Strategic Default (part 1) – Is it Right (for you?)
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Viewpoint 07/07/10
Strategic Default (part 1) – Is it Right (for you?)
“If you owe your bank 100 pounds, you have a problem. But if you owe a million, it has.” – John Maynard Keynes
Strategic Default – a definition
the voluntary foreclosure occurring when a homeowner makes a conscious decision to stop making mortgage payments on a house which is worth less than the balance of its mortgage. (my definition)
Note that my definition does not include the following phrases:
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Homeowner CAN make the payments but CHOOSES not to
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Action taken specifically to increase homeowners’ net worth and let the bank take the loss
I’ve talked with scores of people over the last couple of years – friends and strangers alike, who had gone through or were going through the foreclosure process. One thing I’ve learned is it’s not an easy process, and not one to take lightly. Someone making a strategic decision to undergo that process has probably spent many sleepless nights weighing the pros and cons.
In this series I’m going to look at the process of strategic default – the pros and cons, financial and ethical considerations, and when it might be a good or bad idea.
Author’s Note – this Viewpoint is more opinionated and less “statistical” than most. I will highlight facts and share examples to support my opinion, but this is a topic where the “right” or “wrong” is unique to each individual. Read on if you want to hear my thoughts on the topic (or go ahead & hit the delete key – I won’t be offended.)
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Everybody is Unique
There is not one single situation which represents a strategic default. Every homeowner (and his/her family) is unique, with different incomes, savings, future prospects, future needs, and future goals & dreams. Here are a few very basic scenarios resulting in default:
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A man loses his job, and after months of looking for work while emptying his savings account, he and his family are forced to move out of their home.
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A 2nd family is significantly upside-down on their home. They decide to walk away from their home, even though they are still able to make their mortgage payments, and let their mortgage company take the loss.
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A 3rd family is also upside-down on their home and will be moving out of state in a couple years to take care of family. They know the home will still be worth less than the mortgage balance, and they know they won’t be able to write a check to sell it. They decide to walk away today, giving the house back to the bank and giving themselves a headstart on rebuilding their credit.
I could write about 20 more families, but the point is there are lots of different scenarios leading families to default on their mortgage. Sorting out the “legal vs ethical” for each scenario can be difficult, especially for those who haven’t walked a mile in one of these families’ shoes.
This will be a longer than usual Viewpoint, with lots of ideas, charts, and links to other sources as I work my way through a number of semi-related topics, before ultimately getting to my conclusions on the ethical ramifications and financial intelligence of strategic defaults. (note – this article became too long to read & digest in one sitting, so I’ve broken it down into multiple parts.)
Lots to do, so let’s get started…
It’s the banks’ fault, really.
Very few “true” strategic defaults
Strategic defaults oftentimes aren’t the best solution
It’s the bank’s fault, really.
I generally live my life along the lines of “do unto others as you would have them do unto you.” I’m not perfect, but I try to treat people the right way, show respect for others, and build win-win relationships. I usually encourage others to do the same.
When I’m watching a movie and the bad guy / bully meets with an unfortunate demise, I’m ok with that. And when I meet somebody in real life who’s arrogant, cocky, &/or condescending, I don’t wish bad things for him, but I’m not as torn up if luck turns against him as I am when I hear about something bad happening to a really nice guy.
In today’s economy, the banks (along with Wall Street and other big money investors) are playing the part of the bad guy. Their short-sighted actions helped cause a GLOBAL Great Recession, yet they’ve acted arrogant, indignant, uncaring and unhelpful throughout the problem, all while using public money to help them through a tight spot and then posting huge profits once things loosened up for them.
I don’t wish bad things to happen to the banks, but they’ve lost my moral support along the way. They’ve used and abused their customers, and the system in general, for almost a decade now (2004 – 2010). If one of their customers is able to better his/her own personal situation, and the bank takes a relatively small loss in the process – it’s sort of like the bad guy getting his comeuppance, and it doesn’t bother me at all.
On a side note, somewhat related and a good example of “fair practices” in contract negotiation, let’s take a look at the people I hear more about regarding contracts than anyone else – professional athletes.
It’s sometimes hard for me to pick a side in a world where millionaires negotiate with billionaires – after all, is there really a difference between $80 million over 4 years and $90 million over 5 years? Come on! But here’s where I usually end up:
Football – these contracts are NOT guaranteed, meaning the team is allowed to break the contract and cut the player from the team whenever they want. Consequently, a player signing a 5 year deal with the Arizona Cardinals, for example, isn’t guaranteed a nickel after day 1. This creates an attitude of “get what you can when you can” in the players, and I don’t blame them for holding out or asking to renegotiate their contract after a terrific season.
Basketball and Baseball – these contracts are guaranteed, meaning the team will pay the player regardless of the player’s ability or performance in the future. The teams in these sports are far more likely to overpay their players than the players are to have to “play out” an undervalued contract. (and even when the player is “underpaid”, they’re usually still earning millions of dollars per year!) In fact, there are scores of NBA players you’ve probably never heard of who have earned more than $30 million during their career! For this reason, I get very frustrated with players in these leagues who complain about the terms of their contract.
Do Unto Others as they would do unto you, only Do It First! (or put another way, Actions Speak Louder Than Words.)
The banks (and many other people) believe a strategic default is morally and ethically wrong, tantamount to lying. After all, they argue, the borrower/homeowner signed a contract agreeing to pay the bank back. That sounds fair in principal; but how do the banks act in the real world?
1. I spoke with a friend of mine last week who is in the process of moving; selling his current home & buying another one. He had charged a few expenses related to the two transactions (preparing the house for sale and preparing to move into the next one) on various credit cards, and planned to pay them off with the proceeds from the sale. He received an offer from one bank to transfer balances to their card and pay 0% interest rate, so he wrote out the checks included with the offer & mailed them out. In the meantime, the bank had decided to reduce his credit line to his existing balance, causing the checks to bounce, and then trying to charge him for overdrawing his credit line!
2. I spoke with somebody this spring who bought a house a few years ago. He applied for a Home Equity Credit Line as soon as he moved in, thinking he would one day put a pool in the backyard. Last year he finally felt comfortable enough with his employment being stable that he & his family decided to go ahead with the pool. Trouble is, his bank had closed his credit line without warning. No pool for you!
3. Personally, I had an American Express account with a $30,000+ limit that I used extensively in 2006 and 2007. The account had a great rewards program, so we charged everything we could to that account and paid it off each month. One month something came up and I didn’t pay the balance off in full; the next month American Express lowered my limit to my then-current balance. No warnings, no phone calls, no discussions about it – they simply decided to change the terms of our agreement.
Each of these stories shows an example of the bank unilaterally making changes to the bi-lateral agreement they had with their customers, presumably because times had changed and they no longer believed the agreement was in their best interest. I don’t think the banks are in a position to cry foul if/when their customers make the same decision.
It’s just Contract Law
A good contract clearly shows what each party is getting, what each party is responsible for, and what the penalties are should either party fail to perform.
The banks have stacked the deck in their favor in this arena. They’ve had decades to practice trial and error, they’ve hired hundreds (or thousands) of high-priced attorneys, and they’ve made millions of individual loans over which to hone their contracts. And when John Q Public applies for a mortgage to buy a house, he’s going to use a contract written by the bank – whether it’s a Mortgage or a Promissory Note with a Deed of Trust will depend on state law.
Banks, along with other businesses of all sizes, use these same attorneys to help them get out of contracts they’ve previously agreed to whenever it’s in their best interest to do so. In the 3 examples cited above, the banks were applauded by their shareholders for “reducing their exposure to future risk.”
Since the banks wrote the contract, and the contract clearly spells out what will happen if the borrower doesn’t pay (the bank gets the house back), then why should I feel bad if the borrower decides not to pay the loan and let the process defined in the contract play itself out? Whether the buyer lives in a “recourse” or “non-recourse” state may effect the decision-making process, but once the borrower makes the decision, that’s that and contract law takes over.
What if Everyone Did It?
This is a question I ask myself when I’m trying to figure out the long-term, mass-market effects of a potential decision.
For example, one family may decide to host Pampered Chef parties – inviting their friends and neighbors over for an evening of fun, food, and buying kitchen wares. One family is able to earn a little extra money “on the side”. But if everybody did it, there wouldn’t be any friends and neighbors to sell to, and the whole process would fail. The Pampered Chef system isn’t scalable to include the whole community.
So what would happen if every homeowner who owes more than his house is worth decided to strategically default? Let’s take a look at some potential dominos..
First of all, it’s not possible that everyone will choose to default. Some people are ethically/morally opposed to the idea. Others will think about it but decide not to ruin their credit rating (which could impact other parts of their financial life). Still others won’t have a choice; they simply won’t be able to continue making the payments.
But what if everybody in the smaller subset of “those who weigh the pros and cons”, and we’ll talk more about the pros and cons in a little bit, decide to go ahead & strategically default, and they all decide to do it this month?
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We’d have a large number of homes going back to the banks.
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The banks would either foreclose on them all immediately and flood the market with new homes, or take their time foreclosing which would cause a shadow inventory to develop and the banks would be sellers in the market for years to come.
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This could cause prices to fall, causing more homeowners to get upside-down and potentially compounding the problem.
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In the meantime, these former homeowners would all need a place to live, so the rental market would expand.
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This competition in the rental market would help keep rental rates somewhat firm.
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Falling prices and stable rental rates would make home-buying more profitable for investors, who would bid against each other until profit margins got too thin. This would cause prices to stabilize.
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Many of the former homeowners believe that owning a home is a smart long-term investment, so they would begin entering the market again as their credit is rebuilt.
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As these former homeowners enter the market, the rental market would soften, causing investors to leave, but the demand for housing would be stronger, causing prices not to fall when the investors sell.
In the end, if everyone decided to strategically default, it would have a vast impact on the market over the next decade. But it wouldn’t cause a collapse in society – it would just be different, and we’d get through it. Again, I’m ok with that.
Part 1 Conclusion
I’m sure you’ve gathered by now I’m not a big fan of the banks’ actions over the last few years. I feel they played a major role in causing the problems we all face today, and I feel they’ve ignored common sense measures (or even acted against good financial sense) to help fix the problems. It makes me think there are political or economic incentives for the banks to NOT work efficiently, but that’s a conspiracy theory topic for another day!
In the next Viewpoint we’ll discuss how there are very few “true” strategic defaults, and we’ll examine some of the hidden costs of a strategic default to show it is oftentimes not the best alternative.
However, once the pros and cons have been weighed, and a homeowner decides a strategic default is in his best interest, I don’t think any homeowner “owes it to their bank” to continue paying an economically unwise mortgage.
Additional Reading (not necessarily related to this topic):
Here are a few other articles we’ve written recently.
Not all banks are utterly moronic
The Shiny – don’t confuse shiny with valuable
Phoenix has less Shadow Inventory than other major markets
Until next Viewpoint,
Your wouldn’t wish a default on anyone (even a bank) Realtor,
Chris Butterworth
Chris & Heather, The Phoenix Agents
at Thompson’s Realty
http://thephoenixagents.com
623-570-9940
Chris Butterworth and Heather Barr are The Phoenix Agents at Thompson’s Realty. The Phoenix Agents are Realtors in the Greater Phoenix area, who have built a loyal following over the years by offering superior service levels coupled with a low-pressure approach. You can visit http://ThePhoenixAgents.com online to learn more about Chris, Heather, and the Phoenix-area real estate market. If you have real estate questions or needs, please contact us anytime; we’d love to hear from you.
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