Living by Default

James Surowiecki's New Yorker piece sums up how many of us feel about the hypocrisy of corporate America defaulting left and right while claiming consumers have some moral obligation to avoid it.

The Financial Page
Living By Default
by James Surowiecki December 19, 2011

We normally say that a company “went bankrupt,” implying that it had no choice. But when, recently, American Airlines filed for bankruptcy, it did so deliberately. The airline had four billion dollars in the bank and could have kept paying its bills. But it has been losing money for a while, and its board decided that it was foolish to keep throwing good money after bad. Declaring bankruptcy will trim American’s debt load and allow it to break its union contracts, so that it can slim down and cut costs.

American wasn’t stigmatized for the move. Instead, analysts hailed it as “very smart.” It is now generally accepted that when it’s economically irrational for a company to keep paying its debts it will try to renegotiate them or, failing that, default. For creditors, that’s just the price of business. But when it comes to another set of borrowers the norms are very different. The bursting of the housing bubble has left millions of homeowners across the country owing more than their homes are worth. In some areas, well over half of mortgages are underwater, many so deeply that people owe forty or fifty per cent more than the value of their homes. In other words, a good percentage of Americans are in much the same position as American Airlines: they can still pay their debts, but doing so is like setting a pile of money on fire every month.

These people have no hope of ever making a return on their investment in their homes. So for many of them the rational solution would be a “strategic default”—walking away from the mortgage and letting the bank take the house. Yet the vast majority of underwater borrowers keep faithfully paying their mortgages; studies suggest that perhaps only a quarter of all foreclosures are strategic. Given how much housing prices have fallen, the question is why more people aren’t just walking away.

Part of the answer is practical. Defaulting (even in so-called non-recourse states) is still a lot of trouble, and to most people it’s scary. In addition, homeowners are slow to recognize how much the value of their homes has dropped, and have inflated expectations of how much it will rise in the future. The biggest hurdle, though, is social: while companies get called “very smart” for restructuring their contracts, there’s a real stigma attached to defaulting on your mortgage. According to one study, eighty-one per cent of Americans think it’s immoral not to pay your mortgage when you can, and the idea of default is shaped by what Brent White, a law professor at the University of Arizona, calls a discourse of “shame, guilt, and fear.” When the housing bubble burst, the banking industry was terrified by the possibility that homeowners might walk away en masse, since that would have stuck lenders with large losses and a huge number of marked-down homes. So strategic default was portrayed as the act of dishonorable deadbeats. David Walker, of the Peterson Foundation, waxed nostalgic about debtors’ prisons, and John Courson, the head of the Mortgage Bankers Association, argued that defaulters were sending the wrong message “to their family and their kids and their friends.”

Paying your debts is, as a rule, a good thing. But the double standard here is obvious and offensive. Homeowners are getting lambasted for doing what companies do on a regular basis. Walking away from real-estate obligations in particular is common in the corporate world, and real-estate developers are notorious for abandoning properties that no longer make economic sense. Sometimes the hypocrisy is staggering: last winter, the Mortgage Bankers Association—the very body whose president attacked defaulters for betraying their families and their communities—got its creditors to let it do a short sale of its headquarters, dumping it for thirty-four million dollars less than the value of the building’s mortgage.

When it comes to debt, then, the corporate attitude is do as I say, not as I do. And, while homeowners are cautioned to think of more than the bottom line, banks, naturally, have done business in coldly rational terms. They could have helped keep people in their homes by writing down mortgages (the equivalent of the restructuring that American Airlines’ debt holders will now be confronting). And there are plenty of useful ideas out there for how banks could do this without taxpayer subsidies and without rewarding the irresponsible. For instance, Eric Posner and Luigi Zingales, of the University of Chicago, suggest that, in exchange for writing down mortgages in hard-hit areas, lenders would take an ownership stake in a house, getting a percentage of the capital gain when it was eventually sold. Lenders, though, have avoided such schemes and haven’t done mortgage modifications on any meaningful scale. It’s their right to act in their own interest, but it makes it awfully hard to take seriously complaints about homeowners’ lack of social responsibility.

Of course, many borrowers made bad decisions and acted irresponsibly. But so did lenders—by handing out too much money and not requiring sensible down payments. So far, banks have been partially insulated from the consequences of those bad decisions, because Americans have been so obliging about paying off overinflated mortgages. Strategic defaults would help distribute the pain more evenly and, if they became more common, would force lenders to be more responsible in the future. It’s also possible that a wave of strategic defaults—a De-Occupy Your House movement—would get banks to take mortgage modification more seriously, which would be all for the better. The truth is that banks have been relying on homeowners to do the right thing. It might be time for homeowners to do the smart thing instead.  See Jeff's Iowa Bankruptcy Guide and MathiasLaw.com.

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Jeff also handles Iowa Family Law.  See Des Moines Divorce Child Custody.

Staying in your Home during Foreclosure

Foreclosure is one of the big "triggering events" that lead people to file consumer bankruptcy. When you can't afford your home and can't sell it and pay off the note, or modify the loan, it may go into foreclosure. Banks then sell the home for whatever they can get and apply the proceeds to pay off your loan. Normally the proceeds are not sufficient to pay off the note completely. What is left is called a deficiency.

Some states don't let banks collect the deficiency from you, others do. Even where it is legal to sue you for deficiency, some lenders don't because it is too much trouble and expense for them or they may think they can't collect anything from you anyway if you are already broke, sometimes referred to as being "judgement proof".

So if foreclosure is your only financial problem, you may not want to rush into filing bankruptcy. But I know from experience that foreclosure does not happen in a vacuum. People in foreclosure have normally used credit cards to try and keep the home and may have had to wait on paying medical and other bills. So bankruptcy may be just what you need to fix your wagon.

Lately we have seen an extra advantage. Since the resale market is so poor for homes, lenders are not in a big hurry to dump all their foreclosure inventory into a bad market at once. Some lenders are taking two years or more to complete foreclosure, especially the big national banks. Many of my clients are filing Chapter 7 here in Iowa, surrendering the home but staying in it. During this time they do not make house payments although they do normally keep up with taxes and utilities.

If you pay association dues this can be especially wise since homeowners associations tend to get impatient when the owner stops paying and they don't get caught up until months or years later when the bank finally pays them. Hence, they tend to send threatening letters to people who have filed bankruptcy and would prefer to be able to turn the page.

So if you are considering bankruptcy to address your foreclosure, discuss staying in the home for a while with your attorney. You may be able to save big money that you will be use for your new home later!

NOTE: As of late 2011, some banks are becoming more aggressive on collecting deficiencies in Iowa, apparently they are frustrated with people who have the ability to pay the mortgage but do "strategic default" due to poor market values. US Bank and Chase are said to have quit waiving deficiency in some cases. If you are filing bankruptcy anyway, this is not a problem since you discharge this debt. And it can help you since filing a state court Demand for Delay of Sale gets you a full year when the bank fails to waive.

Property division in Iowa Divorce - Des Moines.

Iowa bankruptcy attorney Jeff Mathias practices in Des Moines.