Strategic default is not a moral failing

“Strategic default” involves homeowners deciding to walk away from their homes and mortgages, not because they cannot afford to pay, but because they owe more than their homes are worth. Read the news, and you’ll see that a lot of experts and pundits believe this is unethical.

At the same time, investors routinely “strategically” default on agreements — among them major pension funds… commercial-property ownersbond issuers… and real estate developers

The list goes on and on. The very real possibility of default is why banks have — or should have had — underwriting standards and loan covenants.

First American CoreLogic has issued a study which highlights the pressures on homeowners with negative equity:

Shame, guilt and fear stop many homeowners from reneging on their mortgages…. The government and big banks actively cultivate those emotional constraints because the economic consequences of a large-scale walkaway phenomenon could be dire…

Strategic defaults have widespread repercussions. Ongoing foreclosures destabilize the housing market because the homes are sold at bargain prices. They also undermine the entire economy because banks must eat huge losses and homeowners rein in spending as their own homes lose value. Empty homes hurt neighborhoods and attract blight. And walkaways may inspire copycats – people who’ve seen their neighbors deliberately default feel more emboldened to do so themselves.

… Studies estimate about one-quarter of all defaults are voluntary “walkaways,” also known as strategic defaults and jingle mail (for the sound the abandoned keys make in a mailbox)….

Of all U.S. mortgage holders, about one quarter, or 11.3 million households, are underwater, according to First American CoreLogic, which collects and analyzes mortgage data. In California, 35 percent of mortgage holders are underwater.

…First American said a tipping point seems to come when homeowners have negative equity of 25 percent or more – owing $500,000 on a $400,000 house, for instance. At that point, owner-occupants default as frequently as investors. [emphasis added]

Mark Gimein, blogger and columnist, argues that while there “are many good reasons to keep paying your mortgage to avoid the black mark of foreclosure, the immorality of sticking the bank with a loss isn’t one of them.”

It’s banks, not home buyers, that are in the better position to judge the real estate market and how much their collateral is really worth. The bank approves the assessment and decides how much equity a home buyer will be required to put up. All the mechanics of mortgages are designed to let a lender avoid the situation in which it is owed more on a house than it is worth. The limits on banks’ ability to collect on badly underwritten mortgages places the responsibility for judging the sanity of real estate loans in the hands of lenders.

Clearly in the last few years all these mechanisms failed utterly. They failed, not because of morally bankrupt borrowers who go back on their “promises,” but because bankers decided to count on a perpetually rising real estate market to absolve them of the necessity of responsible lending. [emhasis added] Far from misusing the lending laws, borrowers who use the rights the law gives them to walk away from mortgages merely place the risks of insane lending where the law intends them to lie. What they do is not dishonest; on the contrary, a key reason we give borrowers the ability to do that is to keep bankers honest and responsible.

In periods of market insanity, this doesn’t work. But don’t blame the walkaways for exercising their rights. Blame the bankers who didn’t worry about lending a whole lot more than they could get back in a foreclosure. The lesson of watching debtors walk away is a harsh one (not least for the taxpayers, who now effectively guarantee most mortgages), but the more bankers pay attention to it now, the better their chances of steering clear of the next bubble.

My opinion: the financial system is corrupt and broken. Congress and the Executive branch, being extremely well-funded by the banks and investment houses, are beholden to and controlled by them. Reasonable attempts to provide control and transparency are thwarted (for example, rejecting consumer protection via a mandated “plain vanilla” mortgage option, the suspension of mark-to-market rules, etc.) Nothing will change until we suffer enough to force change. I support a homeowner’s legal right to strategically default, and believe strategic default will be a mechanism of suffering and an aid to change.

Full disclosure: I am a CPA and CFE, with no financial or housing investments, and no debts. As a career auditor, I have seen repeatedly that businessmen will cheat, steal and defraud, just because they can. I am favor of strong regulation where there is potential for and a proven history of large-scale economic harm.
Cross-posted from Asymptotic Life

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