FICO, a provider of analytics and decision management technology, has announced an analytic advance that substantially improves lenders' ability to identify borrowers at risk of strategic default on mortgages. The company is consulting with top mortgage lenders to provide custom analytic solutions for their mortgage portfolios, allowing them to take preventative action and reduce the costly impact of strategic defaults.
Strategic defaults occur when a borrower who has the capacity to make their mortgage payments chooses instead to default, often because the property value is less than the mortgage's outstanding principal. Lenders have traditionally used the degree of home price depreciation as a basis for predicting strategic defaults; however, new FICO Labs research indicates that borrowers whose houses have lost the most value are only twice as likely to default as those whose houses have lost the least value. Through the use of custom analytic models, FICO Labs researchers have demonstrated the ability to identify borrowers who are over 100 times more likely to default strategically than others.
In addition, FICO Labs researchers have found that, as a group, strategic defaulters tend to be more savvy managers of their credit than the general population, with higher FICO Scores, lower revolving balances, fewer instances of exceeding limits on their credit cards and lower retail credit card usage. This indicates that strategic defaulters display a different type of credit behavior than distressed consumers who miss payments.
"Mortgage payment patterns have shifted, and some borrowers are intentionally defaulting on their mortgages because they believe it is in their best financial interest, and because they believe the consequences will be minimal," said Dr. Andrew Jennings, chief analytics officer at FICO and head of FICO Labs. "Before mortgage servicers can work effectively with potential strategic defaulters, they must first be able to identify them. Our new research shows it is possible for servicers to find those at greatest risk of strategic default, both to prevent losses and to prevent borrowers from making a decision that will damage their credit future."
Experts say continued weakness in the mortgage sector is driving greater numbers of strategic defaults. Studies from the University of Chicago Booth School of Business indicate that in September 2010, 35 percent of mortgage defaults were strategic, up from 26 percent in March 2009. A March 2011 study by CoreLogic shows that the number of residential mortgages with negative equity reached 11.1 million in the fourth quarter of 2010, or 23.1 percent of all residential mortgages in the United States, up from 22.5 percent in the third quarter.
"The continued weakness in the housing market makes it imperative for the mortgage industry to develop more profitable lending strategies," said Craig Focardi, senior research director with TowerGroup. "Preventing strategic defaults—a relatively new problem—is a critical area of focus for mortgage lenders. Lenders and servicers need to evaluate and implement new analytic innovations to deal with new and traditional forms of risk."
The FICO Labs team built strategic default analytics to test the ability to rank-order both current and delinquent borrowers by their likelihood of strategically defaulting on their mortgage. Their custom models achieved excellent separation of borrowers into high versus low strategic default risk bands. Among current borrowers (i.e., those not delinquent on any loans):
►The riskiest borrowers were found to be 110 times more likely to commit a strategic default than the least risky borrowers.
►The riskiest 20 percent of borrowers included 67 percent of those who later committed strategic default. In other words, a servicer could reach two-thirds of those who would commit strategic default by targeting just 20 percent of its borrowers.
"The ability to spot likely strategic defaulters before delinquency enables servicers to intervene early," said Dr. Jennings. "Strategic defaults are bad for lenders and investors, they're bad for the homeowners who elect to default and they're bad for neighborhoods and cities. Preventing them is in the interests of everyone involved."