This article discusses contemporary attitudes toward mortgage default and turns a critical eye to the social consequences and economic results of strategic default.

Traditionally, a mortgage lender’s underwriting practices required a homeowner to inject sufficient equity in the form of a down payment into his home to ensure he viewed payment of the mortgage as necessary to protect the equity in the home—a safeguard against default. However, as lenders moved toward less restrictive credit risk models that relied increasingly on credit history as a gauge of borrower fitness, the down payment as a gauge for qualifying for a loan took a back seat to the credit score. Lenders relied exclusively on those studies showing borrowers with optimum and medium credit scores have a 0.9% and 4% chance of default, respectively.

For instance, during the Millennium Boom, many buyers with optimum credit scores were not asked to make a down payment to qualify for mortgages with loan-to-value (LTV) ratios of 100% or more. Both lenders and Wall Street Bond Dealers (along with their rating agencies) thought the fast-rising prices of real estate would more than make up for the lack of a down payment. They methodically created an equity spread, erasing any lack of incentive to pay brought about by the initial disparity between the amount of the mortgage and the value of the home. However, permitting LTV ratios above the traditionally safe 80% threshold became common practice during the five-year millennium boom which preceded the Great Recession.

Presently, California’s real estate market is reeling from the swift evaporation of mortgage lenders and lending that was a bellows to the conflagration of home ownership—a Ponzi scheme that fell apart when Wall Street lost the means to issue bonds to fund mortgage lenders and their borrowers. Many homebuyers with upper-echelon credit scores who bought during the boom are now stranded in homes worth far less than the mortgage, a condition called negative equity and colorfully referred to as being “underwater.”

What are underwater homeowners to do? The logical choice for many distressed owners who are employed is strategic default. This is especially relevant in California, a nonrecourse state where more than a quarter of homeowners have negative equity exceeding 25% of their home’s value, disqualifying them for a loan modification. But if strategic default is the perfectly rational, legal and financially beneficial choice, why are so few doing it?

In a recent paper titled “Underwater and Not Walking Away: Shame, Fear and the Social Management of the Housing Crisis,” Brent T. White of the University of Arizona College of Law details the forces pushing homeowners against the tide of logic and influencing them to keep paying their distressed, dead-end mortgages. The social control mechanisms White discusses are:

  • the emotional desire to avoid shame and guilt; and
  • the fear of adverse financial consequences due to a foreclosure.

His point is well taken and widely observable. There is no shortage of seemingly authoritative voices extolling the “responsible” homeowner and his “ethical” duty to pay (no matter the debt amount). Representatives of the Obama Administration warn homeowners the upstanding, moral choice is to “stay and pay,” to do good so the lenders do well. Treasury Secretary Henry Paulson accused nonpaying homeowners of failing to honor a “moral obligation” to pay.

Unfortunately, what should be a personal financial decision has become a talking point for moral prognosticators. There is no moral obligation to pay that any lender in California can enforce; only legal obligations exist in this land of laws. For the past 75 years, since the dawn of non-recourse anti-deficiency laws in California, the lender is legally barred from obtaining a money judgment against a homeowner for his failure to pay on a purchase-assist mortgage, economically called a put option. Contained in all trust deeds, the put option can also be seen as a means of holding lenders’ feet to the fire: make sure the risk is sound or end up with a deed-in-lieu. [For more information on the put option, see the first tuesday article, California homeowners: exercising your right to default.]

Media outlets and pundits offer far more severe language than government officials and at higher volumes. Defaulting homeowners are called criminals, unethical and are compared to deadbeat dads and Nazis. Commentators, however, care not about the distressed homeowner who struggles needlessly to amass retirement savings that could have otherwise been enjoyed but for paying a bubble-inflated mortgage on a worthless home. Especially disheartening is the lack of public and political focus on the entire U.S. financial system which bears most of the responsibility for the negative equity epidemic. This brings us to another important issue raised by White’s paper: there is no popular or public inquiry into why and where blame is to be properly placed.

To judge the credit crisis and the epidemic of negative equity a ‘moral crisis’ and an ‘ethical failing’ on behalf of homeowners is to lose sight of the nuance of fault. While some buyers are guilty of biting off more house than they could chew (or agreeing to too great a price), the vast majority of homeowners carrying negative equity do so as a result of the poorly managed mortgage market. Wall Street failed to regulate itself the way the Federal Reserve, Congress and the White Home believed it would. Like rickety scaffolding, a corrupt credit rating system was constructed to pack in mortgage-backed securities (bonds) of dubious rating—again, based on ever-rising home prices and borrower credit scores rather than the more reliable 80% LTV. Studies show negative equity is the single greatest predictor of owner default—not credit ratings. [For more information on negative equity and its effects, see first tuesday articles, The speculative price (dis)advantage: negative equity and the Great Liquidation and Negative Equity and Foreclosure.]

Aided by the Treasury’s 9/11-influenced decision to constantly look backward in an effort to keep rates low, lenders were able to produce reams of mortgages to feed the greed of Wall Street Bankers who peddled the paper into the bond market. Despite clear and damning evidence of systemic failure and analytical corruption throughout the U.S. banking and financial systems (conditions that paved the way for the mortgage and housing crisis), distressed homeowners remain the politically popular party to blame (together with mortgage loan brokers) for the negative equity epidemic, forced to passively shoulder a disproportionate amount of fault.

Modifying underwater mortgages by a cramdown of the principal balance is the lender’s “socially beneficial and morally responsible” response to a crisis which they alone facilitated, the homebuyer being the complicit chess piece. However, lenders and loan servicers have deliberately avoided calls to meaningfully modify (i.e. instead of extend-and-pretend) bad loans.  Interestingly, the mortgage documentation prepared by the lender and signed by the borrower contains a contractual put option, granting forgiveness of the loan debt in exchange for delivering the property’s title and possession to the lender. Thus, lenders are legally bound to accept the property in lieu of payment whereas homeowners have a choice to either pay the loan and keep the property or default as an exercise of their option to force the lender to take the property.

It is not as if lenders were ignorant of the deteriorating state of the nation’s mortgage market, or had zero warning. As with all experts, many homeowners and individual investors on Wall Street relied on financial professionals to be in-the-know about the health of the mortgage market. But as housing and the financial system were being run into the ground (in tandem) by lousy underwriting standards and the observable build up of extreme regional and huge national housing bubbles, these professionals sounded no alarms and took no preventative steps. Rather, homeowners were offered first and second mortgages at 125% the value of their homes—homes that would lose tens (and in California hundreds) of thousands of dollars in value in a matter of two years.

To illustrate the point, take the fictional couple in White’s paper: Sam and Chris. They purchased their three bedroom home in Salinas California for $585,000 in January 2006 (the average price of a home of this size in Salinas in 2006). The couple had optimum credit scores, reliable income and qualified for a fixed rate (6.5% APR) loan with zero down, giving them a total monthly payment of $4,300, or just shy of 31% of their gross monthly income. With two children, the couple barely made ends meet to cover expenses and pay a mortgage on their first home.

Traditional underwriting standards would have required the couple to make a down payment of about 20% of the value of the home, bringing the LTV to 80%. During the boom, however, borrower fitness was evaluated based on credit score. The LTV of the couple’s home in 2006 was 100%. Prices of homes peaked in Salinas and throughout all of California in the first quarter of 2006. [For more information on historical pricing trends in California real estate, see first tuesday Market Chart, California Tiered Home Pricing.]

With the beginning of the Great Recession in 2007, the housing market fell apart and Sam and Chris still owed about $560,000 on their home. However, as of the third quarter of 2009, their home was only worth about $187,000 (according to data from A comparable sale in the neighborhood puts the actual market price of their home at about $179,000 with nearby homes renting for about $1,000 per month. What is the couple to do?

Assuming the couple intends to stay in their home until their children finish at the local high school (10 years from now), Sam and Chris would save approximately $340,000 by walking away. On the other hand, if the couple sticks with their $560,000 mortgage, it would take over 60 years for the home to resurface from its current point of negative equity—that is if they live that long, home values have hit bottom and the Salinas market appreciates at its historical trend-line rate of 3.5%.

But these numbers are not fully representative of the hit property owners with underwater homes take on property taxes as a result of California’s Proposition 13. For Sam and Chris, Prop. 13 tags a base year value (the price at the time of purchase) at $585,000 and taxes are  1% of the assessed value of the home with increases in assessed value pegged to inflation and capped at 2% per annum. For Sam and Chris, the breakdown occurs thus: from 2006 to 2007, the assessed value of the couple’s home increased by 2% to 596,700 and increased again by 2% from 2007 to 2008. There was a very small increase in the value from 2008 to 2009 of .06% causing the assessed value of the couple’s home to top out at $609,000 for 2009.

With the Prop. 13 tax schedule in place, based on the price they paid at the top of the boom market, Sam and Chris are on the hook to pay a bill of 1% of the $609,000 assessed value of the property for 2009. However, $6,090 is 3.4% of the $179,000 market value of their home. Of course Sam and Chris could petition for a reassessment of the value of their home to current market prices, but as soon as real estate prices begin an upward trajectory (albeit meager), they will once again pay an annually  compounded 2% on top of the $585,000 base year assessment.

Alternatively, the couple could walk away, buy a replacement home of comparable quality to the one they own and save big on costs and taxes over time. To walk away now would allow for the California recovery to take place much sooner since money that would otherwise be sunk into an underwater property (between $3,500 and $4,000 per month in this scenario) would be injected into local, regional and state economies through purchases, allowing individuals like Sam and Chris to provide their families an overall better quality of life and higher standard of living.

Like more than a third of U.S. homeowners, Sam and Chris are faced with two choices: they can either continue paying the dead-end loan, lugging the negative equity of their home as an albatross around their necks for the rest of their lives or default and save hundreds of thousands of dollars. Nationwide, only 3% of underwater homeowners strategically default and lenders know this fact. But many more homeowners should be walking away to save themselves from dumping money into a losing horse and depriving themselves of valuable retirement savings and improved living conditions. When viewed as a scenario afflicting thousands in California, couples like Sam and Chris who “stay and pay” impede the state’s recovery.

Despite the preponderance of the evidence to the contrary, society’s arbiters of political and public opinion demand homeowners flog themselves for their poor decisions by paying their underwater mortgages to defend the lenders from loss. The government calls for homeowners to remember their moral or ethical obligations, never suggesting that we are a country of laws which guarantee a legal result. Fellow citizens who continue to make the irrational decision to continue paying their mortgages demand justice for homeowners who decide not to pay. Thus, any homeowner searching for answers or help from among his peers is met mostly with shame, fear-mongering and disinformation, keeping distressed and ill-informed homeowners in a financial catatonic state.

In one corner, we have the lenders who made terrible decisions in their risk assessment of homebuyers and homeowners and the excessively credit-driven economy of the 2000s. They are fighting to recover the money they lent the homeowner. In the other corner, we have the U.S. homeowner who—encouraged by government subsidies and homeownership slogans which are framed and guided by mortgage lenders—signed a note worth more than 100% of the value of his home. What is a nation thus divided to do?

Had everything gone according to plan, prices would continue to increase at a natural rate, not the artificial millennium boom rates. Sellers would have continued to reap profits and buyers would have continued pouring into the real estate market; all while Wall Street racked up profits on the securities market. Homeowners would have paid mortgages and wages would rise at the rate of inflation and improved production while owners fund purchases with equity financing: eating well, buying new cars, etc. But the exact opposite of all of this is happening and the homeowner should not be the only party held responsible when those with authority orchestrated the fiasco, from the Federal Reserve supplying the cash on down. Since lenders will not cooperate in this call to “moral” order by granting cramdowns of principal on modification, homeowners should ignore the noise and walk away from their negative equity—rather than cripple themselves with a dead-end  loan.

Lenders in need have reacted unfavorably to homeowners in need. They have shown less courtesy and willingness to mediate than is warranted in these trying financial times considering the homeowner’s option to strategically default. A homeowner contacting his lender often waits on hold for a long time to speak with someone who cannot help him. In the rare event the homeowner can get in touch with a helpful customer service representative, he is told he must default first before the lender will help, a move deliberately intended to leave a blemish on his credit score. Next, after defaulting as he was instructed, the homeowner is threatened with foreclosure if he does not pay late fees and past due amounts and only after those amounts are paid will the lender agree to a common loan modification plan (read: scam) that is anything but helpful.

The scam is referred to as extend and pretend activity and appears to be helpful from the perspective of the homeowner since his monthly payment is lowered. But each monthly payment made by the homeowner is only allocated to a portion of the interest due on the loan. At the end of the modification, the homeowner will be forced to pay an unaffordable balloon payment, which places him right back where he started. Thus, the lender takes money from the homeowner during the temporary modification period (extending his stay in the home) and the lender pretends to help, but is really playing a money-making trick on the distressed and emotional homeowner. Most of these homeowners end up defaulting again when the balloon payment comes due or the installment payments reset to an amount higher than before the modification.

The intelligent move would be to stop paying, pack up and pay rent elsewhere until the crisis has passed since a re-default on a modified loan is a double hit on the credit score. Besides, making timely payments on rent, utilities, credit cards and a car loan will repair the defaulting homeowner’s credit rating within several months. Coupled with a letter of explanation about the sole cause of the blemish (default), the homeowner’s credit score will weather the financial crisis—especially with a job intact.

A study cited by White’s paper shows a defaulting homeowner can secure new lines of credit in as little as 18 months after default. Even the FHA will insure a loan to a bankrupted homeowner after two years. Besides, the cash savings derived from defaulting will mitigate any future need for credit. With prior planning for the financing of purchases to be made during the period of financial limbo, the homeowner avoids the penalties imposed on defaulting homeowners.  All considered, a temporarily damaged credit score should be the least of a distressed homeowner’s concerns.

Over time, negative equity is far more damaging to a family than losing a home to foreclosure or taking a temporary hit to one’s credit rating. Credit heals and can be rebuilt quite quickly under a single event blemish, but supporting a negative equity compounded by lost savings in this zero sum game equals a prolonged retirement age (if ever) and decades of struggling to “get by.” Imagine watching a neighbor purchase a new car, make repairs to his home or send his children to college while the underwater homeowner is never fully able to enjoy his property, living one large unforeseen expense away from financial ruin. With lenders refusing to aid the over-encumbered homeowner and the federal government reticent to enact effective measures since homeowners are being intimidated into paying, the rational and amoral choice is to walk away.