The Case for Strategic Default

Posted by Jim DeBellis on June 16th, 2011

It sounds like a very unethical, and perhaps even immoral thing to do – just walk away from your mortgage even though you could continue to pay if you wanted to.  It’s called “Strategic Default,” and it’s been on the rise in recent months as housing values continue to erode and home equity disappears or becomes negative.  My initial thought was to write a diatribe against this practice, but the more I researched it the more uncertain I became.  I’m not ready to endorse it, but lets look at the some of the supporting arguments from the CEO of HomeLiberty, a company that helps strategic defaulters buy back their homes at the current market rate (more info).

Of the 11 million folks whose mortgage is now more than the value of their home, more than 10 million of them have made every payment.  They didn’t pull out all of their equity for speed boats and vacations.  The bubble was not their fault, and much of the blame, in fact, can be placed on the financial institutions that loaned them the money, secured appraisals of the property values, and deemed the borrowers to be credit worthy.

Now, many who have not made all of their payments (though certainly not all) may have played the system, misrepresented their income, knowingly bitten off more than they could chew, and truly did contribute to the housing crisis – but not the ones who are still making their payments, even though they are getting absolutely no equity out of their payments.  Basically, they are paying rent and losing equity every month in order to keep the bank – a co-conspirator in the collapse – 100% whole on the deal they made. Why should the good people who did everything right take 100% of the loss and the banks get off scot-free?

Furthermore, millions of these people have approached their banks for a mortgage modification, but the banks have turned them down.  Homes have lost one-third of their value, on average, since the decline began in 2006.  So, if their $300K house is now worth $200K, but their mortgage is $240K, what would be wrong with splitting the difference and reducing the loan to $220K?  The bank could amortize the loss, and, after all, they took a risk too and should share some of the downside.

And there’s one more thing.  Most default clauses are very cut-and-dried and not dependent on the reason for default.  They simply state that if the payments are not made, the mortgage is in default, at which point the bank can begin the process of foreclosure.  It is not illegal to default, because you have put the home up as security, and the bank has deemed the home to be worthy collateral.  There is no legal reason, then, why default cannot be a choice.

Loan modifications could, in many cases, stave off many foreclosures which cost the banks and the economy much more than than the amount of a modification.  Still before anyone decides to give the keys to their home back to the bank, there are a lot of things to consider.  Besides the ethics of it, people who default will take a big hit to their credit rating, not to mention the potential that they will still owe the balance if it is not a nonrecourse loan (and if it has been refinanced, there is a good chance that it is, in fact, a full recourse loan).  And don’t forget about possible tax consequences, as the cancelled debt may be taxed as income, especially if it is not your homestead.