Monday, November 17, 2008

The Economics and Ethics of Mortgage Default

(Felix Salmon) Noel Sheppard is mad at Kathleen Pender for educating consumers about their financial options. Pender's article is headlined "Are you an idiot to keep paying your mortgage?", and, yes, Joe, it does lay out a pretty strong argument in favor of going into arrears on your mortgage, in the hope and expectation that the loan will be restructured once you're 90 days delinquent.

It's similar to the argument that was put forward by Mark Gimein earlier this month:

Lenders and developers have through the years shown a great deal of ability to maneuver unsophisticated buyers into crummy real estate deals. The reason that the one act rule exists is to put the risk of these deals on the lender, not the buyer. The purpose is to discourage bad underwriting, dishonest marketing, and unjustified price inflation by making it very, very hard for a lender to get back the money if they lent more on a mortgage than a house was worth. The system is designed to let people walk away. California has a system that puts a higher premium on keeping people out of debt slavery than avoiding bank losses. I see nothing wrong with that legislative choice.

Except now, homeowners get to have their cake and eat it: rather than walk away from their house, they can stay in it, become delinquent on a mortgage, and then have their lender restructure their loan into something easier to repay.

A few caveats are, of course, in order. For one thing, your loan has to be owned or guaranteed by Fannie Mae or Freddie Mac, and it has to be worth at least 90% of your home's present value. For another thing, you have to be paying more than 38% of your income in mortgage payments right now. And then of course there's the ding to your credit, the importance of which is easy to overstate -- even the official FICO spokesman says that "one isolated delinquency will do less damage to your score than it has in the past," and that "if it was me and I was certain that I could keep my home even after missing a couple payments by working out a deal with the lender", that's what he'd do.

If the government passed a bill giving $1,000 to anybody who asked, then it would be entirely responsible for every personal finance columnist in the land to give advice on exactly how to get that money. And the situation here is similar: the government is passing a bill which essentially gives money, in the form of greatly reduced liabilities, to people who default on their upside-down mortgages. Incentives matter: if you reward default in this manner, then people will be more likely to default, and quite rightly too.

Peter Schiff notes that the scheme rewards more than just default: it rewards seemingly crazy behavior like quitting one's job.

Peter Schiff, president of Euro Pacific Capital, predicts that many homeowners who have little or no equity will stop paying their mortgage and then reduce their income to get the biggest payment cut possible. They could stop working overtime or, if two spouses work, one could quit. After the modification, they could try to boost their income again.
"This is a once-in-a-lifetime opportunity," Schiff says. "People are going to feel like complete morons if they don't participate. The people getting punished are the ones who never made an irresponsible decision to buy a house they couldn't afford."

He's right: if you can get your principal reduced by hundreds of thousands of dollars just by quitting your job for a few months, that's a deal which makes a certain amount of sense. It's a pretty perverse incentive for the government to give you, but that's the hand that millions of Americans are now being dealt. And it's entirely the fault of the people who dreamed this scheme up.

Remember that it's not a crime to default on your mortgage. The banks are perfectly happy scraping around in the fine print of credit-card agreements to screw their customers; the customers should be perfectly happy similarly to optimize their own situation with respect to the banks. It's an unfortunate situation all round, but it's not something you can blame the financial press for.

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