Don’t Strategically Default on your Mortgage

I like Roger Lowenstein; he is a bright guy.  I have reviewed several of his books, and would recommend to readers that they are worth buying.

But, I disagree with Lowenstein in some ways regarding defaulting on home mortgages.  I want to give some credit to my wife here.  My dear wife of 23 years, who I thought about many times while we were attending a wedding today (I could not sit with her because I was leading the singing), and who does not have an economic bone in her body, helped me think about the issues around defaulting on home mortgages.

There is a false notion that because firms default when it is in their economic interest to do so, so should homeowners whose mortgages are greater than the underlying house value.

First, firms can’t so easily enter Chapter 11.  How does Chapter 11 work for firms?  Two things must be true — a firm must not be able to raise cash to make a debt payment, and the assets of the firm are worth less than the liabilities.  If a firm can’t pass both tests, the bankruptcy court should refuse the filing, forcing the firm to sell assets to make a payment.

To use this analogy for defaulting on a home mortgage, it is one thing to take out a mortgage in buying a home, having reasonable margins for error, and then disaster hits, and the mortgage payment can’t be made.  It is quite another thing to have the capacity to make the mortgage payment, and default.  Corporations usually can’t get away with that (please ignore KMart); if they can make payments on the debt, they can’t go into Chapter 11 bankruptcy.

Bankruptcy primarily exists as a protection for borrowers who have suffered loss, leading to inability to pay their debts.  It does not exist to allow people with the capacity to pay to slip out of contracts, simply because the creditor won’t go after them because it is not worth their effort, or, they don’t want the negative PR.

Would you borrow from a relative and default, because you know they would never sue you?  Would that be ethical?  Taking advantage of the extreme kindness of others may be legal, but it is never ethical.

If you can pay, you should pay.  That the mortgage lender will not enforce their rights does not mean that the one who can pay but defaults is ethical.

Imagine a society where any can default at their pleasure.  My, but the interest rates should get high to reflect the possibility of loss from borrowers that could pay but won’t.

If you can keep your word, and make your payments, do so.  You entered into the mortgage agreement with no assurance of where housing prices would go.  That they turned against you is no reason to default; but if your ability to pay has declined, well, that is another thing — default if you must.