Strategic Default - Essay Example

Strategic Default] First Business Law 308 T/Th 8:00 a.m. Spring Today a staggering number of households are under water on their mortgages in the United States. The term under water here means that they owe more than the worth of their houses. According to Hagerty and Timiraos (2009), around five million households in the U.S. have mortgage balances equaling a minimum of 20 times the value of their houses. Among these five million households, approximately two million are at least fifty percent under water. These numbers predict a gloomy picture as the today under water individuals may decide to default tomorrow triggering a nationwide foreclosure crisis. The tendency to default when you are under water even if you have the ability to pay the mortgage is known as strategic default. In this paper I would first outline the legal and ethical constraints associated with such defaults and then discuss its implications on the lender, the borrower, and the society as a whole. In recent years many states in U.S. have witnessed dramatic fall in home prices. This has encouraged homeowners in these states to simply walk away from their mortgages not out of an inability to pay the mortgages, but because strategic default seems the best available option financially. In order to understand the reasons behind walking away better consider the example of a man who bought a house on credit for $300,000 in a year when the home prices were expected to rise. Suppose now that two years later the homeowner still owes $250,000 but the home prices have taken a serious downward plunge resulting in him owing more than what his house is worth of. Given such an eventuality, it makes much sense, economically, for the homeowner to completely stop making mortgage payments and invest the money saved elsewhere. In fact, defaulting on the mortgage payments seems to be the only option for the homeowners if he were to make his decision to default on a pure financial basis. Yet, it can be seen that in actuality, a great number of underwater homeowners carry on paying off their mortgage debts. This non-exercising of strategic default option may be as a result of two reasons: (1) state regulations that allow banks and lenders to pursue legal claims on borrower’s other assets, and (2) shame and fear associated with joining an exclusive club of defaulters that may have made the homeowners reluctant to default. It is important to note that the activity of strategic default is perfectly legal in U.S. There is no law as such that disallows it or deems it punishable. States like Florida and Nevada, however, allow lenders and banks to pursue legal claims against the defaulters either themselves, or through some collection agency or firm, making it costly for the homeowners to default. On the other hand, states like California and Arizona prohibit lenders and banks from pursuing other assets of mortgage borrowers. This should theoretically make California and Arizona safe havens for defaulters with every under water case resulting in a strategic default. Brent White (2010), however, disagreeing with this notion says that the shame and guilt of a default along with the fear of implications of a foreclosure prevent most under water homeowners from exercising the strategic default option. According to White such “emotional constraints are actively cultivated by the government, the financial industry, and other social control agents in order to induce individual homeowners to act in ways that are against their own self-interest, but which are - wrongly this article contends - argued to be socially beneficial” (White, 2010, p. 2). He argues that although homeowners are expected to follow the social and moral norms that require them to keep paying their mortgage payments, lenders are allowed to maximize profits without any of these concerns. The lenders are allowed to resist calls for modifications of under water mortgages even though doing that makes it difficult for the borrowers to pay their mortgages on time. White further says that lenders’ allowance for modification of under water mortgages would be socially beneficial and thus should be pursued with the same vigor as default cases are. As of now homeowners are forced to bear most of the burden of the inequality arising out of the “norm asymmetry” (White, 2010, p. 2) between the lender and the borrower. What White fails to take into account is that it is the lender who has lent the money to the homeowner in the first place. The lender thus has every right to demand his money back in case of a default. Also, a strategic default by one particular individual may encourage other individuals in the locality to default as well. This “cascade effect” (Hagerty and Timiraos, 2009) is particularly significant in neighborhoods with high concentration of foreclosures like in California where a large number of people are under water. “A study by researchers at Northwestern and the University of Chicago found that as many as one in four defaults may be strategic” (Hagerty and Timiraos, 2009). The feelings of guilt, fear, and shame usually associated with a default may not hold in a neighborhood where a high proportion of the population is under water. This makes the current situation in California and other states much graver as a mass strategic default is always on the cards. Such a mass strategic default would in turn push the whole country into a crisis similar to the subprime mortgages one as there would be sudden dearth of loans available from banks. Lenders would be less willing to lend funds to borrowers which would result in less expenditure in the economy as whole. Consequently, unemployment would rise and there would be a decrease in output as firms would respond to reduced demand arising out of a general shortage of money in the economy. To some extent strategic default is harmful to the homeowner as well. Once homeowners have defaulted their credit rating takes a serious beating preventing them from taking bigger loans in future. The lenders would now think twice before giving them any loans. The loss to the lenders is most significant of all. They have to bear legal fees if they decide to take action against the defaulting homeowners in the courts. A legal process is lengthy and may not always result in lenders getting their money back. In States like California and Arizona legal action is disallowed anyways. Also, if they do not take the defaulters to the courts then there money would be lost, money that could easily have been invested elsewhere. As a result, unless defaulted borrower has significant wealth besides the home, the cost of legal procedures is sufficiently high so that most lenders are unwilling to sue the defaulter. The borrowers should therefore exercise the option to default strategically after much consideration. They should consult their attorneys for the implications of such a default and for any alternative options that they might have. The role of attorney is thus important as their advice may shape the future course of action of the homeowner. The most important question that arises at this point is that are the attorneys obligated to advise their clients to engage in strategic default? The answer to this question depends on the legality of strategic default itself. According to Steven Schwarcz (2010) if the client’s actions would result in a violation of law then the attorney should not advise him at all of that action as “lawyers have a duty to not engage or assist a client in performing an unlawful act” (Steven Schwarcz, 2010, p.9). If, however, no violation of law takes place then the lawyer must inform the client of all the options that he/she has. As strategic default is legal in U.S. the attorney can thus advise the client to engage in strategic default. Even in the absence of any moral or social constraints, it is argued that there are a number of other economic reasons not to default. First, walking way from the house involves relocation costs. Second, the homeowner has an advantage in delaying the default if the rental that is to be paid on an alternative house is more than the interest on mortgages that is to be paid. Third, homeowner faces the risks of action by the lender on his other assets. Finally, as previously mentioned, it leaves a significant dent on the borrower’s credit rating deeming him unsafe for future lending. After adjusting for such costs, a strategic default may no longer seem feasible. Studying strategic default decision moreover is easier said than done because it is, in fact, whether with lawful authority or not, an unobservable event. Even though we can observe defaults in the real world, determining whether a default is strategic can not be observed in the same way as a simple case of default. This is because strategic defaulters have nothing to lose by posing themselves as people who can not afford to pay the money so they will appear alongside non strategic defaulters in the data. I would like to conclude by weighing up moral and ethical reasons why the strategic default option should or should not be used by the homeowners given that it is perfectly legal to default strategically. Brent White (2010) argued that homeowners should make the decision on whether to keep paying mortgage based on their own interests, unaffected by any feelings of guilt or shame. He argued further that borrowers should take a leaf out of the lenders’ book whose sole aim is to maximize profits or minimize their losses without any redistribution concerns. I however argue that since strategic default involves non-payment of borrowed money – money that was not your own and money that could have been invested by the lender elsewhere, it would be ethically wrong to default knowing that you have the means to pay back the mortgage. In addition, the cost of one person defaulting can be high for the society as a whole since it would encourage other under water individuals to follow the lead of the defaulting person. As already mentioned, the cost of one individual defaulting would be particularly high in the long run as more and more individuals default. Accordingly, there would be shortage of credit money in the economy resulting in decreased demand which would in turn lead to unemployment as firms would cut their supply. For this reason too, individuals have a moral responsibility to try to pay their mortgages on time. To sum up, if judging the option of strategic default purely on moral or ethical grounds then it is surely wrong to knowingly gobble up other people’s owed amount and hence should be avoided at all costs. References Hagerty, James R., and Nick Timiraos. "Debtors Dilemma: Pay the Mortgage or Walk Away." The Wall Street Journal (2009). Web. 25 Mar. 2010. Schwarcz, Steven L. "Keynote Address: The Role of Lawyers in the Global Financial Crisis." Australian Journal of Corporate Law (2010). White, Brent T. "Underwater and Not Walking Away: Shame, Fear and the Social Management of the Housing Crisis." Arizona Legal Studies (2010). Read More