Ethics and the Decision to Walk Away
[Walk Away (2010)]
The average Joe and Jane are quick to sign on the dotted line with what they think is the American dream clearly in sight. Meanwhile mortgage originators are only too eager to facilitate the dream, knowing that a secondary market created by the federal government is waiting to buy the paper.
And why not? Eighty-one percent of people believe it is immoral to default if you can afford to pay. However, "9% are willing to walk away with a shortfall of $50K, 26% with a shortfall of $100K and 41% with a shortfall of 200K," according to Luigi Guiso, Paola Sapienza, and Luigi Zingales in their paper "Moral and Social Constraints to Strategic Default on Mortgages" written for the University of Chicago Booth School of Business and Kellogg School of Management.
But even more interestingly, people who know someone who has strategically defaulted are 82% more likely to at least declare their willingness to strategically default. Plus an increase in foreclosed property in a particular zip code, Guiso, Sapienza, and Zingales find, greatly increases the likelihood that homeowners will walk away.
"Overall, we find that the most important variables in predicting the likelihood of a strategic default are moral and social considerations," write the three professors. "Social considerations are directly affected by the frequency of foreclosures and the probability that somebody knows somebody else who strategically defaulted."
As the University of Arizona's Brent White explains, "the asymmetry of moral norms for borrowers and market norms for lenders gives lenders an unfair advantage in negotiations related to the enforcement of contractual rights and obligations, including the borrower's right to exercise the put option." A put option meaning the borrower gives the house to the lender.
Lenders are most often corporate entities run by managers with the fiduciary duty to exercise financial prudence on behalf of the company owners. These managers would most likely not view it to be in the best interest of the shareholders to negotiate with an underwater homeowner if the homeowner is current on his or her payments, because given societal pressure and norms, the prudent thing to do is for the lender to deny an attempted negotiation; historically, the likelihood is that the borrower will continue to pay. It is only when a borrower does not pay that the lender's attention is gained and negotiations begin. Thus, an underwater borrower must wreck his or her credit score, a reflection of their character and honesty, before a lender will negotiate.
So does the individual have a fiduciary duty to oneself? The short answer is — no. A fiduciary means "one who acts in the interest of another person," so by definition one can't be the fiduciary of oneself. But how could it possibly be that corporate entities have a duty of financial prudence while individuals have a moral duty to destroy their dignity and finances in the process of honoring a contract that lenders themselves would not honor if put in the same position?
Aristotle explained that man is a rational being. Man learns what works in the world, natural laws, to achieve his desired ends — survival and prosperity. As Murray Rothbard explained in The Ethics of Liberty, "the very fact that the knowledge needed for man's survival and progress is not innately given to him or determined by external events" shows that man has the free will to either employ reason or not and that an act set against his life and health would objectively be called immoral.
In the same book, Rothbard writes of "the perfectly proper thesis that private persons or institutions should keep their contracts and pay their debts." But the mortgage market is anything but private. Grant's Interest Rate Observer, in its May 14, 2010, edition points out that Fannie, Freddie, and the FHA "accounted for 97% of new mortgage lending in the 50 states. That is, they either purchased or guaranteed all but 3% of new homes secured by American dwelling places."
Now that lenders have learned the hard way that home prices can and do fall, they have abandoned the mortgage market. What private market there is for loans exceeding the government-guaranteed maximum, the interest rates are considerably higher and the terms much more stringent.
It's hard to imagine that Rothbard would insist that private individuals be poorer and less prosperous by sacrificing to pay Fannie and Freddie, entities that are only in business because, as the White House quietly disclosed on Christmas Eve 2009, "it had," as NYT reports "in effect, given the companies a blank check by making their federal credit line unlimited; the ceiling had been $400 billion; by the following spring the government said it had spent $126 billion propping them up."
With government support, financial behemoths can hold out and play hardball with underwater homeowners, refusing to negotiate, while hoping the real estate market rebounds.
Rothbard goes on to make the point that "Relations with the State, then, become purely prudential and pragmatic considerations for the particular individuals involved, who must treat the State as an enemy with currently prevailing power."
Since Government Sponsored Entity (GSE) debt (Fannie and Freddie) is now considered government debt, as Rothbard says, the payment of this debt by taxpayers is coercion. So the funding these GSEs use to buy these mortgages in the first place is obtained through "coercion and aggression against private property." "Such coercion can never be licit from the libertarian point of view," Rothbard explains.
Rothbard advocated "going on to repudiate the entire [government] debt outright, and let the chips fall where they may." And in the same article Rothbard ridicules the Social Security Administration, because it "has government bonds in its portfolio, and collects interest and payment from the American taxpayer, allow[ing] it to masquerade as a legitimate insurance business." It is impossible to imagine Rothbard viewing Fannie Mae and Freddie Mac as legitimate mortgage businesses.
He went on to write that if the idea of debt repudiation is considered too harsh, at least put the federal government into bankruptcy. But, "we first have to rid ourselves of the fallacious mindset that conflates public and private, and that treats government debt as if it were a productive contract between two legitimate property owners."
Supposing that Fannie, Freddie, and Bank of America had been left to fail, the mortgage paper the entities held would have gone on the open market to be purchased by investors. What price would the mortgages fetch? Certainly not 100 cents on the dollar. But with government support, these financial behemoths can hold out and play hardball with homeowners, refusing to negotiate, putting their heads in the sand hoping that the real-estate markets will improve.
When BB&T Bank analyzed Colonial Bank's loan portfolio when negotiating with the FDIC over the failed bank in 2009, they believed the loans to be worth 63 cents on the dollar. When US Bancorp purchased the failed Downey and PFF Savings & Loans in 2008, it valued those loan portfolios at 68 cents on the dollar. Of course these acquiring banks would only complete the deals with lucrative loss-sharing arrangements in place.
Entities like Colony Capital and Lennar's Rialto have most recently paid (in 2010) the FDIC 40 to 44 cents on the dollar for equity stakes in distressed loan pools being sold by the deposit insurer, and that's with the FDIC providing seven-year, interest free financing on half to two-thirds of the purchase.
The point is clear, whether the borrower is current or not, in the free market a mortgage that is significantly under-collateralized would not sell for the full note amount. Buyers of these notes would pay an amount that would allow for a margin of safety from the collateral based upon current or the buyer's expectations for future housing prices. The buyer of these notes would have an incentive to restructure the obligations and have a performing mortgage. That's what would maximize the note buyer's return.
For example, Selene Residential Mortgage Opportunity Fund purchased the mortgage secured by the home of Anna and Charlie Reynolds in St. George, Utah, for a deep discount, the Wall Street Journal reported in a front-page story. The Reynolds were struggling with a $3,464 monthly payment and the value of their home had plummeted.
Selene, run by Wall Street legend Lewis Ranieri, "buys loans to make a profit on them, not as a public service, but company officials say it is often more profitable to keep the borrower in the home than to foreclose. If a delinquent loan can be turned into a 'performing' loan, with the borrower making regular payments, the value of that loan rises, and Selene can turn around and either refinance it or sell it at a profit."
Home values in St. George had plummeted in similar fashion to that of Las Vegas, only a two-hour drive away. Selene slashed the principal balance of the loan due from $421,731 to $243,182 and lowered the interest rate, reducing the Reynolds' monthly payment to $1,573.
"Around 90% of Selene's loan modifications involve reducing the principal," James R. Hagerty wrote in the WSJ, "compared to less than 2% of the modifications done by federally regulated banks in the first quarter."
And while many upside-down borrowers can't even find a human to talk to about their loan, let alone sit down and re-negotiate terms that will benefit both parties, Selene immediately tries to contact the borrowers on the notes they have purchased, "sometimes sending a FedEx package with a gift card that can be activated only if the borrower calls a Selene debt-workout specialist."
One quickly realizes that what makes the Selene modifications work are principal reductions. Amherst Securities Group mortgage analyst Laurie Goodman wrote in late 2010 that 11 million borrowers could lose their homes to foreclosure if the mortgage principal was not reduced. "Ignoring the fact that the borrower can and will default when it is his/her most economical solution is an expensive case of denial," Goodman wrote.
A bailed-out lending institution such as Fannie Mae or Bank of America has no incentive to negotiate. And in fact the banks are doing nothing. The research of Whitney Tilson at T2 Partners LLC shows that of homeowners who haven't made a payment in a year, 23.6 percent haven't been foreclosed upon. Of homeowners six months behind, nearly 32 percent haven't received notice of any nasty filings by their lenders. Even 14 percent of mortgage nonpayers of two years haven't been foreclosed on.
Bank of America's head of "credit loss mitigation" Jack Schakett during a conference call told the assembled analysts, "There is a huge incentive for customers to walk away because getting free rent and waiting out foreclosure can be very appealing to customers."
A typical foreclosure, he said, takes up to 14 months, and as a result, the number of strategic defaults is "more than we have ever experienced before."
An April 2009 change to FASB rules 157, 115 and 124 allowed banks to foreclose on a home without having to write down a loss until that home was sold. However, if a bank agrees to a short sale, it must take the loss immediately.
"Loan modifications in Nevada particularly are a joke," Las Vegas housing analyst Larry Murphy told the Las Vegas Review Journal. "They are a waste of time, effort and expense for everybody — borrower and lender alike." RealtyTrac's Rick Sharga claims there would probably be fewer strategic defaults if banks were more willing to work with homeowners in good faith.
The federal government's Making Home Affordable Program (HAMP) was implemented in the wake of the crash to modify mortgages. The program was budgeted for $75 billion, but by the end of October 2010, the expected cost was $29 billion according to the Treasury's chief of the Homeownership Preservation Office Phyllis Caldwell.
The Atlantic's Daniel Indiviglio made some assumptions and crunched some numbers to determine the cost per modification. Indiviglio found that the program had only a 41 percent success rate, but he assumed it would get better — 50 percent.
He goes on to write, "But we're not done. Many of these will redefault. So far, HAMP's re-default rate is actually pretty good. Just 25% of loans at least 12 months old are 60 or more days delinquent. But as time wears on, this percentage will increase." A quarter of HAMP modifications redefault and Indiviglio thinks that's good?
The staff editor at TheAtlantic.com assumed a 40 percent redefault rate and ultimately just short of 530,000 successful modifications for $29 billion, or $54,757 per modification. This cost didn't reduce the principal of anyone's loan, but just paid for the bureaucracy to administer the program and push paper around.
"If you know much about mortgage modifications," Indiviglio writes, "then you know many are destined to fail."
The big banks are even reluctant to approve short sales, despite this being the most cost-efficient way to settle underwater mortgages. Michael Powell reported for the New York Times of a Phoenix woman attempting to do a short sale, where the short-sale price was only $6,000 less than her loan balance. The lender GMAC refused, instead choosing to foreclose on the home, despite the lender's estimating that it will recoup $19,000 by going that route.
"Banks are historically reluctant to do short sales, fearing that somehow the homeowner is getting an advantage on them," Diane E. Thompson, of counsel to the National Consumer Law Center, told the NYT. "There's this irrational belief that if you foreclose and hold on to the property for six months, somehow prices will rebound."
But Powell points his finger at the real reason banks don't want to approve short sales: "an April 2009 regulatory change in an obscure federal accounting law. The change, in effect, allowed banks to foreclose on a home without having to write down a loss until that home was sold. By contrast, if a bank agrees to a short sale, it must mark the loss immediately."
Amendments to FASB rules 157, 115, and 124 allowed banks greater discretion in determining what price to carry certain types of securities on their balance sheets and recognition of other-than-temporary impairments.
"The new rules were sought by the American Bankers Association, and not surprisingly will allow banks to increase their reported profits and strengthen their balance sheets by allowing them to increase the reported values of their toxic assets," James Kwak, coauthor of 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, wrote on his blog "The Baseline Scenario" just after FASB amended their rules.
The man who runs the world's biggest bond fund, Bill Gross, says the United States should go all the way to the "full nationalization" of mortgage finance. Pacific Investment Management Company (PIMCO) is among the biggest holders of US-backed mortgage debt and Mr. Gross, PIMCO's head man, said at a housing conference in August of 2010, "To suggest that there's a large place for private financing in the future of housing finance is unrealistic. Government is part of our future. We need a government balance sheet. To suggest that the private market come back in is simply impractical. It won't work."
On the PIMCO website Gross amplified the comments he made on Capitol Hill.
Later that morning, in front of cameras from my favorite television station, C-SPAN, I exercised (exorcised) my leadership role in proposing a solution for the resolution of Fannie Mae (FNMA) and Freddie Mac (FHLMC) and the evolution of housing finance in the United States. I proposed a solution that recognized the necessity, not the desirability, of using government involvement, which would take the form of rolling FNMA, FHLMC, and other housing agencies into one giant agency — call it GNMA or the Government National Mortgage Association for lack of a more perfect acronym — and guaranteeing a majority of existing and future originations. Taxpayers would be protected through tight regulation, adequate down payments, and an insurance fund bolstered by a 50–75 basis point fee attached to each and every mortgage.
Gross goes on to write,
My argument for the necessity of government backing was substantially based on this commonsensical, psychological, indeed sociological observation that the great housing debacle of 2007– 2010+ would have a profound influence on homebuyers and mortgage lenders for decades to come. What did we learn from the Great Depression, for instance: Americans, for at least a generation or more, became savers — dominated by the insecurity of 20%+ unemployment rates and importance of a return of their money as opposed to a return on their money. It should be no different this time, even though the Great R. is a tempered version of the Great D. Americans now know that housing prices don't always go up, and that they can in fact go down by 30–50% in a few short years. Because of this experience, private mortgage lenders will demand extraordinary down payments, impeccable credit histories, and significantly higher yields than what markets grew used to over the past several decades. Could an unbiased observer truly believe that housing starts of two million or even one million per year could be generated under the wing of the private market? In front of Treasury Secretary Geithner and the assembled audience, I said that was impractical. Let me amend that to "ludicrous."
Policymakers not only have to consider the future "flows" of new mortgage originations, but the existing "stock" of mortgages already created. FNMA and FHLMC either own or have guaranteed $4.5 trillion of the $11 trillion mortgage market now on the books. As the Treasury contemplates the "transition" from Agency conservatorship to either public or private hands, how could private market advocates reasonably assume that pension, insurance, bank, and PIMCO-type monies would willingly add nearly $5 trillion of non-guaranteed, in many cases junk-rated mortgages to their portfolio? They would not. We are in a bind, folks. Having grown accustomed to a housing market aided and abetted by Uncle Sam, the habit cannot be broken by going cold turkey into the camp of private lending. The cost would be enormous in terms of yields — 300–400 basis points higher than currently offered, crippling any hopes of a housing-led revival to the economy. (emphasis is Gross's)
Gross told the Financial Times he won't buy mortgage bonds without a continued explicit backing by Uncle Sam. "Without a government guarantee, as a private investor, I'd require borrowers to put at least 30% down, and most first-time homebuyers can't afford that."
What Gross was saying, without saying it, was that the mortgage paper his firm was holding was worth a fraction of its face value but for the government guarantee. Allowed to go bankrupt, the mortgages that Fannie and Freddie hold would trade for pennies on the dollar in some cases. Gross also realizes that private lenders are not going to issue 30-year loans with little money down and may not make 30-year bets at all.
It is only with government guarantees and a taxpayer-supported secondary market that these loans become viable investments.
In The Ethics of Liberty Professor Rothbard constructs the example of the theater owner contracting with an actor for a performance on a certain date. The actor changes his mind and doesn't appear. Should the actor be forced to appear? Rothbard says no, that would be slavery. Should the actor be forced to reimburse the theater owner for advertising and other expenses? No, the actor should not "be forced to pay for their lack of foresight and poor entrepreneurship."
But of course if the actor has been paid and he doesn't perform, the actor should be forced to return the money. Rothbard points out that problems like this are solved in a libertarian society by requiring the actor to put up a performance bond. "In short, if the theater owners wished to avoid the risk of nonappearance, they could refuse to sign the agreement unless the actor agreed to put up a performance bond in case of nonappearance."
In the case of mortgage defaults, the collateral to the property is the performance bond. If the borrower doesn't pay, the collateral is surrendered. A basic part of underwriting the risk of a mortgage loan is making "sure that the home is of sufficient value to cover the amount of the loan," Guy Stuart writes in Discriminating Risk. If that doesn't satisfy the debt, in most states lenders can choose to go after the borrower's other assets. Any deficiency or loss the lender suffers is from "their lack of foresight and poor entrepreneurship."
Some also contend that walking away from mortgages will lead to a fall in the value of other properties in a neighborhood and is immoral because the defaulter's action is harming the finances of their neighbors — as if we have a duty to our neighbors to do all we can to maintain and increase property values throughout the neighborhood. No one has that power. This is a similar argument that politicians use denouncing short sellers, that the short traders are aggravating price moves and driving stock prices or bond prices lower.
The denigrating of a neighbor's property value can be compared to besmirching their good name as in the case of slander or libel. As Rothbard explains in For a New Liberty, "What the law of libel and slander does, in short, is to argue a 'property right' of someone in his own reputation." But a person does not own his or her reputation, and likewise, while he or she may own title to a home, a person does not own the reputation or reputed value of their home. The reputed value is "purely a function of the subjective feelings and attitudes held by other people," as Rothbard explains about reputations. The same goes for the collective feelings and attitudes in the property market. Just as "a person's reputation fluctuates all the time, in accordance with the attitudes and opinions of the rest of the population," so do the values placed on properties.
To sacrifice for the common good means trading a greater value for a lesser value. It requires impoverishment on the part of the individual to benefit those around him.
A similar argument is that strategic defaulters will increase the cost of borrowing for the rest of us. Banks will have to charge everyone higher interest rates on our mortgages in order to factor in the risk that many Americans will simply walk away from their mortgages if their house values crash.
On the contrary, it's more likely that lenders will offer even lower interest rates to those with good credit scores and low loan-to-value and loan-to-cost loans because they recognize that home values can go down. As bubbles prop up inefficient producers, extraordinary increases in collateral values make all mortgage borrowers seem creditworthy. Why offer low rates and good terms just to the creditworthy when increasing collateral values make all loans good ones?
Crashes, depressions, and recessions weed out the inefficient and the uncreditworthy. Loan pricing may actually be more rational going forward. The creditworthy will be recognized as such for performing during difficult circumstances and the loan pricing offered will reflect that. Higher interest rates will be paid by those who are viewed as less-than-creditworthy. Or the less-than-creditworthy will not get credit at all, forcing lenders to compete aggressively for fewer good-quality loans. This would force rates lower, not higher.
The idea that we as individuals are responsible for those around us conflicts with the libertarian view. As Linda and Morris Tannehill point out in their pathbreaking anarchocapitalist manifesto The Market For Liberty, "Since man's life is what makes all his values possible, morality means acting in his own self-interest, which is acting in a pro-life manner." The Tannehills point out that sacrificing for "the common good" makes man a sacrificial animal, a less than pro-life proposition.
To sacrifice for the common good means trading a greater value for a lesser value. It requires impoverishment on the part of the individual to benefit those around him. "Conflicts are produced when men ignore their self interest and accept the notion that sacrifice is beneficial; sacrifice is always anti-life," the Tannehills write.
A moral person acts in his or her self-interest and in turn doesn't require others' sacrifice. The default moralist libertarian might claim that others are sacrificing if the strategic defaulter doesn't fulfill his or her obligation. But, again, the defaulter does not walk away without cost and lenders take an entrepreneurial risk when lending money. That is why lenders take houses as collateral for mortgage loans and don't lend the money unsecured.
But are modern lenders even taking entrepreneurial risk? The federal government has made sure that no matter how many bad loans they have, Fannie Mae, Freddie Mac, Bank of America, and the other large, systemically-important financial institutions remain in business. As David Einhorn from Greenlight Capital explained in a speech given at a Grant's Interest Rate Observer conference in 2008,
The owners, employees and creditors of these institutions are rewarded when they succeed, but it is all of us, the taxpayers, who are left on the hook if they fail. This is called private profits and socialized risk. Heads, I win. Tails you lose. It is a reverse-Robin Hood system.
Amplifying the point is bank analyst Chris Whalen, who wrote on The Institutional Risk Analyst website,
The policy of the Fed and Treasury with respect to the large banks is state socialism writ large, without even the pretense of a greater public good.
Forget Treasury Secretary Tim Geithner lying about the relatively small losses at American International Group (AIG); the fraud and obfuscation now underway in Washington to protect the TBTF [To Big To Fail] banks and GSEs total into the trillions of dollars and rises to the level of treason. And the sad part is that all of the temporizing and excuses by the Fed and the White House will be for naught. The zombie banks and GSEs alike will muddle along until the operational cost of servicing bad loans engulfs them. Then they will be bailed out — again — or restructured.
So while borrowers are expected to make payments on hopelessly underwater assets until they go bankrupt, the lenders these borrowers are paying are not allowed to go bankrupt no matter the entrepreneurial mistakes that have been made. One has trouble seeing the morality in that.
When asked about the morality of strategic defaults many people will respond that it's okay to default if you can't make the payment, but if you can it's immoral — similar to the "ability-to-pay" argument of those who support progressive taxation. Rothbard explained in Power and Market that the ability-to-pay principle of taxation cannot be justified with a logical argument. If the able are penalized, production and services are diminished, "and in proportion to the extent of that ability," Rothbard writes. "The result will be impoverishment, not only of the able, but of the rest of society, which benefits from their services."
How does one define ability to pay? Enough after-tax income with all adults working to service the debt and enough money left over to pay for groceries and other essentials? What if each adult can work two jobs making enough to service the mortgage? Or three jobs each?
Should homeowners have another family move in and have the families rotate to use the house, with the respective adults working opposite shifts (one set of adults working day shift, the other night shift)? Many Hispanic families did this in a 24-hour town like Las Vegas during the housing boom in order to afford housing. Builders catered to these buyers in the lower-priced northeast part of the city by constructing relatively small homes (under 2,000 square feet) that were carved into seven bedrooms.
What should a person give up in order to make their payments? Food, education, transportation, funds to live on in old age?
During Weimar Germany's hyperinflation, middle-class wives and daughters engaged in prostitution to keep a roof over their families' heads and food to eat. Is it a strategic default if the family females (or the males for that matter) do not sexually service clients for money in order to pay the mortgage? If not, one wonders why the default moralists draw the line there.