The ethics of strategic default

OPINION: Here are three words that can stir moral outrage: Just walk away.

The phrase refers to strategic defaulters - US homeowners who are opting not to keep paying mortgages that they can afford. Unlike the millions of hardship foreclosures afflicting residential real estate, strategic defaulters conclude that it no longer makes economic sense to do so when mortgage balances far exceed the value of a property's plunging value.

The number of strategic defaults is rising in a chronically ill housing market, and the phenomenon sparks a strong emotional response.

"I would like to know where all the accountability went, and why the government is not holding people accountable for their debt," wrote one outraged commenter on my post last week about strategic default.

"People should also be thrown in jail for walking away from a home while the rest of us law-abiding citizens follow the rules."

Eighty percent of Americans think that defaulting on a mortgage is immoral if you can afford to pay it, according to researchers at the University of Chicago and Northwestern University. It's also been argued that homeowners have an obligation to keep paying - if they can - to help preserve neighborhood property values and thereby support the broader economy.

It doesn't seem likely that Americans would really make big real estate decisions based on what's good for the community - that sounds downright socialist. But does strategic default constitute a moral or ethical breach?

I posed the question to Robert Davis, executive vice president of the American Bankers Association. He argued that banks want to help homeowners find alternatives to default, and stressed the importance of talking to lenders first, citing the all-but-certain hit to credit ratings, and the possibility that a bank will come after a defaulting borrower's other assets.

But he stopped short of calling a mortgage a moral obligation. "It's a strategic decision to back out of an obligation, but the world has changed. Would they like someone else to take on the paper loss that they have? Do people do things like that? Obviously they do."

Brent White, a law professor at the University of Arizona, has stirred the pot with several provocative articles suggesting that strategic default can be a rational economic move - and that morality and ethics have nothing to do with it.

Instead, White argues that a mortgage is simply a contract - one that spells out the consequences of failure to pay. "In other words, the lender has contemplated in advance that the mortgagor might be unable or unwilling to continue payments at some point and has decided in advance what fair compensation to the lender would be," he writes.

In an interview, White adds that many underwater homeowners are blameless because they were taken in by hype about homeownership and real estate investment.

"They were told by government and the media to buy homes, and that the good, responsible thing to do was to buy, not rent. As late as 2007, the secretary of HUD was saying that buying a home was the best investment you could make."

But White emphasized that he's not urging all underwater homeowners to simply walk away. "It's not a attractive option because there are real costs."

Along with a plunging credit score, there are moving costs and the need to find a new place to live, he notes.  Moreover, Fannie Mae recently said it would penalize strategic defaulters by locking them out of  Fannie-backed mortgages for seven years, and go after them in court.

However, White notes that the wisdom of a strategic default depends heavily on where you live. Some states have non-recourse laws that prevent banks from going after the personal assets of homeowners who default; others don't offer consumers this protection.

"People have to weigh their circumstances and make a decision," he says. "In my view, there's no moral difference between an individual defaulting on a mortgage and a corporation doing the same thing."

The propensity to walk away from a mortgage rises among homeowners whose negative equity exceeds 10 percent of home value, research shows.

But White counters that the definitions of ability to pay can be murky, and that the decision to walk away can be more emotional than rational.

Says White: "People who do strategic defaults are at the end of their emotional rope. They don't default just because it's a rational decision, but because of anxiety about the future. They try to contact their lenders and can't get help, and they start to feel hopeless - and angry. The banks have been bailed out. Homeowners who they consider irresponsible have been bailed out... (But) if you keep paying, you'll get no help. So they are pushed to default by a sense of injustice and anger."

- Reuters