According to RealtyTrac, nearly 3 million foreclosures were filed in 2009. And with almost 10 percent of all mortgages now delinquent nationally, those homeowners are faced with a painful decision: Continue to make payments even if they are underwater, or do a “strategic default.” 

In January, 2006, a young professional couple with two children bought a three-bedroom home in Salinas, California, for $585,000.  With excellent credit, they signed the papers for a no-money-down, 30-year, fixed-rate mortgage, with payments of $4,300 a month. Today, the balance they owe is $560,000, but the present market value of their home is estimated to be about $187,000. Here is their dilemma: They made a promise, and signed on the dotted line, fully expecting to make timely payments over the term of the loan. But there is a home for rent just down the street with payments of just $1,000 a month.  

When they do the math, the outlook is not promising. Even if housing prices rise at 5 percent a year, starting today (assuming that housing prices have found a bottom — a highly optimistic assumption), it would take many years for them just to break even on the investment in their home.  

Brent White, a law professor at the University of Arizona, explains their situation this way:

Assuming they intend to stay in their home ten years, [the homeowners] would save approximately $340,000 by walking away, including a monthly savings of at least $1,700 on rent verses mortgage payments, even after factoring in the mortgage interest tax reduction. If they stay in their home, on the other hand, it will take [the homeowners] over 60 years just to recover their equity — assuming, of course, that they live that long.

A strategic default is sometimes called “jingle mail,” where the house keys are simply mailed to the bank holding the mortgage. But an increasing number of people are taking the default strategy to the next level, stopping making payments but continuing to live in the house until the bank kicks them out. The foreclosure process, as discussed here, can take as long as a year, during which the savings between renting and making mortgage payments could be put aside as a down payment on another home with better prospects. A study by Experian and Wyman estimated that nearly one in five homeowners holding underwater mortgages is strategically defaulting.  

There are consequences, of course, including damage to the homeowners’ credit score. A new mortgage will be denied for at least 3 years (FHA) to 5 years (FNMA). And when the foreclosure takes place, there’s a good chance that the mortgage is “recourse,” giving the bank the opportunity to try to get back some of the money owed to them. And the IRS is involved, too, of course, because the difference between the value of the home at the time of foreclosure and the amount owing is considered to be ordinary income and subject to income tax as “debt forgiven.” At present, however, the Mortgage Forgiveness Debt Relief Act has granted a window lasting through December of 2012 that such “phantom income” will not be subject to tax.  

Several commentators are holding that such defaults are the right and proper thing to do. A writer for the Wall Street Journal said, “You shouldn’t feel bad [sic] about it, and you shouldn’t feel guilty. The lenders would do the same to you – in a heartbeat.  You need to put yourself and your family’s finances first.”  He goes on:  “Stop trying to chase your lost equity. That money is gone. Don’t think like the gambler who blows more and more cash trying to win back his losses. That’s how a lot of people turn a small loss into a big one…If you are reluctant to give up ‘your’ home, realize that it isn’t ‘yours’. If you are in negative equity, it’s the bank’s home. You’re just renting it…You need to be ruthless about your cash flow…walking away from debts is as American as apple pie.”  

Highly publicized “walkaways” like Tishman Speyer and BlackRock walking away from their apartment complex, Stuyvesant Town and Peter Cooper Village in Manhattan, appear to support such conclusions. They bought the property for $5.4 billion at the height of the real estate boom in New York City, and today it’s worth about $2 billion. They tried to refinance the project with no success. They said, “The only viable alternative to bankruptcy would be to transfer control and operation of the property … to the lenders…”

There is the moral or ethical side of the decision. In January, CNBC said, “Some folks argue that home mortgage walkaways are destroying the housing market by pushing up the number of foreclosures, which in turn drive down the values of the homes around them.”  Continuing pressures from those foreclosures would “push more homeowners into negative territory, leading to still more defaults,” according to Luigi Zingales, professor at the University of Chicago.

Zingales also points out that “as more strategic defaults occurred, the social stigma associated with them would lessen…every time a borrower defaults, moreover, he makes future mortgages more expensive… This higher cost and reduced availability of credit would depress house prices even more, jeopardizing the possibility of an economic recovery.” George Brenkert, professor of business eithics at Georgetown University, says borrowers “do have a moral responsibility to keep paying.” When reminded about the Stuyvesant project default, Brenkert said, “The fact that we recognize that [others are defaulting] doesn’t make it the right thing to [do].” Kevin Jackson, another professor of business ethics, notes that the homeowner must also consider the needs of his family. “The homeowner is holding onto a failing investment [but] he also has an obligation to himself and to his family to cut his losses as best he can.”  

And there it is:  Government intervention in the marketplace continues to reverberate through the economy and is now eating away at the vital moral structure of society on which the economy rests. By forcing homeowners to choose, many will not “choose the narrow way” but will walk away instead.  

Photo: AP Images

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jc said:

	Is this a real example, down 70% since 2006? Is the current value of $187K based on an anticipated distress sale at foreclosure or is this the current appraised value? Down 70% in 50 months, is Salinas the worst RE market in the universe? It seems impossible. If CA RE markets are down this much what happens when ARMs must be refinanced in big numbers the next 2 years? Down 90-95%?
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April 08, 2010
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Patriot1776 said:

... Under normal circumstances I would agree with the author that "walking away" would be immoral but these are not normal circumstances. We live under a debt as money system where banks create money out of nothing and the loan it to people at interest. It's an impossible situation and the problem is the corrupt laws and Federal Reserve that enable this scheme. The American people are the victims here.

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April 08, 2010
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rprew said:

Stupidity $4300 per month? Assuming that is PITI (principal-interest-taxes-insurance), and adding in cost of utilities (electric, gas, water, sewer, cable, telephone, waste pickup) at a very conservative $300 per month, that comes to $55,200 per year for housing expense. Traditional wisdom dictates that a family should spend 30-36% of its income for housing, this family would need a income of AT LEAST $165,000 per year to justify having this home. If after 4 years they still owe $560,000 on a $585,000 home, they would have bought the house for about 4% down. Again, traditional wisdom dictates that the minimum down payment should be at least 10%, and 20% would be much more reasonable. I'm sorry, but lack of planning on your part does not constitute an emergency on my part. You made your bed... now sleep in it. The people I feel sorry for are the ones who have played the game fairly (20% down, total housing costs (payments, utilities, taxes, insurance) of about 1/3 of their income, but lose their job because it could be done cheaper in China.

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April 09, 2010
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Money Matters said:

... Patriot1776 puts it well. The issue at heart is the fact that banks create loan monies out of thin air. In defaults, they lose nothing but are merely denied further interest payments. For defaults to be a moral issue, someone has to lose something they worked for. A personal loan made by someone who earned the money from a 40-hour work week represents labor value. In defaulting, the borrower denies the lender of his labor value. Therefore, it is a moral obligation to repay. Bank loans are funded by keystroke so defaults deny no one of his labor's value. Therefore, there is no moral obligation to repay, only a legal one.

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April 09, 2010
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CAS said:

... Yes JC it is possible in CA to lose that much. I live in Patterson CA and bought a 440k house with a 360k mortgage in 2006. It is now worth 175k, but even at that price homes aren't selling. Homes in the 130-140k range are. The only reason prices were so high back then is because the banks lent money to who ever they could, they never verified anything. People were buying and putting houses back on the market without even living in them and making a profit. Massive amounts of mortgage fraud and greed. Of course no one has been brought to justice and I'm left holding the bag and paying for it. The banks have been bailed out and are back to paying huge bonuses and making profit. As far as I'm concerned if this new "hamp" program doesn't lower the value of my home to its current market value then I will also walk away. I have little hope that the program will work. Iam sure they will say I make too much money of find some other bs reason to deny me. Ive talked to my family and co-workers about all of this and everyone understands our situation and is supportive. Ive been working and paying taxes since I was 15, for 27 years, and Im disgusted with how f'ed up this country has become, so if you dont like the strategic default you can kiss my tax paying a$$. Until you find yourself in this situation you will never understand how f'ed up it is.

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April 10, 2010
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