7. The Cost (and Benefits) of Walking Away

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CHAPTER

SEVEN

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The Cost (and Benefits) of Walking Away

People that walk away from a mortgage aren’t insisting that they should be allowed to stay in the homes that serve as the underlying collateral without making payment. That would be morally objectionable. Ironically, because of the legal chaos created by securitization and the bursting of the housing bubble, delinquent borrowers are able to stay in their homes for extended periods of time (sometimes years) without making payments.

Those who walk pay a considerable price. There are the costs of uprooting the family and possibly the stigma of stiffing a lender, but also in most states lenders to have the opportunity to sue borrowers for deficiency and thus attempt to seize other assets to satisfy the mortgage. However, the fact is the costs are high versus the potential gain from the sale of these assets, so many lenders don’t choose to undertake that. But lenders have that option: to make loan defaulters’ lives miserable for years as the lender chases assets to satisfy the debt. In some states a personal judgment can last as long as 20 years. And these judgments are transferable, so a big slow-moving lender may sell a judgment for 10 cents on the dollar, and suddenly the borrower must deal with a ruthless, aggressive and nimble pursuer looking to turn a profit on that cheap judgment.

Plus, Fannie Mae, which now controls the mortgage market, is “locking out” any borrowers from getting a new mortgage loan for seven years if the GSE determines the borrower strategically defaulted.

Walking away from a mortgage will also have a detrimental effect on the defaulter’s credit score. Not only will lower credit scores keep the defaulter from obtaining credit, or having to pay higher interest rates for credit (because defaulters are seen as higher risks, as they should be), but it potentially could keep someone from obtaining a job in the future. A Society for Human Resource Management survey reports 60% of their companies run credit checks on some or all potential hires. That was up from 35% in 2003, and a mere 13% in 1996, according to CNNMoney.com Even Transportation Security Administration (TSA) applicants for airport screener jobs are rejected if they have more than $5,000 in overdue debt!

If fewer people were able to over-lever themselves buying homes, that capital would be freed up for more productive uses—loans to businesses.

A point that Murray Rothbard made frequently and that investor Doug Casey often makes today is that one of the benefits to American society if the U.S. government repudiated or defaulted on its debt would be that people would think twice about lending it more money. Politicians will waste money with impunity if the government can continually borrow.

The same can be said for individuals. Taking on too much debt to live in more house than a person needs (McMansions as they were called in the boom) is a waste of capital. Mortgage debt is unproductive debt.

Robert Prechter, owner of the Elliott Wave International writes in his book Conquer the Crash that the lending process for businesses “adds value to the economy,” while consumer loans are counterproductive, adding costs but no value. The banking system, with its focus on consumer loans, has shifted capital from the productive part of the economy, “people who have demonstrated a superior ability to invest or produce (creditors) to those who have demonstrated primarily a superior ability to consume (debtors).”

Prechter made the point in the November 2009 edition of the Elliott Wave Theorist that banks have lent sparingly to businesses for the past 35 years.

Businesses report that since 1974, ease of borrowing was either worse or the same as it was the prior quarter, meaning that—at least according to business owners—loans have been increasingly hard to get the entire time.

The case Prechter makes is that banks have lent to consumers at the expense of businesses—and that it is only business loans that are “self-liquidating.” Healthy businesses generate cash flow that can pay off debt, while consumer loans “have no basis for repayment except the borrower’s prospects for employment and, ultimately, collateral sales.

“Banks have lent to consumers at the expense of businesses.”

Lines of credit to businesses are provided with the understanding that the business borrowers will “revolve the debt,” borrow to pay vendors and employees and then pay down the debt as their customers pay them for product. Thus, the debt is directly tied to the business firm’s production. The funds tend to be borrowed only for short periods of time. Credit in this case aids a business in potentially earning entrepreneurial profits, which build capital, which ultimately fuels economic expansion.

Conversely, consumer debts are not self-liquidating, but instead stay on the banks’ books for long periods of time, with payments being made only to service the interest and pay down very small portions of the loan principal balance. Also, as Hans Sennholz explained,

[N]ew debt in the form of a second mortgage on a home may finance the purchase of a vacation home, new furniture or another automobile, or even a luxury cruise around the world. The debtor may call it “productive,” but it surely does not create capital, i.e., build shops or factories or manufacture tools and dies that enhance the productivity of human labor.

If fewer people were able to over-lever themselves buying homes, that capital would be freed up for more productive uses—loans to businesses. Jörg Guido Hülsmann explains in The Ethics of Money Production, “The mere fact that such credit is offered at all incites some people to go into debt who would otherwise have chosen not to do so.”

Hülsmann is writing in the context that fiat inflation makes borrowing irresistible and makes the point that as “soon as young people have a job and thus a halfway stable source of revenue, they take a mortgage to buy a house—whereas their great-grandfathers might still have first accumulated savings for some thirty years and then bought his house with cash.”

Professor Hülsmann alludes to another benefit that would come to borrowers who walk away and have a harder time obtaining credit to the temptation to accumulate debt. Household debt has thrown “entire populations into financial dependency,” Hülsmann explains. “The moral implications are clear. Towering debts are incompatible with financial self-reliance and thus they tend to weaken self-reliance also in all other spheres. The debt-ridden individual eventually adopts the habit of turning to others for help, rather than maturing into an economic and moral anchor of his family, and of his wider community. Wishful thinking and submissiveness replace soberness and independent judgment. And what about the many cases in which families can no longer shoulder the debt load? Then the result is either despair or, alternatively, scorn for all standards of financial sanity.”

While it was not considered good news by most observers, Deutsche Bank’s research indicated in August of 2010 that a third of Americans did not have good enough credit histories to qualify for a mortgage. According to the report, 35 percent of Americans had credit scores of 649 and below, including the 26 percent of Americans with scores below 600.*

According to Don Luth, Executive Loan Consultant at Hamilton Ladd Home Loans in Ridgefield, Connecticut, a 30-year veteran of the mortgage business, “for all intents and purposes, sub prime lending has now been legislated out of business. So the sub prime financing options that were available to the sub 600 score consumer during prior recessionary periods are no longer available today.”

“Mortgage holders do sign a promissory note, which is a promise to pay,” writes Roger Lowenstein. “But the contract explicitly details the penalty for nonpayment—surrender of the property. The borrower isn’t escaping the consequences; he is suffering them.”

The simple fact is banks know that walking away from underwater mortgages is the logical thing to do. “American homeowners are now minimizing the human toll of losing homes and so forth,” writes Whitney Tilson for T2 Partners LLC. “Purely as a group, on an economic basis, they’re the only rational players in this bubble. They’ve pocketed $2 trillion in cash and now, when the value of the property falls below their debt, they’re walking away.”

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*A person with credit score below 600 is considered a risky borrower, while those with credit scores of 700 and above are considered low risk borrowers.