This article originally appeared on the Irvine Housing Blog.
Underwater loan owners with payments exceeding rent have a moral imperitive to strategically default to provide deterence for banks to inflate future housing bubbles.
A sacred cash cow with sickly tits
Dripping temptation for hypocrites
to death she’s beaten
The prosperous endlessly stating the obvious
Caught in your words, sever the knot this time
Somebody show me their true face
Face me once as I leave all that I despise
Face me as I unleash this hate refined
Lamb Of God — In Your Words
The fear of strategic default is a necessary deterrent to foolish lending. Without it, lenders are emboldened to make all manner of bad loans because they believe they will get paid back. Lenders will make nearly any loan if they believe they will get their money back with interest. It’s only when they feel they won’t get repaid are they prompted to loan responsibly.
Signatory versus asset-backed debt
Some have questioned how I can be so against debt, yet I am leveraging up to the max to buy cashflow properties in Las Vegas. Isn’t that being hypocritical?
No. Not all debt is created equal. The debt I am taking on is backed by a cashflow-producing asset. The income stream is being used to repay the debt with interest, and if for some reason I am unwilling to pay back the loan, the lender can take back the property and obtain a cashflow equal to or greater than the payment on the debt. That is asset-backed debt.
I had the good fortune to meet a gentlemen who provides asset-backed debt from a major lender. His company provides debt for property, plant, and equipment to other major corporations. When he analyzes the collateral for a loan, he considers it’s useful life, the recovery and resale value, and the cashflow the asset may generate (if any). He assumes the debtor’s word means nothing and any recovery of capital will come solely from the collateral pledged to cover the loan. In his world, there is no signatory assurance of repayment. There is only collateral repossession, cashflow, and resale.
Asset-backed debt is essential to the functioning of our economic system. Many businesses could not raise the equity to obtain the property or equipment necessary to it’s operations. Lenders can loan against working capital at very low rates with little risk. If businesses have their money freed up to grow the business, our economy grows and prospers. In short, asset-backed debt is useful and freeing.
On the other hand, signatory debt is slavery. Signatory debt is money given to a borrower simply based on the borrower’s promise to repay. It has nothing to do with an asset, and if the borrower chooses not to repay, recovering signatory debt can be very difficult because it is not backed by tangible collateral.
Signatory debt provides no useful purpose. It provides a short-term economic boost as demand is pulled forward, but once it is consumed, money that would ordinarily have been spent by the borrower on consumer goods is instead diverted to the lender for debt service. It’s only when signatory debt is expanding that the economy is stimulated. The expansion of signatory debt is a Ponzi scheme.
Signatory debt creates Ponzis
The problem with signatory debt is simple: people don’t want to keep their promise to repay when it is inconvenient. Ponzis live to consume. They will take money under any terms offered, and when it comes time to pay the bills, they will seek more borrowed money to keep the system going. Borrowing money to repay debt is the essence of Ponzi living. Has anyone been watching events in Greece unfold?
Ponzis will inevitably spring from signatory debt. Not everyone who borrows with no collateral is a Ponzi, but Ponzis could not exist without signatory debt. The losses created by Ponzis are the only deterrent from lenders giving out free money. In our current home mortgage lending system backed by the government, without strict controls, Ponzi borrowing with home loans is inevitable.
Conflating asset-backed debt and signatory debt
Lenders are keen to conflate the distinction between asset-backed debt and signatory debt by over-loaning on assets. The housing bubble is a classic example, but lenders do this with car loans, commercial loans, and personal property loans.
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.
Strategic default is moral imperative
Lenders attempted to enslave an entire generation. They issued copious amounts of signatory debt to borrowers who only intended to repay that debt if house prices went up. Lenders created the Ponzis I profile on this blog on a daily basis.
Strategic default has been portrayed as immoral by lenders. This is wrong. Lenders were immoral when they abdicated their responsibility to sound lending practices that ensured their borrowers could remain solvent. It is outrageous after such irresponsible lender behavior that lenders have the nerve to chastise borrowers for being immoral when borrowers fail to repay their debts.
Borrowers have moral responsibility to default on loans where the payment on an amortizing mortgage exceeds the cost of a comparable rental.
If borrowers don’t default, if lenders are given a free pass to make another generation insolvent, then we have failed our children. We are sentencing them to live in a world where lenders enslave them through excessive mortgage payments to afford properties comparable to rentals.
Without the fear of strategic default, lenders will conflate asset-backed debt and signatory debt again. Lenders will inflate future housing bubbles, and our children will be faced with the decision to own something far less desirable than what they can rent or sentence themselves to a lifetime of debt servitude.
The next time you read or hear that borrowers who default are being immoral, ask yourself who is really being immoral, the lender or the borrower. In my opinion, it is the lenders who were immoral when they inflated the housing bubble and over-burdened borrowers. The borrower who strategically defaults is behaving morally by doing what’s best for their family.
Gary Anderson — Jun. 27, 2011, 1:31 PM
If congress does not take action, and I hope they don’t, September 30th is the date these homes will be governed by the private market, with interest rates likely being higher.
The FHA, Fannie Mae, and Freddie Mac will pull out of these markets, as these loans are perceived by both political parties as being a burden on taxpayers. Potentially, less demand will cause the values of these homes to go down.
Of course, this deflation of housing brought on by less demand is necessary to forge another housing bubble down the road whichbankers apparently want. I think government believes, however, that strategic default will not be an overwhelming issue, since polling seems to back the view that only 39 percent of eligible defaulters would consider defaulting. This actually emboldens banks to want more easy money loans because they know that everyone will not default. If everyone did default, banks would reconsider easy money lending, which would be a good thing. But there could be a change coming regarding views on the morality of the practice.
The change in morality has already occurred: Strategic mortgage default has become common and accepted in 2011.
It is this change of view regarding the morality of the practice that has banks worried. They are so worried that they are instituting tough measures to scare the potential defaulter into obedience.
While I don’t like to see housing values decline, because it hurts people who have worked hard to attain their status, housing should not be inflated artificially. Housing should be shelter first, and an inflation hedge second. It should never be a speculative commodity, rising faster than inflation, because it is too important to the nation. If the decline in price for these houses becomes a long term reality, then many more people could afford to buy these houses for a long time into the future, and they would have more discretionary income than some owners have now. Their wealth would be founded upon a sound market and not on the shifting sands of speculation.
It’s simple math. If a smaller portion of a wage earner’s salary is diverted to housing costs, particularly interest, then money is freed up to be saved or spent on other things. Mortgage debt is a drain on the economy.
People in New York, Massachusetts,California and other high end regions should brace for less demand and higher interest rates for mortgages above the conforming limit. This is the jumbo mortgage arena where less demand has already caused a decline in house prices. But perhaps we haven’t seen anything yet, as people will flee the higher rates until the prices themselves bottom out.
And owners should beware, because in the highest of high end areas, conforming loan limits could drop by the hundreds of thousands of dollars. This is something for even the most affluent members of our nation to think about. But knowing that most of them are staunch free market zealots should make the decline of their house values more palatable. Or maybe not.
The Irvine Company has already been plagued by flagging sales. What is going to happen when borrowers find it tougher to get loans at the price points they want to sell?
But since Fannie and Freddie are pulling out of this high end arena, they will have no influence on the defaulter like they did. As of last year, they were scaring defaulters with the threat of a 7 year ban on their mortgages. Now there is little to scare the strategic defaulter other than a credit score decline.
And, it has been shown that defaulters have a shorter window of risk in recourse states to lawsuit than do short sellers. And we know that California is a non recourse state. If a borrower does not have a recourse HELOC, or a refinance into a recourse loan, that borrower is really free to walk away in a non recourse state. So, potential strategic defaulters, what are you waiting for?
I predict a wave of strategic default at the $750,000+ price ranges. Many of these borrowers were Ponzis who were only holding on because they believed prices were coming back. Once they realize the demand is gone, and it may not come back in the next decade, why would they keep making the oversized payments? After all, the plan was to live off the HELOC booty and appreciation, and that isn’t going to happen. I expect Orange County delinquency rates to rise along with the rest of Coastal California.
No appreciation eight and a half years later
Back in 2007 and 2008, we would marvel at 2004 rollbacks. Those only represented about four years of zero appreciation. However, as the housing bust has dragged on, prices keep rolling back, and the dead time of zero appreciation has not extended to over eight years — and it will get worse.
Buyers from 2002 and 2003 are facing resale prices that often barely cover their sales commissions. There certainly isn’t enough gain to compensate them for the additional cost of ownership they paid during the years of bloated mortgage payments. Also, inflation has eroded the value of money over the last eight years, so on an inflation adjusted basis, they are certainly behind those who rented instead.
Appreciation is supposed to justify making excessive payments. When it doesn’t materialize, the people who opted for oversized loans played the fool. Banks are the beneficiaries along with realtors, mortgage brokers, and the former owners who obtained a windfall.
Slow steady gains in the housing market are much preferable to periods of boom and bust. If home prices were tethered to incomes through sane debt-to-income ratios and stable interest rates, homeowners would steadily gain equity, and none would be facing the terrible problems they are today. The goal of government policy should not be to maximize borrowing to save the banks and preserve loan owners illusions of wealth. The goal should be stable home prices and sound lending practices to sustain home ownership and preserve disposable income to sustain a consumer economy.