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.