credit as much as you think.

The New York Times reports that banks, in an effort to boost their credit card business, are courting customers who decided to default on their home loans. So-called “strategic defaulters,” who walk away from their mortgage loan because they owe more than their house is worth, are now apparently considered to be good potential customers. Voluntarily choosing foreclosures was once seen as financial suicide. It was assumed that banks would shun those that didn’t end up paying back their home loans. But it turns out that was more of a threat by the banks. That’s good news from the millions of Americans who are underwater on their homes. But if banks are truly giving strategic defaulters a pass that could lead to a new wave defaults, and more pain for their mortgage lending divisions and the housing market in general. This seems like another dumb move for the banks and for our economy. Here’s why:

The banks’ credit card businesses have taken a hit from the recession and new financial regulations. So they need new customers. The question is where will they get those customers. In the past two years, many people have had problems paying off their debt. Others are already over leveraged. So in that context it would seem that people who walked away from their homes would make good candidates to be new credit card customers. First of all, they could have kept paying their loans. Second, most strategic defaulters are now all of a sudden much more debt free, especially if they chose to become renters.  That may mean they are even a less risky borrower.

The problem is that while there have been a significant number of strategic defaulters, there are millions more who are underwater and still paying their mortgages. On Monday, research firm Corelogic reported that there are nearly 11 million homes around the country that are worth less what borrowers owe on those houses. That was down from a peak of 11.3 million homes in the beginning of the year. But it is still a lot. According to Corelogic, 22.5% of all homeowners with a mortgage are now underwater. Worse, home prices have started to fall again. If values were to drop another 5%, Corelogic estimates the number of borrowers who owe more than they own would jump 2.4 million.

Not all of these people will end up defaulting. Many borrowers, out of love for their house or obligation, will choose to continue to pay even if it makes more financial sense to walk away. Still, we have come a long when from the moral outrage that was once associated with walking away from your mortgage. And that makes sense to me. When a bank makes a home loan they should realize they are taking on real estate risk as well as credit risk. They share the risk of falling home prices along with the consumer. So individuals should have a right to stop paying on their mortgage if it will improve their finances. If banks want to keep them paying, they should have to offer incentives, like the very good Responsible Homeowner Reward Program.

Yet, I think shunning those customers that do end up walking away from their mortgages is a good thing as well, for the banks and for the economy. For the banks, even offering tacit approval for strategic defaulting seems like another dumb move. Even if many of the loans were sold off to investors, banks lose money when people stop paying their mortgages. And while I haven’t done the numbers, my guess is that they would lose more money from the added defaults than they gain from the new card business.

Second, one of the problems that led to the financial crisis was too much risk. Strategic default should be one of the mechanisms that helps to deleverage the economy. But if the people who walk away from their mortgage just become the pool from which banks pitch high-cost credit cards, then financial healing process we need won’t happen.