Tuesday, March 16, 2010

More on the Ethics of Strategic Defaults

There is presently a great conversation among commercial real estate professionals in a LinkedIn group to which I belong, questioning the honor of those who choose to walk away from bad mortgages.  Here's my two cents (note that I reference my previous blog post at the end of the comment):

...I'm sure you know that Arizona is an anti-deficiency state, particularly regarding "purchase money" loans for single-family dwellings on 2.5 acres or less ( http://www.azleg.state.az.us/ars/33/00814.htm ). This means that homeowners in Arizona who find themselves in a negative equity situation have the right to reevaluate their financial situation and consider turning over the real estate that secures the loan. In so doing, the homeowner makes the obligation whole and the bank cannot pursue any damages due to changes in the asset's value resulting solely from market conditions (in most cases). This has been the law in AZ since 1971, and it is the environment into which banks decided to invest their money during our latest bubble, even when making loans to very risky borrowers and failing to properly account for market risk.

On an individual basis, borrowers often feel guilty about exercising their legally granted right to walk away from a deed of trust secured debt for personal gain or preservation. This is largely due to the reasoning that you provided -- that it breaks down our system of trust that makes our debt-driven economy hum along. Or even more extreme, your comparison to wife-beating. But these premises are both wrong because they assume a falsely placed sense of morality as it relates to one's treatment of legal documents and investment agreements. In fact, while our society has a duty to be moral, our economy is fundamentally amoral, and economic transactions can only be as moral as the law declares they must be (where laws result from society's moral and ethical views).

If you believe that those laws need to be changed, then so be it. But also please recognize two related facts: 1) Bankruptcy protection laws have been significantly weakened in recent years, and the negative effects of bankruptcy are perhaps a tad extreme for many of the cases where homeowners should walk away; and 2) Bank notes are not the equivalent of handshake deals between two equal and trusting parties, which is why they must be loaded with lengthy descriptions of recourse and other contingencies. If you truly believe that we need to take greater measures to compel people to pay their debts, then I recommend that you take a step back in our legal history to the times before England's signing of the Magna Carta. Those were the days....

By the way, I've logged several other online discussions about the morality of walking away on my personal blog (not regularly updated). Feel free to take a look:
http://bit.ly/aHyrcO .

Also, there's a discussion on ABC 15's website to which I couldn't help but contribute my personal views on the matter: http://bit.ly/ctMhHW:
This should not even be considered a moral versus immoral choice, but an amoral financial one. Arizona law provides for efficient breach of contract, which means that a party can breach a contract when that contract becomes an excessive financial burden. Further, Arizona is a non-recourse state: if your loan is collateralized by an asset, then that asset shall serve to make the debt whole in the case of a default. These rules were created with a moral compass in mind, for without them imagine how much the powerful could take advantage of the powerless and how the economy could stagnate by forcing people to honor bad contracts for their whole lives. But since when is it considered a moral choice to take advantage of legal protections that benefit us all....
 ...
 How do you decide to walk away (different than foreclosing, btw)? Easy! When your mortgage payment is double market rent and your house is valued at less than 75% of what you owe, then there's a pretty good case for pocketing the extra $12,000-25,000 per year that you are throwing at a poor investment. "But then I can't buy again for 2-3 years..." Lucky for you, there's still about five years of inventory on the market. "But what about my credit?" Keep all your cards and other accounts current, and it'll rebound in the next couple of years. Plus, with an extra $25,000 on hand, maybe you should consider paying cash for the next family car or big screen TV. "But what will my friends and family think?" They'll be jealous, even if they say otherwise, because it's the right choice. "But what about my neighbors?" If you walk away and leave an intact home to the market, you're doing better by them than if you fall into serious default involuntarily and they must watch you go into financial and personal ruin. If you can afford to buy again and have cosigners willing to help, then buy the place across the street and you've actually helped the market (and you would want to move across the street if you really care that much about the neighbors, right?). "So what's stopping me?" I don't know -- maybe you've bought into the banks' PR plan to guilt you into padding their pocket books rather than yours.
 ...
 For anyone questioning the decision to walk away, I would recommend that you seriously analyze your financial situation and the pros/cons of doing so, with the assistance of a financial calculator (or ask a friendly accountant, financial analyst, or upper division college business student for help). First, what are all your current monthly expenses related to the house you would consider leaving? There's your status quo.... Next, do you plan to rent or buy a new place (or rent, and then buy in a couple years)? If so, what is your initial investment, when will you make that investment, and what will your new expenses be? Here's the financial comparison you must consider..... And finally, why do you feel compelled to walk away? If it's purely for financial reasons, then you must consider the above calculations above all else. But if it's because of work opportunities or some other reason, then you will need to reconsider your priorities and consider the above calculations helpful references in helping to make that decision. (And if it's for a new job, you could even consider the changed income/expenses into the calculations pretty easily).
 ...
lender, thank you for the compliment [a mortgage lender, with the screen name"lender," thought my above comments summed up the situation well]. I would love to see a little more common sense on this topic and a little less of the emotional zeal that surrounds our rough housing market (and the supposedly negative impacts of one course of action versus another). If you resent the family down the street for "damaging your property values" by foreclosing, then you really need to reevaluate the situation and consider the fact that the damage was done years ago -- before anyone talked about walking away. It seems rather counterproductive to kick others while they're down, just as it is to fixate on having once made a costly decision for which you continue to pay. People should seek to make the best decision today, based on their current situation, and then move on. As soon as we the public can move toward rationality, the better our chances for an efficient recovery. 

3 comments:

  1. I hope readers will notice that this has been something of a learning process for me. Two months ago, I couldn't have offered you any citation of the law that protects homeowners whose foreclosed homes are sold for less than they owe. But let's please keep the discussion alive and at the forefront so that we can all learn more from it.

    As noted in the comments section of my last post on the matter, AZ Republic's Real Estate writer, Catherine Reagor has published a story that is generating a ton of comments (and I'm quoted in the text). Here it is: http://bit.ly/chyqon.

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  2. And to clarify my quote in the AZ Republic article, I posted the following in their comment section (among many others):

    To clarify, I wouldn't say that I am "angry at lenders" -- at least not in my motivation to walk away from an underwater mortgage. We all have a moral obligation, myself included, to do what is best for our families. As I stated in the article, I don't stand to gain much from walking from our mortgage for now, so I won't do it. That should be the only deciding factor, rather than putting one's family into a precarious situation in order to stick it to the banks. I've gathered more information on my personal blog at http://bit.ly/9cmcLE.

    As for morals in business transactions, let's go with Milton Friedman's free market principles, which state that business is inherently amoral. However, a well-run business has an ethical mandate to create value, especially for its shareholders. We all have the same obligation to our families, above and beyond the paper documents we hold. And just to drive the point home, walking away is not "against the contract," but rather the contract has provisions for how to proceed with the agreement after payments cease -- release all claims to the property and leave it in good condition. So if it suits you financially, I say that you should walk away from a mortgage and be honest about it; accept the consequences, just as you would with any other course of action. Why is this so difficult for people to understand?

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  3. Here, again, is the link to the aforementioned AZ Republic article: http://bit.ly/chyqon.

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