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The Morality of Strategic Default

February 2, 2011

Selective Default is the term used to describe when a home owner chooses to walk away from a mortgage because the house is no longer worth what they paid for it.  Or in other words, abandoning ship on an underwater house. It is becoming more common during this economic downturn.  The idea has been met with scorn and is generally viewed as dishonest and immoral.  I came across an article about a law professor, Brent White, who claims that it is not shameful, it just may make the most financial sense.  His argument is that “a mortgage isn’t a moral document — it’s a straightforward contract between a borrower and a lender in which both parties agree that if the borrower can’t or won’t make his payments, the lender will get something of value in return: the house.”  He likens the mortgage contract with a pre-nup.  The borrower and the banker are hoping for the best, but if it doesn’t work out the buyer is able to walk away.  He furthers his argument by saying that this kind of practice happens regularly in the corporate world, including banks.

Up until now my personal view has been in line with the pervasive attitude that a mortgage, or any contract for that matter, is a moral document.  And when one agrees to do something, they should do it unless something extreme (like illness, loss of income, etc.) prevents them from following through on the contract.  If you agree to do something, you should do your best to keep your word. 

But  what Mr. White has me thinking is that perhaps it’s not as simple as all that. 

There are a couple of points he makes that have me giving the issue more thought.  As mentioned above, White contends that the agreement you have with the bank is that you’ll make payments and that if you stop making payments then the bank gets the house, which presumably has value to bank (he does not go into mortgage insurance and other tools banks have at their disposal to protect themselves).  He asserts that this is a practice that banks themselves employ when a deal stops making financial sense for them (citing a 2 billion dollar default Morgan Stanley pulled off in 2009). 

He also appeals to the moral obligation to one’s family.  People rack up debt to survive or take from their 401k and children’s education accounts just to keep making payments to the lender.  This would lead any sane person to consider what takes precedent, the contract with the bank or the well-being and future of the family.  But I suppose that’s his point: banks don’t want you to be sane, they want you to give them money.

It isn’t difficult to see the logic in this way of thinking.  If you add to it the spiteful attitude  people have toward big banks (some of which is justified) you’ll have yourself a nice cocktail that once drunk makes it pretty easy to walk away, provided it makes financial sense to do so.

I’m not sure that I’m completely won over but I am compelled to give it more thought.

I’d love to know what you think on this subject.  Chime in if you have an opinion and go here for the full story.

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3 Comments leave one →
  1. Verms permalink
    February 2, 2011 10:36 pm

    ok, I need to read the whole story and do some research, but this is exactly what I been thinking over lately…

  2. Aquaamarina permalink
    February 5, 2011 5:24 am

    I, too, started seeing things differently after reading a few articles on the topic. Because I am now in just that predicament, where my home us worth 100k less than it was when I bought it 4 years ago, it may very well be the only realistic option for me.

  3. Tom permalink
    March 27, 2011 11:30 pm

    Hey, that sounds like a concept I’d like to adopt…’walking away because the house mortgage is no longer worth what they paid’. However, the problem is more than a moral issue. One party needed money and another party borrowed money to buy a house based on the concept of equity. And it is because of the equity, many are sold on owning one which, of course, is based on appraised value placed on other houses or the surrounding area.

    And so, if a small house that has not improved in sq footage gains a huge equity it should not be a surprise when owners borrow against it and do what he/she pleases. But since the market has reversed, are we to advocate the borrower to walking away? No, it makes no sense.

    People who buy houses should not be reminded of the signed legal document and that mortgages need to be paid according to the terms. Morally, is religious-based or is innate in most people. That is to say, a god-fearing person does not cheat nor become dishonest toward others.

    Job loss, divorce or some other reason I can understand but straight out abandoning should not be advocated because there are some options to help reduce the high probability of a property becoming REO status.

    One effective way that is currently used is lease option. The idea is simple because a buyer and a homeowner can get what they want. Since the situation is mostly short-sales, the owners can opt for a middle person to help submit a short-sale package with the understanding of zero cash to them (homeowner), walk away without a bad credit report and have some moving money, and the middle persons owns property. Or, owner can opt to be a tenant to the middle person (as new owner) and buy it back after 5 yrs.

    Of course Mr White points out so many contributing factors i.e. credit-rating agencies that make homeowner feel handicapped, socially, morally, and emotionally. All it takes is to have someone point out some options and create a win-win situation because banks/lenders are not interested in anything but what is owed.

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