In my previous two blogs, I introduced the definition of strategic default and compared and contrasted the population to other types of consumers with mortgage delinquency. I also reviewed a few key characteristics that distinguish strategic defaulters as a distinct population.
Although I’ve mentioned that segmenting this group is important, I would like to specifically discuss the value of segmentation as it applies to loan modification programs and the selection of candidates for modification.
How should loan modification strategies be differentiated based on this population?
By definition, strategic defaulters are more likely to take advantage of loan modification programs. They are committed to making the most personally-lucrative financial decisions, so the opportunity to have their loan modified – extending their ‘free’ occupancy – can be highly appealing. Given the adverse selection issue at play with these consumers, lenders need to design loan modification programs that limit abuse and essentially screen-out strategic defaulters from the population.
The objective of lenders when creating loan modification programs should be to identify consumers who show the characteristics of cash-flow managers within our study. These consumers often show similar signs of distress as the strategic defaulters, but differentiate themselves by exhibiting a willingness to pay that the strategic defaulter, by definition, does not.
So, how can a lender make this identification?
Although these groups share similar characteristics at times, it is recommended that lenders reconsider their loan modification decisioning algorithms, and modify their loan modification offers to screen out strategic defaulters. In fact, they could even develop programs such as equity-sharing arrangements whereby the strategic defaulter could be persuaded to remain committed to the mortgage. In the end, strategic defaulters will not self-identify by showing lower credit score trends, by being a bank credit risk, or having previous bankruptcy scores, so lenders must create processes to identify them among their peers.
For more detailed analyses, lenders could also extend the Experian-Oliver Wyman study further, and integrate additional attributes such as current LTV, product type, etc. to expand their segment and identify strategic defaulters within their individual portfolios.