FICO Profiles the Strategic Defaulter

The credit assessment firm FICO says it’s developed a method, using consumer behavior analytics, that will allow lenders to identify borrowers who are a risk for strategic default.

As home prices began heading further and further south, the term “strategic default” made its way into industry jargon…and into the minds of lending and servicing professionals already struggling to keep up with large volumes of borrowers who actually can’t afford their mortgage payments.

Strategic default refers to a relatively new phenomenon where borrowers who have the capacity to make their mortgage payments but choose instead to default, often because the property value is less than what they owe on the mortgage loan.

Last year, the practice had become such a concern within the industry that Fannie Mae announced policy changes aimed at stepping up penalties against borrowers who simply walked away from their mortgage obligations even though they had the ability to continue payments. But the problem is, how do you pinpoint a strategic defaulter?

The credit assessment firm FICO says it’s developed a method, using consumer behavior analytics, that will allow lenders to identify borrowers who are a risk for strategic default.

Lenders have traditionally used the degree of home price depreciation as a basis for predicting strategic defaults, but with property values tumbling far and wide, homeowners who are actually distressed and can no longer afford their mortgage payments are likely to be just as underwater as strategic defaulters.

In addition, new FICO Labs research indicates that borrowers whose homes have lost the most value are only twice as likely to default as those whose homes have lost the least value.

Through the use of custom analytic models, FICO Labs researchers say they have demonstrated the ability to identify borrowers who are over 100 times more likely to default strategically than others.

They say, 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.

All factors point to the fact 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 the Minneapolis-based FICO and head of FICO Labs. “Before mortgage servicers can work effectively with potential strategic defaulters, they must first be able to identify them.”

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.

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. The company says their custom models “achieved excellent separation of borrowers into high versus low strategic default risk bands.”

Among current borrowers, 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, FICO says.

“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.”

FICO is already consulting with top mortgage lenders to provide custom analytic solutions for their mortgage portfolios, in order to take preventative action and reduce the costly impact of strategic defaults.

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