There’s a certain glue that holds societies together and in the U.S. one of those unwritten standards is the idea that you don’t walk away from your home.
Such community standards actually have a financial value. If walking away from a mortgage becomes socially acceptable then lenders will have more risk, interest rates will rise, monthly mortgage costs will increase and foreclosure levels will shoot up.
Unfortunately, there has been an increasing willingness by consumers to simply abandon their homes in the face of rising mortgage costs, a willingness that has not gone unnoticed. Fitch Ratings says that “the apparent willingness of borrowers to ‘walk away’ from mortgage debt has contributed to extraordinarily high levels of early default, which is particularly noticeable in the 2007 vintage mortgages.”
While there are no scientific studies regarding the matter, there’s little doubt that the idea of “walking away” from a mortgage has begun to gain traction. As 60 Minutes explains, when it comes to foreclosure “there is a certain cold logic to just walking away.”
The usual barriers to walking away from a mortgage are not only social, they are also practical and financial. However, these barriers have begun to fall in the past few years, making “jingle mail” (when keys are mailed back to a lender) and “trashouts” (when homes are abandoned with faucets running and garbage everywhere) more common.
How can this be?
A foreclosure is not a minor one-time event, an experience somewhat akin to a flu shot. Foreclosures instead have traditionally been life-altering experiences with negative consequences that can stretch for years and even decades.
However, in the past few years the nature of the foreclosure process has changed in ways that have made walking away more palatable and easier to rationalize.
Federal bankruptcy rules traditionally allowed courts to modify mortgage contracts.
However, with the passage of the Bankruptcy Abuse Prevention and Consumer Protection Act the standards changed: Judges no longer had the right to modify mortgage agreements, meaning that consumers lost important leverage when contesting lenders. While judges could change the terms of financing for yachts and second homes, revisions to loans for prime residences were suddenly off the table.
No less important, the 2005 law also required homeowners to obtain credit counseling six months before filing for bankruptcy. In many jurisdictions foreclosures can be completed well within a six-month period so that by the time a borrower could even go to court their home had been auctioned.
The 2005 changes to the bankruptcy law were widely seen as nothing but a sop to the lending industry by political allies in Washington. In fact, the proposed revisions were regarded as so unfair that ING Direct, a bank, took out a major ad in the Washington Post which said the bankruptcy reform bill then before Congress "fails to encourage and enable America’s savers as it’s written today. It doesn’t even protect them. In fact, the only real protection it offers is to lenders, institutions that have little interest in a saving public.”
With great foresight, ING said “we believe that lending institutions should share responsibility with the people to whom they lend. Through aggressive marketing, irresponsible lenders create their own problems. When something goes wrong and irresponsible lending has played a role, lenders should shoulder their share of the consequences as surely as they do the profits of that lending. It’s only fair.
“As originally envisioned more than a century ago, our bankruptcy laws were intended to allow hard working Americans to make a new start. Bankruptcy doesn’t just happen to people who are careless or deliberately irresponsible. It also happens to people who work hard, save their money, and despite this simply have more bad luck than they can afford. If the Bankruptcy Reform Bill fails to protect them, it robs America's savers of the hope that makes them strive for financial independence.”
For many decades one of the great oddities of the tax code has concerned something called “imputed income.” Virtually no one was impacted by this obscure rule — except homeowners who failed to repay their mortgages.
Imagine a situation where Smith gets a $300,000 loan, loses his job at a time when home prices are falling and is then only able to pay $250,000 to the lender. This is essentially what happens with a short sale — or a walk away.
What happens next is that the property owner gets a form at the end of the year explaining that the lender has reported to the IRS that he has received income worth $50,000. Income? The money not paid to the lender — the money the borrower didn’t have and never received — is now regarded as taxable income.
Now, under the Mortgage Forgiveness Debt Relief Act of 2007, imputed income from unpaid mortgage debt on a prime residence is no longer taxable. While this new legislation makes enormous practical sense — the government had little hope of collecting the tax under the old rule — it also creates an unintended consequence: The ability to walk away from a mortgage and not worry about a tax bill from Uncle Sam.
Foreclosure practices vary enormously by jurisdiction. One by-product of these distinctions is that in some states it can take six months, a year or even longer for a homeowner to lose title to their property once the foreclosure process begins. For instance, figures from RealtyTrac show that a typical foreclosure takes 445 days in New York, 300 days in Illinois and 290 days in Wisconsin.
Nicolas Weill, Chief Credit Officer with Moody’s, says “current losses are still low in part because the loans remain relatively unseasoned and in part because foreclosures are taking longer than in previous years for those mortgages that have already fallen behind.”
If walking away is seen as increasingly acceptable, then — goes the thinking — why not stay as long as possible and not pay the mortgage? In effect, lengthy foreclosures can mean free rent for 10 months or longer in some jurisdictions.
California: The Special Case
In California, the nation’s biggest real estate market, a “purchase money” mortgage is generally a “non-recourse” loan under state rules. In other words, if Jenkins borrows $500,000 to purchase a home and must sell for $400,000, the lender has no right to pursue the borrower for any repayment shortage because the extent of the homeowner’s obligation is limited to the value of the home. This arrangement does not apply when a home is refinanced, to second liens or when a loan is originated on the basis of fraud.
The California rules create an unusual ripple: Imagine that Williams owns an $800,000 California house, has good credit but faces a mortgage re-set in a year. Williams places his home for sale, buys a $400,000 replacement home and moves from the first property. The first property does not sell and goes into foreclosure. Williams, however, already has a replacement prime residence with a new mortgage. He has a new home, no deficiency judgment and a smaller mortgage. As to the foreclosure, after a few years it will have no impact on his credit.
The most significant reason not to walk away from a mortgage is the simple reality that for most borrowers during the past few decades a home has been a growing storehouse of value, something to keep if at all possible. However, in today’s market two factors have changed this equation:
First, recent buyers may well have bought at the top of local markets. In Florida, as one example, condo investors often placed deposits on units that were not scheduled for completion for 18 to 24 months. Given recent price declines, these borrowers have no equity to lose. Borrowers in many markets with little or nothing down are in a similar situation.
“Some subprime borrowers with ARMs, who may have counted on refinancing before their payments rose, may not have had enough home equity to qualify for a new loan given the sluggishness in house prices,” says Ben Bernanke, Chairman of the Federal Reserve. “In addition, some owners with little equity may have walked away from their properties, especially owner-investors who do not occupy the home and thus have little attachment to it beyond purely financial considerations.”
Second, many toxic loans allow negative amortization. With negative amortization low monthly payments are possible during start periods because not all interest is being paid. Instead the interest cost not covered by monthly payments is added to the loan balance. Combine negative amortization with little down and falling home values the result can be a borrower with loan debt which is substantially larger than the home's fair market value.
The Sting of Walking Away
Kenneth Lewis, Bank of America’s CEO, told the Wall Street Journal that “we’re seeing people who are current on their credit cards but are defaulting on their mortgages. I’m astonished that people would walk away from their homes.”
The idea of walking away from a mortgage remains far beyond the norms of either socially-acceptable or financially-responsible behavior. No less important, the act of walking away has substantial consequences.
For most borrowers the threat of a monetary judgment cannot be ignored. Under federal rules, judgments can remain on credit reports for seven years or “or until the governing statute of limitations has expired, whichever is the longer period.”
In many states, judgments remain in force for 10 years — a period which can be extended for an additional 10 years if the judgment is renewed.
Not only do judgments remain on credit records for many years, lenders routinely require that judgments must be repaid before new credit will be granted for larger loans, such as those used for cars and homes.
The result is that those who walk away from mortgages may be pauperized for decades because they will be unable to get credit at reasonable cost — if they can get credit at all.
“In the same way that we expect lenders to meet baseline standards of conduct, we must also have the same expectations with borrowers,” says James J. Saccacio, chief executive officer of RealtyTrac.com, the online foreclosure site that receives more than three million visitors each month. “The idea that walking away from a mortgage is somehow acceptable should be seen for what it is: A destructive notion that will result in sharply-higher mortgage rates for all borrowers, something any thinking person should vehemently oppose.”
Peter G. Miller is the author of the Common-Sense Mortgage and is syndicated in more than 100 newspapers.