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The Morality of the Strategic Default

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OptimizedPrime
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Hello folks,

Whereas I consider myself an expert of applying the proper rational ethics to a situation and I'm usually quick to tear apart an issue to its roots, for some reason this one left me stumped. Maybe I'm being dense (happens), but I can't decide on the proper way to treat an issue that's come up in my study of the recent housing downturn in the US ("Housing Crash").

The broader topic of the Housing Crash is very BIG one that I'm sure has fostered countless threads here. I suspect most of the discussion has been centered around economics and politics, and clearly there is a lot to discuss in these areas. I have personally been involved in a lot of these discussions under the pseudonym you see before you in various forums dedicated to the realms of business, markets, macroeconomics, trends, politics, and so on.

One key component of the Housing Crash that has a distinct personal and ethical angle is the concept of the Strategic Default. I don't want to fill this post with a bunch of background, so I'll summarize quickly and leave you with a link for more detail (or just Google it):

http://online.wsj.com/article/SB126040517376983621.html

The summary is this. A buyer "buys" a home using a home loan from a bank. The house and the local market then depreciates to the point where a) the house is worth far less than the remaining balance on the loan; b ) the house's price has dropped to a level where it is "obvious" that the price will "never" recover in the buyer's lifetime; c) because of the market downturn and a bubble-finance-driven disparity in the price-to-rent ratio, the rent for a comparable house is far cheaper (sometime multiples cheaper) than the mortgage payment for the underwater house.

(This, by the way, is a situation that Credit Suisse predicts will happen to about 6.5 million homes in the US and many estimate that it might be as high as 30% of all US homes within the next two years. It is not a small or peculiar situation. It's mainstream).

Faced with this situation, many decide to commit what is called a "Strategic Default". That is, even though they may still have the means to make the mortgage payments, they actually stop paying INTENTIONALLY in order to let the course of the mortgage contract play itself out. Since many states in the US (the lion's share of dollar the volume) actually preclude banks from making "full recourse" loans, the mortgage contract states that, upon ceasing to make payments the bank will: 1) take your ("your") house; 2) ruin your credit rating (i.e. tell other banks about this).

So far this is all just headline news. The question for THIS forum is the debate that is starting to take place in many an op-ed: is the Strategic Default moral?

In my own analysis, I've come up with two arguments:

Immoral. You made a promise to the bank that you'd pay back the loan and you are breaking that promise. This is fraud and as such any value you derive from it is not real. You cannot derive any real happiness from this and even worse you are displacing valuable opportunity in your life to do things you can derive enjoyment from. Every enjoyable minute of your life from now on will be tainted by this transgression because they too will be less real thus displacing valuable time, etc. etc. etc. Committing fraud is unselfish and immoral and that's what this is.

Moral. The contract you sign with the bank was just that: a contract. A contract doesn't say, "you will not" but rather "if YOU do A, then the BANK will do B". There cannot be any fraud since there was NO deception involved. Both sides were perfectly aware of the contract's terms, one of which was the exact action you are now taking. You signed your name on the contract and swore everything you said at the time was true, and it was. Since you were perfectly truthful the bank had all the necessary information to take the risk that they are in the business of taking. They assumed that your house would not plummet in value, they assumed the downside to you of ruining your credit rating would prevent most people from doing this, etc. [And the bank assumed the government would bail them out no matter how stupid the risks they took / the bank committed fraud in repackaging these loans to others who thought they were safer than they were / etc. etc. etc. -- but I said I'd stay on topic :-) ].

Here's what I think is NOT relevant to this discussion:

1. "The government created this mess". They did, but stealing is still not selfish. Try again.

2. "The banking system will simply price this possibility in, and this won't break the system but rather just change it". True enough, and mortgages of the future WILL be much more expensive in an absolute sense, but they system will live on in a different (more expensive) form. However, this has nothing to do with YOU in any direct sense.

3. "The State Government forced the bank to offer a 'no recourse' loan". True enough, and that is wrong, but nobody forced them to be in the loan business and none of this was a result of anything you did. The law was known to both sides when the loan was written. It's certainly possible that in a free market banks would continue to pass up full recourse in exchange for a higher interest rate. for instance.

4. "Stupid evil banks deserve what they get". It's not quite that simple, and there's all kinds of blame to pass around for the whole situation and a lot of fraud and force all over the place, but this again has nothing to do with you per se.

5. "This behavior will ruin it for everybody". It will certainly make the once low-risk instrument of home loans look more like venture capital, but this again is not relevant to THIS discussion.

6. "You made a bet that the house would go up, and you stood to gain if you won, but you lost so so pay up". The contract you signed was not a "bet" on a given outcome, it was a mortgage for a home with specific rules related to that. That it might amount to a "bet" by both parties is irrelevant to our discussion about the morality of this move.

So let the debate begin. I'm curious to see what folks think.

OP

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I don't have a definitive argument, but I do have an analogy. Strategic default looks a bit like divorce. When you get married, you make a lifetime commitment -- "for better or for worse, in sickness or in health, till death do you part" is the traditional formulation. You don't just walk away at the first sign of difficulty, because doing so would make it impossible for you to have the profound values that flow from a decades-long romantic relationship. But sometimes things change so dramatically that you're no longer talking about momentary difficulties in an otherwise sound relationship. The marriage itself has gone sour, and sticking with it would mean dedicating a large portion of your life to the pursuit of something that is no longer a value to you. Strategic default could be viewed in a similar light.

And here's a thought on analysis. We can divide immoral actions into two broad groups -- the categorically immoral and the contextually immoral. The former are actions that are wrong regardless of a person's specific value hierarchy. No matter what your values are, it is immoral to be dishonest, to be a parasite, to be irrational, etc. The latter are actions that involve a sacrifice, a surrender of a greater value for a lesser. Sacrifice is immoral, but whether a specific action counts as a sacrifice depends on how your values are prioritized relative to each other, and this ordering has options. Another person's value hierarchy can be legitimately different from yours, which means an act that would be a sacrifice for you might be perfectly moral for him. So we should start by asking whether strategic default is categorically immoral. If it is, we should be able to identify a specific moral principle which it violates. If strategic default is not categorically immoral, only then does it make sense to look into the possibility that it is contextually immoral -- and to identify the specific impact that it has on one's values in hierarchical context.

Edited by khaight
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I think there's a bit of a problem with the divorce analogy. You choose to get divorced when something about the person you married changed to make them basically no longer what you agreed to get married to while in strategic default, nothing about the house changed (at least, nothing that the other party in the contract is responsible for). Strategic default, if compared to divorce, sounds like deciding to divorce your partner because they used to be seen as really hot by other people and you were envied as their partner, but now red hair and being perky is out of style and other people no longer want your partner, since people are doing these defaults based on what other people are now willing to pay for their house even though they themself had seen the house as worth the cost for whatever reason when they bought it.

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Here's what I think is NOT relevant to this discussion:

1. "The government created this mess". They did, but stealing is still not selfish. Try again.

Saying that the government's actions justify your action is, of course, wrong. The government's actions do not justify stealing. However, this situation is not stealing. Defaulting on a loan with collateral, when the collateral is transferred to the lender, is not stealing. It is the selfish responsibility of the lender to require collateral that will cover the possible default. Under current law there are situations in which a resident in a property may take advantage of a lender, but that is a different issue from the mortgage default. Defaulting is not a criminal activity, per se. (If someone entered a mortgage with the intent to default, i.e., committed fraud, it would be.) Defaulting when you can continue to pay may be unjustifiable. It would be necessary to be sure you weren't rationalizing a decision to default.

OptimizedPrime has set this up with very limiting specifics, namely, the person can still meet the mortgage payments. Whatever the government did would seem to not justify walking away. Most of the people that OptimizedPrime has described would be culpable.

Yet, it must be remembered that the government's actions have a wide range of consequences. Rejecting the government and its actions as having responsibility in this case is not as solid as it would seem. The government's actions included many elements that preclude understanding the economic situation by undercutting, hiding, or completely distorting the economic information necessary to make rational decisions. This is one of the most important points made by the Austrians, especial von Mises. Bad information means bad decisions.

Both the lender and the mortgage holder are victims. You could suggest that both of them should have realized that the situation was not tenable. Perhaps. We all know reasonable people who got in over their heads and mortgage lenders that were doing what they thought was reasonable, too. There were very few who recognized that this situation could turn out as it has. This level of ignorance of economics is part and parcel of the government's and the politician's intentions.

Each individual has to look at their situation and make hard choices. Stealing is wrong. Defaulting is unfair when unnecessary. When a person puts themselves into a bad situation, they must suffer the consequences. When the government does, there is no good fairy to save us. Reality will hit us anyway, as it has. You can't sacrifice another person for your problem, even if it isn't of your making. Sitting in a situation forced on you by the government in which it is either you (and your future or long-term financial health - even if you can make the payments at this time) or the bank is closer to the life-boat context, and as Ayn Rand has said about other situations involving the government, may be impossible to untangle.

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khaight makes a great analogy in marriage, and I'd take it one step further: if you entered into a marriage with the INTENTION OF DIVORCE then that is fraud. In an honest commitment you are in effect saying, "this relationship works for me and to the best of my knowledge at this time I think it will continue to do so forever". Whereas we lack omniscience, our initial judgment could be wrong. However, a person who enters into a marriage with the intention of a quick divorce is both sadly common and immoral. This is a person usually for something unearned and creates a complicated conspiracy (a marriage) to get it. Honest divorce, on the other hand, "happens to the best of us".

The same could be said for Strategic Default. Clearly if you enter into a mortgage for the sole purpose of collecting free rent for 12-18 months (thank you, "foreclosure assistance" programs) then that is fraud. However if you and the bank had a plan, and it involved the house price doubling in five years and both sides making lots of money--and that plan went south--then both parties should revert to the legal contract in question, which of course spells out the procedure when the plan goes wrong.

In the current state of the US housing market, it would appear that the contracts written heavily favor the home occupier over the lender. That people are simply taking advantage of a favorable situation is perfectly "fine" as long as they didn't plan it that way from the start.

OP

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Clearly if you enter into a mortgage for the sole purpose of collecting free rent for 12-18 months (thank you, "foreclosure assistance" programs) then that is fraud.

It's worth noting that 'fraud' is not a moral concept; it is a legal one. The moral principle most directly applicable to this situation is honesty, and its specific formulation is worth noting: the commitment to never attempt to gain a value by faking reality. If you deliberately enter into a mortgage contract with the intention of getting a place to live without paying for it, that is clearly a violation of the virtue of honesty as formulated above. On the other hand, if the situation has simply changed in such a way that continuing to pay on the mortgage would constitute a sacrifice, and you decide it is in your self-interest to return the house to the bank and take the hit on your credit report, that is not a violation of the principle of honesty. Which value are you trying to obtain, and what part of reality are you trying to fake?

Here's a concrete scenario in which strategic default might be moral. Suppose that you bought a house as a 'fixer-upper', with the intent of remodeling it and selling it for a profit a few years down the road. Then the market collapses, such that it would take you many more years to be able to sell even the remodeled house for enough to make your investment back. Selling the house wouldn't even make you enough money to cover what you own on the mortgage. In such a situation it might well make sense to just wash your hands of the whole situation, give the house back to the bank and move on. In essence, you bought the house as a means to an end, and due to circumstances beyond your control it ceased to be a means to that end.

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The same could be said for Strategic Default. Clearly if you enter into a mortgage for the sole purpose of collecting free rent for 12-18 months (thank you, "foreclosure assistance" programs) then that is fraud. However if you and the bank had a plan, and it involved the house price doubling in five years and both sides making lots of money--and that plan went south--then both parties should revert to the legal contract in question, which of course spells out the procedure when the plan goes wrong.
This is the key to your question about whether Strategic Default is immoral. As you've correctly stated above, the relationship between borrower and lender is governed by a contract and that contract provides for certain consequences in the event of a default. If the situation is such that one party must default, then that party should be willing to suffer the consequences spelled out in the contract. None of this reaches the level of immorality unless a party enters a contract with the intention to defraud the other party. If, for example, one mortgaged a property and then added a second mortgage without recording/notifying the bank of the first mortgage, then that would be fraud and clearly immoral. This sort of thing has certainly occured, but it's not the situation you have described. By the way, businesses commit "Strategic Defaults" on loans all of the time and nobody brings up the issue of morality. I don't see how such a default on a mortgage is any different.

In the current state of the US housing market, it would appear that the contracts written heavily favor the home occupier over the lender. That people are simply taking advantage of a favorable situation is perfectly "fine" as long as they didn't plan it that way from the start.

Whether the contract is written in favor of one party or the other has no moral implications (assuming no force was involved).

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I think there's a bit of a problem with the divorce analogy. You choose to get divorced when something about the person you married changed to make them basically no longer what you agreed to get married to while in strategic default, nothing about the house changed (at least, nothing that the other party in the contract is responsible for). Strategic default, if compared to divorce, sounds like deciding to divorce your partner because they used to be seen as really hot by other people and you were envied as their partner, but now red hair and being perky is out of style and other people no longer want your partner, since people are doing these defaults based on what other people are now willing to pay for their house even though they themself had seen the house as worth the cost for whatever reason when they bought it.

Once upon a time a man met a beautiful House, and he fell in love. He saved all of his money and bought it.

For years he blissfully owned his wonderful new House and there were very happy together.

Unfortunately the years wore on and the House started aging. Cracks grew where there were none before, some of its parts didn't sit up as straight as they once did. The paint on the house faded and turned gray.

Meanwhile, there were houses elsewhere that were brand new with the latest technology appliances and brand new paint. Many thought they were much more beautiful.

Not this man though. He was still in love.

You see, those young and fresh houses were built in the middle of the desert in giant housing tracks. This man's old ugly house was a one-off custom home built on Malibu Beach and was worth perhaps one hundred times what those other houses were worth even though it was barely standing.

The man bought the house as an investment (he lived far away) and this house was his investment for retirement.

He sold the house and profited handsomely and was able to have a comfortable retirement. He's still in love with that house, after all of these years.

***

Love is about values. If a man falls in love with physical beauty alone, neither will last.

OP

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There's no fraud here. Consider what fraud actually is - quoting Rand, "fraud ... consists of obtaining material values without their owner’s consent, under false pretenses or false promises." [TVoS, TNoG] There is no promise or pretense in a mortgage contract, it's simply a series of if-then statements. (If you pay your mortgage in full, then the bank removes the lien and the house is yours outright. If you don't, then the bank repossesses and you lose the property.) There's no false pretense here - the possibility of default is built right into the contract.

The strategic default is not an immoral action.

Edited by Jas0n
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... If you don't, then the bank repossesses and you lose the property.) There's no false pretense here - the possibility of default is built right into the contract.
It is not really like that. The contract usually specifies that you owe the bank the amount you borrowed, not limited to the value they can realize through the sale of the property. It is separate law (in some states) that makes it expensive or impossible for banks to come after the borrower for the rest of the money. This is not a simple situation where there's a contract and you're free to walk away under the conditions of that contract. Rather this is a situation where the contract is made with certain mandates imposed externally. So, while one can make the case that the bank ought to know this while going into such a contract, it is not as clear-cut as you imply.

In addition, many borrowers who signed such contracts acted immorally to begin with, when they took on debts that they should reasonably have known they would not be able to repay.

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There's no fraud here. Consider what fraud actually is - quoting Rand, "fraud ... consists of obtaining material values without their owner’s consent, under false pretenses or false promises." [TVoS, TNoG] There is no promise or pretense in a mortgage contract, it's simply a series of if-then statements. (If you pay your mortgage in full, then the bank removes the lien and the house is yours outright. If you don't, then the bank repossesses and you lose the property.) There's no false pretense here - the possibility of default is built right into the contract.

I still think that, as has been noted earlier in the thread, if one enters into the mortgage contract with the deliberate intention of defaulting, that would be fraud. It takes time, effort and money to go through the process of repossession, and while that process is underway you would be living in the house. You would have obtained a material value under false pretenses. The material value is the house (until repossessed), the false pretense would be the promise to pay the mortgage, which you never intended to keep.

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I still think that, as has been noted earlier in the thread, if one enters into the mortgage contract with the deliberate intention of defaulting, that would be fraud.
Yes, and also -- since this is about morality as opposed to legality -- some are guilty of evasion. There are people who took loans they could not afford, with some type of vague thought that they would make ends meet "somehow". Much of the ignorance on the subject of what they were getting into was immoral ignorance, because they were surely not ignorant that they needed to understand the decision better before proceeding.
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There are people who took loans they could not afford, with some type of vague thought that they would make ends meet "somehow". Much of the ignorance on the subject of what they were getting into was immoral ignorance, because they were surely not ignorant that they needed to understand the decision better before proceeding.

This is also true. I bought a house in 2003, and the first thing I did when I decided to enter the market was go down to the bookstore and buy several books on mortgages and the home-buying process. I read them all too, before I contacted a real estate agent. The research paid off in exactly the way you reference -- the banks were willing to lend me substantially more money than my own calculations suggested would be prudent. I declined to take them up on their offer. The result is that I bought less house than I might have, but I can actually afford it so it isn't a financial albatross now that home values have declined.

There is a vast amount of good information about responsible home buying, and responsible financial management more broadly. But you can't force a mind -- all you can do is allow it to experience the consequences of its choices.

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  • 2 weeks later...
  • 4 months later...

I just finished developing a small website for a company in the business of selling "mortgage underwater advice". Looking around for places to advertise I stumbled across this website. Since there are many similar websites popping up, I suppose the problem is only getting worse in this country. Even with the economy coming back and a few more people going back to work, this does not necessarily mean home prices will increase any time soon. Perhaps the so-called bubble in home prices was a bubble where home prices "will not recover" for decades.

I read an Ayn Rand book in my philosophy class decades ago. I pretty much agreed with her philosophy then - but over the decades I guess I've lost most of my academic interests. I am just trying to figure out how to put together the most for my retirement.

I am a freelance programmer now. Too old to do much new.

Today, I am wondering if comparative research exists concerning companies / websites selling "mortgage underwater advice". Is there a "moral status" associated with any of these websites? If so, how should they be changed to improve "moral status"?

If anyone does a research effort please collect info from the folks at the website I just finished. I will just type the name in words and without the dot com. I am sure a good researcher can figure it out. Leave Your Home with Money

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