If It Feels Good Do It: Maybe Strategic Defaults Aren’t So Bad After All

I bought my first home in 1990 at the top of the Southern California real estate market and promptly found myself with an “underwater” mortgage. And although I owed more than the home was worth over the next seven long years, I never walked away from that loan — even though I wanted to — because I felt I had a moral obligation to myself and society as a whole to continue paying it as long as I was financially able to do so.

Perhaps that shouldn’t be surprising, considering I am the proprietor of a blog that promotes itself as “the personal finance blog for responsible people.”

However, I’m now beginning to rethink that philosophy. That’s right; maybe this whole strategic default thing ain’t so bad after all.

The reason for the change of heart has a lot to do with a recent Chicago Tribune story on strategic defaults that featured a gentleman with an annual household income of $150,000 who decided to walk away from his underwater mortgage even though he described his financial situation as “manageable.” According to this gentleman, he considered his promise to repay his lender as purely a financial obligation. In other words, it’s just business. And while that may seem a little too convenient to a lot of folks, perhaps this guy is on to something.

Think about it. When people lose their jobs, or suffer other financial hardships beyond their control that result in a catastrophic loss of income, and then exhaust their emergency savings, nobody considers the act of walking away from their home and giving the keys to the bank as dishonorable or immoral — and that’s exactly how it should be.

So why should it be any different for people who choose to walk away, even though they can still afford to make their mortgage payments?

I mean, I’m all for personal responsibility, but when it comes to making the decision to strategically default, you can’t blame it all on the homeowners; the lenders knew the risks involved. And I don’t remember many lenders warning folks before they signed on the dotted line that there was a risk of home prices falling. Do you? How were the borrowers supposed to know that?

True, some people will argue that folks who choose to strategically default selfishly undermine their neighbors’ home values in the process, but nobody is stopping those neighbors from strategically defaulting too if their home prices eventually fall further. Right?

To be honest, I’m surprised the whole strategic default thing isn’t spreading beyond the housing market. In fact, the more I think about it, the more obvious it seems that if everyone were allowed to walk away from any type of debt obligation or other IOU whenever the end-results didn’t turn out as expected — even though we had the means to pay — we’d all be a lot better off.

For example, consider people who find themselves saddled with massive college loan debt. In many of those cases, people not only overpaid for college degrees, but they also failed to realize until it was too late that their chosen major simply didn’t make the best career choice from a purely dollars-and-cents perspective. So why shouldn’t they be able to strategically default? Especially if the only jobs they can find with their new degree pay much less than they anticipated.

On second thought, why limit strategic defaults to loans? Why should anyone ever have to pay for any type of investment that goes sour?

I guarantee you life would be a whole lot easier if we could all go to our broker and demand a refund every time we bought a stock that lost money for us. Hey, it’s only fair. You can’t reasonably expect otherwise decent, hard-working, well-intentioned, responsible people to know when they’re investing in things that are overvalued. You just can’t.

Yep. The more I ponder it all, the more I like the logic behind strategic defaults. I bet if more people started to think like this, then all our financial troubles would vanish into thin air. Poof! Just like that.

If we all begin to fully embrace the notion that strategic defaults are honorable, then doesn’t it follow that every financial “inconvenience” that happens to spring from a civil society’s dependence on our sense of personal responsibility, integrity and strong moral character will disappear too? Best of all, won’t those dreaded financial losses for us little guys eventually become a distant memory — the personal finance equivalent of everyone getting a trophy in Little League?

So go ahead, people. The next time you feel like defaulting on a loan you have no trouble paying simply because you realize you misread the market, take the plunge. After all, what’s the harm? It’s only business.

Photo Credit: walknboston

Comments

  1. 1

    says

    I like the tongue in cheek attitude. I know of someone close (a relative) that lives in a state where there is a high “strategic” default rate. They decided to go with the flow, per se, and default as well. We can’t figure out all the details (they aren’t really sharing) but I don’t think it’s going so well.

    Their house is no longer being short-sold and they’ve packed up all their stuff. I’m pretty sure they’re on their way to a foreclosure. And, they were really hoping to buy another house right away (the real kicker!) They were unhappy with the price they paid since they can now get the same kind of house (you know, those cookie-cutter ones) for half the price.

    So much for personal responsibility.

  2. 3

    says

    Len, I saw your poll results yesterday were largely in favor of paying your debts if you are able.

    I guess your readers must agree with your take-not a big surprise…

    I’ve got beach property that is so under-water I need scuba gear to visit, but I’m hanging on. My grand kids will appreciate it. (if my darn kids would ever learn how to make them!)

    • 4

      Len Penzo says

      On the bright side, at least your house is by the beach, Dr. Dean! My underwater property was about 75 yards from a busy set of railroad tracks!

  3. 5

    Steven-H says

    I’m asking this as I am in a similar situation: Friends of mine (known them 25 years) in their early 50s, bought their house here in Lee County, Fl in 2003. It was appraised at $140K at the time. They paid over $6000 to get in the house & the mortgage is around $1000 monthly for 30 years.

    Now since the economy & property values have fallen so bad their house is appraised at $60K & their mortgage balance is still around $121K.

    What would you recommend they do in this underwater mortgage case?

    Stay in a house that they owe twice what it is worth & can’t sell?

    Stay in a house that they *can* afford the mortgage payment but *can’t* afford to save for retirement?

    Or??

    • 6

      Len Penzo says

      Well, here is how I look at these situations. If I was happy with the home, with few exceptions I wouldn’t care how far the mortgage was underwater. Why should a lack of equity in the home affect my desire to live there? After all, the primary purpose of my home is to provide me with shelter, preferably in an area that is safe and comfortable and pleasant to live in. I didn’t buy it as an investment.

      The only time it would matter to me is if: 1) I was forced to move for (fill in the blank reason); 2) I lost my main source of income and could no longer make the payments.

  4. 8

    Joe says

    Agreed, Len. Not paying is in the contract and choosing not to pay is simply fulfilling that part of the contract.

  5. 12

    says

    I feel like a dinosaur because I believe that a contract is a contract. My word means something to me. I guess that is why I approach things conservatively and really think it through before I jump on board.

  6. 14

    Kyron says

    I am of the opinion that strategic default is ok if it makes financial sense (which is calculated by taking into account the 7 years of pain one will go through, lost opportunities such as jobs, rentals, insurance rates, state laws w.r.t recourse, etc). It is a cold financial contract give-and-take.

    If banks will not give consideration to people who cannot pay (after taking tax payer money) and it is a cold financial decision for them, people should not give consideration to banks even when people can pay their mortgages, it should be the same cold financial decision. Especially when banks can write off depreciating assets on their balance sheets, hide underwater assets from books by not marking them to market, get near zero interest rates from the government, etc. It’s all a question of legality to them, it is not a question of morality.

    To all people who say strategic default is morally wrong, please introspect on the following items:

    The one promise a person truly makes is to their spouse when they say “I do” in response to the question “till death do us part”. Apparently, even this event has an exit clause called divorce which, according to your beliefs, must be obscenely immoral. But would you treat divorce on the same grounds as strategic default? Nothing physically prevents anybody from continuing their marriage (unless of course, they are being battered, etc) but a lot of people choose to walk away.

    Do you believe divorce is immoral? What about breaking an apartment lease? What about a cellphone 2 year contract?

    If your neighbor strategically defaults and your beef is that it depresses your home value, then let me tell you this. You should have paid the right price for your home and gotten a good deal. If you did, then you wouldn’t be complaining about artificially depressed home prices. If you paid anything more than the right price, then you indulged in risk taking … so introspect on the ugly side of risk-reward see-saw.

    • 15

      Len Penzo says

      I think it is fair to say that most people who frown upon those who willingly choose to strategically default, do not begrudge people who lose their home to foreclosure through no fault of their own. I know I don’t.

      Even though I think it’s an apples and oranges comparison, it’s the same story for divorce; it’s hard to question the character of anyone who breaks off a marriage because their spouse, for example, cheated on them, or was a wife-beater, or (fill in the blank with thousands of other good reasons).

      Yes, I believe broken apartment leases and cell phone contracts should be honored.

      “If your neighbor strategically defaults and your beef is that it depresses your home value, then let me tell you this. You should have paid the right price for your home and gotten a good deal.”

      Really? I’ll argue that the “right” price was struck the moment buyer and seller agreed to terms. I don’t know how others may feel, but my primary beef with any neighbor who might decide to become a strategic defaulter is not that they would depress my home value — if only in my case because my equity is currently triple what I owe — it’s the symbolic “financial finger” that said neighbor essentially gives to me and the community. I don’t think it’s a stretch to say that if everybody acted like that, our economy and civil society would quickly break into chaos.

      • 16

        Kyron says

        Len, yes, nobody begrudges a helpless person who defaults.

        (1) You are holding a very consistent and high moral ground (w.r.t divorce, leases, cell phone contracts). Which is a good thing. I admire you for that. It is not very practical (and Im not talking about the “convenience” or “short-sighted gains” aspect of it). You would be right if you said “everybody must be generous” and I would agree with you. But you can’t expect people to be generous, helpful and self-less as does communism which would insist on sharing the fruits of one’s labor. The baker needs to look out for his self interest and not worry about feeding society. Yes, the sad downside to this practicality is that we are being brutal like the animal kingdom and not rising to loftier values.

        (2) I agree that “a” price was struck at the time of purchase. I am saying everyone should be very careful and ensure that it is the “right” price. Clearly, strategic defaulters were not careful or else they would not find themselves debating whether to s-default or not. My point is that others can’t argue that s-default is bad because of “depressed home prices for others”, “bad for economy”, etc. It’s their own fault if anybody overpaid for houses.

        (3) If s-defaults happen: the defaulter pays for it by taking super credit hit. The lending institution takes another super loss that will make it behave in the future. Perhaps I am subscribing too much to the Austrian School but the pain is needed to learn. Who is to say the borrower must suffer while the lender is being reimbursed?

        • 17

          Len Penzo says

          You make some good arguments. I bet you were on the debate team in high school. :-)

          (1) I have to admit, I sincerely had to sit back and think about your argument. I found it to be an intriguing one and, for a few moments, very compelling. But the more I thought about it, the more I convinced myself that it is not correct (at least to me) to compare forcible redistribution of wealth as morally equivalent to honoring a contract between two parties. Still, I appreciate the point of view.

          (2) Fair enough. But what about people that didn’t overpay for their house and are still affected? Let’s say Joe puts up his house (with, say $300k, in equity) up for sale, and then three of the neighbors strategically default — thereby delaying the sale of Joe’s home unless he brings the price down by $100k to compete with the foreclosures. Joe still made a profit but, through no fault of his own, he lost $100k.

          (3) I appreciate your position here, Kyron. I’m pretty much a laissez faire guy myself when it comes to economics. I have to say though, in fairness to the lending institutions, things didn’t start going downhill until the Federal Government began passing laws over the past 30+ years that resulted in looser lending standards so more people could participate in home ownership — and then telling us there was no problem with the lending industry when the evidence was clearly there for anybody who wanted to look at it.

  7. 18

    says

    I’m a big fan of personal responsibility and not a big fan of stretegic default. However, I honestly don’t blame most of the people who choose this.

    Most of the people I know who defaulted were wrangled into terrible loans, with unconcsionable terms, even though they were qualified for better loans. This happened because of Yield Spread Premiums (kickbacks from banks to mortgage brokers to put people into subprime loans). The banks stood up in front of Congress and promised to modify these loans, but they didn’t. Since they got the bailout money, they had no incentive to modify loans. So they lost everyone’s modification paperwork and brought in robo-signers to illegally foreclose on homeowners.

    The worst part of this true story is that taxpayers are paying for it instead of the banks, who should be.

  8. 23

    Logic Rules says

    Here’s my deal with strategic defaults: the mortgage that is signed is a contract. If you keep up the payments along the agreed-upon schedule for the duration that is agreed upon, you own the house when the term of the loan is up. If you do not keep up with the payments, whether you can afford to or not, the contract specifies that the bank can and will reposess the house. Now, there are a number of other steps that can separate the latter option (like renegotiation, short-sales, etc.), but exclusively speaking, the contract is still being fulfilled. The banks see each loan as a business investment, and they hold to their portions of the agreement: they provide the capital to buy the home in the hopes that they make money on the interest, and if the loan sours, they take back the house, as agreed in the mortgage. If the banks can view this as a purely business transaction, why is it so wrong for a person to view it the same way?

    Not that I think everyone should mail in the keys for their underwater houses (I currently have 2 of them and am keeping them), but sometimes it makes more financial sense to cut your losses and move on(to a rental).

    • 24

      Len Penzo says

      I agree that it probably makes financial sense for those who s-default. I also agree it technically doesn’t violate the terms of the contract. The question is, is that behavior good for the viability of the housing market — and society — in the long-run? (Especially if everybody decided to behave that way.) I am certain the answer is no.

      • 25

        says

        It’s probably “good behavior” if everyone “strategically defaults” and “clears the market” almost at the same time. The problem with the housing market is that it takes time to “clear”. First, we deny things. We say it will “rebound in 2 quarters”. Sellers refuse to lower their prices. Then when people start to get realistic, it is 6 or 7 years since the “pop in the bubble”. That is why most real estate market goes in 10 year cycles.

        To compound the problem, we gave home owners incentives (remember the first time tax credit), which spurred sales, but front loaded them and prevented the adjustments.

        If you care to study the Hong Kong real estate, you will realize that prices fall quickly 50% in 2 years. But the recovery is just as dramatic…

        So whether someone wants to “strategically default” and face the consequences of crap credit, or face foreclosure, the relevant thing is that the process has to facilitate this so the markets can clear and move on.

  9. 26

    says

    I thought all that matters is not what’s right but what’s legal, right? I mean, that’s what our politicians resort to every time they’re in trouble, no? “but it wasn’t illegal”. These are the leaders we elect and look at their behavior.

    The strategic default phenomena is pretty disturbing and I suspect we wouldn’t have seen this (OK, we DIDN’T see this) in prior generations. We’ve changed as a culture.

    • 27

      Len Penzo says

      I agree, Darwin. The culture has changed somewhat, but I think it can be reversed if we start speaking out more and explaining our position.

  10. 28

    MikeJ says

    You can’t be serious, talking morals and banks in the same sentence. What is moral about taking hard earned tax money to keep from going out of business then doing nothing to help those same people who it was taken from in the first place. Then only after they get another pay off do they even begin to do the right thing, and it turns out that they don’t even know who really owns the mortgage so they start forging documents. What is moral about cranking up the printing press so they pay back their obligations with worthless dollars and in the process steal the value of my labor.
    In a mortgage the bank makes a bet that you will pay and gets the house back if you don’t, that’s the deal they sign into of their own free will. Why should I care if that house is now worth less then it was. They make the same kind of bets with automobiles and they know that they have already lost value when they leave the sales lot. What about commercial loans? There has also been a firestorm of defaults on those too but no body makes it a moral issue because it is just business. What’s the difference?
    I strive to pay my obligations because I believe it is the right thing to do and think others should too but that is what contracts are for.
    I had paid off my mortgage a year or so before the mess began so as long as I just want to stay in my house it doesn’t affect me that much. It only will if I wanted or needed to move.

    • 29

      Len Penzo says

      I’m very serious. I don’t like the banks’ behavior or the Fed’s unrelenting money printing any more than you do, Mike, but the old quid pro quo argument (i.e., banks are arguably immoral in their actions so therefore why can’t I?) is a weak one in my opinion. To me it makes no sense to compromise one’s integrity simply because they may perceive others do too. (Again, if everybody acted that way, our civil society would quickly become completely corrupt.) Furthermore, the banks aren’t the only ones abusing the taxpayer; I suspect the majority of mortgage holders also used the system to reduce their tax liabilities with the mortgage interest deduction before they decided to strategically skip out on their obligations.

      Now be honest; something tells me if most of your neighbors decided to s-default and that resulted in your neighborhood becoming a run-down slum — not to mention your home value falling by 80 percent — you’d be up in arms whether your house was paid for or not. Yes?

      I’m just thankful most people do believe that s-defaults are morally wrong, otherwise there would be a lot less opportunities out there for everyone, simply because the level of uncertainty and general distrust would greatly increase the cost of doing business for all of us.

  11. 30

    MikeJ says

    About my neighbors doing a s-default and that causing all the housing values to decline. That is unlikely because they would only be doing it AFTER their home has already lost a significant percentage of its value. I doubt anyone would walk away in a stable economy. Truth is we are only talking about this because of the inevitable correction of what can only be called unsustainable economic policies.

    Like you, I would hope that we as a nation have a certain moral core. If our main stream media is any indication, I am beginning to see a decline.

  12. 31

    says

    Buying a home is exactly what you have stated Len a roof over our heads. I think too many people forget that and focus on the money part to the exclusion of everything else. Strategic defaulting is in my view a cowardly way to go especially when you are able to maintain the payments because you did sign the dotted line and made a commitment. A lot of people buy cars brand new with a car loan and yet the minute you drive the car out of the lot it loses its value that you agreed to pay for, are we all supposed to start strategic defaulting in that situation as well. When you start walking away from your obligations your character is besmirched because you walked away. How are the rest of us to know you will honour a commitment when you show a past history of walking away from them!!

    • 32

      Len Penzo says

      Well said, Leisa! I know that is hard for a lot of people to wrap their heads around though. The “it’s just business” argument rings hollow with me.

  13. 33

    IrishRed says

    What Federal laws do you believe were passed over the past 30 years that reduced underwriting standards? Underwriting standards are set by lenders, not the Federal government. Fannie and Freddie, which did need to report to the Federal government, LOST market share throughout the 2000’s because they were required to hold underwriting standards at levels that made them uncompetitive with most originators.

    It seems incredible to me, given what we know today about the massive amounts of fraud that fueled all aspects of the home lending industry, that anyone can still believe that individuals have some kind of obligation to honor any contracts entered into over the past decade. In fact, I could argue that continuing to pay mortgages that were fraudulently originated, transferred and securitized is damaging to the economy because it just encourages more of the deplorable behavior that has already cost the American middle class so much.

    I don’t personally have a dog in this fight because our home is already paid off but I think anyone who feels any kind of obligation to the crooks and frauds who brought down the global economy is a fool, frankly.

    • 34

      Len Penzo says

      Yes, underwriting standards are set by the lenders.

      However, it was the federal government that put the loose-lending standards ball in motion with the passage of the Community Reinvestment Act of 1977 — that’s the law that pushed lenders into making loans to more people (read: people who couldn’t otherwise afford a home). It was also the federal government that liberalized lending standards (via the Federal Housing Administration). As for Fannie and Freddie — their reduced market share notwithstanding — it was the federal government that mandated affordable housing goals that they eagerly did their level best to make good on under the constant prodding of Congress.

      Yeah, the eye-for-an-eye screw-the-bankers-as-long-as-I-get-mine thing sounds like a great idea (I’m not big fans of them myself), but if everybody thought like that and followed up on their threats, then it would be the end of economy as we currently know it, and a big reduction in everyone’s standard of living — not to mention lots of civil unrest, if not outright societal collapse. To me, this is clearly a “greater good” issue.

  14. 35

    Guy says

    This is purely financial and the free market at work. This is how it should be working. Taking “morals” into it takes something that is objective (this is the financial markets at work) and makes it subjective (this is how we WANT the markets to work). When a bank gives a loan for a mortgage they build into the interest the risk of default (by taking the house as collateral and if your credit is bad upping the interest) and their profit margins. When your house is under-water it is in your best interest to walk away and default. The banks lost their bet. Sucks for them, but that is part of the market. I am not a charity and the banks have no right to guaranteed profits.

    >>”the lenders knew the risks involved.”
    Yes, they knew the risk of default. They didn’t care. That is their problem, not mine. Why should I care about them making bad bets?

    >>”True, some people will argue that folks who choose to strategically default selfishly undermine their neighbors’ home values in the process, but nobody is stopping those neighbors from strategically defaulting too if their home prices eventually fall further. Right?”
    Exactly. Each person can do what they think is in the best interest of themselves. You think it is worthwhile staying in your house and wait it out. Fine, do that. I think it is better to buy a different home while the housing market is depressed and default on my first house. That is the great thing about capitalism, what I do with my private property is my business and that many individuals acting in their own interest is beneficial to all.

    This seems asinine anyway since the banks got bailed out for their lending ways (government sanctioned or not isn’t relevant). So it isn’t like I am hurting them in anyway and I never signed a contract with my neighbor saying I would protect the value of their house so everything seems fine to me.

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