Strategic Default

I had read an article in the Wall Street Journal last week, and it troubled me. I figured it was something that I’d have to write about this week, but didn’t plan on writing about it until later in the week. Then my brother, who is much smarter than me, but not nearly as handsome, emailed me the link with a subject line of “Very conflicted about this, but generally I think these people are lame”. On Saturday, I was sitting in the living room of a new clients lake house, when the conversation turned to foreclosures. Apparently, another owner in a condo building that he owns rental property in decided to stop paying his mortgage payments, and the resulting foreclosure has forced property values in this small building downward. He asked the great question of me, “what’s in it for me to keep paying my mortgage?”

Ah, the greatest question of 2009. I’ve written at length on the foreclosure issue, and ruffled a few feathers when I wrote the following in a piece titled “The Foreclosure Truth” that appeared on several other national sites.

…Washington needs to understand why this foreclosure boom is happening. It’s happening because people are choosing to just walk away. If you owe $500k on a home that’s now worth $300k, why keep paying? Valuation that was lost in 18 months might take 48 months to gain back, so why pay the juice in the mean time?

I wrote that back in November of 2008, when the foreclosure mess was still being sorted out, and we were all trying to figure out the factors that were leading to this new foreclosure phenomenon. I was of the mindset that foreclosures were rampant because of a deadly combination of negative equity and a culture that had labeled those who were foreclosed on as victims, thus creating a newfound social acceptance of the foreclosure. If you were underwater on a mortgage 15 years ago, you might have scraped and clawed to try to stay in the home and honor the terms of your mortgage, after all, that was the “right” thing to do. Today, if you’re underwater, you just rent the home next door and hand the keys back to that big, bad bank. You figure they were the ones stupid enough to lend you the money in the first place, so now it’s their problem.

That’s what I thought 13 months ago, and that’s what the Wall Street Journal just realized last week. The article in question, nicely written by Mark Whitehouse, explores a neighborhood in California, and follows three couples as they navigate the world of negative equity and cultural acceptance of the newest craze in real estate, strategic default. A particularly troubling excerpt from the Wall Street Journal piece about the lifestyle habits of the folks that are willingly defaulting on their loans…

Ms. Richey’s family of five used some of the money (that they saved from walking away from their mortgage) to buy season tickets to Disneyland, and plans to take a Carnival cruise to Mexico in March.

See how easy it is to vacation when you willingly abandon personal responsibility? If that sentence from Mr. Whitehouse’s article sounds familiar, it’s probably because you read what I wrote back in 2008 about what I saw as a burgeoning trend in foreclosure motivation. From my prophetic 2008 article…

The mortgage note is a unique creature. You promise to pay the bank monthly payments, they give you money, and their money is most often secured only by the real estate that you’re purchasing. This practice is built on trust. You trust that the bank won’t foreclose if you pay on time, and the bank trusts that you’ll pay the money back. If you don’t pay, the bank forecloses on your home, but only several months after you’ve stopped paying them. You live rent free for upwards of six months while the bank works the foreclosure channel. You give them the house, they destroy your credit, and you keep any uncollateralized assets that you have. You have a $250k mortgage, and $250k in the bank,. What happens when the bank forecloses? You give them the house that isn’t worth the amount of your mortgage, you keep your $250k. Now you can go to Cancun in January because that annoying mortgage isn’t hanging over your head. The American dream.”

There’s a huge difference between strategic default, and unfortunate default. In the traditional, unfortunate default, the homeowner is trying their best to stay current on their loan, and is seeking every available option available to do so. Job loss, health issues, and divorce, are all factors that can lead to an unfortunate default, and subsequent foreclosure. The issue being discussed here is much different than hard luck default, as this strategic default is being instigated on purpose, with the little concern for personal responsibility or the ramification of that default.

The personal situations in the WSJ article are classic examples of the new American, government endorsed mindset that says the best way to handle ones business is to privatize profit, and nationalize loss. In other words, if you’re going to make money on a deal, keep that money for yourself without complaining, but if you’re going to lose money, then it’s best to force the loss on the bank, its’ shareholders, and ultimately the American tax payer (your neighbors). Strategic default might be a legally acceptible way to handle one’s housing trouble, but is it really the right way?

As an unapologetic capitalist, I, like my bother, am conflicted about the concept of strategic default. On one hand, I’m all for making money by any legal means possible. On the other, there is the moral issue created by an awareness that any loss not suffered by you in a personal default, will certainly be suffered by others. I don’t feel like I’m being very clear in this post, but perhaps that’s a result of my lack of willingness to accept strategic default as anything by a manipulative tool being used by those who would rather keep their $700 car payment than keep their word to a bank.