Mortgages

Strategic Default and the Morality of Walking Away

Comments 15 Comments

The role of the banks … and an alternative

On one issue, Zingales and White almost agree. White points out that in many cases, debtors who initially resist strategic default are ultimately pushed to do it because their lenders have been unresponsive when it comes to renegotiating the terms of their loan. Zingales, for his part, has proposed that as an alternative to strategic default, an amendment be made to the bankruptcy code that allows banks to reset mortgages to the current market value, and then split any future appreciation in value with the debtor.

These arguments recognize the central role banks played in creating the mortgage mess. Originally, mortgages were designed so that both the debtor and the lender share the loan’s risk and potential reward. It was in both sides’ interests to make sure that properties were realistically appraised and the borrower could afford the monthly payments. That’s supposedly why banks run credit checks on borrowers and inspect properties to assess their value… because they knew that if the borrower ran into trouble, they could end up owning the house.

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But during the housing bubble, the relationship between banks and lenders changed.
Instead of holding onto mortgages for 30 years, banks sold them within days of closing and packaged them into securities for investors to buy. Now banks no longer had financial incentive to care about the long-term performance of those loans. Instead they simply needed volume to keep the sales and securitization fees rolling in. So they started lending to just about anybody, using sketchy investment vehicles like stated income loans (also called “liar loans”) to get the job done.

In some states, banks have lessened their risk even further through a process called recourse. That’s when a bank can sue defaulters for the difference between what the property sells for at auction, and what is owed on the place. Though banks rarely exercise this right because of the legal costs and the likelihood of bad PR.

Looking for answers in 2011

People can argue the morality of strategic default until the cows come home, but I suppose the more important issue is how to resolve the issue. 2011 will be a telling year for that question. This year we’ll see a large number of option ARM mortgages reset (these are mortgages that start with a low teaser rate, for five years or so, and then get bumped up to a higher rate). As a result, and many borrowers will see their monthly payments increase.

Will this lead to a new wave of strategic defaults? Will the threat of a wave of defaults encourage banks to renegotiate the terms of these loans, and forgive a portion of the principal? Only time will tell, but I wonder whether you think either party is morally obligated to do one thing or another in these situations. Please tell us what you think in the comments section below.

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  • Call me Sara, Sara Strategic Default

    No the borrower is not morally required to hand over even more money to the lender who wrecked the housing market in the first place. If they hadn’t sold to people who really couldn’t afford homes in the first place, then we wouldn’t be in this mess. But the banks did it because it was profitable. They were making money, money, money!

    And they have already been paid, again–with TARP (my taxes, all of our taxes).

    Main Street still hasn’t gotten a bailout, and probably never will. The supposed government subsidized “mortgage renegotiation” programs aren’t happening. Our bank got TARP funds, and they won’t renegotiate.

    The borrower had an “appraisal” done on the house before we purchased it. It was for $325,000. Now, It’s down to $90,000.

    It was our dream home. But now I see it for what it really was… a statistic of the GREAT SWINDLE. Sorry we’re on the losing end, of course. Strategic default is our solution. More people should go this route. Maybe then the banks WOULD do something, like renegotiate the loans of those who can hold on until that happens?

    The banks and bankers know where they can go.

  • Michael Schreiber

    Sounds like you mean business, Sara. Any concern that in the states where recourse is allowed banks would start suing borrowers for the balance?

    • Sara

      Sure, I suppose the big banks could very well go after people to recoup their losses in those recourse states. I don’t know how something like that would play out politically though. Banks that received TARP money were supposed to make a good faith effort to work with troubled loans. They haven’t done that.

      If large numbers of people started choosing strategic default, I don’t think big banks would be doing anything to improve their reputations by going after people on a grand scale. And I don’t know that politicians would be scoring votes for their reelections if they supported banks in their endeavors to reclaim such losses.
      And people could always fight back by giving up on big banks altogether. There are credit unions, and we are members of ours.

      Oh, and thankfully, I’m in a non-recourse state.

  • Strategic Defaulter

    My husband and I missed our first mortgage payment in December (the first payment I have ever even been late on in my entire life!). We both have stable jobs, excellent credit, and can afford the payments, but our house has devalued significantly (our purchase price in 2007 was $531K, and zillow.com has it currently valued at $246K – even though it appraised for $305K a few months ago). We do not want to become prisoners in our townhome that will be too small once we have children, and the only way to get out is to just give it back to the bank… Though the damage to our credit will be great, we have calculated that the time it will take to repair our credit will be less than the time it will take for our house to appreciate even back to our original purchase price (and we can rent for 30-40% cheaper in the meantime). I am even willing to bet that in 7 years, we will be able to buy back the home we are foreclosing on for less than what we currently owe!

    Before coming to this decision, we tried to refinance and work with the bank, but the bank told us we didn’t qualify because our loan-to-value ratio was outside their limits. If it doesn’t make sense for them to refinance us because the value is so low, why would it make sense for me to keep paying the inflated mortgage amount?!

    Deciding to default was not an easy decision, but we consulted with an attorney who told us to run and not look back. We didn’t want to come to this decision, but it is the unwillingness of the bank to negotiate that pushed us here. Luckily, we have a non-recourse loan, so we do not have to worry about being sued for the deficiency.

    • Michael Schreiber

      Curious… How long did you live, or have you been living in the home, without paying?

  • http://hubpages.com/hub/Strategic-Default-Is-Growing-In-Popularity-Finally Gary Anderson

    Strategic default is growing in popularity and since the ponzi housing scheme was a Wall Street churn, with borrowers set up to do the churning, there is nothing immoral about walking away.

  • Strategic Defaulter

    December was the first payment we missed. We have not yet received a notice of default, so we calculate that we have a minimum of 3-4 months left (and it could be much, much longer, depending on how things turn out and how many foreclosures the bank has to process). We are continuing to pay for HOA dues as the homeowners’ association can and will go after you for unpaid dues, so we are not completely living “rent free.” As for the money that would have gone toward paying mortgage and property taxes, we set up a separate savings account. That way, we can track how much we’ve “saved” – so far, we are up to almost $10K!

    For those considering walking, I would definitely consult with a real estate attorney as each state (and each situation) is different.

    • Michael Schreiber

      Thanks for sharing that. Agree. Consulting with an attorney is very sound advice.

    • Unbelievable

      I can understand someone being down on their luck, but this sounds cheating to me. How clever for one couple to call their ill-gotten funds “savings”. When you intentionally take something without paying for it, it’s usually called stealing. I’m not surprised one lawyer would advise a client to take the money and run, lawyers advise guilty folks all the time. I just wouldn’t consider a lawyer’s advice to a defendant justification for any practice. I guess we should blame the banks for the “default”, because they chose to deal with this element of society. Scheming and conniving out of a legal agreement is morally bankrupt. Paying two or tree times what a house is worth because you can borrow the money is just plain stupid.

      • Jak

        WWTDD? (What would the Donald do?) Well, he’d view it all as “just business” and treat the underwater property as a “market failure”. One of the few times I might agree with The Donald…..

  • John

    Although I’m a home owner and I live in the area of the country where home values have deprecieated much less, I empathize with Sara and I share her sentiments in regard to the banks.

    The banks and mortgage companies were making bad loans and passing them on like hot potatos. And both political parties were complicit in making this happen. They should all be hung for treason for creating this economic disaster.

    There were unscrupulous home owneres and investors, too. And consumers did use their homes like piggy banks. But, it was all sanction by the money lenders and their litttle congresspersons they keep in their pocket.

    I was approved for a home loan at twice the value of the home I purchased. However, I was concerned about being overly extended. That was one of my better financial decissions.

    But, if a home owner like Sara is hopelessly upside down in her mortgage, I can’t blame her. It is a financial decision and large and small banks and businesses do this all the time. However, if she was my neighbor, I wouldn’t appreciate it.

    I’d rather take the pitchfork after the mortgage companies, banks and our congresspersons.

  • ed

    A mortgage is a contract like any other. It has terms and conditions and can be amended by mutual agreement. One of the conditions is if I don’t pay, the bank takes my house and my debt is satisfied (I live in a non-recourse state). I have tried repeatedly to get the bank to lower the principal to the current market value but they have absolutely refused to even consider this (My mortgage is approx 2x what the house is worth). It makes no financial sense to keep paying as my home will never again be worth what I owe so I’ve stopped paying. If the bank won’t make a deal, they can have the house back.

  • Jon

    Although I’m not opposed to the idea of strategic default, I’m a little baffled by some of the rationale by some of these comments.

    Maybe the banks shouldn’t have made these loans (and the politicians on both sides were complicit). But you realize that the bank didn’t decide the sales price of the homes when you purchased them, right? And that it was the seller, not the bank, that received the inflated price? The bank is legitimately out every dollar they loaned you. It’s ridiculous to expect them to change the amount owed just because the value changed.

    That would be like getting a loan for a new car, driving it 10K miles, checking the Kelly Blue book value of the car, and calling up the bank and arguing that the car isn’t worth $30K anymore, so you shouldn’t owe $30K. Seriously???

    But, the bank did sign the contract too, so I really don’t have an argument against strategic default. They price that risk into the loans. Like I said, they shouldn’t have made many of these loans, and if they get bit for that, so be it.

  • http://www.home-liberty.com Mark Moore

    Mike, your article doesn’t discuss much about the actual morality of strategic default (SD), though it does touch on Angelina’s moral repugnance.

    The best moral analysis I have seen was written by Brent White, a professor at UofA,[1]

    I think the parties to a bad contract have a moral obligation to try and negotiate a better (mutually agreeable) arrangement in good faith.

    If they can’t find a fair and mutually agreeable solution, then basically, the gloves are off and anything the contract and the law allow should be “morally acceptable.”

    When the banks refuse to even consider reducing the principal on a loan that is hundreds of thousands of dollars underwater, they are telling the homeowner to exercise the termination clause that strategic default provides.

    -Mark

    [1] http://www.sacbee.com/static/weblogs/real_estate/SSRN-id1494467.pdf

  • Sara

    “When the banks refuse to even consider reducing the principal on a loan that is hundreds of thousands of dollars underwater, they are telling the homeowner to exercise the termination clause that strategic default provides.”

    Thanks for putting that so well, Mark.
    _____

    Update…
    Now happily renting. Really have no desire to buy again.

    Still hoping those responsible for the Great Swindle of 2008 are brought to justice. I won’t be holding my breath though.

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