The morality of strategic default: businesses vs. homeowners

This article comes from First Tuesday Journal Online

This article discusses the purported moral implications of a homeowner’s decision to strategically default and why no such implications exist for a strategically defaulting business.

Is a strategic default un-American?

In their collective effort to encourage homeownership by any means necessary, the government and the media make no apologies for characterizing the strategically defaulting homeowner as an unpatriotic contradiction to capitalism.

As the jobless Lesser Depression continues wreaking havoc on home values and shriveling opportunities for the unemployed, speeches and press conferences by society’s figureheads continue emphasizing the importance of sending the “right message” to your family by paying back what you promised to pay.

Why aren’t those same figureheads pointing fingers at strategically defaulting businesses?

It seems a business that chooses to declare bankruptcy at the opportune moment to preserve cash flow is a wisely managed entity in the eyes of financial analysts everywhere, but a homeowner who does the same is labeled a cheat. The ability to strategically default with impunity is unique to businesses since the concept of morality in finance varies depending on whether it’s businesses or individuals involved.

The double standard

Political rhetoric aside, the decision to strategically default is not a moral decision. Every trust deed contains a put option, a contract provision requiring the lender to buy the home on any default. Homeowners are not committing a crime (or even a theological no-no) by exercising their put option, but merely making a wise financial decision in light of current economic conditions. [For more information regarding the put option, see the July 2011 first tuesday article, Strategic default smarts.]

Declaring bankruptcy is very commonly used in the business world as a sort of restart button; a chance to pare down debt before it gets out of hand. American Airlines recently declared bankruptcy, but not as a last ditch effort to salvage the company. They made a tactical decision to cut their losses, shed some debt, get competitive standing and preserve their earnings — and investors rewarded them for it.

Underwater homeowners can do the same, but most don’t because of the perceived social and seemingly moral consequences. Though businesses are commended for a strategic bankruptcy to avoid going under, homeowners who owe more than their homes are worth are warned not to employ the same wisdom for fear of public ridicule and a scarlet letter from their lender.

What’s ironic is organizations that criticize the strategic default have chosen to strategically shed their black-hole assets themselves. The Mortgage Bankers Association (MBA), whose president has publicly argued that strategic default “sends the wrong message” to society, recently completed a deliberate shortsale of its headquarters for millions of dollars less than the remaining principal balance of the building’s mortgage – no recourse of course.

Strictly business

While the government drones on about an underwater homeowner’s moral duty to faithfully pay his mortgage through thick and thin, lenders focus only on the bottom line when making financial decisions. Lenders could approve more modifications or principal reductions for the unemployed and beleaguered in the name of morality, but they choose profit (read: sound business decisions) over social responsibility every time.

Washington and Wall Street have deliberately confused homeowners by muddling the difference between moral decisions and business decisions. Lenders have no problem forgiving the debt of big business politicians because it earns them political clout. In the long run, it is more lucrative to stay in the good graces of politicians and business executives, which makes forgiving their debt a rational decision. [For more information regarding public policy and homeownership, see the October 2010 first tuesday article, Is homeownership a luxury or a necessity? and the March 2011 first tuesday article, The home mortgage tax deduction: inducing debt and stifling mobility.]

Debt forgiveness for one homeowner, on the other hand, means debt forgiveness for all homeowners, and that is just too much lost profit. [For more information regarding principal reduction, see the January 2011 first tuesday article, The inconsistent cramdown policy.]

Many homeowners unknowingly made bad decisions when they were encouraged by everyone to borrow money under subprime lending conditions. But lenders who made loans with adjustable interest rates and no down payments must also be held responsible for their part. As long as underwater homeowners keep faithfully paying their mortgages, lenders suffer a lesser degree of consequences for their irresponsible, overzealous behavior during the Millennium Boom.

De-occupying our homes

Lenders have made it clear they won’t budge; they fully expect homeowners to pay their mortgage no matter what. Homeowners who disagree must actively decide to stop paying their mortgage and walk away from the property, a mere exercise of the put-option written into their mortgage contracts.

The Occupy Wall Street (OWS) diaspora has migrated to foreclosed homes around the country, their motive being to stop lenders from taking homes through foreclosure. But if OWS really wants to vindicate underwater homeowners, they will picket to force lenders to take back the collateral no longer worth the amount borrowed. [For more information regarding OWS, see the December 2011 first tuesday article, OWS occupies foreclosures.]

If homeowners want to salvage their finances, they will stop believing the government- and lender-endorsed rhetoric of the good American borrower and stop making personally pointless mortgage payments.

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