The Ethics Of, and Response To, "Strategic Default" (part I)

My reflections on this topic ended up being far too long for a single blog post, so I’ve divided it into three for easier reading. I’ll post them over the next three days).

Part I: Strategic Default: What is it, and why would anyone consider doing it?

Banks, once the paradigm case of fiduciary responsibility, have taken quite a reputational hit in the past half-decade. Where once the banker was the very stereotype of responsible, conservative financial management, whom you’d trust with your money more than you’d trust yourself, many people now see banks as just one more institution interested in nothing more than taking your money from you. While this is a broad generalization, it’s not without some basis in fact. Mortgage lenders and mortgage brokers, particularly, played a substantial role in the current financial crisis. However, an emerging trend called “strategic default,” where homeowners who are capable of repaying loans walk away from their homes because of a drop in investment value, takes unfair advantage of this perception and could possibly endanger the entire home loan ecosystem. Because of the recent reputation of dirty-dealing in lending, though, banks need to very careful in how they analyze and respond to this trend.
Strategic default, as it has come to be known, is when a homeowner who has the means to pay his or her mortgage stops paying their mortgage and allows the bank to foreclose. For example, let’s say a family took out a $400,000 loan in 2005 to buy a house at the peak of the market. They were able to pay the loan at the time and it is still within their means to do so. But let’s further assume that the value of the house, should they sell it today, would be $250,000 (a drop that would be entirely likely in some parts of California). The “strategic” defaulter, seeing that they have $-150,000 in equity, decides that letting the bank have the house and taking the 7 to 10 year hit on his or her credit is worth the $150,000. They know it would probably be 7 to 10 years before they recover the original value of the house, to say nothing of the thousands payed in interest.
Looked at from a purely financial point of view, it’s easy to see their point. Let’s look at the math. In May 2005, the average interest rate for a 30 year fixed rate mortgage was 5.75. Let’s use the following assumptions:
House price: $420,000
Down payment (5%): $20,000
PMI: .5%
Taxes: 1.25%
Current value: $250,000
Rate of return for the next 10 years: 4%
A homeowner would be likely to analyse his or her cost benefit analysis as follows:
The value of the house at the end of the period: $370,000
Total payments: $418,000
Investment value $-48,000
It should be pointed out that this isn’t a very sophisticated way of doing a cost benefit analysis, but I think it is pretty close to the intuitive way people think about their housing investment. A good CBA would consider the pre-2010 payments sunk costs, take into consideration the value of housing for that period, and would include transaction and opportunity costs, etc. But still, I suspect it’s this sort of analysis that leads people to walk away from their homes. They think that for the $418,000 of payments they will have made, a $48,000 loss is a pretty bad return. And who could blame them for thinking that? But a mortgage is not just a financial, but a legal and ethical transaction, as well.
While there has likely always been a small percentage of homeowners who default on their loans for investment reasons, this number has remained small for few reasons. First, since the early 90s, the real estate market has almost always been a good investment. Over that period, there was never a period where the overall market dropped ( see graph for illustration of this phenomenon). Second, homeownership has traditionally held an exalted place in the American psyche and there has always been a good deal of social pressure to own a home among the middle and upper classes. Finally, in a another manifestation of social pressure, anyone who walked away from a home for purely financial reasons would be ostracized as a thief or, at the very least, a deadbeat.
The 20-40% market drop, in some places more, removed the investment incentive. While this has happened before, however, and there was not a wholesale abandonment of homes. The primary difference is that the fallen reputation of banks has provided a sort of excuse for people who would otherwise have been ashamed to walk away from their homes. The assumption of superior ethical standing has moved from the lenders to the borrowers. Now a person who is foreclosed upon is seen as a victim rather than a perpetrator, regardless of the actual circumstances of th default.
(Tomorrow: Risk and Consequences)

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