Part 3: How lenders should handle the situation
So, if strategic default is clearly unethical, financially irresponsible and certainly legally questionable, how are the banks to respond? In the days before the sub-prime meltdown, this would have been an easy question. Since banks were assumed to have the superior ethical standing, they could afford to take a hard-line approach to defaulters and quickly use whatever legal and financial means at their disposal. Now, however, the ethical presumption lies with the borrowers, so the lenders have to be very careful about how they respond.
We will need to approach this issue sensitively and creatively. I have to admit that my first reaction upon hearing about this trend was neither sensitive nor particularly creative. Given the ethical in-defensibility and dire consequences of strategic default, it’s an understandable reaction. Lenders are going to have to resist the urge to play hardball with these borrowers, however. For one thing, it probably won’t work. Since debtors prison hasn’t existed for two hundred years, the borrowers already know that the worst that can happen is that their credit will be ruined; they’ve already worked that into the cost benefit analysis.
The first step will be to draw a profile of who the strategic defaulters are. Since no one bank is likely to have enough data to draw solid conclusions from, there will need to be inter-bank or, preferably, industry-wide cooperation. I’m assuming, since I don’t have access to that sort of data, that a statistical picture of the strategic defaulter is possible and that a predictive model could be constructed. Again, this would have to be an industry effort to aggregate enough data to make meaningful predictions.
Once the picture of the likely defaulter is developed, banks would need to develop individual ways of dealing with them. The most effective way will be to proactively approach the borrowers that fit the profile and offer them some kind of pre-emptive workout plan. It will be harder for the borrowers to default if they feel they’ve been treated fairly by their banks. It would be a way of building brand loyalty and it would skew the cost benefit analysis toward keeping their homes. While it will cost the lenders in the short run, given the fall in value in some real estate markets, the cost of foreclosure and disposition of the defaulted properties will likely even out. Beyond that, should the effects of strategic default become systemic, the losses would be far greater. Dealing with this problem is going to require foresight and a long-term view of these assets and the market as a whole.
Once these proactive workout plans are offered, there will be several further practical steps required to adequately address this problem. First, so that strategic defaulters do not get lumped into the category of those who merely borrowed beyond their means or were victims of the economic downturn, additional means testing would have to be added to work-out planning by the banks. This adds a further burden to non-strategic defaulters, but this is one further consequence of the strategic defaulters’ actions (in other words, the banks can’t be blamed for this…blame the people walking away from their homes).
Second, government regulators and legislators should be brought into the conversation. This sort of activity by individuals borders on fraud and theft and while it may not be universally popular, the systemic danger of strategic default becoming widespread and having a serious impact on the functioning of the lending ecosystem transcends short-term popularity.
Finally, a coordinated publicity campaign about the dangers of strategic default to the society at large and its ethical indefensibility should be undertaken. If the presumption of ethical activity could be more neutral (i.e., neither with the banks nor with individuals), the peer pressure that used to exist that kept people from walking away from their homes could be revived. While it’d require careful execution, I think the intuitive reaction of most people to strategic default is negative, so merely pointing out the possible dire consequences of such defaults might be enough to turn public option strongly against it.
It goes without saying that all three responses would have to be cautious, careful, and sensitively planned and executed. Banks and other mortgage lenders have fallen into the same category as lawyers and politicians in terms of public esteem and ethical estimation. Because of the possibility of systemic consequences such as the possible disruption of the entire mortgage ecosystem (which would have ripple effects in real estate, building, tax revenues, and ever other system that depends on a functioning lending system), I don’t think it should be ignored. The challenge will be convincing the public, regulators, and government officials that the concern of the banks isn’t merely with coughing short-term gains out of already struggling homeowners. By offering proactive help to borrowers who could fall into strategic default, lenders could demonstrate that they are working in the best interest of not only their customers but the economic wellbeing of the entire home owning ecosystem.