Throughout the United States, lenders are attempting to identify and evaluate the creditworthiness of “strategic defaults”—those customers that have chosen to stop making mortgage payments because the mortgage was greater than the value of the residence. Many lenders are now asking: Are these customers prudent credit risks—or incredibly risky?
Consumers that strategically default are potentially very risky—after all, they are intentionally not paying their mortgage bills, even though they have the financial means to do so. Clearly each consumer will have an impacted credit bureau and lower FICO® Score. Since these consumers refuse to pay a contractual credit obligation, some lenders consider them more risky than other consumers who have defaulted. Others expect that this segment, since they are not under the same financial duress, will outperform customers who don't have a strategic default profile.
So which view is correct?
To answer that question, more research is needed—and on current data. Predicting credit performance during an economic recovery is always challenging, as recoveries do not have a common profile. The most recent recession was clearly unique due to the depths of the recession, and the increasing relationship of economic performance and consumer credit.
The issue of whether these consumers will pay their bills as the economy recovers creates some unique challenges:
• First and foremost, it is necessary to identify the segment of likely strategic default consumers. FICO is working to do just that using credit bureau information. Many lenders already have this data and, in fact, may have more detailed information from collections activity notes and other internal data.
• Next, the subsequent offers to these consumers need to be carefully tested and evaluated. While the generally accepted practice may be to price higher for the incremental risk, a high-priced offer to a consumer that has chosen not to pay their bills due to dwindling asset value may induce higher risk due to adverse selection. These consumers may have had only the one credit challenge that was a proactive decision. Low credit lines and higher rates for HELOC, overdraft or unsecured credit may lead these consumers to be alienated further and lead to subsequent delinquency that might have been avoidable.
• Therefore, testing of multiple bundles of product and product pricing for lending conditions is vital for this audience. It will also be necessary in the early stages of economic recovery to engage in more active communications policies to assure the quality of information on the consumer is strong, and to take more timely action in both promotion and adverse treatment of the consumers.
Perhaps the most interesting dichotomy is that lenders experiencing strategic defaults have been the most reluctant to extend further credit to these consumers—yet they have the most information on which to make a credit decision, especially if there are relationships beyond the mortgage. While those lenders may wish to sever these relationships, it may well be that they would be better off continuing the relationship with these customers.