Strategic Default: What about the Insurer?

I haven’t covered strategic default in a while because I worried not only about giving borrowers the wrong idea, but also about simply beating the subject to death through overexposure. Recently, however, I realized there was one aspect of strategic default that I hadn’t covered: mortgage insurance.

As I wrote in previous posts, lenders cannot sue for deficiency judgments in sates with non-recourse laws, regardless of whether they can prove that borrowers defaulted intentionally. In addition, while Fannie Mae has announced that borrowers that strategically default will be barred from obtaining a new mortgage for 7 years, it also lacks the authority to seek penalties against borrowers. In this tidy summary, however, I appear to have left out mortgage insurers.

Some background: borrowers that obtain mortgages with an LTV of above 80% (aka down payment below 20%) are usually required to purchase private mortgage insurance (PMI), paying both an upfront insurance premium as well as annual premiums. When the balance of the loan falls below 80% LTV (as a result of mortgage repayment and home price appreciation), PMI is typically no longer required. The purpose of PMI is to protect the lender against default, which is statistically much more likely with mortgages with such low down payments.

In the event of the default, the lender (or investor, if the loan was sold) will receive remuneration from the PMI insurer equal to the difference between what the house can be sold for and the balance of the loan. Naturally, PMI insurers are inherently unhappy about paying insurance claims, regardless of the circumstances of the borrower that caused him to default. Strategic defaults are probably even more agitating, since they tend to be associated with underwater mortgages, and hence, insurance payouts.

In such situations, PMI insurers might have a legal basis for seeking deficiency judgments against borrowers. Personally, I’m not clear on how this is impacted by non-recourse laws; it probably depends on the contract that governs the insurance agreement. At the very least, however, it would probably be a good idea to investigate your potential liability in this regard if you have private mortgage insurance and are contemplating strategic default.