One of the more interesting challenges lingering for financial institutions in the aftermath of the recession is the mysterious strategic defaulter.
These are consumers who saw a large reduction in the value of their homes during the housing market's collapse and made a strategic decision to stop paying their mortgages.
They chose to prioritize the payment of their other financial obligations (credit card, auto loans, etc.) over their mortgages, which had become greater than the value of their homes.
In the wake of the recession, close to one fifth of troubled mortgages in the U.S. involved strategic defaulters, according to some estimates.
The trouble with strategic defaulters is that they don’t behave like regular defaulters. They still use credit. They still pay a majority of their bills. They still act like prime consumers even if their credit scores don’t agree. This creates both obstacles and opportunities for financial institutions.
In collections, the last thing a financial institution wants is to waste time treating a delinquent account that doesn’t cure. The collections group has limited resources. They can’t contact every consumer who misses a payment. They need to prioritize.
Sophisticated financial institutions are applying analytic models to help them optimize their treatment resources by segmenting delinquent accounts into different groups.
On one end, you have your low risk accounts. These are consumers who missed a payment or two, but have the willingness and ability to repay. You don’t want to spend time treating these accounts because they are likely to self-cure.
On the other end of the spectrum, you have your high risk accounts - those consumers who have neither the ability nor willingness to repay. You don’t want to invest time on these accounts because it is unlikely that any treatment will be successful.
In the middle, you have the accounts where you want to focus your treatment resources. These are the consumers that probably won’t self-cure, but might repay if they get the right treatment. This is the segment strategic defaulters fit in.
Strategic defaulters, by definition, have the ability to repay but not the willingness. They are intentionally avoiding payment on a specific account in order to optimize their own financial situation. They are very different than the other type of account in this middle segment - the economically distressed consumers that are willing but unable to repay.
These consumers aren’t strategically defaulting on a single account; they are defaulting on accounts across the board because of a change in their financial situation.
For financial institutions looking to optimize their collections resources, the challenge is identifying which delinquent accounts fit into which segments.
It is relatively easy to segment out the low and high risk ends of the spectrum - the ones that you shouldn’t attempt to treat. The harder problem is further segmenting that middle group - the ones that might pay if you apply the right treatment.
It’s critical to be able to separate the strategic defaulters from the economically distressed consumers because the appropriate treatments for each group are very different.
For strategic defaulters, the treatment needs to convince them to honor their obligation. For economically distressed consumers, the treatment needs to provide a realistic plan for working out of delinquency.
Credit Risk Opportunity
Financial institutions are looking to grow their portfolios, adding new customers and deepening relationships with existing customers. Credit risk groups at these financial institutions are tasked with identifying low-risk prospects for acquisition.
The problem is that, coming out of the recession, the competition for the traditional prime segment of consumers is incredibly fierce and consequently the cost of acquiring those consumers is very high. While strategic defaulters are vexing to the collections group, they are rapidly becoming an interesting opportunity in the eyes of credit risk analysts.
According to industry research, before the recession, strategic defaulters were typically good credit risks. This makes sense. Someone who strategically decides to stop paying a single account based on external economic conditions is clearly savvy when it comes to finances.
This is further supported by research that says that most strategic defaulters have jobs (good jobs in many cases) and that before defaulting on their mortgages, many took out additional credit cards (indicating planning and awareness of the impact of a default on their credit scores).
As counter-intuitive as it may seem, this means that strategic defaulters might actually be good credit risks for other financial products like a credit card. They typically have the income and money management skills to make payments and meet financial obligations.
More importantly, the damage incurred by their mortgage default to their credit scores means that the competition for these high-performing customers will be much lower than it should be.
Essentially, a strategic defaulter with a 680 FICO score that can be properly identified and evaluated is likely to be more profitable and less risky than a regular consumer with a 680 FICO score.
Identifying Strategic Defaulters
The recession created a number of interesting variables in the financial industry. Strategic defaulters are one such variable. They represent both an obstacle and potential opportunity for financial institutions.
To successfully deal with the challenges and capitalize on the opportunities associated with these consumers, financial institutions will first need to figure out how to identify them.
Alex Johnson is the marketing specialist for Zoot Enterprises, located in Bozeman, Mont. His email is firstname.lastname@example.org.