Comments on: Don’t Strategically Default on your Mortgage

By: David Merkel

David Merkel — Thu, 15 Apr 2010 15:12:49 +0000

Rob & others, you are right, I was wrong there about Ch. 11 — I was taught wrong by a junk bond manager around a decade ago, and have now unlearned that. I will have a follow-up post on this issue though, because the argument stands regardless of my misviews on Chapter 11.

By: Rob

Rob — Wed, 14 Apr 2010 18:40:11 +0000

Sorry, I stopped reading when you attempted to describe the limited circumstances under which a corporation can file for Chapter 11. As Mark points out in post #22, your premise is completely false. It is quite easy for a company to avail itself of bankruptcy protection (whether chpt. 7 or 11) and the circumstances under which the filing will be refused are extremely limited.

By: Patrick

Patrick — Thu, 21 Jan 2010 23:03:02 +0000

I object to the analysis presented in this post. Specifically, I believe the analogy between companies and individuals is DEEPLY flawed in one simple way. The analogy makes reference to unsecured general obligations of corporations. By contrast, mortgages are non recourse loans. The correct analogy, therefore, would be comparing personal mortgages to non-recoures, bankruptcy remote notes such as pass through bonds secured esclusiely by particular payment streams. It is explicitly clear in mortgage contracts that the obligations under the loans are non-recourse. That means the person behind the mortgage has not pledged his other assets as collatoral for the loan. That provision–which is clearly known to both parties–makes it completely moral, ethical, and reasonable to default on a mortgage at any moment. Implicitly and obviously, the mortgage contains an option for the borrower to swap the collatoral (the home) for the liability. That is a clear consequence of mortgage loans, and not in the least bit ethically dubious.

By: Mark

Mark — Wed, 20 Jan 2010 03:06:01 +0000

“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.”

This is simply wrong. One of the better uses of the Bankruptcy Code is when a business is unable to raise sufficient cash to make its debt payments but the assets of the firm are worth MORE than the liabilities … provided the assets are not sold at fire-sale prices. A firm can become liquidity constrained without being balance sheet insolvent. It is often difficult for a firm to sell a single asset or even a group of assets to re-establish liquidity.

Going back a couple of years, I represented a corporate debtor which ran nursing homes. It had very little in debt — and the state was slow on its reimbursements due to a system change over that generated a significant set of challenges to the company’s cash flow. It could not get financing for a couple of reasons – including a politicized indictment of the organization (which was never prosecuted but hung over the organization) because a patient with Alzheimer’s succeeded in wandering away from the home and died as a result. If Chapter 11 had not been available, the only alternative would have been to shut the homes down — resulting in the death of a number of patients. (Indeed, the US Trustee went on record before the Court to testify that he had no one on the trustee panel which would have been willing to run a liquidation due to the associated risk of litigation.)

More recently, certain developers and associated organizations have been going into chapter 11 because they lack the necessary liquidity to continue … and a fire-sale of the assets is not in the best interests of anyone involved except the buyer.

Quite honestly, though, I’ve seen firms file for Chapter 11 who could pay their obligations as they came due and were arguably solvent. A bunch of the mass tort bankruptcies fall into this category. If the business tried to defend each and every suit brought conventionally, the mere costs of the defense arguably could render the company insolvent — even disregarding the risk of a runaway jury. A chapter 11 bankruptcy allows such a firm to orderly marshall its assets and liabilities, maximizing the value of its assets and helping minimize some of its liabilities.

By: IF

IF — Fri, 15 Jan 2010 05:32:04 +0000

One last thought: in many countries if you buy something in a store (like a knife or a vacuum cleaner), you can’t change your mind later and return it. In the US it is the most normal thing to buy something, use it for a while and return it. Why should a house be different? This custom is ingrained into US culture.

David, did you (or your wife) ever return something to a store because you did not like it anymore (not a warranty issue)?

By: tradeking13

tradeking13 — Thu, 14 Jan 2010 22:22:14 +0000

Lease agreements and marriages are contracts, too. They get broken all the time.

By: Becky

Becky — Thu, 14 Jan 2010 21:41:48 +0000

I agree with the author. Many financial transactions are based on good faith. People used to do business on a handshake and now a written, notorized contract is meaningless.

When property was increasing in value, buyers didn’t want to share the profits, they shouldn’t expect to share the losses.

I am in the construction industry and saw many couples reach for the biggest house they could based on payments, not price. After the house was built, the new cars were bought, for if they bought cars first, they didn’t qualify for a mortgage. Never been able to figure that out.

Part of the bubble was also fueled by home builders who developed lots of subdivisions and slammed out house after house of minimum quality houses targeted at young first time home buyers. (young people love nice things, especially if they come relatively easy). Home builders are closely tied to bankers in a mutual relationship. There is not one group(banker, buyer, builder) that is more guilty than the other in the housing burst. When the buyer couldn’t buy anymore, then well, stuff happens.

By: Stone Barrington

Stone Barrington — Thu, 14 Jan 2010 20:28:07 +0000

David, how do you square this position with the fact that banks are unilaterally cancelling millions of perfectly good/performing credit card accounts of hard working Americans?

By: IF

IF — Thu, 14 Jan 2010 04:52:17 +0000

sg, the house was sold to many people as an “investment” for retirement. If somebody bought it for pure consumption reasons, you are completely right. But most people have to chose between the house (as a bad investment) and other consumption. Now, it is in general not the house that lost value, but the land it is standing on. Replacement cost was roughly constant during the bubble. The main volatility was due to the land, or better, location. After all, you can get the same house in CA for 0.8 million or in TX for 200k. Or maybe now for 300k across the street in CA! Why give up the freedom to move (to a cheaper location), if there is a put option embedded in the contract? Considering that the future of CA (and hence the discounted value of the future income) of a home debtor in CA looks much less rosy now, why should the debtor commit the same cash flow as before to the (now bad) location? It binds him to the place with nowhere to go and might squeeze him empty over time. Just my 2 cent. If you know there is a high chance to default, probably worth to do it early.

No, I never had any debt. I rent. But then again some friends just bought condos. One of them exclaimed that owning at 2700 a month is just 1100 more than renting (at 1600). The bubble in the low end is doing just well, thank you.

By: sg

sg — Thu, 14 Jan 2010 01:43:35 +0000

Bob in MA said, “Anyone paying skimping on saving for his kid’s college so he can service a $500,000 mortgage on what is now a $300,000 house should send in the keys.”

Call me an ignoramus, but it seems to me that if a person was willing to pay $500K for a house, why are they suddenly unwilling to pay just because their house is no longer appraised for what it was when they bought it? I mean, why were they ever willing to pay that price if the house isn’t worth $500k to them? Isn’t something worth what a willing buyer will pay? Why were they willing then but not now? It is the same house. It hasn’t lost any utility. Where is the reasoning in all of this? I don’t get it. I am not trying to be idiotic. I just don’t understand.

I do understand default if he loses employment and can’t pay, but if he can pay it then why does he suddenly not want the house when he wanted it before?