Feb242017

Was strategic mortgage default ruthless or merely accelerated?

Very few strategic mortgage defaults were ruthless. Most strategic defaults were inevitable, and the borrower merely chose the timing.

People form strong attachments to their homes. Walking away is never a decision they take lightly. We can discuss the pros and cons and come up with our own beliefs and attitudes about it, but the turnover of our housing stock caused by the housing crash will be very painful for those who go through it.

Ruthless default or accelerated default?

I write often about hidden premises buried within the arguments writers make. These distinctions are important, and unless we uncover our fallacious beliefs, we make erroneous judgments and carry false beliefs. I wrote many times about strategic default, and in my last post on the subject, I uncovered something new.

There is no accepted definition of strategic default. Lenders have tried to define the issue as any borrower who is capable of making a payment and chooses not to. On the surface that sounds reasonable, but that misses a very important distinction. Some people chose to default because they know they can’t afford the home and they are merely choosing the timing of the inevitable.

When I think about strategic default, I think about people who chose the timing of their default when there is little reasonable hope of having equity and they are facing escalating payments. The only thing strategic about the default is the timing, not whether or not they will lose the home.

True strategic default — a default by a non-distressed homeowner who can afford the payment on a fixed-rate amortizing mortgage — is rare. In cases where the owner is severely underwater and they can rent for far less than their current payment, the incentive certainly exists, but most borrowers in that circumstance with a fixed-rate mortgage will choose to ride out the collapse. The borrowers with the strongest incentive to default are those with toxic financing or temporary loan modifications that know they are facing an increased debt and an increasing payment. When those borrowers default on their own schedule, is their default truly strategic or merely accelerated?

It is a difficult distinction to make between the truly ruthless default and the merely accelerated one. It is certainly much easier to feel empathy for the accelerated default because these people could never sustain home ownership. There is a dignity in choosing your own time rather than being subject to the whims of bankers and legislators. In contrast, the ruthless defaulters won’t get much sympathy from anyone. What criteria separates the two groups? Who decides? It is possible to embrace one and reject the other?

Do you see a distinction between ruthless (strategic) default and accelerated default?

Turns out strategic mortgage defaults weren’t really strategic

Russ Wiles, The Arizona Republic, May 7, 2016loan_owner

“Strategic default” was the buzzword phrase to describe owners who simply defaulted on their mortgages based on declining values rather than an inability to pay. Their actions fostered a debate centered as much around ethical implications as the financial causes.

A 2015 study, recently highlighted by Harvard’s Shorenstein Center on Media, Politics and Public Policy, takes a much closer look at the types of homeowners who engaged in strategic defaults from 2009-2011. …

The research team … found that unemployment and falling home values make for a toxic financial cocktail, especially if mixed with little or no household rainy-day funds.

A job loss, the researchers concluded, is probably the single biggest financial shock that can lead to a mortgage default. More than 40% of defaulting households who couldn’t make payments were headed by an unemployed individual or one who went through a recent divorce or faced hefty medical expenses.

Nevertheless, most financially distressed households didn’t default, which the researchers said reflected the ability of many of these people to  tap resources such as friends or relatives to tide them over. Even among unemployed households lacking enough savings to make even one monthly mortgage payment, more than 80% stayed current.

In other words, despite no income and no savings, most households in the group continue to pay their mortgages,” the researchers wrote.

The greatest fear of lenders during the bust was that strategic default would spread like a disease once people realized they could quit paying their mortgage and face no consequences. The fear of moral hazard never really materialized.

Another intriguing issue was centered around families who could afford to keep paying their mortgages but chose not to do so. Despite a lot of media attention at the time paid to strategic defaulters, they were rare, according to the study. Fewer than 1% of households with the financial means to pay instead chose to walk away.

“Most households in positions of negative equity with relatively high net worth choose not to default,” the researchers wrote.

Although very few homeowners strategically defaulted on their loans, many large commercial property owners did. The height of hypocrisy on this issue was when the Mortgage Bankers Association defaulted; after all, they were the group telling homeowners not to default.

John Stewart on the MBA defaults from 2010:

The study  largely confirmed that personal financial shocks lead to mortgage defaults — job losses in particular — without citing negative housing equity as an overriding factor. It also showed that many homeowners struggle to hang onto their homes when times get tough, perhaps longer than they should.

Some hang on because they believed prices would rebound, and they would be rewarded. This was residual kool-aid intoxication from the mania. However, most hung on because despite the financial hardships, for moral and practical reasons, they didn’t want to deal with the hassles of moving into a cheaper rental and surrender their identity as homeowners.

The fear of strategic default is a necessary deterrent to foolish lending. Without it, lenders are emboldened to make all manner of bad loans because they believe they will get paid back. Lenders will make nearly any loan if they believe they will get their money back with interest. It’s only when they feel they won’t get repaid are they prompted to loan responsibly.

Lenders attempted to enslave an entire generation. They issued copious amounts of signatory debt to borrowers who only intended to repay that debt if house prices went up. Lenders created the Ponzis I profile on this blog on a daily basis.

Strategic default has been portrayed as immoral by lenders. This is wrong. Lenders were immoral when they abdicated their responsibility to sound lending practices that ensured their borrowers could remain solvent. It is outrageous after such irresponsible lender behavior that lenders have the nerve to chastise borrowers for being immoral when borrowers fail to repay their debts.

Borrowers have moral responsibility to default on loans where the payment on an amortizing mortgage exceeds the cost of a comparable rental.

If borrowers don’t default, if lenders are given a free pass to make another generation insolvent, then we have failed our children. We are sentencing them to live in a world where lenders enslave them through excessive mortgage payments to afford properties comparable to rentals.

Without the fear of strategic default, lenders will conflate asset-backed debt and signatory debt again. Lenders will inflate future housing bubbles, and our children will be faced with the decision to own something far less desirable than what they can rent or sentence themselves to a lifetime of debt servitude.

The next time you read or hear that borrowers who default are being immoral, ask yourself who is really being immoral, the lender or the borrower. In my opinion, it is the lenders who were immoral when they inflated the housing bubble and over-burdened borrowers. The borrower who strategically defaults is behaving morally by doing what’s best for their family.