What’s Wrong With Homeowners Defaulting? Companies Do It all the Time

When we say that a company “went bankrupt,” we imply that it had no other choice. But American Airlines deliberately filed for bankruptcy. The airline had four billion dollars in the bank and was in a position to pay its bills. American has been losing money for some time and its board decided that it made no sense to continue throwing good money after bad. By declaring bankruptcy, American can trim its debt, break its union contracts, so that it can slim down and cut costs.

According to James Surowiecki, a financial writer for The New Yorker, “American wasn’t stigmatized for the move. Instead, analysts hailed it as ‘very smart.’  It is now generally accepted that when it’s economically irrational for a company to keep paying its debts it will try to renegotiate them or, failing that, default. For creditors, that’s just the price of business. But when it comes to another set of borrowers the norms are very different. The bursting of the housing bubble has left millions of homeowners across the country owing more than their homes are worth. In some areas, well over half of mortgages are underwater, many so deeply that people owe forty or fifty per cent more than the value of their homes. In other words, a good percentage of Americans are in much the same position as American Airlines: they can still pay their debts, but doing so is like setting a pile of money on fire every month.”

Families so deeply underwater realize that they will never make a return on their investment in their homes. The rational solution for many would be a “strategic default” – walking away from the mortgage and letting the house revert to the bank. Yet the vast majority of underwater borrowers are still paying their mortgages; studies suggest that perhaps only 25 percent of all foreclosures are strategic. When you consider how much housing prices have fallen, one can’t help but wonder why more people aren’t just walking away.

According to Surowiecki, “Part of the answer is practical. Defaulting (even in so-called non-recourse states) is still a lot of trouble, and to most people it’s scary. In addition, homeowners are slow to recognize how much the value of their homes has dropped, and have inflated expectations of how much it will rise in the future. The biggest hurdle, though, is social: while companies get called ‘very smart’ for restructuring their contracts, there’s a real stigma attached to defaulting on your mortgage. According to one study, eighty-one per cent of Americans think it’s immoral not to pay your mortgage when you can, and the idea of default is shaped by what Brent White, a law professor at the University of Arizona, calls a discourse of ‘shame, guilt, and fear.’ When the housing bubble burst, the banking industry was terrified by the possibility that homeowners might walk away en masse, since that would have stuck lenders with large losses and a huge number of marked-down homes. So strategic default was portrayed as the act of dishonorable deadbeats. David Walker, of the Peterson Foundation, waxed nostalgic about debtors’ prisons, and John Courson, the head of the Mortgage Bankers Association, argued that defaulters were sending the wrong message – to their family and their kids and their friends.”

“Paying your debts is, as a rule, a good thing,” according to Surowiecki. “But the double standard here is obvious and offensive. Homeowners are getting lambasted for doing what companies do on a regular basis. Walking away from real-estate obligations in particular is common in the corporate world, and real-estate developers are notorious for abandoning properties that no longer make economic sense. Sometimes the hypocrisy is staggering: last winter, the Mortgage Bankers Association — the very body whose president attacked defaulters for betraying their families and their communities —got its creditors to let it do a short sale of its headquarters, dumping it for thirty-four million dollars less than the value of the building’s mortgage.”

In the case of debt, the corporate attitude is do as I say, not as I do. While homeowners are advised to think of more than the bottom line, banks do business in coldly rational terms. They could have helped keep people in their homes by writing down mortgages (similar to the restructuring that American Airlines’ debt holders now face). “And there are plenty of useful ideas out there for how banks could do this without taxpayer subsidies and without rewarding the irresponsible,” Surowiecki said.  “For instance, Eric Posner and Luigi Zingales, of the University of Chicago, suggest that, in exchange for writing down mortgages in hard-hit areas, lenders would take an ownership stake in a house, getting a percentage of the capital gain when it was eventually sold. Lenders, though, have avoided such schemes and haven’t done mortgage modifications on any meaningful scale. It’s their right to act in their own interest, but it makes it awfully hard to take seriously complaints about homeowners’ lack of social responsibility.”

Of course, many borrowers made bad decisions and acted irresponsibly. But so did lenders — by handing out too much money and not requiring sensible down payments. So far, banks have been partially insulated from the consequences of those bad decisions, because Americans have been so obliging about paying off over-inflated mortgages. Strategic defaults would help distribute the pain more evenly and, if they became more common, would force lenders to be more responsible in the future. It’s also possible that a wave of strategic defaults — a De-Occupy Your House movement — would get banks to take mortgage modification more seriously, which would be all for the better. The truth is that banks have been relying on homeowners to do the right thing. It might be time for homeowners to do the smart thing instead, Surowiecki concluded.