A lot of people are sitting in houses that are underwater and they have an absolute legal right to walk away and hand the house back to the lender without recourse. But they weren't doing so.
WEST JORDAN — If being underwater in a home mortgage were literal, Alan Smith would be stranded on the roof by the flood, water lapping around his ankles. And if the whop-whop-whop of a rescue helicopter's spinning blades hovered above him, Smith would just wave them off.
Come heck or high water, Smith and his family are staying put.
Fortunately being underwater in a home isn't literal. Being underwater simply means you owe more on your home mortgage than the house is worth — what realtors call "negative equity."
At least Smith, a realtor with Coldwell Banker Residential, is not alone in his pain.
CoreLogic, a business analytics website, released second quarter 2011 data that showed 10.9 million residential properties were underwater. And of those underwater, nearly three-quarters paid above-market interest on their mortgages. By the third quarter Zillow, a website for real estate statistics, estimated that 28.6 percent of all single-family homes were underwater.
Dave Anderton, a spokesman for the Salt Lake Board of Realtors, said about 20 percent of homes in Utah are underwater. One in five, whether they know it or not. And that doesn't even touch the worst states' figures. CoreLogic reported Arizona mortgages at 49 percent underwater, Florida was at 45 percent, Michigan at 36 percent and California at 30 percent. The worst was Nevada at 60 percent. A study by the Nevada Association of Realtors found that 23 percent of the state's foreclosures were from people who just walked away from their underwater homes. And the impact of negative equity across the country threatens property values in neighborhoods and contributes to the sluggishness of a recovering economy.
For individuals in that situation, it can destroy retirement and education plans. It makes it appear options are limited and shakes moral certainty. Should you keep your promise to the bank and stick it out? Or should you look to your own financial interests and walk away?
Smith was doing fine before the Great Recession hit. In 2007 he and his wife took out a second mortgage on their home in West Jordan, around $35,000 to convert their scrapbooking store at Gardner Village into a shoe store. "The store went gangbusters for about six months," Smith said.
But the recession took them down and a few years later they had to declare bankruptcy. They were left in a home that he says is worth about $220,000 but on which they owe about $245,000. "I literally could have walked away from the home because of the bankruptcy," he said, "and it wouldn't have affected my credit any differently."
But they stayed.
Brent T. White's interest in the plight of those stuck in negative equity situations began when he looked at the large numbers of people underwater who, like Smith, did not walk away. White is a University of Arizona law professor and author of "Underwater Home: What Should You Do if You Owe More on Your Home than It's Worth?" He noticed people would stay in their situation — even in Arizona where lenders can't sue the homeowner for the outstanding amount on the mortgage after the lender sells the home.
"A lot of people are sitting in houses that are underwater and they have an absolute legal right to walk away and hand the house back to the lender without recourse. But they weren't doing so," White said. "The question is, 'Why would they make a bad financial decision and forego a legally available option?'"
White said people stay in their homes because they are either unintentionally keeping their heads in the sand or are underestimating how underwater they really are. But many people understand their situation and still won't default.
White said it is about fear and anticipatory shame. "They think about how they would feel if they walked away from their mortgage," White said.
And they think it is immoral.
White said about 70 percent of Americans think defaulting on one's mortgage is always immoral.
Smith is in the position of someone who is underwater in his home and stays. He said from his point of view he wouldn't feel comfortable walking away. "I didn't walk away because I can pay it. It was my choice," Smith said. "When people get a loan and in good faith sign it, they have a financial responsibility to pay it. They thought it was reasonable when they made the purchase, the only thing that has changed is the value."
Luigi Zingales, a professor at the University of Chicago Booth School of Business, has written on "The Menace of Strategic Default" and is glad people perceive a moral cost to walking away from their homes. He said there is also a stigma associated with it — and that stigma is reflected in a long-term ding on your credit rating. "And many people are hoping this whole thing will recover," Zingales said.
But White thinks financial reality pushes in a different direction. "The media, government and financial institutions convey the message to homeowners that it's basically financial suicide to default on their mortgage," White said. "The reality is, for many people, walking away from their mortgage is the first step to regaining their financial footing. It could be the best financial decision they'll ever make."
Why walk away?
For the majority of Americans, a home is their primary form of investment for retirement and to send their children to college. But when a homeowner is underwater, White calls it a "toxic investment" with real detrimental costs against future financial success.
Banks have little financial incentive to negotiate a change in a mortgage with someone who has good credit and pays on time. "If someone calls their lender and says, 'I'm in a bind. I'm deeply underwater and I need to work something out.' And then the bank doesn't return their call or refuses to deal with them, then I think the borrower can take their cue from the bank and say, 'Hey, I'm going to behave in the same kind of ruthless economic manner and do what's in my economic best interest.'"
And that means strategically defaulting on the loan.
White said the mortgage contract — that the bank drafted — sets out the consequences for default. "There is nothing morally wrong to holding the bank to its agreement," White said, "and exercising the right to default as long as you are willing to accept the consequences — which are the bank has a right to take your home, and in some states they have the option to pursue a deficiency judgment for the difference."
The danger of a deficiency judgment is a risk. But White says banks usually don't pursue deficiency judgments for financial reasons.
Moral damage and loss
Zingales said he has no problem with a "non-recourse mortgage" that states clearly that the borrower can stop paying and give back the house. "That is perfectly fine. That is what commercial lenders do — and they pay a higher interest rate because it is a non-recourse mortgage."
But for residential mortgages, this is rarely the case. In Illinois, for example, the lender can take legal action for the deficiency, but suing can itself be costly for lenders and so they avoid it. But Zingales doesn't think its rarity should be an encouragment to choose default. "It is like saying it is fine to not pay taxes because it is very difficult for the IRS to get you."
He worries that if people default more it will lead to lower real estate prices and create "moral damage" that will make it easier for society to ignore their promises.
"I feel pretty strongly about the social norm that when you make a promise you shouldn't try to breach it unless you are desperate," Zingales said. "From an economic point of view we should have that norm and we should try to enforce it because it makes society work better."
White, however thinks the real question is about who is better able to shoulder the loss: Individuals or banks? "Many economists would argue, and I tend to agree," White said, "that it would be better to shift those losses to the banks who could better bear them than to the individuals, who because of this burden, don't spend, can't move to take better jobs, and it is a long prolonged drag on the economy."
The back-and-forth moral and business arguments of White and Zingales are familiar to business consultant and ethics author Quinn McKay.
McKay said most people live by two different moral standards. One is "personal ethics" — where people try to be honest in all they do. The other is "gaming ethics" — a different standard found in sports and games where players deceive and take advantage of opponents' weaknesses. "If business is a competitive game, then I suggest gaming ethics is appropriate for business," McKay said.
But is business a gaming ethics situation?
"If a business chooses to use gaming ethics, they should let their customers know and let them play by the same rules," McKay said. "If you argue that this is a competitive game and we are playing by gaming ethics, then I think (White) is absolutely right. If you think we live all of our life by personal ethics, then (Zingales) is right."
The danger of making moral decisions doesn't come from choosing between good and evil, McKay said, but from between two rights — when two right principles come in conflict with each other. He said in the mortgage situation the "promise to pay the mortgage" comes into conflict with "doing what is best for family finances." "Both are right principles," he said.
Add pressure to the mix and McKay said people have more difficulty making a better choice. "Sometimes these pressures get overwhelming and causes us to justify things we otherwise find morally repugnant."
Although Zingales thinks it is better for society if people keep their promises when their circumstances allow it, he also doesn't think the status quo is a good situation.
He proposes a law requiring banks to lower the mortgage amount to what homes are currently worth. The banks would then be entitled to 50 percent of the appreciation on the home. Even White has expressed his approval of Zingales' plan, but it hasn't been adopted yet. "It hasn't gotten any traction because it is fair solution," Zingales said. "There isn't a big winner, and without a big winner there isn't a big lobbyer for that solution."
Meanwhile Smith stays in his home in West Jordan. He continues to pay off the mortgage and works to rebuild his financial life. For him the ethical and moral considerations boiled down to his 13-year-old girl and 11-year-old boy. "We could have walked away very easily. We decided we were going to stay because of stability reasons — for keeping our kids in their school, keeping them near their friends. We didn't want to make those big changes," Smith said. "Every payment just goes to interest or buys down the amount I owe. But maybe I'll catch up in a few years."