Monday, February 8, 2010

Advice to Homeowners: Walk Away

Regarding "strategic mortgage defaults:" Yes Yes Yes! These are a good solution to a big problem (and yes, I live in an area where we would see significant short-term repercussions, but that's okay). Here's a comment that I recently posted to a Motley Fool article, which featured outspoken UA professor Brent White (

As a college student, I spent multiple semesters compiling research on the economic value of bankruptcy. Most notably, the research pointed to the fact that allowing a financial reset button to investors has almost always helped spur future economic growth. In fact, it is usually the risk-takers who most help the market grow, and then it is the risk takers who most often require a bailout of sorts when hard times hit the economy.

Combine this with the knowledge that commercial investors are almost universally
considered unwise if they fail to renegotiate or default on expensive loans (and often have default clauses in their contracts to accommodate such decisions). Like those commercial loans, a home loan is a collateralized debt instrument -- and some states, like Arizona, wisely protect homeowners from undue recourse after the collateral has been converted to the lender's ownership. This means no risk to one's credit score for turning over the keys to a money trap. [Ummm, I think I covered this elsewhere, but please disregard my comment that there is no risk to your credit score.  That's not what I meant to write.]

So blame the banks. When they put forth 80-100% of the values that their misguided appraisers projected on bad investments, they made much poorer decisions than the homeowners who submitted the remainder. So from an both an economic and ethical perspective, why should we insist that there be a false moral obligation on the part of the downtrodden homeowner to help the bank that refuses to renegotiate a bad loan.

Read more of Professor White's argument about "efficient breach" and non-deficiency in last weekend's local paper:

Follow-Up: I recently posted the following to azcentral's brief opinion piece on this subject (, which I think helps to illuminate the many facets of this debate and my views on the subject.  And, by the way, the story's comments are some of the most intellectually stimulating that I have yet seen on

@animadvert4: The harm is already being done on a massive scale, through unfortunate and often unavoidable mortgage defaults.  Good luck effectively pointing the finger at all the borrowers "causing" your diminished home value; better yet, good luck identifying a legitimate baseline appraisal for your home in an established neighborhood, where many homes sold for less than today's prices in not too distant memory. [Note: This commenter alleged that purposeful defaults constituted tort damage to neighboring homeowners.  While this is a compelling concept, it is a failing argument on many levels, certainly including the suggestion of recourse that I strongly doubt to be applicable in any practical sense.]

Another important note: Financial institutions constituted the single largest moneyed political lobby for the ten years that precipitated our burst real estate bubble (and this transcended political lines, although spending tended to favor Republicans who were in power).  This spending effected policy like Bush's poorly conceived home ownership plan as well as his misguided policy on student loans, Congress's bankruptcy "reform," and several other [policies] designed to increase the fees collected by banks in recent years.

Not only should the banks carry greater blame for this crisis than individual borrowers, but they should be credited with failing to understand the greater ramifications of their greed.  Or maybe a better question would be whether they did in fact misjudge the outcomes of this cycle.  While most of the large banks guaranteed themselves a federal backstop for their errors, they have also strategically built up a foundation for a very profitable recovery.

Why aren't we more concerned about the fact that the American public is guilted into taking the least advantageous path to financial salvation, when we regularly expect that more savvy corporate interests will do otherwise?  I'm quite grateful for provisions like the "efficient breach" law, which I consider tantamount to bankruptcy protection in its ability to provide efficient recovery for failed investors in a down economy.  While one could argue the potential that people will unjustly take advantage of such "clean slate" provisions like bankruptcy, research has consistently proven that this is not the case.  Instead, for every wave of debt forgiveness among individuals (like personal bankruptcy), there have been greater than proportionate increases in overall wealth, i.e. economic recovery. [While I can't readily cite sources, there is plenty of evidence that defends this position.  If not for a crashed hard drive a few years back, I'd be able to draw from sources used in my previously mentioned academic paper.  But if you so wish, I think you can find it in the UA library.]

Our economic system has historically seen the greatest benefit from rewarding risk takers, for they are the ones who most contribute to economic growth.  So why now are we seeing such a reversal of sentiment, now that our economy could most use such relief?


  1. There is a great article on John Talton's blog that I think elevates the discussion about Phoenix's situation: It is appropriately titled, "The Godot Housing Recovery."

  2. More details on the issue of strategic defaults, and the likelihood that they should continue, from ABC News:

  3. And here's a news flash about the ongoing mortgage crisis in the Phoenix market:

  4. Here's a little diatribe I posted in response to my friend's commentary about the classic scenario of irresponsibly spendy neighbors who suddenly find themselves overleveraged and in trouble:

    I think that's an excellent point, although it also comes down to a truly strategic default from the economic perspective. If someone behaved responsibly, yet they saw their equity drop to extreme negative levels while rent/purchase remains much cheaper..... they face a purely economic decision. And any well-written contract provides for some type of default, even in AZ, which is a non-recourse state.

    ***Note that the borrowers and lenders should have known that AZ is a non-recourse state, meaning that our houses truly do represent the entire collateral for many loans. So again, is it unethical for the borrower to take that legally guaranteed default option?

    I'm not advocating that people breach their contracts and expect to escape free and clear, but that people may want to consider the pros and cons of staying versus leaving. According to the most recent report from Dr. Butler's office, foreclosures are not expected to go away anytime soon in Phoenix. So I'd prefer to see the borrowers remain in good standing and short-sell or walk than go through an unnecessary foreclosure. Add to that the fact that we need to become much more honest about this stark reality and deal with it proactively -- as opposed to most news reports that are trying to spin this finding to focus on higher transaction numbers from last year.... See More

    People's credit will be ruined, their life savings wiped out, and our economy will keep hurting for some time yet. Hopefully the reckless and dishonest folks have learned their lessons and will be at a disadvantage to the rest of us when the time comes for them to seek other loans.

    But that said, I'm convinced of the following, from extensive research into bankruptcy history (and the overall history of debt in Western society):

    1. Dishonest people who game the system are an extreme minority (as can be found in historical U.S. bankruptcy data), which I'm sure remains mostly true, even at the end of our "lost decade" of decadent debt.

    2. Allowing failed investors a process by which they can unburden themselves tends to accelerate economic recovery. Like it or not, while risk takers are most often the ones needing help, they too are the ones who will likely reinvest the fastest.

    3. The institution of money lending has never in modern history been so sloppy and dubious as it was these last few years. The banks are reaping what they sowed.

    Furthermore, we need to recognize that our bankruptcy protection laws were seriously gutted about five years ago, thus removing a major release valve from our toolbox for recovery. Mortgages are the new mass failure from which most people need relief, not to mention better understanding. Hopefully we can do something about it -- and fast!

  5. A forthcoming story about strategic defauls in AZ? Hmmmm, I'm all for it:

  6. Response to a Facebook friend who responded 'mixed-feelings' in the following poll: She unfortunately then asked my opinion....

    Eh, if my somewhat obsessive posts on the subject are at all telling, I'm for it in many cases. In our case, we just don't stand to gain much from walking away, so we'll stay. But I feel that it's important for average consumers to better understand the difference between an impersonal contract, which specifically provides for the case of potential default (because it's impersonal), versus a personal agreement that likely does not, because it's based more purely on trust.

    If I make a solemn promise to you as a friend/neighbor/family member, and then choose to not honor it because I changed my mind, then you may very well deem me dishonest and unethical. The same goes for business to some extent, although there is a duty for both parties to perform due diligence in a business transaction. So if I managed to hide my inability to perform and made the promise anyway by contract, then I'm probably guilty of fraud or at least fraudulent omission -- which of course is bad.

    But taking the default option in a contract is neither fraudulent nor immoral/unethical -- it's pure economics. This happens in business all the time, and the defaulting parties can still engage in the same line of business again while maybe or maybe not being held accountable for their past default.... See More

    But it's about honesty of intent, and I maintain my optimistic and well-researched belief that most people tend not to game the system immorally. While there may be greater prevalence of dishonesty and greed in recent years than in the past, I believe that we must be learning something from this experience.

    From a more utilitarian macroeconomic perspective, aside from personal worldviews, we are faced with the dilemma of what type of recovery our market requires. In the past, it's been proven that people who are absolved of their debts in some way tend to be more productive members of our economy. Rather than have a bunch of hopeless, debt-burdened neighbors with no hope of personal financial recovery, I would prefer to see them freed to take on additional risk so that they can reinvest in our economy and society as a whole.

  7. The Motley Fool columnist who authored the aforementioned article about strategic defaults also made a compelling comparison between our culture's view of personal morals versus those of companies: After all, we are debating acceptable ethical frameworks regarding legal contracts.....

    So, here was my take on whether I expect companies to behave morally:

    I think that many of the commenters here are confusing capitalism as an economic construct with that of a social system. According to Milton Friedman, capitalism is amoral; there is no inherent provision for morality in the basic premise of capitalism. Debating this is like comparing apples and oranges (even to the extent that we will barter different amounts of apple for orange at different times -- we value them separately and for different reasons).

    So if capitalism can't be moralistic, then can your morals include capitalism? Yes, this would be a more utilitarian, economizing worldview. This is certainly why so many of us are so concerned with protecting the sanctity of an effective capitalistic system, or rather I prefer to use the term free market in place of capitalism -- for not all of us need be capitalists in a free market. But we do believe that a free market is the most efficient way to deliver goods and services.

    So there are only two ways for morality to enter the free market system:

    Either, as this poll suggests is a realistic measure, because enough of the market will indeed demand certain "moral" behaviors on the part of companies and their leadership. While none of us can argue the merits of this if it indeed takes root, our temperaments often change to reflect our preference for different qualities, not always including a consideration of a company's social policy.

    Or, a social construct, such as a government-appointed regulatory agency, can enforce the people's will for certain moral behaviors. In lieu of government, perhaps mob rule or a warlord can fulfill this role in order to maintain a social contract with fellow members of society. But in any sense it's the same: people circumvent the market to enforce certain behaviors that they deem desirable.

    I think you'll find that both ways can work incrementally, and in targeted areas. However, the fact that we have an almost even split over whether we should require moral actions from companies demonstrates why we don't see more government enforcement along these lines. Instead, government intervention more often takes the form of enabling market efficiency when it comes to investments -- also a good cause, but an entirely different issue. Or we see these government agencies like the EPA, which often impact businesses even though they were not created for this purpose.

    Meanwhile, certain companies that subscribe to principles like the triple bottom line tend to become immensely successful when well run (I've got nothing to say for the overly idealistic types who forget that they compete in a market environment and thus fail to properly manage their business operations or offer desirable products). And this is because, as is demonstrated in this very poll, roughly half of us tend to support these practices. And guess what: that half tends to be pretty devoted, and therefore a highly profitable market.

    So as an investor concerned with overall branding and execution of concept, I will indeed support a company that does a great job of demonstrating that it behaves in a way that its most loyal customers want. I see this as a great investment opportunity when I can catch it before it becomes overvalued or overleveraged due to rapid expansion.

  8. And here's another comment regarding morality and capitalism, which better draws this topic into the debate of strategic defaults:

    Back to the question of moral conduct in commerce as it relates to our attitudes about contracts, I've observed a perfectly efficient and acceptable way to navigate this issue in my commercial real estate experience.

    I prefer getting to know people with whom I do business so that I can determine whether we can agree to a handshake deal or if everything needs to be in writing. While I certainly value the former, I have no problem with the latter (and usually get there anyhow in some fashion). But when I'm dealing with a faceless entity, where there is no personal connection, I see it as my duty to get absolutely everything in writing -- all the way down to the default clause.

    I want to know what will happen if and when one party fails to act, knowing that it may very well happen for any number of reasons. And in a well written contract, there should always be an acceptable outcome for both parties, whether they move forward as described is the plan or otherwise.

    Would I do business again with someone who defaults on a contract? Yes, as I have done in a couple of cases. If I perceived that they defaulted for dishonest reasons (or wasted my time, etc.), then I will certainly be more guarded about future dealings. But that's it. Life goes on.

  9. And in case I didn't yet mention it specifically, here's Professor White's paper:

  10. "Slumburbia" - from the New York Times:; a snapshot of the mortgage crisis and its effect on communities.

  11. Another article from the NY Times about the tough choice to walk away:

  12. Interesting. Patrick, are you commenting on your own blog post or transliterating visitors' comments? One way or another, here's another idle observation...

    IMHO, White has got something. When you're stuck with a bad loan, it may be financially irresponsible NOT to walk. And there's no reason to feel guilty or morally incompetent when the mess results from no fault of your own.

    My son and I copurchased a small house in mid-town Phoenix, in the north central corridor, at a time when we believed the real estate collapse was nearing bottom. Our agent, a very smart older man with an MBA and many years of experience in business and real estate, thought the same thing. We estimated the house's value would drop about $4,000 to $6,000, level out for a year or two, and then begin to rise at about 3% to 6% p.a., the historic rate of increase in that area before the bubble.

    Neighbors were furious at our seller for unloading the house at what they thought was a rapaciously low price.

    How wrong could we all have been?

    The house is now worth (optimistically!) $75,000 less than we paid for it and $51,000 less than we owe.

    We had planned to hold the house for 10 years, with my son living in it most of the time or renting it should he take a job in another city or marry and need a larger home. After a decade, we expected to break even or collect a small profit, split whatever equity we recovered, and go on our respective ways.

    Now my son is stuck in the house. He can't move to another city in search of a better job (as you know, workers are famously underpaid in Arizona) or go out of state to pursue his MBA at a decent school (I am late an 20-year employee of ASU, and so I know whereof I opine). There's no way we can sell the house for enough to pay off the loan, and rentals in the area are now way below the mortgage payments.

    Fortunately, we did have enough sense to get a loan through our credit union. Unlike the banks of recent infamy, the credit union has been willing to negotiate, although they resist even contemplating a cut in principal, which is what needs to happen.

    In response to my layoff from ASU, the credit union arranged to prorate our payments over 40 years (instead of 30) and to cut our interest rate to 4 percent. This dropped the mortgage payments into a more affordable range -- and to something close to what we could theoretically get in rent.

    The deal is good for only a year, however. After that, the credit union will consider renewing it for another year or will give us the option to refinance.

    Although of course I'm pleased to see our payments reduced to something almost within reason, I'm still unhappy with the underlying predicament. In the most optimistic scenario, it will be another ten years before the house's value rises to what we owe on the say nothing of what we paid for the property. And please: don't even ask what we put into renovating a 1950 cottage!

    Fortunately, my son likes the house and is comfortable there. He rents one of the rooms to bring in cash to cover maintenance and repairs. With me putting my share into the mortgage, the roof over his head is costing him no more than he would pay for a rental. But the point is, we're both losing money on this dog.

    We did everything we could to make a responsible decision: purchasing a house that was certainly no McMansion, selecting a centrally located neighborhood ripe for gentrification and close to the much-ballyhooed lightrail line, buying within our means, avoiding shady mortgage instruments, and selecting a lender that was unlikely to rip us off. And we're still behind the 8-ball.

    A corporation's board of directors would be remiss not to default under those circumstances. So...why should a homeowner be held to a different standard?

  13. Yes, your son's situation sounds similar to mine and my wife's. For us, the operative part of our personal NPV equation is that our mortgage payment is comparable to market rent, so it doesn't make sense to move out and start over UNLESS it is to pursue higher wage employment elsewhere. It sounds like we walked into our home purchases with a similar outlook (I was a little more pessimistic about value, but still thought we'd see a manageable drop of 15-20% max).

    To answer your question, "are you commenting on your own blog post or transliterating visitors' comments?" I have mainly used this post as a dumping ground for other articles germane to the discussion and/or my personal comments in response to those articles or their readers. I'm sure it looks like a mess in certain ways, but I'm trying not to focus too much effort on this subject, despite being obsessed with it. In fact, in an effort to clean up the flow a little, I've started a new discussion titled, "More on the Ethics of Strategic Defaults:" I hope you enjoy it.