Why You Haven’t Strategically Defaulted Yet

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 Upsidedown House attrb Stopmangohome 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?

[Photo: Stopmangohome]

No Comments

  • By Jim, December 8, 2009 @ 2:08 pm

    Those are all good points and I agree with them.

    Another reason I think people don’t walk away is that they believe their homes will recover equity faster. I mean if you buy a house in California 2 years ago for $500k and its now worth a measly $200k then you might expect it could / should / might / will return to the $500k value within a few years. So I bet a lot of underwater people are just planning to “wait it out” assuming that they’ll have positive equity a lot faster than is likely.

    You pose an interesting question there asking if people would be willing to sell their house for 1/3 more and trash their credit. I think I might do that, but its a tough call. I bet my wife wouldn’t want to. Theres nothing special about our house really but there is some emotional attachment to it. Plus moving is a big hassle.

  • By Rick, December 8, 2009 @ 4:11 pm

    Ok, I’ll bite.. Who are the other 9 non-recourse states?

  • By Kosmo @ The Casual Observer, December 8, 2009 @ 11:48 pm

    “… 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 …”

    Yeah, good luck with that one.

  • By JFP, December 9, 2009 @ 9:20 am

    Walking away from a mortgage isn’t the end of it. You have to go to another residence. You won’t be able to get another house, and you may even have a hard time getting an apartment, if they decide to check on your credit.

  • By Frank Curmudgeon, December 9, 2009 @ 12:32 pm

    Rick: According to the Richmond Fed paper (worth reading if you have the time) the 11 non-recourse states are: Alaska, Arizona, California, Iowa, Minnesota, Montana, North Carolina, North Dakota, Oregon, Washington, and Wisconsin. NC is actually only non-recourse for purchase mortgages, so I guess it’s 10 1/2 states.

  • By bex, December 9, 2009 @ 11:48 pm

    Trashing your credit score would be perfectly kosher if you then became a David Ramsay acolyte…

  • By Craig, December 10, 2009 @ 11:09 am

    Excellent analysis–I think you hit the nail squarely. In particular, although “they do not know any better” is perhaps not the most charitable phrasing, has got to be the dominant factor. Strategic default requires a combination of financial acumen, foresight, and cunning that would seem to correlate negatively with being upside down in a house in the first place.

  • By Kosmo @ The Casual Observer, December 10, 2009 @ 11:49 pm

    Iowa? Sweet, I’m in a non-recourse state!

    Ah, sh*t. We have equity. So this wouldn’t work so well for me :)

  • By Guzzo, December 12, 2009 @ 11:00 am

    This is a great post with a lot of food for thought. It would seem that anyone living in a non-recourse State, holding a mortgage significantly underwater, would be crazy NOT to default.

    I’m living proof that defaulting is not as bad as one would think. I live in Arizona. Back in the 80′s, during the S&L crisis, we walked away from our condo after it was valued $50,000 less than what we paid. Except for arranging a settlement with the home owner’s association for dues, we really didn’t experience any serious consequences or owe anyone else any money. Luckily, a deficiency judgment against us was avoided by deeding the property back to the lender, who accepted it as payment in full. But, that’s not a worry now after The Mortgage Forgiveness Debt Relief Act of 2007 was passed.

    Even with this foreclosure we had no problems being extended credit soon after. Why? Because just like now, extending credit, even to the unworthy, is a good way to stimulate the economy… and that takes priority.

    With the housing situation the way it is, I’d be willing to bet that those who walk away from their overpriced mortgages, but still have stable and good paying jobs, could probably re-qualify for a newer lower-rate mortgage on a much less costly house.

    The banks don’t want these homes on their books and would probably be more understanding about “why” you defaulted. Heck, even the Government seems to be encouraging defaults.

    So, like Professor White says, and even with equity in one’s home, if one’s mortgage is significantly underwater, it still “may” be a good financial move to default.

    DISCLOSURE: Looking at the big picture, by the mid-1990s (about 10 years later), the price of our former condo more than tripled in value. So, who’s to say that can’t happen again (but, I seriously doubt it).

  • By Guzzo, February 2, 2010 @ 8:50 am

    Here’s a follow-up post from The Arizona Republic that relates to this post.

  • By Jstkrsn, August 17, 2010 @ 3:45 pm

    what if you have a rental in a recourse State that you must give up because the renter lost their job, but you live in another state which is a non-recourse state. Can they come after you in the other state? Or get a judgment that can only be saerved if you enter the recourse state?

  • By Vernice Vann, October 4, 2010 @ 7:35 pm

    Cheers! Very nice site!

  • By getagrip, November 5, 2010 @ 12:36 pm

    People are forgetting that for now they are also shielded from taxes on the “forgiven” debt in the non-recourse states. The Mortgage relief act of 2007 is only good until 2012. After that, unless there is an extension, if you walk away on a $500K Loan, and the bank sells the property for $350K, the IRS considers the $150K difference taxable income you’ve benefited from, so you’d likely be on the hook for about $50K above your usual taxes that year, and that’s assuming the extra “income” doesn’t trigger you for the Alternative Minimum Tax on your regular salary on top of that. With your credit trashed, it might not be easy to get the money together to pay that off. Though I’m sure the IRS has a payment plan.

  • By Tammy, June 30, 2012 @ 8:04 pm

    Wow. I really liked your thoughts on this subject. I live in Arizona with my husband. We did a stratigic default a year and a half ago. It was the wisest thing we did for our finances. Our house we defaulted on we initially had a morgage on it for 180,000. We paid it down around 170,000 at around 1400 each and every month. This went on for 3 years, then we were looking at each other when we got a statement saying that our house was only worth around 58,000. After stewing on it for a few more months we took action and found a forclosed house for 42,000 that was the same size and it needed to be fixed up. We were able to borrow from my father inlaw 20,000 and we had 25,000 that we scraped together and we bought the house cash and now have the deed! We will have the 20,000 borrowed from good ol’ dad paid off next year! We used our credit cards and opened lines of credit at home depo and Lowes to get everything we needed to fix the place up…and we stopped paying morgage on the other place as soon as we had all we needed to extend credit and buy material. That 1400 dollars we were not paying toward our morgage we put to fixing up the house also. We lived in the upside down house until we got the notice to vacate in 60 days…which was 5 months. By then, we had a really beautiful house to move into…and its the same size, nicer, and it’s ours….so if people don’t do it, they are fools. My husband and I have gotten some flack for doing it from co-workers or some people in the community…I think they are just to afraid to do it themselves. While they are slaving away paying off a house that isn’t worth anything, we buckled down and worked on a re-roof, plumbing, and a complete remodel on something that we are proud to say we own! So suck it! And we did it with our own hands and the help of friends and family.

  • By Tammy, June 30, 2012 @ 8:28 pm

    I must add too…we are not paying our credit cards right now. We are opting to save the 20,000 owed to father in law first and paying him back fast. We figured that since our credit is already in the dumpster because of the foreclosure we were going to make up our own rules about paying back our debt. We are on our way to knocking out student loans at the moment…we have 40,000 in student loans and will have those paid off in 2 years. So 60,000 with interest paid off in two years. We won’t have student loands hanging over our heads or any personal loans After that we are going to take a sabatical to go hike around europe for 3 months, then when we get back we plan to settle the credit card debt one at a time. 25,000 in card debt…but the thing is, they can’t go after us for anything because its unsecured. They can go after you for student loans and your home. If we would have stayed in our old situation we would be paying on all of that for 20+ years. We will basically be debt free in 4-5 years…owing nothing to no one with our new plan…pretty crazy if you ask me. We have other friends who are doing the same thing, once we helped them see the madness of the whole system. I want to add also that I did go through some financial problems when I went through a divorce at 25. I was unable to pay back my credit cards and I didn’t pay them for 3 years. I ended up settling on them when I had a large sum saved up. Most of them settled for around 1/3 or what they were saying I owed. So the whole thing is a scam. My credit recovered in 7 years…I had credit being thrown at my feet. The card companies and banks want you to be kept in debt. They love tacking on more interest and penalties because they have you in fear. And another thing, when they do call you…tell them you have every intention on paying them back…you will…when you have all the money saved up to pay them back…when you have a lump sum…call and negotiate with them…they will settle. It’s all a big game anyway to keep the sheeple in order.

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