Strategic Defaults

[Gumby]

I invest in REITs that are very much leveraged. When I lose money I take the loss. I don't expect anyone else to hold the bag for my bad decision.

You are making an equity investment and accept both the risks and rewards of that choice. Secured lenders are entitled to either repayment of the loan or possession of the collateral. That's it.

 

[brewer12345]

I invest in REITs that are very much leveraged. When I lose money I take the loss. I don't expect anyone else to hold the bag for my bad decision.

Au contraire, you leave the lenders holding the bank when the REIT blows up, same as the defaulting homeowners sticks it to the holder of the mortgage.

 

[Gone4Good]

Although we, as a society, expect our citizens to repay their debts and generally feel they have some kind of moral responsibility to do so, at the end of the day that debt is governed by a legal contract. That contract spells out the rights and the remedies available to each party. I assume everyone here accepts that the bank would exercise its rights and remedies to its greatest advantage and profit. But why not the borrower?

 

[unclemick]

I am kind of in both camps.... not looking kindly at people who walk away from their debts... but also in the camp that this is a business decision... and the law allows this to happen...

If you were running a business and you had an asset that was not 'productive' for the costs.... and you could get a similar asset for a lot less... and your debt was non-recourse.... you would be a fool not to get the cheaper asset...


I also think that the banks should stop lending in the states that do not allow recourse... or the banks should require a larger down payment... or get the law changed... I bet if there was no one that would lend you money to buy a house, you would be complaining to the gvmt about it...

Better to laugh than to cry.

I remember 1970 having left Seattle for Denver - the Sunday paper ads(paid by the US govt) - come retire in Seattle - they had thousands of houses where people walked out some leaving the keys in the door. In those days they were actually unemployed and most left town looking for work.

Also a certain 24 yr young lady made dozens of millionaires(herself included) in the subsequent decade by forming a partnership and buying and renting a lot of the empty houses at attractive terms.

Sister city Kobe, Japan was sending America thousands of care packages for Seattle soup kitchens until the govt got a little embarressed and provided some relief. The number 79,000 people a week comes to mind(memory?).

heh heh heh - ? So do I laugh or cry? . . .

 

[Gone4Good]

Here people have the money to repay the debt, they just can't be bothered.

Sounds like the big, sophisticated, bank signed a really dumb loan agreement. Apparently all they cared about was the ability to foreclose on the property in the event of default. And that's all they got. Why are they entitled to more?

 

[samclem]

Here's a very recent study on mortgage default rates, and the differing modes of default, between recourse states and non-recourse states.

It's a .pdf file, and I'm not smart enough to know how to cut/paste from it. Major conclusions:
1) (No surprise): Default is less likely in recourse states. "At the mean value of the default option at the time of default, the probability of default is 20% higher in states with no recourse as compared to states that allow recourse." Also, the number of deficiency judgments probably understates the importance of recourse laws because the threat of a deficiency judgment probably deters many people from skipping out when they are underwater. (the term "strategic default" is used in the paper).
2) In recourse states, when defaults do occur they happen in ways that result in reduced losses to the lenders (again, no surprise).
3) In recourse states, wealthier people are less likely to strategically default than those with less wealth.

Of interest: "The no-recourse moertgage is virtually unique to the United States. That's why falling house prices in Europe do not trigger defaults"

I was hoping to find a study comparing loan costs in recourse vs. non-recourse states. If this info is in the study linked above, I didn't see it. Whatever the difference in rates/terms were before the "bubble", I'll bet going forward there is more of a difference.

IMO, both options (recourse loans and non-recourse loans) should be available on the market to borrowers, if sellers want to offer them. Then the actual cost of the "jingle-mail" option will be explicit to everyone. And, there'll be less stigma from walking away from a mortgage. Some will see that as a bad thing, but I'd rather that the entire bargain be explicit so that people with an (overly?) developed conscience aren't paying a bill that they don't need to, and so those with less scruples aren't getting an advantage.

 

[audreyh1]

In some ways I'm very glad the banks are feeling the consequences of several years of extremely reckless lending. This is what happens. We can hope this lesson maybe sticks for a while.

If the banks could take your first born for a mortgage - the lending would have been even more reckless IMO!

Not that I would ever walk from a mortgage - not my style.

I guess I don't see how this is hurting me personally. I hold no debt and need no new mortgage. House prices went way up before they came back down.

Audrey

 

[youbet]

Unless banks learn the lesson that in non-recourse states they must build in a cost for assuming the risk of home price deflation (either due to the market for homes falling or due to careless home upkeep by the occupant), they'll continue to be at risk. At a minimum, I'd like to see the mortgage market develop so that the true cost of loans in non-recourse states truly reflects the added risk the lender assumes and the true cost of loans in recourse states reflects the lower level of risk to the lender.

 

[Gone4Good]

At a minimum, I'd like to see the mortgage market develop so that the true cost of loans in non-recourse states truly reflects the added risk the lender assumes and the true cost of loans in recourse states reflects the lower level of risk to the lender.

In a free market, that is exactly what should happen. If loans aren't priced that way, it is because banks are dumb. See post # 30.

 

[youbet]

I guess I don't see how this is hurting me personally. I hold no debt and need no new mortgage. House prices went way up before they came back down.

Probably isn't to any great degree...... When banks fail it costs the gov't money and you might be contributing to that. It's only another drop of water in an ocean of debt we'll either monetize or raise taxes to pay or some combination.

 

[youbet]

In a free market, that is exactly what should happen. If loans aren't priced that way, it is because banks are dumb. See post # 30.

I'm not sure. It's been 40 yrs since I took "Money and Banking." And I'm not sure I understood it then.

But, yep, if there aren't gov't regs making it difficult for them to price different costs into their rates from state to state, then they were indeed dumb to not do so.

This discussion makes the govt's request for lenders to step in and offer better deals to borrowers to get houses moving again seem more interesting than when I first heard it! Should banks only make loans where they are willing to place big bets that housing will not deflate further and then only to top notch credit risks? Or should they "help American families" by assuming more risk and bringing more borrowers into the fold?

I dunno....... Like Audrey, I don't really have a dog in the fight other than my taxes and the general state of the economy.

 

[skyvue]

The mortgage company should be entitled to any money in non-retirement accounts and capable of takinig cars and other similar assets in my opinion. It is simply wrong to walk away if you can afford it.

I am kind of in this situation right now. I bought my townhome 3 years ago (new construction). The unit next to me is identical to mine and on the market for $30K less than we paid for them new. Even at that price, no offers or interest in it. I did put 20% down though with a 15 year fixed loan so I am about even. Still stinks though. I rented my whole life up till that point and wish I would have never "given in". I listened to all the people who clamed renting was wasting money.

 

[clifp]

Great, now our infamous "keep or pay off the mortgage?" debate can have a third point of view: "keep or pay off or walk away from the mortgage?"

Actually, I made this point several months ago. Part of the decision to pay off the mortgage should be how much equity you have in your house. If you have little or no equity in the house than the implied put (i.e. ability to mail the lender the keys and say cya sucker) associated with a mortgage is quite valuable and probably more important than most other factors.

This is especially true for FIRE people who have little need for credit. Imagine you retired 5 years ago moved to a sunny place highlighted in the WSJ article, like California. You bought house for $500K put 20% down and got a $400K 30 year loan @6%. You recently recieved a big chunk of money and are looking at what do with it. Normally, it would be a no brainer to pay off a 6% loan especially considering current CD rates, the stock market etc. However, the walk away option is really worth considering. If the value of the house has dropped to 325-330K (pretty typical in many parts of CA). After expensee, Realtor fees etc you maybe lucky to clear $300K but you owe $400K. Is a good credit score and feeling like you did the moral thing worth a $100K? You don't even need to rent since you could presumably pay cash for the new house. You are retired so you don't care about employers checking your credit scores. About the only thing that will be impacted by the default/foreclosure is paying a bit more for auto insurance, and you'll get less credit card offers...

Does the moral equation change if your mother, daughter, brother, best friend lost their job, had a major medical problem, or needs a nursing home. Is your obligation to pay back the bank higher or lower than to help friend/relative?

Now mind you as direct shareholder in a number of banks, and indirect shareholder via mutual funds in most banks, and of course as Taxpayer I am bond holder and preferred stock holder in other banks, I am very unhappy about strategic defaults. I would like to string up the bank lending officers, government regulators, as well as the folks defaulting....
However, I think it is increasingly less and less a right and wrong issue and more a business one.

 

[audreyh1]

Probably isn't to any great degree...... When banks fail it costs the gov't money and you might be contributing to that. It's only another drop of water in an ocean of debt we'll either monetize or raise taxes to pay or some combination.

It's not clear to me that us taxpayers are really going to be on the hook for bank failures after all. OK - maybe FDIC or other costs get passed along to the customer, but that just part of the cost of doing the banking business so of course customers pay for federally guaranteed banks. That doesn't sound off.

Audrey

 

[tmm99]

I am kind of in both camps.... not looking kindly at people who walk away from their debts... but also in the camp that this is a business decision... and the law allows this to happen...

If you were running a business and you had an asset that was not 'productive' for the costs.... and you could get a similar asset for a lot less... and your debt was non-recourse.... you would be a fool not to get the cheaper asset...

I actually have to agree with you. I am surprised to say this, but there is no place for ethics/morals in the kind of capitalism we have created. That we have all witnessed in the last couple of years with what the banks, mortgage companies, etc have done in the past decade to advance their profit, and the government let them in the name of capitalism.

All these things that have been unfolding makes me think of the book "Animal Farm" by George Orwell (high school gov't class). I'm sure many people here have read the book too - the book about utopia (derived from communism ideology) turning to greed and corruption. I don't remember the details of the book, but I have a feeling the book wasn't really about communism, but more about human nature, because what's written in the book seems to be happening to us now, in a grand way.

Capitalism doesn't work all that well without some socialistic (moralistic, ethical, or whatever you call it) regulations/controls, is my conclusion.

 

[Texas Proud]

Not sure if the rates are different from the states that allow banks to go after lender and those that do not.... probably not since FNMA etc. were the big dogs in lending...

BUT, there is a difference in costs to someone who puts zero down and someone who puts 20%... I put 20% down to save on PMI... I think it was a few hundred a month... not sure since I told them up front that I was not going to need it....

So the cost to the borrower is real if you don't have much skin in the game...

 

[Caroline]

If you were running a business and you had an asset that was not 'productive' for the costs.... and you could get a similar asset for a lot less... and your debt was non-recourse.... you would be a fool not to get the cheaper asset...

I'm not a lawyer but I seem to remember hearing, somewhere, somehow, that if you're a public company in the above situation you have a DUTY to your shareholders to get the cheaper asset. If a company you're contracting with doesn't write enough of a penalty into the contract to keep you from defaulting, it's their fault, not yours.

Again, no law degree here. But if this is true it causes one to think.

Interestingly (to me, anyway), the question of defaulting on a mortgage was asked a few years back and I responded that I wouldn't walk away if I were under water. That was before the housing crisis, and before the house I sold for $405 three years ago came back on the market at $167K.

Ethics are getting costlier by the minute.

 

[Gumby]

I'm not a lawyer but I seem to remember hearing, somewhere, somehow, that if you're a public company in the above situation you have a DUTY to your shareholders to get the cheaper asset. If a company you're contracting with doesn't write enough of a penalty into the contract to keep you from defaulting, it's their fault, not yours.

Again, no law degree here. But if this is true it causes one to think.

Interestingly (to me, anyway), the question of defaulting on a mortgage was asked a few years back and I responded that I wouldn't walk away if I were under water. That was before the housing crisis, and before the house I sold for $405 three years ago came back on the market at $167K.

Ethics are getting costlier by the minute.

Caroline:

You are describing the efficient default theory. It may be envisioned as follows: Suppose you are a manufacturer and have a contract to buy from one company all your requirements for an important widget that is a component of your product. Further suppose that the market price of such widgets has now dropped far below the price you are paying under your contract. Under the efficient default theory, you should default under your contract and buy the widgets on the open market if the savings from doing so exceeds the damages you will be required to pay to the other contracting party.

Under modern corporation law, the board of directors has a duty to shareholders to default on contracts that are not cost efficient for the company. I see no reason why this should not also hold true for individuals.

 

[samclem]

I would hope the "efficient default" theory leaves a lot of room for discretion on the part of decisionmakers.

In 1973 there was a shortage of tomatoes which led to a shortage of ketchup. Prices went way up. Heinz had a decades-long relationship with McDonalds, but elected not to fill the normal orders from McDonalds during the shortage, as a lot more money could be made selling the scarce ketchup in supermarkets. I don't even know if they had a contract, but McDonalds certainly had an expectation that their relationship would mean something.

McDonalds has never forgotten the snub. To this day, over 35 years later, McDonalds will buy almost no ketchup from Heinz for their US restaurants (exception--you can get it in Pittsburgh and in one pocket in MN or WI where the Krok family insisted on Heinz.). McDonalds formulated their own ketchup and started having it made by regional sources. Good and cheap.

Now, if they had a contract in 1973, Heinz probably made a good short-term financial decision to default and pay any damages to MickeyDees and sell ketchup at retail. But that penny-wise, pound foolish choice cost them the biggest ketchup contract in the world for three and a half decades.

Smart managers will certainly look well beyond the simple contract to determine the true costs of their decisions.

McDonalds is just now starting to buy Heinz for some of their foreign stores.

 

[Gumby]

I should have used the qualifier "all other things being equal". Boards are generally protected by the business judgment rule. If, in their best exercise of business judgment, it would have been prudent to stick with a money-losing contract for the sake of the longer term relationship, then it is unlikely a court would second guess that decision. But that's the chances you take being a director.

 

[lifeisgood]

Don't forget that it is the newspaper's job (new media as well) to provoke reactions just like this. It's like poking the beehive with a stick - the bees swarm out on cue and buzz around every time. The WSJ editors would be thrilled to see all of us riled up like this. Next week, they'll write one on welfare mothers or illegal aliens and we'll buzz again.

 

[Texas Proud]

I should have used the qualifier "all other things being equal". Boards are generally protected by the business judgment rule. If, in their best exercise of business judgment, it would have been prudent to stick with a money-losing contract for the sake of the longer term relationship, then it is unlikely a court would second guess that decision. But that's the chances you take being a director.

Samclean..... Your point is well taken... supplying a product for your customers to keep your customers is very important... the cost of getting a new customer is huge... so losing some money short term is not a big deal...

My boss has said that after this crisis, the people we deal with will remember who helped them out when they were down... it is relationship building...


What may original post was dealing more with the real estate (or other production asset)...


As an example... I remember a LONG time ago some company was leasing computers... and the people who leased had an option to put the computer back for a newer one... surprise, surprise, they had a LOT of return for newer and better computers... because there was no penalty... but even if the penalty was there, it still might be better to pay the penalty and get a new one...

So to me, an individual doing it is the same... I can tell you that IF I had bought a house for $400K and it was now worth $175ish.... and there was no way they could get the difference since it was non-recourse... I would probably return the keys.... now, this is an extreme case... since the cost to me is real... a lower credit rating... a 1099 for $225K (you still have to pay the tax on that don't you)...

But, if the loan was $150K and the house was $120K... then the 'savings' does not justify the costs....

BTW, it does matter if you have a high interest rate or not.... I saw something on nightline where the rate for someone in Phily was 9% and going up to 15%!!! Someone ripping off customers like that deserves to get screwed back.....

 

[samclem]

Don't forget that it is the newspaper's job (new media as well) to provoke reactions just like this. It's like poking the beehive with a stick - the bees swarm out on cue and buzz around every time. The WSJ editors would be thrilled to see all of us riled up like this. Next week, they'll write one on welfare mothers or illegal aliens and we'll buzz again.

I'm not "riled up", and I think this discussion resulting from the news article has been very enlightening. I've changed my mind on the issue as a result. To those who say "no one ever changes their positions as a result of these posts," I can now point them toward this thread.

Former view: Defaulting on a home mortgage when you have the means to pay is cheating. You had a contract with the lender and you deliberately broke your promise to pay.

New view: This is a business deal, a contract. The obligations of both parties need to be fully spelled out in the contract, and no one owes anything that's not in the contract. Lenders need to assure the contract provides them sufficient protection from default (whatever causes it) and if the law requires them to take higher levels of risk (e.g. no recourse) then they should price the product accordingly or take other steps (less loan-to-value, etc). This is not a loan from your brother-in-law.

 

[growing_older]

If that's as far as it went, then perhaps I can see your "its just a contract position" but in this case, I was never consulted or a party to the contract, but I will still have to pay for these defaults with bank bailouts, toxic asset programs and higher taxes. It's not as simple as just get away with whatever isn't explicitly illegal.

In the article, the people walking away deliberately stop payments to pile up money until the bank takes action. Meanwhile they have plenty of income and assets, including they own multiple rental properties themselves. They are just more aggressive about taking advantage where they don't think the counter party can enforce the agreement.

 

[samclem]

If that's as far as it went, then perhaps I can see your "its just a contract position" but in this case, I was never consulted or a party to the contract, but I will still have to pay for these defaults with bank bailouts, toxic asset programs and higher taxes.

It seems to me that your gripe is properly with the government that put you on the hook to bail out these lenders. Did you sign up for that? I know I didn't.

In the article, the people walking away deliberately stop payments to pile up money until the bank takes action. Meanwhile they have plenty of income and assets, including they own multiple rental properties themselves. They are just more aggressive about taking advantage where they don't think the counter party can enforce the agreement.

They are doing exactly what is allowed by the contract. The bank should have written a better contract--more money down, etc. The bank was [-]greedy[/-] aggressive and wanted to write a bunch of loans, and apparently believed house prices would never come down. Now they are reaping what they sowed. The borrower was never obligated to sell other properties to pay the loan, sell their cars, eat beans every night, or anything else.
The borrowers will take a credit rating hit which will put other potential lenders on notice that these folks defaulted on a debt. That will let others price their products to these people appropriately.