The new buzzword in real estate is Strategic Default. It’s a phrase that would make political spin doctors proud and has a much nicer sound than many other words for walking away from an obligation. It sounds so very professional. It’s like the corporations that proudly proclaim that they “chose bankruptcy in order to make the company stronger.” Somehow I don’t think that the business plans of those companies had bankruptcy listed in the strategy section.
What at one time considered unthinkable has become perfectly acceptable to many. To be sure, a business has to do what it must in order to remain profitable. But is it ethical? Do ethics matter anymore? Given a choice between going out of business and letting one or more properties lapse into foreclosure, the prudent choice is foreclosure. There has recently been a heated discussion on this topic in the Forums here. But what about the investor who uses “strategic default” as a business strategy when there is no real need?
In the first case we have an investor who owns several dozen rental properties. Most of them were purchased using loans requiring 20% down payments and had fixed rates. This was not some wanna-be tycoon trying to game the system, it was a long-time, well-seasoned investor. Despite his conservative approach many of his properties are significantly underwater. He continued making payments even though there was little hope of any near-term recovery. Watching all the novice investors walking away made him wonder why he bothered.
With a revised his strategy, he has decided to let his negative equity properties lapse into foreclosure. He tried getting lenders to consider short-sales but they either balked because they were investor loans or refused to waive their right to seek a deficiency judgment. He fully understands that the lenders may still seek deficiency judgments after foreclosure but he is betting that sheer volume of cases will prevent them from doing so. In his mind he has the option of bankruptcy in his back pocket. To him it is just a financial decision. The kicker is that he has the financial means to keep paying on the notes but he isn’t concerned about ethics simply because no one else seems to be.
The second example is of your typical owner-occupant. It actually stems from a conversation I was involved in a few days ago. A young woman was sharing her battle with a bank in trying to get them to modify her loan. Her attitude is a prime example of how many people feel about the situation today. She and her husband purchased a home during the boom years with a low down payment but fixed-rate loan. When their home’s value skyrocketed they decided to pull out equity to pay for a pool and fancy landscaping. So they refinanced into an adjustable rate mortgage that had an initial payment that was lower than their initial loan despite having taken a significant amount of cash out.
When the loan reset to a much higher payment it was impossible to refinance because values had dropped significantly. She started her efforts to modify the loan and reduce the principal balance, but the bank refused because she couldn’t demonstrate any hardship and the reality was that she could repay – she just couldn’t understand why she had to. Her position was that she shouldn’t have to pay because the value had dropped, never mind the fact that she had signed a document agreeing to do so. When asked why the bank should be on the hook for the drop in value she stated that they should have known somehow. The conversation became heated at one point when she was asked if a bank should be liable for the difference when an automobile drops in value. She said no because everyone knows that cars lose value but houses never do. We now had gotten to the crux of the problem – she, like many others, had the mistaken belief that houses only increase in value.
The Faceless Enemy
We seem to have a prevailing attitude that banks are somehow a greedy beast that deserves to pay for everyone else’s mistakes. Without a doubt the banking industry was a huge part of the problem. However, they don’t exist in a vacuum. We all share in the losses suffered by the banks. Whether it’s the retiree depending on dividends or pensions, mutual funds, and individuals who own bank stocks, we all share the pain. The ripples spread throughout the economy. So the next time you hear someone talking enthusiastically about strategic default, keep in mind that, either directly or indirectly, you are bearing a portion of that cost.
Ethics is knowing the difference between what you have a right to do and what is right to do. – Potter Stewart – U.S. Supreme Court Justice
Photo: Andrew Bain