Still Considering Strategic Defaults

I received an email this weekend from a reader asking about the effectiveness of strategic defaults. Even though this has been long debated, the continued weakness in housing has kept the discussion alive. The reader posed a scenario that many are facing today: “Consider a family whose home is worth less than 50 percent today than when they bought it. They believe that the house will never recover to the value it was in 2007. If they walk away now they reduce their losses to their downpayment. They would also save the mortgage payments for the 6-9 months it would take the financial institution to take possession of the house. The money saved would allow them to move and rent till the job market becomes more stable.”

Furthermore the reader paints a justification scenario as well: “A [strategic default] strategy would put the burden of the losses on those financial institutions that sold insurance to back the mortgages. I guess that is Fannie and Freddie, and some of Buffett’s holdings.”

While underwater homes are frustrating, there is a good deal in this email to be challenged. Since most of the moral argument in opposition to strategic defaults has been long articulated (that article is from 2009), I will stick to some reminders on the practical side of the argument against strategic default.

It can be very unwise to walk away from a home unless you absolutely have to. In most states (including Florida, where the reader is from) banks have the right sue the homeowner for any losses they incur on the foreclosed mortgage. For instance, if you your home was worth $300,000 in 2005 when you got a mortgage for the full amount, but is only valued at $200,000 today, and you walked away from the mortgage leaving the bank to foreclose, the bank could sell the home for $200,000 at auction and sue you for the difference of $100,000. (Here is a full list of recourse states.)

Walking away from a mortgage also has the potential to irreparably destroy your credit, making it difficult to buy any home in the future or get substantial credit. It may sound great to pocket a few months worth of mortgage payments, but it won’t matter if you can not get a mortgage in the future. Nor will it come close to making up for the deficit the bank can sue for.

If you can use your life savings (other than money in retirement accounts, which banks can not access if they sue you for the unpaid mortgage balance) to pay for a short-sale or cover the deficit after a sale, then you’d be better off doing that and keeping the bank from coming after you then just crossing your fingers. If, on the other hand, you’re facing a spread between mortgage owed and house value beyond your savings and assets, then it might just be best to move on if you have to and, if the bank comes after you, consult a bankruptcy lawyer.

Moving on to the attitude towards who takes the losses, while the “Buffetts” of the world did buy some mortgage investments, many mortgages are financed by institutional investors, and some of those are pension funds. Calpers, for instance, has been one of the world’s largest investors in mortgages (the book value of the CMOs they were invested in by June 2006 was more than $3.5 billion). Yes, many of the losses will filter through to firms like AIG, but many also will hit the pension funds of ordinary Americans.

Furthermore, even when losses are taken by the CDS issuer (the people who sold insurance on the mortgage-backed securities), like AIG, there are thousands of Americans who work for those companies. These and other non-AIG employees also owned lots of stock in AIG, so it is false to believe that when a company takes losses on something mortgages that only the fat cat bosses feel the pain. This doesn’t mean we should bail those companies out, but it does mean we should recognize the real people who do lose out when losses hit the idea of a company and not consider this a way to justify walking away from a home.

Finally, Fannie Mae and Freddie Mac have lost nearly $200 billion since they were taken over by the government in 2008. All of those losses have been covered by taxpayer money from the US Treasury. So walking away from your home thinking that the losses will just be felt by Fannie and Freddie means putting the losses on the taxpayers as a whole.

Housing prices will never inflate back to their inflation-adjusted 2007 levels (unless the government propagates another bubble) and that means a lot of losses to be felt remain in the system today. What homeowners should consider is the local area housing prices and their own particular circumstances: if home prices are mostly stable in your area then being underwater only becomes a problem if you want to refinance or move. Continuing to pay a mortgage is not throwing money away because you will have more equity in the home when you do move. It only is throwing that money away if you decide in the future to walk away from the home and not sell it.