October 09, 2011
– Comments (9)
I was reading Greg Fielding's blog and he has a post which is justifying strategic default as the morally correct thing to do.
He's trying to make the case that societal ends justify individual means, which is the opposite of conventional morality.
I tend to think this forum attracts a better educated, better read and group with over all better math skills then the population as a whole. I teach. I am absolutely passionate about math and its importance, but from being a teacher I see the extremes of math and reading abilities and the degree to which some people just don't get it. There is no question in my mind that the banks had the higher level of responsibility in this mess. I know under what terms I'd loan my money out and the only standard they applied was the terms they'd earn a bonus. Conventional morality works two ways and the banks never used it in loaning the money.
This was my response to the article.
Very good article, but I highly disagree on one point. "A home loan has a component of asset-backed debt. The portion of the cost of ownership (payment, interest, taxes, insurance, HOA) equal to rental is asset-backed. If the loan balance is limited the size supportable at rental parity, the property could be rented for an income stream capable of sustaining the debt service."However, once the cost of ownership exceeds the cost of a comparable rental, the only assurance the lender has of getting repaid is based on the signatory promise of the borrower. Therefore, the loan is part asset-backed and part signatory. When lenders cross the line from asset-backed to signatory debt, they turn good debt into evil debt and inflate asset bubbles. Lenders did this in both the residential and the commercial real estate markets during the 00s."Once lenders cross the line from asset-backed debt to signatory debt, they are inflating an unsustainable Ponzi scheme. Inevitably, prices will crash back to asset-backed levels determined by rental parity. it’s not a matter of if, only when. We are seeing this play out across America right now with the deflation of the housing bubble."This implies a standard where nothing changes over the long term and it allows for gross asset price inflation due to the "static" nature of how the cost to rental compare. It also does not take into account a completely missing concept in the entire housing bubble debate, and that would be the ability to get out of debt.Let me explain, and for simplicity I will only contrast two examples and I have simplified the numbers. Around 2000 a mortgage might have been 9%. Today it might be 3%. I am Canadian and I'm only going to look at an amortization for paying back the debt, nothing else in it. Lets say in both cases of interest rates the household has $60,000 of income and they are allowed 25% of that income to go to the mortgage, which may be a more stringent standard then what the lenders actually applied. I am not looking at utilities or taxes, but we can assume they are constant in both examples.So, 25% of $60k is $15k to mortgage, or a $1250/month mortgage payment. The table I'm using shows that at 9% you could qualify for a mortgage of $155,400 amortized over 30 years. Say you have about $39k down, so the home is about $194,000. At 3% you'd qualify for a mortgage of 296,400, with just over $74k down and the home is about $370,500. Assume the rent equivalent is the same and also assume that the figures I'm using are the rent equivalent break-even.So, because the amount you can borrow is tied to a fixed amount of your income, but the rates of interest are variable, there is an asset price inflation of 91%, yet all other costs and comparisons are the same.In both cases the households have the same amount of income committed to housing for 30 years, but what is enormously different between the two is what I'd call the "debt freedom factor." Lets define the debt freedom factor as the dollars saved over the original mortgage amount by making a 20% increase in monthly mortgage payment. A high debt freedom factor is good and a low one shows debt slavery. Ok, so in this example the families want to retire debt early and decide to dedicate $1500/month to the mortgage instead of $1250. For the 3% loan, it can be paid off in 273 months at $1500 instead of 360 months at $1250. For the 9% loan it would be paid off in 201 months.So, in the 3% example, which has significant asset price inflation, the dollars saved is (1250*360 - 1500*273) = $40,500. And $40,500/296400 = 0.13In the 9% example the dollars saved is (1250*360 - 1500*201) = 148500. And 148500/155400 is 0.96, so there is a very high debt freedom factor.So, no one can assume that variables will remain constant long term and as rates decline, consumers have far less choices about how to get out of debt with the current nonsense of how a loan qualification is tied to a fixed percent of income when the rates that determine the amount that can be borrowed are variable, and as the rates decline cause huge leverage risk to loan repayment.This model must go. Indeed, my historic look at mortgages suggests to me that the 30 year mortgage only came about because people had gotten themselves into trouble with debt with having to pay mortgages back over something like a 15 to 20 year period. By bringing in a 30 year mortgage people's payment were reduced and foreclosures were avoided. Unfortunately, this mortgage fixture became common. It worked when mortgage rates were high because there was a high debt freedom factor, but it is failing miserably in the low interest environment and causing excessive debt slavery because of the asset price inflation and lack of ability to get out of debt.
In your example, are you assuming the house you could buy with a $155,400 mortgage in 2000 is the same house you could buy with a $296,400 mortgage in 2011?
In most places in North America that's not a good assumption. You can buy more house with $296K now than $155K then. (Particularly if you adjust for inflation, or at least for wage increases.)
I think Greg is wrong - strategic default is wrong. While I agree that lenders acted very irresponsibly, that doesn't justify homeowners' immoral behavior.
I currently pay a mortage that is higher than what my tenants pay in rent. I can afford to make my payments, but I'll admit that it's sucks pi$$ing that money away. Many people have tried to convince me to walk away from the house, telling me that it's alright because everybody's doing it. To me, the fact that more and more people walk away from their mortgage only means that we're living in a world where more and more people won't accept responsibility for their actions.
I preach personal accountability to my children - how can I strategically default and not be a hypocrite?
If I default, I'm not only hurting the banks; I'm hurting myself, my children, and my neighbors.
Default is a business decision for you just like it was a business decision for the banks to give you a loan in first place. The only way I could see a moral dilemma is if the bank didn't charge you interest. The only way usury can be legal is for the individual to be able to default at will.
The bank is getting your house (and any improvements you have done to it) plus any payments you've made. The idea behind banking as the article points out, is not to make loans horribly in excess of the value of the home (or the NPV of the rent you can get for the home) and to make a little bit of profit.
It is a very real possibility that someone with a 15 year loan could become ill in year 10, spend all their money on treatments, and the bank gets the home + 10 years of payments. What would your children think about that? It's not like the bank ever considers their moral position...at least not mine.
Strategic default is defined as not paying your mortgage when you can afford to. It has nothing to do with sickness, or when you can't afford your mortgage payments.
You make a good point on how banks are not left in the lurch if I default. So, if I default, who's hurt the most? I would argue that my neighbors would be hurt the most.
So really what you're saying is - "It's alright to screw your neighbors over when you decide to default on a bad financial decision you voluntarily made."
This kind of attitude is the root cause of our current flustercluck.
MegaShort, I can see how you made the connection about the asset price inflation being tied to the same home. That is not at all what I expected. The actual home in the analysis is irrelevant. With declining rates people can borrow more, significantly more, and more money available does push prices up. That played out very differently in different places and in some places that would be true, the same home for that kind of difference in price. In other case maybe a better home, but not as much to justify the increase in debt. Overall, as the rates go down, people can borrow more and it does push prices and debt levels up. My point is that the criteria for prudent lending standards, which as they existed were ignored, don't work for a low interest rate environment because even people willing to make sacrifices have little ability to retire their debt early.
The easier it is for people to get out of debt, the more money people have to spend on goods and services that give jobs and keep the economy humming. I have no debt any more and I spend so much more on goods and services then I used to. When I lived in bubbled Vancouver with what I considered a big mortgage and was trying to pay it down, well, I used to say to myself if everyone did this the economy would come crashing to a halt. Well, right now we have too many people trying to tackle debt and it is hurting the economy, and because the debt is at low rates, they can pay and pay and pay and they won't make that big of dent in their overall debt obligation.
eldemonio, I think right now when you continue to make your payments you are taking the entire burden for irresponsible and in some cases fraudulent practices on the part of the banks. When people strategically default, they are forcing the banks into taking the burden for the irresponsible practices. I'm not convinced that either is the "morally" correct thing. I think there should probably be some kind of share responsibility for the mess. I think some of the strategic defaults out there are with people that tried to negotiate a fair settlement that split the burden with the banks and didn't get anywhere.
I agree that sharing responsibility makes sense, but it's not like my bank tricked me into my mortgage. My home value has plummeted, not because of my bank's shadiness, but because people in my neighborhood have walked away from their homes.
I know a lot of people who've strategically defaulted, most didn't try to negotiate a fair settlement, some did. No matter the reason, one thing is common for all of these defaulters - their neighbors are the ones who suffer the most from their "business" decision.
Overall, thought provoking article. Thanks for the reply.