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The Hidden High Cost of Strategic Default

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If you’re one of the 28% of U.S. homeowners with a mortgage that’s higher than your house is currently worth, is it time to toss the keys to your lender and walk away?

According to Zillow’s third quarter Negative Equity Report, some 14 million people owe an estimated $1 trillion more on their mortgages than their homes would sell for in today’s depressed real estate market. Perhaps that helps explain why a recent ID Analytics survey estimated that 32% of all adults in the U.S. (nearly 68 million people) say they would be comfortable with the notion of strategic default.

Homeowners who tactically elect to default on their mortgage obligations aren’t typically short on cash, nor are they in financial distress. Rather, they have the means to make their monthly payments but choose not to do so for a couple reasons: their mortgage loans are underwater and they happen to live in states that have enacted so-called anti-deficiency legislation.

The concept behind these laws is fairly straightforward — to protect against or limit the extent to which lenders are able to pursue hardship-experiencing consumers for the difference between what their foreclosed upon houses ultimately sell for and the unpaid loan balances. The laws vary from state to state and are focused on first mortgage loans for primary residences as opposed to second mortgages (homeowner’s equity lines of credit and loans) and financing for vacation houses and investment properties.

On the surface, at least, the motivation appears to have been well intended — helping those who’ve lost a basic human need: a place to live. However, as it too often happens, good intentions are undermined by heavily rationalized self-interest.

In this case, strategic defaulters make two arguments. The first is that it’s the banks’ and mortgage brokers’ fault — they knew housing prices were overvalued and they also knew that consumers were getting in over their heads, but they approved the loans anyway. The second has to do with companies that have, according to those making the argument, reneged on their loan commitments, without suffering the consequences. So why shouldn’t consumers be able to do the same?

Taking the loan approval argument first, I thoroughly agree with the assertion that those lenders and intermediaries who are guilty of malfeasance should pay the price for their actions, although we’ve seen astoundingly little of that to date. In fact by most reports, the financial industry’s hasn’t done nearly enough to address the impaired values of the under-collateralized mortgage loans that are currently on their books, let alone to help the financially distressed mortgagors who continue to struggle to keep up with their payments.

As for the “If the company can do it, why can’t I?” half of the argument, sorry, it doesn’t wash. Subject to the structure of the contract and the corporate entity to which the loan was made, default is rarely a “no harm, no foul” proposition. For example, in my previous life, the loans my companies routinely made to commercial borrowers typically included “cross-collateralization” and “cross-default” language, which permits lenders to claim additional property and to place all of a borrower’s loans into default at the same time even if only a single loan heads south. Moreover, companies that willfully defaulted on their obligations were branded untouchable by the lending community for years to come.

Setting aside for the moment all the legalities, tactics and opinions that make strategic default such a controversial and interesting topic, I see it as an opportunity to think about the consequences of when ethics T-bones morality at the intersection of What I Can Do and What I Should Do.

Although anti-deficiency laws weren’t intended to encourage this type of behavior, they have yet to be modified or repealed. Therefore, strictly speaking, it is not unethical to take advantage of what the law permits. But is it moral? Consider this:

Credit is based upon trust: I trust that if I lend you money, you’ll do all you can to pay me back. However, should you choose not to pay me back, especially when we both know you have the financial wherewithal to do so, it’s going to affect how I operate in the future.

All lenders make four, basic decisions on every loan request they receive: whether they want you as a customer, how much they’ll be willing to lend to you if they do, how much to charge you for the loan they decide to make and the contractual terms and conditions to require. With that in mind, imagine how lenders that do business in anti-deficiency legislation-states will adjust their underwriting standards to take this added risk into effect. They’ll want higher down payments to offset the potential for a loan-to-value shortfall, higher rates and fees to offset the added risks and tighter loan covenants to ensure that they’ll have the ability to pull the trigger that much faster if you start to get creative.

Borrowers that elect to strategically default on their loans may indeed be able to walk away with their financial holdings intact, at least for the time being. However, those who follow will most certainly be made to pay the price. So, is strategic default moral? You decide.

This story is an Op/Ed contribution to Credit.com and does not represent the views of the company or its affiliates.

Image: Sadie Hernandez, via Flickr

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