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The overblown threat of strategic defaults

Walkaways. Jingle mail. Strategic defaults.

Those of you already experiencing nostalgia for the cliffhanger days of the housing crisis will remember those terms. They were applied to homeowners who were supposedly so distressed at the collapse of the homes’ values that they were abandoning the properties to foreclosure, even though they still had the wherewithal to keep up their mortgage payments.

These borrowers were just “walking away” from their homes; “jingle mail” was a fanciful way of describing the sound made when they mailed their keys back to the bank; “strategic default” was the sober, nonjudgmental way of describing the phenomenon in financial journals.

The alarm was sounded mostly by banks and other lenders, who suggested that this outburst of moral turpitude by previously obedient homeowners threatened to make the housing crisis indescribably worse.

As the panicky talk of jingle mail picked up volume in May 2008, I wrote an article pointing out that there was no hard evidence that it was actually happening. Sure, millions of Americans entered foreclosure — but the notion that any of them did so even though they could afford to pay the mortgage was unproved.

Still, at the time home prices nationwide had only fallen by an average 15% from their peak, judging from the Standard & Poor’s Case-Shiller home price index, and still had a ways to go. The default rate on first mortgages was yet a year shy of its May 2009 peak, when it would reach nearly 6% across the board. (It’s now down to just over 2%.)

So it’s proper to look back at whether the threat of mass walkaways ever did materialize, as home values continued to plummet and defaults soared. The answer is: There’s still no firm evidence that it ever happened.

That’s not for want of searching. The shelf of mortgage market analyses groans under the weight of efforts to quantify walkaways. Federal Reserve Banks, academic researchers, investment analysts all have taken a crack at the topic.

But here’s the bottom line, from an academic study sponsored by the Mortgage Bankers Assn.: It’s easy to count the absolute number of defaults, but “whether or not those defaults are due to an inability to pay or an unwillingness to pay is typically unobservable from market data.”

“It’s always going to be fuzzy,” Michael J. Seiler of Virginia’s Old Dominion University, the study’s lead author, told me.

Researchers do know that default rates rise in tandem with the depth of negative equity. That could be evidence that people who are underwater are giving their homes back to the bank even though they could afford to pay the mortgage. Or it could mean merely that even distressed borrowers will try to hang on to their homes in the hope of recovering their equity, until the hopelessness of their situation finally overwhelms them.

Researchers have tried every which way to mark a line between the unable and the unwilling. The consulting firm Oliver Wyman and the credit bureau Experian, for example, jointly figure that if your mortgage is in default but your non-housing debts are all current, you’re a “strategic defaulter.” Their rationale is that traditionally people let everything else slide as long as they could keep their house, so if the trend is reversed, something else must be at work. By this measure, they say, strategic defaults peaked at the end of 2008 at 20% of all defaults.

That still involves a lot of guesswork. For one thing, a mortgage payment may be a homeowner’s biggest bill every month, so paying it may wipe out a debtor more thoroughly than taking care of a host of smaller bills. Plus once the foreclosure process starts, it can drag on for a year or more before the house is lost. A credit card issuer, however, can cut you off in a nanosecond.

But even presuming that many people could manage to stay in their house, that doesn’t mean they necessarily should. If there’s no prospect of recovering equity in a home for years or decades, the wisdom of keeping it at the expense of money better put toward college savings or retirement diminishes.

What often gets overlooked in the debate over walkaways is why it should matter. A default is a default, isn’t it? Seiler, for one, disagrees — he argues that defaults for noneconomic reasons have a uniquely corrosive effect on social behavior.

That’s based on the notion that borrowers have a moral obligation to pay their debts. Yet a mortgage contract is a legal document, not moral catechism. It doesn’t require you to make your payment regardless of your financial state; only that you recognize that if you don’t, you might lose your house.

Mortgage lenders customarily try to price the likelihood of delinquency or default into the loan; that’s why borrowers with the best credit scores typically pay the lowest interest rates. Nor is the credit score a gauge of moral purity — it’s an empirical reflection of the borrower’s debt load and bill-paying record.

No less a towering figure in American jurisprudence than Oliver Wendell Holmes Jr. wrote skeptically in 1897 of the inclination to invest contracts “with a mystic significance.” He explained that the duty of fulfilling a contract means “you must pay damages if you do not keep it — and nothing else.”

Nevertheless, as the recent housing crisis gained steam, bankers, government officials, financial columnists and others admonished homeowners that they had a sacred obligation to virtually bankrupt themselves so their mortgage lenders would remain whole.

In other words, strategic defaults were wicked, though strategic bankruptcies by corporations looking to shed such obligations as union contracts and pension commitments were apparently just fine. Here’s then-Treasury Secretary Henry M. Paulson in full harangue in 2008: “Any homeowner who can afford his mortgage payment but chooses to walk away from an underwater property … is not honoring his obligations.”

Lest you mistake Paulson for an ordained minister with a diploma from a recognized divinity school, I’ll remind you that he’s a former chief executive of Goldman Sachs, which instead of eating its $14 billion in losses from the collapse of American International Group in 2008 mewled like a baby until the U.S. government — that is, you the taxpayer — covered those losses at 100 cents on the dollar. Paulson oversaw that bailout as Treasury secretary. If you need an ethics guru, look elsewhere.

The myth that a homeowner is morally bound to commit his wealth down to his cuff links to pay his mortgage chiefly benefits the mortgage industry. It distracts borrowers from looking objectively at their financial choices and rationalizes the lenders’ resistance to modifying mortgage terms to stave off foreclosure.

“It’s unfortunate how many people will squander their savings out of some misguided sense that it’s immoral to make a good financial decision,” says Brent T. White, a University of Arizona law professor who has written about the moral pressures on borrowers.

The vilification of strategic defaulters as walkaways or deadbeats has still not ebbed, although their numbers are still murky. What’s known is that default rates on underwater homes have consistently been lower than economists would have expected, and that only a small percentage of defaults have been walkaways by any definition.

All the industry blather about the sanctity of the mortgage payment may have had its effect, after all. Given the economic realities of recent years and the wisdom of rationally weighing one’s financial options, the problem may be not that too many people walked away from their devalued homes, but too few.

 

By Michael Hiltzik @LA Times

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