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.
That is a *very* strange piece of advice.
It is pleasant to read about moral principles, contractual honesty, etc., but the question arises, would the author actually follow suit if he himself would find himself in a situation when (over-inflated) mortgage is now worth a but a fraction?
As I understand it, if the borrower can’t pay, he must surrender the mortgaged property. There is mostly no other collateral. (Or?)
If that is the case, well, please let the banks suffer. After all thats they who created the bubble.
What about fraudulent comps, and inflated appraisals that were deliberate? Many buyers entered contracts based on real estate comps and appraisals that were in every way fraudulent. The banks knew this, so they repackaged the debt into opaque tranches for sale on secondary markets. Home buyers in America in 2005-2007 were victims of fraud, perpetrated by the finance and real estate industries. See, for a down-home indignant vignette: http://www.calculatedriskblog.com/2010/01/late-night-jim-realtor.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed:+CalculatedRisk+(Calculated+Risk)&utm_content=Google+Reader
You write:
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.
I think you’ve sidestepped the example that Roger Lowenstein highlighted respective of corporate behaviour: Morgan Stanley ceasing to make payments on five office buildings. Issues of bankruptcy need not be in play when one is dealing with non-recourse mortgages and by going into them I think you’ve moved past Lowenstein’s original point.
You are right, a contract is your word, but in a no-recourse contact, “the word” that you give is that the remedy for default is that the lender gets back the property. If you give back the property, you have kept your word. Non-recourse is simply a way of ex ante allocating risk. But I suspect that I am telling you something that you know, so I’m not sure that you have made clear what your moral objection is.
I strongly disagree with your position.
“Taking advantage of the extreme kindness of others may be legal, but it is never ethical.”
Given all that’s happened in the last five years, that statement strikes me as stunningly naive. Let’s look at Wells Fargo. They were one of the biggest packagers of subprime mortgages. When people pointed out how absurd they had become, Wells Fargo noted they had off-loaded the risks to the sucker class’s pension funds, etc. Or Goldman Sachs and their direct line to the Treasury…
The message is clearly that the deck is stacked and woe to those who don’t look out for themselves. If I were in a situation where my family would be better off by my walking away from a mortgage, I’d do it in a heartbeat.
And for the record, I have zero debts and have never had a need to default on one.
I too disagree. I think you are advocating unilateral disarmament for the middle class. Wall Street and Washington have conspired to pillage the wealth of the middle class. There’s precious little we can do about it, but walking away from a hopelessly upside down mortgage is one big thing. The alternative is to make many folks debt slaves for the rest of their lives while the primary perpetrators in the finance industry have been largely let off scot-free.
I will agree with you that ruthless bankruptcy and intentionally running up non-recourse debt before declaring a bankruptcy is fraud and should be prosecuted, but that is separate from the level of debauchery that existed in the housing industry and for which many average people had no idea or no recourse to deal with.
David, while in general I got the impression that you are sharp and honest thinker, you are letting your moral and religious values override this here. The kindness of strangers does not exist anymore. People have been made corporations by issuing them SSNs at birth. They have to follow their own interests and (if necessary) exercise all options embedded in a contract (deed in lieu of foreclosure), even though you might not like them. A contract is a contract, as you say. And what is wrong with interest rates going up? That would ruin the economy, but would be the free market outcome. Since when do free markets bother you?! Even from a leftist perspective walking away is the proper thing to do: “Food comes first, then morals.”
David, isn’t the contract on a mortgage not “I will keep making payment no matter what” but rather “if I stop making payments you can take the house?” I don’t see anyone insisting that they can stay in the house without making payments (they may do it until foreclosure, but I haven’t heard anyone make the argument that the house is really theirs.
To me, the mortgage agreement is an if-else statement. If “I make all the payments for thirty years I will own the house” else “you, the lender will own the house.”
That is all.
Wow, you’ve stepped across the line from law and finance to morality and ethics. There are so many things wrong with that approach that I won’t try to enumerate them. Almost universally, decisions in one area about the other lead to bad outcomes.
On the question of whether the mortgage defaulter has any contractual obligation beyond turning over the house, in fact many mortgage holders have recourse. This is decided by state law. In California, a first loan to buy is without recourse, but if you refinance the lender has recourse, and there probably aren’t a lot of mortgages in California that weren’t refinanced over the last 6-10 years. But in fact, this recourse is rarely enforced.
A couple years ago, I tried finding out what percentage of mortgages were without recourse and essentially no one knows. The state laws are all worded differently. But only in rare circumstances do the banks go after other assets.
So I think there are two separate issues. But personally, my position is that in this completely jaded system where the letter of the law is determined by political contributions and revolving door bureaucrat/banker/lobbyists, your chief moral duty is to look out for your family. 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.
David:
I believe you are referring to moral hazard and are simply speaking from the “non-economic” perspective of your wife so I will not berate you for sharing this perspective, but rather find common ground in the following way:
First, moral hazard, explained well by a Wikipedia entry, arises when a person or institution “does not take the full consequences and responsibilities of its actions, and therefore has a tendency to act less carefully than it alternately would, leaving another party to hold some responsibility for the consequences of those actions.”
Perhaps the only antidote to moral hazard, other than laws that would constrict freedom conducive to a productive society, is ethical behavior, as you have suggested here.
Ethically, one would think more of the “greater good” than their own personal gain (or prevention of loss). Our challenge is that, in an individualistic and relatively free society, what is best for the whole is considered less than what is best for the individual. “What’s in it for me” is asked first and “what’s the right thing to do for the greater good” is asked second, if at all.
This is the achilles heal of living in a free society, which for the record, is my preferred society in which to live.
Thanks, David, for provoking thought…
Kent @ The Financial Philosopher
After a crisis short of people operating economically rationally, I don’t think encouraging people to continue acting irrationally is reasonable. Let people weigh all the benefits and costs of their actions and decide what is best. We are all better off from such actions, not just some lender that acted irresponsibly in the first place. Economic thought and behavior needs to be encouraged, not negated, for that is the truly ethical path.
Isn’t our economy based on a business taking enormous risk by borrowing funds and if successful, will be wildly successful. However, if not successful, can weasal out of their obligations by claiming bankruptcy. Most corporations do not have personal equity at risk as a homemowner does or a private business owner.
David, I have to disagree with you here.
A mortgage is just a contract. Companies default on contracts all the time. Penalties are (attempted to be) enforced. It’s just a business decision.
If I don’t pay my mortgage, the lender gets the house. If I don’t pay my car payment, a couple of burly guys repo it. No difference at all.
My greater responsibility is to my family. You seem to suggest that I should bankrupt them before breaking a contract. A more rational course would be to walk away from the mortgage in order to shelter (perhaps dwindling) remaining resources.
The flaw in your argument is business has perfected limited liability, asset stripping, that turns business into one sided options. A non-recourse mortgage is really nothing more than a limited liability company. Now if you want to argue in favor of absolute liability and do away with the corporate structure and business as we know it that is one thing, but to argue business should have privileges and perks unavailable to individuals lacks equity.
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?
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.
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?
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.
Lease agreements and marriages are contracts, too. They get broken all the time.
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)?
“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.
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.
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.
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.