Tuesday, November 4, 2008

Morally Conflicted About Walking Away? Don't Be.

In my last post I mentioned that it was not my responsibility to give lectures in responsibility to borrowers struggling to make the payments on their houses. I want to delve into this a little bit further for a second. In story after story about the foreclosure crisis, you will find the implicit idea that borrowers who can afford to pay their mortgage should keep on paying it no matter how much their house sinks in value because they have made a promise to pay and to do otherwise would be an abuse of the system.

Propagating this idea is good for lenders and probably good for taxpayers, but basically, it's nonsense. Most states--California being the most relevant example--make it very difficult for a lender to go after borrowers for more money after they have foreclosed on a house. In California, lenders can foreclose in two ways. One way, the non-judicial foreclosure, lets the lender take back the deed with a 60 day notice after the first missed payment. In practice, this means that lenders can take the house in a matter of about four months. If they do that, however, they cannot get any more money. The other way lets lenders go to court to get the full amount due on the mortgage. This can take years. If the lender wins in court, then the borrower still has 366 days to pay off the mortgage and take back the house, which means that for all practical purposes it can't be sold. Thanks to California's "one action" rule, a lender cannot pursue both options: the bank must choose one.

In practice, this means that a bank that doesn't want to get bogged down in a two year long morass has little option but to take back the keys, accept a huge loss, and call it even. Is this an "abuse" of the system? I don't see how. The loss was something that lenders could have anticipated at least as easily as borrowers. The reality is that ordinary people are lousy at figuring out the ins and outs of real estate transactions. Relying on the one act rule to get out of a mortgage is not to abuse the system--it is to use the system in precisely the way it was intended to be used. The reason that the one act rule exists is that lenders and developers have through the years shown a great deal of ability to maneuver unsophisticated buyers into crummy real estate deals. The reason that the one act rule exists is to put the risk of these deals on the lender, not the buyer. The purpose is to discourage bad underwriting, dishonest marketing, and unjustified price inflation by making it very, very hard for a lender to get back the money if they lent more on a mortgage than a house was worth. The system is designed to let people walk away. California has a system that puts a higher premium on keeping people out of debt slavery than avoiding bank losses. I see nothing wrong with that legislative choice.

It's worth noting, also, that invariably stories that mention the prospect of foreclosure talk about the hit that this causes to a borrowers' credit rating. Obviously, there is a hit. However, journalists are mistaken when they imagine that a credit score is a judgment on the character of borrowers. It's not. It's a judgment about the likelihood of someone repaying a loan. Bad marks like a foreclosure affect this. But being overextended on credit affects this even more. You might imagine that if you have the magic word "foreclosure" on your record you are automatically a worse risk than someone who doesn't. That's just not true. Lenders don't like to lend money to people who have not paid their debts in the past. But what they like even less is lending money to people who have a mortgage they can't afford and are likely to stop paying their debts in the future.

Update Oct. 2009: This post was written a while ago. My basic views haven't changed, but I expand on them somewhat in a more recent story for The Big Money.