Last week The Consumerist had a post telling readers to Go Ahead, Strategically Default On Your Underwater Mortgage. This was based, more or less, on a paper from a law professor at the University of Arizona which addressed the legitimate conundrum of why strategic defaults are not more common.
A strategic default on a mortgage is when a borrower can make the payments but chooses not to. In other words, the borrower hands the keys over to the lender and walks away. It is important to remember that, despite much play in the media and academia, this is still a rather exotic maneuver. In order for a borrower to even begin considering such a move two things need to be true.
First, obviously, the house has to be worth a lot less than the outstanding mortgage balance. Or, in current slang, it needs to be substantially underwater. Swapping ownership of the house for extinguishing the debt is, essentially, selling the house for what is owed, and if what is owed is not meaningfully higher than what the house is worth, this would be a bad deal.
Second, less obviously but perhaps more importantly, the borrower needs to be sure that the lender cannot, or will not, come after him for the "deficiency", the difference between what the house is worth and what is owed. And this is generally a matter of state law.
The question is often simplified into dividing states into "recourse", where lenders are allowed to go after borrowers for the deficiency, and "non-recourse" where they are not. Most states (39 of them) are recourse, meaning that, in most of the country, strategic default is a no-go. (Of course, this is a gross simplification. Another academic paper, put out by the Richmond Fed, did an exhaustive survey of state laws and found no two alike.)
Not at all coincidentally, two non-recourse states, California and Arizona, are also states with very high proportions of underwater houses, 42% and 51% respectively. More than half of those underwater houses are worth less than 75% of what is owed. California and Arizona do have high mortgage delinquency rates, around 10% are more than 60 days past due as against 6.25% nationally, but it is clear that the majority of seriously underwater homeowners are passing up their option to walk away.
Why is this? Brent White, the Arizona law professor, blames it on homeowner emotions of fear, guilt, and shame which are in turn caused by a conspiracy of evil-doing elites.
these emotional constraints are actively cultivated by the government, the financial industry, and other social control agents in order to induce individual homeowners to act in ways that are against their own self interest….
Although White’s paper brings up a good question, his answers are left-wing by academic standards, which is to say pretty far out there relative to mainstream discourse. In his view, the lenders are responsible for the whole mess and should bear as much of the financial burden as possible. Homeowners are hapless victims, sensitive creatures who relied on the lenders to ensure the house was worth what they paid and are now being emotionally manipulated into giving up what meager rights they have.
In White’s view, the commonly discussed moral objections to walking away are merely a false consciousness. Homeowners have been deceived into thinking that living up to their mortgage obligations is some kind of ethical issue, forgetting the money lesson taught us all by Michael Corleone: "It’s not personal, it’s just business."
I will not wade into the moral issues. Not today. But I can think of three good, non-emotional, non-ethical, reasons why most significantly underwater homeowners in California and Arizona do not strategically default.
First, and I think at some level White would agree with this, they do not know any better. It is not that they have been subliminally trained by the ever present social control agents to think that strategic default is wrong, they just do not understand the option. It is, let us remind ourselves, a complex, counterintuitive, objectively scary procedure that at the very least involves hiring a lawyer. In a nation where Roth IRAs and leveraged ETFs are considered deeply confusing, it is no wonder that not many homeowners realize they have an in-the-money put option on the house.
Second, a strategic default will trash your credit rating. The whole point of a credit rating is to gauge a person’s likelihood of repaying future loans, and the fact that you stiffed a bank for some serious money, just because you could, will be a serious mark against you. As it should. White simultaneously says this side effect is exaggerated and that the credit reporting agencies are the thuggish enforcers of the social control agents. He proposes new legislation to prohibit them from reporting mortgage defaults and foreclosures.
Third, and this ought to be more obvious than it is, most people like their houses and do not want to move. Even if exchanging the house for the mortgage amounts to selling the house for considerably more than it is worth, most folks are not interested in selling the house they live in, even for considerably more than it is worth. Would you be interested in selling your house, today, for, say, a third more than the going rate? You have to clear out in a month and because of your newly bad credit score you will not be able to buy another place for a few years.
Moreover, it is worth observing that for homeowners who are not having trouble making the monthly payment, the housing crisis is relatively abstract and far from a pressing matter they need to do something about now. The house may be worth a lot less than what they paid, but that would only be a practical issue if they needed to sell it. In the meantime, the house and the mortgage are exactly what they signed up for. And if strategic default is an option now, it will presumably still be an option next year and the year after as well. Why not wait until you need to move anyway? And if you never need to move, well, then who cares?