Monday, June 28, 2010

FANNIE MAE: Attacking Strategic Defaults


On June 23, 2010, Fannie Mae announced a change to its "waiting period" policy for prior foreclosures. Heretofore, the waiting period that must elapse after a borrower experiences a foreclosure is seven years. However, Fannie Mae allowed a shorter time period - five years - if certain additional requirements were met (i.e., minimum down payment, credit score, and occupancy requirements).

These requirements have now been modified to remove the five year option. Unless the foreclosure was the result of documented extenuating circumstances, which only requires a three-year waiting period (with additional requirements), all borrowers will now be required to meet a seven-year waiting period after a prior foreclosure to be eligible for a new mortgage loan eligible for sale to Fannie Mae. Fannie Mae's policies for extenuating circumstances remain unchanged (see: Selling Guide, 133-5.3-08, Extenuating Circumstances for Derogatory Credit).

The policy change, effective October 1, 2010, reflects Fannie's commitment to reduce the growing epidemic of strategic defaults.

The policy change was announced at the same time that Fannie put forth a News Release entitled Seven-Year Lockout Policy for Strategic Defaulters. In the announcement, Fannie stated that the changes are designed to encourage borrowers to work with their servicers and pursue alternatives to foreclosure, and specifically stating that defaulting borrowers who walk-away and had the capacity to pay or did not complete a workout alternative in good faith will be ineligible for a new Fannie Mae-backed mortgage loan for a period of seven years from the date of foreclosure.

Borrowers with extenuating circumstances who work out one of the foreclosure alternatives with their servicer could be eligible for a new mortgage loan in three years and in as little as two years depending on the circumstances. However, Fannie will also take legal action to recoup the outstanding mortgage debt from borrowers who strategically default on their loans in jurisdictions that allow for deficiency judgments.

Strategic Default Epidemic

A strategic default is the decision by a borrower to stop making payments (i.e., defaulting) on a debt despite having the financial ability to make the payments. This is particularly associated with residential and commercial mortgages. Strategic defaults usually occur after a substantial drop in the house's price such that the debt owed is greater than the value of the property (a negative equity condition called "underwater") and is expected to remain so for the foreseeable future.

Borrowers that stop making mortgage payments despite having the ability to pay have traditionally been called "walkaways" - the new term being "strategic defaulters."

Strategic defaults account for almost one-third of all defaults (31% in March 2010), according to research conducted by the University of Chicago Booth School of Business and the Kellogg School of Management. Experian places this statistic at nearly one in five mortgage defaults through the first half of 2009.

More and more defaults are considered "strategic" - where borrowers choose to "walk away" from underwater mortgage obligations regardless of their ability to pay - although to what extent is still up for debate as the two studies cited above demonstrate.

Waiting Period After A Foreclosure

Fannie-Chart (Foreclosure)

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Walking Away

There are two lines of thinking about strategic defaults. One position argues that the borrower has a duty to make payments on debt if the ability to pay is intact. The other position argues that there is no such duty, a loan being a contract between consenting adults, and further noting that financial investors (especially commercial mortgagors) routinely default on non-recourse loans that have negative equity without retaliation from the mortgagee.

In fact, there is an extreme view that argues there is a moral duty to strategically default based on the fact that one should make such decisions based on one's financial interest "unclouded by unnecessary guilt or shame", as lenders who do not modify mortgages do the same, "seek[ing] to maximize profits or minimize losses irrespective of concerns of morality or social responsibility," or to put it more bluntly, stating that "the economy is fundamentally amoral."

Further, obligations to honor a contract are balanced by obligations to oneself and one's family, the latter speaking in favor of strategic default, some arguing "You need to put yourself and your family's finances first," while one also has obligations to a community, which may be damaged by default.

Economist Paul Krugman has noted that strategic defaults will happen after a housing bubble bursts. Many other economists take a similar view. This is consistent with studies and anecdotal information which conclude that most defaults are driven by house equity falling to below the value of the mortgage, combined with a major downward shock to income (i.e., loss of wages).

Of course, foreclosure of the borrower's house will result in a negative credit rating, possibly making obtaining loans in the future more difficult or more expensive for the borrower. With otherwise good credit a new mortgage from US government agencies will be denied until 3 (FHA), and, with the new Fannie announcement, to 7 years (FNMA) have passed since the actual date of foreclosure if extenuating circumstances cannot be proven.

Fannie is updating the additional requirements that apply to borrowers with documented extenuating circumstances to reflect a maximum LTV ratio of the lesser of 90% or the LTV ratio per the Eligibility Matrix for all transactions.

Jurisdictional Variances

Effects vary by jurisdiction: different states in the United States treat default on mortgage debt differently, often depending on whether the mortgage debt is recourse debt or non-recourse debt (i.e., meaning whether the mortgage lender can pursue claims against the defaulted debtor).

Furthermore, mortgage refinancing may be treated differently from a purchase money mortgage, and mortgages on second homes may be treated differently from mortgages on primary residences.

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Underwriting Borrowers with a Prior Foreclosure
Fannie Mae: SEL-2010-08
June 23, 2010