There is a certain phrase that’s been popping up around mortgage industry water coolers for the past year or so and it seems like it’s getting more and more attention as time goes on. It’s a term that most people understand simply out of context but probably don’t quite comprehend the significance of right now. This little phrase is so important that most banks are more concerned about its impact on their books than they are about generating any new business. It’s only a couple of words long, but the influence that it can have on a bank or hard money lender is expansive. The term we’re talking about is: strategic default.
What is strategic default? The Wikipedia definition is actually pretty good in this case. It states that…
Strategic default is the decision by a borrower to stop making payments (i.e., to default) on a debt despite having the financial ability to make the payments.This is particularly associated with residential and commercial mortgages, in which case it usually occurs after a substantial drop in the property’s price such that the debt owed is (considerably) greater than the value of the property – the property has negative equity or is “underwater” – and is expected to remain so for the foreseeable future.
Great definition, right? But why do we care? Simple: any time a mortgage balance is higher than the value of the real estate that it’s secured by the lender is at risk of a strategic default, and that risk exists regardless of how well qualified the borrower is. Over the last several years this country’s banks have become the largest victims of strategic default from coast to coast. Thousands of borrowers that could have continued to make payments on their mortgages have walked away from property simply because it was easier to let the bank own it than continue to throw money at it. After all, many of these borrowers put very little money down when they purchased the property. Others were able to refinance and borrow back any money that they put into the property. So what do these borrowers have to lose? Usually nothing. Their properties have become money gobbling monsters, and they’re tired of feeding them. But the monster doesn’t go away just because it’s not being fed by the borrower – it’ll just eat someone else’s lunch.
Many private lenders have fallen victim to the same fate that hundreds of banks have. Their doors are now closed because they can’t afford to feed all of the monsters that they’ve inherited from their borrowers. But, for those lenders that are doing business today it’s crucial to understand what happened to all of the defunct lenders from the last several years in order to avoid making the same mistakes.
In a nutshell, lenders were at fault for lending too much money and not requiring enough security. For several years, most of the country forgot that real estate values don’t always go up, especially at the rate that they were increasing. So, the second that the real estate marketplace took a turn it didn’t take long before a large portion of property owners were faced with the obligation to make payments on loans that were secured by assets worth less than their debt. The solution at that point was simple – walk away. Unfortunately, this is still happening today and will continue to happen well into the future as some lenders continue to overextend credit.
There are a few points to be made here:
- Nothing in the loan underwriting process is more important than ensuring that you have good, solid collateral. No matter how much money a borrower makes every month, how well off he or she claims to be, or how big of an inheritance they’re soon to receive a lender isn’t going to see a dime of their money back if the borrower senses that their investment isn’t worth it. Instead, the lender will have essentially purchased the property for about the amount that they loaned the borrower. It’s just simple math.
- Lending in 2011 is about quality, not quantity. Smart lenders may make fewer total loans than some other lenders, but they’ll survive and thrive in these tough times. The loans that smart lenders will make will be of utmost quality. The other lenders out there may continue to extend far too much leverage on real estate while the potential for further market decline looms, but the smart lenders won’t fall into the same trap. They know that if the market hits another bump in the road there will be three letters they’ll be getting to know very well: R – E – O.
- Borrower quality is important, but not nearly as important as asset quality. Asset-based lenders exist for a reason: today’s “quality loan” is properly secured, mitigating any prevailing market risk. Smart asset-based lenders sleep well at night knowing that tomorrow’s headline isn’t going to affect the safety of their investment.
So how do hard money lenders handle strategic default? They don’t ever make a loan that a borrower will be able to walk away from. If you’re going to invest in mortgage loans in today’s market, be sure that you’re properly securing your investment, and if you’re a borrower that’s going to look for a hard money loan in today’s market then be sure you understand what lenders are up against and what you’re going to have to do to secure financing. These aren’t easy times, but solutions do exist for both borrowers and investors that understand what they’re up against.