On the ethics of “strategic default”…

Strategic default: When homeowners make a “business decision” to walk away from their underwater mortgage (and home), not because they can’t afford it, but because it’s no longer in their financial interest to keep paying on it.

At least two recent media pieces have focused on that practice, and are worth a read/listen.

The first is from the NYT (January 23). An excerpt:

…millions of American homeowners are “underwater,” meaning that they owe more on their mortgages than their homes are worth. In Nevada, nearly two-thirds of homeowners are in this category. Yet most of them are dutifully continuing to pay their mortgages, despite substantial financial incentives for walking away from them.

A family that financed the entire purchase of a $600,000 home in 2006 could now find itself still owing most of that mortgage, even though the home is now worth only $300,000. The family could rent a similar home for much less than its monthly mortgage payment, saving thousands of dollars a year and hundreds of thousands over a decade.

Some homeowners may keep paying because they think it’s immoral to default….

But does this really come down to a question of morality?

A provocative paper by Brent White, a law professor at the University of Arizona, makes the case that borrowers are actually suffering from a “norm asymmetry.” In other words, they think they are obligated to repay their loans even if it is not in their financial interest to do so, while their lenders are free to do whatever maximizes profits. It’s as if borrowers are playing in a poker game in which they are the only ones who think bluffing is unethical.

The second is the January 29 edition of NPR’s Planet Money podcast. The attorney interviewed in that podcast asserts that defaulting is not against the law; that violating a contract is not illegal; that courts have never allowed punitive damages for breaking a contract.

And yet…I’m having trouble squaring the notion of “strategic default,” of breaking a contract simply because it’s no longer in one’s financial interest, with the fact that the person gave his word that he’d repay the loan.  Do his financial interests trump his word? Does the fact that it’s a business deal give him an out?

As one of my Mississippi REALTOR® friends suggested to me the other day, “Our whole civilization is built on agreements. If we stop keeping agreements, we stop being civilized.” And she added, “It’s bad to be without assets, but it’s worse to be without self respect.”

What do you think?

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15 Responses to On the ethics of “strategic default”…

  1. Julie Emery says:

    I think the question is worth asking on a personal level. What do I believe? What would I do? But I also believe “judge not lest ye be judged”. Thankfully I’m not in this situation. It’s very easy, from a place of security, to say what I wouldn’t do. How do I do my job if I’m judging the decisions my clients are making? Some days I worry that we’re all a little too busy pointing out the sliver in the guy’s eye instead of working on our own issues.
    Yes, it would be awful if everyone in the country began feeling free to tear up contracts that were no longer convenient. That’s not really going to happen. As the NYT mentioned, most of those homeowners are still paying those mortgages.
    If a family pays $600K for a $300K home is that a good use of resources? Would that $300K have been better used elsewhere in the economy? What if that $300K would have bought a better education for the kids?
    I don’t have the answers here but am suspicious of people who absolutely have it all figured out.

  2. I think this will have a trickle-down effect, if every-day people see the big wigs doing it, then they will start doing it too. Just like ‘monkey-see–monkey-do’. There are lots of people who don’t care what a foreclosure does to the credit report.

  3. Pingback: Top 10 real estate posts of the day for 2/1/2010 : Tempe real estate and free home search

  4. Joe Vita says:

    Let your “yes” mean “yes” and your “no” mean “no”.

  5. I find Professor White’s legal arguments compelling especially for people in the state of Arizona. (http://www.azcentral.com/business/articles/2010/01/31/20100131biz-walkaway0131.html) Especially this portion:

    A legal concept known as “efficient breach” holds that it is ethical to breach a contract in cases where the ramifications for doing so are less harmful to the party than adhering to the contract would be.

    White said he’s in the process of crafting another legal argument, based on Arizona’s non-deficiency statute, that says lenders don’t have the legal right to report mortgage defaults to the credit bureaus, and that walking away should not have any negative effect on the borrower’s credit score.

    Scottsdale civil-rights attorney Donald Loeb said he thinks White is absolutely correct.

    Non-deficiency statutes such as the ones in Arizona and California essentially say that lenders trying to collect on an unpaid mortgage loan have a right to foreclose on the home but cannot pursue any other legal claim against the former borrower.

    For instance, the lender can’t sue for the difference between the original loan value and the proceeds from a foreclosure sale of the home.

    The reason it’s called a “non-deficiency” statute, Loeb said, is that it establishes default and subsequent foreclosure as a valid means of fulfilling a mortgage contract, as opposed to being a breach of contract in which one party’s actions are considered “deficient.”

    Loeb said he thinks much of the criticism aimed at homeowners who default is based on a poor understanding of what a contract is.
    A contract is nothing but a legally binding agreement between parties with competing interests that sets forth mutually acceptable terms for their interaction.
    Loeb said every mortgage loan agreement includes default and home repossession as a possible outcome.
    “If you stop making payments, you’re not breaching the contract, because default and foreclosure are valid means of fulfilling the contract,” he said.”

  6. As usual…everyone has to say. That is always the situation. Instead of giving meanings on what is happening, try to help those people by posting articles on how to help themselves…just a piece of advice. Thanks.

  7. First, I think you have some good friends in Mississippi. Next, I believe we live under three laws: legal, moral, and natural. If you went to New Orleans for NARdiGras you got a good dose of natural law at its finest. You saw how we, Realtors, responded morally through the Habitat houses we constructed and by the large number of members who came to the convention after Katrina, and you learned how legal laws have to work so that this place can be rebuilt. With the lending crisis I feel that we need to do the same. We need to give our moral commitment, as we did in NARdiGras, so that legal laws don’t take over moral commitments.

  8. I think this will have a trickle-down effect, if every-day people see the big wigs doing it, then they will start doing it too. Just like ‘monkey-see–monkey-do’. There are lots of people who don’t care what a foreclosure does to the credit report.

  9. mortgages are really helpful to those who does not own a home.but millions of American homeowners are underwater due to these mortgages.

  10. Lenn Harley says:

    WHO INVENTED THE TERM “STRATEGIC DEFAULT”?

    Seems to me that, for an action to be considered strategic, it must be part of a plan of action which would have to have originated before the home buyer purchased. In the case of home owners returning the keys or just walking away, let the chips fall where they may is a reaction to forces far beyond their control.

    In military terms, strategic would mean a plan of military action designed to defeat an enemy.
    In financial terms, strategic would mean using one’s assets to leverage a financial gain.
    Where’s the “financial gain” for the home owner who simply throws in the towel and admitting:

    I know my credit is ruined for probably 5-10 years.
    I know that I won’t be able to buy a home for years.
    I know that I’m foregoing the tax benefits of home ownership.
    I know I’ll probably be renting in a building with high security deposit and few amenities.
    But, at least I won’t be paying for a property with no real value for the foreseeable future. I’m willing to take my medicine, but not contribute to the profit of a mortgage company who is in far better position to take a hit for my home than I. The banks have tax benefits for these losses that I do not have.

    Would any sane person volunteer for this strategy to cure a debt that has no foreseeable end to the demeaning treatment and continuing financial punishment by the world around them??? The defaulting home owner has no defense against the total collapse of their financial life.

    The fact that the home owner is defaulting is indisputable, it’s a simple fact.

    However, the description of that default as being strategic is, to me, quite disputable.

    Perhaps the so called default is not really a default. Of course, it is a technical default under the terms of the mortgage instruments. However, when the industry classifies that default as strategic, then an examination of the action itself could lead to a conclusion that, while technically a cessation of payments is a default, in the larger picture of the mortgage mess, that default could be considered. . . .

    SURVIVAL.

  11. Scott Brunner, VAR CEO says:

    Lenn — All good points…except…the kinds of defaults focused on in the stories I spotlighted are not by folks who are hurting. They haven’t lost their job. They can pay their mortgage. They don’t need to move. It’s not about survival. Instead, they’re simply saying, “I’m underwater. This deal is no longer in my financial interests. I know my credit will take a hit, but I’m outta here.”

    Ethically, I think it’s a different situation than having to default in order to survive financially.

    The comments that have been made here are helpful, and I admit I’m torn about the right and wrong of this situation.

  12. Lenn Harley says:

    Scott. Thanks for your comment, but think about this.

    Did the home buyers who eventually defaulted execute a “strategic plan” to buy, watch the value of their home decline to an amount less than their mortgage, then, in the last step of their “strategic plan” walk away???

    Or did they decide to default rather than continue to drown in a sea of monumental debt for which they would probably never survive.

    I suspect that the term “strategic default” was coined by the public relations department of a large mortgage company to guilt home owners into continuing to make contributions to the lender’s bottom line each month with a payment equal to abut twice it should be for the value of the property.

  13. Tina Merritt says:

    If I buy a stock and it turns out to be a poor investment, it’s ok for me to cut my losses and walk away. If I start a business and the business doesn’t make money, it’s ok to close up shop and move on. But….if I buy a house and it turns out it was a horrible financial decision, I should feel morally obligated to pay for it anyway? That doesn’t make sense. My moral obligation includes supporting my family financially (and to the best of my ability). That is much more important than any “moral obligation” I have to abide by the terms of a mortgage or deed of trust to a lender. I agree with Lenn (as usual), the term “Strategic Default” is incorrect by definition. I think “Planned Default” is a better term.

  14. Even though the homeowner is upside down right now, that won’t always be the case. If the payments can be afforded, and paid on time, the balance will eventually be reduced. And, I expect, market conditions will also shift in favor of the property value rising. So, unless the loan is an ARM about to adjust astronomically, what has really changed from the day you bought the house? You have a fixed, per month cost to live there, raise your family, etc. This hasn’t changed.

  15. It’s true that the homeowner MAY not always be upside-down but it’s also true that the homeowner may not live long enough to reach a zero-equity position.

    Mike’s point is well taken. If your choice is to have a foreclosure or default on your record and you become unable to purchase a property for several years, will your equity position in another home be equal to or greater than your current home at the end of say…10 years?

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