Strategic Defaults, The Rich And Non-Recourse Loans

The topic du jour is David Streitfeld’s article in the NYT about the rich opting for strategic defaults. If you missed it, he uses some data from Core Logic and anecdotal tales to argue that the rich are defaulting at a rate in excess of the general population.

Streitfeld points out the concern that strategic defaults cause in the lending community:

Lenders are fearful that many of the 11 million or so homeowners who owe more than their house is worth will walk away from them, especially if the real estate market begins to weaken again. The so-called strategic defaults have become a matter of intense debate in recent months.

Fannie Mae and Freddie Mac, the two quasi-governmental mortgage finance companies that own most of the mortgages in America with a value of less than $500,000, are alternately pleading with distressed homeowners not to be bad citizens and brandishing a stick at them.

In a recent column on Freddie Mac’s Web site, the company’s executive vice president, Don Bisenius, acknowledged that walking away “might well be a good decision for certain borrowers” but argues that those who do it are trashing their communities.

Felix Salmon succinctly sums up his thoughts on whether or not people ought to walk away from their mortgages:

Well, sure, it’s not good social policy to strategically default. Fine. That doesn’t stop the rich, and it shouldn’t stop the rest of us either. I think it’s pretty clear which direction we’re headed in, and moralistic exhortations aren’t going to turn the tide.

I can’t disagree with Felix. If the rich or anyone else for that matter find themselves underwater on their homes and are astute or lucky enough to live in a non-recourse state then it’s folly all else being equal not to bolt. The situation, however, does raise a couple of questions.

One, should we eliminate non-recourse mortgages? Before you respond that they’re a product of state law and changing those laws is well nigh impossible, consider what would happen if Fannie, Freddie and FHA simply changed their standards and henceforth refused to purchase any loan that didn’t provide full recourse to the borrower. After the ritual political outrage, most state legislators would grudgingly amend their statutes in order to allow their local real estate markets to resume functioning.

And don’t think that this would now have an effect on the non-conventional mortgages. Fannie and Freddie still set the standards for underwriting and most jumbo lenders would not only jump on board, they would do so with glee.

Second, didn’t the Congress to an extent create this situation? Once they decided to suspend the tax liability for forgiven debt associated with home mortgages they eliminated a major barrier to strategic defaults. Maybe they need to revisit this. The tax code is already full of measures that discriminate against those with large mortgages so a tweak that, say, reimposes the penalty for non-conforming mortgages would not be inconsistent, nor would it be politically difficult.

If, and it’s a really big if, reform does come to residential mortgage finance that incorporates market disciplines, one would expect that homebuyers who live in non-recourse states would be socked with higher rates to compensate the lender for accepting that risk. Given that probability why shouldn’t we get a jump on it and get rid of non-recourse home loans now rather than later?

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