What is 'Strategic Default'
A strategic default is a deliberate default by a borrower. As the name implies, a strategic default is done as a financial strategy and not involuntarily. Strategic defaults are commonly employed by mortgage holders of residential and commercial property who have analyzed the costs and benefits of defaulting rather than continuing to make payments and found it more beneficial to default.
BREAKING DOWN 'Strategic Default'
A borrower usually strategically defaults when the property involved is underwater, or has negative equity. The borrower may be financially capable of making the mortgage payments on said property, but nevertheless owes more than the property is worth. Therefore, the borrower may decide that strategic default is a better financial decision than continuing to pay the mortgage. It provides a means for the property owner to mitigate loss when the value of the property drops below the amount owed on the property. Owners who use this strategy have been assigned the nickname walkaways. The process of performing a strategic default has been nicknamed jingle mail for the act of mailing keys back to the bank.
Who Uses Strategic Defaults?
Strategic defaults are common among corporate borrowers who use it as a strategy to cut their losses when the value of an investment property has plummeted, leaving the borrower with negative equity. For example, in 2010, real estate developers Tishman Speyer Properties and BlackRock Realty strategically defaulted on mortgages worth $4.4 billion that they held for two Manhattan apartment complexes, after the property dropped in value by more than half.
Individual mortgage holders may also exercise strategic default. This was common in the years following the bursting of the U.S. real estate bubble in 2006-2007, which led to the Great Recession. Strategic defaults have remained common among individual mortgage holders in the years following the recession, as home values have failed to increase enough to free many debtors from the burden of negative equity.
Consequences of Strategic Default
While strategic default can free a debtor from the burden of negative equity on an underwater mortgage, and can allow the debtor to use his or her income for other expenses or the payment of other debts, it can also cause substantial damage to the strategic defaulter’s credit rating. A mortgage holder with otherwise good credit can expect to lose at least 100 points from his or her credit rating as a result of strategic default. For this reason, many debtors plan for strategic default by saving money, opening new high-limit credit cards, or taking out new car loans or even mortgages on other properties before defaulting.