The Cost of Not Walking Away From An Underwater Mortgage

In the ongoing debate about whether one should walk away from an underwater mortgage or not, one University of Arizona professor speaks out strongly in favor of taking a hike. According to Brent T. White, an associate professor of law at the University of Arizona:

A failure to grasp the true economics of the situation is holding back many Americans whose home values have dropped far below the amount they owe and who would be better off renting, Mr. White says. Fear, shame and guilt also are preventing rational decisions, he believes. And, he says, those “emotional constraints” are encouraged by politicians and bankers, who ruthlessly and amorally follow their own economic interests while telling Joe Soggy Homeowner he has a moral duty to pay his debt so long as he possibly can.

I was sent the above article by Doom friend M.R., and highly recommend reading the comments section. There are a number of intelligent comments taking up both sides of the walking debate. The article discusses White’s paper Underwater and Not Walking Away: Shame, Fear and the Social Management of the Housing Crisis.

White says that he is not amazed by the number of folks walking away from their mortgage- he’s amazed by the number that don’t. He repeatedly refers to walkers as “rational homeowners”. We often hear how you might as well hang on and sit tight- markets are cyclical and values will come back in a few years. Besides, you don’t want a black mark on your credit rating. Here’s why White refers to walkers as “rational” though:

White gives the hypothetical situation of “Sam and Chris”. Sam and Chris purchased a typical home in Salinas, CA for $585K in January 2006. They have a monthly payment of $4,300/mo., slightly less than 31% of their income. The couple just break even every month.

Unfortunately for Sam and Chris, the housing market began to collapse in 2007. Though they still owe about $560,000 on their home, it is now only worth $187,000. A similar house around the corner from Sam and Chris recently listed for $179,000, which, with a modest 5% down, would translate to a total monthly payment of less than $1200 per month – as compared to the $4300 that they currently pay. They could rent a similar house in the neighborhood for about $1000.

Assuming they intend to stay in their home ten years, Sam and Chris would save approximately $340,000 by walking away, including a monthly savings of at least $1700 on rent verses mortgage payments, even after factoring in the mortgage interest tax reduction. The financial gain for Sam and Chris from walking away would be even more substantial if they took their monthly savings and put it into an investment account. If they stay in their home on the other hand, it will take Sam and Chris over 60 years just to recover their equity – assuming, of course, that they live that long, the market in Salinas has indeed hit bottom, and their home appreciates at the historical appreciation rate of 3.5%.

I personally think the world is a better place when people make a good-faith effort to pay their bills. Consequently I was a little disturbed by this statement of White’s:

Unlike lenders who follow market norms, individual homeowners are encouraged to behave in accordance with social norms of “personal responsibility” and “promise-keeping.” Thus, individual homeowners tend to ignore market and legal norms under which strategic default might not only be a viable option but also the wisest financial decision. As a result, individual homeowners have born a disproportionate share of the costs of the housing meltdown.

Given that the “market norms” for lenders have been governed by greed and a lack of responsible behavior, it hardly seems that encouraging homeowners to follow the same market norms would lead to a better society or a more stable economy. White makes this point however:

One obvious response to the above discussion is that society benefits when people honor their financial obligations and behave according to social and moral norms, rather than strictly legal or market norms. This may be true if lenders behaved according to the same social and moral norms. In the case of lender-borrower behavior, however, there is a clear imbalance in placing personal responsibility on the borrower to honor their “promise to pay” in order to relieve the lender of their agreement to take back the home in lieu of payment. Given lenders generally superior knowledge and understanding of both mortgage instruments and valuation of real estate, it seems only fair to hold them to the benefit of their bargain. At a basic level, sound underwriting of mortgage loans requires lenders to ensure that a loan is sufficiently collateralized in the event of default. In other words, in appraising a home the lender should ensure that the loan amount, at the least, does not exceed the intrinsic market value of the home.

I believe people have an obligation to pay their financial agreements to the best of their ability. On the other hand, I also believe that people have an obligation to try and not be a financial burden to others. How can a couple like the hypothetical Sam and Chris pay for their kids college and braces, save for emergencies and fund their retirement if they spend the rest of their working careers trying to pay off one financial mistake?

Two things have become clear to me in all of this. One is that both parties need to have skin in the game to minimize unethical behavior. When either party has access to easy money and low risk, the odds are that they are going to exploit it to their own advantage. The other thing is that at the end of the day, it is very difficult to judge those who are walking away. As White points out in his paper, the vast majority of defaults are not strategic- people simply have no choice. As for the rest, there are as many situations out there as there are people. Walkers run the gamut from the fraudulent scumbags who planned on walking before they ever closed to the heartsick couples who painfully decided that walking is the lesser of several financial evils.

White does not advocate all underwater borrowers walking. [In fact, he indicates that he is also underwater, but feels he is better of staying put.] He does however believe that in many cases walking is the rational thing to do. If I were sitting in the position of “Sam and Chris”, it would be difficult not to agree with him.

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