Borrowers who strategically default on their first mortgage often continue to pay on home equity lines of credit, according to a new white paper from two authors with the Philadelphia Federal Reserve
The authors, Julapa Jagtiani and William W. Lang, said they wanted to take a closer look at the little-studied phenomenon of strategic default behavior as it relates to first- and second-lien mortgages.
“Predicting mortgage losses has become more difficult with the increase in strategic default behavior and the increase in loan modifications,” the paper said.
“Focusing on mortgage defaults, our results indicate that the default rate for first mortgages far exceeded those of the second-lien mortgages during the financial crisis. This behavior was not observed in the pre-financial crisis period (i.e., the booming period of 2004-2006)."
About 20% of borrowers in the process of foreclosure due to defaults on the first mortgage kept their second-lien mortgage current. Among those who defaulted on their second-lien mortgages, about 80% also defaulted on their first-lien mortgage.
Data for the study came from a large random sample of individual credit records drawn at the end of each quarter from Equifax
, a national credit bureau. The authors only studied consumers who had one first mortgage and at least one home equity line of credit or home equity loan over the period beginning in the fourth quarter of 2004 and ending in the second quarter of 2010. The study
merged the Equifax data with another database of loan-level data from LPS Applied Analytics
The data contradict the hypothesis that consumers would strategically default on a second lien and keep their first lien current to reduce their monthly payment and thus avoid a foreclosure, the white paper said. Instead, a far larger number of households do the opposite; that is, they default on their first lien — thus risking a foreclosure — while keeping their underwater second-lien mortgages current.
The authors hypothesized that borrowers have incentives to keep their second lien current — after having stopped paying their first mortgage — in order to maintain their access to credit through the HELOC.
The study also found that the size of the unused line of credit is an important factor. Homeowners with larger credit lines are less likely to default, as they are motivated to maintain their access to the credit line.
Like other studies and white papers, this one also found that negative equity is a big driver in strategic default.
“A large portion of first mortgages with estimated LTV (loan-to-value) ratios greater than 100% is still current, but the continued willingness and ability of these homeowners to make their mortgage payments is subject to great uncertainty,” the authors wrote.
The paper also noted that banks are not punishing borrowers who default on their first mortgages by limiting access to their home equity lines of credit. That could be due to poor risk management practices or lack of timely updates on consumer's risk scores, the paper said.
“Most of the HELOC lines were not increased or decreased after the borrowers defaulted on their first mortgages,” the paper said. “About 90% of the lines remain unchanged even after three quarters following first mortgage default. Interestingly, a small percentage (3% to 6%) of these borrowers had their HELOC lines increased.”
Lenders have the right to foreclose in defaults of first- or second-lien mortgages.
Given the large number of current homeowners with negative equity, there are likely a large number of borrowers who could default on their home equity loans without being forced into foreclosure, the paper noted.
“The data indicate, however, that borrowers rarely engage in this strategy even though it appears to be viable."
Although homeowners could default on their second-lien mortgages, lower their mortgage payment, and stay in the home, the loan contract stays valid and unpaid interest payments would keep accumulating. Should the house be sold, the second-lien creditor would be eligible for the recovery after the first-lien creditor is paid, the paper said.
Write to Kerry Curry