Understanding Strategic Defaults
Popular opinion and personal viewpoints are mutually exclusive ideas. There are times when the two overlap but a true personal perspective is driven by real life, personal circumstances and is not always at the behest of popular or even rational thought.
Popular opinion relates to generalities. As a framework, what moral guidelines should we follow as a society to establish order and maintain peaceful coexistence? Personal views tell us if, in the heat of the moment, with the additional emotional burden of personal experience added to the situation, our answer would be the same?
The issue of Strategic Defaults creates such a moral dilemma. Most agree that it is morally reprehensible to blatantly disregard commitments or contracts. Regardless of whether it's a nickel on the playground or a million dollars in the boardroom our social contract is that both parties are bonded by trust and an expectation that each will follow through on their pledge. To that end most would generally agree that Strategic Defaults are wrong.
But what if it were you? What if you came to realize similar behavior was acceptable from someone other than you? What if your choice directly impacted the comfort and well being of your children? What if walking away from an upside down mortgage was socially acceptable? How would you decide what to do?
Calculated Risk - Why Banks Lend
Let's first consider why banks lend at all. Business. They want to make money. Simply put they have identified a need in the market (capital) and have devised a way to benefit (profit) by delivering their product (money) to the marketplace. They provide a fundamental service to our capitalistic system and without it we would fail.
If you were to buy any type of real estate other than your primary residence you would notice that your lender would require a larger down payment and likely charge you a higher interest rate. The reason for relaxed standards when buying your primary residence is two-fold. First, the federal government has decided that widespread homeownership is a social benefit to society. Second, the banks understand that shelter is a basic need. Thus if things go bad, you are less likely to walk away from your home than any other real estate asset.
Throughout most times in recent history, banks would not lend to everyone. Interest rates were related to the banks cost of funds, and a borrowers credit worthiness. However in the past decade lenders threw caution to wind. Loans were given to borrowers without requiring proof or documentation supporting the stated income on their loan applications and haphazard policies were in place to insure the banks were lending against collateral that could support the loan. Unadulterated appreciation is the elixir that makes every loan look safe, every investor look like a genius, and allows every homeowner to feel safe in their decision to pay just a little bit more than they could afford.
In moderation these cycles of growth do no harm and are always followed by periods contraction allowing market fundamentals to catch up with values. However unabated for too long, we find ourselves unable to absorb losses without devastating impacts across the economy. Someone is always left holding the bag. From the banking perspective, good banks absorb bad banks, certain lending practices come to an end, losses are taken and passed along to shareholders or the taxpayers, and the whole cycle of calculated risk is started again.
Taking the Loss - When it's Time to Walk Away
In the business world knowing when to cut your losses is not just an admirable trait, it is critical for survival. From the smallest start up to the largest conglomerate the idea of not throwing good money after bad is commonly followed and the primary determinant of success or failure.
In his article, "The Way We Live Now, Walk Away From Your Mortgage" New York Times columnist, Roger Lowenstein cited several good examples of this practice. From private equity firms deciding it's a better financial decision to close the factory than keep it running, hedge fund managers leaving to start fresh with new funds and new investors after their existing investments turn sour, Sam Zell allowing the Tribune Company to file for bankruptcy, to banks themselves deciding to complete strategic defaults when their own real estate investments go bad.
In another recent article for Bloomberg News, Dan Levy quotes Morgan Stanley spokeswoman Alyson Barnes describing an "orderly transfer" of five San Francisco office buildings the bank purchased at the height of the market; they paid $6.7 billion in 2007. Ms. Barnes goes on to explain "This isn't a default or foreclosure situation," rather she suggests "We are going to give them the properties to get out of the loan obligation." Doesn't that sound just like a strategic default?
This bank practice of cutting losses and maximizing returns is not limited to commercial investments. This past Friday I had to personally inform one of my clients that the bank felt it was in their financial interest to foreclose rather than allow a short sale on their personal residence. I presented Litton Loan Servicing with an all cash offer, which would have allowed for a full payoff of the first trust deed on which they were foreclosing. I requested an extension so my client could negotiate with the lender on the 2nd and 3rd trust deeds. I explained that the seller was willing to sign a promissory note with the second to avoid the foreclosure and further clarified the non-contingent; all cash offer would fully satisfy the debt owed to Litton Loan Servicing.
Their response: It's in our financial best interest to foreclose on this property. Tell your investor to go to the court steps and buy it there.
Artificial Support - The Consequences of a Bailout
In a recent policy white paper published by Luigi Zingales, along with colleagues Paola Sapienza, and Luigi Guiso, the trio asserted their belief that a public policy aimed at helping people in arrears with their mortgages could have devastating effects on the incentives to strategically default of people who can afford to pay their mortgage if it is perceived to bail out people unjustly and thus undermine the moral commitment to pay.
They point to moral norms in society, which prevent people from defaulting in most circumstances but caution that "the effectiveness of moral rules, in turn, may be affected by economic policies that may undermine a sense of fairness."
The Kellog School paper by Mr. Zingales, et. al was followed by another white paper from University of Arizona professor Brent T. White, suggesting that many homeowners continue to make payments even when they are significantly underwater, not because it's in their financial best interest, rather because of social impacts like fear, shame and exaggerated anxiety over the perceived consequences of foreclosure. Mr. White goes on to suggest that government policies and other "social control agents" encourage homeowners to stay in potentially bad financial situations. He states, "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" (see my two examples above).
So how can we seek to work through the estimated $4 Trillion in excess housing debt encumbering residential property across the nation? Clearly, the burden cannot be placed solely on the shoulders of the borrowers without risking a backlash when it's no longer socially taboo to default on your mortgage. Equally, allowing the banking system to collapse by forcing the full load upon them would have far reaching consequences from which it could be difficult to recover.
Band aid approaches and government programs that do not address the root of the problem simply prolong the pain and unequally distribute the relief by placing income limits on participation and targeting only those who have already defaulted on their obligations.
Clearly, we will not see a full housing recovery until the majority of excess debt is removed from the system. Loan modifications, short sales, deeds in lieu, and foreclosure are the four most common ways to deal with the problem. The most devastating and costly impact on everyone results from a foreclosure. Short sales are a viable alternative for some but still force owners to leave their homes. Further, banks continue to treat the process as a temporary menace remaining understaffed and inconsistent in their policies and procedures; deed in lieu even more so.
Loan modifications simply don't work without including a principal reduction, so far an elusive task for both the government and banks. Even Barney Frank who has long pushed for "cram down" legislation forcing banks to write down principal balances with the help of bankruptcy court judges realizes this is an unrealistic possibility. Yet, the New York Fed, in a December staff report No. 417, recognized that loan modifications that reduce loan balances are far less likely to re-default.
Nick Timiraos at the Wall Street Journal highlighted this point in a piece he wrote last week. In his article he refers to the fed study noting, "modifications that write down loan balances can double the reduction in re-default rates achieved by payment reductions alone."
If we are to keep people in their homes and/or avoid mass foreclosures, we must make short sales more efficient and reduce principal loan balances as part of the loan modification process.
The Fallout - Less Credit, Tighter Standards
All of this will clearly come at a cost to the American borrower and taxpayer. Business concerns burned once typically learn from mistakes and seek to avoid such pitfalls in the future. If borrowers who can still make their mortgage payments "strategically default" because it's in their financial best interest, we can all be assured that qualifying for loans will be more difficult in the future and costs will be far greater.
In light of our current circumstance, I don't see too many no-documentation, negative amortization, 100 percent loan to value loans in our immediate future. Ultimately fewer Americans will be able to achieve the dream of owning their own home and will remain renters. Additionally, fewer lenders will be around to provide loans for the masses.
Another possibility is that fewer borrowers will attempt to fit a square peg into a round whole. What I mean by that is, if a borrower's income cannot support buying in a market they desire, perhaps they will consider seeking a purchase in an area that fits their budget rather than "fibbing" on their loan application and getting in over their heads to stay local. Perhaps house values won't rise beyond reason and without support from the sound economic principles. Finally, perhaps banks will become more financially sound and make more prudent decisions, reducing their risks and ultimately providing good loan products to capable borrowers. That doesn't sound too bad.
We all learned on the school playground that we should honor our promises. Currently, most people still see strategic defaults as morally reprehensible, but I wonder for how long? It seems not too long ago short sales were a foreign and unacceptable concept. Regardless, as some of our banking leaders suggest, sometimes an orderly transfer is warranted to get out of a loan obligation and sometimes it's simply in our financial best interests to let a home go to foreclosure.