Morality and Mortgages: Further Reflections

In a recent paper, Brent T. White, professor at the University of Arizona School of Law, argued that it is not immoral for a borrower to walk away from his mortgage obligation if he is far under water, meaning he owes a lot more than his home is worth. Yet many people don’t walk away.

It’s not surprising that most people think that financing a home is both a business decision and the assumption of a moral obligation. After all, the entire credit market is based upon the assumption that borrowers will repay their obligations. 

Indeed, we learn ethics and moral responsibilities at a very early age from our parents. We learn that we should do what we say we will do. We also learn that there are kids in the neighborhood who are not to be trusted, who will not do what they promise. As we develop into adults, these beliefs are ingrained in the fabric of our character – or not (sometimes). 

It’s not that lenders will always trust borrowers. Obviously, in the case of secured loans like home mortgages and car loans, the lender takes a security interest in the collateral asset. He can have title to the asset in case of default.

But the lenders and borrowers start out the transaction with the underlying assumption that the loan will be repaid. So what happens in the current situation when something like 15 million homeowners owe more than their home is worth? Although we obviously have a foreclosure problem, it seems that many, many borrowers are staying put and continuing to make payments when it would make more sense, at least economically, to walk away. So why don’t they?

First, let’s look at the math, run some numbers, and see what the costs are. On the one hand, you can stay where you are, making, say, a $2,500 per month payment. But if you sold your home and rented, the rent would only be, say, $1,500 per month. That’s a saving of $1,000 per month, or $12,000 per year. Over a five year period of time, you would save $60,000 if you walked away and rented rather than by staying.

It may well be that your home is more than $100,000 under water and at the end of that same five year period, it would still be under water because of a long recovery in the housing market. If you were to stay in a home that far under water, that $60,000 extra you spent would be a total waste of money. 

The lending industry has said that a foreclosure would put you out of the mortgage market for 5 years, but assume that you are willing to endure that 5 year freeze-out period. When you start house hunting again, you have a $60,000 down payment, your new equity that you have saved. And if your old house were still under water at that point, then you ought to be able to buy a comparable home for even less than your old mortgage; your new mortgage would be even less because of your $60,000 down payment.

So why aren’t more people walking away and letting their homes go into foreclosure, especially if it would not be considered “immoral” by certain people, including professors of law? In many cases, there is the prospect of shame and guilt when you do that and the disapprobation of your neighbors who have now to deal with another foreclosure on the block. 

So many stay, some because they want to “live up to their obligations,” or “be responsible” or some other reason that express the perceived “immorality” of walking away.

But let’s look at the mortgage industry for a moment. Here are the players in the chain of origination:

A loan officer sees that a borrower could qualify for a much better loan than the Subprime or Alt-A loans his company offers, but he does not want to chase the borrower away because then he will not earn a commission. Is that moral?

An appraiser gets an assignment and is told the “target” value the lender needs to make the deal work. The property is not worth the target value, but if he doesn’t bring it in on target, he will not get any more business from the lender, so he “pushes” the numbers to make it come in at a high enough appraisal amount. Is that moral?

A lender teaches loan officers how to sell the company’s loan products, even inappropriate loans like these ones just mentioned. They know that some, maybe even half, of those that they originate contain fraudulent elements of one kind or another, but they do them anyway. Is that moral?

As just reported about one big subprime lender, when the company reports to investors on the quality of the loans they do, they use fraudulent numbers in the calculations, thus misleading investors. Is that moral?

The Wall Street investment bank that buys the loans and packages them into a Mortgage Backed Security (MBS) for further sale dices and slices the security into different pieces with different risk characteristics and different returns. That makes it harder for investors and rating agencies to decipher the true value of the security. Is that moral?

The rating agency does an inadequate job of rating the security, giving it a higher rating than the facts justify, allowing the investment bank to peddle the security to someone else as an AAA security. Is that moral?

You can see clearly that there was a widespread pattern of immoral and dishonest behavior on the part of people – not all people, certainly – but many, many people in virtually every layer of the mortgage and securities industries. Thus I think it is a bit disingenuous for lenders to now stand up and try to play the morality card: that although they acted immorally, that the poor, under water borrower must “hold up his end of the bargain.”

Let’s look at it this way. You are a traveler who comes upon a man who did not bring enough supplies for the journey and he is now dying of hunger and thirst. You have food and water plentiful enough to get both of you safely to the next town. What is your moral obligation? Do you share with him or do you lecture him on preparedness and leave him to his fate? All the religions say that you have an obligation to help, the concept of the Good Samaritan.

So you are a lender. You have a loan on the books that your accountants made you write down from $300,000 to $200,000. The borrower’s home is now worth $250,000 and the borrower wants you to reduce his principal balance to $250,000, at which point he can afford it and will stay and make payments. What is your moral obligation to this borrower? Remember: You do not get damaged in this transaction, as you already took the loss on the loan.

Now let’s make one last assumption: If you as the lender foreclose, you will only net $200,000. Forget morality. What is the best business decision?

Bottom line: I think that it is time to get past the moralizing and get down to the business of getting us out of this mortgage mess. And that is going to involve more principal reductions than the industry is currently considering.

Final note: I would never encourage anyone to enter into an agreement without feeling a full moral obligation to fulfill its terms. I also realize that many people who are under water were not victims of predatory lenders. It’s just that the future turned out differently.

If you are under water, whatever you do, spend a lot of time thinking about your options and choices. These are very personal decisions. The banker can’t help because he will just tell you to “live up to your obligation.” If you do decide to stay in your home, it’s time to talk with your lender about a mortgage loan modification.