Take My Home And Shove It- Strategic Default

STRATEGIC DEFAULT- TAKE THIS HOUSE AND SHOVE IT

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Despite reports that homeowners are increasingly “walking away” from their mortgages; most homeowners continue to make their payments even when they are significantly underwater. This article suggests that most homeowners choose not to strategically default as a result of two emotional forces: 1) the desire to avoid the shame and guilt of foreclosure; and 2) exaggerated anxiety over foreclosure’s perceived consequences. Moreover, these emotional constraints are actively cultivated by the government and other social control agents in order to encourage homeowners to follow social and moral norms related to the honoring of financial obligations – and to ignore market and legal norms under which strategic default might be both viable and the wisest financial decision. Norms governing homeowner behavior stand in sharp contrast to norms governing lenders, who seek to maximize profits or minimize losses irrespective of concerns of morality or social responsibility. This norm asymmetry leads to distributional inequalities in which individual homeowners shoulder a disproportionate burden from the housing collapse. Millions of homeowners in the United States are “underwater” on their mortgages, meaning that they owe more than their homes are worth. Yet, despite all the concern over homeowners who are simply “walking away” from their homes,the vast majority of underwater homeowners continue to make their mortgage payments – even when they are hundreds of thousands of dollars underwater and have no reasonable prospect of recouping their losses. This includes underwater homeowners that live in “non-recourse states” such as California and Arizona, where lenders cannot pursue defaulting homeowners for a deficiency judgment.

The current housing bust should be viewed for what it is: a market failure – not a moral failure on the part of American homeowners. That being the case, it is time to take morals out of the picture and search for an equitable solution to the negative equity problem.

While such behavior may appear irrational on its face, behavioral economists explain that underwater homeowners simply suffer from the same kind of cognitive biases that lead individuals to make other suboptimal economic decisions. Homeowners aren’t knowingly making bad choices, they just can’t cognitively grasp that they would be better off if they walked away from their mortgages.Unlike lenders who seek to maximize profits irrespective of concerns of morality or social responsibility, individual homeowners are encouraged to behave in accordance with social and moral norms requiring that individuals keep promises and honor financial obligations. Thus, individual homeowners tend to ignore market and legal norms under which strategic default might not only be a viable option but also the wisest financial decision. Lenders, on the other hand, have generally resisted calls to modify underwater mortgages despite the fact that it would be both socially beneficial and morally responsible for them to do so. This norm asymmetry has led to distributional inequalities in which individual homeowners shoulder a disproportionate burden from the housing collapse.

More than 32% of all mortgagedproperties in the U.S. were “underwater,” meaning that the homeowner owed more on their mortgage than their home was worth. This percentage is expected to increase to 48% by the first quarter of 2011, by which time housing prices in the largest 100 metropolitan areas are predicted to have dropped 42% from their peak.⁷The national numbers hide the full extent of the problem, however, as the percentage of underwater mortgages is much higher in the regions suffering the worst price declines. For example, as of June 30, 2009, 66 percent of mortgage borrowers were already underwater in Nevada, 51 percent were underwater in Arizona, 49 percent were underwater in Florida, 48 percent were underwater in Michigan, and 42 percent were underwater in California.

Lenders lost sight of the importance of positive equity in lowering the risk of mortgage default,and failed to ensure that homes were actually worth what they were being purchased for. This is not to say that lenders are solely responsible for the housing run-up and bust, but that they do in fact bear a substantial portion of the blame – and thus should thus bear a substantial portion of the cost. But lenders, of course, do not operate according norms of personal responsibility, and seek instead to maximize profit (or minimize losses). Indeed, to the extent that the lender is a corporation, the directors and executives of the corporation have a legal duty to shareholders to maximize profit and/or minimize losses. Appealing to this duty, it has been suggested that, given the great cost to lenders of foreclosure, they have an economic incentive to modify loans for homeowners in danger of default. This argument has flown in the face of the reality, however, that lenders have been reluctant to modify loans, even for borrowers in the pre-foreclosure process. To modify loans for these homeowners would be to throw money away – and to encourage more homeowners to ask for modifications. Second, a significant number of homeowners who temporarily default on their mortgages “self-cure” without any help from their lender – though self-cure rates have dropped precipitously in the last two years

What is strategic default?

Not everyone even defines strategic default in the same way, but panelists were generally in agreement that it involves a borrower who has the ability to pay his or her mortgage but chooses not to. Often that decision is tied directly to the property being underwater — when the borrower owes more than what the home is worth. This practice is becoming more common place than any other time in U.S. history.

It is called strategic default – borrowers who have enough money to make their mortgage payments but do not. They owe so much on a home that is now worth so little, that they decide to walk away.

It is not an easy decision. But it is not the inevitable blow to their credit score that troubles some strategic defaulters. It is the ethical dilemma of refusing to repay a loan when they are able to and worrying about what the neighbors will think.

How prevalent are strategic defaults?

Although the exact number is unknown, half the homeowners in a study conducted by the Federal Reserve Board walked away when they owed twice what their home was worth. A Palm Beach Post analysis of foreclosed homes purchased since 2006 found 72 percent – about 4,124 homes – are worth less than half of the original loan.

In the business world, strategic default is a common tactic – considered a savvy move for financially troubled companies. However, consumers have been browbeaten and trained to believe that it’s not honorable to not pay your debts. Why should it be any different for consumers?

Last year, Morgan Stanley walked away from a $1.5 billion mortgage on five buildings in San Francisco despite record-breaking profits in 2009. Real estate giant Tishman Speyer Properties strategically defaulted on $4.4 billion in loans on two housing developments in New York after the properties lost $2.2 billion in value. The company had billions of dollars in assets, including Rockefeller Center and the Chrysler Building, which it could have leveraged to meet its loan obligations.

Even the Mortgage Bankers Association, whose president chastised homeowners who strategically default for the “message” it would send to their “family, kids and friends,” dumped its Washington headquarters in a short sale. After working out a deal with its lender, the MBA sold the building for $41.3 million last year. In 2007, the group purchased it for $79 million .

“No, it’s not wrong,” said Randy Cohen, author of the weekly Ethicist column in The New York Times. Although homeowners are emotionally attached to their property, a house is still an investment.

“I don’t understand why you would be asked to make a decision on this investment any differently than you would on any other,” Cohen said. “Why should homeowners be held to a higher ethical standard?”

In many strategic default cases, the moral imperative is self-imposed. Among the arguments: Walking away from a mortgage will depreciate your neighbors’ property values. If all underwater homeowners walked away, the housing market would crash.

“Most people considering strategic default come to me and want my permission,” said Ronald Kaniuk, a Boca Raton foreclosure defense lawyer. (SEE MR. KANIUK AT http://www.foreclosureself-defense.com/the-library/videos/) “People who cannot pay their mortgage are apologetic. For people who can afford their mortgage or can just barely afford their mortgage and see it as a losing investment, they want absolution.”

They should not get it, according to Luigi Zingales, an economist and professor at the University of Chicago’s Booth School of Business, who became embroiled last year in a debate over the morality of strategic default.

“When you borrow money you make a commitment to pay it back,” Zingales said. “If you walk away because it’s in your interest to do so, you are violating the letter and the spirit of the law.”

Zingales wanted to know why it had become so easy for upside down homeowners to walk away. The answer was simple.

“The stigma is very much a function of how many people do it, “Once you think it’s socially acceptable, it becomes easier to do.”

Expect more many defaults as housing prices continue to drop.

But there are consequences, including the long-term health of the housing market, Zingales said. Zingales predicts we will reach a tipping point where getting rid of a bad investment outweighs the damage to neighbors’ property values and the borrower’s reputation. In other words, expect more defaults.

We’re not there yet, and clearly this creates a tension in society.

On one side are homeowners who did not lose their jobs or live beyond their means and are now struggling to make their mortgage payment. Next door are neighbors who have stopped paying their mortgages and are living largely free until they are booted from their homes. It’s a legitimate resentment.

 The lender could get a “deficiency judgment” to go after the couple for repayment of thedefaulted loan.

Their credit score will take a hit, but at least with a strategic default they won’t be homeless. Homeowners should be walking away in droves. But they aren’t. And it’s not because the financial costs of foreclosure outweigh the benefits. To be sure, foreclosure comes with costs, including a significant negative impact on one’s credit rating. But assuming one had otherwise good credit, and continues to meet other credit obligations, one can have a good credit rating again – meaning above 660 – within two years after a foreclosure. Additionally, in as little as three years, one can qualify for a federally-insured FHA loan to purchase another home.Given the credit rating system’s role in enforcing norm asymmetry, however, additional measures might be necessary to level the playing field between borrowers and lenders and empower homeowners to renegotiate underwater mortgages. One such solution, for example, would be to amend the Fair Credit Reporting Act to prevent lenders from reporting mortgage defaults and foreclosures to credit rating agencies. Preventing lenders from reporting mortgage defaults to credit rating agencies would, as a practical matter, eliminate lenders’ ability to hold borrowers’ human worth as collateral

There are, of course, costs to foreclosure other than temporarily poor credit. These  include moving costs and possible transportation costs if one is required to live further from work or school. But again, these costs are minimal when compared to the savings of shedding a home that is hundreds of thousands of dollars underwater. The most significant financial risk from a foreclosure is the risk of a deficiency judgment or, in the alternative, tax liability for the unsatisfied portion of one’s loan upon foreclosure. But even these potential costs are significantly less than one might expect. First, a number of states – including many with the biggest declines in home values – are non-recourse states, meaning that lenders may not pursue homeowners for a deficiency judgment if the home was their primary residence. Second, even in recourse states, lenders rarely pursue borrowers for deficiency judgments unless they have special reason to suspect the borrower has means to pay it.  This is particularly true to the extent that the home is in a state where lenders are overwhelmed with foreclosures. Third, tax regulations have recently changed to waive taxes on the unpaid portion of a mortgage upon foreclosure, which was previously classified as income to the borrower if the lender reported it as such.

Predictions that more and more servicers will begin to pursue judgments against strategic defaulters although it still needs to be a case-by-case review on whether to go that route. Servicers should sit down and negotiate with borrowers who want to do short sales to potentially collect a deficiency payment at that time.

So, you’ve applied for a loan mod: What are your chances of getting it with your servicer?

(Source: Treasury Department)

These are the breakdowns for the largest eight servicers. 

Denied: You didn’t get a HAMP mod. You may have lost your home to foreclosure, sold your home through a short sale, or you might simply be waiting for further action from your servicer, including a possible offer of the servicer’s in-house modification. 

In a trial mod: You’re in the program’s trial period, making payments to show you can afford your home with a HAMP mod. The trial is supposed to last three months but usually lasts longer [20]. From here, you’ll either end up with a HAMP mod or your trial will be canceled. If that happens, your servicer may still offer you a non-HAMP mod. 

Trial canceled: You were denied a HAMP mod, either because your servicer decided you didn’t meet the program’s requirements or, less likely, because you didn’t make the trial payments. You may have lost your home to foreclosure, sold your home through a short sale, or you might simply be waiting for further action from your servicer, including a possible offer of the servicer’s in-house modification. Advocates say it’s worse for a homeowner to be rejected after making months of trial payments [21] than to be rejected up front. 

Non-HAMP mod: Your servicer rejected you for a HAMP modification but has offered you an in-house modification. These mods generally are less affordable than HAMP mods [22]. 

HAMP mod: Your servicer offered you a HAMP mod. 

Left in limbo: You might not fit into any of these categories, since servicers have struggled to process homeowner applications: Many homeowners, for example, go several months without getting any kind of response. [18] As we’ve noted earlier, this data, provided by the Treasury, only includes loans where the servicer says it has responded to a homeowner’s HAMP application. There are no records of how many people fall into that category. 

The current housing bust should be viewed for what it is: a market failure – not a moral failure on the part of American homeowners. That being the case, it is time to take morals out of the picture and search for an equitable solution to the negative equity problem.