Ethics of Real Estate Strategic Default

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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?

Two Examples

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.

Case #2

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

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21 Comments

  1. There are also many people who never took out a second that are are massively underwater but you never seem to write about them. You always pick the example where someone took out a second and used the money to buy something. Further more it was the banks that were pushing the idea of using your home as an atm so YES the banks are 100% reasonable for this disaster. Are you some kind of bank lobbyist or getting a kick back from them for this article?

  2. You forget example #3. The large number of people who bought their first homes in 2005 and 2006 put no money down, stretched as much as they could to buy a home thinking their income would go up. Now they are looking at a home with a 250% LTV ratio in a neighborhood that has a 80% foreclosure rate and many houses that have actually been foreclosed on twice since the crisis started. Are you really telling me that person (me) shouldn’t strategically default. Almost all the people in the houses around me now paid less than half of what I did so I certainly don’t feel bad if their houses loses a little value because I made a decision that will make the lives of my entire family exponentially greater.

  3. Richard Warren on

    A lobbyist for the bank or getting a kickback? That’s laughable. You must have missed the following line:
    “Without a doubt the banking industry was a huge part of the problem.”

    To say the banks are 100% responsible is absolutely ludicrous. It was a feeding frenzy of borrowers taking money they couldn’t pay back and banks looking only at profits giving people money when they shouldn’t have. There’s plenty of blame to go around. Did people use their homes as piggy banks? Absolutely and they were encouraged to do so by the banking industry.

    Apparently you feel that the borrowers have no responsibility to repay a loan as they legally obligated themselves to do.

    The premise of the article was how people’s attitudes about ethics and personal responsibility have changed. We should all blame someone else for our poor decisions rather than admit that we were at least partly responsible. Your attitude is exactly what I was talking about so I thank you for your comment because it proves my premise.

    • very funny article. the collapse was inevitable. not the peoples fault. mainly the banks fault, and primarily the government and the FEDS fault. When you give out free and easy money at an unsustainable rate and then take it away, this is the guaranteed result. Hence, people should walk away and rent, banks should take their long over due and well deserved losses, new younger people should take advantage of the older generations mistakes and take their homes from them. everyone gets what they deserve and we move on. You are an idiot to blame the people by the way.

      • Richard Warren on

        So now we have to resort to personal attacks? If I am an idiot to believe that a person’s word has meaning, that ethics have value, and that personal accountability and responsibility are important, then please call me an idiot.

    • Ebony Saunders

      Hi, I’m taking an online ethics class at Georgetown and your article is one of our required readings this week by my professor. I do agree with you. I feel borrowers do have a responsibility to repay the loans they took on, they signed the dotted line they should be held accountable.
      However, I do believe the banks are more responsible because why would you lend to borrowers who you are not sure could pay back the loan back? That is just insane. Would you lend me money if you were not sure I could pay you back? Probably not. The banks should be the gatekeepers of the money they lend just like it is now. It is so difficult to get a loan from a bank now they are going through every documentation with a fine tooth comb. Rightfully so, it is called responsible lending. Not saying subprime lending is a straight up bad thing, but could banks put a cap on how many subprime loans they gave out? Diversify maybe? Why jeopardize your entire loan portfolio with a bunch a risky loans that would inevitably take the firm under and have tremendous ripple effects on the entire real estate market? Consumers are like children, at some point you have to say no to them for the greater good of your own company and the industry. You may not agree with my logic but the banks are definitely saying no today for this very reason.

  4. Great article Rich,
    This topic is widely discussed, as you say! Having been employed as VP for a large S&L back in the early 80’s and witnessing 4 previous real estate market cycle recessions (this one the worst), Strategic defaults are nothing new. The bottom line is; Does it make financial sense, to just walk away and start over. Having a foreclosure on your credit report will only take 3-5yrs before you can qualify for another loan. Whereas, it may take 10-15 yrs for my current home to get back to break-even. Although one may look at their home first as a place to live, It’s also an Investment. Unfortunately, in today’s market Morality and ethics are pretty much out the window. Whoever I can blame to justify my decision to walk is common thinking. Sorry to say!!!
    .-= Dwight (Matt) Mathews´s last blog ..The Next Great Recession 2011-2012?? =-.

  5. romeotybalt on

    I am walking away from my 350k nightmare in Chicago, into a formerly bank owned property for 60k in a better area. Do I feel guilty? HELL NO!

    Strategic default is part of the market risk that the bank assumes when factoring in loan costs, and part of the risk that I assume once my credit is wrecked.

    But, I was lucky enough to buy my new home outright, thus minimizing my risk.

  6. interesting case(s) its funny how everyone has the prospective that the bank should have to pay for the decline in value.
    the problem is the home owner needs to have an incentive to pay and even if the bank lowers the principle what is a fair value. if a house was sold for 200k and now selling for 150k what is it worth then? and the loan still has zero equity and would be considered not a good loan

    with still millions of homes left to go to foreclosure i think the best thing banks can do is to work out loans in a way to give an incentive to the home owner by first making the loan affordable and some how giving them an incentive , my idea is to let certain owners re-buy the home close to the market price they would have to come up with a new down payment and the interest rate will be higher than the market rate and it will have a prepayment penalty of five years or so. bankers are smart and i think they will reach a point where it makes sense to do something like this

  7. Jehovah B. on

    The ethics of strategic default can easily be argued either way. But I agree with the other posters who point out that your two “cases” appear to be designed to show the least defensible examples. I bought a condo in ’06 with 20% down and promptly saw my maintenance fees increase from $274 to $380, a special assessment passed of $103 per month for 15 years, and then the equity fall from $62,000 (the down payment) to negative $78,000. Interested buyers cannot loans for anything near my asking price. What do you think the sensible thing to do is? I’ve since moved out and rent it for $600 less than total expenses.

  8. Richard Warren on

    Unfortunately the limited amount of space doesn’t allow me to cite every possible example.

    Jehovah B., you say: “But I agree with the other posters who point out that your two “cases” appear to be designed to show the least defensible examples.”

    You are absolutely correct that those examples show what you call indefensible actions and that is exactly the point. Earlier in the post I say “Given a choice between going out of business and letting one or more properties lapse into foreclosure, the prudent choice is foreclosure.” Many, if not most, foreclosures are cases where people have little choice but to let a property go into foreclosure. That’s not the point here.

    The issue for me is when people who choose the so-call strategic default when they have other options. I was raised in a time where your word meant something and you honored your commitments even when that was not the easiest or most profitable choice. The prevailing attitude today is very different. It’s not a surprise that so many people think that way given the plentiful examples of corporate greed, government excess, and the entitlement mentality that seems to grow each day.

    Where does it end? When do the corporations and banks stop acting so recklessly? Will government ever stop throwing money at every problem in a quest for votes and power? When will people accept responsibility for their own actions?

    I don’t pretend to have an answer for that. I do believe that it begins with each of us being accountable for his or her own actions. Unfortunately, as you can see from the responses here, many people don’t seem to agree.

    • You seem to forget that the average home buyer on a thirty year loan pays back about three times the amount of the original price of the home. The bank always makes money. The question is how much. I have a condo that is now worth half of what I paid for it. Given that banks send out appraisers prior to approving a mortgage I feel the contact is no longer valid since the property is not worth what I agreed to pay for. I feel no pity for these organizations. I feel for the thousands of people out of work right now or with pensions that are worthless due to the actions of the banking industry. They get their property back in the end so they can sucker some other poor smuck into a thirty year note.

  9. Richard–you write “Where does it end?”
    It ends in the letter of the law–period. You added a quote from a surpreme court justice–about what is lawful and morally correct? Businesses and individuals should act in their own financial interest within the law–period. Is it moral that a bank sold a BS loan to a person, knowing full well that they couldnt pay it when the rates increased from their terribly low levels? I bet youd argue that it was moral that they did this and then forclosed on that very property. None of this is about morality–its about bottom line-law. Thats the only code that a country lives by when it comes to business. Are you and others arguing that if we allow the “little people” to act like businesses and banks that that will somehow ruin the system? HAHAHHAHHA
    It is morally correct that a person who bought a home should be saddled with a sustainable, yet, stifling debt that in many cases could affect how he or she raises their family? Is it moral that little Johnny doesnt get to go to college because pops refied years ago, all so some senior bondholder gets a return on his bank stocks that were propped up by free govt money and scandalous actions by people like Goldman Sachs? Get real guy. EVERYONE is taking a hit here and ought to. Banks, people who bought homes, everyone involved ought to feel the pain. These people whose homes are going to drop–sorry, your house was overvalued to BEGIN with. Your house is only worth what it is today because of obsecenly low interest rates, free govt money to banks, $8000 free dollars to sellers (recently ended)–etc etc ect. In short your home values can only stay higher if people are duped into selling out their future to keep your equity higher and the values of bank stocks higher. So try to sell everyone a bill of goods unless you’re honest about how current and past values were a mirage.
    Japan has had years of economic stagnation becuase the hits werent taken by homeowners and bankers. Let the system fall in value so we can find a true value, only then will we have affordable housing and end the painful, yet necessary, deleveraging process. Its a process that must occur (debt writedown) for economic growth and all its parts to begin anew. Blaming consumers for not wanting to deleverage, you expose your own ignorance of what needs to happen economically in this country.

    • Darrel Fletcher on

      I have to say that you comment is probably the best one I see here so far. You really have a good sense of the situation. I partly agree with Mr. Warren, but something is amiss about his article. He is looking at that situation from a strictly moral overview and is not too practical at all.

      In reality, their are plenty of homeowners who simply cannot afford Mr. Warren’s morality approach, and they must look after their families future.

  10. “The issue for me is when people who choose the so-call strategic default when they have other options. I was raised in a time where your word meant something and you honored your commitments even when that was not the easiest or most profitable choice.”

    So what about individuals with non-recourse loans, where both bank and buyer agreed that in the event of nonpayment ownership of the house would revert to the bank, but the bank would have no further claim on the buyer? It seems to me that a buyer defaulting in a case such as this is still honoring the commitment made to the bank, they are just choosing the option of paying the mortgage back with the house instead of with cash.

    Please note that I say this having never owned a home.

  11. Great article, Richard. However thought provoking, I’m afraid it’s academic, and after reading the responses, a sad commentary on what our society has devolved into. At the same time, however, the option to strategically default has less to do with ethics than it has to do with legal options and their lack of consequences. Homeowners or investors who choose strategic default, like the company presidents that spin bankruptcy as a survival strategy are simply making a perfectly legal and economic decision, one that favors their own self interest and passing that cost on to others. The lemmings were leveraging up (everyone was doing it), the banks would loan to anyone (if XYZ bank wouldn’t do it, Countrywide would), the Fed kept interest rates in the bargain basement in order to “spur the economy” and govt deregulation gave us such winners as sub-prime, ARMs, high LTV and no doc loans, credit deferred swaps and all the other wonders of the new millennium. It’s all perfectly legal and government approved. So now, everyone wants to blame the banks, and the govt is blaming the banks to cover their own lack of regulation and oversight, Joe Homeowner or Joe Investor has every right to lower themselves to the same level as….. those stinking bankers. The lemming mentality “why should I when nobody else is” rationalization trumps any individual sense of ethics, character, obligation or personal responsibility. Well, rationalize it any way you like. It’s purely an economic, not ethical, decision. And as long as it is legal, and govt approved, and the homeowner or investor accepts the consequences, there will be strategic defaults and bankruptcies. The only thing that will change that behavior, is a change that makes the consequences worse than holding onto an underwater property. Maybe bring back debtors prison.

    FWIW (and it’s not worth much), I’m with you, Richard. We’re down to one rental, a $60k FMV with the $80k mortgage we bought in ’04, still with a little cash flow, but we’ve taken a tremendous hit. Basically, we never leveraged up, we didn’t let bankers, or anyone else, decide for us what we could or could not afford. When we saw the bubble bursting, we didn’t sit on our hands, either. Dumped all but one of our rentals (bought prior to 2001) in 2007, basically breaking even. Got rocked in 2008 when we sold our dream home and relocated, bought way down into a much smaller and older home that has since lost more equity, seen our IRAs decimated and am now relocating (a second time in 2 years at our expense) to start work after 13 months of unemployment. I’m not really worried about such things as maintaining a certain quality of life, whining about my neighbors mortgage being so much lower than mine, or whether poor Jr will go to college, I’m over 50 and fighting like hell to keep what’s left. All told, down well over $300k, maybe 4, all without a SS, loan mod, missed payment, passing blame or whining.

    If you bought or leveraged up or took out an ARM near the top and have sat on your hands for the last 3+ years rationalizing why you should wait, or why you couldn’t or wouldn’t sell, well, your time has come, that’s right folks, just blame the bankers and bail when it becomes uncomfortable. It’s all the rage, legal, easy and with relatively little consequence. You know, when they give it its own special name, it’s for real! Our elected officials have made this possible, just for you!

  12. Unfortunately you pose this as a “moral” or “honorable” issue of paying back your loan. If when I signed for a mortgage I signed a clause that said “I will pay, come hell or high water, regardless of circumstance or financial hardship, my mortgage back to the bank” then you would be write.

    Unfortunately for your argument, most loans run more along the lines of “I will pay, and if I don’t I understand I will lose my house”. So there is nothing moral or honorable or keeping your word entering the picture. It’s simply a business transaction that you decided to take “option B” on, fully expecting the bank to be forthcoming with the consequences of option b.

    Nothing to do with morals, hurting others, obligations, honor. Some nice reasoning though, but based on that false assumption.

  13. Richard when you find yourself in our situation perhaps a strategic default will make more sense. Go buy a 440k house, with 80k down, 360k affordable mortgage, that is now worth 165k. Most of us left in Patterson Ca feel we were gamed by the banks. I could have taken that 80k to Vegas and bet on black or red and had just as good results. Your right, when will it end? Its been happening for a while, but now that the “rich” people are beginning to see the effects this problem seems to finally be going mainstream. My attitude, and those like me are based on the banks behavior. Shoddy lending, false ratings, mortgage fraud, and lying, are the reason prices climbed so high. I’m not going to be left holding the bag for the banks bad behavior any longer. They can have my house, I dont care anymore. The 4 neighbors I have left don’t care if I walk away, we’ve all talked about this. Heck theres so many foreclosures in our area the banks wont even let them all on the market just so they can keep the prices up and the supply down, its called a “shadow inventory”, and another reason to hate the banks. Just wait after all these strategic defaults you too will be underwater, and you can have the banks tell you that you make to much to qualify for any help, and you will see that your financially smart recourse is walking away.

  14. Oh and I forgot to mention that the fact goldman sachs was able to “short the american dream” is another reason why I dont care. F the bailed out bonus paying oligarchy banks. Good for you if you want to support them, I’m done with it.

  15. Richard,
    Did you ask the woman in Case #2 if she would have felt *obliged* in anyway to share the excess profits from the sale of her home with the bank if the circumstances had worked out differently? Perhaps the value of her home doubled in 8 years and she sold and moved, would she have taken 10% of the capital gains and shared them with the lender?

    Just as we have seen in other circumstance: Privitize the Gains, Socialize the Losses.

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