Mortgage Deadbeats Plague Home Market
Benjamin Franklin observed that lending money to a man of good character could pay dividends for society if the borrower found success in life, because then he was more apt to help others the way Franklin had helped him, thus creating a virtuous chain of future lending.
But the opposite is also true, that the influence of money lent unwisely to the undeserving can reverberate for years. During the housing bubble, for instance, many borrowers eager to cash in on the real estate boom obtained mortgages under dubious circumstances. Some lied about their income levels, past credit history or their reasons for buying a home. Eager to do ever more business, many lenders turned an eye away from these obvious fabrications, even when they hid a mountain of potential troubles.
With so many questionable loans on the books (the FBI estimates that mortgage fraud increased 10-fold from 2001 to 2007), it's no wonder that our current housing market has been plagued by a sharp upsurge of people who are simply walking away from their mortgages because they no longer see the prospect of making a killing on their homes. According to two recent studies, these so-called "strategic mortgage defaulters," an innocuous name for deadbeats who can afford to pay off their mortgages but choose not to, make up a far greater share of the market's woes than we generally assume.
Examining patterns among people who default on their mortgages, a new study by Experian, the credit agency, and Oliver Wyman, a consulting firm, estimates conservatively that some 18 percent of those who defaulted on a mortgage as recently as the fourth quarter of 2008 could afford their loans but simply decide to walk.
Most of these defaulters share a few common characteristics, most notably that they stay current on all of their debts and then suddenly without warning stop paying only their mortgages. This group also characteristically (though not exclusively) took out their mortgages in 2006 or later and hence have seen no appreciation in the price of their homes, which means they are most likely to owe substantially more than their houses are worth. That's an especially common situation among those granted loans which required no down payment, or only a small one. These borrowers, who have little to lose by defaulting, are not the people you see profiled in media stories who go into foreclosure because they have lost their jobs, or didn't understand the steep terms of their mortgages, or have big health care bills to pay off.
Using different data collected from surveys, economists Paola Sapienza and Luigi Zingales estimated over the summer that mortgage defaulters were an even greater part of the market's problem, making up more than a quarter of all defaults as recently as this spring. The economists noted that this was a far higher percentage than in previous housing downturns, such as the market slump of early 1990s, when studies found "very few people who could afford their mortgage chose to walk away from their homes."
In either case, based on these two estimates, somewhere between 590,000 and 850,000 of last year's mortgage failures could have been strategic defaults, and more are likely to come based on a growing acceptance of this "strategy" among borrowers. That's a staggering toll on bank balance sheets, on housing prices and on our wider financial system.
Moreover, the federal government's latest housing policies put us at risk of encouraging new rounds of mortgage deadbeats. In an effort to re-stimulate the market, the Federal Housing Administration is backing hundreds of billions of dollars in loans that require only a small down payment. These are mortgages which will quickly be underwater if housing prices should dip further. Who knows how many additional strategic mortgage defaulters the FHA is cultivating with such lending strategies.
One source of the problem is the large number of borrowers who are willing to walk away from their primary residence when it becomes a bad investment. For the most part, researchers consider mortgages on second and third homes to be for investment purposes and typically more likely to default in a downturn. But the Experian-Wyman study found that 64 percent of all strategic defaulters abandon their primary residences. That fact should cure people of the sentimental notions we have about home ownership in America, which over the years has nourished such clichés as "a man's home is his castle," and "a family will do anything not to lose their home," and other gibberish.
Another contributor to the spread of strategic defaulters is the perverse incentive of so-called "no recourse" mortgage laws. In many states these laws treat mortgages differently from other types of loans, prohibiting a lender from pursuing the wages or other assets of a borrower if he defaults. In still other states, the judicial process is so lengthy and expensive that even when lenders can technically lay claim to a defaulter's other assets, they seldom do. Virtually unique in the world, these laws assure that the worst thing a deadbeat has to worry about when he absconds on his mortgage is his credit score.
But perhaps the greatest cause of the rise in mortgage defaulters is the gradual erosion of social and moral standards in a market where cheating became common and a loan nothing more than a financial strategy to be discarded at the first sign that it no longer made sense. Zingales and Sapienza's research found that mortgage defaults have spread fastest in places where a few homeowners employed this strategy early on and word spread among others. As the practice continues, it may become embedded in our culture, they warn: "As defaults become more common, the social stigma attached...will likely be reduced, especially if there continues to be few repercussions for people who walk away from their loans...[T]he after-effects of more defaults and more price collapse could be economic catastrophe."
Most troubling, perhaps, is that we seem incapable of learning from our past. We have had at least one other period of extended strategic mortgage defaults, during the bailout program of the Great Depression, when the federal government's Home Ownership Lending Corp. purchased some 1 million mortgages from banks and rewrote them on more generous terms. About 200,000, or 20 percent, of those new mortgages defaulted despite the better terms. And HOLC's mortgage officers were clear what was behind the massive string of nonpayment: They classified about 65 percent of these defaults as resulting either from borrowers' "noncooperation" with HOLC or their "obstinate refusal" to pay even though, in the estimation of the loan officers, the borrowers could afford the loans. The problem grew as word spread that the government would only foreclose on people reluctantly and take years to throw people out of their homes. Most of these non-paying borrowers simply lived rent free at the government's expense.
The experience of HOLC may explain why our current mortgage bailout efforts have resulted in such high rates of default, with as many as 40 to 50 percent of those who have gotten more favorable terms from some government-subsidized mortgage bailout programs failing to pay off their new mortgages. As the folks at Experian and Wyman note, "Strategic defaulters are likely to take advantage of loan modification programs, and try and stay in their homes as long as possible while making as few payments as possible. They should have a high propensity to re-default."
Our entire experience with the housing bubble and its troubling aftermath should be like a bracing slap in the face. It should cure us of many of our precious but misguided ideas about home ownership and remind us that if we build the wrong kinds of incentives into our laws and lending practices, people will take advantage of them, and we'll all pay for it, as we have in the last few years.