Strategic Mortgage Defaults Revisited

Back at the end of September, I wrote about strategic mortgage defaults - purposefully defaulting on your mortgage on a property that has a mortgage for more than the property is worth. A story in the L.A. Times reported that these types of defaults were on the rise.

Now, University of Arizona law professor Arizona Brent T. White has published a paper (pdf) stating, contrary to news reports, not many people are doing this - but they should. He cites people's emotional fears as the driving force preventing them from acting in their own financial best interests - the fear of the shame and guilt of foreclosure and an exaggerated sense of the consequences of foreclosure. He also argues these fears are actively encouraged by the government, lenders, and other social agents to induce borrowers to ignore what might be the wisest financial decision for them.

I found this paper very interesting, mainly because it presents almost the complete opposite picture of human behavior that Freakonomics does - namely that people will NOT act in ways which benefit them financially the most. I think the difference here is due to the amounts of money involved, as well as social pressures. The actions looked at by Freakonomics dealt with relatively small amounts of money and with actions whose consequences have fewer social repercussions.

White states:

Homeowners should be walking away in droves. But they aren’t. And it’s not because the financial costs of foreclosure outweigh the benefits. To be sure, foreclosure comes with costs, including a significant negative impact on one’s credit rating. But assuming one had otherwise good credit, and continues to meet other credit obligations, one can have a good credit rating again – meaning above 660 - within two years after a foreclosure. Additionally, in as little as three years, one can qualify for a federally-insured FHA loan to purchase another home.

While the actual financial cost of having a poor credit score for a few years may be hard to quantify, it is not likely to be significant for most individuals – especially not when compared to the savings from walking away from a seriously underwater mortgage. While a good credit score might save an average person ten of thousands of dollars over the course of a lifetime, a few years of poor credit shouldn’t cost more than few thousand dollars.

I find his arguments to be well-thought out and worth thinking about. There is a definite basis against people who walk away from their mortgages:

This is not to say that there is a grand scheme to manipulate the emotions of homeowners, or even that the government and other institutions consciously cultivate these emotional constraints on default. But, to be sure, the predominate message of political, social, and economic institutions in the United States has functioned to cultivate fear, shame, and guilt in those who might contemplate foreclosure. These emotions in turn function as a form of internalized social control – encouraging conformity to the norm of meeting one’s mortgage obligations as long as one can afford to do so

What I find particularly interesting in the concept of how the lender-borrower relationship is an example of a asymmetric relationship - one side, the lender, has all the power. The lender is free to walk away from the loan (by selling it to another company), is free to make loans based on over-inflated property values (without doing any significant research to verify those values and then expect a government bailout when their lack of due diligence catches up to them), and is free to, in effect, modify the terms of the mortgage to include more than just the property as collateral, without any legal or moral ramifications, yet the borrower has no such options. In fact, even though the mortgage document specifically states the lender's SOLE COLLATERAL for the loan is the property, the lender is able to also use the borrower's credit score and self-image as collateral as well.

One obvious response to the above discussion is that society benefits when people honor their financial obligations and behave according to social and moral norms, rather than strictly legal or market norms. This may be true if lenders behaved according to the same social and moral norms. In the case of lender-borrower behavior, however, there is a clear imbalance in placing personal responsibility on the borrower to honor their “promise to pay” in order to relieve the lender of their agreement to take back the home in lieu of payment.

Given lenders' generally superior knowledge and understanding of both mortgage instruments and valuation of real estate, it seems only fair to hold them to the benefit of their bargain. At a basic level, sound underwriting of mortgage loans requires lenders to ensure that a loan is sufficiently collateralized in the event of default... In other words, in appraising a home the lender should ensure that the loan amount, at the least, does not exceed the intrinsic market value of the home...since lenders generally arrange the appraisal (which home buyers must pay for) and home buyers rely upon the lender to ensure the home is worth the purchase price, one might argue that lender should bear much more than 50% responsibility for the bad investment of the homeowner and lender.

So what does he propose be done to help homeowners? One suggestion is to prevent lenders from reporting foreclosures to credit reporting agencies. This sounds crazy, but he makes a good case:

The suggestion that Congress should amend the Fair Credit Reporting Act to prevent lenders from reporting mortgage defaults is premised upon the underlying mortgage contract, in which lenders agree to hold the house alone as collateral. In the case of underwater mortgages, however, the portion of the mortgage above the home’s present value essentially becomes unsecured. Lenders compensate for this by holding the borrowers’ credit score, and thus their human worth, as collateral – thereby altering the underlining agreement that the home serves as the sole collateral. As a consequence, lenders are often able to reap the benefit, but escape the costs, of their bargain.

There are many more arguments he makes, which I don't have the space to go into here. I encourage people to read his paper with an open mind. Needless to say, the banking industry fiercely opposes his ideas.