Strategic Foreclosure & Back Door Bailouts

Strategic foreclosure is a subject near and dear to all our hearts. We had a pretty robust debate about it back in May after 60 Minutes ran a special on it (video below). For those who don't know, strategic foreclosure is when a homeowner who can otherwise afford to pay their mortgage defaults on purpose, usually because their mortgage balance is well above the market value of the property. The idea is catching on like wildfire, with the Wall Street Journal reporting in June that nearly 1 in 5 foreclosures during the first half of 2010 was a strategic foreclosure.

Naturally, a cottage industry has sprung up in response to the phenomenon, guiding homeowners through the process and assuring them that there is no longer any social stigma to walking away from your obligation - even though you can still afford to pay. There's even a nifty online calculator that estimates how much money you will save by pulling a strategic foreclosure.

Our debate on the subject in May seemed to center on the morality of the issue, as in "Are these people scumbags, or are they just exercising the inherent put option in a mortgage?" I see both sides of the argument, frankly. Yes, it's pretty sleazy to bust a contract you've willingly agreed to, especially while you still have the ability to perform. However, the bank did agree that the property would be fair compensation in the event of a default, so it's not the homeowner's fault that the market for the home has dropped below the value of the mortgage.

In response to this growing problem, Fannie Mae is proposing a solution that could end up being worse than the problem itself. The mortgage giant is proposing to lock out strategic defaulters from receiving a new mortgage for seven years.

Those home owners who walk-away and had the ability to pay the mortgage or did not complete a workout alternative in good faith will be ineligible for a new Fannie Mae-backed mortgage loan for a period of seven years from the date of foreclosure.

This might seem like a good idea on the surface, but if the numbers are correct and 20% or more of 2010-2011 foreclosures are strategic, locking that number of buyers out of the market for seven years could stall a real estate recovery for a decade.

Meanwhile, a back door bailout of sorts is being proposed which will enable the most underwater and least credit-worthy borrowers to not only remain in their homes, but to refinance under better terms. The argument in favor of such largess is that it would enable consumers to spend more, which is kinda what got us into this mess in the first place.

Analysts at the investment bank contend that millions of mortgages backed by the U.S. government could be refinanced without the need for an analysis of a borrower's credit quality because the principal is already backed by the government. Many homeowners who are unemployed, have poor credit or who owe significantly more than their homes are worth currently can't refinance, but would be permitted to use such a program.

In a final bit of irony, Fannie Mae and Freddie Mac have returned hat-in-hand seeking another $1.5 and $1.8 billion respectively, just to keep the lights on (not two weeks after President Obama pledged there wouldn't be another penny of taxpayer money spent on bailouts, I might add). Are these really the smartest guys in the room when it comes to American real estate?

Isn't it possible to let homeowners do what they're going to do and just let the chips fall where they may? What is the argument against that, exactly? Shouldn't the market regulate who gets a home loan and who doesn't? How would locking someone out of the mortgage market for a number of years help anything? And is strategic default really bad for the economy when in fact it helps properties to seek their proper value?

Going forward, what changes should be written into mortgages to prevent strategic foreclosures? A margin call on your mortgage, maybe? Finally, I wanted to leave you with the original 60 Minutes video because it does the best job of explaining the phenomenon to those who haven't seen it.


Watch CBS News Videos Online

Comments (19)

 
Aug 10, 2010 - 9:22am

There are consequences to "strategic defaulting," including the destruction of your credit score for a long period of time. There is nothing illegal about it, and the parties who are looking to foreclose on your home certainly don't take morals into account.

So if you do the calculus and figure out that the benefits outweigh the consequences, do it. Don't worry about morals. When you pay $3 at an atm to get money out, do you think some executive sat around and worried about whether or not that was moral? Its a financial decision, treat it like one- or at least keep in mind how the mortgage holder would treat you.

The way out of all this mess is to let housing prices correct, and the sooner the better. Yes it will suck that you took $50k out of your fake equity and blew it on granite counter tops and a Lexus, and now you have to pay for that, but the sooner we get prices back to proper levels (and what a better way to stoke demand than to reduce prices!) the sooner we can scramble to adjust to the "new normal" and start recovering.

Personally I think the only people who should be eligible for any sort of bailout are those who need to sell their home so they can move to get a job. At least then there will be an economic benefit for giving all of this money away.

Locking people out of the market seems even more foolish. All you are doing is reducing the pool of potential buyers, and they might wake up and realize that renting that house for 35% less than what it would cost to buy it isn't such a bad deal after all. Its going to take 7 years for your credit to recover anyway.

Everyone keeps talking about Wall St getting a bailout, but "Main St" is getting the biggest bailout this world has ever seen.

Before I get accused of being a bitter renter, I must tell you I am both- I actually rent where I live in NYC, but own residential investment property that is a considerable portion of my net worth. I was buying a property a year until 2004, when I started running the numbers on places and they just didn't make sense. At ALL. The only thing I regret is not dumping my stuff on some schmuck in 2007, when places were going for triple what I bought them for.

 
Aug 10, 2010 - 9:50am

I look at it like this:

Let's say I bought my home for $500,000, put $50,000 down, and have a mortgage of $450,000.

My home is now worth $375,000,a 25% reduction in value, I'm paying around $2,600 a month on my mortgage.

Instead of the bank writing off, lets say $50,000 to to now have a $400,000 principle, they say F You.

Now you walk away, and the bank is left with a home with the value of $375, 000.

When the home owner walks away it is the worst thing the bank can have happen!! It is the last resort, yet that is what they are doing. They now have a bad loan, a bad home that won't sell for months, and lost revenue.

The whole thing is just f*cked anyways.

Yours truly, The Young Investor
 
Aug 10, 2010 - 11:18am

The Young Investor:
I look at it like this:

Let's say I bought my home for $500,000, put $50,000 down, and have a mortgage of $450,000.

My home is now worth $375,000,a 25% reduction in value, I'm paying around $2,600 a month on my mortgage.

Instead of the bank writing off, lets say $50,000 to to now have a $400,000 principle, they say F You.

Now you walk away, and the bank is left with a home with the value of $375, 000.

When the home owner walks away it is the worst thing the bank can have happen!! It is the last resort, yet that is what they are doing. They now have a bad loan, a bad home that won't sell for months, and lost revenue.

The whole thing is just f*cked anyways.

To take it a step further.......

Hopefully I can come in and buy your previously $500k home somewhere in the upper $200s from the bank (hopefully with zero down at 5%). I can then rent that home for positive cash flow for the next 5-10 years and then if the government is successful in artificially inflating RE prices I can sell it for that $500k.

Obviously, there are a ton of variables in my scenario, but as in all situations those of us that are responsible and fairly smart with our $s can hopefully find a way to profit.

twitter: @CorpFin_Guy
 
Aug 10, 2010 - 10:40am

"This might seem like a good idea on the surface, but if the numbers are correct and 20% or more of 2010-2011 foreclosures are strategic, locking that number of buyers out of the market for seven years could stall a real estate recovery for a decade."

So what? All this is attempting to do is reinflate a bubble and re-establish an intergenerational wealth transfer. If you default on your mortage, seven years (based on the biblical remission of debt idea?) is too short to be locked out. You should face massively higher rates for much longer than that.

People overpaid. They got fcked (o rather, fcked themselves). Hell, I overpaid for stocks in 2000 and in 2007/2008 and am more underwater on that than a lot of people are on their houses. No one is bailing me out, nor should they. Let real estate come back to more realistic levels and everyone will be better off.

 
Aug 10, 2010 - 1:59pm

Jimbo:
"This might seem like a good idea on the surface, but if the numbers are correct and 20% or more of 2010-2011 foreclosures are strategic, locking that number of buyers out of the market for seven years could stall a real estate recovery for a decade."

So what? All this is attempting to do is reinflate a bubble and re-establish an intergenerational wealth transfer. If you default on your mortage, seven years (based on the biblical remission of debt idea?) is too short to be locked out. You should face massively higher rates for much longer than that.

People overpaid. They got fcked (o rather, fcked themselves). Hell, I overpaid for stocks in 2000 and in 2007/2008 and am more underwater on that than a lot of people are on their houses. No one is bailing me out, nor should they. Let real estate come back to more realistic levels and everyone will be better off.

so it looks like people still think home buyers simply over-paid and its their fault. the real estate mkt is not the stock mkt, so you cant really compare apples-to-apples. if youre looking to blame somebody, blame the banks. they lent too much and caused the bubble. it was more debt-driven demand than over-speculation.

so now the banks and homeowners are screwed, this much is obvious. a couple of things that are not so obvious but more important:

*banks and regulators are running out of ideas. there is NO solution.
*the bad debt/collateral - both res and commercial - that banks have on their balance sheets is enough to wipe out the financial industry. that's a bold statement, but i can assure of that fact.

why not let the free mkt fix the problem? b/c the free mkt would ass fuck the banks. and that would ass fuck the economy, b/c america runs on credit.

hypothetically, if a 'free mkt solution' existed, regulators would have already set up an RTC type plan to flush the system. but there isnt an RTC. freddie and fannie are trying to dump homes and the fdic is trying to dump cre, but it is NOT pretty. i saw res re comps that sold through fannie's auction, a home in palm springs with a morgtage of 240k sold for 3k in 6/2010.

to underscore the issue:

*http://www.zerohedge.com/article/commercial-real-estate-lobby-ask-taxpa…. cre lobby believes the next best idea is to give tax-payer money to the banks to recapitalize bad debt/collateral. does that sound like a 'free mkt solution'? i know this is cre specific, but you can compare apples-to-apples b/c the same thing happened in both mkts.

*http://blogs.reuters.com/james-pethokoukis/2010/08/05/an-august-surpris…. rumors of debt forgiveness for consumers (more like debt forgiveness for fannie and freddie). does that sound like a 'free mkt solution'?

i think we have breeched the 'point of no return'.

--- man made the money, money never made the man
 
Aug 10, 2010 - 10:42am

"I actually rent where I live in NYC"

So do I. From what I can tell this is almost always the right decision at these levels.

 
Aug 10, 2010 - 1:05pm

Edmundo Braverman:

Isn't it possible to let homeowners do what they're going to do and just let the chips fall where they may? What is the argument against that, exactly?

That would be Un-American.

 
Aug 10, 2010 - 1:39pm

and dont blame the homebuyer for strategic foreclosure. you would do the same and if you say otherwise, youre lying.

--- man made the money, money never made the man
 
Aug 10, 2010 - 3:31pm

"so it looks like people still think home buyers simply over-paid and its their fault. the real estate mkt is not the stock mkt, so you cant really compare apples-to-apples. if youre looking to blame somebody, blame the banks. they lent too much and caused the bubble. it was more debt-driven demand than over-speculation."

And the people who overleveraged themselves aren't to blame? If you make 50k a year and buy an 800k house hoping to flip it, it's your own fault. And sure, the banks enabled this.

 
Aug 10, 2010 - 10:15pm

Jimbo:
"so it looks like people still think home buyers simply over-paid and its their fault. the real estate mkt is not the stock mkt, so you cant really compare apples-to-apples. if youre looking to blame somebody, blame the banks. they lent too much and caused the bubble. it was more debt-driven demand than over-speculation."

And the people who overleveraged themselves aren't to blame? If you make 50k a year and buy an 800k house hoping to flip it, it's your own fault. And sure, the banks enabled this.

no, and i will tell you why. b/c there was a time when a donkey of human being with half an asshole for a brain could get a mortgage. think about that for a sec. donky-man walks into wachovia and says 'hi i want a loan' and wachovia says 'ok'. a sub prime financial system lent to sub prime borrowers.

of course, this is after the fact. so who gives a shit. i think we have bigger problems today.

i dont want to talk about what is or is not moral. you can talk morals, i can talk morals. at the end of the day, i dont give a shit.

--- man made the money, money never made the man
 
Aug 10, 2010 - 5:12pm

"and dont blame the homebuyer for strategic foreclosure. you would do the same and if you say otherwise, youre lying."

What a great way to argue! Either you agree with me, or if you don't you're lying.

Maybe some people believe in honoring their obligations?

 
Aug 10, 2010 - 10:57pm

If you want to do it the correct way: 1) save up money, 2) buy when the market corrects, 3) invest in rental properties, 4) repeat

Unfortunately, Americans don't want to follow the rules, they want to change them.

 
Aug 11, 2010 - 10:40am

Umm, ok, I completely disagree with the OP and most of the rest of you. Not that it matters, but I work in the industry. Umm, ok, where do I start? Fannie Mae is simply ONE lending entity. If you can't get a Fannie Mae loan, then you can get a Freddie Mac or FHA loan (in fact, getting an FHA loan would make the most sense for someone with no cash). Or you could get a loan purchased by a private buyer or a VA loan. Nobody is being locked out of the market because Fannie Mae won't take their loan. In addition, your credit score is so f*cked for the next 7 years anyway that it is unlikely that ANY lending institution in the current climate would lend to someone who has been foreclosed on, so it's really a moot point.

Second, Fannie Mae is making a strategic decision--there are four Cs to credit, and one of those KEY Cs is character, which is measured by your loan history and credit history and score. Why would Fannie Mae throw out one of the key Cs of credit when determining its underwriting standards? It's an insane proposition. And why would any company take on a customer who has screwed them before? That would be totally illogical.

Finally, on a mortgage contract, you make a PROMISE to make regular payments to the best of your ability. It is IMMORAL to make promises and then to break them on purpose. The bank doesn't break its promise when it forecloses on a loan--in fact, the bank is keeping its promise. There is nothing in a mortgage contract that implies there is a "put option" to walk away from a loan that could otherwise be serviced. That's absolutely absurd--again, that would assume the bank tossed out one of the Cs of credit in its underwriting--capacity.

Array
 
Aug 11, 2010 - 11:51am

Worked in real estate as well, people do it from time to time. I think it's a shame that people no longer follow the buy low sell high adage.

I agree with the point that it's a financial decision rather than a moral one. Was it even moral in the first place for banks to give out subprime loans to the 80% of the foreclosures which dragged down housing prices? banks treat it as a financial analysis and so should you.

Granted, if the low credit score hurts you in the future, then you didn't make the right decision.

 
Aug 11, 2010 - 12:49pm

VT4E,

I have to call bullshit on the premise that character and capacity had anything to do with real estate lending before the banks got their asses handed to them. It might be a factor now, but banks were throwing money at anyone who could fog a mirror up until 2007. Morality certainly didn't enter the lending side of the equation so I'm having a hard time seeing the argument that it should be a part of the borrower's side of the equation.

 
Aug 11, 2010 - 1:58pm

Edmundo, it's called a contract. If the banks did anything felonious, which they certainly did (and most of those lenders have been shut down or gone out of business), then they should pay. If no fraud was conducted and a legal contract was made, then the borrower has a moral responsiblity to keep his promise. There has never been a guarantee that your real estate will maintain its value. Never.

Array
 
Aug 13, 2010 - 12:36am

Have you guys thought about what will happen if instead of a strategic default the homeowner turns and fights with clear chain of title actions using MERS as a weapon? They won't be walking away, they'll be winning quiet title in court.

What happens when there is no more mortgage payments and no house to foreclose on?

www.chinkinthearmor.net

 
Aug 13, 2010 - 1:38am

Calling a strategic default immoral is highly subjective. Plain fact is this brow beating and guilt tripping is what screws the common man. What would a business do? What would an advisor recommend. You bought an asset. You made a mistake. Now make the most advantageous decision you can.

If breaking a promise is now the definition of immoral then I guess both my parents are going to burn in hell for not getting me a Sega when I was 7. Get real.

Realize what a contract is. I agree to pay XYZ. If I break the contract the other party has a legal right to do xyz. Banks foreclose all the time, but in old cases people desperately wanted to keep the homes. In these cases people don't care. I guess people don't give a shit when their home loan is deep underwater. I suppose banks should of figured on this happening. I mean it doesn't take a genius to realize people with no equity In a home with an upside down loan wouldn't mind it if the bank took the house back.

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