The Coming Storm from 'Strategic Mortgage Defaults'

Last Updated Dec 23, 2009 10:06 AM EST

It's an act that, when you first read about it, seems incomprehensible. Home owners who have seen the value of their property plummet below what they owe are simply giving up, throwing the keys in the mailbox, and walking away. Defaulting, in essence.

These folks are different from home owners who can no longer make payments because they lost a job; government programs are in place to help them. No, these "strategic defaulters" are making the calculation that they will be better off financially in the long run, even if their credit rating becomes radioactive for a while.

"Owners can do the math: money saved on the mortgage versus money spent for rent versus costs of an abysmal credit rating for five years," writes Nicolas Retsinas, director of the Joint Center for Housing Studies at Harvard University. "If they do not want to make a major purchase for those years the decision is easy. Indeed, defaulters may end up renting a fancier house, at a lower net cost, in the same neighborhood. Some people net enough for vacations."
Moralists and neighbors may have a problem with this action, but let's remember that many of these homes were purchased during the housing bubble as an investment, not as a place to set down roots. Defaulting now when the investment no longer pays off is, well, rational from that perspective, Retsinas observes.

But here is the bigger problem if strategic defaults continue to increase. Damage to the overall economy could be significant.

"In 2009, almost 25 percent had negative equity," Retsinas writes. "If even half of those owners defaulted, there would be more depressed neighborhoods, more troubled banks -- and, looking not too far into the future, stringent lending standards that would shut the doors of home ownership to the next generation. Lenders calculate risk: adding the risk of 'strategic defaults' to their calculus would lead to higher down payments and higher borrowing rates."
Retsinas' bigger point, I believe, is that America created this problem by encouraging a system that handed out credit like candy, wildly inflated property values, and turned homes into ATM machines. There is no government sponsored fix waiting in the wings.
  • Sean Silverthorne

    Sean Silverthorne is the editor of HBS Working Knowledge, which provides a first look at the research and ideas of Harvard Business School faculty. Working Knowledge, which won a Webby award in 2007, currently records 4 million unique visitors a year. He has been with HBS since 2001.

    Silverthorne has 28 years experience in print and online journalism. Before arriving at HBS, he was a senior editor at CNET and executive editor of ZDNET News. While at At Ziff-Davis, Silverthorne also worked on the daily technology TV show The Site, and was a senior editor at PC Week Inside, which chronicled the business of the technology industry. He has held several reporting and editing roles on a variety of newspapers, and was Investor Business Daily's first journalist based in Silicon Valley.