She has a sales job with a six-figure salary. He owns a successful tech company. And they are in foreclosure.
But unlike countless other Americans faced with losing their homes, this couple could make the $5,200 monthly mortgage on the waterfront property in Pompano Beach that they bought for $585,000 in 2004. Foreclosure was their decision – not the bank’s.
They crunched the numbers: $525,000 outstanding on their first mortgage and a $245,000 second mortgage on a home now worth about $319,000. His business was way down, her company was laying off workers and other investments had tanked. It made no sense to hang on to their underwater home. So they stopped paying their mortgage and waited for the foreclosure notice. It came in October.
It is called strategic default – borrowers who have enough money to make their mortgage payments but do not. They owe so much on a home that is now worth so little, that they decide to walk away.
It is not an easy decision. But it is not the inevitable blow to their credit score that troubles some strategic defaulters. It is the ethical dilemma of refusing to repay a loan when they are able to and worrying about what the neighbors will think.
“It felt like such an awful thing to do,” the woman said, who spoke on the condition of anonymity. “I got a car loan at 14 and paid $35 a week until I paid it off when I was 16. “
How prevalent are strategic defaults?
Although the exact number is unknown, half the homeowners in a study conducted by the Federal Reserve Board walked away when they owed twice what their home was worth. A Palm Beach Post analysis of foreclosed homes purchased since 2006 found 72 percent – about 4,124 homes – are worth less than half of the original loan.
In the business world, strategic default is a common tactic – considered a savvy move for financially troubled companies. However, “consumers have been browbeaten and trained to believe that it’s not honorable to not pay your debts,” said Margery Golant, a Boca Raton attorney who represents the Pompano Beach couple in default. “Why should it be any different for consumers?”
Last year, Morgan Stanley walked away from a $1.5 billion mortgage on five buildings in San Francisco despite record-breaking profits in 2009. Real estate giant Tishman Speyer Properties strategically defaulted on $4.4 billion in loans on two housing developments in New York after the properties lost $2.2 billion in value. The company had billions of dollars in assets, including Rockefeller Center and the Chrysler Building, which it could have leveraged to meet its loan obligations.
Even the Mortgage Bankers Association, whose president chastised homeowners who strategically default for the “message” it would send to their “family, kids and friends,” dumped its Washington headquarters in a short sale. After working out a deal with its lender, the MBA sold the building for $41.3 million last year. In 2007, the group purchased it for $79 million.
Ethicist OK with decision
“No, it’s not wrong,” said Randy Cohen, author of the weekly Ethicist column in The New York Times. Although homeowners are emotionally attached to their property, a house is still an investment.
“I don’t understand why you would be asked to make a decision on this investment any differently than you would on any other,” Cohen said. “Why should homeowners be held to a higher ethical standard?”
In many strategic default cases, the moral imperative is self-imposed. Among the arguments: Walking away from a mortgage will depreciate your neighbors’ property values. If all underwater homeowners walked away, the housing market would crash.
“Most people considering strategic default come to me and want my permission,” said Ronald Kaniuk, a Boca Raton foreclosure defense lawyer. “People who cannot pay their mortgage are apologetic. For people who can afford their mortgage or can just barely afford their mortgage and see it as a losing investment, they want absolution.”
They should not get it, according to Luigi Zingales, an economist and professor at the University of Chicago’s Booth School of Business, who became embroiled last year in a debate over the morality of strategic default.
“When you borrow money you make a commitment to pay it back,” Zingales said. “If you walk away because it’s in your interest to do so, you are violating the letter and the spirit of the law.”
Zingales wanted to know why it had become so easy for upside down homeowners to walk away. The answer was simple.
“The stigma is very much a function of how many people do it,” Zingales said. “Once you think it’s socially acceptable, it becomes easier to do.”
Expect more defaults
But there are consequences, including the long-term health of the housing market, Zingales said. Zingales predicts we will reach a tipping point where getting rid of a bad investment outweighs the damage to neighbors’ property values and the borrower’s reputation. In other words, expect more defaults.
“We’re not there yet,” Zingales said. “Clearly this creates a tension in society.”
On one side are homeowners who did not lose their jobs or live beyond their means and are now struggling to make their mortgage payment. Next door are neighbors who have stopped paying their mortgages and are living largely free until they are booted from their homes. “It’s a legitimate resentment,” Zingales said.
“We never bought cars or jewelry,” the Pompano Beach woman said. The second mortgage they took out on their home went toward purchasing and renovating a condominium as an investment rental property. When her husband’s business lost its best client and her company began layoffs, they decided to get out from under all their debt.
There will be consequences. They will lose the $65,000 in loan payments. The lender could get a “deficiency judgment” to go after the couple for repayment of the defaulted loan.
Their credit score will take a hit, but at least with a strategic default they won’t be homeless.
After liquidating some assets and scraping together what they could, the couple bought a new house – down the street and nearly identical to the old house – for $353,000. They walked away from $770,000 in debt.
“It felt like such an awful thing to do,” she said. “When this is all over I’ll feel like I made a good choice.”