Apr302010

Strategic default is merely collecting on home price protection insurance sold by lenders

Do loan owners really want to spend a decade or more under water? It will be difficult to send their children off to college when they make too much for their kids to get aid, but they haven’t saved anything because they are paying on a bloated mortgage. At some point, they may decide they don’t want to stay, but then they can’t move because they can’t sell. They spend the rest of their lives quietly fading away.

Many in California will stay because they believe the next housing bubble is right around the corner. Like gamblers at the craps table who were just wiped out, everyone places their bets and hopes for another long run. At least with HELOCs, you never have to worry about leaving chips on the table.

Buyers have no moral duty to lenders

by Brent T. White Brent T. White – Apr. 25, 2010 12:00 AMguilt_mortgage
Associate professor of law, UA The Arizona Republic

As a result of the housing collapse, many Arizonans have seen their homes lose half of their value. Many owe several hundred thousand dollars more than their homes are worth and are unlikely to dig out of their negative equity hole for decades.

For these homeowners, the American dream has become a nightmare – and their financial future is dim.

To compound the stress and anxiety, when they’ve called their lender to work out a solution, they’ve discovered that their lender won’t even talk to them about a loan modification or a short sale as long as they are current on their mortgage.

With no help in sight, some of these underwater homeowners have decided that they would be better off letting go of their homes and have stopped making their mortgage payments. Many have done so with the hope that defaulting will finally bring their lender to the table, but they are also resigned to the fact that they will likely lose their homes.

Wait until Cartel Crusher LLC makes its way to Arizona. They appear to need widespread debt destruction to enable them to get on with their lives. I suspect a broadcast message of hope to home debtors to stay in their homes and eliminate the crushing debt would be well received, at least among the indebted.

It has been suggested that such homeowners are immoral or, at least, irresponsible. I disagree.

Before explaining why, it is important to emphasize that the decision to strategically default on a mortgage involves many complex, localized and individualized factors. No one should decide to strategically default on their mortgage without sitting down first with a knowledgeable professional.

I wonder if professor White laughed to himself as he wrote that silly disclaimer.

But let’s say that you’ve actually sat down with a professional to do the calculations and have concluded that defaulting on your mortgage is the only way out of your financial nightmare. Would it be immoral or irresponsible for you to do so?

The arguments against homeowners intentionally defaulting on their mortgages generally center on the same three basic points.

First, underwater homeowners “promised” to pay their mortgages when they signed the mortgage contract. Second, foreclosures lead to depreciation of neighborhoods, so underwater homeowners should hang on in order to help preserve their neighbors’ property values. And, third, if all underwater homeowners defaulted, the housing market might crash. Homeowners thus have a social obligation to pay their underwater mortgage in order to save the economy.

While all three of these arguments might hold some initial appeal, none holds water.

I had never considered the final two arguments Dr. White presents because they are so silly, but he does go on to address them.

First, a mortgage contract, like all other contracts, is purely a legal document – not a sacred promise.

Think of it this way: when you got your cellphone, you likely signed a contract with your carrier in which you “promised” to pay a set monthly payment for two years. Would it be immoral for you to break your contractual “promise” to pay for two years if you decided that you no longer needed the cellphone and elect instead to pay the early termination fee? Of course not. The option to breach your “promise” to pay is part of the contract.

Though involving more money and something of great sentimental value to most people, a mortgage contract is simply a contract. Like a cellphone contract, a mortgage contract explicitly sets out the consequences of a breach of contract.

A mortgage is like a cellphone contract? Wow, I broke one of those and paid the fee. When you break it down like that, you see how much of the argument about morality and mortgages is pure emotional bullshit. Commercial lenders deal with default all the time because commercial borrowers are completely unemotional about their decisions to pay or default. Since loan owners get emotional about their houses, lenders have learned to play on that emotional bond to create a bogus moral connection.

In other words, the lender has contemplated in advance that the mortgagor might be unable or unwilling to continue making payments on his mortgage at some point and has decided in advance what fair compensation to the lender would be. Specifically, the lender included clauses in the contract providing that the lender can foreclose on the property and keep any payments that have been made. By writing this penalty into the contract, the lender has agreed to accept the property and any payments already made in lieu of the remaining payments.

Moreover, lenders charge Arizona borrowers on average an extra $800 per $100,000 borrowed because Arizona is a non-recourse state, meaning the lender cannot come after the borrower for a deficiency judgment on a purchase money loan. In other words, borrowers in Arizona pay for the option to default on a purchase money loan without recourse. The lender can only take the house.

That’s the agreement. No one forced the lender to make the loan or sign the contract. Indeed, the lender wrote it. And, to be sure, the lender wouldn’t hesitate to exercise his right to take a person’s house if it was in his financial interest to do so. Concerns of morality or socially responsibility wouldn’t be part of the equation.

In short, as far as the law is concerned, choosing to exercise the default option in a mortgage contract is no more immoral than choosing to cancel a cellphone contract. Indeed, exercising the default option in your mortgage contract is similar to cashing in on an insurance policy. You paid for it – and have you a right to exercise it.

I have demonstrated that borrowers used mortgages as option contracts. It is the same idea. Lenders sold downside risk protection to borrowers. They assumed 100% of the risk of price decline, and now lenders want to appeal to borrowers misguided sense of right and wrong to cajole borrowers into paying for the lender’s mistakes.

 

But what about the argument that mortgage default hurts neighborhoods and the economy?

Well, first, in a capitalist society, we don’t generally expect individuals to make personal economic decisions for the collective good. Aside from this fact, however, it’s unfair, in my opinion, to ask underwater homeowners to prop up neighborhood property values, or the housing market, on their backs – especially if means sacrificing their ability to send their children to college or save adequately for their own retirement.

Distressed sellers are under no obligation to endure pain for the fantasies of their neighbors. If the neighborhood values get inflated by a few stupid buyers enabled by reckless lenders, and if the owners in that neighborhood concoct fanciful dreams of wealth, the people become poisoned with entitlement and HELOC spending and other abuses. In my opinion, distressed sellers are doing the neighbors a favor by removing the air from the bubble. As long as the bubble air is present, lenders have room to enable more HELOC borrowing.

Why take homeowners, and not lenders, to task for putting their own financial interest ahead of the common good? Indeed, if lenders were less intransigent and more willing to negotiate, underwater homeowners wouldn’t have to walk away from their homes in order to save themselves from financial ruin. And we wouldn’t have to worry about the fragile housing market crashing again.

Why it is that we speak of morality and social responsibility only when talking about the little guy, who must take his lumps for the common good, while financial institutions are free to protect their bottom line?

It just can’t be the case that it’s morally acceptable for banks to look out for their financial best interest, but it’s not OK for the average American do to exactly the same thing.

I covered Dr. White when he came on the national scene with his paper on walking way, Should You Walk Away from Home Debt?

Underwater and Not Walking Away: Shame, Fear and the Social Management of the Housing Crisis

Brent T. White

Abstract

“Contrary to reports that homeowners are increasingly “walking away” from their mortgages, most homeowners continue to make their payments even when they are significantly underwater. This article suggests that most homeowners do not strategically default as a result of two emotional forces: 1) the desire to avoid the shame and guilt of foreclosure; and 2) exaggerated anxiety over foreclosure’s perceived consequences. Moreover, these emotional constraints are actively cultivated by the government and other social control agents in order to induce homeowners to ignore market and legal norms under which strategic default might not only be a viable option, but also the wisest financial decision. Unlike lenders, individual homeowners have thus generally not acted to minimize their losses and have born a disproportionate share of the burden from the housing collapse.”

WalkingAway1029.pdf

From the main text:

“This article suggest that most underwater homeowners don’t default as a result of two emotional forces: 1) the desire to avoid the shame or guilt associated with foreclosure; and 2) fear over the perceived consequences of foreclosure – consequences that are in actuality much less severe than most homeowners have been led to believe. Moreover, fear, shame, and guilt are not mere “transaction costs” that homeowners calculate according to their own personal tolerance for each. Rather, these emotional constraints are actively cultivated by the government, the financial industry, and other social control agents in order to induce individual homeowners to act in ways that are against their own self interest, but which are – wrongly this article contends – argued to be socially beneficial.”

Dr. White gets it.