By Steve Merrel, Partner
Willow Ridge Capital Advisors
In the aftermath of the housing bubble and the lending frenzy that fueled it, more and more families find themselves stuck owing a lot more on their mortgages than their homes are worth. Pressed with rising mortgage rates and falling incomes, many of these families face a dilemma: Should they sacrifice to pay their mortgage even though their home’s value may not recover for several years? Or should they simply walk away?
According to the Los Angeles Times, many people are choosing to walk away. The report quotes a recent University of Chicago study which found that 26% of all foreclosures are “strategic”, meaning they are calculated moves to get out of upside-down mortgages by people with the ability to pay.
The pressure can be intense. As the LA Times article states:
In some parts of California and Nevada, more than half of all households have negative equity. In a few localities, the size of the equity deficit is staggering: In the Salinas, Calif., metropolitan area, for example, the median equity for people who bought their homes in 2006, near the peak of the boom, is now a negative $214,305.
If you haven’t personally faced this dilemma, it may be difficult to fully appreciate the anger and fear many of these people feel. To help make this more real, let’s consider the case of an actual young couple caught in this situation. Their father, a very good friend of mine and well-respected CPA, recently told me, “My kids bought a house at the peak of the market. They now owe $300,000 more on the home than the home is worth. Why shouldn’t they walk away? The bank certainly wouldn’t hesitate if the roles were reversed.”
The moral dilemma
The father and his children find themselves on the horns of a dilemma. On one hand, the young couple made an agreement with their lenders to repay a loan. On the other hand, the economics of the transaction have changed putting them in a very precarious financial position. Should they feel an obligation to the lender beyond the collateral value of their home? What are the moral or ethical implications for their actions?
One person’s view
These are difficult questions and they sometimes evoke strong emotions. One such person recently expressed a very popular argument for walking away from upside-down mortgages when she wrote:
Mortgages are not ethical documents, they are legal contracts. The typical residential mortgage for an owner-occupied home gives the borrower two options: pay on time and in full, and keep the paper title to the house, and full entitlements to any appreciation upon its later sale after the mortgage is satisfied; or, stop making payments, and hand the keys back to the lender.
Morality and ethics don’t even enter the equation. Either option is perfectly legal for the borrower, and the only criteria should be business-based. All the ethics you need are contained within the four corners of the pages of the mortgage contract.
A different opinion
Personally, I disagree. Contracts are ethical documents. They formalize a promise to perform between two parties. They are not intended to preempt ethics or provide cover for moral lapses. The terms of the contract layout the boundaries of behavior between the two parties. The way the parties behave within the terms of the contract is very much driven by ethics.
In the case at hand, a mortgage is a contract that entails a promise to pay. The collateral provides additional or supplemental security for the lender in the event the borrower loses his ability to pay. It is not intended to be an escape hatch for a borrower who decides payment is inconvenient. Therefore, in my opinion, strategic walkaway is a breach of ethics.
With these opposing opinions in mind, let’s go back to our young couple and muddy the waters a little. The young couple got into their home using an adjustable-rate mortgage. Their plan was to refinance their mortgage to a fixed-rate once the value of the house increased enough for them to qualify. Now, with the home’s value depressed, they may never qualify. If interest rates rise, they may be forced into foreclosure anyway. Should they stay and “tough it out” risking years of financial insecurity for the sake of an unfortunate loan, or should they walk away?
Another person I spoke with about this issue said, “A few years ago I told my kids to ‘hang in there’ and pay their debts. They lasted a couple of years and finally ended up declaring bankruptcy anyway. If I had it to do over, I would give them different advice.”
The question at hand
Which brings us to the question at hand. What is the responsibility of borrowers? Are they morally justified in walking away? Or do we expect heroic action to sustain the note even when the economics turn upside down? What advice would you give them?