Robert Lowenstein Advises Homeowners To Just Walk Away
An interesting article opinion piece in today's New York Times Magazine says that it's okay for a homeowner to walk away from a mortgage if his or her home is underwater. His reasoning is that it's okay for homeowners to walk away from their financial obligations because financial institutions routinely walk away from theirs.
Putting aside the obviously infantile excuse that it's okay to do something because everyone else is doing it, I have some real problems with the idea that a mortgage is a disposable legal and financial obligation that ceases to exist whenever a homeowner deems it to be in their personal interest to leave it behind.
First, the homeowner and the mortgage holder are not the only two that will be affected by this behavior. There almost certainly will be significant externalities like higher mortgage rates and required larger downpayments that will apply to others who want to buy or refinance a home as lenders seek to protect themselves from this happening again. The homeowner who is walking away almost certainly won't give a damn whether I will have to pay more, but I sure as hell do.
Second, the rationale Lowenstein uses -- that financial institutions default on obligations when they no longer see the return they were expecting so homeowners should be expected to do the same -- isn't the correct analogy. The far better one is: Homeowners shouldn't be allowed to walk away from a mortgage that they can but no longer want to afford because the mortgage holder can't sell the home to someone else while the mortgage is in effect just because the prospective new buyer will pay more. That's the deal between the lender and the homebuilder: We'll buy this house for you and won't sell it to anyone else and you'll be responsible for all of the agreed-upon payments.
Third, while most homeowners in the U.S. hope (or used to, anyway) to get more than they paid for their home when they sell it, there never was a guarantee that would happen. History may have convinced them that the price would always go up, but there was and is always the possibility that it would go in the other direction. Get over it.
Fourth, while most homeowners in the U.S. hope (or used to, anyway) to get more than they paid for their home when they sell it, most don't buy it as an investment; they buy it to get a place to live. There are significant tax and other advantages to buying that homeowners enjoy in addition to (hopefully) making a huge profit. If underwater homeowners are saying they really bought their homes as investments, we should rethink the mortgage deduction and seek a refund of the taxes they didn't pay while the mortgage was in effect.
Fifth, there is an exquisite irony to what Lowenstein is saying. Underwater homeowners typically complain vociferously about the practices of financial institutions, but Lowenstein is arguing that they should be allowed to do the same things as financial institutions. Stop complaining about what they do if you want to do what they do. And if you want to do what financial institutions do, expect the same type of regulatory oversight.
My very strong preference is that any homeowner capable of paying his or her mortgage who walks away from it simply because they don't want to pay it any longer have their credit rating lowered significantly. I don't want them to be able to buy another home any time soon or get a loan for any other purpose without paying extra for the privilege. That will impose on them at least some of the costs others will bear for what they're doing.
I'm also not convinced about a federal program lowering principal for all underwater homeowners. I'm not sure why the underwater homeowner who can make the required payments but doesn't want to do so shouldn't be forced to declare bankruptcy and in the process bear some of the costs of his or her actions. That will likely lower what the mortgage holder can get for the home along the same lines as a reduction in principal and it will impose costs on the borrower that he or she should have to consider before walking away.
Really?
So how would you penalize corporations who engage in strategic defaults?
I think we should make those who walk away be serfs. Let them work on the grounds of the estates owned by senior managers at Goldman Sachs for the terms of their mortgages. We could build them little sheds and allow them small plots to farm cabbages and potatos so they could feed themselves. They could weed the lawns and fetch newspapers for the noble leaders of finance and industry who wrecked the world economy. Imagine, citizens thinking they could break a contract! The nerve! Don't they know, in America, we reserve such privileges for their honestiores.
One of the examples provided
One of the examples provided in the column:
>>Morgan Stanley recently decided to stop making payments on five San Francisco office buildings. A Morgan Stanley fund purchased the buildings at the height of the boom, and their value has plunged.<<<
sure looks like an apples-to-apples comparison to me. I'm not getting how that's different from an individual walking away from a mortgage obligation that no longer makes financial sense for him. Every last one of the points you make about homeowners applies just as well to Morgan Stanley in the example.
The larger point is that businesses are commonly regarded (especially by laissez-faire types) as having, not just the right, but the fiduciary duty to be profit maximizers and to ignore the moral sentiments of the communities in which they conduct business. There's no basis for holding individuals with far less power, purchasing or otherwise, to a higher standard.
>> There's no basis for
>> There's no basis for holding individuals with far less power, purchasing or otherwise, to a higher standard. <<
Are you kidding? This is america!
Power and ethical standards are inversely related.c
Double standard
Morgan Stanley defaulted on its obligations in spite of the ability to pay.
Why should a home-debtor be held to a different standard than a major bank?
Please note also that this bank has major financial back-stopping by the US government - AND STILL ELECTS TO DEFAULT.
Who cares what home-debtors complain about? That is not part of the issue. What is at the heart of the issue is what is in the best financial interest of the parties - as banks/businesses/MBAs have long been acutely aware.
Now that the sheep have recognized the need to keep some of their fleece, you object. As a businessman might say "It's nothing personal, just a business decision!" :)
On the one hand, and the other, then the third.
When we develop a society in which everyone walks away from their debts because they can -- either technically or practically -- we'll also develop a society in which lenders lend a lot less and do so at much higher price while imposing a lot more uncomfortable safeguards for themselves, so everyone loses.
Consider what happens when societies develop cultures of mass tax evasion ("other people do it ... there's always loopholes ... what are they going to do, put everybody in jail?"). Everybody's costs go way up.
But on the other hand, the reason why people almost never walked away on mortgages during past generations was that they almost always paid a significant (20% typical) down payment, so they almost always had equity in their homes that they'd lose if they walked.
There never were 10 million underwater mortgages before -- with most being nonrecourse loans! Or we'd have seen plenty of walking away for sure.
The whole point of making mortgages "nonrecourse" is so that borrowers can walk away from them and not be liable for the difference between the value of the home and the balance on the loan.
If we don't want people walking away, why do we make mortgages nonrecourse as a matter of law? "Nonrecourse states" include California, Nevada ... the whole "ground zero" area of the housing bubble/collapse. Coincidence? And making mortgages nonrecourse is a matter of policy.
Which brings us on the third hand to what should be most upsetting: Right now, even after all recent experience, the FHA is flogging not merely "no money down" mortgages but ones which actually become -- when combined with the "homebuyer's tax credit" generously provided by Congress -- effectively negative equity loans.
Quoting the FHA...
~~
FHA home loans allow first time home buyers and current home owners buy a home with less than 3.5% down, or FHA home mortgage refinance up to 96.5% of the home's value.
Research FHA loan programs which help you with buying a home with no money down...
~~~
Combined with the tax credit these are "Cash Back Mortgages"!, just like getting cash back from using your debit card, only a lot more cash. Buy a home, put zero money down, have no equity -- and get thousands of dollars of cash back!
On a nonrecourse loan.
And this is fully considered federal government policy.
Let's get to the next housing market crisis as fast as we can!
Stan, good thoughtful post
Stan, good thoughtful post but I think your come off as one sided in certain cases. The negative externalities to some also produce positive externalities for others, namely lower prices for buyers.
Second someone who defaults does face consequences. Credit hits do happen, bankruptcy in recourse states is possible. No institutions who made contracts giving home onwners a put option should be 'bailed out' for moral reasons. I think the institutions are in a much better position to price the optionality in the first place. Of course you imply if someone can pay now, they should, assuming they have perfect knowledge how adjustable rates work and ability to predict future interest rate changes (compared to institutions who can largely hedge out this options).
If you could switch to a more favorable loan, 30 yr fixed say, I think more people made be open to doing this, but Pre Payment penalties often prevent this.
Morality of homeowners is the least of the problems. The true benefits of the tax breaks would be interesting to look at further, especially on second and third homes.
States are non-recourse for a reason
Like others who have taken this line of reasoning, you do not seem to differentiate recourse and non-recourse states. States that chose to be non-recourse did so for a reason; they chose to put the risk of mis-pricing housing assets on the lender, rather than the borrower. Lenders are in a better position to determine the true value of a home than are buyers. Absent non-recourse laws they have every incentive to lend as much as the borrower can repay, regardless of the true value of the home. Non-recourse laws are intended to balance the information asymmetry and give the lenders incentive to limit their lending to the value of the property.
Now, we can argue that non-recourse laws have not worked, and that the system would be healthier without them; that would be an argument for changing the laws going forward, but would not be an argument for expecting borrowers not to take advantage of the laws in place at the time they borrowed.
All of the actions of government to deal with the current financial crisis is best understood as an attempt to shift the losses created by the bad lending decisions made over the last decade from those who deserve to bear them - the stock- and bond-holders of the institutions that made those bad decisions - onto less powerful entities that do not deserve to bear them - the taxpayers, or in this case borrowers who took out a loan they can afford to repay, even though it is in their best interest not to do so.
Legal rights
If you have a nonrecourse mortgage, or you are willing to go through a chapter 7 bankruptcy, the walk away strategy makes sense. Those are risks the lender took when it made the loan and the homeowner is merely exercising its rights.
There is no moral hazard in that.
This is very different from the argument that defaulting homeowners should be allowed to default and stay in their homes. That is changing the rules of the game in hindsight. This is just exercising rights your lender knew you had all along.
refusing to walk away kills capitalism
A traditional mortgage contains two embedded options: a call feature on the bond ('refinancing') and a put feature on the property ('walking away'). You're telling people whose put option is deep in the money not to exercise it, but instead to gift it to the lender. That sort of behavior destroys markets, price signalling, and taken to extremes, capitalism itself.
A looney leftist from way back, I have some sympathy, but I have to wonder: do you really want to destroy capitalism? If not, why are you trying to prevent rational economic actors from maximizing the values of their portfolios?
Intentionally Breaching Contracts
I feel uneasy about the idea of people who can afford to perform their voluntarily-assumed obligations choosing not to, but that is an inherent part of U.S. contract law, and not just mortgages. Parties who enter into contracts know that, if one side breaches, the government will force it to compensate the innocent party by some measure fixed by law ("damages for breach of contract"). The parties also know, or should know, that if it is cheaper for one of them to breach the contract and pay the compensation than it is to fulfill the contract, that party will breach. The logic is that the innocent party is compensated at a rate that it found acceptable (otherwise it would not have entered the contract) while the breaching party is better off - clearly a Pareto optimum.
"My very strong preference is
that any homeowner capable of paying his or her mortgage who walks away from it simply because they don't want to pay it any longer have their credit rating lowered significantly."
I'm reasonably sure that individuals strategically defaulting on their home loans have factored this into their considerations and fully expect to be penalized in credit markets of the future. (Though, given the number of families in this boat, one wonders how much of a "pass" they will receive down the road.)
The fact of strategic defaults stinks. There is no facet of the situation that isn't ugly whether starting with the loan-making process or ending with attempts to work with lenders.
That makes it pretty hard to wag a finger at families who decide that walking away is the best financial option. When the daily news is filled with stories of banks feeding at the public trough like pigs, how can you expect someone to continue paying a few $1000/month extra to hang onto a home that's $100,000s underwater today with no reasonable expectation of recovering values within the next 5-10 years? Go ahead and wag your finger at someone who's decided to walk away from their mortgage and, instead, direct the freed up cash flow into buttressing their retirement investments.
If anything has been made nakedly obvious by the past year's corporate and individual behavior, "doing the right thing" is for fools and idiots.
"My very strong preference is
"My very strong preference is that any homeowner capable of paying his or her mortgage who walks away from it simply because they don't want to pay it any longer have their credit rating lowered significantly. I don't want them to be able to buy another home any time soon or get a loan for any other purpose without paying extra for the privilege. That will impose on them at least some of the costs others will bear for what they're doing."
I'm good with this, but I think we're already there. So no change needed?
"I'm also not convinced about a federal program lowering principal for all underwater homeowners. I'm not sure why the underwater homeowner who can make the required payments but doesn't want to do so shouldn't be forced to declare bankruptcy and in the process bear some of the costs of his or her actions. That will likely lower what the mortgage holder can get for the home along the same lines as a reduction in principal and it will impose costs on the borrower that he or she should have to consider before walking away."
I'm good with this, too, but my understanding is we need a change in the law to allow bankruptcy courts the power to adjust mortgage balances, no?
Not getting off scott free.
"My very strong preference is that any homeowner capable of paying his or her mortgage who walks away from it simply because they don't want to pay it any longer have their credit rating lowered significantly...."
Your wish is granted. If you walk away, your home goes to foreclosure and a huge black mark is left on your credit rating. It can take 3 - 5 years before a lender will allow you to purchase a new home and as much as 10 years to clean your credit.
Most of those who walk away are by no means getting off Scott Free.
I had a job making about $200K a year, this economy shrunk it to $40K a year. How can I afford a $4000 mortgage payment on $40K a year? I guess it's my fault because I did not see the bubble crashing so quickly. When I took out the loan paying $4000 a month was no problem whatsoever. Now it's rent for 4 months in a nice condo. The house I purchased lost half its value in less than a year. If you have a better solution than walking away I am all ears.
Simple. Make economic
Simple. Make economic decisions, not emotional ones.