Saturday, February 06, 2010

WWJD: Would Jesus walk away from His mortgage?

In the middle of the financial crisis, Donald Trump coldly walked away from his contractual obligations on a real estate deal:

Guess who is complaining that condominiums in Donald Trump’s latest big project are ridiculously overpriced.

Donald Trump is.

But he isn’t cutting the prices. He says the banks won’t let him.

The project is the Trump International Hotel and Tower in Chicago, which is to be the second-tallest building in that city (after the Sears Tower). By Mr. Trump’s account, sales were going great until “the real estate market in Chicago suffered a severe downturn” and the bankers made it worse by “creating the current financial crisis.”

Those assertions are made in a fascinating lawsuit filed by Mr. Trump, the real estate developer, television personality and best-selling author, in an effort to avoid paying $40 million that he personally guaranteed on a construction loan that Deutsche Bank says is due and payable.

Rather than have to pay the $40 million, Mr. Trump thinks the bank should pay him $3 billion for undermining the project and damaging his reputation.

He points to a “force majeure” clause in the lending agreement that allows the borrower to delay completion of the building if construction is hampered by such things as riots, floods or strikes. That clause has a catch-all section covering “any other event or circumstance not within the reasonable control of the borrower,” and Mr. Trump figures that lets him out, even though construction is continuing.

“Would you consider the biggest depression we have had in this country since 1929 to be such an event? I would,” he said in an interview. “A depression is not within the control of the borrower.”

He wants a state judge in the Queens borough of New York to order the bank to delay efforts to collect the loan until “a reasonable time” after the financial crisis ends.

Deutsche Bank thinks the idea that an economic downturn should free people from the obligation to pay their debts is laughable.

Mr. Trump, it may be noted, does not think remorseful condominium buyers are in a similar position. When I asked him if he would let them walk away from contracts to buy apartments at predepression prices, he said he would not. “They don’t have a force majeure clause,” he said.

The suit, and a parallel one by Deutsche Bank seeking the money, provide a glimpse into both how Mr. Trump does business and into the way the real estate loan market was operating in 2005, when the loan was made.

Christians teach that people should generally act with fidelity and honesty in their contracts. But what if you're in a contract with a sociopath?

Corporations are legally required to be responsible only to their shareholders. They are immortal and any legal penalties they suffer in response to misdeeds are typically small in comparison to their business. In other words, they exhibit many characteristics of sociopaths. See this ICD-10 description of the antisocial personality disorder:

(a) callous unconcern for the feelings of others;

(b) gross and persistent attitude of irresponsibility and disregard for social norms, rules and obligations;

(c) incapacity to maintain enduring relationships, though having no difficulty in establishing them;

(d) very low tolerance to frustration and a low threshold for discharge of aggression, including violence;

(e) incapacity to experience guilt and to profit from experience, particularly punishment;

(f) marked proneness to blame others, or to offer plausible rationalizations, for the behaviour that has brought the patient into conflict with society.

Donald Trump is a particularly slimy example of a business leader, but his behavior is not qualitatively different from corporations. For example, Morgan Stanley bought five office buildings in San Francisco at the peak of the housing bubble. When their value plunged in the housing crisis, Morgan Stanley turned the properties over to Blackstone, the private equity firm that lent them the money. Morgan Stanley admitted it could afford to make the payments. Charitably, they could be said to have successfully negotiated a deed in lieu of foreclosure. Less charitably, they strategically defaulted - they could have afforded to pay but they walked away. Homeowners have been known to unilaterally mail in their keys to their lenders, a practice known as jingle mail, when they are upside down on their mortgages and can't pay, or they don't want to pay.

We are very judgmental about people who violate their loan contracts. Liz Pulliam Weston, one of my favorite personal finance columnists on MSN Money, describes a law professor who advised people to walk away if their financial situation dictated as "wrong, wrong, wrong". Walking away from our properties en masse would hurt our communities by driving down property values and increasing crime. It would also be an assault, she says, on our personal integrity - which is priceless.

And then, I read the article by the law professor in question, Brent White. The article, Underwater and Not Walking Away: Shame, Fear and the Social Management of the Housing Crisis, is available free from the Social Science Research Network, but you have to register. In a stunningly well-argued combination of law, economics and sociology, Professor White essentially argues that people who are severely underwater on their mortgages and choose not to default are fools. From the abstract:

This article suggests that most homeowners choose not to strategically default as a result of two emotional forces: 1) the desire to avoid the shame and guilt of foreclosure; and 2) exaggerated anxiety over foreclosure’s perceived consequences. Moreover, these emotional constraints are actively cultivated by the government and other social control agents in order to encourage homeowners to follow social and moral norms related to the honoring of financial obligations - and to ignore market and legal norms under which strategic default might be both viable and the wisest financial decision.

About 32% of mortgages are underwater across the country. In the 3 hardest hit metropolitan areas of Merded, El Centro and Modesto (all in California), 84-85% of mortgages are underwater. Nationally, 16% of homeowners were underwater by at least 20% of their home's value - in California and Nevada, these figures rise to 25% and 47% respectively. White gives a specific example of a hypothetical couple:

Consider, for example, Sam and Chris, a young professional couple with two small children, who stretched to buy their first home - an average 3 bedroom, 1380 square foot house in Salinas, California – for $585,000 in January of 2006.31 Sam and Chris had excellent credit and a solid income, and were thus able to qualify for a 30-year fixed interest loan with nothing down. At an interest rate of 6.5%, their total monthly payment is $4300,32 which is just under 31% of their gross monthly income, and within the payment-to-income ratio considered “affordable” by most lenders. However, after paying for taxes, health insurance, student loans, childcare, automobiles, food, and other necessities, Sam and Chris do well to break even each month. At the time they bought their home, they were not overly concerned about this - as they saw their mortgage payment itself as an investment in their own and their children’s futures.

Unfortunately for Sam and Chris, the housing market began to collapse in 2007. Though they still owe about $560,000 on their home,33 it is now only worth $187,000.34 A similar house around the corner from Sam and Chris recently listed for $179,000, which, with a modest 5% down, would translate to a total monthly payment of less than $1200 per month – as compared to the $4300 that they currently pay. They could rent a similar house in the neighborhood for about $1000.

Assuming they intend to stay in their home ten years, Sam and Chris would save approximately $340,000 by walking away, including a monthly savings of at least $1700 on rent verses mortgage payments, even after factoring in the mortgage interest tax reduction. The financial gain for Sam and Chris from walking away would be even more substantial if they took their monthly savings and put it into an investment account. If they stay in their home on the other hand, it will take Sam and Chris over 60 years just to recover their equity – assuming, of course, that they live that long, the market in Salinas has indeed hit bottom, and their home appreciates at the historical appreciation rate of 3.5%.

And yet, only 3% of all mortgage owners strategically default. These folks represent about one quarter of the total number of people who default - most people really can't pay because they've lost their job, divorced or otherwise run into financial difficulty. While strategic default hurts our communities in the ways that Pulliam Weston said, foolhardy staying (my term) can hurt our families by making us unprepared to meet other financial emergencies - like being hospitalized.

White says that because mortgage lenders have superior understanding of mortgage instruments and valuation of real estate compared to consumers, they should bear a greater share of the blame than consumers. They had the means to protect themselves, by using sound underwriting standards - but they threw these out the window. If consumers are to be held to societal norms regarding staying in their mortgages, then mortgage lenders need to uphold societal norms as well. They need to work with consumers who are in financial difficulty to lower the principal amounts on their mortgages. If they merely reduce the monthly payments or allow a consumer to suspend payments for a limited time, the consumers don't amortize their principal as fast (or at all), and they owe more in the long run. In reality, lenders have generally refused to negotiate lower principal amounts. Instead, they have stalled consumers and "lost" their paperwork.

More than that, there has been immense social pressure on people not to default - sociologists call this sort of thing social control:

The worst criticism has been reserved, however, for those who would walk away from mortgages that they can afford. Typical of such criticism is that of Secretary of the Treasury Henry Paulson, who declared in a televised speech: “And let me emphasize, any homeowner who can afford his mortgage payment but chooses to walk away from an underwater property is simply a speculator – and one who is not honoring his obligations.”

Paulson’s comment is mild, however, compared to the media invective toward those who strategically walk from their mortgages. Such individuals are portrayed as obscene, offensive, and unethical, and likened to deadbeat dads who walk out on their children, or those who would have “given up” and just handed over Europe to the Nazis.

There is similarly no shortage of moralizing about the responsibilities of mortgagors. Typical media messages include: "we need a culture of responsible consumers and homeowners;" “one should always honor financial obligations;125 “when you enter into a contract that should mean something;” “there was a time when people felt really bad about not paying back debt,” and, “money is more than a matter of numbers. There are ethics involved. Most people feel, or should feel, an obligation to pay their debts.” Even sympathy for those who default because of predatory lending is frequently lacking: “We’ve read too many sob stories in the press about ‘predatory lending’ — a rare, misunderstood, and vastly exaggerated phenomenon. It’s time for the poster children for irresponsibility to get some face time.”

As a result, homeowners have been forced by businesses, which are backed up by social control, to bear the brunt of the damage from falling home values. If they were Morgan Stanley, they could have forced their lenders into some sort of agreement. But homeowners don't have the bargaining power of Morgan Stanley.

In theology, a covenant is similar to a contract in the business sense that two parties exchange promises. However, if one party violates their promise, the other party is still bound to their side of the agreement. For example, Christians believe that God's love for humankind is unconditional, regardless of how badly we mess up. Pulliam Weston and society are asking people to treat our loans as covenants, but the fact is that the business world treats loans as simple contracts. White calls this "norm asymmetry". I call it an invitation to be exploited - you cannot make a covenant with an amoral entity. Indeed, in theology, covenants are only made between deities and people, and sometimes people and other people (e.g. marriage).

And so, we come to the question of what Jesus would say to underwater homeowners. It's not possible to say for sure - they didn't do mortgages or have corporations in ancient Israel, so Jesus never addressed this subject directly. However, I feel confident in saying that your mortgage lender is treating your mortgage as a simple business arrangement, and people should do the same, especially if they are in financial distress. In a business arrangement, you both agree to do something and there are specified penalties for noncompliance by either side. You simply have to be prepared to face the penalties. For people who walk away, the damage to your credit scores will be significant but not insurmountable. In some states (like California), the lender is legally prevented from suing you to collect the owed amount, so your cost of nonperformance is lower. Even if you are in most of the states that allow recourse, it is often not worth the lender's while to come after you.

If more people strategically default, this might force lenders to voluntarily modify more loans - which is what they should be doing in the first place. It might also enable the government to step in and give bankruptcy judges the ability to reduce principal on primary residences - the banks lobbied against this in the past. It is possible to get amoral entities to behave in a socially responsible fashion, but you have to make a significant threat to their profitability and/or existence to do so. If businesses want consumers to treat their loans as covenants, then businesses have a reciprocal obligation to do the same. But if businesses are treating loans as mere contracts, then consumers may do the same. They should consider their own finances, and they should take into consideration the effects on their neighborhoods. But they have the right - indeed, the responsibility - not to be taken advantage of, and they have the right to press government to exert more pressure on lenders to modify loans.

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