Hector S. Felix
Shan KhanStrategic Default
There are times throughout our lives where we face ethical dilemmas, some coming face-to-face with these quandaries more often than most. Do I eat that cookie before dinner, even though my mother told me not to eat sweets? It won’t hurt to copy my classmate’s homework, will it? I can leave early from work and not have to make up the hours, right? Although lighthearted, they are still ethical dilemmas. These are more well-known internal battles, but shine a light on life in the late 2000s, and a rather interesting and hotly debated ethical dilemma pops up.
The financial crisis has hit and many people faced an economy no one has seen since the 1980s. Not only is the business world taking a pounding, but it is starting to affect you at home. Common as it was to lose your job, the crescendo was in attempting to sell your home and leave in search of job opportunities elsewhere, only to deal with the shock of your life: the value of that perfect house you bought just a few years ago dumbfoundingly comes in below what you owe, more commonly referred to as “underwater.” Scrambling to find a solution leads you to dig deep down into newfound internal territory. Interestingly, there is a choice; this internal debate leads to a new term that is introduced and bandied about everyday life: strategic default.
Faced with the impossible climb back up in home value, you are left with the decision to fight through this or walk away, but choosing to walk away from the debt even when you do have the financial means to continue paying seems wrong, right? Some would call this strategic default, but what exactly is it? Difficult to define, not only because it ties directly with how your particular morals and ethics align, but also because it is difficult to measure the strategic piece. In short, strategic default is a deliberate default by a borrower, done as a financial strategy and not involuntarily (Investopedia). Now comes the question: is strategic default ethical? A fascinating question, and one that does not seem to have an easy answer. In tackling this, the first thing we did was identify four main stakeholders: homeowners, neighbors, lenders, and financial markets.
Homeowner
As a homeowner, the decision to strategically default on their home isn’t as easy as it sounds, nor does it come without consequences in the short-term and long-term. Our assumption is that the homeowner is able to pay other financial obligations such as a credit card and/or car payment, however, they neglect to pay their mortgage and essentially leave their keys at the door. We believe strategic defaulting in a scenario where the homeowner has the means to pay the mortgage is morally wrong for a number of reasons that not only affect them but things they are indirectly involved with. Strategic Default would be considered the easy way out and someone taking this path is acting in a selfish manner and is not looking at any of the other individuals and businesses they would affect.
Lender/Bank
The stakeholder that the homeowner is most directly involved with definitely has skin in the game. As banks have defaults, it makes the overall loan portfolio less profitable and since they are subject not only to shareholders but also to the government and it’s requirements, it is important that this is well-managed, diversified, and profitable. The bank has some recourse, but none of it comes without cost. Once in default, the foreclosure proceedings will begin, but the costs are high and the bank is not in the business of repossessing homes. In addition, these costs will get passed along to future loan applicants and the spiral begins. At this point, the money has been lost, they will not make the intended profit, and this will only depress the access to funds for future applicants.
Financial Markets
The stakeholders furthest downstream are the financial markets. As home loans became more and more prevalent, banks saw a chance at more profit and they were sold and packaged as financial instruments traded on the financial markets. When the financial crisis hit and defaults began, these instruments lost value and in turn the company was not as profitable. Defaulting in a traditional sense is already a problem; add in those that chose to strategically default, and you can see that the problems multiply. Usually the lack of pity would be deafening and no matter the opinion towards Wall Street and the banks, you can question the ethics of those that strategically default. The short-term band-aid from those that go down the path of strategic default creates this long-term scar affecting the financial markets in a way where it makes it harder for the normal market dweller to invest.
The Neighbor
As the stakeholder with least control of the situation when it comes to the person deciding to strategically default, the neighbor is in a really unfortunate spot as the value of the neighborhood depreciates when someone takes part in strategic default. In today’s world, most people know their immediate neighbors and some have created strong ties and friendships with those communities. This further complicates the ethics of this decision as you indirectly decrease the value of neighboring homes values, creating a domino effect and accelerating the downward spiral.
Having considered the stakeholders, we then began to ask: is it the right way? Life happens and situations present themselves, and then come the tough decisions. There is more than one reason a homeowner faces defaulting; it is the ethics behind the default that makes it strategic. An interesting wrinkle in this ethical decision is the power of emotion, such as anger or despair from the past or the present. As stated in the Determinants of Attitudes towards Strategic Defaults, “People have been shown to be more likely to inflict a loss on others when they have suffered a loss themselves, especially if they consider the loss unfair (Guiso, p. 4). That said, we expect that an individual is more likely to default strategically when s/he feels treated unfairly.” (Guiso, p.8). When people don’t feel like they get a fair shake, their mindset and tendencies go towards giving up, which, in the case of the homeowner considering strategic default, further drives the need to go down the immoral path and leave their home. But again, is it the right way? Whether a result of laziness or ignorance, some felt it was the only way. If there was more research done, they would have realized banks had absolutely no interest in stockpiling homes; there were options to help the owner out and they make money by lending money, not by auctioning houses.
Is strategic default the right thing to do? A hairy subject no doubt, as the reasons are plentiful and individualistic with far-reaching consequences. As Luigi Zingales mentions, as more people default, the more properties get auctioned off, further depressing real-estate prices (Zingales, p.9). Massachusetts faced a similar mortgage default situation in the early 90s. Back then, there was much skepticism towards people walking away from mortgages. As stated in Menace, even members of the board at banking institutions scoffed at the idea, claiming, “the idea that people would walk away from their homes when they can still afford to pay the mortgage is unfounded (Zingales, p. 3).” Zingales also mentions that a study done from the Federal Reserve of Boston seems to confirm that perspective; only 6.4% of Massachusetts “underwater” borrowers ended up foreclosing including those that fell under traditional default (Zingales, p. 3).
For them, it was not the right thing. But is their situation truly comparable and is it the right thing to do for others? Perhaps so, especially when looking at the difference between the early 90s and the recent financial crisis. Prices fell 22.7% from peak to trough in Massachusetts during that 1990-91 recession, with most buyers making a 20% down payment, and even those that bought at the peaked owed, on average 3%, more than the value of the house. (Zingales, p. 3). In comparison, the more recent recession has stark differences; home prices fell by 40-50 percent in several areas and had far smaller down payments and Massachusetts did not have the prevalence of home equity loans (Zingales, p.4). In Nevada, over half of the mortgages were more than 25% underwater, in Arizona and Florida, about 30%, and Californians were not left out either, coming in about 20% underwater (White, p.155).
If you are facing that much of a mountain, it may make sense to just walk away, more so if you consider the house as an investment. In the case of many in the 2000s it no longer really was and many did walk. In Menace, Zingales mentions a study done by Experian and the consulting firm Oliver Wyman. Trying to measure strategic default, they identified people never missing payments to all of a sudden being 180 days late on their mortgage, while staying current on all other debt (Zingales, p. 4). The study estimated that in 2008, 17% of all of the recorded defaults were strategic (Zingales, p. 4).
This then brings another question: is it the right reason? Defaults are financially driven, so if you simply cannot afford to pay and the bank is not willing to work with you, then you may have to default. In the case of strategic default, the ability exists. In one point of view, it’s clouded by only a short-term lens and discounts the long-term damages it can have on you individually from your credit score to your moral compass. In another, one must consider if the money could help elsewhere. Brent T. White offers that the argument against strategic default centers on three points: the promise to pay and the immorality in breaking the promise, depreciation of neighborhoods, and the crash of the housing market. He then offers a compelling view: they do not hold water (p. 157).
The mortgage is a contract, nothing beyond that. Like any other contract, the option to breach the promise to pay and the consequence in doing so shows that there is nothing immoral in exercising either of the two. The lender contemplated in advance that the mortgagor might be unable or unwilling to pay and negotiated it into the contract, through fees and interest rates (Morality, p. 158). Although a solid argument based on legality alone, we offer that his argument does not hold water. The major flaw we see is that in the end, it is a cost towards the stakeholders: choosing to default on your mortgage is far more dangerous and costlier than it is to forego the cell phone contract or not pay the car note. The law is the law, but, ethically, we cannot side with Brent.
Right way, right thing, right reason? We would argue no, it is not an ethical approach in any of the three. There is a plethora of reasons to strategically default, but we’d argue none of them fall on the side of being ethically sound from a personal and economic standpoint. When you weigh all the pros and cons of strategically defaulting, it is not the one-way ticket out of financial purgatory it may seem. It definitely was not the right way, as they had options besides just simply defaulting. Putting some effort into searching out those options would have led to a better solution for all involved, instead of taking the lazy and unethical way out. It is also not the right reason, as there is more on the line than getting some cash back from your current mortgage payment in the form of a foreclosure on your record and the lack of faith future lenders will have with you. Ultimately, it comes down to the right thing, which, we argue, it definitely is not for any stakeholder involved. After taking into consideration the falling home value and the severe damage that depreciation causes to the housing market, how could it be? For the homeowner who makes the final decision on this ethical dilemma, we judge this as ethically wrong; they have the means to pay their mortgage, they are just running away from a bad investment that they willingly signed up for.
Bibliography:
Guiso, Luigi, et al. The Determinants of Attitudes towards Strategic Default on Mortgages. European University Institute, 2011.
Staff, Investopedia. “Strategic Default.” Investopedia, Investopedia, 21 Aug. 2018, www.investopedia.com/terms/s/strategic-default.asp.
White, Brent T. “The Morality of Strategic Default.” SSRN Electronic Journal, 2010, doi:10.2139/ssrn.1597835.
Zingales, Luigi, et al. “The Menace of Strategic Default.” City Journal, 4 May 2016, www.city-journal.org/html/menace-strategic-default-13273.html.