Strategic Home Mortgage Default in Recourse States and Non-Recourse States

It was the best of times, it was the worst of times; it was the time when borrowers would do anything to pay their mortgage, it was the time when some borrowers walked away from their home mortgage; it was the time when lenders held onto home mortgages for 30 years; it was the time when lenders promptly sold home mortgages.

Business Strategic Mortgage Defaults

Roger Lowenstein, author of The Way We Live Now, Walk Away From Your Mortgage, gives an example of strategic mortgage default in the business world.  A Morgan Stanley fund decided to stop making payments on a real estate purchase in San Francisco because the value of the real estate had decreased.  He suggests that the owners of any company that defaults on bonds and chooses to let the company fail rather than invest more capital in it are practicing “strategic default”.

Maguire Properties, Inc. (Ticket Symbol: MPG) a Real Estate Investment Trust (REIT) with holdings in California walked away from buildings because they were worth less than their mortgages.  As the stock tumbled, I did roll the dice on its stock!

It was reported that Tishman Speyer Properties and BlackRock Realty, the owners of the huge New York residential real-estate complex consisting of 54 buildings and 11,000 apartments called Stuyvesant Town and Peter Cooper Village decided to walk away and hand over the property to the lenders because the complex was worth less.

Residential Strategic Mortgage Defaults

Luigi Guiso of European University Institute, Paola Sapienza of Northwestern University,  Luigi Zingales of University of Chicago, authors of Moral and Social Constraints to Strategic Default on Mortgages found that

1. 26% of the existing mortgage defaults are strategic.
2. No household would default on the mortgage if the negative equity is less than 10%.
3. 17% of households would default, even if they can afford to pay their mortgage, when negative equity reaches 50%.
4. With other things being the same, people who consider it immoral to default on their mortgage are 77% less likely to declare their intention to do so,
5. With other things being the same, people who know someone who defaulted are 82% more likely to declare their intention to do so.

Recourse States and Non-Recourse States

In a non-recourse state, the lender is not allowed to pursue the borrowers who walk away from their mortgages for the difference between the loan and the resale price of the primary residence.  The lender can sell the house through foreclosure.  If the foreclosure sale is deficient, that is, the sale price is not sufficient to satisfy the loan, the lender must accept the loss.  In non-recourse states, the lender is not allowed a deficiency judgement.

Now, how a lender may attempt to minimize its losses by resorting to what is being referred to as a bank walkaway (lender walkaway).   In a bank walkaway, the borrower-owner is no longer occupying the property but the lender is not the legal owner of the property!  With the lender not taking ownership, the borrower is on the hook for maintenance, property tax bill.

A study indicates that in recourse states, the cost of legal proceedings is sufficiently high that it is not worthwhile for lenders to sue a borrower under default unless the borrower has significant wealth that can be recouped.  Cost to benefit ratio/cherry picking applies.  But lenders are entitled to exercise their rights, depending on the borrower characteristics and local laws, to pursue unpaid mortgage balances by wage garnishments, tapping bank accounts and placing liens on assets held by wealthy borrowers.  The lender may also choose to sell these deficient mortgagge accounts to collection agencies and other parties who are likely to pursue the borrower.

Richard Thaler, author of Underwater, but Will They Leave the Pool? suggests that borrowers in nonrecourse states pay extra for the right to default without recourse.  These fees are not made explicit to the borrower, but if they were, more borrowers might be willing to default, figuring that they had paid for the right to do so.

Consequences of Strategic Home Mortgage Default due to negative equity

According to Stephanie Armor, author of More Walk Away from Homes, Mortgages, walking away from a home mortgage has a mild punishment.  It can knock 100 points off the credit score and make a borrower ineligible for a new home mortgage for 7 years.

Brent White, Associate Professor Law, University of Arizona, James E. Rogers College of Law and author of the excellent paper titled, Underwater and Not Walking Away: Shame, Fear and the Social Management of the Housing Crisis found that

Most homeowners do not strategically default as a result of two emotional forces:

(1) the desire to avoid the shame and guilt of foreclosures and

(2) exaggerated anxiety over foreclosure’s perceived consequences.

Moreover, these emotional constraints are actively cultivated by the government and other social agents in order to induce homeowners to ignore market and legal norms under which strategic default might not only be a viable option, but also the wisest financial decision.