Fair Isaac, also known as FICO, is the company that computes credit scores. Last year, the firm says, folks with FICO scores of 760 or higher defaulted on real estate loans at three times the pace they defaulted on credit card debt. The number of consumers current on their cards but delinquent on their mortgages exploded by 50% in the year after Lehman went belly up.

Strategic defaults rose 128 percent to 588,000 in 2008, according to Experian, one of the other credit bureaus. Strategic defaults are expected to top one million in 2009. Home loans more than 90 days overdue climbed to 5.09 percent in the fourth quarter compared with 4.38 percent the previous quarter, according to the Mortgage Bankers Association. (Yes, the same MBA that recently lost its headquarters in a short sale. The MBA says homeowners have a moral obligation to pay mortgages but apparently the MBA does not.)

Millions of mortgages were issued in the last decade on the basis of nothing more than the credit score issued by FICO, which reveals exactly nothing about a borrower's income, or how his debt load compares to his income, or if the purchase was a good deal, or if the terms of the mortgage were good or bad, or if there was high loan to value.

FICO's CEO told Bloomberg TV he's stunned the phenomenon isn't limited to subprime: "Now we're starting to see at the high end of the marketplace people with good FICO scores having serious delinquency problems."

The business model for credit bureaus appears to have a flaw. The execs at FICO are shocked. They expected subprime borrowers to default, but why would people with good credit scores default?

Let’s look at the numbers on how to execute a strategic default:

A buyer purchased a home 4 years ago with a mortgage of $300,000. Because his credit score was in the 790 range, he makes a down payment of only 3%. The mortgage payment is $2,000 per month. The homeowner has 6 credit cards with a total of $150,000 in available credit ($25k per card).

The current market value of the home is about $125,000 to $150,000. The homeowner is upside down. The homeowner stops paying the mortgage and takes the $2,000 per month and saves it. It takes 14 months before the house is foreclosed, and during this time, the homeowner has set aside $28,000. The home is eventually sold through short sale or the bank forecloses; in either case, the mortgage contract is fulfilled according to the terms of the contract.

The homeowner takes $125,000 out of his credit cards, maxxing out 5 of the 6 cards; he keeps the sixth card for use in emergencies. He takes the $125k and pays cash for a comparable home.

He defaults on the credit card debt and reaches a settlement for all outstanding credit card debt by paying off 22.5%, (That’s the best rate that I have heard of). The cost to wipe out the credit card debt is just over $28,000, which is paid from the $28k saved by not making mortgage payments for the past 14 months.

The homeowner’s credit score is now shot. He goes to a credit repair firm and for about $900, the firm gets all the derogatory credit information removed from his credit reports. After a few months his credit score comes in at 780.

He has wiped out more than $700,000 in total mortgage payments on the first house. He owns the new home free and clear. Instead of making mortgage payments for the next 26 years, he pays himself $2,000 per month or a total of $624,000, and he invests the money in ultra-safe US Treasuries and gold. At the end of 26 years he still has the house, plus several million dollars to enjoy in retirement.

The problem with people who have good credit scores is that many of them know how to use a calculator.

Sinclair Noe

Eat the Bankers

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written by DWG , March 04, 2010

Unfortunately this does not really work in practice unless you are extremely fortunate. When you credit score goes down by 250 points because of the default mortgage, your credit card issuers rapid cut your credit limits and even cancel lines of credit. I should know as I haven't paid my mortgage in 14 months. I went from 100k in available credit to about $7000 in that timeframe and my FICO went from 810 to about 550. I never paid a single cc payment late nor did I even carry a balance from 1 month to the next. That being said I did manage to save up around $50,000 and took another $10,000 loan from my 401k to pay cash for a much smaller place than the one I defaulted on.

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written by Sinclair Noe , March 04, 2010

You are correct that it is difficult to make this strategy work. It requires timing. Still, your own case shows that it can be done (more or less). Thanks for the comments.

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