In his must-read October 2009 paper “Underwater and Not Walking Away: Shame, Fear and the Social Management of the Housing Crisis“, Professor Brent T. White, of the University of Arizona, James E. Rogers College of Law, submits the case that homeowners should walk away from mortgage payments if their house is far enough “underwater” (mortgage debt is more than the house is worth). It’s not illegal, immoral (or fattening), despite what banks, government and others tell you. In fact, there can be financial benefits, if you do the math (especially in California, Florida, Arizona, Nevada).
And, if you default “strategically“, the punishment is bearable:
To be sure, foreclosure comes with costs, including a significant negative impact on one’s credit rating. But assuming one had otherwise good credit, and continues to meet other credit obligations, one can have a good credit rating again – meaning above 660 – within two years after a foreclosure. (emphasis added)…..
Additionally, in as little as three years, one can qualify for a federally-insured FHA loan to purchase another home….
…a few years of poor credit shouldn’t cost more than few thousand dollars
Here is an Abstract of the Paper:
Despite reports that homeowners are increasingly “walking away” from their mortgages, most homeowners continue to make their payments even when they are significantly underwater. This article suggests that most homeowners choose not to strategically default as a result of two emotional forces: 1) the desire to avoid the shame and guilt of foreclosure; and 2) exaggerated anxiety over foreclosure’s perceived consequences. Moreover, these emotional constraints are actively cultivated by the government and other social control agents in order to encourage homeowners to follow social and moral norms related to the honoring of financial obligations – and to ignore market and legal norms under which strategic default might be both viable and the wisest financial decision. Norms governing homeowner behavior stand in sharp contrast to norms governing lenders, who seek to maximize profits or minimize losses irrespective of concerns of morality or social responsibility. This norm asymmetry leads to distributional inequalities in which individual homeowners shoulder a disproportionate burden from the housing collapse.
Some crib notes:
- underwater homeowners aren’t knowingly making bad choices, they just can’t cognitively grasp that they would be better off if they walked away from their mortgages.
- credit rating agencies play a central role as enforcers of moral and social norms against walking away from one’s mortgage.
- the consequences of foreclosure are, in actuality, much less severe than most homeowners have been led to believe.
- lenders have generally resisted calls to modify underwater mortgages despite the fact that it would be both socially beneficial and morally responsible for them to do so.
- As of June 2009, more than 32% of all mortgaged properties in the U.S. were “underwater”. This percentage is expected to increase to 48% by the first quarter of 2011.
- the percentage of underwater mortgages is higher still if one isolates the hardest hit metropolitan areas
- the vast majority of defaults have involved subprime or Alt-A loans– with over 47 percent of subprime loans non-performing as of the second quarter of 2009. In contrast, the combined default rate for prime loans was only 5.44 percent.
- rent v. buy: As a rule of thumb, a potential homebuyer is generally better off renting when the home price exceeds 15 or 16 times the annual rent for comparable homes.
- The most significant financial risk from a foreclosure is the risk of a deficiency judgment or, in the alternative, tax liability for the unsatisfied portion of one’s loan upon foreclosure. [But not all states allow banks to come after the homeowner for a deficiency judgment]
- Homeowners refuse to default to save money because of what behavioral economists call the status quo bias.. selective perception.. and emotional bias
- recent work of Luigi Guiso, Paola Sapienza, and Luigi Zingales found that 81% of homeowners believe that it is immoral to default on a mortgage
- another powerful emotion that may be keeping homeowners from defaulting: fear. People not only fear losing their homes, but fear having ruined credit for life, not be able to find a decent place to live, to buy a car, to get a credit card, to get insurance, to ever buy a house, or even get a job.
- buyers have a contractual right [option?] to default
The Social Control Agents Cultivate Homeowners’ Fear
Banks, government, and credit institutions cultivate feelings of guilt, immorality and fear to keep homeowners from defaulting, fearing a foreclosure tipping point. But while the government offers programs to make payments affordable, banks are lax in modifying loans and thus help keep payments unaffordable– which will encourage folks to walk away from underwater homes.
Folks have suggested this bank non-modification behavior is contrary to their own self-interest in getting paid over losing money on foreclosed homes. Others say it is greed and knowledge of human nature. They know creditworthy folks won’t default for fear of the whack on their credit score– now a measure of pride, social status, and self-worth. Banks often tell homeowners to default, before they will entertain the thought of a modification— a clever test to see if the homeowner will do it– most don’t. And if they do default, the banks point out their credit score drop makes a loan mod undoable. Catch-22.
Strategic Default
White advises homeowners who can save a lot of money by walking on the mortgage to default “strategically” before bailing on the current mortgage:
….one who plans to strategically default can take steps to minimize even this marginal cost [of poor credit for 2 years]. For example, one could purchase a new vehicle, secure a new home to rent, or even purchase a new house before beginning the process of defaulting on one’s mortgage.
While the greatest financial risk is a deficiency judgment against the homeowner, it is not across the board. In anti-deficiency, non-recourse, states like California and Arizona, mortgage lenders have limited or no legal rights to pursue defaulting homeowners’ assets beyond the house itself, if the home is the primary residence, Prof. White writes. In other states, lenders may decide it’s not worth the legal expense (and headache) to pursue walkaways. Besides, consumers may be able to find flaws in the mortgage note or lending documents, disclosures or underwriting to challenge the original contract.
How Much Can You Save from Walking Away?
It depends on how far underwater you are. On page 11, White gives an amazing example of the “financial benefit” from walking away from a house well “underwater”:
(Sam & Chris) they still owe about $560,000 on their home, now only worth $187,000. A similar house around the corner from Sam and Chris recently listed for $179,000, which, with a modest 5% down, would translate to a total monthly payment of less than $1200 per month – as compared to the $4300that they currently pay. They could rent a similar house in the neighborhood for about $1000.
Assuming they intend to stay in their home ten years, Sam and Chris would save approximately $340,000 by walking away including a monthly savings of at least $1700 on rent verses mortgage payments, even after factoring in the mortgage interest tax reduction. The financial gain for Sam and Chris from walking away would be even more substantial if they took their monthly savings and put it into an investment account. If they stay in their home on the other hand, it will take Sam and Chris over 60 years just to recover their equity – assuming, of course, that they live that long, the market in Salinas has indeed hit bottom, and their home appreciates at the historical appreciation rate of 3.5%.
Wow.
This 54 page paper is well worth a read. You might share it with a client whose bank has not agreed to a loan modification, along with the names and phone numbers of a lawyer and accountant — to explain the law and do the number crunching on a walkaway. Will anyone dare share this option with their clients?
Related Post:
What Banks Will Not Tell You: You Might Not Be Liable if You Walk Away From Your Mortgage.
