EquityScout.com :: Real Estate Investment Blog

WEDNESDAY, FEBRUARY 13, 2008

Moral minefield of foreclosure and bankruptcy

Mortgage payments are on the rise. Prices have collapsed. "I'm outta here."

Over on Money.com there’s an interesting piece on when is it ok to walk away from your mortgage, which reports on the deluge of homeowners who are upside down on their mortgages and are simply sending their housekeys back to the banks and walking away. "Jingle mail" they're calling it.

Well the idea was enough to push me into a state of moral indignation, thinking about the great American blame game and the general lack of accountability in our society.

But, having though about it a bit, I’m not sure so sure...

But look at it a different way. The rules of the game are clear: you sign, you get the house, you pay. And just like in sports, the penalties for violating the rules are clear as well; in this case, if you walk away you get a nasty-gram in your credit file.

The banks know this when they sign up homeowners. That’s why they charge higher interest rates on riskier loans – rates which they themselves set.

So perhaps my moral indignation was...a bit misplaced. And I think my opinion was changed a bit by reading some of the 1,000+ comments submitted by readers (and yes there are a lot of stupid comments in the mix as well – to be expected). Upside down borrowers who walk away stick it to the banks – and that in turn forces the banks to reevaluate their algorithms for evaluating risk. And that in turn forces them to get better at the game of offering competitive rates to creditworthy borrowers and also realize that peddling high-margin negative amortization loans isn’t good business in the long run.

So does a financially troubled homeowner have a moral obligation to keep paying the note on a property that suddenly has negative equity and a resetting ARM payment? What if the stress of making the payments threatens his marriage and/or pushes him towards bankruptcy?

So perhaps a homeowner who makes $50k per year and walks away from the $300k mortgage on a house now worth $250k that the bank financed for him using a zero down ARM is doing the system favor by sticking the bank with the loss and nudging it just a bit close to a sounder lending policy.

This isn't painless for the borrower, who sees his or her credit in tatters - but there is an argument that says that banks who make bad lending decisions deserve to get burned.

Thoughts?

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posted by: Chris Smith

Comments

KC Investments

February 13, 2008

05:37 PM

This is an excellent subject that I have danced around on the comments section of many different blogs. And I know from where you come.

Walking away from a loan should be based on what is best for the debtor. But it should also not be taken lightly. There was a promise to pay. There was a promise to maintain the house.

But on the other hand, banks know their risks and like Vegas usually win. An example I use is their unscrupulous marketing of college students for credit cards. These kids are financially undisciplined, inexperienced and without gainful employment.

The banks know, however, that if they get in too deep that mom or dad will probably bail them out in hopes to "save" their credit and teach them a lesson. It's all calculated to enslave a age group of people to debt that will help to support the shareholders of said bank.

So I feel your "moral obligation" argument and feel a tug that way myself. On the other hand I feel very little for the banks that didn't mind lording an 8.675% rate over a buyer of which they knew had little leverage.

Jay-Bird

February 14, 2008

11:09 AM

Thanks so much for the article, it has certainly given me food for thought...

John Huval

February 14, 2008

06:37 PM

The WSJ also ran an article entitled, "The Rise of the Mortgage Walkers", that discussed the debtor's walk-away risk. The law of large numbers may help mitigate the effects of foreclosure and bankruptcy for the credit-impaired, as noted in the article.

As for the propriety of the walkaways -- they're showing about the same level of ethical behavior as the lenders that closed the unaffordable and/or poorly documented loans.

While the walk-away phenomenon is getting lots of press, it's not entirely new. During the oil bust, lots of debtors walked away from their homes, both in Houston and my hometown of Lafayette, LA. When I arrived in Houston in 1988, there were some west-Houston neighborhoods rows of empty houses -- back then the walkaways didn't have jobs to pay for their mortgages.

Today's phenomenon appears different in one important aspect -- some walkaways may indeed be able to pay the mortgage, but choose not to once they've reached an upside down position. Speculators, in particular, don't have much incentive to bail out their failed investments with more cash or loan-mods. I expect that in the largest declining markets(CA,NV,AZ,FL), lenders will experience more walkaways -- they're going to pay for their loose-lending ways.

Christopher Smith

February 14, 2008

07:53 PM

John: Good observation. People forget that the mother of all real estate busts occurred in Texas and other oil rush markets back in the '80s - something I wrote about recently at http://www.equityscout.com/oil-and-real-estate. Interesting to note that the markets have reacted differently to $100 oil today than they did back in the day.

Chris: Good summary - "Walking away from a loan should be based on what is best for the debtor." I didn't realize that this was my view until I sat down and thought about the issue.

Mike-TWA

February 16, 2008

10:36 AM

Chris, I agree with your conclusion. There is just no moral component to this equation. Our law of 200 years tends to reflect that view. Unlike in the case of fraud, where the law imposes civil penalties (punitive damages) and criminal penalties (well, prison) to deter conduct that we regard as immoral, contracts have no equivalent. Contracts are enforceable by damages for breach purely to reflect the economics of the benefit of the bargain, but there is no additional penalty to deter breach of contract. No borrower owes their lender any moral obligation to pay any more than the lender owes the moral obligation to allow the borrower no to. The only immorality arises when one party to the contract can cause lawmakers to change the deal after the fact, as is happening now with foreclosure moratoria for late-pay borrowers, or in the past, with bankruptcy reform to "protect" Visa and Mastercard.

A borrower has no greater moral obligation to pay his mortgage (nor escape the contract consequences of failing to do so) than I do to voluntarily increase my mortgage payment to my lenders in their "time of need."

James Orr

February 22, 2008

12:45 PM

Whether it is right or wrong, our country seems to be moving toward more socialistic policies. It seems like if one person makes a questionable financial decision, shame on them. If a large enough group does, then all of us are expected to step up and help.

Joe Crose

February 23, 2008

02:28 AM

Ultimately the banks and lenders have a fiduciary responsibility to their shareholders. Many people who got loans the last three to five years would have never qualified five, ten and for sure twenty years ago. It is clear to me that lenders were happy to get 7.5% to 9% from a high credit risk borrowers. After all that is 300% what they were borrowing money for at overnight rates. Package the deals together and the goose that laid the golden egg arrived.

Years ago when I was struggling with the choice to walk away from a terrible loan on a mobile home or finish paying the loan a friend of mine looked me square in the eye and told me, “You shouldn’t feel bad about walking away. The bank had no business lending someone like you money. After all you never had the ability to pay them back with your earnings.”

Those were hard words from a friend. I continued paying until I sold it to someone for a four thousand dollar hit. The bank made money for years because I tried doing what I thought was the right thing. I know today I was wrong and my friend was correct. All the trained moneylenders knew exactly what they were doing. The problem is their greed overtook good judgment.

Credit card companies jacking up rates on people who pay onetime should be held accountable for their immoral and unethical practices. If it was not for the politicians having their palms filled with lobbyists money people could still walk away from credit card debt. How strange it is that bankruptcy laws changed to protect credit card companies from their horrible lending practices and a secured lender is left holding the bag. Just not enough power or money in the right places to get bailed out from their self created problem.

If some of the people I know were not so overburdened with credit card debt that will never be paid they could afford the increase of one or two percent to their mortgage. Congress should go back and reinstitute the old bankruptcy laws and let the market take care of its own poor practices.

Joe Crose
www.assistedproperties.com

Foolishin Florida

March 08, 2008

10:14 AM

Thanks for admitting that the banks share responsibility here, for making loans with 0% down, and then following that up with 2nd mortgages for inflated home values. I've been losing money all along, and they have been making it.

I need bankruptcy answers for people like me (investors who are losing money.) I about have no debt other than my home mortgage and several upside down investment properties, which I want to walk away from. Spouse and I make decent salaries, and probably could, with difficulty, continue to make the payments on these investments which were supposed to be "flipped" quickly but will not sell now.) If the properties go to foreclosure, and deficiency judgments are attached, will there be any relief with Chapter 13, or will I just have to pay back all the debt? Any suggestions?

Christopher Smith

March 08, 2008

12:10 PM

Foolish: Banks certainly are complicit in this mess - and they'll take a hit in the pocketbook from all of this non-performing debt.

I'm pretty sure, though, that solutions for underwater investors and speculators is not in the cards. Your options will be limited: walk away (and get foreclosed), declare bankruptcy, or continue to make payments in the hope that the market turns around (and save your credit).

There are variations on all of these themes so consult your local attorney/accountant - but it's clear that as the politicians focus on foreclosure relief they're focusing on homeowners - they're not going to be consdering speculators who hopped into the market to make a profit.

Not helpful counsel, perhaps, but I think that's the reality of the situation.

Discountproperty auction

March 10, 2008

04:37 PM

Mortgage is a good alternative for unpaid debts and for those people who want to make investments.

Thanks.

RealEstateInvestment Software

August 15, 2009

01:11 AM

I think the general consumer or even investor is getting a bad rep. Not all consumers have the idea to walk away from their mortgage. There are a great many who do try. Unfortunately the ones who do walk, walk BIG, causing more problems for everyone down the road.