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. 

Definition of Entrepreneur

I'm a firm believer that what the world needs now is a new entrepreneurial class, and particularly in these great western states where properties/resources are relatively cheap and out-of-work talent is plentiful.  If the debt markets thaw, or more young and knowledgeable individuals figure out a way to escape the debt trap that keeps them tied to their 9-5 jobs (and build the necessary savings to sustain several months or years without income), then there's never been a better time in recent decades to pursue this dream.

But what is an entrepreneur?  Ironically, I was asked this question on a recent online job application, where I offered the following definition in 150 words or less:

An entrepreneur is someone driven so strongly to create a successful business that they will risk the security of a traditional career to pursue that dream.  An entrepreneur values mistakes as the greatest learning opportunities, but only with an understanding that the difficult process leads to successful execution of the business plan, economic freedom, and hopefully great financial and experiential wealth.

It was a somewhat hurried response, primarily because this wasn't a job that I'm dying to get (I even offered a somewhat ego-driven and tepid response when asked why I would want to work for the company, because I'm not sure that I do, and recession be damned, I don't believe that talented people should sell themselves out at the first site of an opportunity).  But I felt comfortable enough to throw it out there as a mostly fitting definition and a great discussion starter.  What do you think an entrepreneur is?

Hotel Deals to Rise, Thanks to Lender Transactions

Here's a great article that I think will ring true in 2010.  And yes, I joined a crowd once in grumbling/booing at Mr. Reay's gloomy predictions for years of hardship to come in the hotel market.  Of course, it was not the news anyone wanted hear (even if we believed it), and I recognized that Mr. Reay was taking too much pleasure in accepting the new "gloom and doom" spokesperson role for the industry.  But the fact that others have been so slow to recognize and address the problems that led to so many distressed hotels and so few transactions means that Atlas Hospitality has rightfully earned its spot as the top-quoted group in trade articles about how stale the market had become.  So without further ado....

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 (http://bit.ly/cazvPT):

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: http://bit.ly/9CIHoK.

Follow-Up: I recently posted the following to azcentral's brief opinion piece on this subject (http://bit.ly/cEX05W), 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 azcentral.com.

@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?

When Will This All Turn Around?

The pundits are all over the place, but it seems that there is some sort of optimistic consensus that the economy will start to look better by sometime next year. Kiplinger's has an index for such a prediction: http://kiplinger.com/businessresource/recovery. And while I think this is a great traditional (and thus conservative) tool for monitoring lagging indicators, I'd argue for a newer approach. Otherwise, we are completely discounting the fact that we may find a truly transformative path toward economic recovery.

I'm more interested in reevaluating our methodology in looking for leading indicators than measuring our lagging ones, in order to better reflect changing values. There was a great article on fool.com about the historical performance of large cap stocks (http://www.fool.com/retirement/general/2009/06/23/its-already-worse-than-the-depression.aspx). On the one hand, the article's observation begs the question of a bottom in the market--even though I predict another year of poor lagging results--but it also raises the possibility of a new kind of growth.

What if we the entrepreneurial class decide to overturn traditional economics by bringing forth an era of immense economic growth coupled with deleveraging. Not only do I believe that we need this for the long term, I also think it's possible with a short-term focus on old school yankee ingenuity. And I think that Gen X is uniquely capable to take on such an ambitious goal. What choice do we really have? More on this later.... including a tie-in to why this should especially concern those of us in the western U.S.

The Truth About Changing Hotel Revenue Models

Here's a great story from Michael Schindler, themed "Things I’d Prefer Not to Hear Anymore." In it, he discusses the whining that is all too prolific in our industry right now. Following is a reprint of my comment on his blog:

I feel the same way as Michael about our industry's currently sorry state. To his final point in this story about being a cheerleader, I would take his comments a little further to the acerbic side by saying "shut up and work through the tough times." Our industry is reeling right now from an era of all talk and cheap money. This meant that no one had to do much in the last few years aside from managing their time to process all the business transactions. Now, deals are tough to come by--as they should be in an efficient market (where efficiency is tied to parity on upward and downward forces in the economy). We should each focus on succeeding rather than pegging the date that the market makes it okay to do so again. That means working with what we've got.

Also, I often wonder why hotels aren't getting more creative in their reaction to the once again dynamic nature of our business. I have made a couple of recent trips to Las Vegas, where I frequently gamble at MGM properties in my spare time (low dollar amounts, I promise). While I regularly receive deals for $49 or $69 room nights, which are far below "acceptable rates," I know that these are offered at huge discounts to their simultaneously advertised rates. Thus, the hotel is using a classic marketing strategy to segment pricing based on overall customer value. Some people are indeed paying $200 per night, while I'm only paying $50; also, I'm making up for my room discount by dining out, attending shows, and gambling. A good marketing analyst is likely tracking these numbers to ensure that their strategy is working.

While this financial model is different from the limited service world where I operate, it's really not too different in its approach to the market. Hotel operators need to leverage their relationships with revenue sources and influencers to look for opportunities for quality promotions. Here in sunny Arizona, for instance, I would consider tapping into the cheap rates at golf courses and other currently struggling businesses to promote stay-and-play packages. Given all of the automated marketing and property management tools available, it doesn't take too much effort to try. And if you fail in one area (or marginally succeed), then simply move on to another idea. Remeber, if you fail to capitalize on such opportunities, I bet that the bigger players (Hotwire, Priceline, etc.) will happily do this with or without you.

In a nutshell....

I think this pretty well describes the world we've been in for the last year or so. Great stuff. The sad part is that when everyone goes through the motions, deals tend to get done. Now things are changing so that you have to put up the money in order to demonstrate the justification for everyone doing the work.