The Tricky Ethics of Strategic Default

[alcibiades_mystery]

Three points on strategic default (walking away from a mortgage):

1. Why Strategic Default is Ethically and Morally Fine - Over a year and a half ago, Roger Lowenstein set out the case for walking away from a mortgage. Lowenstein's point here is simple: questions of moral rightness or emotionality do not attach to the financial agreement of the mortgage. The lender is "protected" by the collateral (the house itself), and, indeed, entered into a risky financial agreement wherein that very protection was agreed upon. The lender is owed no further obligation, and certainly has no MORAL right to insist on payment as opposed to the collateral. The lender, of free will and with significant financial acumen (supposing it was a mortgage broker or bank), agreed that it would recoup its outlay in one of two ways: through scheduled payments or through the collateral. The borrower similarly agreed to make the lender whole in one of those two ways. There is no moral or ethical obligation to prefer one of these ways to the other. The banks, of course, seek to obscure this simple fact by pretending that making them whole through the collateral is some kind of immoral act or ethical breach. They further want the borrower to experience some sort of emotional shame at finding the scheduled payments route irrational or against their best interests. That is because they don't actually want the inventory they agreed to, especially now that its value is significantly reduced from the time of the initial agreement. But that's the same situation that the borrower is in! Both the lender and borrower made projections about future value that turned out to be mistaken. But that's no reason for the borrower to suffer while the lender prospers - they both made the same "mistake." A strategic default puts the mistake in the lender's column rather than the borrower's column. There is nothing morally or ethically wrong with this, as it is an agreement they both freely entered into.


2. How Strategic Default can be Ethically Suspect - As I've suggested in Point #1, walking away from a mortgage is not morally wrong relative to the bank or lender. However, the way it may affect other doesn't end there. A foreclosed property, as we well know, has effects on the other properties that surround it. First, of course, is the matter of property values. My neighbor's foreclosed home may drag down the financial value of my own home, particularly if it sits for some time in states of disrepair. If we move away from pure financial "property" values, we also see the degradation of the aesthetic value and quality of life in the neighborhood if a number of foreclosed homes sit on a given street or in a given community. The question here, then, is whether the strategic defaulter has any kind of ethical obligation to the community or to the neighbors to prevent their own property values and life quality from declining.

3. How Strategic Default Constitutes Resistance - What became devastatingly clear in the wake of the housing bubble collapse is this: banks will resist any attempt to revise loan terms such that they are in line with current values. Put another way, banks will seek almost compulsively to keep the "mistaken" projections of value on the borrower's side. This really amounts to a "too bad" strategy on the part of the banks: they think it's just too damn bad that the borrower made a mistake in projecting income or value, and they think the borrower should simply live with that mistake - just 'eat it" financially. This is a rather astounding position to hold, of course, since they (the lenders) made precisely the same mistake, and seem unwilling to themselves "live with it." One-on-one and in the abstract, it's a wash: both parties to the agreement want to avoid eating the loss. As a population phenomenon and in concrete terms, however, we know that the banks will have to be moved on their position, and that it is even in their own interest to be so moved. Lowenstein's second point, then, is that the only way to move the banks toward loan modification is to make them suffer for their intransigence. In this sense, walking away from your mortgage is a form of class struggle: it is a strategy for forcing the banks to take the reasonable course of modifying loan terms.

So, the tricky ethics: it is not obvious that any of the courses of action available to someone who might walk away are "right." Rather, we have to - as a people and as individuals - weigh the damage done to neighbors and communities against the benefits for our own financial health and the broader community benefits that may flow from forcing the banks to modify loan terms. Neither of the options are cost free, and neither is a no-brainer. We should start from such acknowledgements.

[Warren Stupidity]

1. I think you lay out the issues here well but...

I find the second issue weak. Certainly nobody is running around claiming banks cannot foreclose on 'non-strategic' defaults because it 'wrecks the neighborhood' - this is only an issue when individuals act in their own best interests. I also rather doubt that an isolated foreclosure causes measurable damage to property values - and in fact the strategic default is because PROPERTY VALUES HAVE ALREADY FALLEN. The strategic default (and the non strategic ones) are recognition of the realized new and lower property values. (2) confuses cause for effect.

[alcibiades_mystery]

4. I dunno, Warren

I'm not a particular fan of Point #2, but I can see the reasoning. If my decision causes my house to sit vacant and increasing states of disrepair, there's at least an argument to be made that I'm doing some harm to my neighbors, even if property values have fallen across the board. It's safe to say that they would be able to sell their own homes more easily if I stayed and kept up the property than if I didn't, regardless of a general drop throughout the neighborhood. At the very least, it's an open ethical question, which is how I presented and left it.

[Warren Stupidity]

7. So my neighbor who has had his house on the market for over a year

now is an unethical asshole because he can't sell his empty house? Again, the whole point of a strategic default is that the property values have already fallen to the point where walking away makes financial sense. To blame the defaulter for the fall is backwards. This is the bankster's argument for 'do as I say, not as I do'. They don't hesitate ever to walk away from bad investments.

[alcibiades_mystery]

8. I think we can agree

That an attempt to sell the house oneself is different from leaving the keys and walking away, particularly if the latter results in the house falling into disrepair. None of this has anything to do with anyone being an "unethical asshole," and I'm not really interested in engaging in such terms.

I have no doubt that the "banksters" make such arguments. So do many on this board who feel that they've been harmed by other people walking away.

Once again, I'm merely noting that the argument can be seen to have some validity.

I go on record again saying that it is not an argument I put much stock in, but I see how others could.

[undeterred]

2. I know someone who is about to walk away from a mortgage.

He's "underwater".

Been living there for the last 2 years without making any mortgage payments at all. He's working, but has garnishments due to credit card debt, gambling debt, you name it. Thinks he's going to miraculously renegotiate with the lender in the next 2 weeks or somebody is going to bail him out. Mortgage is ARM but its 9 years old, way before the bubble.

The less I knew, the more sympathy I felt.

[ejpoeta]

3. every case is different. i would argue that your neighbor is not the rule.

most people tried really hard and did their best and ended up getting screwed and are trying not to go down with the ship so to speak. sounds like your neighbor is going to drown either way and should have gone to a bankruptcy lawyer or something instead. and maybe could use some serious counselling. I have a sister and brother who just went through their second bankruptcy a couple years ago... just before the bankruptcy laws changed whenever that was. I can understand the not feeling much sympathy. But I don't consider them to be an example of everyone's predicament.

[alcibiades_mystery]

5. Here's my point: none of this requires sympathy or is even about sympathy

[exboyfil]

6. Good summary

If you only consider ethics, then I think the buyer could make a good faith offer to reduce the mortgage and satisfy his/her ethical obligation.

If I was in a nonrecourse loan situation, and I had far less equity than value, I think I would also default on the loan. It is a business decision like any other. That decision would be irrespective of my financial condition. If it made good sense financially, then I would do it. Businesses make these decisions all the time.

[B-Stupid]

9. Here's an excellent writeup on the subject:

http://mises.org/books/walkaway_french.pdf

[snot]

10. I disagree with much of this.

First, just try applying for a loan and telling the lender up front that you consider it just as likely that they'll have to foreclose as that you'll repay the cash loan, and let us know how far you get.

In truth, it is extremely rare for a lender to actually consider foreclosure an equally desirable option.

Second, from a "moral" point of view, foreclosure after making a loan is extremely inefficient. There are all kinds of costs and risks in owning, operating, and trying to sell real estate, and lenders are not well-qualified or -equipped to do those activities; they have to hire a lot of other people to deal with it. And the additional costs incurred don't just come out of the lender's employees' or managers' pockets -- they also end up being borne by shareholders (which might, e.g., include retirees) and taxpayers. I.e., there is a cost to society at large.

Third, a borrower who walks away from a mortgaged property remains liable for any deficiency on the loan -- a deficiency that is highly likely to result in bad economic times; for even if the foreclosure and marketing of the property proceed as efficiently as possible, not only will there will be costs for lawyers, an appraisal, managers' and/or brokers' fees, while insurance and taxes continue to accrue, but all that will be on top of the loss on the property if it sells for less than the outstanding balance on the loan. If the borrower also has full personal liability for the loan, as individual borrowers usually do, and the total deficiency is more than a few thousand dollars, there's a good chance the borrower will eventually get sued for it. If a judgment is obtained, the lender may be able to get a lien on the borrower's existing and future property and garnish future wages.

In sum, I do not consider walking from a mortgage to be without moral implications just because there's collateral; and as a practical matter, I don't think any borrower should walk from a mortgage with consulting a lawyer about the particulars of local law and the borrower's own circumstances.

(From another angle, for similiar reasons, when a "big player" borrowers have personal liability for a loan, they usually do NOT walk from it, but rather to re-negotiate the loan or reach a settlement and release through bankruptcy or the like.)