Strategic default. When a Wall Street firm does it, it’s just business; when an underwater homeowner does it, it’s morally repugnant and irresponsible. What’s wrong with this picture? Roger Lowenstein, writing for the New York Times, opines that there’s no difference and that the government should stop trying to scare the pants off delinquent homeowners and get to work forcing Wall Street to modify these fraudulent loans. It would be in the best interest of those deeply underwater on mortgages to simply walk away from them.
What Lowenstein doesn’t say is that it’s well past time for Wall Street to write down their losses on these bad bets.
Strategic default is actively choosing not to pay an underwater mortgage—the condition where more is owed on the mortgaged property than the property is worth. Lowenstein estimates that’s 10.7 million properties in the United States including 65% of all residential mortgages in Nevada. That’s nearly 25% of all US mortgages.
Businesses use strategic default as an accepted practice. Lowenstein reports that Morgan Stanley “recently decided to stop making payments on five San Francisco office buildings.” No one considers such actions to be irresponsible or morally wrong. Yet when a homeowner buys a US$800,000 home with no money down at the height of the housing bubble and that property devalues to US$150,000, he’s considered a—wait for it—speculator. That’s what former Treasury Secretary Henry Paulson Jr. said: “Any homeowner who can afford his mortgage payment but chooses to walk away from an underwater property is simply a speculator—and one who is not honoring his obligation.” One has to wonder, as Lowenstein points out, just how much speculation and failure to honor obligations Paulson was responsible for during his 32-year tenure at Goldman Sachs.
Lowenstein opines that merely the possibility of mass strategic defaults by consumers might “unstick” the financial system. “If lenders feared an avalanche of strategic defaults, the would have an incentive to renegotiate loan terms,” Lowenstein writes. “In theory, this could produce a wave of loan modifications—the very goal the Treasury has been pursuing to end the crisis.”
If the loan modifications include forcing the banks to reduce mortgage principals and write down the loss of the bad loan—without reimbursement as proposed by the Obama administration—it may work for some percentage of those with underwater mortgages. But such a program does absolutely nothing for those with underwater mortgages and over their heads in homes they simply can’t afford. The Obama administration’s US$75 billion program to avoid foreclosures has been an abject failure. Michael Powell, writing for the New York Times reported on December 29, 2009 that “[l]enders have accepted more than one million applications and cut three-month trial deals with 759,000 homeowners. But they have converted just 31,000 of those to permanent new mortgages….”
Powell reports the story of Jaimie Smith of Lakeland, FL. Smith’s employer lowered her bonus and she approached Chase about a loan modification. Last April, Chase lowered her payment by about US$200 per month on a three month trial basis. Powell reports that Smith “made all three payments on time and submitted required documents, Chase confirms. She called the bank almost weekly to inquire about a permanent loan modification. Each time, she says, Chase told her to continue making trial payments and await word on a permanent modification.” Last October, Chase foreclosed on Smith’s home and sold it to itself at auction for US$100, Powell reports.
We’re learning, yet again, that change comes only through massive, concerted nonviolent public action. Maybe Lowenstein is correct and Wall Street will be scared into positive action on those who can be helped by the actions of those who can’t.
Update Sunday, 24 January 2010 10:21AM CST: The New York Times hammers away again at it being in the best interest of those underwater on their mortgages to simply walk away from them in Richard H. Thaler’s “Underwater, but Will They Leave the Pool?” Thaler reports underwater homeowners feel moral pressure not to default from the likes of former Treasury Secretary Henry Paulson Jr.: When Paulson was in office he said that “anyone who walked away from a mortgage would be ‘simply a speculator—and one who is not honoring his obligation.’” Pretty rich coming from a former investment banker and one of those driving when the US and global economies came dangerously close to the brink.
University of Arizona’s Brent White says underwater homeowners are suffering from a “norm asymmetry.” They feel a moral obligation while banks do not. Thaler sums it up nicely:
“That norm might have been appropriate when the lender was the local banker. More commonly these days, however, the loan was initiated by an aggressive mortgage broker who maximized his fees at the expense of the borrower’s costs, while the debt was packaged and sold to investors who bought mortgage-backed securities in the hope of earning high returns, using models that predicted possible default rates.”
Thaler points out that in states where mortgages are nonrecouse loans—loans where the mortgage is secured by the property itself, not the borrower’s other assets—borrower’s pay a hidden US$800 for each US$100,000 borrowed for the right to walk away from their mortgages.
The banks remain steadfast in their reluctance to renegotiate mortgages. Thaler speculates that the phenomenon of strategic default will only grow.
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