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“I weep for the liberty of my country when I see at this early day of its “successful experiment” that corruption has been imputed to many members of the House of Representatives, and the rights of the people have been bartered for promises of office.”     Andrew Jackson

June 1, 2010

Strategic Default – Not Good, But Sometimes Necessary

by Brad Warbiany

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”.

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7 Comments

  1. The lenders have to take the property back, it is part of the contract. That they’re stuck with it after making idiotic loans they subsequently bundled into CDOs and pandered off to other greedy idiots is their problem.

    The government shouldn’t be bailing out either side of the stupidity.

    Just to note, some of these mortgage lenders have so obscured their ownership rights via re-sale of the mortgage that they can’t prove ownership and foreclosure judges are awarding the houses to the borrower.

    Comment by John — June 1, 2010 @ 3:49 pm
  2. From where I sit it looks like the lenders are still completely unable to deal with this melt down.

    I bought my house a bit over 3 years ago. I’m probably upside down on it but that doesn’t bother me. My wife, who at the time was my girlfriend, moved in with me and we put her place up on the market shortly after.

    It still hasn’t sold. We’d get an offer well below what she owed and the bank wouldn’t entertain a short sale. Because we were paying. So, she quit paying the mortgage. We are now nearly a full year behind on payments and they just approved a short sale on an offer we got 4 months ago. Obviously the buyer is long gone. But now we have a deal with them: We pay $15k to cover some of the difference and they’ll do a short sale at that price.

    If they had just come out with that deal the first time we asked for a short sale they’d have their money and somebody living there. But they took over a year to get there. And for some unexplainable reason their initial offer was $15k over 15 years with no interest on it. So, obviously, we’re going to pay it off slowly and let that money (which we have on hand) sit and collect interest because we can earn just about that monthly payment in interest in a good checking account.

    It’s no wonder these guys are hurting. They’re asleep at the switch.

    Comment by Anon — June 1, 2010 @ 5:46 pm
  3. John,

    Actually, they could renegotiate the contract (loan modification). They could even do so to reduce the principal to a more reasonable level and allow people to keep their homes*.

    The contract stipulates that because the loans are in default, the lender has the RIGHT to foreclose, seize the home, and evict the now-trespasser. That doesn’t mean they have to do so in a timely fashion, and if they choose to let a squatter live rent-free for months, it is their own decision.

    We agree that the gov’t shouldn’t be bailing out either side.

    * Perhaps not, since there is a legal question about these loans being sold off into CDO’s restricting the servicer from reducing the principal, as you point out in your final paragraph… But for the sake of argument, let’s assume they can do it.

    Comment by Brad Warbiany — June 1, 2010 @ 7:46 pm
  4. Anon,

    Thanks for the anecdote. From my own anecdotal experience with a relative who bought a short sale, it’s a very slow process and the opaque decisions by the banks can be mind-blowingly counterintuitive from time to time.

    I assume that for your wife’s place, she was far enough below rental parity to make it a cash flow hole if you’d tried to rent it out?

    Comment by Brad Warbiany — June 1, 2010 @ 7:48 pm
  5. I have seen much anecdotal evidence of banks unwilling to re-negotiate loan terms. That is anecdotal doesn’t mean it is accurate, but there is a dearth of stories about successful re-negotiations occurring.

    I did see a piece today about BoA is working to lessen its walkaway problem by re-capturing those borrowers still able to make payments but are over 25% underwater with principle reductions and term extensions.

    Easy terms, playing fast and loose with facts by both borrowers and lenders, absolute greed by house flippers and CDO generators bear the bulk of the problems in the situation.

    The market should have been allowed to correct itself. History shows the bulk of the mess that came to light in late 2007 would have cleared by now without the current long-term market sluggishness created by the improperly and artificially propping up of the housing market.

    Comment by John — June 2, 2010 @ 12:18 pm
  6. John,

    One of the tricks I’ve seen on the loan modifications is a loan mod that doesn’t affect the balance of the loan, but just turns it into a longer term or a interest-only/neg-amortization for a short time. The real advantage of modifications would be principal reduction, but a lot of banks are purely trying to keep payments coming in.

    One of the members of my extended family bought a condo in early 2007, and even with a $50K downpayment he’s probably at least $50K underwater now (based on a quick look at the comps in the neighborhood, possibly more than $100K). He got a modification, but it was purely a temporary payment reduction. I haven’t discussed the terms of the loan with him, but I’ll bet it just pushed the unpaid principal off to the end of the loan term.

    Comment by Brad Warbiany — June 2, 2010 @ 12:36 pm
  7. Those I’ve seen, but didn’t count them as negotiations since nothing actually changes, just the inevitable is postponed.

    This is the BoA story I saw today.

    http://finance.yahoo.com/news/BofA-Mortgage-Walkaways-Have-cnbc-1882183584.html;_ylt=AtgJG96UzHfHhuDe.iR5_ca7YWsA;_ylu=X3oDMTE1Y3FuY28xBHBvcwM4BHNlYwN0b3BTdG9yaWVzBHNsawNib2ZhbW9ydGdhZ2U-?x=0&sec=topStories&pos=6&asset=&ccode=

    Still, there’s far too much government meddling in the economy and too much dishonesty on Wall Street.

    Comment by John — June 2, 2010 @ 12:54 pm

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