Strategic Default – Not Good, But Sometimes Necessary
The big one making the rounds today is the NYT story on people who’ve simply stopped paying their mortgages, living in their houses for free, waiting on the potential eventual foreclosure machine to spit them out whenever it gets around to it (which isn’t happening quickly).
Quite a few folks (TJIC, James Joyner) are weighing in on these freeloaders like they’re the scum of the earth. And frankly, the quotes in the article are almost enough to make me agree with them. Here are a few samples:
“Instead of the house dragging us down, it’s become a life raft,” said Mr. Pemberton, who stopped paying the mortgage on their house here last summer. “It’s really been a blessing.
“I tried to explain my situation to the lender, but they wouldn’t help,” said Mr. Pemberton’s mother, Wendy Pemberton, herself in foreclosure on a small house a few blocks away from her son’s.
“They’re all crooks.”
It was a stupid move by their lender, according to Mr. Pemberton. “They went outside their own guidelines on debt to income,” he said. “And when they did, they put themselves in jeopardy.”
“The longer I’m in foreclosure, the better,” she said.
Their attitude seems to have changed since he went into foreclosure. Now their letters say things like “we’re willing to work with you.” But Mr. Tsiogas feels little urge to respond. “I need another year,” he said, “and I’m going to be pretty comfortable.”
A lot of these people are simply blaming others for their own problems — some explicitly. That is a behavior I can condemn all day long. Although the weakened lending standards are quite a proximate cause of this mess — the companies who gave loans to people who clearly couldn’t pay them unless prices continued to skyrocket never should have done so — nobody forced people like the Pembertons to REFINANCE their house to take out equity in the middle of the boom. People clearly went way too deep into debt for completely unnecessary reasons, and now they’re in foreclosure. While they’re not yet paying the price for their mistakes (it won’t come until they actually get kicked out and/or need to use credit), that is a hammer that will one day drop.
So the real questions are these?
1) Do these folks have a “moral” obligation to pay back a loan rather than accepting the results of breaking their contract?
2) Are these folks stealing by continuing to be squatters in their foreclosed residence.
For the former, I have to say that the moral obligation is lacking. A mortgage is a business contract. In that contract there are terms for severance of the contract. Those terms are often unhappy for the borrower, but those terms are clearly spelled out. In a market such as this, that borrower has to make a business decision — are the negative effects of breaking my contract worse or better than the negative effects of sustaining my end of the bargain?
Frankly, there are a lot of people who can clearly say “no”. In the Pemberton’s case, they owe $280,000 on a house likely worth half that. If they continue to pay, even with the amount paid to principal it may be easily 10 years before they’re above water, as the housing market is unlikely to return to its peak for at least a decade. If they are evicted, they can probably rent far cheaper than the cost of their mortgage. And for the time being, the money saved on their mortgage is helping them to keep their own business running. While the negative impacts to their credit will be painful, it’s probably a better option than trying to stay in their mortgage.
In short, the economic calculation they made is no different from this one, where a hotel investment group chose to default on a loan for a luxury hotel despite having adequate liquidity to repay the mortgage. At some times, it simply makes more sense to get out from under the burden.
The second question is more complex. Is it stealing to remain in the residence despite not paying for it? Here’s where the tables get turned…
It’s stealing *IF* the lender says it is.
These are hard times. Right now lenders know that they aren’t going to get their money, and that they have every legal right to kick these freeloaders out to the curb. To do so, they merely need to work with the local sheriff to evict them. But there’s a problem — they don’t have the capability to manage these homes and put them on the market. So if they evict the tenants, it doesn’t mean they’ll turn around and auction the house immediately; it means they’ll be sitting with a vacant house for months. They’ll be sitting with a house with no utilities being paid for. They’ll be sitting with a house with an unkept, un-tended yard. They may have a house that becomes inhabited by other squatters, or vandals, or worse. In short, they end up dealing with a property that has only downside if it goes vacant.
How does the lender deal with this? They don’t. They string the freeloader along with the prospect of maybe performing a loan mod somewhere down the road, or at the very least, they simply let them be squatters. I honestly believe that it’s a calculation on the lender’s side of the table to let them stay, because they realize that it’s easier to let someone live in the house and keep it moderately maintained than it is to send them packing and have to deal with it themselves. Further, for the lenders, the longer they can string this inventory out, the better chance they have of not having house prices crater a second time, throwing even more people into the foreclosure pool as their houses drop in value.
I liken it somewhat to an amicably broken marriage. A divorce is a tremendously unsettling event, and one which upends the life of both spouses and potentially children. In some cases, though, it isn’t exactly easy for the parties to quickly part ways and have one (or both) party leave the shared residence. It’s not unheard of for a divorcing couple to live together for a time until they can make more stable long-term arrangements. One of them probably ends up on the couch, of course, but we wouldn’t consider the one on the couch to be a trespasser just because the marriage is broken, would we?
The thing to understand about the economic mess that we’re in is that we need to make up the rules as we go along. We’re looking at foreclosure rates well in excess of normal. We’re looking at a nationwide cratering of house prices. We see a lot of people, through their own fault and also due to a lack of any natural checks on market excesses, in a situation that they simply didn’t have any concept of in 2005.
Granted, the road that led us here gives us a lot of hindsight. Borrowers today are helped by the fact that it is extremely difficult for lenders to go after your other assets to cover the difference between your home’s foreclosure auction price and the balance of the loan. In some states, government interaction gives the borrower excessive legal cover to fight foreclosure, making this process harder on lenders than it needs to be, which is certainly being exploited by the debtors here. Lenders, to the dismay of many of us, were similarly shielded from the negative consequences of their bad decisions through government bailouts and the backstopping of the mortgage market by Fannie and Freddie. There is a lot of government-induced systemic intervention that has distorted market operation.
Will the long-term effect of this have negative externalities? Yes. The long-term consequence will probably be tighter lending standards and the inability of those on the margin to get a loan and the chance at home-ownership that many of us — including myself, who has sat on the sideline as a renter since returning from GA to CA in 2007 — dream of. At the same time, though, this tightening of lending standards will be one of the critical cogs of preventing another similar bubble in the future. The sad, and yet at the same time necessary, fact is that expectations about home ownership must change, because a mortgage market built on liar loans and the constant expectation of rising prices is not reality.
But that doesn’t change the nature of contracts. Contracts can be broken by either party, and in the case of many homedebtors, the economic calculus is that it is a net positive to default on a loan. As many have pointed out, it’s improper to assign a moral component to what is an economic decision, despite the natural inclinations we have towards a society “where people pay off their debts”. Once the borrower makes that calculation, the lender holds the cards, and it is the LENDERS decision to allow the homeowner to continue to squat, rent-free, in what is now the lender’s home. I don’t fault a lender for choosing to go the eviction route, as it is their right as the property owner, but until they choose to exercise that right, it’s premature to label the borrower’s continued residence as “stealing”.