Tuesday, May 11, 2010

Strategic Default

In the end, it amounts to a contract. Most mortgages say, in essence, if you make your payments you can keep the house. If you don’t, it’s ours. If it works out the way the lender hopes it does, they make a ton of money, you get an appreciating asset, and a place to live and store your stuff.

But these days, when a house is often a depreciating asset, more and more people are fulfilling the mortgage contract in a different way: turning the keys back over to the lender and walking away. Many of the people who are doing this can afford the monthly payment; they’ve just decided the contract is far too favorable to the lender, and are willing to take the “hit” on their credit for a few years, give up their equity (if any), and walk away.

Veteran newsman Morely Safer did his best Sunday night on 60 Minutes to shame a few people he found who are walking away from their mortgage, but he really didn’t succeed. He even dragged out that old saw about “back in the depression, when people lost their house, it was a mark of shame”.

Big difference between “losing” your house and walking away from your mortgage, Morely.

And the depression Mr. Safer was referring to was 80 years ago, not the one we’re in now.

Remember the first time you ever “closed” on a house? If you’re like a lot of folks, you were probably in your late 20’s, married, tired of renting, had saved up for a decent down payment, and when you looked at how much money you’d actually be paying the lender over the term of your mortgage (usually 30 years), it probably staggered you. You’d actually be paying for the house twice or three times over.

The lender made a huge amount of money, and you owned a hugely appreciating asset.

In 1962, my parents built the big 5-bedroom colonial ranch-style house our family grew up in, for 28 thousand bucks. Dad borrowed 25 grand at 1.875% over 30 years. He paid off the mortgage early, and in 1987 sold that home for well over a hundred grand to buy the smaller “retirement” home on the lake. They paid cash for the lake home – no mortgage.

That’s the way it used to work.

The last few years have changed that model dramatically. Liar’s loans, zero down payments, inflated prices, housing bubbles, collateralized debt obligations and credit default swaps have changed the model.

Every couple that Safer interviewed for his 60 Minutes piece said they’d tried to work with the lender to strike a new deal, but the lenders refused, saying the borrowers were “able to make the current payment”. I’d call that greed on the lender’s part, and they’re now about to reap the harvest of their greed.

When you strip the emotion from buying a house – which is practically impossible – you’re left with a business deal. Business deals revolve around contracts and terms. Those who have chosen strategic default, and can afford to live with the impact it will have on their credit for a few years, have interpreted home ownership in its essence: a contract.

As the lenders are learning, the terms of the deal can work in ways they didn’t bank on.


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  3. Banks routinely cut their losses and walk away from bad deals. If there was embarrassment in that the bankers would have died of shame years ago.

    Defaulting on a home mortgage is no different. The would-be homeowner pays the agreed-upon penalty - loss of the property and all money invested up to that point. That's pretty steep, and nobody takes the step lightly.

    Platitudes apply: If you find yourself in a deep hole, stop digging. Get out while the getting is good.
    BTW ... Please add my name to the list of folks who find the reverse-type effect difficult to read.

  4. Hier's correct on the 'difficult to read' observation.

    And the depression Mr. Safer was referring to was 80 years ago, not the one we’re in now.

    ....when Morley was 22 years old....