How does one explain a concept like banking to a small child? If your education was anything like mine, the first time you encountered the concept it was explained with very basic hypotheticals.
Suppose Mary earns $100 and puts it in the bank. The bank has to hold onto her money for her, but they know that Mary probably won't want to take out the whole $100 anytime soon. So they loan from Mary's money to Bob, and they charge Bob "interest.
" Bob pays back $11. Mary's $100 is safe and the bank has made $1. Capitalism for tots.
This oversimplification is an effective way to explain banking to a 6 year old (or, as I've seen in macroeconomics textbooks, concepts like reserve requirements to 18 year old). I think it underscores an important point that seems very far removed from the minds of most people who think about abstract things like "the housing crisis", bank bailouts, and foreclosures. When we borrow money – and I say "we" because I doubt many of us go without a credit card, an auto loan, a student loan, or a mortgage – the bank is giving us someone else's money. We think of it more often than not as The Bank's Money, but the bank has no inherent resources independent of what it can convince customers and investors to deposit with it. You already know this, but I'd be surprised if many people thought about it very often.
When I read about things like "strategic default" – defaulting on a mortgage when the value of the property collapses even though the borrower can afford to continue making payments – it is particularly important to keep the basics of lending in mind. While I am among the most enthusiastic critics of our financial system and the ethics of private enterprise in this country as a whole, it is difficult to understand how responding with equally dubious ethics will lead to better outcomes for any of us:
Jeff Horton, a 33-year-old Orlando, Fla., technology manager, is among those who recently decided to take the step.
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He told his lender that he's done making payments on the condo he bought in 2005 and the home he bought in 2007, because he wants to move from Florida and can't sell or rent the properties at a price nearly high enough to cover his payments.
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Jeff Horton, a 33-year-old Orlando, Fla., technology manager, is among those who recently decided to take the step. He told his lender that he's done making payments on the condo he bought in 2005 and the home he bought in 2007, because he wants to move from Florida and can't sell or rent the properties at a price nearly high enough to cover his payments. "Life is too short," said Horton, who has mortgages totaling about $400,000 with Bank of America — about twice as much as he thinks he would get if he could sell the property. He says he has little choice because the bank has refused to refinance the mortgages or adjust original terms…"I felt guilty at first," said Horton. "It all stopped when I saw them take $90 million in executive bonuses. They take bailout money and do nothing for the little guy. They wouldn't do anything for me."
I applaud Mr. Horton's remarkable skill at rationalizing his selfish behavior. Nonetheless, to describe this approach as short-sighted would be an understatement. In whose interest is this "strategic" default? Mr. Horton won't be getting another loan anytime soon. The bank raises the cost of borrowing to everyone – including those credit cards Horton likely uses to make ends meet – to cover its losses on the defaulted loans. And if enough people engage in this behavior, the government has to step in, through either the political process or FDIC, to cover what depositors are owed.
I would prefer that We maintain the moral high ground in this crisis. Banks have only themselves to blame for their lack of ethics, abandonment of lending standards, and borderline sociopathic inability to accept responsibility for their actions. I understand that when people cannot pay a loan they are going to default on it. The question is, are we at a place as a society at which it's OK to blow off an obligation just because we no longer feel like repaying it? I have no sympathy for a bank that lends money to some yahoo who quite obviously has no hope of paying it back. That said, I have a difficult time mustering sympathy for a borrower who makes an investment – using someone else's money, mind you – and then expects to be absolved of the obligation when the investment loses its value.
HoosierPoli says:
He bought TWO houses and can still be a self-righteous little guy. Nicely done.
Mike says:
A few thoughts.
1. Strategic default isn't a widespread phenomenon, or at least nobody has really recorded it – if anything, people aren't strategically defaulting anywhere close enough to what someone would expect.
2. People pay for the ability to strategically default; interest rates are higher in states where the recourse law (the ability to go after those with balance outstanding on a mortgage) is weaker.
3. For a property with an LTV of 200, or where you owe twice as much as the property is worth as in the example blockquoted above, you will probably be paying something like 12-15 years (including inflation and historical housing price appreciation) to get it to the time where the balance equals the housing value. Or to the point where you could sell it and not take a bath. I understand all the sides of the arguments, but it's tough for me to think this guy should sit out a decade of following a new job and instead add to the stagnant Orlando employment market in order to pay into a debt that isn't worth anything (and if it was a corporate debt, would have been written down long ago).
4. The banks and mortgage servicers fought so hard against intermediate solutions (cramdown, notably, special forms of mortgage bankruptcies in general) and have ignored getting consumers current that this was inevitable. They only have themselves to blame.
quimby says:
Maybe I could be persuaded otherwise, but law school definitely impressed upon me the notion that breaking a contract is generally a morally neutral act. Walking away from obligations doesn't typically occur because contracts — and contract law — are built to keep the non-breaking party from suffering. But the banks here, despite being sophisticated institutions with batteries of lawyers, went and made monumentally stupid bargains. They wrote contracts saying "if you don't pay the mortgage we get your house." And then brilliantly overinflated the worth of the houses and overstated the ability of the borrowers to pay. Maybe I'm a soulless lawyer now, but it's hard for me to see how paying a mortgage that will result in double the value of the home going to the lender is the ethical thing to do. If a high-end gallery sells someone a painting that it estimates to be worth $1 million with a contract clause that says, "pay us every month or we'll come take the painting," does the buyer keep paying after the artist starts doing the covers for O Magazine and the painting is worth $1.50? The reason it sucks for the rest of us here and now is that the banks were so criminally stupid on such a large scale that it put everyone in jeopardy for the borrowers to act rationally.
Spy Hill says:
When did McArdle start guest posting at Ginandtacos?
Mr. Horton's behavior may be motivated by self-interest and doesn't inspire sympathy, but so what? He is not asking for special treatment or government assistance, he is simply following the terms of the original agreement with the lender.
Ed says:
I think that the effects of that reasoning on the incentive to lend (namely that there is none whatsoever unless the borrower is buying something that is guaranteed to hold its value) will be quite harmful if – IF – this practice becomes more generally accepted.
As Mike points out this is far from a widespread phenomenon. Were it to become more common, the rest of us are going to suffer the consequences. I haven't wrapped my head around what will happen on the macroeconomic scale if even qualified borrowers can't take out a mortgage, but perhaps you're right and that's a road we should go down. If defaulting on a loan is morally neutral, we're going to see the end of lending on the terms we're used to at the moment. Maybe you see that as a good thing, but personally I'd like to think someone can borrow $200,000 to buy a home without having to put up almost the same amount as collateral to make it worth the bank's risk that you're simply going to walk away if the home depreciates.
ladiesbane says:
First: this is somewhat the way medical insurance works: I pay $250 per month ($3000 per year) so that, if someone else wrecks his motorcycle and has a $14,000 airlift / $17,000 physician / $42,000 facility-lab-Xray-titanium parts from China-bill, I can pay for the a small part of what his "name your premiums" policy didn't cover (assuming I didn't need any emergency, maintenance, or routine care that year.)
It's NOT "rob the rich and feed the poor", it's "distribution of risk." Right? Or should Mr. "I'm Young And Immortal And Being Held To My Promises Lasts Longer Than My Interest Can Be Held By Some Paper (pffft) Contract Or Whatever" actually be held to his word, and not his attention span, or his assessment of profit potential?
There are some circumstances under which a defaulter may not be ethically wrong, but there are others in which he is. Can we stop trying to paint with an over-wide brush, and acknowledge that we can't say All Lenders Are Evil or All Borrowers Are Evil? I don't have a horse in this race, but overgeneralization bores me limp.
eau says:
Huh? Whazzat?
Text book prices, baseball insignifica, and now responsible feduciary…umm… feduciarity?
Someone be a dear, and wake me when Ed starts making pant-shitting jokes again…
Halcyon says:
Sorry, Ed, but I'm gonna have to disagree on this one. If the bank that made the loan was in a building whose value was less than what they owed on it and they thought it was to their financial advantage to walk away, not only would they, the officials would be *required* to or their investors could sue them for not acting in their best financial interests. Playing by imaginary rules when the people who are waiting to collect don't bother and can't even if they wanted to doesn't make you moral, it just makes you a sucker.
Like quimby said, it's probably the residual effects of Contracts class, but if the banks are worried about people walking away, they shouldn't have made loans to people that would be encouraged to walk away, or they should have taken the risks into account by asking for more upfront. Sometimes you win the capitalism game, and sometimes you lose. Thanks for playing, mortgage lenders, better luck next time.
And, by the way, it's not necessarily true that the outcome would be bad even for people who want to buy homes, in the long run. If the end result is that home prices fall to levels that don't take 30 years to pay off and stay there, people won't *need* $200k to buy a decent home (alternately, as a bonus side effect, people might stop seeing their homes as ATMs and more as life choices that aren't necessarily going to pan out as investments. And if suburban sprawl decreases as a result, double extra bonus).
duck-billed placelot says:
Others have said it, but I will chime in: what happens in case of failing to pay is written into the contract and a perfectly reasonable solution. Strategic defaulters are not stealing from the bank; the bank gets the house, plus all the equity they've built up. If the banks really want to stop systemic defaulting, they'll start writing down loans. Instead, they're saying that the only people who should take a hit for the bubble (which they SYSTEMICALLY caused) are homeowners.
I bet if a big bank introduced a 'meet you half-way' program in which they would agree to write off half the underwater value of a home, strategic default would become statistically insignificant. But they won't.
Aslan Maskhadov says:
Look, whether people start doing this and banks get tight with lending or not really doesn't matter. Here's a startling fact for you- unless the entire economic system is eventually overhauled, or better send so long as the mode of production of wealth is based on private property and the profit motive, you will continue to have periodic crises, depressions, bailouts, austerity measures(for the workers of course!), and so on.
The ruling class in America has its head up its own ass if they truly believe that people are going to go back to spending beyond their means as they did in the 90s with credit. Remember how people who grew up in the Depression were defined by being excessively frugal, even during the post-war prosperity? Remember how Grandma used to have a freezer full of virtually everything, usually bought at rock-bottom prices from one of the dozen warehouse club stores she had memberships with? Remember how Grandpa or Grandma would wash off something they dropped on the floor and proclaim it "still good"? The Great Depression influenced peoples' spending habits. It's only logical that this depression will have an effect on people living through it now.
Even when people do start spending outside their means, the crises will not stop. Some group of investors will inevitably proclaim a new cash cow, everyone will put their money into it for the sake of short-term profit, they will fuck themselves again, and the taxpayers will get to foot the bill again. And don't even think that regulation is the answer- regulate, and they will use their resources to eventually get the regulations repealed as they did in the past.
keith says:
We've seen how the top down bailouts work. Defaulting is a kind of bottom up bailout. Some lenders are agreeing to short sales as a sort of "meet you half way" program. If strategic defaults increase, my guess is we'll see a lot more shorting, and this would be a little bit better for any neighboring properties.
doug says:
Fail, Ed. It is a business contract. The bank gets the collateral. End of story. There is no morality at play.
brent says:
If defaulting on a loan is morally neutral, we're going to see the end of lending on the terms we're used to at the moment.
I really think that this is the wrong way to think about this. Others have made the necessary points but I think it is worth emphasizing that markets work best when people respond to financial and not moral incentives. The person who decides to go ahead and pay two or three times what a property is worth is also having an impact on the market by increasing both the price of property and the price of borrowing for the rest of us without any corresponding change in actual value.
The bit about whose money it is is really a bit of a red herring. The bank makes money by providing a service but mostly by managing the risk of any investment in their favor. They are not much different than a casino in that respect. That's all fine and good but, just as in a casino, this particular business relationship works most favorably for the client when they don't take their relationship with the banker too personally. Its a business transaction. Treating it as anything other than that tips the balance heavily in the favor of the banker and diminishes the leverage one has to obtain the most favorable terms in that transaction.
anotherbozo says:
Great topic, Ed, and in this case it's not your post alone that's worthwhile but the informed response of your readers. I agree with most of them, for a change. But a win, anyway.
Andy Brown says:
I have no doubt that I wouldn't like Jeff Horton or want him to date my sister. (Based on the quote) I think he's a bit silly and hypocritical to rationalize his defaulting in moral terms. And you are more than a bit silly to insist that his default is a moral failure that we ought to be concerned about. Contracts are written in such a way that we shouldn't have to rely on the morality of the other party (I think that's one of the main points of the exercise, no?) The morality part of it is just a ploy being used by one side or another to shame someone into accepting some disadvantage that they are not legally obligated to accept. (And it's not the Jeff Horton's of the world that are driving that process.)
Elder Futhark says:
The tragedy of the tragedy of the commons is that the whole argument is based upon a hypothetical toy model. Out in the real world, real people manage to do just fine with shared resources. Certainly not the result of this crisis, but probably the one after next, when a globaly monumental shitstorm hits category 5, will be the realization that money is too important to be left to the rich.
grumpygradstudent says:
The existence of the 30 year fixed rate mortgage is entirely the creation of the federal government. It was only when the feds said, "yes, we will guarantee these mortgages" that banks were willing to finance a home without ridiculously high down payments and a short (5-10 year) repayment schedules.
I think the larger point here is that this bubble existed because of our 50 year jerk-off fest over the virtues of homeownership. We've spent a preposterous amount of money promoting it, through mortgage guarantees, tax deductions, and tax credits, while we've systematically neglected low-income rental housing. It has been artificially propping up the dwindling middle-class for quite some time, and maybe it's time for us to realize that we have underlying structural problems in our system that home ownership can't solve.
Jeez, I'm rambling. Ok, yeah, I agree with the rest of the comments. Each party understood the risks when they entered the contract. And both parties are gonna suffer. And if there are substantial externalities to their private decisions, the government should step in to incentivize the socially optimum outcome.
Elder Futhark says:
and not exactly pant-shittingly funny, but perhaps fartingly funny, in an ironic way, that these capitalist crises end up with a commie America, thanks to Reagan, whose neoliberal revolution busted down labor, and fucked us all.
john says:
I find it interesting that most of the comments disagreeing with Ed argue one of two points:
1. There is no morality
2. The banks are immoral
These don't seem compatible to me.
I'm with you, though, Ed. Someone who borrows money should pay it back if he/she can. Would those who disagree rethink their opinions if the roles were reversed (a corporation walking away from a contract to repay an individual)?
glf says:
A few months ago I read this opinion piece and found it interesting:
http://www.prospect.org/csnc/blogs/tapped_archive?month=07&year=2010&base_name=walking_away_structural_injust
grumpygradstudent says:
No, the arrangement is "I will pay you back OR ELSE you get this house." Now, if the guy figured out some way to keep not pay AND prevent the bank from taking the house, then I might say there are some moral problems.
brent says:
I find it interesting that most of the comments disagreeing with Ed argue one of two points:
1. There is no morality
2. The banks are immoral
I assume by 1, you mean that the sentiment is that there is no morality in business contracts. If so, then that is essentially correct if a bit overstated. That is basically the point of contracts: to remove moral considerations from the equation. If that isn't the point of contracts then what is exactly?
With respect to 2, I would say the point is that they are amoral, not immoral. I can't speak for everyone but that is what I read from the comments here and again, that seems basically correct.
Would those who disagree rethink their opinions if the roles were reversed (a corporation walking away from a contract to repay an individual)?
I disagree and I would certainly not rethink my position in that circumstance. Any such contract would involve a significant penalty to the bank that walks away just as it does for the client that walks away. As long as those terms are fulfilled and that penalty applied than my answer would be that I may not like what the bank does but I find it in no way unethical. Indeed as others have pointed out, publicly traded investment entities are legally and ethically required to "walk away" if that is in the best interest of their shareholders.
marismae says:
My husband and I have been discussing this very issue, recently. And personally I find myself a bit torn on it. Unlike Mr. Horton we only have one house. And, while we don't intend to default on our payments we are looking to do a short sale that will simply cover the balance of our mortgage so that we can go move into an apartment. We have no trouble making our payments each month, but we were not expecting the careless behaviour of our upstairs neighbor whose constant plumbing problems have caused a great deal of water damage to our condo.
While we could sue them for the money to fix the damages because it's their fault, we know they have even less then we do. And, we cannot afford to pay to fix the water damage ourselves. The neighborhood has also become less safe, and we have a 4 year old daughter to worry about that we didn't have when we bought the place. The value of our home has also gone down due to the economy and the neighborhood. So for someone in an even worse financial situation then we are… I'd have a hard time blaming them for a strategic default on the loan. What else do you do when faced with that list of problems and the opportunity to move somewhere else with a better job and more opportunity for your family?
Mike says:
It's my firm belief that the average borrower doesn't have the mental capacity to make accurate financial judgments. The seeming success of generations of borrowers has more to do with the overall progress of society and less to do with any stellar fiscal judgments. The more I spreadsheet and debate homeownership, even with a household income over the median for our area, even with mortgage rates around 4%, I can't see ourselves buying a home for the 5 year or 7 year timespan. The odds are too high that nominal prices, let alone real prices, are going to drop over that period. Combine that with relatively low rents, high basis and transaction costs(high home prices) and it makes sense for almost anyone to hang on to the money, or buy investment property in another state.
Do I think the average person is capable of doing a net present value calculation and throwing in some uncertainty? Hell no. I think most people bought because they could, not because they should have. And they could, because the lenders let them. It was the era of the NINJA loan and nodoc loans. Even the government is doing everything it can to raise homeownership rates by making it easier for people to get loans through the GSEs. But the applicants are incapable of making the necessary calculations to keep themselves safe.
But back to your question , while I have little sympathy for the defaulter I don't see why all of our criticism should fall on the one guy who was both incapable of the calculation AND had timing unfortunate enough to get hurt. A great portion of borrowers screwed up. And the culpability for the bubble in prices I believe, lies primarily on the financing side, not the buying side. So while the same innumeracy is contributing to purchasing the whole time, it was the timing that made the winners and losers.
Cat says:
What grumpygradstudent said. The 'current' way we in America buy houses is solely because the Federal gov't will buy 30 year fixed mortgages from banks. Most of Europe I believe still does it the old way with floating interest rates and short term loans with balloon payments.
As a side note, this is done because a bank can't afford to loan out such large amounts money out over such a long period of time. Varying interest rates can make it so that they have to pay more to borrow the money to replace the depositors funds they lent out then the loan will make them.
What happened in the last 10 years was an abnormal, not the norm. If that kind of lending ever comes back it will because there is another housing bubble.
BTW, we are already back to the 'old' way of financing mortgages. Nobody is buying residential mortgages right now other then GSE. This is because people are going into foreclosure in droves due to the bad economy, not because of strategic defaulters.
Cat says:
@Mike
If you believe the oligarchs don't have the sense to actually fix the economy and we'll be luckly if we ONLY do as bad as Japan in the 90's. Deflation will reward cash holders.
I'm going to believe they'll come to their senses and kick start the economy by printing money and driving up inflation which means debt is good.
But then I have a 30 year fixed rate mortgage so I maybe biased. :)
CaptBackslap says:
I have to agree with people saying that defaulting on a contract is morally neutral; that's why it's critical to make sure that you adequately protect yourself from default in the contract itself. Relying on social norms and eternally-continuing house price increases as a replacement for adequate collateral was an terrible error on the part of the lending industry. There's a reason lenders demanded 20% down for decades, and it wasn't loathing for their customers.
Robert Arctor says:
Thank you, Ed. I understand walking away because some unforeseen/unplanned event (job loss, illness, etc.) wreaks havoc with your finances, but walking away because you don't like being underwater on your loan (even though you can make the payments) is total garbage.
JM says:
Just adding to the consensus here that Ed's morality in contracts is off-base and backward.
Since you consider defaulting on a loan a matter of morality, is this the most immoral thing that ever happened in lending history?
BruceJ says:
Ed sez: "I think that the effects of that reasoning on the incentive to lend (namely that there is none whatsoever unless the borrower is buying something that is guaranteed to hold its value) will be quite harmful if – IF – this practice becomes more generally accepted."
Well, yes. Lenders will require higher down payments and impose more rigorous vetting of borrowers…gee, almost as if they were performing due diligence instead of originating mortgages for fun and profit. Harmful? Not nearly as harmful as lending trillions of dollars to people who couldn't possibly pay it back.
This is straightforward capitalism. Someone walking away from a mortgage WILL suffer penalties; they will find it very hard to borrow money for some years without much more onerous terms and rates than you or I can get, for instance.
Moreover the bank now owns the house that they were perfectly will ing to believe was worth $400,000. It's not as if they end up with nothing.
Excoriating homeowners for somethig that's taught as a normal business practice to MBA's is the essence of a hypocritical moral scold.
Among the things that lender are charging interest FOR is the risk of a borrower defaulting on the loan.
Finally, in the long run, a lot of strategic defaults like this will have the effect of ripping the band-aid off quickly. There's a lot of people in the US and they need places to live, and we have a lot of houses the banks need to sell. At some point the buyers and sellers will come to an agreement on what these houses are worth, but first we need to start clearing the wreckage from the bubble.
Metamarama says:
It's the banks who ruined the housing market through sheer greed. As long as they could sell the paper (and the documentation is a whole other issue, as we are now learning) to Wall Street, they kept shoveling the loans out the door. There's no way they didn't realize what the end of the game was going to look like. And now the people who are stuck with huge mortgages on property whose value has nosedived should just suck it up and pay up? Doesn't make any logical sense to do it. Bad business move. It is crucial to remember that the banks never had any intention of holding the paper and thus being in a position to get stiffed, as they knew would happen. They passed that hot potato along as fast as they could. And made lots and lots of money for their trouble.
tones says:
It is like Doug says [above] …
The contract is "pay these payments or we get the house back" .
He gave it back.
They kept all of his money – and the house.
tones says:
addendum:
I just bought a condo and had to put down 20% because it would not qualify for FHA.
If I don't keep paying , they get the house and keep my 20%, plus whatever I paid.
[the loan has changed hands 3 times in the span of the first 3 payments, BTW]
cartmanne says:
Ed I think you need to give more thought to the whole lending process. In a borrower-bank relationship, the party that has the power, the attorneys, the money and everything else on their side at the front end is the bank. The bank has far, far more ability to be aware of the situation and exploit it at the front end. This worked great for the banks when they could over-sell mortgages, push unwitting borrowers into more expensive loans (ie loans that are front loaded with expenses) and generally take very unsavory steps at the front end of the loan. In other words, banks long ago abandoned any pretense of morality on the front end of the loans. IT IS NOTHING BUT A BUSINESS DEAL AT THIS POINT.
Now that the market has tanked, both sides are taking their hits. Anyone who frets over the banks at this point is a fool. They had all the power, ability, and tools to protect themselves, but they were far to busy pushing people like Jeff and tens of thousands like him into any kind of loan they could throw up. More specifically, the banks more than anyone else should have foreseen that we were in a major housing bubble, and it might be time to stop making 100% LTV loans. They chose to ignore those signs, and now they will have to pay a price, one that is typically miniscule compared the suffering of the majority of borrowers.
It is very important to remember in this whole equation that one thing banks are supposed to do is think about the amount of their loan vs. the value of their security. If the loan exceeds the security, they are unsecured in that amount, and, as unsecured creditors, their avenues of relief are considrably less than secured creditors. As an unsecured creditor, they run the risk that borrowers like Jeff will walk, and, under the dictates of pure capitalism, they should be prepared to deal with the consequences of that entirely predictable and rational action. They are certainly in a better position to deal with it than Jeff, particularly on the front end of the deal. As you point out, they can and will crush Jeff's credit rating, and they can seek a deficiency judgment that will hang over Jeff's head for 10 years or more likely longer. They are not empty handed at all.
Personally, I will be cheering Jeff on as he vacates the state of Florida, runs across the country, and blows rasberries at the bank as they try to chase him down.
Jim says:
I have to agree with the fact that the contract has no morality contained within it. The money for the house. If the money does not get paid the house is taken back. These types of defaults are good because they cause banks to require higher and higher deposits. It is much easier to walk away from a 5% down payment then it is to walk away form 20%. The higher the down payment, the less chance the price of the house will be inflated, thus housing becomes more affordable for everyone.
A minor quibble about your example of capitalism for tots. Since we are talking about banking we have to enter the land of make believe. Mary's $100 undergoes a wonderful transformation. The bank has magic powers and can make the $100 appear as $1000. Then the $1000 dollars is loaned to others to buy things that they would need with the idea that those others would pay back $1100 making the bankers very happy and very rich (giving Mary a $1 for the use of her funds, that's quite a profit margin right?). But they got greedy and turned the $100 into $2000 or $5000 instead and gave it to people for frivolous things like granite countertops or jet skis. The money wasn't paid back. Luckily the government came in an created some money to bail them out, more magic but of a different sort (and a different tale altogether).
Our money is created by debt, if there were no debt in our society there would be no money in circulation. And what does that say about our society?
Nunya says:
I agree with the premise. You agreed to pay your loan back. You signed your name, agreed to the terms, you are on the hook. However, if you can't or won't pay on your loan, the bank can sieze your collateral and totally destroy your credit rating.
Before the zero down loan when a 20% down payment was required, you had quite a few bucks in that investment that prevented this kind of behavior. When the banks went on a bender and assumed the old rules no longer applied, they failed to do what any sensible investor would do.
Strategic default has been part of the business lexicon for decades. Getting sued? Declare bankruptcy, screw your creditors and start fresh. Made a series of bad investments? Declare bankruptcy and get a fresh start. Now if you're simply a working stiff, well George W and his cronies decided in 2005 that they were going to make it nearly impossible for you to declare bankruptcy and start over that has always been a right, although very rarely used by most Americans who took pride in their word.
When businesses describe "deleveraging", they are announcing their intention to fuck over their creditors. It makes sense on paper to ddo so and they don't lose a minute's sleep over it. When a person looks at a home they purchased that, historically, was a pretty sound investment, and discovers that it may take them 60 years just to break even, well, morality starts to take a back seat to being financially decimated for the better part of your life.
These people may look irresponsible but they are practicing sound business. The bank wrote the terms of the loan, knedw full well that they were irresponsible in their lending, and are now holding the consumers' feet to the flame and demanding "personal responsibility."
As a homeowner who isn't currently underwater, I understand that this whole mess won't turn around until the entire economy deleverages. There is too much debt held by too many people and the insanely overinflated housing market needs to come down to a realistic level. I may end up underwater as a result but I have no intention of not paying my mortgage unless I have no other option.
CaptBackslap says:
Also, as the article points out, homeowners have their own families to consider when they're stuck in a deeply underwater mortgage. I don't think kids would be very impressed when mommy and daddy explained that they couldn't have Christmas this year because it was more important to be extra-nice to Citigroup.
Ed says:
How does the decline in the value of the house affect the ability to make the payment? If he can't afford Family Christmas or college tuition now, he couldn't afford it when the house was worth more either.
Talk about red herrings.
CaptBackslap says:
Most strategic defaulters (up to the point where LTV is really gigantic, like 160% or something) are people who are both underwater and have suffered income shocks. They might still be able to make the payment, but their living standard suffers substantially.
Ed says:
Source?
Mike says:
(disclaimer, not the first mike. I'm the 2nd mike)
The decline in house value affects the liquidity of the labor market. You can't switch regions and move without selling your home and you can't close a deal unless you can meet the shortfall in LTV through a sale or a bank approved short sale. And if you can't do that, you've got to default.
The inability of the average borrower to calculate all risks is a strong recommendation for reducing the leverage available to borrowers. Ten to twenty percent down payments should be required for a home loan if we're going to let every retard in the world apply for one. That is, unless you want a really volatile housing market that's going to lock in the labor market every few decades.
Of course moving to high down payment requirements right now is almost impossible. It would cause existing home prices to drop MORE and thus encourage more strategic default. And what politician is going to look his constituents in the eye and say "I have the cure and the cure is to cut your home value in half"? When you consider that the average schmuck has most of his net worth tied up in home equity you can bet that reducing leverage in the housing market is not on the political agenda. What is way more likely is that we'll inflate this all away and kill a few birds with one stone: the high debt(public and private), and encourage demand through exports.
Mike says:
* that should be, "the average borrower can't calculate a damn thing let alone risks of home ownership."
-Part time calc/stats tutor
CaptBackslap says:
http://www.federalreserve.gov/pubs/feds/2010/201035/201035abs.html, although looking again I was misreading it (don't drink and surf, kids). I was thinking that the sample was different. My bad on that!
But the specific (flagrantly, cheaply emotional) example I used is honestly beside the point; if you can significantly enhance your family's standard of living by taking the default option in a contract, it's hard to say why you're supposed to have more loyalty to whatever entity is currently (ostensibly) holding the note.
And it doesn't actually say in the mortgage contract, "the BORROWER shall try really hard to make this payment no matter what pretty please." It just says the noteholder gets your house if you don't.
Mike says:
First Mike here.
CaptBackslap is probably citing a May 2010 Federal Reserve Board study* that found up until you get to an LTV of 160 (or a spot where a homeowner is 10-12 years underwater on the mortgage) most defaults consist of income shocks and negative equity as opposed to just negative equity. I have some minor problems with it, but overall it's a good study.
As for why this might be the case, states with a higher percentage of owner-occupied homes that are underwater are very strongly correlated with high unemployment. You also see that with homes that are deeply (more than 50%) underwater**. There's a lot of debate on how that causation works, but it's going to be a weaker job market and thus more likely homeowners will hit longer duration unemployment spells and fall behind on their mortgage in places where they are more underwater than less underwater.
(Sorry I do this argument for a living.)
* – http://blogs.wsj.com/developments/2010/06/28/how-far-underwater-do-borrowers-sink-before-walking-away/
** – http://rortybomb.files.wordpress.com/2010/08/deep_underwater_u3.jpg
CaptBackslap says:
that is the study I was thinking of, although like I said, I was wrong on the internet about the sample group.
there's a lot of gray area here, too. Exactly how much of a living-standard reduction are homeowners expected to take before it's acceptable for them to throw in the towel?
Mike says:
Mike, No offense on the employment graph but if you pull the right five states from the mix the slope coefficient's going to go to zero. Granted California and Florida are probably in there, but really what other high population states are in those five? That one far out there is probably Michigan and really, how the fuck is Michigan representative of the US?
Could just be bimodal with no relationship between unemployment and LTV. I mean consider the bubble states as a separate phenomenon and a whole new line of questioning opens.
-2nd Mike
Mike says:
…might be more enlightening to see that data per MSA rather than state. There's too much structural difference across states (urban/rural percentage, economic structures etc).
Ben says:
Corporate profits are made generally within the confines of the law. Extreme corporate profits are made at the absolute edges of the law (finding loopholes, special cases and organizing yourself to establish exemption status). Regulation is not enough to ensure the consumer is protected, regulation with oversight and revision is.
The mortgage companies found ways to mitigate their risk and drafted up contracts in such a manner that, like the mob, no matter what your situation became, they were your first debtor and they were going to squeeze you for every penny.
If the tables were turned, and the banks could screw consumers more so, there is no reason to think that they wouldn't if it meant positive income for their balance sheet. Strategic default, while scummy, provides folks a way out of a bad deal. Even if it only was benefiting shmucks right now – which I can't say it is, there are probably a few good people who are doing this too.
No worries, on the list of legislation, be sure that strategic default will be criminalized much faster than anything that would actually regulate financial institutions.
I will say this though, I think that the fact strategic default doesn't damage anyone's credit score enough to prevent the future purchase of a home is completely baffling. The punishment and risk for doing so should run much closer to bankruptcy than it seems to.
Brighton says:
Two things: strategic default goes on in the business world all the time. Banks do not suffer much from foreclosures – they have always had them, and it makes sense for them to sustain a certain percentage of losses, which, btw are tax deductible.
Second, while Jeff may in fact be a douche, the recession wasn't his fault. It is absurd for anyone to blame borrowers for not being able to predict their income flow for the next 30 years when they can't do it themselves. A loan is just a contract, and all contracts can be renegotiated. Jeff's bank is free to give him a rental agreement that lets him stay in the house. Other creative agreements are possible as well. If indeed the banks are so worried about losses due to foreclosures (which they're not) and if the losses were passed on to other customers (which they're not), bank loss prevention people could get a little more excited about loss prevention.
Also, Jeff's bank assigned out that loan before it was even written, so we're not even talking about Jeff's bank. The risk was securitized among a pool of investors and will not affect the price of tea in Fort Lauderdale.
Mike says:
In the current financial system, your capitalism for tots analogy is flawed – it is too simplistic.
Lenders (consumer banks) are not using Mary's money to loan to Bob. Lenders are taking Bob's loan and selling the potential profit from it's interest to lenders higher on the chain (investment banks). But Bob is a deadbeat, and it's likely he will default on his loan. So, those new lenders take Bob's loan and slice it up into tiny little pieces, package it with loans from the more reliable and wealthy Tom, Dick and Harry so that the overall package looks like a safer investment. The lender then pays a rating agency to "rate" the package as AAA, super safe, everything-is-fine-here, investment. Those packages are then sold back to Mary and her ilk as personal investments.
As for whether Bob's defaulting (strategic or not) is selfish. Meh. I appreciate what you're saying- and honestly the immediate impact to his neighbors property value is just as destructive than the domino debit impact of his lost interest – but I just can't find myself that moved by the argument.
The convoluted, completed F-ed up system the financial system created as described above is what caused Bob's house to be worth less than half of what he owes. What more, they probably pressured Bob into a bullshit sub-prime agreement, which completely misrepresented the way Bob is being asked to pay back the loan.
I have a hard time getting mad at Bob for this.
Mike says:
Oh and for the most entertaining and incredibly illuminating look at this whole mess I've ever seen, see Inside Job. I just saw it at the NY Film Festival and it's absolutely fantastic!
http://www.insidejob.com
Andrew says:
But strategic default is built into the loan contract, which basically says, in California at least, either (a) make the payments, or (b) surrender the property. If the borrower does either one of these, he/she is honoring his/her obligation under the contract. Why loans don't cost more in non-recourse states than in other states, I'll never know. You'd think that risk would be priced into the loan.
Bob says:
A house is not an investment. It is a purchase.
Shane says:
Any substantive comment I would make has already been said, but the title of the post inspired me to share this work of art, Kristi Noem explains the deficit to her kids through a board game.
http://www.youtube.com/watch?v=YTReX0i7Zm8
Bugboy says:
If you remove all the moral bits…what do you have?
You have a guy that INVESTED in 2 investment vehicles (sorry Bob, housing hasn't been a straight purchase for over half a century, they've been an investment against future housing costs, which in turn drove up housing prices in the 40's and 50's as the finance industry expanded the mortgage business) which the value of said investments plummeted to half their value, while he still owed 100%.
In whose book does anyone call that a sound investment? With the bank holding all the cards, I can see how the guy feels like a sucker continuing to pay into the hole with no end in sight. I don't think anyone is seeing housing values regaining thier original heights any time soon.
Is the guy selfish? Of course. Is he any more selfish than Wall Street? HELL NO!
Paul W. Luscher says:
"Moral high ground"? Dude, are you kidding??? You haven't figured out yet that for a great number of Americans, their standard of ethics goes no further than "It's all about me"?
And then you wonder why America is in the trouble it's in….
jwm says:
Adding this, mortgage bankers association strategic default on property.